Bankers’ liability and risk taking

Bankers’ liability and risk taking

Peter Koudijs, Laura Salisbury, Gurpal Sran 06 October 2018

So as to protect the economic climate from excessive risk-taking, many argue that bank managers have to have more personal liability. However, if the liability of bank managers includes a significant influence on risk-taking can be an open question. This column studies a distinctive historical episode where similar bankers, operating in similar institutional and economic environments, faced different examples of personal liability, according to the timing of their marriages, and finds that limited liability induced bankers to take more risks.


In 2015, seven years following the failure of Lehman Brothers brought the financial world to the brink of collapse, Dick Fuld, the former CEO, sold his Idaho mansion for about $30 million dollars, setting an archive for private home auctions. It appears he was prepared to leave his private trout-fishing stream and go back to the world of high finance.

Naturally, Dick Fuld lost significant sums of money when his bank collapsed. Bebchuk et al. (2010) calculate that, in 2000, Fuld owned about $200 million of Lehman Brother stock, which would eventually become worthless. Nevertheless, Fuld withdrew about $520 million from the lender between 2000 and 2008 by means of cash bonuses and equity sales, none which was accessible to Lehman’s creditors.

This raises the question of whether bank managers’ incentives are set appropriately to safeguard the economic climate from excessive risk-taking. Managers can profit from a bank’s profits when things ‘re going well, however they shoulder minimal losses if the lender fails (Bhagat and Bolton 2014). This limited liability may cause them to become take undue risks with depositors’ money. You will find a growing chorus of commentators arguing that the economic climate is only going to be safe if bank managers have significantly more personal liability (e.g. Kay 2015, Cohan 2017).

If the liability of bank managers includes a significant influence on risk-taking can be an open question. Bank managers value their reputations and future careers; so, they could stay away from the failure of their bank no matter what. Other stakeholders, such as for example uninsured creditors, might be able to force banks to lessen risk-taking (Calomiris and Kahn 1991, Diamond and Rajan 2000). To create their case, proponents of increased personal liability often indicate what happened to investment banks during the last few decades. Prior to the 1980s, investment banks operated as partnerships with unlimited liability. Through the 1980s, they went public. Anecdotally, this appears to have gone together with an increase of risk taking. However, this coincided with an interval of general financial deregulation. So, just how do we realize what caused investment banks to take more risk?

In recent work (Koudijs et al. 2018), we study a distinctive historical episode where similar bankers, operating in similar institutional and economic environments, faced different levels of personal liability, according to the timing of their marriages. Our findings claim that limited liability really matters for bank risk-taking.

Banker liability during the past

While bankers today shoulder relatively little risk, this is not necessarily the case. Through the US National Banking era (1864-1912), shares in national banks carried double liability. If a bank failed, each shareholder had a need to repay depositors out of personal assets, up to the quantity of his original investment in the lender. For instance, if he initially invested $1,000, he could lose that investment plus yet another $1,000. Bank presidents – who were in charge of the day-to-day operations of the lender – were major shareholders, typically owning 10-20% of their bank’s stock.

The early portion of the National Banking era coincides with a change in the marital property laws of certain US states. Under traditional American common law, whenever a woman married, her property became her husband’s. Starting in the 1840s, states began to pass Married Women’s Property Acts (MWPAs), which allowed married women to possess property within their own right. However, these laws only put on couples married following the passing of the MWPA. Crucially, the MWPAs protected a married woman’s property from claims against her husband. If her husband was a national bank president, this included double liability claims on his bank’s shares.

The normal national bank president through the 1860s and 1870s was a middle-aged, married man. Based on his birth year, age at marriage, and state of marriage, he might have already been married before or following the passing of a MWPA in his state. In the latter case, his wife’s property could have been protected from any double liability claims if his bank failed. As such, his household liability could have been significantly less than that of an otherwise identical banker who was simply married before a MWPA.

Here’s a straightforward example. A banker with $100 in assets marries a female with $100. The banker invests $75 in his bank. If this marriage occurred before a MWPA, depositors (represented by the regulator) could lay claim to $75 of the household’s remaining personal assets if the lender failed. However, if the marriage occurred after a MWPA, depositors would only have the right to the $25 the banker individuallyhad left. This decrease in personal liability may have led the banker to place his depositors’ money into riskier but higher-yield investments.

Limited liability and bank risk-taking

We collect data on the actions of New England national banks through the 1860s and 1870s, and also information regarding bank presidents’ marriage histories. This enables us to classify bankers as ‘protected’ (i.e. married after a MWPA was passed in his state) or ‘unprotected’. We then compare the risk-taking behaviour of protected and unprotected bankers.

A key way of measuring bank risk-taking is leverage. We define this as loans and securities – inherently risky investments created by the bank – in accordance with capital invested in the lender by shareholders. A bank that extends more loans in accordance with capital is much more likely to suffer losses that render it struggling to repay depositors.

