Academic journal article Journal of Money, Credit & Banking

A Contracting-Theory Interpretation of the Origins of Federal Deposit Insurance

Academic journal article Journal of Money, Credit & Banking

A Contracting-Theory Interpretation of the Origins of Federal Deposit Insurance

Article excerpt

When Congress enacted federal deposit insurance in 1933, scholars understood it to be a tool for helping small banks and for restoring the liquidity of bank deposits. Still, Calomiris and White (1994, p. 164) note that by late 1931, representations of urban constituencies in "eastern states that had not supported deposit insurance for decades introduced federal deposit insurance bills." These authors argue that the severity of losses experienced in the early 1930s caused this switch, energizing small depositors into a political force strong enough to overcome unvarying large-bank opposition to deposit insurance. In their view, "small, rural banks and lower-income individuals (with small deposit accounts) were clear winners, while large, big-city banks, wealthy depositors and depositors in failed banks were losers."

It was, of course, recognized that deposit insurance could also have incentive effects. At the outset, Emerson (1934) explained that deposit insurance would intensify risk-taking incentives at banks unless it was properly priced and principles of sound banking were consistently enforced. In the late 1960s, scholars began to argue that deposit insurance was mispriced (Scott and Mayer 1971) and had in fact fueled a massive reduction in stockholder-contributed bank capital (Pelzman 1970). But it was not until the onset of the 1989 FSLIC debacle that the profession came to appreciate the many and perverse ways that this substitution of subsidized government guarantees for stockholder-contributed capital at insured institutions shifted risks from owners to taxpayers.

This paper shows that the rebalancing of Congressional support in the 1930s may have been assisted by changes in the funding-cost benefits that deposit insurance could offer stockholders in a substantial number of large urban banks. The analysis uses theories of regulatory competition and financial contracting under information asymmetry to explain these benefits and to challenge the Calomiris-White characterization of the initial beneficiaries of federal deposit insurance.

Evidence of stockholder benefits at large banks was first developed by Wilson and Kane (1997). Wilson and Kane show that at large national banks the longstanding contracting protocol in which stockholders attached contingent personal guarantees to bank debt began to unravel in the late 1920s. This protocol dictated wind-up rules for insolvent banks that--at national banks and at banks chartered by all but ten states--extended the liability of shareholders for bank debt beyond the value of the assets owned by the firm (Esty 1998).

The predominant wind-up rule divided stockholder-contributed capital into separate par and surplus accounts. Par capital (sometimes called "legal capital") is the minimum amount of capital (PAR) that the jurisdiction chartering a bank dictates that the stockholders maintain as on-balance-sheet equity. Surplus capital (SUR) is the sum of additional paid-in capital and undistributed profits that have not been allocated to the par account. Stockholder in national banks and in state-chartered banks in most extended-liability states were subject to "double liability" on the par value of their stock. Double liability means that, to cover a liquidating bank's unpaid debts, the receiver could personally assess each stockholder for an amount up to its pro rata share of the bank's par capital. For stock held in a "street name," the nominee would be assessed and incur the cost of collecting the reimbursement it was due from the ultimate owner.

Winton (1993) analyzes the agency costs that extended-liability shareholders and corporate creditors face when there is asymmetric information about shareholders' wealth. His model clarifies that contingent liability would affect investor incentives to own and trade bank stock and would influence stockholders' incentive to monitor bank managers. These incentives vary over time with five factors: the condition of the bank, the level of shareholder wealth, the shareholder's proportionate position in the bank, the probity of controlling interests, and the degree of asymmetry in information about shareholder wealth. …

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