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• W51091421 abstract "A bank is considered insolvent when its liabilities (deposits) exceed the value of its assets (reserves, loans, and securities). If assets exceed liabilities, any losses experienced on the asset side of the bank balance sheet result in a corresponding loss in the bank's capital. Insolvency occurs only in the event of losses exceeding the value of capital. All else equal, a bank with more capital is at lower risk of insolvency because the value of the bank's capital fluctuates with the value of assets. Understanding the basic anal)lies of a consolidated bank balance sheet provides important context for calls for financial reform in the wake of the recent financial crisis. For example, recent discussion of financial reform focuses on the role of the mixture of debt and equity finance in banking. It has been argued that banks hold an insufficient amount of capital (Miles, Yang, and Marcheggiano 2012). Put differently, the claim is that banks finance too much activity with debt than with equity. As a result, some have called for imposing higher capital requirements (Admati and Hellwig 2013). While it is true that banks that hold more capital are at lower risk of insolvency, the logic behind calls for higher capital requirements is flawed. The flaw in this argument is that it mistakes the means for the end. The objective of banking reform is conceivably to reduce the Joshua R. Hendrickson is Assistant Professor of Economies at the University of Mississippi. He thanks Harlan Holt for many useful conversations about capital requirements as well as Jim Dorn and an anonymous referee for thoughtful comments on a previous draft. The usual caveat applies. risk of insolvency among banks and other financial firms. Higher levels of capital are a means by which this can be achieved because it insulates depositors from losses, but it does not address the underlying causes that lead to insolvency. An alternative solution is to give banks an incentive to be more prudent. For example, from the Civil War until the New Deal, nationally chartered banks had double liability. Similarly, even state chartered banks had some degree of contingent liability, in some cases more stringent than federal law. In addition, many banks outside the United States had similar liability structures. Under contingent liability, bank shareholders were subject not only to losses from the initial investment but also to losses suffered by depositors. Given that bank managers and members of the board of directors were often large shareholders of the bank, in some cases required to be by law, contingent liability gave banks the incentive to be more prudent with lending by aligning the interests of the shareholders with the depositors. One might be tempted to argue that altering bank incentives and imposing capital requirements are likely to result in the same outcome with respect to the level of capital held by banks. However, even if this were true, the means by which this outcome is achieved is fundamentally different and has important implications for bank behavior both in lending standards and in the event of asset losses. Historical evidence suggests that contingent liability reduced bank risk taking by giving bank managers and shareholders the incentive to do so. This article argues that successful banking reform would give banks the incentive to take on less risk rather than imposing higher capital requirements. Double Liability System Under current federal law, U.S. banks are limited liability corporations. However, this has not always been the case. The National Banking Act of 1864 established double liability for bank shareholders: The shareholders [of every national banking association] shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such association, to the extent of the amount of their stock therein, at the par value thereof, in addition to the amount invested in such shares [See. …" @default.
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• W51091421 date "2014-01-01" @default.
• W51091421 modified "2023-09-23" @default.
• W51091421 title "Contingent Liability, Capital Requirements, and Financial Reform" @default.
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