Bankers’ Liability and Risk Taking

Some economists did a study regarding changes in liability and risk taking by bankers, and looking at a historical changes in regulations to determined that when bankers are not allowed to hide behind corporate bankruptcy, they are less likely to take stupid risks:

In order to protect the financial system from excessive risk-taking, many argue that bank managers need to have more personal liability. However, whether the liability of bank managers has a significant effect on risk-taking is an open question. This column studies a unique historical episode in which similar bankers, operating in similar institutional and economic environments, faced different degrees of personal liability, depending on the timing of their marriages, and finds that limited liability induced bankers to take more risks.

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This raises the question of whether bank managers’ incentives are set appropriately to protect the financial system from excessive risk-taking. Managers can cash in on a bank’s profits when things are going well, but they shoulder minimal losses if the bank fails (Bhagat and Bolton 2014). This limited liability may encourage them to take undue risks with depositors’ money. There is a growing chorus of commentators arguing that the financial system will only be safe if bank managers have more personal liability (e.g. Kay 2015, Cohan 2017).

Whether the liability of bank managers has a significant effect on risk-taking is an open question. Bank managers care about their reputations and future careers; so, they might try to avoid the failure of their bank at any cost. Other stakeholders, such as uninsured creditors, may be able to force banks to reduce risk-taking (Calomiris and Kahn 1991, Diamond and Rajan 2000). To make their case, proponents of increased personal liability often point to what happened to investment banks over the last few decades. Before the 1980s, investment banks operated as partnerships with unlimited liability. During the 1980s, they went public. Anecdotally, this seems to have gone hand in hand with increased risk taking. However, this coincided with a period of general financial deregulation. So, how do we know what caused investment banks to take more risk?

In recent work (Koudijs et al. 2018), we study a unique historical episode in which similar bankers, operating in similar institutional and economic environments, faced different degrees of personal liability, depending on the timing of their marriages. Our findings suggest that limited liability really matters for bank risk-taking.

What they looked at was the effects of the passage of Married Women’s Property Acts (MWPAs) in the early 1800s on banker risk taking.

MPWAs changed property law to allow women to hold their own assets, and when women held their own assets, a bank president wife's assets were not subject to liability from a bank failure, while his assets were subject to recovery from account holders.

Because these were state laws, and the laws were passed at different times, we can compare and contrast the behaviors:

We collect data on the activities of New England national banks during the 1860s and 1870s, as well as information about bank presidents’ marriage histories. This allows us to classify bankers as ‘protected’ (i.e. married after a MWPA was passed in his state) or ‘unprotected’. We then compare the risk-taking behaviour of protected and unprotected bankers.

A key measure of bank risk-taking is leverage. We define this as loans and securities - inherently risky investments made by the bank – relative to capital invested in the bank by shareholders. A bank that extends more loans relative to capital is more likely to suffer losses that render it unable to pay back depositors.

As it turns out, bankers with less personal liability managed more highly levered banks. More precisely, a bank’s ratio of loans and securities to capital was 7 to 10 percentage points higher if its president was married after a MWPA. This does not reflect underlying differences between protected and unprotected bankers (such as age), or the characteristics of counties or towns that they live in. It also does not reflect characteristics of the banks themselves – when an individual bank switches from having an unprotected president to a protected president (through turnover, or a change in the president’s marital status), leverage increases in that bank.

Not surprisingly, the impact of a president’s protection status is contingent on the relative wealth of his wife. Figure 1 plots the difference in leverage between banks with protected and unprotected presidents with different intra-household allocations of property (inferred from the ratio of the wife’s family wealth to the husband’s family wealth). Being married after a MWPA only increases leverage for bankers whose wives own a sufficiently large share of the household’s property.

Figure 1 The effect of limited liability on bank leverage

It is also noted that during financial panics, the more conservative bankers institutions performed better, so the threat of personal consequences produced better behavior.

Eddie Murphy said in Trading Places, "You know, it occurs to me that the best way you hurt rich people is by turning them into poor people."

H/t naked capitalism.