Comparing bankers past and present

Even after verifying that banking was indeed an unlimited liability enterprise in the 19th century, TED appears to struggle with the idea that anybody with wealth would be willing to take on such risks — especially for a measly return of 5% or less on assets.  TED writes:

My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard.

What this sounds like to me is that the employees of our financial institutions are so habituated to making outrageously large risk-free (i.e. government guaranteed) returns, that the idea of risking one’s own assets in order to make a profit seems patently ridiculous — which of course it is — if you happen to be one of the few privileged enough to be able to spend your life sucking at the government’s teat.

(My apologies to TED, Alea, Sonic Charmer and all the other financiers looking for a better system, but this bit of hyperbole seems close enough to the truth to me that I couldn’t bring myself to edit it out of existence.)

Given the growth of unlimited liability banking in the past and the plethora of Americans living lives of quiet desperation in the present, I suspect that the risks of unlimited liability banking could in fact attract many, many small lenders whose initial capital may be little more than significant equity in their own home — if it were not the case that the whole industry is overshadowed by government sponsored mega-lenders.  After all, how many small businessmen and women in this country have already signed up to be personally liable for their business debts?  Putting all of one’s assets at risk to start a business is hardly an unknown or rare phenomenon in this country.

To support the view that unlimited liability banking operates as a constraint on the economy, TED writes:

The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

Given that Britain spent the 19th c. growing economically into its role as a premier world power (“the sun never sets …” etc.) and by the late 19th c. was exporting capital around the world, it’s hard to understand the foundation for TED’s argument that the supply of capital must have been “artificially limited,” since banks were lending at 5%.  If banks in Britain were “overequitized,” there’s little or no evidence that this had an adverse effect on the economy.  As long as banks could be operated profitably, to the degree that existing lenders were at the limit of their ability/willingness to lend, new entrants into the industry — or new partners — could probably be found to expand the business and take advantage of good lending opportunities.

The data on the United States indicates that banks subject to double liability were not “overequitized.”  In 1919 the ratio of the aggregate total capital account for all Federal Reserve member banks to total assets was 11%. (See column 1 of Chart No. 57 here.  This ratio rose to 15% at the depths of the Depression and then dropped with the advent of deposit insurance.)  At the start of the recent financial crisis the Fred database indicates that this ratio was hovering around 10%.  Thus, it’s far from clear that double liability in the US resulted in “overequitized” banks.

I believe that the claim that “the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century,” is just an explanation for the growth of stock markets and limited liability non-financial companies.  It is widely recognized – and I do not dispute this claim – that certain industries with extremely high fixed costs but significant risks in the form of aggressive competition to take advantage of recent technological developments, like railroads or fiber optic cables, can, more or less, only be financed via a limited liability shareholder structure.  Since banking developed as a successful industry before the rise of stock markets, and as Andrew Haldane notes the banking industry was very slow to embrace limited liability, it is far from clear that limited liability is an essential element of a efficient banking system.

Mr. Haldane appears to argue that because systems of extended liability did not protect depositors in the Depression, such systems were rejected.  While this may be a historical explanation for the growth of limited liability banking, it is far from clear that Depression-era problems should be taken as conclusive evidence against extended liability.  It’s doubtful that any banking system could have survived Depression-like events, marked most notably by the world’s reserve currency delinking itself from gold and setting off a reserve currency transition, without significant losses.

In short, while unlimited or extended liability banking would almost certainly mean that the economy was populated with a greater number of smaller banks, it’s far from clear that credit itself would be constrained.  Nor should one assume that interest rates would rise.  After all the risk premium portion of interest rates depends as much on the quality of bank underwriting and social enforcement mechanisms as on the characteristics of the borrower, so incentivizing banks to screen borrowers and lend carefully may actually reduce the interest rates available to most borrowers.

Related posts:
What banks do
The problem of collateral
What is capital?


