Liability, Risk and Bank Failure

Abstract:

Does enhanced shareholder and manager liability reduce bank risk-taking and failure? We compare the performance of around 4,200 state-regulated banks of similar size in neighboring U.S. states with different liability regimes before and during the Great Depression. Limited liability banks took more risk during the 1920s and their distress rate was 29% higher than that of banks with enhanced liability. Results are robust to a diff-in-diff analysis incorporating nationally-regulated banks (that faced the same regulations everywhere) and are not driven by other differences in state regulations, Fed membership, local characteristics, or differential selection into state-regulated banks. Our results suggest that exposing shareholders and managers to more downside risk successfully reduces bank risk-taking and failure.