Politics & Policy

Reshaping Bank Incentives

Bankers need better incentives — ones that limit risk, not encourage it.

Most of the financial reforms that have been proposed since the financial crisis have been misguided, because they typically involve rules that banks would have overwhelming incentives to circumvent, rendering them ineffective or counterproductive. Successful reform, by contrast, would alter banks’ incentives to make their behavior less risky. For an example of such a reform, the United States need only look to its past.

The traditional explanation of the behavior of banks is that they transform illiquid assets into liquid liabilities. They earn profits based on the spread between the rates of return on assets and liabilities. Modern banking is more complicated than this textbook model, but banks still prefer to maximize the spread between rates of return. One way for banks to increase this spread is to reduce the interest paid on liabilities, such as deposits. Competition between banks, however, limits this option.

The alternative for banks is to seek a higher rate of return on the asset side of the balance sheet. Higher rates of return, though, often entail higher risk. Recent attempts at financial reform seek to limit the risk banks can take by instituting new rules. Proponents of higher capital requirements, for example, justify such rules on the grounds that they provide protection from large losses on the asset side of the balance sheet. The “Volcker rule,” by restricting the trading a bank may do on its own account, is also supposed to prevent banks from making investments that do not benefit customers.

These attempts at reform raise some obvious questions: Why aren’t banks sufficiently prudent on their own? If it is in the interest of the bank to maintain higher capital requirements, why don’t they do so? Saying that banks are after a higher yield is no answer; the question is why banks do not accurately assess the tradeoff between risk and the rate of return.

They don’t do so because they do not bear all the risk. Banks, like other corporations, have limited liability, which means that shareholders are liable only for the amount of their investment — if a bank makes bad investments and becomes insolvent, the shareholder loses the value of his or her investment. However, the liability holders of the bank (i.e., the depositors) also lose their deposits, which, under limited liability, has no significance to shareholders. Deposit insurance protects the depositors against losses up to a certain amount but does not alter the incentives of the bank.

The banking system in the U.S. hasn’t always been like this. Between the Civil War and the Great Depression, banks did not have limited liability. Instead, they had double liability. When a bank became insolvent, shareholders lost their initial investment (just as they do under limited liability today). But in addition, a receiver would assess the value of the asset holdings of the bank to determine the par value of the outstanding shares. Shareholders had to pay an amount that could be as high as the current value of their shares in compensation to depositors and creditors.

Shareholders and bank managers (who were often shareholders themselves) thus had a stronger incentive than they do today to assess the risk of investments accurately, because they were risking not just their initial investment but the total value of the banks’ assets. Shareholders also had an incentive to better monitor bank managers and the bank balance sheet.

Modern banking reform takes a different approach, attempting to identify particular actions or functions of banks that legislators and regulators deem to be harmful to bank solvency and crafting rules to limit this behavior. This is a fool’s errand because it doesn’t alter the incentives of banks in the future — other than giving them an incentive to circumvent new rules. Double liability gives the bank itself the right incentives to limit risk. There is, for example, no need for a Volcker rule under such a system, as the risks of proprietary trading would fall entirely on bank shareholders and not depositors, taxpayers, or the banking industry generally.

Critics of double liability have argued that it might be hard to collect the assessments made by receivers from shareholders. Some critics have also pointed to the large number of bank failures during the double-liability era. But the rule did work: The average annual loss to depositors was less than 0.05 percent of deposits. Many banks chose voluntary liquidation in the event of the threat of insolvency. When banks went insolvent, though, scholars have estimated that more than half of the amount of bank assessments was actually recovered. The overall record is one of remarkable success.

If policymakers want to make banks act in less risky ways, they should give them a direct incentive to do so. That’s what double liability does.

— Joshua R. Hendrickson is an assistant professor of economics at the University of Mississippi.


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