Regulation

James Grant: Stick Bankers With the Bill

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James Grant, macho man.

Grant's Interest Rate Observer editor James Grant gives an old-timey suggestion for making sure bankers behave responsibly: Make them personally liable for the losses that, under the Bush/Obama structure, are being taken by you and me:

The substitution of collective responsibility for individual responsibility is the fatal story line of modern American finance. Bank shareholders used to bear the cost of failure, even as they enjoyed the fruits of success. If the bank in which shareholders invested went broke, a court-appointed receiver dunned them for money with which to compensate the depositors, among other creditors. This system was in place for 75 years, until the Federal Deposit Insurance Corp. pushed it aside in the early 1930s. One can imagine just how welcome was a receiver's demand for a check from a shareholder who by then ardently wished that he or she had never heard of the bank in which it was his or her misfortune to invest.

Nevertheless, conclude a pair of academics who gave the "double liability system" serious study (Jonathan R. Macey, now of Yale Law School and its School of Management, and Geoffrey P. Miller, now of the New York University School of Law), the system worked reasonably well. "The sums recovered from shareholders under the double-liability system," they wrote in a 1992 Wake Forest Law Review essay, "significantly benefited depositors and other bank creditors, and undoubtedly did much to enhance public confidence in the banking system despite the fact that almost all bank deposits were uninsured."

Like one of those notorious exploding collateralized debt obligations, the American financial system is built as if to break down. The combination of socialized risk and privatized profit all but guarantees it. And when the inevitable happens? Congress and the regulators dream up yet more ways to try to outsmart the people who have made it their business in life not to be outsmarted. And so it is again in today's debate over financial reform. From the administration and from both sides of the congressional aisle come proposals to micromanage the business of lending, borrowing and market-making: new accounting rules (foolproof this time, they say), higher capital standards, more onerous taxes. If piling on new federal rules was the answer, we'd long ago have been in the promised land.

I'm not sure how this would prevent investment banks from organizing themselves as corporations rather than partnerships and avoiding this liability, though I guess you could write the regulations in a way that blocks that option. More on the proposal and the study Grant cites.

Axel Leijonhufvud, Professor of Monetary Theory and Policy at the University of Trento, Italy, gives another explanation of how the double liability system would work:

To do this, one would first have to create a special type of equity for bank employees. These E-shares would be subject to double liability. If the bank were to fail, the holders would be liable for a sum equal to the value of their shares on the date that they were originally received. E-shares would be non-marketable but exchangeable one-for-one for ordinary shares at market value five years after the owner has left the employ of the financial institution in question.

The second element of such a liability scheme would regulate the extent to which executive compensation would have to be in the form of E-shares. Lower-level employees who are not among the decision makers of the bank should naturally not be part of the program. So, the first $150,000 – or wherever the poverty line is supposed to go in banking nowadays – would be exempt. Compensation would be entirely in ordinary salary. Starting at some such level part of compensation would have to be in E-shares with the proportion rising to, say, 80% at the CEO and CFO level.

Here's how they were discussing double liability way back in Old '37. Grant says bringing back that system would restore the "fear of God" that Chemical Bank's president referred to back when bankers were known for the their staid sense of responsibility. We could use a little more of that attitude. Say what you will about Milton Drysdale, but he was determined that the Clampetts never lose a penny of their deposit, even if he had to impersonate an Indian chief or dress up like Kaiser Wilhelm to make sure of it:

NEXT: First Annual Everybody Draw Mohammad Day

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  1. Right.

    Say no to Corporate Welfare Bums.

  2. I’m not sure how this would prevent investment banks from organizing themselves as corporations rather than partnerships

    This does does not get nearly enough coverage. The conversion of investment banks from partnerships to corporations was a bad, bad thing.

    1. Simple way to fix this, strip corporations stockowners of their limited liability protection and there would be no reason to become a corporation since it would not enjoy government created special privileges.

  3. If we’d let everyone fail who, well, failed, a lot of this might’ve happened. Even corporations don’t completely shield professionals with fiduciary duties from liability. Even with all of the bailouts and government protection, fraud suits and other fun and games are popping up.

