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

[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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