The popular finger now points at the reckless risk taking of bankers and the myopia of regulators. As the financial fires burn, politicians scurry to find solutions and to pass the blame. The sub-prime market collapse was a disaster waiting to happen but we need to ask some simple questions: why did it occur and what can we do to prevent it, or something similar, happening again? Complex events often have simple causes and this crisis like banking crises before has a very simple cause.
There is no doubt that western property owning capitalism with its focus on the empowerment of the individual through home ownership has played a part. The plight of first time buyers in the housing market, and the political pressure to find ways of making property affordable, presented an opportunity for banks to create a new, high risk lending market. But why did the banks accept the risks inherent in this exercise in social engineering? The answer is subtle and lies within the nature of limited liability and the attitudes it creates towards risk.
From Black and Scholes forward we have come to understand that equity in a limited liability business represents a call option on its underlying assets. Viewed this way banks are ‘near the money’ entities. The intrinsic value of the business in the hands of the equity investors – the difference between the bank’s asset value and its liabilities - is very low, but the element of ‘hidden value’ imparted by limited liability – the time value of the underlying call option - is very high. Unlike the typical commercial enterprise where the reverse is the case, bank investors have a positive appetite for risk in the form of increased asset volatility and in setting the incentive structures for management which ensure that they get what they want.
To solve the problems of the banks we need to focus on the agency effects of limited liability: the removal of limited liability through remutualisation would be one option. Another would be to selectively penalise excessive risk taking supported by risk sharing between government and the banking sector. Whatever solution is found we need to attack the root of the problem and that is that equity investors in banks have everything to gain and nothing to lose by excessive risk taking on the part of their agents: the directors who run the banks on their behalf.