Contingent liability in banking : useful policy for developing countries?

Bank owner contingent liability has been important in the development of many industrial countries. Unlimited liability on bank owners was an important element in the success of Scottish banking, which led Scotland to be free of the banking and monetary upheavals that occurred in Britain and the United States. The unlimited liability provision effectively minimized the losses suffered by bank noteholders and other creditors. Three factors were vital to the success of unlimited liability in Scotland: 1) the identities of bank owners were made publicly available, and their level of wealth could be verified; 2) under Scottish bankruptcy law, owner liability extended to both personal and inheritable wealth; and 3) the transfer of ownership claims in private and provincial banks required that ownership first be dissolved before a new bank could be formed. A contingent liability system has three advantages: 1) because double liability imposes postclosure losses on bank stockholders, it increases incentives for banks to hold capital and decreases moral hazard incentives; 2) a contingent liability system can ameliorate asymmetric information problems between bank creditors and owners; and 3) contingent liability can lead to more efficient capital formation if potential capital sources are predominantly in the form of fixed wealth, as is true in many developing countries. But a free-rider problem arises when less-wealthy stockholders rely on the monitoring efforts of wealthier stockholders, who have more incentive to monitor. And in a free and anonymous exchange market, investors with less personal fixed wealth will outbid those with greater wealth, so the value of double liability could collapse overtime.