More Evidence That Shareholder Liability Leads to Less Risky Behavior

An interesting paper at VoxEU provides some empirical support for a commonsensical observation: that the pervasive use of limited liability structures for virtually all financial services activities creates “heads I win, tails you lose” dynamics. If you have no downside and can earn more by taking risk, then why not? While bad incentives like these typically produce bad outcomes, they are particularly problematic in the banking arena, where leveraged institutions are fragile to begin with, and the extensive safety nets under the banking system means that taxpayers bear the cost of reckless behavior. Indeed, in the past, not only were banks much more strictly regulated out of recognition of their quasi-public role, but in some states, even arm’s shareholders were subject to double or even triple liability (ie, they could be assessed a multiple of the amount they invested) in the event of firm failure.

As we and other have noted, in the days of investment banking partnerships, which were unlimited liability structures (meaning the partners could lose everything), the owners of the firm were more cautious, not simply about the nature of their day to day exposures, but also about the firm’s franchise. Most private securities firms were conservative in their promotion choices and concerned about the long-term value of their franchise.

Richard S. Grossman and Masami Imai, both members of the economic faculty at Wesleyan, used a data sample that is sufficiently old (1878 to 1912) that some might dispute its relevance, but how much has human nature changed?

From VoxEU:

One of the striking features in the buildup to the global crisis was the extent of risk taken on by highly leveraged financial institutions. This column blames such behaviour on the limited liability status of these institutions. Using data on British banks from 1878 to 1912, it finds that the banks with greater liability for their debts took on less risk.

From the enactment of the first commercial banking codes in the nineteenth century through the adoption of the Basel and Basel II accords in recent years to the anticipated adoption of Basel III, policymakers have argued that holding increased amounts of capital promotes bank “soundness and stability” (Basel Committee on Banking Supervision 1988, 2004). Even before governments began to mandate explicit minimum capital requirements, law, custom, and market forces led to alternative means for providing sufficient levels of capital, primarily though extended shareholder liability (Berger et al. 1995).

The oldest and most well-known system of extended liability is unlimited liability, under which partners bear liability for all the obligations of a failed firm. In England and Sweden, banks that issued currency during the nineteenth century were typically subject to unlimited liability. In the US, state law often mandated that banks chartered under their authority be subject to “double” liability. In case of the bank’s failure, shareholders would be liable for twice the amount they had originally paid for their shares; some states mandated “triple” liability. The theoretical argument underlying these arrangements is simple. With more “skin in the game,” shareholders will be less willing to undertake excessive risk.

A formal analysis of liability: Uncalled capital

Although the recent crisis has encouraged economists to consider the policy implications of adopting various forms of extended liability (see Kashyap et al. 2008 and Flannery 2009 on “contingent capital”), there have been relatively few systematic attempts to examine this historical experience with extended liability. Exceptions include Esty (1998) and Grossman (2001) who demonstrate that such strict liability rules played an important role in reducing moral hazard problem in the US banking sector during the half-century or so prior to the Great Depression.

In recent research (Grossman and Imai 2010), we consider another mechanism for imposing contingent liability upon shareholders which was common in Britain during the late nineteenth and early twentieth century: uncalled capital. Under this system, firms issued equity with a nominal value, all or part of which might have been required to be paid in by subscribers at the time of the initial offering. Shares which were only partly paid carried with them a contingent liability for the unpaid portion of the share and could be called in by the firm at the management’s discretion.

We investigate the consequences of uncalled liability by analysing bank balance sheet and share price data from British banks during 1878-1912. At the time of establishment, company promoters declared the nominal amount of the firm’s capital, the number of shares into which it would be divided, and the portion of each share that would be paid-in by subscribers. There were no statutory requirements for the amount of uncalled capital, which was determined by a variety of factors, including common practice within an industry and current opinion as to what share characteristics were conducive to promoting financial stability (Jefferys 1946).

Figure 1 demonstrates the extent of uncalled capital in a variety of sectors during 1870-1913. The figure reports data for only a few sectors, including banks, insurance companies, trusts, and land, mortgage, and financial companies. These sectors maintained a high amount of uncalled capital relative to the market as a whole. The high proportion of uncalled capital can be seen as a market-imposed requirement to engender confidence in sectors where leverage was high and the physical assets were either meagre or inaccessible to creditors.

