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

40 Pages Posted: 15 Mar 2013 Last revised: 17 Feb 2023

See all articles by Kris James Mitchener

Kris James Mitchener

Santa Clara University - Leavey School of Business - Economics Department; National Bureau of Economic Research (NBER); CEPR; CAGE; CESifo (Center for Economic Studies and Ifo Institute)

Gary Richardson

University of California at Irvine; National Bureau of Economic Research

Date Written: March 2013

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

Mitchener, Kris James and Richardson, Gary, Does "Skin in the Game" Reduce Risk Taking? Leverage, Liability and the Long-Run Consequences of New Deal Banking Reforms (March 2013). NBER Working Paper No. w18895, Available at SSRN: https://ssrn.com/abstract=2233786

Kris James Mitchener (Contact Author)

Santa Clara University - Leavey School of Business - Economics Department ( email )

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