Banking Capital Requirements Not Enough : Share Holders Share Risks

This is a little in the weeds for most of us but sill interesting to understand how a bank handles risk and why some fail due to their inability to control risk. This answers some of the questions as to why some bank lending requirements are very restrictive to customers of dubious need for a loan.

This article is well worth a read in that good banks are the very foundation of a vibrant community and when a dysfunctional bank fails the community suffers as well. Reform in the business of banking has been front and center especially after the banking disaster that nearly destroyed our entire economy a few years ago.

As we all should know, the government had a huge hand in the failure, actually the very reason why the failures occurred, and now with the Dodd/Frank banking bill, the situation isn't improved but for many reasons, just as bad or worse the before.

Spreading the risk among the share holders, as this article points out, seems to be a step in the right direction. If you have some skin in the game, one has a tendency to be more careful and responsible. When you put your own money at risk rather some ne else's, that seems to change the dynamics of the game.  Who knew?

An Alternative to Higher Capital Requirements
Source: Joshua R. Hendrickson, "Contingent Liability, Capital Requirements and Financial Reform," Cato Institute, Winter 2014.
March 10, 2014

Banks become insolvent when their liabilities (as measured by deposits) exceed the value of their assets. When losses exceed the value of a bank's capital, the bank becomes insolvent, so banks with more capital are viewed as less risky than banks that finance their activity with too much debt. As such, many have called for the imposition of higher capital requirements on banks, says Joshua Hendrickson, an associate professor of economics at the University of Mississippi.

However, such an argument is flawed because it does not address the underlying causes that lead to insolvency in the first place. While requiring larger levels of capital would reduce the risk of insolvency, there are other ways to deal with the problem -- specifically, incentivizing banks to make more prudent decisions and take on less risk in the first place.

• Currently, American banks are limited liability corporations, meaning that shareholders face no risk of loss beyond their own investment.
• However, this was not always so. The National Banking Act of 1864 established double liability for shareholders of national chartered banks, making them responsible not just for their own investment losses but for the losses of the bank as a whole. Thirty-five states also imposed double liability on shareholders. The double liability system ended in 1933.
• The point of these laws was to keep the incentives of managers and directors and shareholders in line with the interests of depositors. Without double liability, banks can transfer losses to depositors without risk that those losses will impact them.
• How successful were these laws? One analysis found that depositor losses as a percentage of total liabilities were only 0.044 percent from 1865 to 1934. And even during a time of heavy bank failure -- from 1930 to 1934 -- those losses were only 0.072 percent of total liabilities.
• The banks also engaged in less risk taking, and states with contingent liability laws had lower rates of failure, higher capital ratios and higher liquidity ratios than the state without the laws.

The problem with contingent liability, for critics, is that it would hurt investment by limiting the marketability of shares. Many argue that unlimited liability would lead wealthy shareholders to sell during threats of bankruptcy to those who had little wealth to be pursued in the event of insolvency -- creating a de facto limited liability regime. Hendrickson dismisses this concern as unfounded, contending that concerns about marketability and share transferability are largely theoretical.

A bank that has to comply with higher capital requirements might, as a result, face less risk of insolvency, but the requirements do nothing to alter the bank's incentives to take on risk. By imposing contingent liability that subjects shareholders to liability for depositors' losses, shareholders would be more attached to the costs of insolvency and the risks that can lead to it.