Arnold Kling writes:
Suppose that you sell your shares in Shakee Bank to me today, and tomorrow Shakee has to be taken over by the FDIC. Am I liable for losses, which probably were caused by decisions made before I bought my shares? Suppose that Shakee has accumulated $8 billion in losses, and all its shareholders of record obtained their shares for a collective $0.10. What happens then?
I don’t envision the FDIC being eliminated, but say the government is in a position to be picking up some potential bondholder losses. Under one version of the reform, bank shareholders already have posted extra collateral, by requirement of the law. That is somewhat like higher bank capital requirements, with the twist that there is now a new legal class of bank capital.
That is an improvement over the status quo, but it’s not the most innovative form of the proposal. One alternative version is for the government to outsource the enforcement to the bank itself. For instance the regulator can say: “as insolvency approaches, the bank is liable for 1.5 to 1, it can come up with the money any way it wants. If it can’t come up with the money, we will take the major shareholders of record, say a year before the event (or consider a more complicated weighted average of this variable) and send them an income tax assessment for 2-1.”
The bank might preemptively organize like a partnership, or it might apply its own collateral and capital requirements to the shareholders, or it might find some other way of meeting the obligation. Banks would compete to find the better solutions.
In response, many people fear banks trying to set up with only hobo shareholders. That would avoid the 2-1 or 1.5 to 1 or whatever, because hobos don’t have extra assets to attach. I just don’t think those banks will become major money center institutions because the quality of shareholders really does matter at some level. For instance such banks could not have wealthy, highly motivated, equity-holding CEOs. Most likely hobo banks would stay small and thus skirt the too big to fail problem or maybe they would not exist in the first place.
One problem with traditional capital requirements is that the government ends up making comovement-inducing ex ante decisions about which assets count toward satisfying the capital requirement. Remember AAA CDOs in America and AAA government securities in Europe? Under non-limited liability, only cash is accepted but it only has to be delivered ex post in the case of failure. The regulations themselves need not create the same kinds of uniformity, misjudgments, and excess systemic risks up front.
One tricky question is how to apply non-limited liability to foreign banks operating in the United States. This is a problem with all regulatory schemes based on less than perfect international coordination. The first cut approach is to insist on non-limited liability for U.S. operations, though of course evasion and reclassification of operations may occur.
Mark Thoma adds lengthy comments. Here is a very relevant paper by Claire Hill and Richard Painter, and a blog post by them. Here is Suzanne McGee. Here are some debates on non-limited liability in economic history, including work by Lawrence H. White.
Any form of non-limited liability would have one simple result — bank shares would no longer be publicly traded. Can you imagine the NYSE, NASDAQ, or any major exchange regulator allowing the ill-informed public to buy such shares? Bank shares would only be held by “sophisticated” investors.
Bank shares could still be publicly traded, but purchasers would presumably have to put extra cash into some kind of escrow which they would get back when it was sold. Logically, all this should do is drop the price of bank stock until everyone is in exactly the same position as they were.
In other words, previously the bank would have sold its stock for $25 per share, but now it will get $10, plus an escrowed amount of $15 held by someone else and available to the bank under certain conditions. The shareholder will be in exactly the same position as they were and the escrow will trade with the share.
I would assume Prof. Cowen has thought of this, so what am I missing here?
Stock market software would have to be adjusted to allow for negative share prices. That would involve Y2K-like reprogramming issues, redefining the meaning of a penny stock for regulatory purposes.
Or, you could disallow share prices below zero, but then your “exactly the same position” would no longer hold, because the stock would become completely illiquid if it needed to fall past zero but couldn’t.
I think the implications for derivatives are more interesting. Imagine pricing a put, call or CDS on a bank when the equity carries this provision! Equity ceases to be a call at zero…
There was an actual case in Australia a few years ago involving an ill-fated infrastructure project named Brisconnections. Shares were publicly traded, but had an additional provision that shares had to be paid over three scheduled installments. So purchasers of shares were buying those future liabilities along with the shares, but didn’t necessarily realize that.
