Reducing Moral Hazard at the Expense of Market Discipline: The Effectiveness of Double Liability Before and During the Great Depression

62 Pages Posted: 15 Oct 2018

See all articles by Haelim Anderson

Haelim Anderson

Government of the United States of America – Federal Deposit Insurance Corporation

Daniel Barth

Government of the United States of America – Office of Financial Research

Dong Beom Choi

Seoul National University - Business School

Multiple version iconThere are 4 versions of this paper

Date Written: October 9, 2018

Abstract

Prior to the Great Depression, regulators imposed double liability on bank shareholders to ensure financial stability and protect depositors. Under double liability, shareholders of failing banks lost their initial investment and had to pay up to the par value of the stock in order to compensate depositors. We examine whether double liability was effective at mitigating bank risks and providing a safety net for depositors before and during the Great Depression. We first develop a model that demonstrates two competing effects of double liability: a direct effect that constrains bank risk-taking due to increased skin in the game, and an indirect effect that promotes risk-taking due to weaker monitoring by better-protected depositors. We then test the model’s predictions using a novel identification strategy that compares state Federal Reserve member banks and national banks in New York and New Jersey. We find no evidence that double liability reduced bank risk prior to the Great Depression, but do find evidence that deposits in double-liability banks were less susceptible to runs during the Great Depression. Our findings suggest that the effect of double liability remains ambiguous because it failed to resolve agency conflicts between shareholders and depositors. The depositor protection feature of double liability weakened market discipline and reduced shareholders’ incentives to limit bank risk.

Keywords: Double Liability, Moral Hazard, Market Discipline, Bank Runs, Great Depression, Financial Stability

JEL Classification: G21, G28, N22

Suggested Citation

Anderson, Haelim and Barth, Daniel and Choi, Dong Beom, Reducing Moral Hazard at the Expense of Market Discipline: The Effectiveness of Double Liability Before and During the Great Depression (October 9, 2018). Office of Financial Research Research Paper No. 18-06. Available at SSRN: https://ssrn.com/abstract=3265163 or http://dx.doi.org/10.2139/ssrn.3265163

Haelim Anderson (Contact Author)

Government of the United States of America – Federal Deposit Insurance Corporation ( email )

550 17th Street NW
Washington, DC 20429
United States

Daniel Barth

Government of the United States of America – Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States
(202) 927-8235 (Phone)

Dong Beom Choi

Seoul National University - Business School ( email )

Seoul
Korea, Republic of (South Korea)

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