Saturday, February 4, 2012

Leverage This

What's your collateral?
Jessie Stevens: “It was exciting at first, but you know now I think it’s more exciting to have them stolen.”
John Robie: “Yes, because you can’t lose financially as long as Hughson is around to make out the check.”
Jessie Stevens: “Well I’d be crazy to take this attitude if I did.”

— To Catch A Thief

I have had an absorbing day thinking about moral hazard, unlimited liability, and the modern financial system, O Dearest and Most Inquisitive of Readers. My thoughts have been guided by two intriguing articles; one, a blog post by Carolyn Sissoko at Synthetic Assets in response to Steve Randy Waldman’s recent pieces on opacity in finance, and two, a speech given by Andrew Haldane of the Bank of England last October. Both have enlightened me immeasurably about the long-term history of banking and finance, of which, I am mildly chagrined to admit, I have apparently been woefully ignorant. Such are the shortcomings of a Modern Man of Action.

Having little to recommend me as a guide to the fields of financial history or economics generally, I will spare you my amateurish glosses on each of these pieces, and encourage you instead to read them yourselves. Suffice it to say that I found their narratives of the transformation of banking and other financial intermediaries from their original state as small partnerships sharing unlimited liability to today’s limited liability corporations fascinating. For one thing, I was unaware of the common intermediate step, which obtained from roughly the second half of the 19th century through the 1930s, in which bank shareholders were subject to “extended liability,” which required them to put up additional (but not unlimited) capital in the event it was required to meet the bank’s obligations. While this system—and the unlimited liability regime which preceded it—did not prevent the occurrence of numerous bank runs and financial panics during this period, Ms Sissoko contends that it performed pretty well as a shock absorber for the financial system. Bank losses hit bank shareholders and partners first, often with the effect of bankrupting them, and depositors were able to recover their monies, albeit with notable delays. Naturally, as one might suspect, having liability in excess of direct capital invested encouraged an excess of caution among banks in the loans they underwrote.

Andrew Haldane explains:

Bank balance sheets were heavily cushioned. Equity capital often accounted for as much as a half of all liabilities, while cash and liquid securities frequently accounted for as much as 30% of banks’ assets. Banking was a low-concentration, low-leverage, high-liquidity business. A broadly-similar pattern was evident across banking systems in the United States and in Europe.

This governance and balance sheet structure was mutually compatible. Due to unlimited liability, control rights were exercised by investors whose personal wealth was literally on the line. That generated potent incentives to be prudent with depositors’ money. Nowhere was this better illustrated than in the asset and liability make-up of the balance sheet. The market, amorphously but effectively, exercised discipline.

It was given a helping hand by market-based prudential safeguards. Directors of a bank had the capacity to vet share transfers, excluding owners without sufficiently deep pockets to bear the risk. Shareholders also maintained their liability after the transfer of their shares. This put shareholders firmly on the hook, a hook they then used to hold in check managers. Managers monitored shareholders and shareholders managers. In this way, the 19th century banking model aligned risk-taking incentives.

Given the common diagnosis of the recent financial crisis as arising, at least in part, from excess risk taking by commercial and investment banks due to misaligned managerial incentives and the (ultimately correct) perception that society would step in to cover bank obligations during a panic, it is tempting to view such a regime as preferable to the one we have now.

But before we force Jamie Dimon to sell his houses and cars to stem a run on JP Morgan, it is important to understand why unlimited and even extended liability banking was replaced. According to Haldane, unlimited liability proved “rather too effective as a brake on risk-taking” and insufficient to the provision of credit in the face of increased societal demands for “capital to finance investment in infrastructure, including railways.” Society’s demand for growth investment began to outstrip the appetite of the wealthy to provide it. Subsequent solutions—first, to extend unlimited liability to a broader shareholder base, and second, to cap liability at two to three times the investor’s initial investment—merely compounded the problem, by bringing in investors without the financial resources to sustain periodic losses and exacerbating panics by calling capital from investors under duress. Banks and other financial intermediaries like investment banks consolidated as their economies grew, and the span of control problem inherent in vetting ever increasing shareholder bases became unmanageable. So, by the 1930s, our current system of large, limited liability financial institutions with dispersed and anonymous shareholder bases was largely in place.

* * *

The question I am left with is the following: given that historical precedent (and common sense) seems to indicate that restricting banking to those wealthy enough to sustain personal losses well in excess of the amounts they invest in such activity limits credit provision, why should we believe there are enough risk-loving wealthy people nowadays to support the enormous credit demands of our national and global economies? To use a more limited example, why should we believe there are enough wealthy investment bankers eager and willing to support the capital requirements of ten mini-Goldman Sachs, each with one tenth the assets of the Vampire Squid? More importantly, where are the wealthy commercial and retail bankers eager and willing to support the lending activity of 1,000 mini-JP Morgans, each with one one-thousandth the assets of the House of Dimon? Certainly one can imagine there are lots of retail depositors and wholesale creditors who would be eager to lend to such personally backstopped institutions, but why would a shareholder with potentially unlimited liability—to the extent of her entire personal and family net worth—be remotely interested in borrowing ten times her equity in order to earn 12% on her money?

Hedge funds cannot fill the gap, either: they manage other people’s money. Why would those other people—mostly institutional investors like pension funds, insurance companies, university endowments, and the like—be remotely interested in assuming unlimited liability? For one thing, it would violate their own fiduciary duty: for the most part, it’s not their money, either. It’s firefighters’, teachers’, and pensioners’ money. Do you really think those people want to take unlimited risk? As Steve Waldman says, those people want safety.

Certainly there is a good argument for aligning the payouts and incentives of persons who engage in risky activities more closely with outcomes. It is a noble and desireable objective to undo the privatization of returns and the socialization of risk that we find ourselves plagued with nowadays. But I worry that those who argue for a wholesale return to unlimited liability for the owners of financial intermediaries simply have not thought out the problem of scale inherent in the current global economy.

Plus, I thought we all agreed we don’t like being under the thumb of the very rich. Do we really want to go back to Potter’s Falls?

Related reading:
Carolyn Sissoko, In defense of banking... (Synthetic Assets, January 30, 2012)
Andrew Haldane, Control rights (and wrongs) (The Bank of England, October 24, 2011)

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