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Does "Skin in the Game" Reduce Risk Taking? Leverage, Liability and the Long-Run Consequences of New Deal Banking Reforms

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  • Kris James Mitchener
  • Gary Richardson

Abstract

This essay examines how the Banking Acts of the 1933 and 1935 and related New Deal legislation influenced risk taking in the financial sector of the U.S. economy. The analysis focuses on contingent liability of bank owners for losses incurred by their firms and how the elimination of this liability influenced leverage and lending by commercial banks. Using a new panel data set, we find contingent liability reduced risk taking. In states with contingent liability, banks used less leverage and converted each dollar of capital into fewer loans, and thus could survive larger loan losses (as a fraction of their portfolio) than banks in limited liability states. In states with limited liability, banks took on more leverage and risk, particularly in states that required banks with limited liability to join the Federal Deposit Insurance Corporation. In the long run, the New Deal replaced a regime of contingent liability with deposit insurance, stricter balance sheet regulation, and increased capital requirements, shifting the onus of risk management from bankers to state and federal regulators.

Suggested Citation

  • Kris James Mitchener & Gary Richardson, 2013. "Does "Skin in the Game" Reduce Risk Taking? Leverage, Liability and the Long-Run Consequences of New Deal Banking Reforms," NBER Working Papers 18895, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:18895
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    Cited by:

    1. Howard Bodenhorn, 2015. "Double Liability at Early American Banks," NBER Working Papers 21494, National Bureau of Economic Research, Inc.
    2. Joshua R. Hendrickson, 2014. "Contingent Liability, Capital Requirements, and Financial Reform," Cato Journal, Cato Journal, Cato Institute, vol. 34(1), pages 129-144, Winter.
    3. Grodecka, Anna & Kotidis, Antonis, 2016. "Double Liability in a Branch Banking System: Historical Evidence from Canada," Working Paper Series 316, Sveriges Riksbank (Central Bank of Sweden).
    4. Salter, Alexander W. & Veetil, Vipin & White, Lawrence H., 2017. "Extended shareholder liability as a means to constrain moral hazard in insured banks," The Quarterly Review of Economics and Finance, Elsevier, vol. 63(C), pages 153-160.

    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • N22 - Economic History - - Financial Markets and Institutions - - - U.S.; Canada: 1913-

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