Limited Liability in Banking
Introduction
Majority of modern business corporations are legal entities on their own basis and they posses’
legal characteristics which include the ability to transfer its own ownership and also the ability to
continue in existence despite of death of the major shareholders or major sale of the company’s
shares in the stock market. Limited liability also means that the shareholders of the company also
have limited liability. Limited liability in banking means that the banks shareholders are
insulated from any debts associated with the bank or any adverse judgment that has been directed
towards the bank. Limited liability in banking reduces the financial liabilities of the shareholders
which are limited to the amounts surrendered as shareholding in the corporation. The
shareholders personal assets are protected. The corporations can raise huge amounts of capital
with limited risks to the individual investors.
Banking is definitely not the safest business and they can be exposed to a lot of risk especially
when they finance private business or investments which turn out to be a bad debt. Most banks
go bankrupt after making wrong decisions to finance unproductive businesses and their funds are
not repaid. As a result of these risks the banking industry is heavily regulated in most countries.
Loose or lax regulations may result in banks hiding under the veil of incorporation after a series
of undercapitalization while undertaking excessive risks in the capital market.
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Undercapitalization makes banks vulnerable in cases of financial crisis besides culmination into
bigger problems as a result of excessive risks that are encouraged by the privileges offered by
limited liabilities. When the banks have a low equity base, the effects of limited liability truncate
the probability distribution of the amount of income that it can choose from hence the risky
behavior of risk taking evolves into bigger financial crisis (Cohen, 2013).
The introduction of the Basel I, II, III accords that were introduced by the Basel Committee on
Bank Supervision (BCBS) to control and regulate banks on the three types of risks i.e. capital
risks, operational risks and market risks. The major purpose of the Basel norms was to control
the risks that are associated with banks by providing regulations that ensure that banks
universally have enough capital on their account to meet their relative obligation and also to
absorb any unexpected losses.
The real effects of the Dodd-Franks (2010) proposals are centered on the use and application of
the leverage ratio and also if it provides an alternative to the Basel’s risk-weighted financial
measures (Calomiris and Meltzer, 2014). The emphasis that the Basel norm applies to the
leverage ratios requirements on bank’s especially on the needs for higher ratios on capital
requirements is most likely to achieve a positive, stable and efficient protection to most creditors
from the banking sector (Blundell-Wignall and Atkinson, 2010).
However, the other side of ensuring the implementation of the Basel capital requirements
together with the needs for stricter leverage ratio is also likely to water down the market
discipline as most of the bank’s effort would be to satisfy and if possible manipulate the
requirements of the Basel norms at the expense of the creditors efforts to effectively evaluate the
financial risks. The Dodd-Frank (2010) stress tests are generally expected to complement the
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capital requirements as a way of evaluating the default risks. Stress tests are instrumental and
very effective in evaluating a bank’s financial capital buffer but they rely on the expertise of the
person conducting the tests hence they can also be manipulated in complex financial institutions.
The Bureau of Consumer financial Protection has stepped in to issue and enforce regulations that
are strictly designed to provide protection to the consumers from the bank’s abusive practices
that have been largely benefitted from the limited liable clause that protect the ineffectiveness of
the management’s wrong decisions (Financial Services Committee, 2010).
The Distance-to-Default (DTD) concept is basically a measure that applies the combination of a
bank’s data that has been reported and the general market information that has been collected to
calculate the actual number of standard deviations on average that a bank practically is from the
marked default point that the market values of all the bank’s assets equals to the banks book
value of debts. The formula is based and derived from Black and Scholes (1973) option pricing
model.
The current financial regulations efforts in Europe to reign in the banks are many and varied. The
three most popular ones are the basically the Volcker policies and rules for the US banks, the
Vickers report mostly for the banks in UK and finally the Liikanen report on EU bank report.
The Volcker Rule outlaws all financial institutions from participating on proprietary trading
activities and it’s generally seen as the modern provisions of the Glass-Steagal Act. The Volcker
reform initiative has restructured the entire US financial regulatory control system to restore and
maintain the public confidence on the US banking system. Part of the Volker reform provisions
states that all banks must have a clear structure of making critical decisions on their corporate
Limited Liability in Banking 4
structures and also their operational activities which includes the managements of investments in
all equity and existing hedge funds (Chow and Surti, 2011).
Sir John Vickers regulation proposals place all retail and also the small together with the
midsized enterprises deposits in a closed ring-fenced subsidiaries while placing other riskier
trading businesses on the outside fence. The Vickers reform initiative provides more flexibility to
banks to decide the portion of business that would operate independently and the one that will be
ring-fenced (Viñals, Pazarbasioglu, Surti, Narain, Erbenova and Chow, 2013).
The Liikanen report generally recommends that the entire EU banks other trading business
besides their main stream banking operations be placed in different and separate subsidiaries that
ultimately fence the risky trading operations of the bank. The report also requires that all the
banks to hold sufficient capital against the more risky businesses while holding relative debts
that can be easily turned into equity if there is need to recapitalize a bank that’s ailing.
The solvency requirements are regulated through the Capital Requirements and Directive
(CRR/CRD IV). This directive has been subject to several different changes and it aims at
supporting the Basel Committees on capital and liquidity general framework mostly for
internationally active banks that form part of the Basel III in EU.
