An Alternative to Higher Capital Requirements

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.

Source: Joshua R. Hendrickson, "Contingent Liability, Capital Requirements and Financial Reform," Cato Institute, Winter 2014.

 

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