by Joshua R. Hendrickson
February 24, 2014
In the wake of the recent financial crisis, advocates of policy reform have emphasized the imposition of greater capital requirements as a way to prevent bank insolvency. Banks with greater capital requirements might be at a reduced risk of insolvency, but the imposition of such requirements does not necessarily alter the incentives of the bank. An alternative is imposing some form of contingent liability, in which bank shareholders would not only lose the value of their initial investment in the event of insolvency but would also be subject to compensating depositors for any losses. This is in stark contrast to the current limited liability system, under which bank shareholders have no responsibility to compensate depositors. Contingent liability realigns the incentives of bank shareholders to be cognizant of the preferences of depositors, which results in less risky bank behavior.