The default of a systemically important financial institution (SIFI) can trigger a cascade of defaults and ultimately impose enormous losses on the economy. Consequently, authorities generally bail out distressed SIFIs. However, the near certainty that SIFIs will be bailed out creates acute moral hazard, because it gives SIFIs incentives to engage in excessive risk-taking. Regulators have attempted to address this problem by, inter alia, introducing capital requirements and placing restrictions on the activities in which SIFIs can engage, but the incredible complexity of these regulations make these attempts highly imperfect.
In our article, we take a different path and suggest addressing the problem at its source, namely the incentives for SIFI shareholders to incentivize risk-taking on the part of their managers. More specifically, we propose to extend the liability of SIFIs’ shareholders so that they are more exposed to downside risk. The advantage of our approach is that, by realigning shareholders’ incentives to reduce SIFI risk-taking to more societally acceptable levels, it provides a measured and proportionate complement to existing, highly imperfect regulatory initiatives to reduce excessive risk-taking.
The extended liability rule that we advocate is different from both unlimited and ‘traditional’ limited liability systems. Under the former, which used to be the rule for general partners in partnerships, partners are liable for the partnership’s unsatisfied debts, whether deriving from contractual obligations or torts, with no cap on the amount of liability. On the contrary, under the traditional limited liability rule shareholders’ exposure to downside risk is limited to their investment in the company if it goes bankrupt. Extended liability is located in between these two extremes. The shareholders face losses that are larger than their investment in the company, but their downside exposure is still capped at a pre-set amount.
We articulate the case for extended liability in four steps. First, we show that limited liability for SIFI shareholders is insufficient. The basic reason is that the limited exposure to downside risk, combined with the moral hazard created by the prospect of a bailout, gives SIFI shareholders incentives to encourage and incentivize excessive risk-taking by managers. Second, due to the specific features of SIFIs it is possible to avoid the theoretical and practical shortcomings that are usually associated with extending shareholder liability. For instance, a standard argument against extending shareholders’ liability is that firms would just change their capital structure and finance themselves through debt. However, SIFIs cannot take this path, since they are subject to stringent capital requirements. Third, we show that there are many reasons to believe that an unlimited liability rule would be highly problematic and ineffective. For example, the liability faced by the shareholders would largely depend on unpredictable political decisions on whether and how to structure the bailout of a SIFI. But liability rules are effective only if those facing potential liability can affect the probability and the dimension of their liability by engaging in monitoring and other risk-reducing activities. To be sure, that shareholders might have limited control on the value of the expected harm is a standard objection to unlimited liability. However, the standard objection refers to the partial inability of shareholders to control their own agents, the managers of the corporation. In this context, the inability of shareholders to influence the expected harm runs much deeper because the decision on whether and how to bail out a SIFI depends on agents (the government’s) on which shareholders cannot (and should not) exercise any control.
Last, we show that it is possible to structure a workable extended liability rule that is superior to both limited and unlimited liability. In particular, we suggest that the liability shareholders should face depend on two factors: (i) the value of their investment in the firm and (ii) the ability of their SIFI to impose negative externalities on the financial system. The first component is based on the average stock price of the SIFI, while the second component is based on the centrality indicators developed by network economists. In our article we explain in detail how to calculate each component of our rule, and hence how to determine the value of liability.
We argue that our rule has a number of advantages. To begin with, it minimizes the role that interest groups and the political process play in dealing with SIFI failures, because the criteria to quantify the compensation that shareholders have to pay are defined ex-ante (ie before the distress of the SIFI) and are entirely transparent. Second, the shareholders know at any point in time the exact value of the liability they would face in case their SIFI defaults so that they can set their level of monitoring accordingly. Third, as markets know in advance the amount of liability to which shareholders are exposed, our rule favors the creation of a vibrant insurance and derivatives market so that the risk of SIFI defaults can be allocated to those who can better bear it. Most importantly, the liability to which shareholders are exposed is carefully tailored to the level of systemic risk that their institution creates. Thus, our rule induces shareholders to account for the negative externality SIFIs can impose without unduly stifling such financial institutions’ role within the financial system and in the wider economy.
Alessandro Romano is an SJD candidate at Yale Law School.
Luca Enriques is Professor of Corporate Law at Oxford University.
Jonathan R. Macey is the Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale University, and Professor in the Yale School of Management.