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

62 Pages Posted: 18 Oct 2018

See all articles by Haelim Anderson

Haelim Anderson

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

Daniel Barth

Board of Governors of the Federal Reserve System

Dong Beom Choi

Seoul National University - Business School

Multiple version iconThere are 4 versions of this paper

Date Written: October 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 as a result of increased skin in the game, and an indirect effect that promotes risk taking owing 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 stickier and less susceptible to runs during the Great Depression. Our findings suggest that the banking system was inherently fragile under double liability because of the conflict between shareholder incentive alignment and depositor market discipline; the depositor protection feature of double liability reduced the threat of funding outflows but may have undermined its effectiveness as a regulatory tool for reducing bank risk.

Keywords: double liability, moral hazard, market discipline, bank runs, Great Depression

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 2018). FRB of New York Staff Report No. 869, Available at SSRN: https://ssrn.com/abstract=3266619 or http://dx.doi.org/10.2139/ssrn.3266619

Haelim Anderson

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

550 17th Street NW
Washington, DC 20429
United States

Daniel Barth

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Dong Beom Choi (Contact Author)

Seoul National University - Business School ( email )

Seoul
Korea, Republic of (South Korea)

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
12
Abstract Views
269
PlumX Metrics