Guido Fawkes, aka Paul Staines, takes time out from his usual regime of dishing the dirt on our unlovely Political Class and goes into a more reflective tone of voice with a good piece about one of the lessons of the financial crisis: the problem that the people who run banks often have no financial liability for losses. He’s not the first person to state this, of course: Kevin Dowd, who gets regular plugs on Samizdata, has been writing about this issue for years.
The issue of whether publicly listed, limited liability banks are a problem or not is one that often puts classical free marketeers at odds. Some self-styled free market purists argue that limited liability, inasmuch as it is created by statutory law rather than an emergent phenomenon arising from private contracts, is bad. Others might argue that LL is valuable in making it possible to have large-scale investment projects. Even so, there does appear to be some case, in my view, in looking at the rules under which banks operate. With our current fiat money system, fractional reserve banking, deposit protection and the rest, it seems anomalous that bank shareholders and bondholders, in addition to the cozy protections thus described, have the additional protection of limited liability. One idea, as Dowd has argued, is to increase the total liability that any owners of banks have. So if a shareholder owns, say, £100 of stock in Fred Smith Bank Corp, then his or her liability can be double that amount, or treble that amount. This may not satisfy the purists, but it would, in part, curb some of the more foolish risk-takers.
It should be remembered that in countries such as Switzerland, its collection of genuine private banks (not listed behemoths such as UBS) are private partnerships, and family members – as at Pictet – have unlimited liability for losses. It tends to focus the mind. Exploring how bankers and owners of banks can be made to take a more prudent view on risk-taking makes more sense, in my view, than creating daft and draconian rules on bonuses and salaries for senior staff.
By the way, when Guido Fawkes writes a strong piece like this, it seems to traumatise his less intelligent commenters.
Lloyds was originally funded through personal liability, but they’ve had to back off from that as liabilities have grown.
Guido’s suggestion of Partnerships is a good one, but I wonder if the John Lewis model might be more appropriate? Simply because an employee is more likely to be on the lookout for iffy behaviours if he or she is personally at risk.
Quentin, good point on John Lewis.
The key, in my book, is not to be overly-prescriptive or imagine that there is a “perfect” model of how to own and run anything, be it a bank, football team or motor car manufacturer. (This is one of the reasons why, even though I can see the case against certain forms of statutory limited liability, I am loathe to say that LL per se is bad. It clearly came into existence for rational reasons).
Talking about limited liability misses the point.
However, my opinion is that people should be allowed to set up limited liability banks (or limited liability anything) AS LONG AS EVERYONE KNOWS WHAT THEY ARE CHOOSING TO TRADE WITH.
I dislike the modern practice of leaving off the “Ltd” (in Britain) and the “Inc” (in the United States) from the name of an enterprise.
If an enterprise is limited liability (is incorporated) is should SAY it is. Why hide it?
Still, I repate, to talk of limited liability misses the point.
The point is as follows….
What is a loan?
Is a loan a TRANSFER of money from savers (either the money lender’s own money or money of other savings entrusted to him) to borrowers?
Or is a loan a CREATION OF NEW MONEY – done by “crediting money to the account of the borrower” (or some other book keeping trick)?
The word “deposit” is clearly unhelpful (indeed misleading) here, as money that is to be loaded out is NOT “deposited” (as that implies the money is just sitting there).
If people really want to “deposit” money then they should pay the banker to look after it (after all they are basically demanding a safe deposit service – plus electronic access to their money, these things COST).
And if people want interest – then they must accept that their money is loaned out (not “deposited”) i.e. that they do not have the money any more till when and IF the borrowers pay it back.
Importance…………..
If loans are tansfers of money between savers and borrowers then an economy wide credit boom boom/bust is IMPOSSIBLE (it simply can not happen).
And if loans are CREATIONS OF NEW CREDIT MONEY then a credit money boom/bust is INEVITABLE (it will happen). Although such things as Central Banks (with their demented, Walter Bagehot of the Economist magazine corporate welfare, idea of acting a “lender of last resort”) make these credit money bubbles (the boom/bust stuff) much worse than tney otherwise would be.
The above is the position – and talking of whether a banks are limited liabilty or not just misses the position.
Isn’t the simple answer to go right back to basic capitalist principles – if the business fails it goes bust – just protect the small people who have now no choice but to put their money into a bank – and the legal protection limits for each account holder does that.
And make every bank executive personally liable for losses and bankruptcy.
Executives already have legal obligations to shareholders and to the company don’t they? What is missing from the picture these days is punishment for being crap executives.
The preference for saying nothing bad about a departing executive and paying them a large sum of money is an issue for companies themselves – why are contracts so badly written that mistakes get rewarded?(The same problem has infected the public sector executive level too.)
Gareth, I am unclear on the exact obligations of executives, etc, but remember that the owners of banks – shareholders – are not on the hook for any debts and losses. They may lose their original capital, but nothing more.
In contrast, a privately held bank, run by partners with unlimited liability, means that the owners of said bank could lose everything, even their homes, if things go wrong.
Another possibility would be to require banks to take out insurance for their activities. Thus the dull, workaday stuff with very low rates of default would carry a negligible premium.
That would cover all domestic and, indeed, most corporate lending and would not inhibit the funding M&A activity. That was, after all, covered the scope of the business of the banks before the non-bankers (like the jumped-up accountant Fred Goodwin) got their foolish hands on the levers. Remember that it was the Labour government’s catastrophic removal of regulation from the Bank of England that allowed the disasters at HBOS and RBS. They simply would not have happened if the ‘Old Lady’ had remained in charge.