The provisions of the CRR and the CRD IV major proposals include stricter requirements on the
macro-prudential needs of the banks that aim at addressing the increased risks that threaten
financial stability in the banking industry ranging from capital level requirements, liquidity and
large exposure requirements, public disclosure requirements, capital levels of conservation
buffers, risk weights for all assets and the intra- financial general sector exposures. The CRR
also includes other specific features that are not completely covered or mandated by the Basel III
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general regulations. The Single Rulebook will finally be the only set of harmonized guidelines on
prudential rules across the EU. According to EC (2014b) the harmonized rules would ensure that
a uniform application of the requirements of the Basel III in all the EC member states and also
move in swiftly to close all the major regulatory loopholes and moves towards providing an
effective and a fully functional internal market regulation system (European Commission (EC),
2014a). The new set of rules remove a considerable number of real national options plus
discretions from CRD and also allows the member states to implement stricter requirements in
situations where there are justified for example in real estate where financial stability if
unchecked may lead to financial instability like the Subprime financial Crisis (Blundell-Wignall
and Atkinson, 2008) The application of the single rulebook may be applied successfully but it
would still require some elimination of the sources of the potential implementation of the CRD
policies and also certain levels of discretions may also apply (European Commission (EC),
2009).
There is overwhelming evidence that bank’s sensitivity of the real debt largely depends on the
average degree of protection enjoyed by a bank’s creditors. According to Sironi (2003) the
subordinate debt yields of the banks that are considered too large to fail are mostly less sensitive
to the general risk proxies compared to the yields of the banks (European Council (EC), 2013).
Finally to conclude, the benefits that are provided by the banks limitation clause was evidently
exhibited when in 2006, the Lehman made a unilateral decision to deliberately embark on a very
aggressive growth strategy that had substantial risks without any fallback position despite
increasing its leverage substantially while making large concentrated bets in real estate housing
schemes which included leverage lending and also private-equity investments (Valukas, 2010).
These investments were very risky and despite having a high level of brokering risks in their
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balance sheets, Lehman was still financing short term repurchase financial agreements that
amounted to several hundred billions almost every day. Lehman operated on a risk profile
similar to commercial banks only that the banks regulation system never applied to its operations
and when the subprime crisis developed, Lehman saw another opportunity to double their
earning instead of a threat to its existence and instead the company pushed its risk limits even
further. Lehman Brothers holdings Inc was already insolvent several times before it officially
filed for bankruptcy in September 15 2008 due to its high risks undertakings that were not being
supervised or regulated. The limited liability of shareholders has driven most shareholders into
heights that are generally unsustainable largely due to non accountability of the decisions made
and the protection afforded under the clause. However, the new developments and the regulation
authorities discussed above are meant to stream line the banking sector and restore the general
confidence that banks need not take unreasonable risks that are unsustainable. The most critical
market failure in the banking industry has been the incentives for major financial institutions to
provide quality and accurate information that reveal the true and fair financial position of the
financial institutions and which investors can have confidence in their management.
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References
Black, F., and Scholes M., (1973), “The Pricing of Options and Corporate Liabilities”, Journal of
Political Economy, Vol. 81, issue No. 3.
Blundell-Wignall, A. and Atkinson, P.E., (2008), “The Subprime Crisis: Causal Distortions and
Regulatory Reform”, in Lessons From the Financial Turmoil of 2007 and 2008, Kent and
Bloxham (eds.), Reserve Bank of Australia.
Blundell-Wignall, A. and Atkinson, P.E., (2010), “Thinking Beyond Basel III: Necessary
Solutions for Capital and Liquidity”, OECD Journal, Financial Market Trends, Vol. 2010,
issue No. 1.
Chow, J. and Surti, J., (2011), “Making Banks Safer: Can Volcker and Vickers do it?” Working
Paper 11/236, Washington, D.C.: International Monetary Fund.
Cohen, B. (2013), “How have banks adjusted to higher capital requirements?”, BIS Quarterly
Review, September 2013: pp. 25–41.
Calomiris, C. W. and Meltzer, A.H. (2014), “How Dodd-Frank doubles down on ‘Too Big to
Fail”, Wall Street Journal, February 12.
Dodd–Frank. (2010), Wall Street Reform and Consumer Protection Act (Public Law 111–203,
July 21).
European Commission (EC) (2009), “The High-Level Group on Financial Supervision in the EU,
report, 25 February,
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European Commission (EC) (2014a), “Stability and Growth Pact
European Commission (EC) (2014b), “Regulatory Capital
Financial Services Committee (2010), one year later: The consequences of the Dodd-Frank Act,
Washington, DC.
Sironi, A. (2003) “Testing for Market Discipline in the European Banking Industry: Evidence
from Subordinated Debt Issues.” Journal of Money, Credit, and Banking, 35, 443-472.
Valukas, A. (2010) “Report of Anton R. Valukas,” Examiner, on Lehman Brothers Holdings
Inc., United States Bankruptcy Court, Southern District of New York, March.
Viñals, J., Pazarbasioglu, C., Surti, J., Narain, A., Erbenova, M. and Chow, J. (2013), “Creating a
Safer Financial System: Will the Volcker, Vickers, and Liikanen Structural Measures
Help?” IMF discussion notes, May 14.
