Double Liability A Better Response to J.P. Morgan Mess

A regulatory system that counts on regulators to be smarter and more alert than the companies they regulate will fail us every time.

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Hester Peirce is a senior research fellow at the Mercatus Center at George Mason University. Prior to joining Mercatus, Peirce worked at the Securities and Exchange Commission and as senior counsel on the Senate Banking Committee.

Gasps about J.P. Morgan's more than $2 billion in trading losses dominated Washington conversation last week. J.P. Morgan, the government-anointed rescuer of its weaker brethren during the financial crisis, was not supposed to make a mistake like this. As people fret about the need for more regulation to keep big banks from losing money, it is worth asking whether regulating banks into profitability is really the answer.

J.P. Morgan's status as a banking entity means that, for some, Jamie Dimon's apology and the company's own damage control efforts are not enough. J.P. Morgan can't be trusted to clean up its admittedly massive mess the way similarly humiliated nonbanks do when they make money-losing business decisions.

Instead, many observers are calling for a regulatory solution: Regulators would identify bad business decisions in advance and order banks not to make those decisions. That sounds great, except it doesn't work. Remember, more than 400 heavily regulated banks have failed since 2008 and many others survived only because of taxpayer bailouts.

[See a collection of political cartoons on the economy.]

People are so intensely focused on bankers' mistakes that they don't realize that mistakes by regulators have actually contributed to the riskiness of the financial system. Deposit insurance, which has the noble objective of preventing bank runs during financial crises, makes it easier for bad risk managers to go unpunished by immunizing bankers from the consequences of their foolish decisions. President Franklin Roosevelt voiced these same concerns when deposit insurance was first introduced.

Deposit insurance, which politicians unwisely expanded in response to the crisis, will not be going away anytime soon. There is, however, a way to reintroduce some market discipline by returning to a concept that existed before deposit insurance—double liability for bank shareholders. Under this approach, if a bank failed, its shareholders would not only lose their initial investment, but they could be required to kick in an amount equal to that initial investment to cover creditor losses. Bank shareholders, not taxpayers, would fund bailouts.

[Read the U.S. News Debate: Does the J.P. Morgan Loss Prove the Need for Tougher Bank Regulations?]

One benefit of double liability is that it would scare bank shareholders into alertness. Scared shareholders have an incentive to monitor what their companies are doing or make sure someone else is watching closely. This monitoring would not be the superficial, check-the-box approach that regulators sometimes use, but would look deeper. As a beneficial consequence, banks would be forced to be more transparent about their activities. Shareholders would look beyond profits to understand how much risk the bank is taking on to generate those profits. Professors Jonathan Macey of Yale and Geoffrey Miller of New York University studied the history of double liability and found shareholders exposed to double liability "have every incentive to encourage bank managers to increase profits while at the same time discouraging excessive risk taking."

Another benefit of double liability is that it would help address the "too big to fail" problem. It's tough to monitor big companies, so big banks might shrink without a regulatory directive to do so.

Lastly, it would make nonbanks think twice before dipping their toes into the banking realm. If companies did go into banking, their funding costs would rise, because investors would have to factor in being on the hook for additional money down the road.

 [One Lesson From J.P. Morgan: Wall Street Has Changed]

Complicated, new regulations won't change regulators into super-humans. If the Volcker Rule and its hundreds of pages of regulatory interpretation make one thing clear, it is that regulators have no idea how to discern whether banks are taking inappropriately risky gambles with their downside covered by deposit insurance.

A market solution implicitly recognizes that everybody involved is human, even regulators. Regulators have trouble obtaining and analyzing relevant, timely information and are not equipped to react very quickly.

A regulatory system that counts on regulators to be smarter and more alert than the companies they regulate will fail us every time. Shareholders, by contrast, bring to the job diverse perspectives and an ability to send an immediate message to errant bankers by dumping their shares. Putting bank shareholders back on the hook is more likely to moderate reckless bankers and strengthen our financial system than directing regulators to stop J.P. Morgan from losing money.

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