Contingent capital and bank risk‐taking among British banks before the First World War¹

Abstract

The recent financial turmoil highlights the incentive of highly leveraged financial institutions to take excessive risk, given the protection of limited liability. During the nineteenth and early twentieth century, many banks operated under liability rules which obligated shareholders to bear larger costs of bank insolvency in the form of contingent, or even unlimited, liability. This article examines the empirical relationship between the size of banks' contingent liability and their risk-taking behaviour using data on British banks from 1878 to 1912. We find that banks with more contingent liability appear to have taken less risk. We also find evidence that the risk-reducing effects of contingent liability were larger for banks with higher leverage, suggesting that contingent capital mitigated the moral hazard problem at banks.

The Curse of the Credit Cycle: A Theoretical Review of Potential Cures

“…For example, in the UK during the second half of the XIX century, the capital adequacy ratio was at a significantly higher level than 50%. (Grossman & Imai, 2012) The same is true for the USA in the beginning of the XX century (Sinkey, 1997). At the same time, the research of experts of the Bank of England gives great support to the fact of existence of the credit cycle in these periods of time for both the UK and USA (Haldane, 2010).…”

“…10, No. 10; 2014 Grossman & Imai, 2012) will promote the intensification of monetary liability of commercial banks, thereby trapping the problem of limited liability. (Gollier, Koehl, & Rochet, 1997;Sinn, 2001) Unfortunately, this view is based on the idea of full rationality of creditors.…”

Control Rights (And Wrongs)

“…This could be tapped pre‐insolvency at the discretion of bank management. On average, between 1878 and 1913, UK banks had uncalled capital larger than their called capital (Grossman and Imai, 2011). Together, reserve and uncalled capital made for a deep contingent capital pool for even limited liability banks, amounting to as much as 50% of banks' liabilities.…”

Bloody foreigners! Overseas equity on the London Stock Exchange, 1869–1929

“…If a substantial number of these occurred because of decline in company fortunes, the omission could bias the returns upward. Alternatively, if firms called capital to finance expansion of a profitable enterprise, the omission could bias the returns downward; Grossman and Imai, ‘Contingent capital’, p. 139.…”

“…Grossman and Imai, ‘Contingent capital’, pp. 146–54; Acheson et al., ‘Character and denomination of shares’.…”