Bank equity: a mechanism for aligning incentives

Kudos to John Cochrane. To address criticism of his narrow banking proposal, he is willing in a recent blog post to “Suppose it really is important for banks to ‘create money,’ and to take deposits, and to funnel those into risky, illiquid, and otherwise hard-to-resolve assets.” He asks the question: How can we fund banks with deposits while at the same time ensuring that banks are easy to resolve? and argues that the solution is to issue the deposits not at the level of the bank (which funds itself only with equity), but at the level of a holding company whose only asset is bank equity, but which is funded by both deposits and equity. Resolution takes place when holding company equity is wiped out and remaining losses are put to depositors.

Cochrane misses the point about what it is that banks do. As I write in a hopefully soon to be published paper:

The fundamental problem of finance is that even though debt plays an important role in production and growth, what constitutes ‘safe’ debt for a lender is precisely the opposite of what constitutes ‘safe’ debt for a borrower. Because the future is uncertain, borrowing is safe when debt is long-term, unsecured, and expected revenues more than cover interest payment on the debt. Lending on the other hand is safe when debt is extremely short-term and grants the lender the immediate right to seize the borrower’s assets as soon as there is any risk of default. The banking system offers a modicum of safety to both lenders and borrowers, not just by transforming the maturity of the debt, but more importantly by placing the burden of loss due to default on the bank owners, whose interests thus lie in making the system of maturity transformation work.

Banking was able to develop in an environment where the owners and the managers of the banks were the same people — that is, banking developed in an earlier era without access to the corporate form and where unlimited liability was the norm. Thus, an important function of the liability structure of the bank was to align the interests of the owners — and originators of the bank’s assets — with those of the depositors. Depositors could only loose money after every single one of the bank’s owners had declared personal bankruptcy (for a famous 1878 example see here).

So what are the economic functions of a bank? First, to offer both lenders and borrowers an asset that is somewhat safe for each of them; and, second, to warrant the safety provided to the lenders by engaging to bear the first loss on any bad loans. A key function of  banking is the alignment of the incentives of the originators of the illiquid, hard to value assets that finance entrepreneurial activity in the economy with those of the lenders who provide the funding for these loans. The fact that the originators bear the first loss is extremely important to the incentive structure of banking.

The U.S. experimented with corporate banking early in its history, but after a first major crisis that extended from 1837 well into the 1840s, adopted a modified form of the corporate structure. From the 1840s until the reforms of the 1930s U.S. bank owners typically faced double liability — so that an amount equal to the par value of the shares could be called up in the event that a bank failed. The assumption built into the 1930s reforms was presumably that bank regulators would be an adequate substitute for the incentives formerly created by the liability structure of the bank.

Thus, Cochrane’s plan has two flaws: First, he insulates the owners of the bank from the consequences of originating bad assets. Instead of being in a first loss position with respect to the bad assets, the owners share only proportionately in those losses. This structure ensures that their interests are not aligned with those of the depositors. Second, his system puts losses on bad assets in excess of holding company equity immediately to the depositors. But this surely means that the depositors will be unwilling to fund traditional illiquid, hard-to-value bank assets. Given the risk of loss, a reasonable depositor would surely insist that the bank’s portfolio be transparent and full of easy to value assets. As a result, Cochrane’s plan would almost certainly result less funding availability for traditional bank borrowers.

In short, while one appreciates that Cochrane acknowledges that his plan needs to address the role played by banks in ‘creating’ money, he has not yet mastered the ideas underlying this view of banking. I look forward to evaluating his next effort.

 

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