Contingent Liability in Banking: Useful Policy for Developing Countries?

November 1995 Could contingent liability systems play an important role in developing countries' banking systems? 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, for example, and lasted until 1862, when banks were allowed to adopt a limited liability designation. As a result, Scotland was relatively 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. Actual losses from Scottish bank failures were well below those suffered by bank creditors in England. And Scottish banks were not prone to the bank runs and contagion effects typical of British and U.S. banks at the time. Scottish noteholders apparently had little incentive to run because of the effective coverage provided by unlimited liability. Three factors were vital to the success of unlimited liability in Scotland: ° The identities of bank owners were made publicly available, and their level of wealth could be verified. So the degree of noteholder protection from liability could be assessed by adding up an owner's wealth. ° Under Scottish bankruptcy law, owner liability extended to both personal and inheritable wealth. This intergenerational extension of liability expanded the bank creditors' safety net. ° The transfer of ownership claims in private and provincial banks required that ownership first be dissolved before a new bank could be formed. This allowed the transfer of control to be monitored, minimizing adverse selection problems that might arise should ownership be transferred to people with less personal wealth. A contingent liability system has three advantages: ° Because double liability imposes postclosure losses on bank stockholders, it increases incentives for banks to hold capital and decreases moral hazard incentives, such as a go-for-broke strategy. ° A contingent liability system can ameliorate asymmetric information problems between bank creditors and owners. ° 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 over time, creating a role for supervisors to ensure that only credible bidders are allowed. This paper --- a joint product of the Finance and Private Sector Development Division, Policy Research Department, and the Financial Sector Development Department --- was presented at a Bank seminar, Financial History: Lessons of the Past for Reformers of the Present, and is a chapter in a forthcoming volume, Reforming Finance: Some Lessons from History, edited by Gerard Caprio, Jr. and Dimitri Vittas.