New Research: FDIC Paper on Moral Hazard and Market Discipline

New Research: FDIC Paper on Moral Hazard and Market Discipline

Prior to the creation of the Federal Deposit Insurance Corporation, which today guarantees deposits up to $250,000, many banks were subject to “double liability” regulations. In the event of bank failure, these rules required bank shareholders to pay money up to the par value of their bank shares to cover depositor losses.

A new paper from the Federal Deposit Insurance Corporation finds that these laws, while offering greater protection to depositors, increased moral hazard in the banking sector by reducing incentives for depositor monitoring:

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 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.

The abstract pretty much says it all, but it’s worth fully fleshing out the countervailing forces at work here. On the one hand, double liability for shareholders will encourage more conservative investments, lest they be on the hook for depositors’ money. On the other hand, depositors, knowing their deposits are better protected than in single liability banks, have a reduced incentive to monitor deposits and keep banks accountable by withdrawing funds if the bank makes risky investments.

That’s the logic, and while the previous literature is mixed on the effects of double liability (or deposit insurance) on banking stability, this paper finds that double liability was a net loss for overall stability, or at best failed to improve stability.

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By |2018-10-21T18:55:18-07:00October 16th, 2018|Blog, Financial Regulation|