When the stock price plunged to fractions of a cent, naive investors snapped up millions of shares, only to find that they were liable for millions of dollars in future installment payments and faced financial ruin. See for instance here or here or just google.
It’s not quite the same thing, but the lesson is pretty clear: whenever your worst-case scenario is worse than your shares going to zero, it has no business being offered to retail investors on stock markets.
“The issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the banks.
Lord Acton
The banks have been winning this long term battle. We are not very good at fine tuning regulations. The more we can place the responsibility for failure upon the bankers (we should stop conflating the banks with the people who run them), the more we make them manage their own risks. It wont really work until bankers have credible evidence that they can end up as destitute as the people to whom they sell their innovative financial products. IOW, I think we are better served by aligning incentives.
Steve
But the derivatives arms of investment banks would immediately strip the resulting combined asset, creating an “equity tranche” identical to today’s equity, and a “mezzanine tranche” equivalent to preferred stock. Market behavior would not change in the slightest.
I suspect you’re not going to see “hobo shareholders” so much as a web of holding companies that’s a little bit more complicated than the people making the rules thought of.
A ‘web of something more complicated than the people making the rules thought of’ is de rigueur in banking.
Wasn’t the whole point behind Incorporation shielding shareholders’ private assets? Would people be willing to buy shares if they needed to closely scrutinize bank operations to avoid the sort of scenario Kling describes?
Sorry, I have great respect for you but from a real world perspective this is a Hindenburg. One can come up with any number of white board brainstorms but there are four fundamental problems: 1) the nature and amountof liabilities are infinite. The tort system and jury system ensure that. The populist culture ensures that some Eliot Spitzer type seeking to advance his career and gratify his ego will find some cause to impose liabilities on the bank. You would have to create dozens of liability-limiting laws instead. (Spare me the theory about those liabilities being priceable. They aren’t in the real world. Insurance exposure is always capped. Such risks as could be priced and passed through would raise the price of credit and shrink the supply of credit on the margin).. 2) The bankruptcy laws and other pro-debtor laws impair the collectibility of assets. So to avoid the risk of increased loss, those laws would have to be modified or lending would become ultra-conservative. 3) Liquidity. Incentive would reverse such that every bank would lengthen their own maturiies and lend on a short term basis. So demand deposits and fractional reserve banking would shrivel. 4) . People with savings to lend are risk averse on the margin. If you can lend to the fisc at 0% interest or do private lending with a risk of increased loss, we’d wind up with just people lending to the fisc. It would be just another form of financial repression – you want to finance private secgtor activity, put your life savings at stake. That is just another form of financial repression.
We put lots of people in jail after the S&L crisis. Almost none during this one. I dont think your reasoning fits what is currently happening. Besides, we know what bankers will do when completely insulated from liability.
Steve
Interestingly enough Scotland lived with this provision for quite a long time and I don’t think they suffered from such problems. One might assume that modern financial instruments might change the game, but how much?
Shareholders lose when a bank goes bad already. They have little say in the day to day decisions that would bankrupt a bank.
Make the directors and CEO’s liable. Losses come out of their pockets. The scams, lack of due diligence in lending etc. come from their decisions. Let them be reduced to selling apples on the street corner from their bad decisions.
Bingo and this is a well precedented structure. The officers are general partners. They have control and unlimited liability. Other investors can be limited partners. That means limited control and limited liability.
Directors of bankrupt corporations may be liable for losses related to breaches of fiduciary duty and/or gross negligence.
The FDIC Division of Receiverships and Resolutions, among a thousand other things, runs investigations to try to recover from insurance and/or directors’ personal assets where culpability is proven. It’s civil law not criminal. The burden of proof for civil judgment is less stringent.
Banks buy Directors and Officers (DOE) liability insurance policies to cover that.
After the S&L Crisis, premiums became unaffordable for that insurance. I have no idea where such premiums were in the run up to the present debacle.
You can count on the next banking crisis in 3 . . . 2 . . . 1 . . .
You might end up with “hobo” directors.
You might also end up with a “hobo” CEO who’s a mere figurehead constitutional monarch, with all decisions made by a COO.
