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

This paper examines the impact of double liability on bank risks and depositor safety before and during the Great Depression. Under double liability, shareholders of failing banks lost their initial investments and had to pay up to the par value of their stock to compensate depositors. The paper finds that double liability did not reduce bank risk before the Great Depression, but that deposits were less susceptible to runs. (Working Paper no. 18-06)

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

JEL Codes: G21, G28, N22