Reducing Banks' Incentives for Risk-Taking Via Extended Shareholder Liability

Originally published in Prosperity Unleashed

It has long been understood that deposit guarantees and too-big-to-fail (TBTF) policies create a moral-hazard problem—they incentivize banks to take on too much risk by shielding depositors and shareholders from losses in excess of equity (“left-tail” outcomes)—in American banking.1Congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991 to mitigate the moral-hazard problem by restricting forbearance and implicit subsidies for undercapitalized banks. But the mandates of the act (particularly early intervention to reorganize undercapitalized banks) were ignored when they might have made a difference just before and during the recent financial crisis. Common recommendations for mitigating moral hazard would have the FDIC adopt the techniques that private insurance companies use (deductibles, coinsurance, lower effective limits on coverage), but these have not been adopted, in part because (as seen in the British case of Northern Rock) they can give ordinary depositors reasons to rapidly withdraw money from suspect banks (the dreaded “run on banks”).

This chapter considers a different method for mitigating moral hazard: extended liability for bank shareholders. This reform does not put additional legal restrictions on bank activities, but reduces banks’ incentives for taking excessive risks by at least partially neutralizing current safety-net subsidies to risk-taking. It shifts the risk of left-tail events from deposit-guarantee agencies to equity-holders as a means for reducing the moral hazard that promotes inefficient risk-taking. Given that the root of the current incentive distortion lies in deposit and TBTF guarantees, a more straightforward approach would be simply to remove the guarantees, shifting risk from guarantee agencies to depositors and giving them more incentive to monitor and reward safe banking.