Because of limited liability, bank shareholders often prefer banks to take high risk, to the detriment of depositors and the stability of the banking system. Using data on the performance of U.S. banks during the Great Depression, we find strong evidence that increasing shareholder liability can be an effective tool to reduce bank risk taking and distress. Our results are relevant for current initiatives to increase bank stability.
Since the beginning of modern banking in the early 19th century, policy makers and regulators have tried to rein in bank risk. One often-used tool was to force bank shareholders to face some form of additional liability. From 1817 onwards, shareholders in most U.S. banks had so-called “double liability.” Double liability stipulates that, in case of bank failure, the banking supervisor levies a penalty on shareholders (up to the par or paid-in value of their shares) that is used to satisfy the bank’s depositors and other creditors. This system remained the norm until 1933, when the American banking system was restructured. All else equal, double liability should reduce shareholders’ risk taking preferences, potentially reducing bank failures.