Shareholder Liability: A New (Old) Way of Thinking about Financial Regulation

In the wake of a series of crises, international and domestic financial regulation has become highly complex and prescriptive, and oriented to leverage, liquidity, and capital ratios among financial institutions. This raises concerns over monitoring incentives, and over the increased role of deposit insurance, which insulates depositors and shareholders from some or most of the costs of an institution’s failure. However, until the mid-20th Century, banking regulation in the United States, Canada, the UK and elsewhere relied mostly on monitoring by shareholders and depositors. Central banks did not necessarily exist, and where they did, they did not necessarily have a modern lender-of-last-resort function. There were financial regulators, but depositors were expected to pay attention to the behaviour of the banks that held their savings. Senior bank managers often were exposed to liability for net losses incurred in the event that their financial institutions failed, as were other shareholders. The limited-liability corporate form, while it existed, did not apply to deposit-taking financial institutions. The reason was that owner-managers of banks often had incentives, and the capacity, to use for their own benefit the funds they held on behalf of others. Nonetheless, while bank runs, failures and crises occurred, bank depositors were nearly always made whole, and financial crises tended to be sharp, brief, and localized. Over the course of the 20th Century, shareholder liability, or double liability as it is often called, disappeared from the regulatory framework, to be displaced by deposit insurance, which has the political and economic attraction of reducing the incidence of bank runs and limiting their impact on depositors. In Canada, concerns over deposit insurance arise mostly at the provincial level. A number of provinces have expanded the size and range of deposits they cover, and British Columbia, for example, has introduced unlimited deposit insurance. This expansion will pose stability risks for the provinces that oversee the insurers, and for regulators and depositors outside those provinces. Implicit and explicit federal backstops for such insurance raise cross-province concerns. All of these features pose risks that deserve attention. At the national or international level, regulators should focus more on incentives. While reintroducing shareholder responsibility for bank liabilities in an insolvency seems implausible, other equity-based market instruments, such as equity recourse notes as proposed by Bulow and Klemperer (2013) could achieve the same effect. Irrespective of such sweeping change, there are clear domestic imperatives. Provincial deposit insurers should retrench, with respect to their coverage, and converge on a common standard, coincident with that offered at the federal level, for reasons discussed at the end of this review. Further, transitional expansion of federal deposit insurance to cover deposits at credit unions shifting from provincial to federal jurisdiction, announced in January 2014, should be withdrawn at the earliest opportunity.