VoxEU Column Financial Markets

The financial crisis and the structure of contracts

The structure of contracts in financial markets is deeply rooted in history. This column retraces the origins of financial contracting and explains why mutual fund banking proposals are wrong headed. It proposes to shift more of the functions of our current banking system away from limited liability back into partnerships. This would involve requiring hedge funds to be entirely separated from banks.

Economists often have a hard time understanding the reason why both wages and many financial contracts – such as bank loans and bank deposits – are fixed for certain periods of time in nominal terms. Would it not be better, it is often suggested, if all such financial assets could adjust in response to changes in the (market) values of the underlying assets, and if nominal wages could adjust flexibly in relation to underlying changes in demand and profitability. Surely this would eliminate the possibility of financial crises and serious unemployment. Indeed, this would be a better way of operating if we had complete and efficient (financial) markets, and everybody behaved with absolute honesty, so that everyone could have complete trust and confidence in everyone else.

Asymmetric information

Unfortunately these happy conditions do not pertain. Instead the borrower and the employer have far better information on the state of their business than the lender or worker. Under these circumstances, if the lender or the worker relied on the self-certified account of their business by the borrower/employer, what the lender/worker would invariably be told was that business was bad, and that the lender/worker would have to suffer a reduction in their payment as a result. In order to keep the borrower/employer honest, the most obvious and sensible procedure is to negotiate a nominal fixed price contract which can be revised after a period, which involves a penalty on the borrower/employer if the contract is not honoured. The penalty for the borrower is bankruptcy, and the penalty for the employer is that, if he cannot pay the nominal wage, he has to fire workers, and therefore not produce as much as before.

The same analysis applies whether we are talking of banks lending to borrowers, or of depositors lending money to banks. In a world in which human behaviour has left the Garden of Eden, a fixed nominal rate contract is usually superior to some kind of sharing process. Moreover, as has been clearly shown via behavioural economics, investors dislike losses much more than they value gains; so, even for those investments where the valuation varies according to market prices, there is frequently a stop-loss agreement of some kind. An example is the implied commitment that money-market mutual funds in the US would never ‘break the buck’. And when Reserve Primary Fund did so, there was a massive and rapid run from such funds. Indeed, in many cases outside finance is only available in significant quantities if there is some available stop-loss fixed nominal value commitment.

Mutual fund banking: A non starter

Consequently, proposals for mutual fund banking, which once again have started to appear, are invalid. Of course if a major shock occurs, with economic conditions worsening sharply, forcing borrowers into liquidation or throwing off huge numbers of workers, re-contracting then normally occurs, with burden-sharing between borrowers and lenders, and workers accepting wage reductions in exchange for more employment. Even so, such recontracting cannot be allowed to be sufficiently favourable to the borrower/employer that they always assume that it would occur, and that they can improve their position under almost all circumstances by seeking to default on their original contract. In order to make the system work, default on nominal contracts has to be sufficiently painful to keep the borrower/employer honest under all normal circumstances.

Historical organisation arrangements

If we then go back in history to the period prior to 1850, the normal form of organisational arrangement was that projects were owned, and equity was provided, by families, friends, and partnerships, with unlimited liability, financed by bank loans on a fixed nominal basis. The main problem with this procedure was that the scale of operation required in manufacturing and certain other services became so large that the ratio of equity to debt would no longer be viable. The need was to tap outside sources, which would not be involved in management, to provide additional equity funds. But if they did not manage, how could they be assured that they would not get ripped off by the insider executives. There were two answers to this; the first is the requirement for more transparency, e.g. in accounts, and the second was the provision of limited liability.

There were, however, a number of difficulties.

  • First, in a complex world, transparency is always less than perfect, frequently considerably so.
  • Second, the payoff structure of a limited liability equity contract, especially when the share owner can diversify, provides an incentive for the shareholder to seek more volatile and risky projects.
  • Moreover, once limited liability is provided to shareholders, who are nominally the owners, it is very difficult to deny the same to the share-holding of the actual executives and managers.

Indeed one of the (misguided) mantras of recent decades has been that it was supposedly desirable to align the interests of executives with those of the shareholder, with various kinds of option programmes that frequently led to an even greater incentive to risk-taking by these executives.

Limits to limited liability shareholding

There have traditionally been a number of services, usually professional services, and particularly those where personal informational skills, and asymmetric information, have a very large role, where it has been traditionally thought that limited liability shareholding was an inappropriate form of governance, and where partnerships, whether limited or unlimited, were preferable. Until quite recently the operations of brokers/dealers in the US were run on such a partnership basis. That obviously limited their size, and, in the light of recent events, such limitation had its advantages. Once again, however, the argument was that these financial institutions needed to be larger in the new global financial system. It is at least arguable that the recent crisis derived in some large part from this structural change in the governance of these main financial intermediaries.

Implications for hedge funds

Certainly one possibility now would be to define certain forms of financial intermediation that could only be undertaken by a partnership, and not by a limited liability company. Hedge funds might seem to be an obvious case. The difficulty, however, is that if a bank is to undertake the provision of a full set of financial services to its commercial and manufacturing companies, it has to deal, and make markets, in derivatives, and provide underwriting services, which are very difficult to distinguish from prop desks operating via direct position taking. Trying to divide the functions of a bank between those of a ‘casino’ and a ‘utility’ is far more difficult than it sounds, particularly perhaps in the case of European-style universal banks.

Apart from requiring that hedge funds be entirely separated from banks, and that such funds, and private equity companies, be incorporated on a partnership rather than a limited liability basis, is actually quite difficult to see what specific changes in the financial structure could usefully now be done. It would be helpful if those advocating moves towards narrower banks could specify exactly what forms of financing should be removed from existing universal banks, and why. Absent the ability to shift more of the functions of our current banking system away from limited liability back into partnerships, the next question is whether it would be possible to change the incentives of executives and senior management, so that they became less aligned with those of ordinary shareholders, and give a higher weighting to the desirability of avoiding default. One possibility, for example, would be to require the pension plan of all such executives to be invested entirely in the shares of their own company. Though even here this would simply provide an incentive for executives to short sell the equity of their own companies as a hedge; but if this latter could be publicly observed, at least it would provide a warning to other potential investors, and even to the regulators.

Certainly more thought on fundamental governance issues would be desirable now, but what we need are practical proposals, rather than simplistic nostrums.

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