Shadow banks under LPB [Limited purpose banking] will be those without limited liability. They will be permitted to leverage. But the risk of owners' loss will greatly limit their desire to take on leverage as illustrated by the behavior of the unlimited liability banks in Switzerland. Nonfinancial corporations that wish to engage in financial intermediation must operate these businesses as LPB mutual funds.--Christophe Chamley, Laurence J. Kotlikoff and Herakles Polemarchakis (2012) "Limited-Purpose Banking—Moving from "Trust Me" to "Show Me" Banking" The American Economic Review.
One persistent myth about Chicago economics is that it is always in favor of free markets. While this is true, in general, historically the school is very suspicious of free markets in finance. At the height of the depression, the intellectual Godfathers of the school, Frank Knight (a regular in my blogging) and Henry Simons (the smartest Bleeding Heart Libertarian you probably have never heard of) tried to convince the Roosevelt administration to embrace 100% reserve banking (the so-called Chicago plan); this would prevent banks from creating money and, instead, would give the government (or the central bank) full control over money creation (and much else in the financial industry). This is quite radical because in modern credit based, capitalist economies the financial industry is responsible for much of the money creation. (This has not been true in the age of quantitative easing, of course.) In fact, as they developed the plan, they contemplated putting drastic constraints on the whole financial industry. The Chicago plan is not an artifact merely of 'old Chicago'--Milton Friedman defended a version of the plan throughout his life (see here for useful treatment). This is not to deny that other members of the Chicago school, including students of Friedman, also became cheerleaders of the financial industry (e.g., Fama, Miller, Scholes, Merton, Markowitz, etc.).* But versions of the Chicago plan are still being defended in the Chicago school (see here).
Unsurprisingly, features of the Chicago plan were rediscovered and modernized since the events of 2008. The best known is an is an IMF report from 2012 by Jaromir Benes and Michael Kumhof (see here), which is, incidentally, my source for the claim that the financial industry is responsible for much of money creation (not central banks as is commonly believed). But at the top of this post (Chamley et al.), I quote from a quirky (and much shorter) variant on the plan; the paper is worth reading because it pulls no punches and is very funny. Here I want to call attention to a feature of their proposal which deserves wider consideration (even if the Chicago plan never gets implemented). The rule is simple: if you want to take on leverage, then you must have unlimited liability (as Lloyds of London had, and some partnerships still do):
"[W]here owners share joint and several responsibility for the entire amount of debt and other liabilities amassed by the business. Unlimited liability is not capped at a maximum amount and exists regardless of the amount of investment each owner has personally made. If the business is unable to meet any financial obligations or settle any outstanding liabilities, the owner's personal assets can be seized to satisfy the debts."
Unlimited liability greatly reduces the incentive within the the financial industry to make one-way bets in which insiders get all the gains and socialize the losses; it will create serious incentives to improve underwriting standards, do due diligence, and monitor risk. (Obviously, I am not claiming that limited liability is the sole reason leverage can get out of hand; governments everywhere subsidize debt in the financial sector rather than equity.)** This is not just a matter of prudence, it's also a matter of morality (or social justice); in his recent book, Alexander Douglas has nicely argued the moral significance of proper underwriting standards. Reducing moral hazard is one important benefit from reducing leverage; the other is reducing systemic risk--all other things being equal, less leveraged banks means a less fragile system. It's also an easier policy to implement than macro-prudential regulation (which requires skills and information/knowledge that we simply do not possess yet, and probably will never obtain).
Unlimited liability in leveraged finance is also a matter of fairness. In many places the law is very much stacked against debtors (especially in Europe), who can enter bankruptcy if they are unable to pay back a loan. Unlimited liability in the financial industry, say among corporate officers and underwriters, evens the scales again; it ensures that financial creditors, too, run genuine risks. In fact, it treats creditors' losses as ordinary business debts (which they are). It also ends the ugly spectacle in which governments become collection agencies for banks when they have been reckless (or worse).
Somebody may argue that unlimited liability is rather drastic. For it makes one very vulnerable to the effects of fraud or disastrous bad luck. This is why I propose allowing some exceptions to the liability of the (modest) sort allowed to debtors (e.g., modest allowances (see here for an example).) This is also a matter of fairness.
Note that unlimited liability for leveraged financial services companies (banks, insurance companies, investment banks, shadow banks, etc.) can be decoupled from the Chicago plan. While it undoubtedly would reduce leverage in an economy, it is by no means obvious it would reduce the availability of credit in the long run. (I am ignoring here transition period issues.) For, the government has many ways to supply credit to the economy--leveraged banks are just one such mechanism.
Finally, a believer in the efficient market for ideas may ask, if unlimited liability for leveraged financial intermediaries is so prudent, then why is it not widely adopted? The answer is obvious (if one reflects briefly on public choice theory): there is a rich and powerful group of people who have every reason to spend a good chunk of their shareholders' money (it's legal, and it's called 'lobbying') to prevent it from being imposed on themselves. If even Chicago is not fond of leveraged finance, neither should our legal code be.
*It is worth noting, again, the further irony that Black-Scholes formula is a rational pricing formula (rather than supply meets demand pricing).
**I thank my student Frank van Moock for emphasizing this point.
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