August 12, 2015

Extended Shareholder Liability as a Means to Constrain Moral Hazard in Insured Banks

  • Lawrence H. White

    Distinguished Senior Fellow, F. A. Hayek Program for Advanced Study in Philosophy, Politics and Economics
  • Alexander Salter

    Assistant Professor of Economics, Texas Tech University
  • Vipin Veetil

    Assistant Professor, Indian Institute of Technology Madras
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Find at SSRN. 

We explore extended liability for bank shareholders as a method for mitigating moral hazard in insured banks. The dominant approach to maintaining financial stability employs piecemeal regulations concerning specific bank behaviors; we propose this difficult practice can be sidestepped by embracing a legal environment where banks face healthier incentives. We discuss the various kinds of extended liability regimes, show how they worked historically, and address several concerns about the potential downsides of these regimes. We conclude by discussing how extended liability can be used to avoid the difficulties of both ‘microprudential’ and ‘macroprudential’ approaches to systemic stability.