In the early days of banking, liability was not just unlimited; it was often as much personal as financial. In 1360, a Barcelona banker was executed in front of his failed bank, presumably as a way of discouraging generations of future bankers from excessive risk-taking. It has not been conspicuously successful. From the Middle Ages, debtor prisons replaced the gallows. They were a common feature of many developed countries, including the US and UK, right up until the 19th century. The switch to limited liability at that time was a conscious attempt to encourage risk capital into the banking system to help finance growth. In essence, this meant trading off financial risk against future productivity. At first, equity in banks often carried “double liability”, with shareholders liable for losses on the purchase price of their shares plus their par value at issuance. Among state banks in the US during the 19th and early 20th centuries, double liability is believed to have helped constrain risk-taking. This practice was ended at the time of the Great Depression in the US. Given the likely need to rebuild bank equity in the future, now may not be the time to return to unlimited liability. Fortunately, there are two alternative approaches to adapting capital structure which alter the balance of risk-taking incentives, without jeopardising the flow of risk capital. Both involve operating not on equity, but on debt. And both involve making debt, like equity, a more loss-absorbing instrument in stress events.

Firstly, contingent capital is a means of automatically converting debt instruments into equity in the event of a capital top-up being needed. The capital structure of banks thereby becomes more malleable. There has been recent interest in contingent capital instruments as a means of providing banks with an extra degree of freedom in stress situations. The benefits in principle seem clear. The difficulties in practice include whether there is likely to be sufficient investor demand for such hybrid instruments. Secondly, wholesale debt instruments at present rank equally with retail deposits in the UK in the event of a wind-up. In the US, depositor preference has operated nationally since 1993, with retail deposits ranking ahead of wholesale debt. There are benefits to depositor preference both ex-ante (by heightening debtor incentives to monitor risk) and ex-post (by facilitating resolution). There are also some potential downsides, such as causing unsecured creditors to run sooner. It may be a good time to re-weigh these arguments in the UK.

Reconsidering the industrial organisation of banking
Over the past few decades, the global banking system has evolved into a particular organisational form, with a small number of large banks, a high degree of concentration and relatively low rates of entry and exit. Events of the past two years have accelerated these trends. In 1998, the five largest global banks had around 8% of global banking assets. By 2008, this fraction had doubled to around 16% (see Fig.1).

These structural trends worsen the time-consistency problem for the authorities, increasing the pressure for state support to banks “too important to fail”. This has heightened recent interest in rethinking the industrial organisation of finance. There are a number of potential forms such a restructuring could take. In weighing these options, there may be lessons from an, on the face of it, unlikely corner of finance: hedge funds. Hedge funds started this crisis in the doghouse. Yet they are the dog that has not barked. Their industrial structure may explain why. Unlike banking, the hedge fund sector does not comprise a small number of large players, but rather a large number of relatively small players. The largest hedge funds typically have assets under management of less than $40 billion, the largest banks assets in excess of $3 trillion.

Unlike banking, concentration in the hedge fund sector is low and has been falling. The top five hedge funds comprise around 8% of total assets, down from 30% a decade ago (Fig.1). Unlike banking, the business models of hedge funds are typically specialised rather than diversified. And unlike banking, entry and exit rates from the hedge fund industry are both high. The annual average attrition rate for hedge funds is around 5%. At present, it is around double that. Among US banks, the average attrition rate over the past few decades has been less than 0.1%; it has not come close to hitting 5% at any point since the Great Depression.

It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that, despite their moniker of “highly-leveraged institutions”, most hedge funds today operate with leverage less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system.

Redesigning the safety net
Even with systemic risk reduced, the state is unlikely to be able credibly to stand aside when future tail risks eventuate, as they are sure to do. Some bulwark is needed. As in other public policy arena, a pre-defined and transparent regime can help reinforce the credibility of ex-post actions, serving as a pre-commitment device. At present, only some of the ingredients of such an ex-ante framework exist. Internationally, deposit insurance frameworks tend to be fairly well-defined; liquidity insurance frameworks somewhat less so. Both are much better defined than frameworks for capital insurance. A well-articulated framework for the banking safety net would not only provide greater clarity on each of these pieces. It would also set out interactions and interdependencies between them – when and how the different insurance strands come together to avert crisis. At present, no such ex-ante map exists. Having one in future would not guarantee, but could only increase, the chances of it being adhered to.

This is an excerpt from the Bank of England study ‘Banking on the State’, based on a presentation delivered at the Federal Reserve Bank of Chicago 12th annual International Banking Conference on “The International Financial Crisis: Have the Rules of Finance Changed?”, 25th September 2009. For the entire Bank of England study click here.