Liability Insurance, Extended Liability, Branching, and Financial Stability.

• Author: Goodspeed, Tyler Beck

A central theme to discussions of the financial crisis of 2008-09 is the role of excessive leverage by financial institutions due to implicit guarantees of bank liabilities. Yet studies have found that explicit guarantees by poorly designed or imperfectly priced public deposit insurance can also, in the absence of effective regulatory constraints on risk taking, generate similarly perverse incentives through the introduction of moral hazard (Keeley 1990, Kane 1995, Calomiris and Jaremski 2016a). Moreover, while there has been considerable interest in the potential for contingent capital to facilitate resolution of distressed institutions without risking public capital or systemic collapse (Dewatripont and Tirole 2012; Bulow and Klemperer 2013; Flannery 2014, 2016), the implications for bank risk taking antecedent to crises have received less attention. Finally, though recent research has examined the effects of geographic diversification on risk reduction in banking, these studies have by necessity relied on limited observational time horizons (Deng and Elyasiana 2008, Fang and van Lelyveld 2014).

To address these gaps in the literature, I exploit historical discontinuities at contiguous interstate county borders in the United States between 1794 and 1863 to investigate the effects of bank liability insurance, extended shareholder liability, and geographic diversification on bank activity and stability. I find that, while branching lowered the probability of bank failure in noncrisis years and double liability did so in both noncrisis and crisis years, public and mutual liability insurance generally elevated the probability of failure. Moreover, I find that, whereas long-term coverage by double liability was associated with lower risk taking, the reverse was true of long-term coverage by mutual insurance or public insurance of circulating notes. Finally, I also find that long-term double liability attenuated, while long-term mutual insurance amplified, credit disintermediation during crises.

The effects of bank liability insurance, equity bail-ins through extended liability, and geographic diversification have been the subjects of considerable interest in historical contexts. Calomiris (1989, 1990), Wheelock and Wilson (1995), Weber (2014), and Calomiris and Jaremski (2016b) find that public insurance schemes prior to the establishment of the Federal Deposit Insurance Corporation (FDIC) engendered excessive risk taking and were less successful at protecting the payments system in the event of adverse shocks. Calomiris and Schweikart (1991) and Carlson and Mitchener (2006, 2009) additionally demonstrate that branching was generally a more effective means of protecting the payments system than insurance of bank liabilities. Meanwhile, though Grossman (2001) and Mitchener and Richardson (2013) find that banks in states with double liability had lower leverage, higher liquidity ratios, and lower failure rates than banks in states with limited liability, Macey and Miller (1992) and Bodenhorn (2016) instead observe higher measured leverage among double liability banks.

The problem with existing studies, however, is that variation in bank liability rules across states was likely highly nonrandom, correlating with differences in economic activity, as well as underlying social and cultural attitudes toward banking and bank regulation. Such unobservable correlates could result in significant omitted variable bias. To address this threat to identification in the literature, I employ a regression discontinuity approach, exploiting historical discontinuities in the provision of liability insurance, extended liability, and unit banking laws at contiguous interstate county borders in the pre-Civil War United States. Using a panel dataset spanning 1794-1863, I estimate average differences in failure rates and balance sheet metrics for banks in counties covered by liability insurance, double liability, or unit banking laws, versus banks in paired contiguous border counties not covered. Utilizing recently digitized 19th-century decennial census data, I also directly control for a richer set of county-level covariates than was previously possible. Moreover, whereas prior studies have estimated binary treatment effects in any given year, my primary focus is instead the effects of longer periods of coverage by liability insurance, double liability, or branching on bank activity and failure rates. This approach allows for analysis of the longer-term effects of the relevant policy treatments on ex ante bank behavior.