  4. Let’s hope Killinger spends his last nickel two dollars defending himself against shareholder suits.

    1. Killinger!

  5. Grant’s Interest Rate Observer editor James Grant gives an old-timey suggestion for making sure bankers behave responsibly: Make them personally liable for the losses that, under the Bush/Obama structure, are being taken by you and me:

    Wouldn’t it be more direct to just let them fail in the first place? This seems like a roundabout way of making people eat their own losses.
    It’s not like the CEO and upper management types don’t own any bank stocks.

    1. “Wouldn’t it be more direct to just let them fail in the first place? This seems like a roundabout way of making people eat their own losses.
      It’s not like the CEO and upper management types don’t own any bank stocks.”

      I’m all for making sure those responsible suffer the losses, and I’d say this (^) is the best way.
      Seems corporate limits on liability are the best way to collect capital for new ventures, and any attempt to finesse them through some ‘double liability’ scheme is open to more government social-engineering than simply letting them fail.

      1. Seems corporate limits on liability are the best way to collect capital for new ventures, and any attempt to finesse them through some ‘double liability’ scheme is open to more government social-engineering than simply letting them fail.

        Those liability limits become extremely problematic when a bank self-detonates and leaves a smoking hole where its depositors thought their money was supposed to be. Allowing a bank’s officers to take risks with other people’s money without any of their own skin in the game sets up a system of extremely perverse incentive to take large risks, pocket a share of the profits in the event of success, and stick others with the bill for any losses.

        Up until 2008 the theory was that leaving those incentives in place would be fine because the banks were all being watched by super-smart regulators, and we saw how that worked out. There is really no alternative to making sure that the people running a bank are personally invested in its continued success and viability. A lot of the Depression-era devices like the FDIC were an attempt to get around that and all they did was help add to the moral hazard pile which finally melted down in 2008.

        Double liability was a major feature of American banking from the Civil War through WWI, which was hardly a period of vigorous social engineering by government.

  6. Personal responsibility? In today’s political climate? Good luck.

  7. I absolutely love to see the banks get the short end of the stick! Nothing like it!

    Lou
    http://www.anon-vpn.se.tc

  8. Double or even unlimited liability was ere the rule during the era of free banking in Scotland and the US. We should bring it back.

  9. socialized risk and privatized profit

    Ive been using this phrase as an idiot filter for the last few years.

    I stopped reading at that point. For that reason.

    Not saying the phrase isnt accurate, just that it is used by idiots only.

    1. Or is it more idiotic to filter something because someone says something that is true

      1. Nope. I ran a correlation once…there was a 100% relation between using that phrase and being an idiot.

        Now to be fair, a vast majority of the people using the phrase objected to the latter part instead of the former. But even the rest were idiots.

        1. “Vast majority” is a litmus test for idiocy.

          We have a word for “vast majority” — MOST.

          Another litmus test for idiocy — “of the people”.

          Try, “Most who say …”

          Yet another sign of idiocy, beginning a sentence with the conjunction ‘but’.

          Instead, write, “Most who say the phrase complained about the latter part over the former; but the rest were idiots.”

    2. A better idiot filter is to simply watch for anyone calling James Grant an idiot.

  10. strip corporations stockowners of their limited liability protection and there would be no reason to become a corporation since it would not enjoy government created special privileges.

    The problem is not the shareholders, it’s the management, who make large, high risk bets with money which is not their own. If the managers stand to lose their shirts when they blow the company up, they are a little less eager to take on those bets.

    Felix Salmon has a pretty good piece in the WaPo, relating specifically to the conversion of Goldman from partnership to corporation, by (surprise) former TreasSec Henry Paulson.

  11. In his free time, Professor Leijonhufvud is actually an up-and-coming European volcano.

  12. The Sharon Tait montage was really beautiful. I remember her natural beauty now. The Stevie Nicks vocal arrangement was superb. The horror of those violent lunatics invading her home and the murderous rampage of the Manson Clan is hurtful to my soul. That is what can come from drug use and the acceptance of Satan. May God rest and raise her beautiful soul.

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