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

Abstract

Reducing moral hazard at the expense of market discipline: The effectiveness of double liability before and during the Great Depression Staff Report, No. 869

Shareholder Liability and Bank Failure

“…First, depositor discipline, highlighted by many as important for reducing bank risk (e.g., Kahn 1991, Diamond andRajan 2001), might be weakened. Depositors in DL banks receive a payout in case the bank fails, which reduces their optimal monitoring effort Wilson 2004, Anderson, Barth, andChoi 2018). Second, DL shareholders might be adversely selected.…”

“…First, with no deposit insurance during our sample period, depositors might not allow single liability banks to lever up as much as those with double liability. Second, depositors in double liability banks might permit more risk taking while expending less effort on monitoring Wilson 2004, Anderson, Barth, andChoi 2018). Finally, adverse selection of double liability shareholders might reduce its effectiveness (Winton 1993, Kane andWilson 1998), although empirical evidence does not support this concern.…”

“…Its effect on several variables examined in prior studies is, as we will argue, ambiguous. Anderson and Watugala (2017) and Anderson, Barth, and Choi (2018) use deposit outflows to measure bank distress. They find that banks with less shareholder liability suffered larger withdrawals during the Panic of 1893 and the Great Depression, respectively.…”

“…Analyzing different datasets and time periods, studies find mixed results. Some papers report a positive effect of limited liability on leverage (Grossman 2001, Mitchener and Richardson 2013, Koudijs, Salisbury, and Sran 2019, while others find no or a negative effect (Evans and Quigley 1995, Bodenhorn 2015, Grodecka and Kotidis 2016, Anderson and Watugala 2017, Anderson, Barth, and Choi 2018.…”