Equity (Page 2)

This is the third part of a three-part series. 

Financial system default crises can be rendered less frequent, and future bailouts of the financial system can be obviated, by private conversion of limited-liability corporate-form banks into non-corporate-form proportional-liability financial firms. 

Such firms would be less prone to default than banks are, and would not need government insurance to protect their depositors – even if they keep the same employees, payrolls, physical plant and equipment, deposits, depositors, and outstanding loan portfolios as the banks from which they are converted.

Private conversion of banks to proportional-liability financial firms is impeded not only by its conceptual novelty – no one seems to have done it or publicly suggested it until now – but also by governmental obstacles that reduce its profitability or administrative feasibility. 

Government insurance of bank deposits effectively eliminates the greatest profit incentive to convert a bank to a proportional-liability financial firm, namely that this conversion would lessen the default risk borne by its creditors including its uninsured depositors and hence the compensation that they demand. 

In addition, central, state and local governments, having no experience of non-corporate proportional liability firms, make no provision for them in diverse kinds of business regulation and taxation. One example is the issuance of business charters, the standard term for which, “articles of incorporation,” reflects the ubiquity of the corporate form.      

Partly due to the intrinsic advantages of converting banks into proportional-liability financial firms and partly due to political considerations described near the end of the second part of this three-part essay, the House Republican Caucus might best respond to any Biden administration request for a banking-system bailout during this session of Congress by conditioning its support for the requested bailout on prior enactment of legislation mandating imminent termination of governmental impediments to private conversions of banks into proportional-liability financial firms. Such legislation might aptly:

(1) mandate termination of FDIC bank deposit insurance within two years;

(2) repeal Title II of the Dodd-Frank Act, effective within two years;  

(3) and prohibit (under the interstate commerce clause of the US Constitution) any federal, state or local government discrimination against proportional-liability financial firms relative to banks in any aspect of taxation or business regulation, including the issuance of business charters, effective within six months. 

Higher Federal taxes, after two years, on banks not converted to proportional-liability financial firms, might also be warranted for banks that are not functionally specialized and structurally atypical but ought not to be necessary to induce private conversion of nearly all banks into proportional-liability financial firms. 

The rest of this essay, except for a brief envoi, tells how and why proportional-liability financial firms would be better than banks both singly and collectively, i.e., why private conversions of banks into proportional-liability financial firms would be profitable, absent governmental impediments, and why governments should facilitate and encourage such conversions.   

Problems of the corporate business form

The distinguishing feature of the corporate business form is limited liability – the exemption of the owners of a firm’s equity from any personal liability for the firm’s liabilities. 

Limited liability causes the interests of a corporation’s equity owners to be increasingly at odds with the interests of its creditors as the value of a solvent corporation’s assets diminishes relative to the value of its liabilities. 

As a solvent corporation (one with assets worth more than its liabilities) approaches insolvency (the point at which its assets are worth no more than its liabilities), its equity owners increasingly want it to take risks, even risks with negative expected values. 

For the equity owners of a nearly insolvent corporation, whose equity is already worth next to nothing and cannot have a negative value due to limited liability, there is negligible scope for loss but great scope for gain by taking large risks, even if they are bad bets.

All the downside risk of a nearly insolvent corporation is born by its creditors, who increasingly prefer that a solvent corporation not take risks as it approaches insolvency. However, a corporation’s creditors,i.e., the owners of its liabilities, have no voting rights in the corporation’s control. 

All voting rights in a corporation’s control typically are allocated to the owners of its equity, each share of equity being assigned one vote. Consequently, corporations, insofar as their management is informed by the interests of the holders of rights to vote in choosing their directors, tend to become more risk-loving and less profit-maximizing as they approach insolvency.

If a corporation’s equity trades in liquid markets, then individual owners of relatively small amounts of either its equity or its debt may be able to rely on exit (selling out) rather than voice (voting rights in corporate control) to protect their interests so management tends to be relatively independent of equity owners, save for those who own more equity than can be sold without lowering the market price of the corporation’s equity. 

However, if there is no liquid market for a corporation’s equity or if the price at which a corporation’s equity trades is highly volatile, as it may be if the corporation is either highly leveraged financially or engages in business that is unusually risky, then exit substitutes less well for voice, and even owners of relatively small amounts of equity may be concerned to make the corporation’s management reflect the interests of its equity-owners.  

If a corporation’s debt trades in liquid markets at prices that are not highly volatile, then individual owners of small amounts of its debt may be able to rely on exit (selling out) to protect their interests. Otherwise, a corporation’s financial creditors may try to protect their interests by “protective covenants” that constrain management but entail non-negligible monitoring and enforcement costs.   

