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

Abstract

Scholars and regulators often maintain that extended shareholder liability reduces bank risk-taking. Prior to the Great Depression, double liability on bank shareholders was the predominant institutional framework aimed to constrain moral hazard. We examine whether increased shareholder liability effectively moderated bank risk-taking. We find no evidence that double liability reduced risk-taking prior to the Great Depression, but do find evidence that deposits in double liability banks were stickier during the Great Depression, suggesting double-liability banks faced less risk of bank runs. Shifting losses from depositors to shareholders weakened market discipline and attenuated the effects of increased skin in the game.