As it works out, bankers with less personal liability managed more highly levered banks. More precisely, a bank’s ratio of loans and securities to capital was 7 to 10 percentage points higher if its president was married after a MWPA. This will not reflect underlying differences between protected and unprotected bankers (such as for example age), or the characteristics of counties or towns that they reside in. It also will not reflect characteristics of the banks themselves – when a person bank switches from having an unprotected president to a protected president (through turnover, or a change in the president’s marital status), leverage increases for the reason that bank.

And in addition, the impact of a president’s protection status is contingent on the relative wealth of his wife. Figure 1 plots the difference in leverage between banks with protected and unprotected presidents with different intra-household allocations of property (inferred from the ratio of the wife’s family wealth to the husband’s family wealth). Being married after a MWPA only increases leverage for bankers whose wives own a sufficiently large share of the household’s property.

Figure 1 The result of limited liability on bank leverage

Source: Figure 1 in Koudijs et al. (2018).
Note: Figure uses non-parametric local mean smoothing, where both x-axis and y-axis variables are residualised with fixed effects and control variables. The vertical lines denote the 5thand 95thconfidence intervals.

Bankers with less personal liability were much more likely to activate in other risky lending practices aswell. In particular, these were much more likely to ‘hide’ bad loans on the balance sheets, also to extend loans which were ‘too risky’ according to regulators.

Limited liability and financial crises: The Panic of 1873

What were the results of protected bankers’ risky behaviour? We look at what happened to banks managed by presidents who faced different levels of personal liability following the Panic of 1873. The Panic of 1873 was a nationwide financial meltdown, triggered by the failure of an East-Coast investment bank, and accompanied by a string of bank failures and an extended recession (sound familiar?).

Actually, banks managed by bankers with less personal liability fared worse following the Panic. Banks managed by bankers married after a MWPA experienced a more substantial decline in earnings in accordance with capital during the period of the depression (Figure 2). Moreover, this effect is most pronounced for bankers with relatively wealthy wives, whose personal liability could have been most tied to a MWPA (Figure 3).

Figure 2 The result of limited liability on bank earnings following the Panic of 1873

Source: Figure 2, Panel A in Koudijs et al. (2018).
Note: Figure plots coefficients from regressions of aggregate earnings over capital on the protection status of the banker in 1873, including fixed effects and other controls. The vertical lines denote the 5thand 95thconfidence intervals.

Figure 3 The result of limited liability on bank earnings, 1873-1878

Source: Figure 3, Panel A in Koudijs et al. (2018).
Note: Figure uses non-parametric local mean smoothing, where both x-axis and y-axis variables are residualised with fixed effects and control variables. The vertical lines denote the 5thand 95thconfidence intervals.

In a nutshell, limited liability induced bankers to take more risks, which had real consequences for performance throughout a financial crisis.

Implications for policy

Our findings strongly claim that increasing bank managers’ liability would discourage bank risk-taking, at the mercy of the most common caveats about extrapolating from a historical period for this.

What does this imply about optimal bank regulation? A very important factor to consider is whether limiting bank risk-taking is a great thing. While less-risky banks may decrease the likelihood of a significant financial crisis, they could also limit beneficial lending to latest businesses. We find no evidence, however, that was the case in the 19th century – the protection status of local bankers didn’t affect innovation in manufacturing firms, measured through the adoption of steam power. Still, this evidence is suggestive. More work remains to be achieved to determine the ‘right’ amount of banker liability.

One important lesson is that, when it comes to policy, one size will not fit all. The potency of an insurance plan that increases banker liability depends on bankers’ individual circumstances. Bankers with a comfortable ‘cushion’ (through marriage or an unbiased way to obtain wealth) may respond differently than those that do not.

As long as our laws allow bankers to shield the gains from risky investments from the claims of creditors, bankers will see clever methods to do so. Which brings us back again to Dick Fuld. In ’09 2009, when demands personal lawsuits against bankers were loudest, Fuld ‘sold’ his $13.5 million Florida beachside getaway to his wife for only $100-a modern twist on the idea of limited spousal liability that began with the MWPAs. Regulators should ask themselves if the great things about limited liability outweigh the expenses. Our research shows that they could not.


Bebchuk, L A, A Cohen and H Spamann (2010), “Wages of failure: Executive compensation at Bear Stearns and Lehman 2000-2008”, Yale Journal on Regulation 27: 257.

Bhagat, S, and B Bolton (2014), “Financial meltdown and bank executive incentive compensation”, Journal of Corporate Finance 25: 313-341.

Calomiris, C W, and C M Kahn (1991), “The role of demandable debt in structuring optimal banking arrangements”, American Economic Review 497-513.

Cohan, W D (2017), Why Wall Street Matters, NY: Random House.

Diamond, D W, and R G Rajan (2000), “A theory of bank capital”, Journal of Finance 55(6): 2431-2465.

Kay, J (2015), OTHER’S Money: THE TRUE Business of Finance, NY: PublicAffairs.

Koudijs, P, L Salisbury and G Sran (2018), “For richer, for poorer: Bankers’ liability and risk-taking in New England, 1867-1880”, NBER Working Paper No. 24998.

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