I think that the current monetary/banking system has feedback problems that make stable difficult to achieve but making corporations loose their limit liability status slowly and progressively as leverage goes up might be a plus but it would have to be a complicated to cover all possibilities and avoid periodic running for the exits.
Better IMO to work on the feedback problems so that banks are strengthened by the failure of their competitors (and are encouraged to lend more and spend more). If banks are measured against other banks only the weakest banks could ever fail. With he current system all banks can all fail at once as they can be out competed by Government bills and bonds. I think some free banking schemes would work this way.
At your debate link, Google asked me if I didn’t mean “Barry White”. He did not have unlimited liability – but he did have love unlimited (orchestra).
If you’re signed in to Google, they personalize your search queries based on what they know about your profile. You may have publicly revealed more about yourself than you intended!
I realize this is going to seem like a minor point, and perhaps it is, but I would actually guess this has the impact of raising the organizational costs of investing in banks and restricting such investments to sophisticated institutional players. I say this because clever legal structuring of equity ownership (ex. shell corporations), use of derivatives (call on equity + dividend swap strictly better than outright ownership ignoring control issues), etc. would likely , without other legal/market changes, be used to limit exposure to the extra contingent capital call on the part of these investors. I can’t imagine prudent institutions (ex. Vanguard index funds) would invest without the protections.
If increasing the financial sophistication of the average dollar of bank equity is the goal, this would work very well. However, smart people will find ways to structure around this if they want to.
That link on “hobo shareholders” is quite good comedy…
The only way to explain Kling’s story is the bank had just received a clean audit report from one of the Big Four CPA firms.
The owner of a “sole proiprietorship” has unlimited (until his personal assets are consumed) liability for debts and losses of his business.
The owners of a partnership may (unless it’s a limited partnership, but there there is a general parner that has unlimited liability) unlimited, proporational liability in the partnership liabilities and losses.
A corporate shareholder’s loss potential is limited to the carrying value of his investment in corporate stock. In other words (that an academisc may understand) general creditors of a bankrupt corporation may not attempt to collect from the personal assets of shareholders of the defunct corporation.
A corporation has separate legal existence from its individual shareholders/owners.
OTOH, the directors may be personally liabie for losses if gross negligence and breach of fiduciary duty/responsibility may be proven.
I nominate Kling to be Chair of the Fed Bd of Governors.
He shows no knowledge of how the real world operates.
He cannot do no worse than the Bernank or Turbo-Tax Geithner.
Finally,
Is there intelligent life on campus?
This just reduces to, banks should have more capital. For liquidity purposes, people will prefer to deliver it ex ante rather than ex post–easier to explain a claim on a common pool than a potential liability. Banks will be required to hold it as cash. A less attractive investment, unless the return from operations is improved, through greater risk taking.
Actually, and as I recall, the original National Bank Act had a 200% liability provision. The reason it was abandoned is that when the banks went under in the Great Depression, their shareholders lost their wealth as well, and could not cover the liability. Further, the extra liability led to the creation of holding companies to contain it. In the modern world, with jet travel and the internet, shares carrying extra liability would be parked in offshore holding companies, and the liability provisions would be meaningless.
Now for some better ideas. First. Make size expensive. If the base requirement is capital must be at least 8% of assets, then as banks grow bigger, the percentage rate should go up as well.
If you take the natural logarithm of the banks total assets, and set a threshold of say — Ln(195,729,609,429) = 26 the rule would cover the 15 largest BHCs.
http://www.ffiec.gov/nicpubweb/nicweb/top50form.aspx
J.P.Morgan is the largest ($2,289,240,000,000), and its capital requirement would be
8% + (Ln(2,289,240,000,000) – 26)% or 8% + (28.46-26)% = 10.46%,
which would be a disincentive to excessive size, but not a punitive requirement. It would give the biggest BHCs a reason and incentive to restrain their growth. The parameters of the equation could be changed without changing its logic.
