Patrick Jenkins suggests that policymakers have not focused on how to restrain excessive leverage (“Corporate rescues should come with strings attached”, Opinion, June 25). Many of us, including the cosignatories of this letter, have, and we advocate “de-risking solutions”.
We put the main blame for the move into excessive debt/leverage on the incentives/self-interest of equity holders. Shareholders are currently protected by limited liability from the downside of a risky gamble and, as holders of the residual claim on the company, their upside is unlimited, ie equivalent to a call option on the company. Our proposal, set out at much greater length in our paper published in the Journal of Financial Regulation, would divide equity holders into two classes — insiders and outsiders. The insiders — those with the power to monitor and control the corporations — should have multiple liability. The outsiders — those who lack the power to monitor and control the corporations — would continue to enjoy limited liability.
The knowledge of unlimited liability prompts partners to be cautious about the criteria and process for admission to partnership (this is still how many law firms structure themselves), and to aim for dual or multiple oversight of very large and complex matters. There was a time in the City when unlimited personal liability put a check on risk-taking. In 1999, Goldman Sachs was the last major financial services firm to give up this partnership model.
There are other proposals to “de-risk” that we consider — ranging from clawback of bonuses in the event of failure, to requiring automatic equity recapitalisation once the equity market value of a company falls to “dangerous” levels (eg via Cocos) or shifting the legal basis of corporations to have them include an obligation in their articles of association to a much wider group of stakeholders, beyond shareholders.
Our proposal enhances managers’ accountability while tackling the ultimate risk-shifting, moral hazard device: the limited liability for equity holders. A crisis like Covid-19 always brings an opportunity for reform. In a world of corporate bailouts, well-designed equity finance can help the recovery in the post-coronavirus world.
Professor Charles Goodhart
London School of Economics
Professor Rosa M Lastra
Sir John Lubbock Chair in Banking Law, Queen Mary University of London
London WC2, UK