Arnold Kling  

Increasing Liability of Bank Executives

Too Small to Succeed?... Progressive Corporatism Explai...

Axel Leijonhuvfud writes,

In the early days of fractional reserve banking, bank owners were subject to unlimited liability. In the US, double liability for bank shareholders was common up to the Great Depression. All American investment banks were partnerships into the 1970's and the last one, Goldman Sachs, only converted itself into a limited liability corporation about a decade ago. Back in the 70s, US financial sector liabilities were less than 20% of GDP. Today the figure is close to 120%. Leverage has increased enormously. Back then, stringent liability rules inhibited risk taking. In the days when such liability provisions applied to banks, "conservative" was the adjective habitually attached to "banker." It does not fit the high-stakes gambling "quants" of recent years.

Thanks to Mark Thoma for the pointer.

I agree that there is a problem with giving financial executives only limited liability, particularly when they enjoy nearly unlimited taxpayer bailouts. I also agree that Leijonhufvud's gimmicky approach to create a financial penalty for executives of failed financial institutions is only, as he describes it, a "modest proposal." Although I cannot seem to find the original post, I believe that at one point I suggested that in order to ensure compliance with the spirit of conservative banking, executives of insured institutions that fail ought to be shot.

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COMMENTS (8 to date)
Joey Donuts writes:


I think you said go to prison. Shooting is for horses.: )

mulp writes:

As an alternative to executing the executives, I suggest something far more painful: eliminate the tax deduction of interest as a business expense beyond interest earned on debt.

Thus a bank would not pay taxes on the interest paid to depositors because they would be earning more interest from loans issued or their deposits with the Federal Reserve as a backstop.

On the other hand, an investment bank borrowing money in order to buy for securities price swing speculation would not be allowed to deduct the interest paid on such debt.

This would allow firms to factor their credit - credit extended to customers would include an implicit interest payment of the difference between the price for payment on delivery and payment within 10 day discounts.

And what would be promoted is issuing new stock to increase the capital available to pay for work in progress instead of borrowing to grow. Bad management would result in loss of stock value, not debt defaults and debt write downs.

Of course, this would eliminate the free lunch Wall Street has been built on for the past few decades where they reap the profits from highly leveraged increases in securities prices while lenders of all sorts pay for the losses in securities prices.

Shooting the bankers would waste a national resource, however meager, and cause pain to family members. Waterboarding or decimation would be enough I think (smile).

How about this more modest proposal:

() End all government guarantees for bank deposits. If you wouldn't put your money into a bank without that guarantee, then you obviously think your bank has too much risk or is run by crooks. With that guarantee, your bank is a subsidized arm of the government. End the privilege.

() End the idea that banks should intermediate between risky investments and risk averse depositors. Everything works fine until the depositors realize that they can't stand the risk incurred by the bank's investments, or the timeframe of those investments. Bank runs follow.

If the depositors want to be invested in mortgages, then let them do this explicitly through applied accounts. If they want safety, then give them vault accounts; keep the cash in the vault. Of course, insurance to protect against robbery would be appropriate.

It would be a neat trick if intermediation worked, but it doesn't. Risk averse depositors don't know what is going on, and are quick to pull their money out. Risk desiring depositors don't get paid a reasonable rate for the resources they are lending.

How have government guarantees worked out for us so far? The current recession was triggered by collapsing home prices and mortgage losses, after an extended period of government providing easy money and guarantees to support Fannie Mae and Freddie Mac. The government is still doing this. The bad housing policy was designed, encouraged, and required by government.

See We Guarantee It - The Government Caused the Economic Crisis

Nick writes:


Basically you've summed up Charles Calmorisis views on it, though he suggested reinstating the postal savings system, giving people some alternative to just sticking cash under a mattress.

Loof writes:

Agree, Arnold, about conservative banking as well as being “shot” – and know precisely where. Of course, Loof is more a conservative Smithian red tory (“the butcher, the baker”—and the banker, with no privileges; no special rules) and not conservative in nowaday banking, as in the Canadian style for instance.

That is, Loof believes in level playing fields on different levels (little leagues; bigger leagues; biggest league, sort of thing) with simple principles, transparent rules and preferably self-referential – like children playing fairly in a playground according to their self-interest. Notice how kindergarteners will quit and change the game when a selfish child enters and dominates the game. Observe and learn professors—or go back to kindergarten.

So, Loof agrees, bank executives representing private interests should be shot, precisely in the left foot. Further, government executives representing public interests should be shot, in the right foot. Old testament punishment; no new testament here. Private and public partnerships are crippling both feet of society, economically and politically—so geez, maybe they should be shot in the right and left hand too.

Perhaps shooting them both in both hands would work: then, they can’t hold hands. On second thought, that wouldn’t work since the wound would heal over time. They’d have to be repeatably shot in both hands to prevent further hand holding. Wouldn’t be fair as a preventative measure; though fair punishment, L suppose. Banks would never be handy again either. Sorry, too much bending going left right around the backwards bend again.

Stephen Dodson writes:

It wouldn't be realistic to implement unlimited liability for bank shareholders and executives, but you could achieve results in that direction through some policy changes.

For example, you could require top bank executives to pledge personal assets (or portions of deferred comp) to the FDIC as collateral for potential failures. Banks often require commercial real estate loans to include personal guarantees, not just for the money that can be claimed back in the event of a default, but to make the alignment of interests real and palpable. The top 30 executives at Citi/BofA wouldn't have been so cavalier about risk if they had more of their personal net worth at stake, not just their current stock holdings.

It'd also be more effective and straight-forward than ham-handed legislation and/or regulation dictating executive compensation structures.

To Nick,

Thanks for the reference to Charles Calmorisis. I haven't read his work (or much of anyone's work), but I assume he must be a fine fellow. (smile)

Andy writes:

Stephen, how is that different that requiring that banks give most of their pay in the form of deferred equity or debt with a clawback mechanism? I suppose that it is different if you require that they put up money earned before they became an executive but then you just put in place a big disincentive for independently wealthy people to attain executive positions. The LTCM guys lost most of their money, right? Same with Jimmy Cayne, Dick Fuld, etc.

I really feel like this paper has not gotten enough attention. He shows that there is really no compensation scheme that will both adequately reward good money managers while keeping out the fraudulent ones.

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