Limited liability is a ‘faultline’ in more than just banking governance

John Plender writes a piece in today’s FT on a recent speech by Andrew Haldane, executive director for financial stability of the Bank of England.

He describes how “bank equity is treated as a call option on bank assets by investors, because the upside payoffs are unlimited while downside risks are capped by limited liability. The result is a governance faultline that lies at the heart of the imbalance between the privatised returns and socialised risks that have characterised the financial debacle.”

He continues, “Bankers [in their turn] are incentivised to seek bigger and riskier bets because volatility increases upside return without affecting downside risk. They are similarly incentivised to increase balance sheet leverage since this further magnifies the payoff.” [my emphasis]

What he is saying is that the decision to grant limited liability brings us inexorably to sub-prime mortgages, the financial crisis, the eurozone crisis, global recession, and even to the Occupy Wall Street protests.

Similarly in the business world, it is a short step from limited corporate liability to BP/Halliburton’s Deepwater Horizon disaster, to Union Carbide in Bhopal, to lax oversight in the Japan nuclear disaster, and even to climate change. Causation may not be as directly coupled in these cases, but without limited liability managers’ minds would certainly have been focused more clearly.

We sometimes forget that limited liability was not always the norm. It was widely introduced in the eighteenth and nineteenth centuries when the world was a big and empty place, and society wanted to limit investors’ risks so that they would step up to help grow foreign trade, industry, and standards of living.

Now we live in a different world. The priority is less on growth and more on stabilisation. Financial markets are overly-volatile, there is global over-capacity in manufacturing, and foreign trade is so firmly established that ‘developing economies’ are now the engines of growth. Rather than helping to achieve the results society wants, limited legal liability now actually brings results that harm us.

Under these conditions, doesn’t it make sense to look at revoking limited liability, in the same way that it once made sense to think about introducing it?

The insurance industry is mature, large, and well-used to sizing and pricing all kinds of risks. Revoking limited liability would provide business owners and managers not only with an incentive to balance shareholders’ returns against possible ‘externalities’, but also a market-based solution for achieving that.

Unless and until we do this, limited liability will remain, as Andrew Haldane has begun to point out, a systemic faultline — not just in banking governance (and hence in any solution we might propose to the eurozone/banking crisis) but also in the economy and our society as a whole.

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