James Grant: Stick Bankers With the Bill


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: