Limited Liability and Banking

Or what is the justification for not making the shareholders of record responsible for the GM and Chrysler bailouts at the time? What is special about banking in this instance?

Putting shareholders at risk for more than their investment is contrary to the very essence of the corporate form (unless, of course, you can demonstrate the facts to support one of the common law causes of action for piercing the corporate veil). However, I would strongly support a Federal statutory form of “fraudulent transfer” recovery from managers and directors. Set a 6 year look back period, and provide that any officer, director, or manager who received any bonus based upon profits that turned out to be illusory, or anyone who received total compensation in excess of a statutory “safe harbor” (I propose $300,000 per annum, but I’m open to suggestion) is subject to liability to recover all such excess bonuses or excess compensation in the event of any bank failure resulting in any loss to depositors or creditors. As in Bankruptcy, make the Receiver (the FDIC, in the case of Federal or Federally-insured banks) responsible for bringing actions seeking recovery under this statute. That way, the people who are responsible for making the risk-based decisions, and who stand to benefit from bonuses based on the transactions at issue, are put at risk for at least a portion of the losses. This would better align financial incentives of the bank managers with the public interest.

I should add that there is one problem with negative prices that I’m unsure how to solve: If I held a bank share with a negative value of one billion, I would be very tempted to sell my entire holdings for a very small negative price (-$100, let’s say) to somebody who is already insolvent or nearly so (the bum around the corner, for example). Without tracing liability back to previous owners if the current owner is insolvent (which would create the unfortunate situation that you could never really clear yourself of liability if you ever held a bank share), I’m unsure how to fill this gap in the negative price idea.

You don’t really need to tie it to the price paid for the shares, do you?

To every share, attach an obligation that requires you to pay a fixed $X per share you own if the bank becomes insolvent. (That will push the price of the share down somewhat, but a lot less than $X if the bank is doing fine for now.)

The brokerage will require you to have enough margin to cover the $X, just as they require you to have a certain margin when you’re short a put option.

If insolvency becomes likely, the shares might actually have a *negative* value. But that’s not a big problem … just means you have to pay someone to take them off your hands.

But, you know, there’s an easier way to do this. Just require the bank to permanently hand $X per share over to the government. Every year, the government pays shareholders a dividend on interest earned on the $X. If the bank goes insolvent, the $X reverts to the government.

Almost the same incentives … the only problem is that the shareholder has to tie up $X of his capital, instead of just guaranteeing $X. I suppose the government could fix that, if it really wanted to, by subsidizing brokerages to lend the $X back to the (creditworthy) investor at the same rate the government is paying on the $X.

I seem to remember that there was a rule limiting the power of institutional investors in banks. A small investor votes by buying or selling shares but an institutional investor can vote by voting for board members. I think the limit is on the percentage of ownership that any one entity can have. If there were more institutional investors, there would be more accountability.

And I would add that Scottland (except 2 public banks) had ulimited liability until the late 19th century.There was one bank crash which was characterized by shareholders claiming they weren’t shareholders 🙂 Anyway, the scottish system seemed to be quite unregulated and quite stable.

As andi points out, this has been tried and found wanting. In the 19th Century we saw both unlimited liability and shares sold below par (say half par), with the remainder being callable. In 1851 the Banker’s Almanac wrote:

The Times says the regulations stipulated with regard to its issues are sufficiently in accordance with the sound views that now prevail, and although the provision that the proprietors shall be liable for twice the amount of their subscription shows that the Government has not yet learned the fallacious nature of all merely hypothetical responsibilities, which often fail when they are really called upon, while at the same time they mislead the public and lessen the caution that would otherwise be exercised; the error is one which under the ordinary routine ideas will most probably be regarded with favor rather than disapproval.

Wouldn’t Coase’s answer to this be that the risk of being on the hook for the liability was reflected in the price you paid for each share?

Or did I misunderstand something along the way?

Arnold I think the problem is not so great as you imagine it. When you purchase the shares from me, you will be incentivized in light of the increased liability to be more cautious in your choice of whether or not to purchase. Thus you will attempt to take into account to the best of your knowledge the potential that the company will go under after you purchase it.

The adoption of limited liability was largely done to reduce these information costs and lower the cost of capital for joint stock companies. However, there have been instances in the past of companies with double, triple, or even unlimited liability.

For instance, in his work on Free Banking in Scotland Lawrence H. White discusses the fact that many shareholders had unlimited liability. This kind of greater liability system causes investors to keep a closer eye on their companies because of the greater risk it poses to them. Many of these unlimited liability companies lasted for quite a long period, as their conduct convinced investors that they would not engage in the kind of activities that would put them at risk. Tyler also linked to Scott Sumner’s blog post on this subject, which itself linked to a paper discussing the use of relatively less limited financing schemes in the U.S. during the National banking era which discusses the kind of systems markets set up to adapt to the problem you discuss.

I think this is equivalent to saying the shares cost $1.50.

Saying the shares cost $1 and the investor is liable for another 50 cents, is really just a convoluted way of saying that the shares cost $1.50. The only difference is that when each share that is purchased for $1.50 it also includes the option to borrow up to 50 cents interest-free from the bank if you like.

I don’t see why it would be useful or efficient to bundle an optional interest-free loan with the sale of each share of bank common stock.

Just why are the posters on this topic so intent on finding a way to punish, or create anti-risk incentives for, shareholders? One of the defining characteristics of the corporate form is a division between ownership and control. If risky behavior by banks is the problem, then put the incentives on those with the power to change that behavior; the officers, directors, and managers, not the shareholders. Of course, risky behavior by banks becomes much less of a public problem if we just do away with the entire notion of “too big to fail” in the first place, and either eliminate Federal Deposit Insurance, or at least impose risk-rated premiums for that insurance, so that as a bank becomes more unstable, it’s cost of maintaining FDIC insurance increases substantially.

I think that the current system has feedback problems that make it tough to remain stable 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.