Figure 1. Ratio of uncalled to market capital, selected

We measure bank risk in two ways:following Saunders et al. (1990) and Esty (1998), we use the volatility of share prices;the ratio of loans to total assets, under the assumption that loans are riskier and less liquid than other balance sheet assets.

We regress these measures against bank capital-to-asset ratios, a dummy variable for limited liability, a measure of the amount of uncalled liability, plus interaction terms between capital and unlimited liability and capital and contingent liability. The interaction terms are included to capture the possibility that extended liability is less relevant when banks are more adequately capitalised.

The results based on share price volatility are generally not significantly different from zero. Those based on the loan-to-asset ratio, however, are less ambiguous and more robust. The coefficient on contingent liability is negative and significant, meaning that higher levels of contingent liability are associated with less risk-taking. These effects are economically important. Comparing a bank with no contingent liability with a bank with contingent capital equal to the total amount of paid-in capital (i.e., the amount put up by shareholders in at the IPO), the latter’s loan-to-asset ratio is, on average, 16 percentage points less than that of the former. Further, the effects of contingent capital are stronger for banks operating with lower capital-to-asset ratios than with well-capitalised banks, suggesting that contingent capital may act as a brake on risk-taking for banks that are, in fact, in greatest danger of failure.

Do stricter liability rules encourage prudence?

Our results suggest that, at least prior to World War I, British banks which operated under more strict liability rules – particularly more highly leveraged banks – undertook less risk than those operating with lower levels of contingent liability. These results are consistent with both the predictions of economic theory as well as the findings of empirical literature that focuses on the consequences of double liability in the US (Esty 1998, Grossman 2001, Grossman 2010).

Of course, as shown in Grossman (2001), state-chartered banks in US states that imposed extended liability during the Great Depression fared worse than banks in limited liability states, suggesting that the benefits of extended liability may be of limited use in the face of a financial tsunami. Nonetheless, our results have an important implication for today’s policymakers. Extending bank shareholders’ liability can protect taxpayers by directly reducing the taxpayer’s share of bank resolution costs and, more importantly, by altering the risk-shifting incentives of banks.

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  1. jest

    Doesn’t dynamic hedging nullify this?

    In the period under study, the number of swaps, hedging & insurance products were incredibly limited relative to today’s world. The way in which fat tail events were viewed were far different than our contemporaries.

    The whole point of these products is to reduce (or mask) risk, and the liabilities attached to them. It seems the logical conclusion of exposing them to higher amounts of liability would not be conservative approaches to capital, but instead increased hedging (*more* CDS, *more* options, *more* swaps, etc.)

    A new type of uncalled capital seems like a good idea, but I can also see these parasites creating a panoply of new derivatives to hedge their exposure to these losses.

    Human nature may have not changed much, but the proliferation of financial WMD certainly have.

    1. Deus-DJ

      The above analysis and your response leaves out the current rationale given for increasing bad behavior: bonuses. Those bonuses are tied to the popular theory of maximizing shareholder value(as the corporation’s main goal). I forgot to mention in my post right below this that other ways to fix this is to also start putting the word “society” into the vernacular when speaking of maximizing value. I have no ideas to give you at this current moment because I’m feeling like a lazy bastard, again I simply have a polemic interest at heart right now.

  2. Deus-DJ

    I didn’t read anything you wrote above other than the title…I simply have a polemic interest at heart as I just wanted to launch a missive against Michael Jensen. It’s all that Mofo’s fault we’re in this mess with regards to short term equity price maximization. The good ole days when managerial discretion ruled supreme without any immediate desire to maximize shareholder value are by most standards the gold standard. Now managerial discretion still exists but with a desire to “maximize shareholder value”, which among managers has become a popular idea due to the fact that they realized they can up their bonuses using this justification(this is in fact one of the leading reasons why bonuses skyrocketed, which happened around the time Jensen mentioned this theory).

    Increasing liability among residual holders would of course decrease risks, but how viable is it really? I say we just develop a new idea/theory of value maximization of and for a corporation, one that incorporates long term value rather than short term. To do that of course bonuses should no longer be tied to short term performance. We need to change mindsets out there, not simply rules. It has to be shown that without the long term benefits the short term benefits matter zilch.

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