"Skin in the Game"

We examine commercial banking in the United States, from 1910 to 1955, focusing on key regulatory changes related to risk-taking that arose in the midst of the Great Depression. Prior to the 1930s, laws imposed on most commercial banks made decision makers (managers and shareholders) liable for losses in the event of bank failures. This contingent liability – often taking the form of double liability, or up to twice the payment on the par value of one’s shares – applied to the stockholders of all national and most state chartered banks.

Directors and executive officers of those banks faced this liability because the law required them to hold substantial numbers of shares in the organisations that they supervised; if those institutions failed, officers often faced civil liability and criminal investigations.

The banking reforms of the New Deal, including the end of contingent liability, were initially cast as a direct response to the near 10,000 bank failures of the time. But the changes had long-lasting consequences that may have contributed to the leveraging and risk-taking that fuelled the credit boom of the 2000s and ultimately led to the crisis that emerged in 2008.

In an effort to reform the present structure of financial regulation, policymakers have looked back at the pivotal legislation of the 1930s for guidance. Our work shines new light on the changes that affected the incentives and risk-taking of financial firms in that era. Our research shows the ways in which New Deal era banking and securities legislation altered incentives for financial firms to manage their risk, shifted the oversight of commercial banks to new federal agencies, and left the risk management of investment banks to themselves or to regulatory agencies with little mandate to manage it.

If contingent liability appeared to protect depositors and creditors and limited risk-taking by banks, why was it then eliminated in the mid-1930s? Once bank failures began en masse, depositors had little recourse for securing claims against shareholders, many of whom were already in serious financial difficulty. As failures mounted in the 1930s, public opinion began to shift. The view of bankers as victims of harsh economic times emerged in Philip Van Doren Stern’s short story, “The Greatest Gift” (1939), the inspiration for “It’s A Wonderful Life,” in which James Stewart plays the heroic banker, George Bailey. The emphasis of bankruptcy proceedings shifted away from punishment and deterrence and toward measures to keep fi rms intact and operating.

The end of contingent liability eliminated a shield that had provided some protection to depositors for three quarters of a century. In its place, policymakers substituted deposit insurance. Deposit insurance required the Federal Deposit Insurance Corporation (FDIC) to ensure that banks’ contributions to the insurance fund were adequate. This worked under the assumption that the agency could properly monitor risk. Examiners had to carefully examine balance sheets to ensure compliance, banks had an incentive to ‘game the system’ by shifting riskier assets off the balance sheets.

Another pivotal step taken in the Depression era also affected risk-taking among investment banks. In 1933, the Glass-Steagall Act created a firewall between investment banking and commercial banking, eliminating the ability for commercial banks to serve as brokerages and underwrite securities. With the investment banks sectioned off from commercial banks, federal bank regulators focused on commercial banks. The Securities Exchange Commission (SEC) emerged in 1934 as the watchdog agency for securities markets, but not explicitly for investment banks. As a result, risk-taking by investment banks went largely unregulated.

Investment banks had historically operated as partnerships, whereby the firms’ capital originated from existing partners and new partners who joined the firm. The partners in these firms used the capital to invest in deals, sometimes individually, but the pool was monitored by all partners. Under incorporation, however, the tight link between owner/managerial decisionmaking and risk-taking is broken. Indeed, managers’ incentives become aligned with outside shareholders, who might emphasise short-term profits at the expense of long-run goals. As global capital markets began to reintegrate in the 1970s, US investment banks began to face stiffer competition from large, European universal banks such as Deutsche Bank and Credit Suisse. They sought to grow in scale and scope, but the partnership structure that had long provided a mechanism for restraint and self-control appeared to stand in the way. After the New York Stock Exchange repealed a ban that restricted investment banks from being traded publicly on the exchange, investment banks began to convert in large numbers from partnerships to corporations. By moving investment banks outside the purview of bank regulators and allowing investment banks to manage their own risk, the Glass-Steagall Act and related legislation likely contributed to greater risk-taking by these firms.

This risk-taking may have been magnified by the perception that the world’s largest financial conglomerates were ‘too big to fail’. This enabled those institutions to increase profi ts in the short run, without exposing their directors, offi cers, and stockholders to the consequences of risks gone wrong. The modern situation contrasts sharply with the financial world before the 1930s when firms operated without insurance, and decision-makers bore the consequences of unwarranted risks and bad decisions.

Some recent critics of the repeal of this New Deal legislation argue that it permitted Wall Street investment banking firms to gamble with their depositors’ money that was held in affiliated commercial banks. Our research suggests a more nuanced view. Regulation from that period also enabled leveraging by removing incentives for financial firms to limit their risk-taking. As policymakers in the UK and the US re-examine their financial regulation in the wake of the crisis, it is worth keeping a close eye on both the incentives for fi rms to take risk and the long-run consequences of changes to the incentives of financial firms when new regulations are introduced.

Proposed UK legislation prohibits banks with investment arms from using retail depositors’ funds for risky bets. However, the ‘ring-fencing’ of deposits does not resolve the risk-taking issues we highlight and which fuelled the recent crisis. Even if the fence is ‘electrified,’ such that banks could be broken up if they violate this separation, financial firms will still have other means to satisfy their appetite for risk and leveraging, including tapping the money markets as many of them did in the recent fi nancial crisis.

Could we turn back the clock? Directly reinstituting double liability might be impossible today since fi nancial conglomerates now have large numbers of shareholders, many of whom are entities such as holding companies or even foreign corporations. Collecting contingent liability assessments may be impossible in such a setting. But other fi nancial reforms may still encourage bankers to keep ‘skin in the game’. Examples include laws requiring senior executives of fi nancial fi rms to receive substantial components of their compensation as equity that vests at future dates and laws allowing regulators to ‘claw back’ salary and bonuses from executives whose decisions lead to large losses. Another example includes procyclical capital requirements, which during economic expansions, would force fi nancial fi rms to limit dividends and increase capital. During economic contractions, capital requirements would fall. Firms whose investments fell in value would have buffers to absorb the losses. Firms whose conservative investments retained their value could pay out as dividends the earnings that they retained during the expansion.