How the corporate form’s problems afflict banks

With no exceptions known to this writer, US banks are corporations.  Their equity owners are totally exempt from personal liability for banks’ financial liabilities and typically are the only holders of voting rights in banks’ control. 

Financial firms that are not corporations are not called banks. For example, credit unions resemble banks in their main activities – taking deposits and making loans – but differ from banks in not being corporations. A credit union is depositor-owned.  It has no equity distinct from its deposits. Voting rights in its control are typically held solely by depositors in proportion to the value of their deposits.

The structural and behavioral characteristics of corporations described in this essay’s previous section also apply to banks, with variations described in the rest of this section.

A bank’s assets are chiefly the outstanding loans that it has made or loans made by other banks that it has bought, often in risk-diversifying bundles like mortgage-backed securities. The liabilities of a bank are chiefly its deposits, although many banks also issue debt securities.

The creditors of a bank are chiefly its depositors. The relatively few functionally specialized and structurally atypical banks for which not all of this is true fall outside the scope of this part of this essay.

If some of a bank’s deposits are government-insured, then their owners, unlike the bank’s other creditors, do not increasingly prefer that a solvent bank not take large risks as it approaches insolvency. Bank deposits are not readily tradable, but they can be withdrawn, often on demand or on short notice. Owners of uninsured bank deposits typically rely chiefly on exit by withdrawal to protect their interests.

Exit tends to substitute for voice less well for owners of a bank’s equity than for owners of the equity of non-financial corporations, even if there is a liquid market for the bank’s equity because the price of a bank’s equity tends to be more volatile than the price of the equity of a non-financial corporation. 

Bank equity prices tend to be more volatile than the equity prices of non-financial corporations for two reasons. First, banks typically are more leveraged – i.e., they have more liabilities relative to equity – than non-financial corporations. 

Their assets are created chiefly by lending money supplied by their depositors; their equity serves chiefly as a buffer against losses and tends to be little larger than is required by government regulators. Second, many factors affecting the value of banks’ assets, like market interest rates, are social constructs that can change rapidly.

For both these reasons, banking is an extraordinarily risky business. The impressively stable architecture long favored by banks, featuring multiple thick columns that appear able to withstand earthquakes, was deliberately crafted to belie this reality and inspire greater trust in banks than they in fact warrant.

Because exit tends to substitute for voice less well for owners of a bank’s equity than for owners of the equity of non-financial corporations, the management of a bank tends to be more responsive to the interests of its equity owners than is the management of a non-financial corporation.

Consequently, limited liability’s tendency to make corporations risk-loving and not profit-maximizing, insofar as corporate management is informed by the interests of its equity owners, to an extent that increases as a solvent corporation approaches insolvency, tends to afflict banks more strongly than non-financial corporations.

The tendency of limited liability to make solvent banks behave in increasingly default-prone ways as they approach insolvency, to an even greater extent than do non-financial corporations, is at best constrained, not eliminated, by greater government risk-control regulation of banks than of non-financial corporations.

In addition, the susceptibility of banks to default has greater negative externalities for the economy generally than does comparable susceptibility to default in non-financial corporations. Bank failures contract the money supply more than do failures of non-financial corporations, and therefore are uniquely likely to precipitate general economic contraction, as in 2007-08, or to aggravate an already severe economic contraction, as in 1932-33. 

That is why the US government, through the FDIC, has since 1933 been the insurer of first resort for many bank deposits but has never been the insurer of first resort for any comparably large set of liabilities of non-financial corporations.

How to solve the problem: Convert banks to proportional-liability financial firms

A bank’s propensity to take unwarranted risks, which increases as a solvent bank approaches insolvency and thereby makes the bank prone to default, could be eliminated by restructuring the bank as a financial firm with a business form that is neither a joint stock company nor a corporation but is rather between the two.

In a joint stock company, anyone owning any of its equity is personally liable for all of its debt.  Until well into the 19^th century, this aspect of the then-dominant business form helped keep debtors’ prisons full. It also gave us “Ivanhoe”, which Sir Walter Scott wrote in two weeks in order to earn funds he needed to stay out of debtors’ prison after a joint stock company, some equity of which he owned, went bankrupt. 

Beyond the problems entailed by impoverishing equity owners, joint stock companies suffered from the problem that the value of their debt depended in part on the value of the ever-changing personal wealth of each of an ever-changing set of equity owners, and hence was very hard to appraise.

In a corporation, by contrast, equity ownership entails no personal liability for any of the firm’s debt. Its default risk is born entirely by its creditors, who in the case of a bank are chiefly its depositors.

In Western countries, including the US and Britain, the corporate form was legalized and then quickly superseded the joint-stock company form during the 19^th century.  However, in that transition, an intermediate business form that rather obviously suggests itself was seldom if ever tried.

