Tyler Cowen and expanding bank shareholder liability

Tyler Cowen has written a column in the NY Times that has gotten a lot of attention as he proposed that bank shareholders face greater liability and be required to put up money to cover at least a portion of a bank's losses.

To make this idea works requires that the banks provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details.

Without this data, investors could not assess the risk of the bank and the likelihood that they will have to pony up more cash.

Without this data, investors could not exert discipline on bank management when they increase the risk profile of the bank.

As a practical matter, if banks provide ultra transparency, the same benefits can be obtained without requiring shareholders to have greater liability.

There is a better alternative: expanding the liability for major financial institutions. 

If a shareholder invests a dollar in a big bank, why not make that shareholder liable for the first $1.50 — or more — of losses as insolvency approaches? 

In essence, we would be making the shareholders liable for the costs that bank failures impose on society, and making the banks sort out the right mixes of activities and risks. Eugene N. White, an economics professor at Rutgers University, supported a related proposal in a recent paper, “Rethinking the Regulation of Banking: Choices or Incentives?” 

This proposal would shrink the financial sector, while avoiding excess regulatory micromanagement of bank activities. But it could still be combined with other regulations, like limits on leverage, if deemed appropriate or necessary. 

Unlike the “big is bad” view, this proposal would penalize failing banks rather than safe, successful ones that happen to be large. That’s also more in accord with the American ethos of winning at business. 

Under this reform, it’s quite possible that we would end up with some very large and also relatively safe banks. ... 

In any case, the market can adjust bank sizes over time, as perceived risks to banks change, without requiring new legislation to ward off each new source of risk. It’s hard for the law to win that race, especially when Congress is so fractious. 

Expanded liability for bank shareholders might satisfy the Occupy Wall Street movement, and could be sold as a market-oriented, not regulatory solution; it’s probably what markets would insist upon if there were no central bank and no F.D.I.C. 

As recently as the 1980s, the partnership structure, another alternative to limited liability, was common among investment banks — and that hardly seemed a crippling drawback at the time.

All of these are benefits from ultra transparency.

We need to resist vengeful or “feel good” options for financial reform and embrace those that will really work.

Only ultra transparency has been shown to work --- FDR used it to break the back of the Great Depression.