Any discussion of financial regulation and its chronic failures should start with a simple, jarring truth: It’s impossible to outregulate a banker.

Each crisis in the financial sector brings calls for new rules, which take hold after much political jostling. Then we are supposed to sleep easier, certain that this time we are protected. We never are. Fresh rules are like antibodies, and banking ― much like viruses ― keeps evolving to outwit the regulations.

Financial incentives tilt hugely in bankers’ favor. By outwitting regulations, bankers can become unimaginably rich. Regulators, on the other hand, earn a small paycheck regardless of whether the rules work. With incentives like this, bankers inevitably prevail. Regulations will no more protect against future crashes than last year’s flu shot will ward off this year’s flu.

Are we doomed to endless crises and government bailouts? No, but stopping this cycle requires a completely new approach. To avoid future banking meltdowns, we must change bankers’ incentives today. Instead of motivating bankers to take bets that increase the likelihood of us getting into a crisis, we need to reward the opposite behavior.

One way to align incentives requires a credible government commitment not to bail out banks. That would require strict limits on banks’ size to insure that no institution’s failure would threaten the financial sector’s stability. Of course, bankers would immediately object to this proposal, pointing to the supposed “economies of scale” that big banks offer. According to them, without big banks our entire way of life would be threatened.

Luckily, there is another way to align incentives: requiring all bank equity holders to have full liability. Currently, equity holders lose only their investment if banks are bailed out. Unlimited-liability equity ensures that before the government steps in, every shareholder would need to first declare personal bankruptcy.

When an irresponsible decision could literally put you and your family on the street, you scrutinize. You worry. You structure incentives so the bank never comes to your door asking for money. And if it never comes to your door, it will never be at the government’s door.

If you think such an idea is naive and unrealistic, you should know that as recently as the 1990s, the world’s most successful bank, Goldman Sachs Group Inc., was essentially organized this way. Thirty years before, so were most top non-commercial banks, including giants such as Morgan Stanley and Salomon Brothers.

Bankers will carp that if shareholders are fully liable, nobody will want to hold bank equity. Really what they are saying is that nobody (other than taxpayers) is willing to take on their current level of risk. That is the beauty of this idea: We don’t want owners to hold this much risk. By changing their ownership structure, we spur them to act responsibly.

All risk that a bank undertakes must be borne by someone. In the current system, the implicit bailout guarantee means taxpayers hold catastrophic risk, not investors. With unlimited liability, taxpayers exit the picture and investors become the regulators. The only banks that get financed are the ones that do not expose the rest of us to the consequences of a financial meltdown.

There are a few legitimate objections to unlimited-liability equity. First, by forcing investors to hold both the downside and the upside, it might package risk in an inefficient manner. But this limitation is easily neutralized by allowing investors to trade derivative contracts on the equity. For example, limited-liability equity could effectively be recreated by trading a derivative contract on the bank’s dividend payments.

Second, unlimited liability means bank stocks can’t be traded in anonymous markets, making them potentially illiquid and thus unattractive to some investors. However, investors could instead use derivative markets to buy a stake in bank-stock performance. Also, illiquidity per se mightn’t be as severe a problem as one might think. Venture capital and private-equity investments also are highly illiquid. There’s no shortage of investors in those sectors.

Finally, some benefits of diversification are denied to investors with unlimited liability. Consequently, one might be concerned that undiversified investors will demand a steep risk premium, thereby raising the cost of equity for banks. The evidence, however, is that many investors already voluntarily forgo the benefits of diversification without demanding a risk premium.

Two studies in the American Economic Review (the first by Tobias J. Moskowitz and Annette Vissing-Jorgensen and the second by Robert E. Hall and Susan E. Woodward) found that returns on illiquid private investments were lower than those for public equity, even though most owners of private companies tie up most of their wealth in their own companies. This evidence strongly suggests that concerns over the cost of fully liable equity are misplaced.

If we introduce unlimited-liability equity now, we can sharply reduce the probability of future banking crises. After all, when bankers took on risks that caused the 2008 meltdown, they did so in the hope that the government might bail them out. Now they know for certain. If we leave current incentives in place, bankers will circumvent whatever new regulations are passed. Then the next financial crisis will make the last one look mild. 

By Jonathan Berk

Jonathan Berk is the A.P. Giannini professor of finance in the Graduate School of Business at Stanford University. The opinions expressed are his own. ― Ed.

(Bloomberg)