The banks’ racy, risky own-account trading would be subject to regular scrutiny by the insurance market, who would assess the level of risk-control being applied internally, and charge their premia accordingly. No need to force the banks to separate into 2 distinct businesses, as long as all activities were adequately insured. The bankers would benefit from having other financial professionals looking over their shoulders.
Taking out insurance is worth looking at.
Also make directors responsible for losses such that they could lose all their earnings. The present situation is that directors could run a company such that they make profits for several years and earn large bonuses but make a sufficiently large loss in one year that the shareholder loses their capital appreciation. However , the bonuses from several years make up for a lack of bonus in one year for the director. We now have a system whereby the directors are divorced from risk but the shareholders are not.
Albert, insurance happens already, in the form of the derivatives market known as credit default swaps. Essentially, a bank “insures” its credit risks by taking out insurance on the possibility that a debtor won’t repay a loan or bond.
This market has been a mixed blessing. On the one hand, it has enabled banks to remove a lot of credit risk from their balance sheets, thereby reducing the amount of risk capital they have to keep on the side under regulatory requirements. With a listed bank, shareholder returns are maximised when risk capital is reduced to the minimum allowed under the rules, so banks have a strong incentive to “get rid” of as much of their risks as possible. But this creates a moral hazard, just as over-insurance does for other things, like fire risk (leading to arsons).
Default risk spikes during an economic downturn (unlike say, fires). As a risk, it is much more concentrated than the models for most insurance allow for. Far from spreading risk, this sort of insurance may even worsen it.
Insurance is never going to be more than one part of a range of changes that are required for banks.
If you are going to have LL banks, then the Bank’s Auditors need also to have some skin in the game. Make them as liable as the bank managers/employees owners.
As an ex banker, may I point out that insurance can never take the place of proper credit underwriting. People who call themselves bankers often still don’t realise that.
On reflection I think I was too hard on the idea (you really do not want me on a jury – I am likely to declare “guilty” almost automatically).
It is true that idea (of ending limited liability INVESTMENT banks) would not deal with the problem of boom/busts.
But it might help destroy the too-big-to-fail “arguement” – at least if these partnerships really were much smaller than existing banks.
However, we now know that as far back as 1991 Goldman Sachs (then a strict partnership) successful pushed for the last limitations on subsidies (sorry “support”) from the Federal Reserve to be removed.
So if it was not “too big to fail” it would be another “argument” – although “I used to work there – and I plan to do so again” does not sound as good (in the mouth of a Central Banker or other such) as “too big to fail”.
Anyway – I prefer the idea of partnerships and managers with real “skin in the game”.
But then I much prefer the old City of London to the post “Big Bang” one (which is not actually “less regulated” – there are just as many regulations, indeed far more, they are just different).
The old City of London was full of interesting traditions and customs (yes some of them were restrictive practices – but new ones, licensing and so on, have replaced the old guild ones anyway).
And independent Stock Brokers and Stock Jobbers (wholesalers in shares) self employed and with less conflicts of interest.
As well as real merchant banks – ran by the people who owned them (and took the loss if they failed).
I remember various old hands (at the time of the Big Bang and then Financial Services Act – and one can not really divide one from the other, when the old customs and traditions were done away with, the government was bound to step in), saying that the changes would lead to lots of people making lots of money for a few years – but then “the City would die” looks like they may have been right.
Anyway the Economist magazine hates the old City of London and loves the new one.
So that makes up my mind.
As Guido says – at foundation, one must trust one’s gut instinct.
Better custom and tradition than fake “liberalism” that turns out to be statism (leading to both chaos and tyranny) in disguise. And the disguise is now very thin indeed.
However, in this country (and so many others) conservatives (for the above is conservative) are as rare as libertarians are.
Unlimited liability is hardly a new idea for banks. As Quentin says, Lloyds used to be unlimited, and the Bank of Scotland only took on limited liability protection within the last couple of decades (without looking it up; it may be slightly more). Funnily enough, my dad reminded me just the other day that he used to delight in scratching out the “___ Bank Ltd.” that used to appear on forms. As a customer, he was proud of the fact that his bank was better than that.
When you look at the company’s fortunes since, it’s surely hard to argue that limited liability is a good idea. Spectacular growth, yes, but also spectacular failure.
The prospect of losing everything concentrates the mind wonderfully.
Johnathan @ 12.43:
Yes, I know all about CDS (and CDO and all the alphabet soup), having run a derivatives business, but that’s not the point. Employing complex derivatives amounts to self-insurance, which evades the requirement to justify the investment and quantify inherent risk to a third party who does not have a direct stake in the transactions. Self-insurance facilitates self-delusion, as in “I’m certain I’m not going to crash the car today”.
Albert, with respect, it is the point. You talk about third party insurance for bank risk: ie, credit risk. Who is going to sell that risk?
Serious question: in a free market, what insurer is going to write a policy without insisting on very tight risk limits to limit its exposure?
I’d be interested to know how it would work.
Cazenoves was the last partnership to go (it’s now JPMorgan Cazenove). Around 7 years ago; not that long. Driven to it, in part, by stupid regulation, although I forget the details.
If you set up a small limited liability company as an entrepreneur you will soon find that when you seek to borrow money from banks or suppliers that they ask you, as an individual, to personally guarantee the company’s borrowing. The creditors identify the risk of lending to a limited liability company and take action accordingly. We don’t need any fancy new corporate structure, just extend an existing business practice to banks and put the directors on the line.
Personal liability for – what? simple business losses? – will be acceptable so long as it becomes effective no earlier than six months after lawmakers take on personal liability for harm caused by their lawmaking or regulating acts.