Should Bankers Be Forced to Put Some Skin in the Game?

["Dave Farber" <farber () gmail com>]

Begin forwarded message:

> From: Dewayne Hendricks <dewayne () warpspeed com>
> Date: June 10, 2018 at 7:44:50 AM PDT
> To: Multiple recipients of Dewayne-Net <dewayne-net () warpspeed com>
> Subject: [Dewayne-Net] Should Bankers Be Forced to Put Some Skin in the Game?
> Reply-To: dewayne-net () warpspeed com
>
> [Note:  This item comes from friend David Rosenthal.  DLH]
>
> Should Bankers Be Forced to Put Some Skin in the Game?
> A study of 19th-century marital laws shows banks are better off when managers are held liable for bad investments.
> By Sachin Waikar
> Jun 1 2018
> <https://www.gsb.stanford.edu/insights/should-bankers-be-forced-put-some-skin-game>
>
> What does the timing of bankers’ marriages in mid-19th-century New England have to do with the current debate over 
> bank regulations?
>
> A lot, according to recent research by Stanford Graduate School of Business finance professor Peter Koudijs. His 
> paper, “For Richer, For Poorer: Banker’s Liability and Risk-Taking in New England, 1867-1880,” written with Laura 
> Salisbury (York University) and Grupal Sran (University of Chicago), studies the association between personal 
> liability and risk-taking among bank managers of that time.
>
> The researchers found that 19th-century bankers who faced less personal liability due to new marital-property laws 
> were more willing to take risks than their counterparts with more such liability. The findings have implications for 
> liability-related policy related to bank executives today.
>
> “There’s a lot of current policy debate in the U.S. about how best to organize banking and monitor bank managers,” 
> Koudijs says. “One argument is that the recent financial crisis was caused because bank managers didn’t have enough 
> skin in the game. If they took significant risk and it paid off, they could make large bonuses. But if they failed, 
> they wouldn’t personally lose much.”
>
> The Good Old Days of Personal Liability
>
> It’s logical, then, that placing more of bank losses “directly on the shoulders of bank managers,” as Koudijs puts it 
> — in the form of increased personal liability — might result in more responsible decision-making and lower the 
> likelihood of large-scale negative outcomes like the Great Recession. In fact, liability clauses in pre-1930s U.S. 
> banking put the bankers at great personal risk if they made unsafe investments with their depositor’s money.
>
> “We’ve basically done away with personal liability in banking since then,” Koudijs says. “Now the debate is whether 
> to bring it back.”
>
> The researchers studied the New England banking system of the 1870s, comparing the actions of bank presidents who 
> were personally liable for the risks they took to those who were not.
>
> The difference hinged on bankers’ marital status. Before the mid-19th century, husbands legally had unconstrained 
> access to their wives’ assets, including cash, securities, and others. Thus, any claim on a husband’s assets extended 
> to his wife’s property as well. But laws passed during the 1840s and 1850s protected a wife’s assets from such 
> seizure, which limited a married couple’s overall liability in the face of a financial claim.
>
> Doubling the Pain
>
> Those legal changes had significant implications for bank managers, largely because of something called “double 
> liability,” a rule that put bankers at risk of losing up to double the value of their equity in a bank. For instance, 
> if a banker had invested $10,000 in a bank and it failed, the banker would lose that amount plus up to $10,000 more 
> if regulators needed it to pay back depositors.
>
> As large bank shareholders, most bank managers thus stood to lose much of their wealth if a bank failed. But the new 
> marital-property laws changed the extent of personal liability significantly: Bankers who’d been married before the 
> legislation still faced the potential loss of their household assets, whereas those married after the rules went into 
> effect faced less liability because their wives’ assets weren’t subject to seizure.
>
> The contrast enabled Koudijs and coauthors to test whether bankers with less skin in the game took more risk than 
> their exposed peers — using such measures as willingness to take on debt and likelihood of making riskier loans.
>
> Sure enough, bankers with less liability took greater risk. The research also showed that the risk-taking had 
> negative effects on bank performance. “In late 1873 [just after the study period], there was a major financial 
> crisis,” Koudijs says. “Banks that took on greater risk performed worse during the crisis. They lost more money and 
> faced a larger outflow of deposits than other banks did.”
>
> [snip]
>
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