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The small bug that crashed our economic system

Regulators came up with a long list of contributing factors to the financial crisis of 2007-08. But what if all these factors are only symptoms of one underlying, much more fundamental issue?

 

Limited_LiabilityLead

Deutsche Bank recognized that for 31 billion Euros of recorded assets, it lacks fundamental information for a precise valuation. Can we still trust in the accounting of limited liability companies? (Photo: geralt)

 

In this article, we want to draw your attention to a seemingly small flaw in the design of our economic architecture. One that did not matter for a long time, but that has become extremely destructive over the past decades. The most recent banking crisis is a direct consequence of this flaw, and if we do not deal with it, we will have to live with an increasingly fragile financial system. The issue we are talking about has been hard coded in an underestimated but critical component of our economy’s operating system: Limited Liability.

 

Long, long time ago

 

What is limited liability, and why is it a critical component of our economy? Let us go back in time before the concept of limited liability was introduced. Back then, every entrepreneur was fully liable with his entire wealth for all of his business activities. A deal that went foul or a delivery that was stolen could have meant the end of his personal existence – not just the end of his business operations.

 

Without limited liability, a company was inextricably linked to its owners.

 

Stakes in companies could not just be sold, as the liability arising from contractual obligations still resided with the original owner. In this setup, only direct family ties were strong enough to allow succession planning. As a result, corporate life was very rigid. Without limited liability, companies were severely hampered in their ability to thrive, grow, and adapt.

 

Take mediaeval sea trade as a prime example. Sea trade promised high returns. But it was also highly risky: not all ships made it back to port with their merchandise and crew in good order. Both passive investors and active sea captains in charge took large financial risks when engaging in sea trade.

 

While not obvious at first sight, accounting and sea trade are inextricably linked with each other.

While not obvious at first sight, accounting and the rise of medieval sea trade are inextricably linked with each other. (Photo: travelspot)

 

A sea captain who was personally liable for repaying the passive investor even if he lost the merchandise or the ship due to events he could not control, was never more than one step away from bankruptcy. But so was the passive investor, who could become personally liable for all contractual obligations a sea captain might have entered during a long journey far beyond his reach.

 

The solution to foster the profitable but risky sea trade was a new legal organization for businesses named commenda. In a commenda, both the captain and the passive investor could limit their liability against each other, and even against third parties. The limited liability enshrined in the commenda allowed merchants to invest into several different voyages without worrying too much that sea captains could take ruinous actions. And sea captains could make risky decisions and aim for higher rewards, without risking a lifelong debt burden.

 

Sea trade was the nucleus of this new form of economic cooperation that eventually formed a core part of our modern economy.

 

 

The rise of accounting…

 

Invented in Italy to facilitate the financing of sea trade, the new concept of limited liability quickly spread across Renaissance Europe. Not before long, limited liability companies were used for virtually any kind of trading activity. It was a huge success story.

 

Much more than with unlimited liability, however, a company with limited liability has to establish trust with potential stakeholders: Customers, suppliers and also employees need to rely on the company’s ability to settle obligations; and potential investors need to know the value of the company’s assets to assess its ability to repay debts and distribute profits.

 

Without trust, the concept of limited liability is doomed to fail.

 

The solution to build trust was transparency. If stakeholders get a fair and balanced report on the company’s assets, liabilities, income streams and expenses, they would have all the information they need to make informed decisions. Provided the report painted a sufficiently healthy picture, stakeholders would enter into contractual relationships with a limited liability company.

 

The ascent of limited liability is therefore closely intertwined with modern accounting technology. Limited liability companies established financial reporting: Accountants calculated the financial health of the company and provided crucial information to stakeholders. It is no surprise that both corporate law and double-entry bookkeeping emerged both at same place and time: Mediaeval Italy. Double-entry bookkeeping was a prerequisite for modern companies; limited liability companies required new accounting techniques to establish transparency.

 

 

Balancing tricksters and stakeholders

 

Transparency is all good and well, but what if the company’s owners want to exploit the fact that they cannot be held liable beyond their initial investment? The cap on liability provides strong incentives for owners to conduct shenanigans and enrich themselves at the expense of other stakeholders, in particular, lenders and prospective investors.

 

For example, they could try and cook the books by manipulating balance sheets and income statements, inventing fictitious assets and transactions, or inflating the valuation of assets and downplaying the value of liabilities. By doing so, owners could convince unwitting investors to invest their money into overvalued businesses.

