It was suggested recently here that limited liability had proven inappropriate for the banking system. Gambles which are rational from the perspective of individual banks can threaten the economic system, when business confidence is affected by the aggregated effect of all these risks.
Banks are all interdependent. There were other problems that contributed, but no doubt the contribution of stockholders and traders who were indifferent between leaving a company destitute, or insolvent and indebted for millions. Is it possible though to imagine a world without limited liability?
Financial risks cannot be created or destroyed by shifting responsibility. Exposure can manifest, or be diversified. Whatever transactional risk that exists when banks borrow money, currently lies with the lender. There is the risk that they will not be paid back, so they receive a premium.
Meanwhile, shareholders are only liable for their investment. The value of their shares is bounded by zero. In a world without limited liability, they would demand a greater return for taking on the burden of their firm’s debts and liabilities.
Meanwhile, bond-holders and other economic actors that hold claims on firms, are not immune to risk. Rather, they just take steps to reduce their exposure to default through diversification and hedging. There is no reason to think that shareholders would be incapable or unwilling to accept this risk with their shares.
After all, we are just repackaging the returns and risk associated with the company’s activities, but with different claims. Obligations are just being transferred to a different party, but can still be diversified in the same manner.
Philosophically, there is no reason that default risk should automatically lie with the bond-holder. When there are issues created by standard limited liability that create systemic risk, the alternative should be explored. Naturally, there are many shades between limited liability and unlimited liability. For the sake of argument, the balance shall be referred to as ‘extended liability’.
In this simplified model, demand represents the desire of firms to borrow money. Supply represents the desire of investors to lend money to firms. Suppose that we are initially in a system with extended liability, and share-holders are liable beyond their investment.
Firms would obviously be less inclined to borrow funds, so demand in this regard would be lower. Note though the ambiguity over the level of credit which persists under transition to limited liability. It’s not immediately clear whether the new equilibrium has greater extension of credit (optimistic forecast) or reduced (pessimistic forecast).
If extension of credit rises, we clearly have more efficient allocation of risk. Bondholders demand less reward for taking on the same burden, i.e. the default risk. Otherwise, the new allocation will be inferior. It all depends on how creditors perceive default risk under the new system.
The agency problem makes it very clear that the new allocation of risk cannot possibly be more efficient. If we assume the efficient market hypothesis and postulate that shareholders are just as capable of hedging and diversifying risk, they would be at a serious advantage over bondholders.
This is because of their ability to properly control the management of the company at all times. The reality of imperfect information, lack of transparency, time inconsistency and other factors make it considerably more difficult for creditors to make demands of the company.
Bond-holders have no control, and thus no ability to optimise their exposure to risk. Contrast with the opportunity of share-holders, critically when they are incentivised to take a greater interest in corporate governance due to their extended liability.
What about the cost of finance? Perhaps companies would be unable to raise capital, if equity was not limited in liability. However, the reasoning behind the Modigliani-Miller Theorem could be used to defeat this claim.
There can be no doubt that a system of extended liability is possible, at least to some degree. The realities of corporate governance and transparency are such that, if incentivised to do so, the exposure of society to the risks taken by business can be greatly reduced through the actions of share-holders. Unfortunately, limited liability stops this from happening.
© The Free Marketeer 2009