Equity Finance: Matching Liability to Power

• Published in: Journal of financial regulation 2020-03, Vol.6 (1), p.1-40
• Main Authors: Goodhart, C A E, Lastra, R M
• Format: Article
• Language: English
• ISSN: 2053-4841; 2053-4841
• DOI: 10.1093/jfr/fjz010

Abstract In this article we question the wisdom of limited liability for all equity holders in the case of banks and systemically important financial institutions (SIFIs), though our proposals could be extended to all public limited companies. Limited liability can be a major source of moral hazard and excessive risk taking—a privilege that allows shareholders to enjoy the upside from their commercial activity while limiting their exposure in the event of failure. We propose that there should be two different classes of equity for banks and SIFIs. The division should be between outsiders, with no inside knowledge of the working of the firm and/or ability to control its decisions, and insiders, who have both the information and capacity to influence corporate decision-making. Outsiders would remain with limited liability, while multiple liability (double, triple, and potentially unlimited) would apply to insiders. The purpose of our proposal is to shift the costs of failure back to those who have responsibility for taking these decisions. The idea of financial liability ‘with teeth’—which is rooted in history—provides an innovative solution that improves the incentives for managers to take responsible decisions, and promotes a radical change in the structure of capitalism—addressing the unfairness of the current system which has enhanced inequality and encouraged populism.