19 thoughts on “Comparing bankers past and present”

  1. 1. Maybe it is my failure of imagination but I cannot understand what “unlimited liability”, even if theoretically desirable according to some argument, could possibly mean in the context of institutions that employ tens if not hundreds of thousands of people to direct/move tens of billions in capital. Who exactly in that mix is there to be ‘unlimitedly liable’? Whoever it is, feel free to sue that person, if he loses he declares bankruptcy and maybe you recover 0.001%, now what? Seems like a 99.999% synonym for limited liability. The only thing I can envision is that you’re working from a premise that if only The Partners (?) in their paneled offices were unlimitedly-liable, *then* they’d keep *extra special* close watch on the tens of thousands and the millions of little decisions and transactions those tens of thousands might execute every day. But surely a moment’s thought reveals the underlying problem there is less one of incentive than of capability. So how would or could it really work? Well, to describe the likely resulting environment of this as ‘smaller banks’ seems like the understatement of the year. Which is maybe ok, maybe you’re right that credit overall wouldn’t suffer, just saying it is a far bigger leap from here to there than you make it sound.

    2. Aren’t you mistaking *employees* of an institution with the owners of same when you speak of “employees of our financial institutions … making outrageously large risk-free (i.e. government guaranteed) returns”? What “returns”? Is salary “returns”? And “risk-free”? In what other industry can and does a person’s compensation regularly fluctuate by factors on the order of 50% or 100% or more from year to year? Such fluctuation is in fact the opposite of “risk-free”, indeed among the most *risky* salaries one can find, according to how “risk” is usually defined. It also seems to me that when you speak of “employees” of financial institutions you tend to have in mind about 1% of those employees rather than the 99% of them who do administrative, IT support, and other tasks, much like the employees of any other large institution would. Because can’t imagine you’d think they too are supposed to be “liable” for billions in bad trades due to their “government-guaranteed risk-free returns” (e.g., say, a $50k salary). But that just leads bank to (1): what can unlimited-liability possibly mean then?

    1. Thank you for the comment.

      1. “Unlimited liability” is a reference to banking from a century or so ago. The underlying debate is over how much liability to put on banks. As I argued a few days ago, what we’re really probably talking about is:

      “in the event that a bank fails there [should be] a lower standard for creditors to pierce the corporate veil than in non-financial corporations. Imposing the possibility of liability (that would have to be made uninsurable by statute) on directors, officers, employees, and shareholders – to the extent that any of these parties received income from the bank over the previous 10-15 years – may be necessary to prevent misuse of “other people’s money.” Employees should be granted the strongest safe harbors (including, for example, the first $100K per year of income, but not including decisions to gather nickels before steamrollers) and shareholders the weakest.”

      Alternatively there’s a strong argument that the partnership system for investment banks worked just fine — and Goldman Sachs went public less than 15 years ago — so it’s hardly a mystery what “unlimited-liability can possibly mean.”

      2. Volatility as we all know is not necessarily a good measure of risk. Someone whose salary is either $250,000 or $500,000 has a standard deviation of income ten times that of someone whose salary is either $25,000 or $50,000, but it hardly makes sense to claim that the former faces more risk than the latter. The problem clearly is that when we’re talking about income the distance away from zero matters, whereas measures of volatility abstract from this fact.

      As noted in 1, I think the first $100,000 of each employee’s income should be granted an unconditional safe harbor from liability. And it should be difficult to get the next few $100K in the absence of misconduct. On the other hand, it’s not clear to me why compensation in excess of $500,000 should not be subject to clawback, for those who choose to work for risk-taking institutions that are effectively wards of the state.

      This is, of course, assuming there’s no way for firms like Goldman to go back to being partnerships — in which case the employees would obviously have no liability.

      1. Ok it sounds like your answer is ‘partnerships’, basically. You (and philmv) also mention shareholders but I’m trying to picture a sequence like (1) soccer mom buys some BAC stock into her eTrade account, (2) 4.5 years later, a court letter: “sorry, we just discovered an FX options trade was misbooked 4 years ago, we see you own 10 shares of BAC, your share of the loss comes to $500k, so we’re taking your house”. That can’t possibly be what you mean (even though it seems to be what philmv means, unless I misunderstand). In any event I think it’s a much larger leap you’re contemplating from here to there than you made it sound.

        As for risk, you are right that volatility by itself is not a measure of risk; never said it was. But the finance salaries you seem to have in mind are truly *uncertain* (it’s not as if they’re merely ‘volatile’ with some constant, known-in-advance standard deviation), and that makes them risky by definition, and certainly far more uncertain than someone with a non-finance job with a 50k salary, which, sure, might plausibly fluctuate say to 48k or 52k (but not 25k!).

        Re: the 100k safe harbor, I might ask what exactly is special about “100k” (why not 95 or 107.3?), but I take your point. However that no longer sounds anything like ‘unlimited liability’ to me, so maybe you’re conceding mine (or maybe I misunderstood all along?). As for clawbacks, I’m happy to be able to inform you that clawback provisions already exist here and now, so you’ve gotten your wish there. But again that applies to compensation previously paid out, which still seems like a different animal than ‘unlimited liability’.

        Finally philmv wants to apply unlimited liability to ‘anyone on commission’. What exactly is ‘commission’? If phil means the variable component of one’s compensation, I think it’s (usually) a misconception to think of that as ‘commission’, but okay I guess, but firms could always just restate the same salaries as a fixed base, i.e. by raising base salary. To some extent this has already occurred and I suppose if the regulatory environment continues to be influenced by outsiders who think of all variable comp as, like, “commission” then this will only continue. In the event, I would welcome that. It would sure make compensation less risky.


      2. I think shareholders should be liable up to the amount of dividends received over the preceding 10 to 15 years. Financial institution shares should be sold with the covenant that they carry this potential liability.

        “someone with a non-finance job with a 50k salary, which, sure, might plausibly fluctuate say to 48k or 52k (but not 25k!)”

        I don’t think you understand the measure of insecurity that exists for many employees in this country. There’s risk of losing your job, there’s risk of the company you work for going out of business, there’s risk of cut back in hours that reduces your income significantly. Given these realities a 50% risk is something lots of people are worried about — and in fact, especially since the recession that started in December 2007 have experienced. The real difficulty is when the risks don’t just hit you, but they hit your spouse at the same time — which is also far from uncommon. Do not be mistaken: Low level employees bear a vast amount of risk in our society.

        “finance salaries [are] certainly far more uncertain than someone with a non-finance job with a 50k salary”

        Perhaps your point is to parse a specific definition of uncertainty as compared to risk. But I think it goes without saying that anyone who is guaranteed an income of $100K per year bears far less risk in our society than the average worker. In fact, it’s almost comical to claim that someone who is guaranteed an income of $100K has any experience or understanding of true risk. Which was kind of my point at the beginning of this post — some people in our society are so inured to extreme levels of security in their lives that they have no concept of risk-taking — as in putting all one’s assets at risk in order to make money — means.

        ” that no longer sounds anything like ‘unlimited liability’”

        I’ve never actually proposed returning wholesale to an “unlimited liability” regime. Instead, I have pointed out that it seems to have worked very well in the past. What I do believe we need to do is completely restructure liability in our financial institutions. There are obviously many ways to do this.

      3. Grant me that you recognize that I was clearly comparing two types of salaries. Such a discussion tacitly assumes, ‘while one still has the job’. Now it seems you want to have a different discussion, to address not ‘salary’ of working here or there per se but the overall associated financial existence. Fair enough, let’s switch. Okay, someone making $50k can get laid off. Of course. Conceded.

        But wait. Financial employees (supposedly all “guaranteed an income of $100K per year” – where do you get this?) cannot get laid off? Do you see your self-contradiction?

        In fact, there are more layoffs in finance than in most other sectors. I’m pretty sure you realize this too. So I am happy to use whichever terms/ground rules you prefer, but neither justifies a diagnosis of “risk-free” in the slightest when it comes to working in finance.

        In any event, a deeper issue I have with your comments. You keep speaking of the compensation one gets from working in finance as “returns”. You have this view, almost as part of a story of lost morals/ethics, that, seemingly, finance-sector employees need to “put their own money at risk” in order to make money. My question is this: Why does this apply only to financial employees? No people who have jobs “put their money at risk” simply in order to earn their salary. None. So what is special about financial-firm employees. Why don’t, say, college professors need to “put their own money at risk” in order to make their salary? Why can’t I come along and denigrate college professors for being “guaranteed an income of $100K per year” (which they are, in the same sense that finance-sector employees are anyway) without “putting their own money at risk” to achieve that “return”? Do you see how wrong this is as a way of speaking of employees yet?

        Your mental model of what it means to be an employee of a firm that happens to be in the financial sector – for most such employees – is just way off base.