 

Another option, which is not outright fraud, is to abuse the concept of limited liability: Owners could have their company to borrow a lot of money, increase leverage, and take excessive risks. If their leveraged bet pays off, owners become rich. If their bet goes south, their liability is limited to their initial investments. The main damage resides with the stakeholders who were tricked into lending money.

 

So creating transparency about the company to build trust is not enough.

 

Beware the enthusiasm of limited liability company owners, they might take excessive risks with your money.

Beware the enthusiasm of limited liability company owners;  they might take excessive risks with your money. (Photo: geralt)

 

As a Russian proverb says: Trust, but verify. This is exactly what stakeholders of limited liability companies have been doing ever since. In particular, lenders and prospective investors know about the temptations of limited liability; they have a lot to lose from accounting fraud and excessive risk-taking. On the one hand, potential investors perform due diligence to confirm the reported financial health of a company. On the other hand, lenders screen companies thoroughly before lending money and keep a watchful eye until the loan is repaid.

 

In other words, stakeholders – or their representatives – monitor limited liability companies.

 

Despite these efforts, the accounting history is rich in fraud cases. From mediaeval merchants in Italy, over large scale railroad scandals in England, to Enron in California: Monitoring could not always prevent employees from cooking the books or companies from engaging in excessive risk-taking. But these bad examples did not undermine the validity of limited liability; evidently, both lenders and investors still find it profitable to engage with such companies.

 

But wait a minute, where then is the flaw we were talking about at the beginning?

 

 

The rise of systemic risk

 

Imagine what happens if the failure of a company with limited liability wreaks such havoc on the whole economy that the government is forced to save the company from its mistakes?

 

Did someone just say 2008? Spot on!

 

Banks are limited liability companies. Since banking creates systemic risk, however, the companies involved in banking are an anomaly within the universe of limited liability companies. As a result of this systemic threat, uninvolved third parties – governments, that is, taxpayers – and not their stakeholders have to foot the bill when banks fail on their obligations.

 

Banks’ stakeholders – for example, depositors, investors, or derivative counterparties – know that governments jump in if a banking institution fails. In turn, they would waste their time by monitoring the banks they lent money to, because they will get their money back no matter what. If the bank fails, taxpayers will jump in.

 

If stakeholders do no longer have skin in the game, who will ensure that banks do not commit accounting fraud or take excessive risks? Who should raise red flags when leverage increases and a bank’s course of action becomes increasingly rampant? These are the questions that point to the source of the huge mess we are in.

 

 

Corrupted Accounting

 

If stakeholders no longer care about the financial situation of a bank, no one really cares anymore what banks actually publish in their financial reports. Banks get a free pass to put on the balance sheet whatever they like.

 

Zahlensalat

Just because there are lots of numbers, the business behind does not need to make sense. (Photo: geralt)

 

Take Deutsche Bank as an example. Just a few weeks ago, Deutsche Bank posted a quarterly loss of 6 billion Euros because its new CEO acknowledged that the company’s financial health was overstated. However, this valuation adjustment that led to this staggering quarterly loss only represented 0.4% of Deutsche Bank’s assets.

 

Imagine if Deutsche Bank accountants overestimate the value of Deutsche Bank’s assets by 2%. With an overall balance sheet of 1.7 trillion Euros, this would translate into an actual loss of 34 billion Euros.

 

Deutsche Bank recognizes that for 847 billion Euros of its assets, no direct prices are available (so called Level 2 assets). For another 31 billion Euros of assets, Deutsche Bank accountants even admit they lack fundamental information for a precise valuation (Level 3 assets).

 

Also note that Deutsche Bank is notorious “looking at the bright side”: The Securities Exchange Commission has already fined Deutsche Bank for seriously and intentionally overstating the value of their assets during the financial crisis (some estimate the overstatement was up to $ 12 billion).

 

Given this information, how much trust can we place into the accuracy of the financial reporting of Deutsche Bank and other banking institutions? We could not find more appropriate words about the current state of financial reporting in the banking industry than Deutsche Bank’s very own research department:

 

“Much bank reporting has now become so complex it has spiraled out of all control and meaning.”

 

A remarkable statement, coming out of a bank’s research department. But they are absolutely right: Nobody understands anymore what risks banking institutions are taking, how much the assets under their control are really worth, and how large banks’ liabilities are. So if stakeholders no longer keep limited liability companies in check, things spiral out of control.