Second. And libertarians should love this one. More competition. The banks best reason for accumulating assets is that building a branch network is the cheapest and least volatile form of funding. This makes tremendous size an advantage. Another business that has locations easily accessible all over the country, and also handles a lot of cash is groceries. Allow Wal*Mart, Target, Kroger, Safeway, et. al. to go into the banking business, at least to the extent of allowing them to open branches in their stores, and allowing them to provide ordinary banking services to consumers and small businesses.
A few years ago, Wal*Mart sought to start an industrial bank ( a species of small consumer bank). A coalition of labor unions, “community activists”, and bankers lobbied furiously to stop Wal*Mart. Any idea those miscreants hate so much must be very good.
Allowing tough competition in the consumer banking space would remove the monopoly rent possibilities and limit the incentive for existing banks to expand by acquisition.
“The banks best reason for accumulating assets is that building a branch network is the cheapest and least volatile form of funding.” this may have been true in the pre 80s era but it is no longer the case. Most bank funding comes from the repo markets, for all from the slimiest investment bank to the sturdiest retail bank like Citi.
This is similar to “IOR Caps”; see Interfluidity’s post.
There have been financial entities with unlimited liability (American Express, in my lifetime), and, more recently, Lloyd’s of London. Experience indicates, basically, that an entity with a long history of operating under a regime of unlimited liability can raise capital, but once it calls on the unlimited liability of its investors, it can never raise capital again.
In terms of solving the problems of the OWS crowd, I think imposing personal liability on professors for each defaulted student loan that was paid to their employer would be more effective. But Cowen, Kling, et al. love to prate about their moral superiority, although they have probably caused more misery to the young of today than any number of bankers you can name.
I wondered if anyone would bring up Lloyds as a case of unlimited liability under their charter, but since it hadn’t been exercised in anyone’s lifetime, no one understood what it meant. The banks blew up in a housing bubble in the 80s with a TARP done by Bush circa 1990 which was in the lifetime of those involved in LTCM which involved a government coerced private bailout, and the 00s bubble and bank crisis were created in the lifetimes and vivid memories of the 80s and 90s for all involved in deregulating because Kling argued that be total deregulation the 80s and 90s would never repeat and banking and housing prices would return to the stability of 1935 to 1975.
Of course, for student loans and individuals in general, the limited liability that the Constitution intended by Federalizing bankruptcy has been eroded, while the effective unlimited liability of the investment banks has been eliminated so they could blow up the economy. Hey, if you are 19, you are experienced enough to take on a debt you can only shed by dying, but if you are a old enough to be a corporate leader you know to get paid if you end up lucky enough to profit and get paid if you bankrupt the enterprise.
I find this proposal quite shocking. It seems to ignore several potential problems-
1. Defining the concept of “bank”- My understanding is that lots of institutions engage in borrowing and lending of commercial paper and the like. How would this proposal prevent those institutions from taking a more aggressive lending role while avoiding the banking laws? See this wikipedia article on the Shadow Banking system. http://en.wikipedia.org/wiki/Shadow_banking_system.
2. Who would invest in one of these things? Why on earth would I buy shares in a bank when I could simply buy shares in something with limited liability, including, as you pointed out, a foreign banking institution.
3. As a commentor pointed out on EconLog, why not buy and hold my bank shares in an LLC?
4. Why not take physical delivery of my shares, and claim to have gifted them away if my bank goes bust?
5. Wouldn’t you expect shareholders of banks to become nearly 100% foreigners outside the jurisdiction of your proposed rule?
6. As banks decreased in number due to the proposal, wouldn’t we expect to see a ton of detrimental effects such as decreased liquidity, increased cost to consumers of banking services, etc.?
And that’s just the ones off the top of my head. I’m sure there are others. Limited liability is well-ingrained concept in corporate law. Might be worth recognizing the reasons it exists and at least trying to address them before calling for its abolition.
Historically, shifting control from outside investors to depositors, as was done in mutual banks, was enought to dramatically reduce insolvency rates, since depositors weren’t playing with someone else’s money and had much more downside loss exposure and hence favored more conservative management of the bank. If the FDIC hadn’t been invented, almost all banks today would probably be mutual banks.
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