        As for dividend clawbacks, I don’t have a strong opinion but I struggle to understand how much money you think could be recovered, were it actually needed, from such a setup. Either you suppress capitalization as no one is willing to buy such equity, or if they are, you are sending bills for like $37 to a million soccer moms. In short, what’s the point?


      4. Sonic, semantics aside, the point is clearly that those who often make a lot of money are advantaged vis-à-vis everyone else. Any supposedly “risky” scenario in which P obtains >$100k while retaining limbs and neural system, is not actually risky for P. Perhaps in a hedonic treadmill sense but we feel no sympathy for that.

      5. Thank you for the reply.

        I listed three forms of risk for the typical $50K per year employee.
        (i) being laid off. I am willing to grant that this risk is probably equal (especially in the current environment) for financial and non-financial employees.
        (ii) failure of the business you’re working for. Given that the whole discussion is about the “too big to fail” problem and how it distorts the financial system, I think it’s safe to say that this risk is much greater for those who are not employees of the big banks. (Note that I have no reason to believe that hedge funds would be improved by changing their liability structure.)
        (iii) reduction in hours. This is extremely common in the current economy. Most California public employees have had their hours dramatically reduced. While I’m no expert on BLS data, I think that the fraction of the US population that is working fewer hours than they would like is given by subtracting the U-6 unemployment series from the U-5 unemployment series. If I’ve got that right, then a full 5.5% of the US labor force (and 8.4% of LA County which may be why it seems so common to me) is working fewer hours than they want.
        I don’t understand why you think this significant risk faced by nonfinancial workers can or should be ignored.

        Big bank employees are different, because their employers are protected from failure by the government. This gives them a job security that other employees don’t have, more comparable to a civil service job than a job at a business that can fail. When these employees make money by making use of the bank’s balance sheet, I view them as using public funds to do so. I think it’s scandalous that the use of such public funds gets converted into bonuses.

        To the degree that most bank employees aren’t making profits by using the bank balance sheet or other government-subsidized attributes of the bank, you’re probably right that those employees should be protected from liability. And I am completely open to the idea (as I stated at the start) that the safe harbors protecting financial sector employees from liability need to be very strong. That said, I would expect that a restriction of liability to directors and officers would leave too many loopholes, so some liability for employees particularly those whose bonuses come from decisions to pick up nickels in front of steamrollers should be on the table.

        BTW, your average college professor is guaranteed a lot less than $100K per year — half that amount is not uncommon. So while they probably do have security similar to a bank employ (and greater if tenured) the majority of them would be fully protected by the $100K safe harbor, and almost all would be protected when an additional $300K is protected in the absence of misconduct. So I’m not sure college professors would object to being subject to these rules — at least as long as they could impose them on financial industry employees at the same time.

      6. You say big bank employees are different because you partition their risk into three things (without assigning probabilities to those things), and then note that TBTF protects against one of them, which “gives them a job security” that others don’t have. This calculus does not work. Whatever forces affect finance employees, the fact remains that at the end of the day there are more layoffs and turnover in finance than in most other sectors. I can dig sources if you like but I’m pretty sure you realize I am right. So (even if TBTF mitigated this somewhat) it is simply incorrect – indeed laughable – to characterize their existence as “risk-free” or as having any sort of “guarantee”. (Should I try to explain that to those being laid off at my employer in next week’s round of layoffs, or who left in the round last fall, or the one last summer, or..?)

        I do agree with the analogy between bank employees to civil-service employees. Of course, civil-service employees tend to have higher-than-average job security; so (using your language) the “return” they get for disbursing/administering public funds in the service of [some public goal] is far closer to “guaranteed” than what bank employees get. Can I assume you think clawback provisions/liability then also needs to be implemented for Amtrak/post office/welfare-agency/etc employees who are shown to have misused/wasted public funds (i.e. by failing to achieve the public goals)? If not why not? How about GM employees or Chrysler employees or other (non-financial) employees that got public-fund bailouts, why do they get off scot free? I still don’t understand what is so special about ‘finance’ in this regard.

        Anyway, contra your original claim that finance employees somehow get “guaranteed” “risk-free” “returns”, in the course of this discussion you’ve essentially conceded those “returns” are neither guaranteed, nor risk-free (and again, nor are they even “returns”). And sorry to both my interlocutors but there is no ‘floor’ because our host has introduced the possibility-of-layoff into the discussion, hence the floor is 0. We’re just left with the basic observation that (certain types of) finance employees, like, make more money than people in other sectors. Let’s say that’s true. And? I can see no objective takeaways or interesting lessons from that observation.