In that intermediate form, arguably best called the “proportional-liability” form, anyone who owns a specific proportion of its equity would be personally liable for the same proportion of its liabilities, or at least of its financial liabilities including debt securities that it has issued and, in the case of financial firms, deposits that it has accepted. 

(For the purpose of rendering, equity owners less risk-loving, they need not be personally liable for the firm’s unforeseeable liabilities). 

This proportional liability form would expose equity owners to slightly more personal liability than does the corporate form, but to far less personal liability than did the joint-stock company form. It could not impoverish any equity owner who did not foolishly overconcentrate his wealth in the equity of a single firm.

Moreover, a proportional-liability firm could include, in its charter or by-laws, limits on the amount of the firm’s equity that any individual could own, crafted to prevent overconcentration of personal wealth in its equity and in other assets with prices that co-vary strongly with the price of its equity. 

Governmental regulators of financial firms might help in the enforcement of those rules, or promulgate and enforce such rules themselves. Securities brokerages have routinely enforced such rules on their clients for many decades. 

Absent overconcentration of personal wealth in the firm’s equity and strongly price-covariant assets, the value of the firm’s debt would not vary significantly with changes either in its equity ownership or in the personal wealth of individual equity owners. 

Such a proportional-liability firm’s default risk would be born wholly by its equity owners, although no equity owner would bear too much of it. Consequently, the owners of a proportional liability firm’s equity, unlike the owners of a corporation’s equity, would neither want the firm to take risks with negative expected values nor increasingly want it to do so as it approaches insolvency.

Although the proportionate-liability business form might have advantages over the corporate form for a broad range of firms, those advantages, both for the firm and for society generally, seem greatest for financial firms – the firms that we call “banks” when they are structured as corporations – because the high business risk and high leverage of banks tends to make exit substitute for voice less well for their voting-right-monopolizing equity owners than for the voting-right-monopolizing equity owners of non-financial corporations, which tends to make the management of banks more responsive to the flawed incentives of their equity owners than are the managements of non-financial corporations.

Allocating voting rights in proportional-liability financial firms to obviate deposit insurance

A proportional-liability firm could, by provisions of its charter or by-laws, divide voting rights in its control between the owners of its equity and the owners of its financial liabilities (its creditors or debtholders) in a ratio determined by the relative values of the firm’s assets and its liabilities. 

So long as the market value of the firm’s assets exceeds the face value of its liabilities, equity owners would hold most of the voting rights in the firm’s control.  If the market value of the firm’s assets fell below the face value of its liabilities, most of the voting rights in its control would become held by it is creditors – chiefly by its depositors in the case of a financial firm. 

The assets of a proportionate-liability firm, like the assets of a corporation, would not be traded, hence would not have a directly observable market value. However, the value of the tradable equity of a proportional-liability firm would be the market value of its assets minus the present face value of its liabilities, per the basic accounting equation, E = A – L. 

That equation is true for a proportional-liability firm and implies that A = E + L. E and L are directly observable, E being the price of traded equity and L being the sum of contractually specified future payments, each discounted at the risk-free interest rate for the term of its maturity. 

Consequently, A, the market value of the firm’s assets, is readily ascertainable.  This enables voting rights to be divided between the owners of the firm’s equity and the owners of its financial liabilities in proportion to the current relative values of A and L.

Among the advantages of allocating any proportional-liability firm’s voting rights in this way is that it obviates recourse to slow and costly bankruptcy courts as a means of transferring control of a firm from its equity owners to its creditors when the firm becomes insolvent – while also allowing the equity owners hope of regaining control of the firm if the owners of its financial liabilities choose not to liquidate it and it returns to solvency while under their control.

Among the advantages of allocating a proportional-liability financial firm’s voting rights in this way is that it obviates government insurance of depositors. As soon as the value of a proportional-liability financial firm’s assets (chiefly loans) becomes insufficient to cover the face value of its liabilities (chiefly deposits), majority control of the firm passes from its equity holders to its creditors (chiefly its depositors). 

Consequently, either federal or state law or regulation might usefully require any proportional-liability financial firm to allocate its voting rights in this way, even though such voting right allocation has firm-specific efficiencies that could impel any proportional-liability firm to implement it spontaneously.

The problem with banks that has large negative external consequences and requires government insurance of bank deposits is that the incentives of the equity owners who exclusively own voting rights in a bank’s control conflict systematically with the incentives of depositors, and conflict with them more strongly as the bank’s risk of default (insolvency) grows.

That problem seems easily solved by replacing banks with proportional-liability financial firms. So kiss goodbye to the FDIC and to comparably unneeded deposit-insurance bureaucracies in other countries.    