 

How can we fix limited liability then?

 

 

A second meaning of limited liability

 

Banking institutions create systemic risks and, in turn, hold the public liable for their own mistakes. This is the flaw that crashed our system. This is why we have to repair the concept of limited liability. We need to put stakeholders back in charge within every company such that they stop owners who attempt to abuse limited liability.

 

As of today, limited liability features a cap when things go bad on one side: the side of the owners. History has proven that this can spur economic development. The financial crisis, however, has showed that the concept is in need of a second cap – a cap on the side of society.

 

Hence, the concept of limited liability needs to be amended with a second meaning: It should not only limit the owners’ liablity but also the liability of any uninvolved third party; the concept of limited liability needs to account for systemic risk. No one who did not voluntarily enter a contractual relationship with a limited liability companies should be forced to suffer costs as a result of its failure.

 

 

Why now?

 

When limited liability started to spread over medieval Europe, the flaw within the concept did not really matter. The economy was just not interconnected enough for systemic risk to be of any relevance. For a long time, the failure of banking institutions did not wreak sufficiently strong havoc on the rest of society to force governments into action. Large parts of the economy still worked independently from the financial system.

 

But with the industrial revolution, the economy became increasingly capital-intensive and interconnected. The modern economy could no longer operate without a functioning financial system. Banking failures could not be ignored anymore, which is why in the 19th and 20th century governments started to bail out banking stakeholders.

 

Governments knew that their actions unsettled the balance of limited liability, so they implemented a regulatory framework to replace the monitoring efforts of stakeholders. Governmental monitoring replaced private monitoring. This framework kept the banking institutions in check throughout most of the 20th century.

 

With the digital revolution, however, the interconnectedness of the economy accelerated further. Not just institutions called “banks” can now create systemic risks but potentially all limited liability companies. Private monitoring in the financial system is in full-scale retreat, and operating a compensating regulatory regime has become an insurmountable task.

 

The lesson to learn from the financial crisis of 2007-08 is that we have to address the flaw at the core of our financial architecture to set things right again.

 

We have to tackle the problem of systemic risk piling up in today’s limited liability companies. We have to amend corporate law with a systemic solvency rule to fix this serious flaw in our economic architecture. As described in The End of Banking, a systemic solvency rule protects uninvolved third parties from being forced to bail stakeholders of limited liability companies out. The concept of limited liability would be re-balanced, and stakeholders would have to retake their role as the guardians against moral hazard.

 

Some say the systemic solvency rule restricts limited liability companies. Yes, this is true. But this intervention is necessary, and it is the least intrusive one to re-establish a stable economic architecture. Since society can only accept that the owner’s liabilities are limited if these limitations do not harm uninvolved third parties. As we have seen with the fall of Lehman, today’s concept of solvency cannot live up to this requirement. The systemic solvency rule is a crucial amendment to corporate law to align it with the concept of liberty: The liberty of one has to end before it impairs the liberty of someone else.

 

 


admin, 2015-11-12 05:32:39:
"Hi Andrew Thanks for your comment. The point is that the Fed - and the government - were forced to bailout the banks because of the systemic risks they created in an interconnected digital world. It did not just turn out that way, there was simply no other choice.".
Andrew, 2015-11-11 22:28:57:
""Banking institutions create systemic risks and, in turn, hold the public liable for their own mistakes. This is the flaw that crashed our system." I have to push back on that. The public was effectively held liable for the banks' risky bets via the mechanism of the Fed's bailouts. Questions of legality notwithstanding, there was a conscious choice on the part of the Fed to act in this way and open up the half-dozen or so emergency lending facilities that it did. The taxpaying public is not necessarily on the hook for the poor choices made under limited liability, it's just that it turned out that way.".
Should banking be easy? | FEBE Associates, 2015-11-11 02:19:59:
"[…] authors of “The end of banking”, however, see things somewhat differently. In a post last week they outlined how it’s the digital age which has […]".
Patrick, 2015-11-10 18:32:49:
"Excellent Article, i specificaly study this subject and share most of your arguments. the weakest part is here "No one who did not voluntarily enter a contractual relationship with a limited liability companies should be forced to suffer costs as a result of its failure." limited liability has nothing to see with a contract, and so it can not legitimate consumers or tax payer to suffer. Studies in law are necessary to understand this point. Your studies in economics only show how it is dangerous and why. (sorry for my ... limited hability ... in english)".

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