I find that, while double liability in any given year was not associated with lower predicted probabilities of bank failure, the longer the period of coverage by double liability the lower the probability of bank failure, in both crisis and noncrisis years. Similarly, while the permission of branch banking in any given year was generally unassociated with differences in the predicted probability of bank failure, the longer the period of coverage by branching the lower the probability of bank failure, though only during noncrisis years. In contrast, while the effects of public and mutual insurance of all bank debts or circulating notes only in any given year on the probability of bank failure were mixed, the longer the period of coverage by mutual insurance of all debts or circulating notes only, or by public insurance of circulating notes, the higher the probability of failure during noncrisis, crisis, or all years, respectively.

I also find that public and mutual liability insurance, double liability, and branch banking significantly affected bank lending portfolios and methods of funding, with implications for balance sheet risk. Over the long term, double liability was strongly associated with lower risk taking. Not only were banks operating under double liability less leveraged, they also maintained higher reserve ratios, were less reliant on deposits versus notes for funding, and were relatively less exposed to real estate. While branching was associated with greater reliance on interbank borrowing, it was also associated with less reliance on deposits versus notes, higher reserve ratios, and lower real estate exposure. In contrast, mutual insurance of circulating notes had a significant positive effect on bank leverage, while both public and mutual insurance of circulating notes or all debts were associated with increased exposure to real estate and/or interbank lending, greater reliance on deposit-taking and/or interbank borrowing versus note issuance, and lower reserve ratios.

Additionally, I find that long-term double liability significantly attenuated outflows of bank deposits and declines in note circulation during the Panic of 1857 and was associated with large relative increases in both aggregate lending and interbank lending during and immediately following the crisis. In contrast, long-term coverage by mutual liability insurance amplified both deposit withdrawals and contractions in note circulation, as well as contractions in overall and interbank lending, while public liability insurance and branching were generally ineffective at mitigating credit disintermediation during the crisis.

Literature Review

The theoretical case for bank liability insurance is that banks are uniquely vulnerable to panics because they issue short-term liabilities that are redeemable on a first-come, first-served basis and backed by longer-term "opaque" assets whose value is not readily observable or ascertainable by creditors, particularly depositors and noteholders. Thus, adverse shocks that elevate the probability of insolvency among some tranche of bank borrowers can provoke preemptive withdrawals from all banks as asymmetrically informed creditors, able to detect that a shock has occurred but unable to ascertain its incidence, seek to avoid being last in line for redemption (Diamond and Dybvig 1983). Such fears can become self-fulfilling as financial institutions facing reserve drains are consequently compelled to engage in forced asset sales, and can furthermore result in widespread credit disintermediation as banks contract lending and even defensively suspend convertibility (Calomiris 1989). Liability insurance mitigates the incentive for such runs, and in the event of suspension of payments can furthermore mitigate the incentive of insiders to unload bad bank claims onto unknowledgeable creditors (Diamond and Dybvig 1986).

The extant theoretical and empirical literature on bank liability insurance, however, has highlighted that bank liability insurance also has the potential to introduce substantial moral hazard if the insurance is imperfectly or unfairly priced. With privatized gains and socialized losses, banks are encouraged to substitute debt for equity and to maintain lending portfolios with higher risk-return profiles, while depositors and other creditors have diminished incentives to monitor bank risk through withdrawal of funds from high-risk banks.

Calomiris (1990), Wheelock and Wilson (1995), and Weber (2014) accordingly find that pre-FDIC state-level experiments with bank deposit insurance were generally failures, suffering from considerable moral hazard and adverse selection. State-sponsored insurance funds encouraged excessive leverage and asset growth and multiplication of banks, and furthermore failed to protect the payments system in the event of adverse financial shocks. Insured banks were more likely both to fail and to suffer larger declines in asset values. Calomiris (1990) and Weber (2014) also find, however, that privately administered mutual insurance schemes with mutual monitoring were generally more effective at mitigating the problem of moral hazard, reducing bank failure rates, and protecting the payments system during banking crises.

Calomiris (1990), Calomiris and Schweikart (1991), and Carlson and Mitchener (2006, 2009) further find that unit banking laws (prohibitions of...