The benefits of proportional liability cannot be captured by a corporation 

The market value of a corporation’s assets cannot readily be inferred from the price of its traded equity and the present face value of its liabilities, as the value of a proportional liability firm’s assets can.  Consequently, a corporation cannot divide its voting rights between its equity owners and its creditors in proportion to the ratio of the market value of its assets to the present face value of its liabilities.

The same inability, readily to infer the market value of a corporation’s assets, precludes creating an efficient market for corporate default risk insurance that might obviate government insurance of bank deposits.

The basic accounting equation, E = A – L, is not true for a corporation.  For a corporation, E = A – L + P,  E being the market value of its equity, A being the putative value of its assets, L being the present face value of its liabilities, and P being the putative value of limited liability, which can in theory be priced as a put option (hence “P”) owned by equity owners that enables them to sell (A – L) to the firms’ creditors for nothing when A – L is worth less than nothing. 

Because P, the value of that put, can never be less than A – L, E can never be worth less than zero. That is, due to limited liability, corporate equity – unlike the equity of a proportional-liability firm – can never have a negative market value.

Of the four variables in the corporate-form equation, E = A – L + P, only E and L are observable, E being tradable and L being contractually specified.  Consequently, although the value of E + L can be observed and must equal the sum of A + P, neither the value of A nor the value of P can readily be ascertained. 

There is no close-form solution to the problem of pricing either A or P by what is generally deemed the only rigorous and reliable method of pricing market-traded financial securities, namely the Black-Scholes-Merton option-pricing model developed in the 1970s or some variant of it. 

The best way to try to estimate the value of either A or P that is consistent with Black-Scholes-Merton pricing apparently involves simultaneous iterative estimation of both A and P based on past and current prices of both.  However, even this may fail to yield unique values for A and P.

Presumably for this reason, the prevailing method of pricing credit default swaps (CDS) does not apply the Black-Scholes-Merton option pricing model and is crude by comparison. Googling for “CDS mispricing” yields no smaller number of recent academic articles in the titles or bodies of which that term appears. 

The impossibility of pricing corporate default risk rigorously may largely explain why there is still no liquid public market for credit default swaps, so that no reporting on the CDS markets is required or published by any regulatory entity.

It seems impossible to make a well-priced insurance market for corporate default risk, i.e., a market in which corporate equity owners could sell P and corporate creditors could buy P, which would enable them to synthesize the proportional-liability form and capture some of its advantages while the firm remains legally a corporation. 

It seems impossible either to allocate corporate default risk efficiently or to allocate voting rights in corporate control optimally. The corporate business form apparently precludes both. To capture these benefits of the proportional-liability form, a corporation must be formally converted into a proportional-liability firm.

Envoi: the prospective loss of our heritage of bank-hatred

Proportional-liability financial firms would be no less able and willing than banks have been to foreclose on grandma’s farm, to evict widows and orphans from their homes, and to deny working people loans to pay for medical operations needed to save the lives of their children. 

However, they, unlike banks, would neither often cause uninsured depositors to lose their life savings, nor, by defaulting en masse, recurrently precipitate economic contractions that deprive millions of their livelihoods. Proportional-liability financial firms might be merely loathed and despised rather than viscerally hated, as banks have been by most people ever since usury became tolerated and institutionalized.

Saddeningly, we will suffer a vast and irretrievable cultural loss if our financial institutions cease to inspire hatred in enduring them, wit in mocking them and bravery in fighting them. 

Without banks, how will our grandchildren be able to appreciate Dickens’ “Little Dorrit” or Wolfe’s “Bonfire of the Vanities?” How will they be able to savor Barry’s doubling in Peter Pan of Captain Hook, a child-murdering pirate, and George Darling, a childhood-killing banker? 

How will they grasp the symbol-inversion in Mary Poppins’ use of a black umbrella, a badge of office borne by Victorian London bankers even under clear skies, to fly children away from the clutches of their joyless banker-father? 

Without banks, how will our posterity be able to empathize with the Americans of the Great Depression, whose most-admired heroes, during and after the nationwide bank failures of 1932-33, were bank robbers like John Dillinger, Pretty Boy Floyd, Bonnie Parker and Clyde Barrow?

Without banks, how will future generations feel why the Paris Commune and the Bolshevik Revolution were so appealing to so many? How will they feel what has been conveyed by Jew-hatred’s portrayal of Jews as bankers or would-be bankers, which, after the German bank failures of 1931, contributed mightily to the rise of Hitler and the Holocaust?

If banks and their chronic default crises end, even without ending loan denials, foreclosures and evictions, then much of our past will be gone with the wind, as much of America’s past was when slavery ended, even though few freed slaves got their promised forty acres and a mule. 

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