        You’ve also conceded that most bank employees probably don’t merit the conception you voiced of them as ‘making returns using public funds’, and you’ve reframed unlimited-liability for shareholders to mean maybe clawing back some dividends. So strip this post down and it sounds like what you’re talking about, at most, is (a) clawbacks of ‘bonus’ for such-and-such rank and above (which: already exists!), and (b) maybe attempting to recover/mitigate bank losses by clawing back dividends from equity holders (which, is probably unworkable even if it were likely to be a significant source of loss-mitigation, which I doubt. In any event face it, equity holders take a big hit when banks have trouble either way, and rightly so, giving back some dividends would be a rounding error when compared to the stock price itself falling >50%).

        Add it up and I can’t really recognize those of the reforms you originally hinted at -that you’ve been able to stand behind & defend as either differing from status quo or helping anything in any significant way.


      7. “clawbacks of ‘bonus’ for such-and-such rank and above (which: already exists!)”

        Given that I’m proposing “clawbacks” based on piercing the corporate veil (i.e. lifting limited liability), (i) the amount of money sought to be clawed back is measured by the losses to creditors and (ii) the clawbacks I propose could extend over 15 years and include all compensation over $400K or $500K per annum, I suspect that my proposal is a little more extensive than existing clawback mechanisms.

    2. In what other industry can and does a person’s compensation regularly fluctuate by factors on the order of 50% or 100% or more from year to year? Such fluctuation is in fact the opposite of “risk-free”, indeed among the most *risky* salaries one can find, according to how “risk” is usually defined.

      BS. Risk ≠ variation. Floor of $250k with a $250k upside is damned cushy regardless of the “vol”.

  2. I suspect that the risks of unlimited liability banking could in fact attract many, many small lenders whose initial capital may be little more than significant equity in their own home

    Sounds exactly like the P2P lenders who sparked into existence during the last few years, and then fizzled. Average Jane doesn’t have the professional banker’s expertise (or time) to judge loans all day. I can’t imagine that in a mercado libre someone who did have the skill and put in the time would fail to attract AUM.

    After all, how many small businessmen and women in this country have already signed up to be personally liable for their business debts? Putting all of one’s assets at risk to start a business is hardly an unknown or rare phenomenon in this country.

    No, I think it’s like TED said. if you have $70k nest egg you put $30, $40, $50k into the teahouse.

    1. The question is the degree to which the current structure (and the government subsidized bank earnings that enable bankers to earn extremely high salaries) has created an environment where it’s harder to get a small bank going. The question seems unanswerable to me.

      “it’s like TED said”: In my experience optimism — not always reasonable optimism — leads people to risk more than they should with some frequency. And careful management can make it possible to shelter a fraction of wealth out of reach of creditors — at least if you have friends or family that you can trust.

      1. In my experience optimism — not always reasonable optimism — leads people to risk more than they should with some frequency.

        I guess I am just talking about my personal experience. I put down ~1/30 my nest egg to start a business, prob wouldn’t have done more than 1/2.

        The question seems unanswerable to me.

        No other countries / historical with slightly or majorly different regimes?

        government subsidized bank earnings

        You keep saying that and it seems like a keystone of your views. Are you talking about the US’ backstopping of JP Morgan et al or something else?

      2. “government subsidized bank earnings”

        It seems to me that ever since Continental Illinois and the repo amendments of the early 1980s the government has played an increasing role in “stabilizing” the financial sector by protecting it from failure. The 2008 crisis was just one in a long series of crisis/bailouts that have allowed the financial sector to profit from risky activities without bearing enough of the downside of those activities. I view this as a subsidy — and think that it is possible to run a lender of last resort so that the subsidy is eliminated.

  3. unlimited or extended liability banking would almost certainly mean that the economy was populated with a greater number of smaller banks

    How does this follow from the evidence you presented?

    1. Can you imagine anyone taking on personal liability for a monster bank like Citibank? I can’t. To the degree that banks are smaller, I’m guessing that the demand for bank services will mean that there are more of them.

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