Staff Reports
Reducing Moral Hazard at the Expense of Market Discipline: The Effectiveness of Double Liability before and during the Great Depression
Number 869
October 2018

JEL classification: G21, G28, N22

Authors: Haelim Anderson, Daniel Barth, and Dong Beom Choi

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.

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AUTHOR DISCLOSURE STATEMENT(S)
Haelim Anderson
The author declares that (s)he has no relevant or material financial interests that relate to the research described in this paper. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Daniel Barth
Daniel Barth has no financial interests to disclose related to this paper. Prior to circulation, the Office of Financial Research had the right to review this paper. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Dong Beom Choi
I am employed by the Federal Reserve Bank of New York. The views expressed in the article under submission reflect my views and the views of my co-authors, but do not necessarily represent the views of the Federal Reserve Bank of New York, Federal Reserve Board, or the Federal Reserve System.
I have not received outside financial support for the research in this article.
I have not received any fees or payments from any institutions that might be relevant to the content of the research under submission.
No close relative has received funding or financial support, or is an officer, director, or board member of any relevant organization.
Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.