naked capitalism

Sorry for thin posts, have to do a quick turnaround trip to NYC, then back to Maine.

Study slashes estimated rates of ice loss from Greenland, West Antarctica Raw Story (hat tip reader John D)

Fears of a Decline in Bee Pollination Confirmed Science Daily (hat tip reader John M)

AP Begins Crediting Bloggers as News Sources The Next Web (hat tip reader John D)

Overseas Visitors to U.S. Start Paying $14 for Tourism Promotion Bloomberg

Top Democrats Throw Cold Water on Obama’s Jobs Plan Roll Call (hat tip Huffington Post)

NYT Pushes BP’s PR Line on Its Ability to Pay Ryan Chittum

Beggar thy Neighbour Credit Writedowns

Deep Read: ‘Traders, Guns & Money‘ Planet Money. A podcast, but you can also read the transcript if you don’t do podcasts.

Do financial statements tell the truth? Steve Waldman. Eeek, from a few days ago……

In Connection With Steve Lubben, Credit Slips. On Chase/Lehman litigation.

Wall Street Firms to Cut 80,000 Jobs in 18 Months, Whitney Says Bloomberg

Rome is Burning Karl Smith (hat tip reader Michael C). A great rant and a must read.

Antidote du jour:

This post first appeared on April 17, 2008

I am frequently mystified at what goes on in the markets. I am even more mystified when people who ought to know better make pronouncements that appear to be profoundly counter-factual. Even if they are talking their own book, the high odds of being revealed as bald-faced liars proven wrong ought to make them worry about damaging their credibility.

Is this wishful thinking? Delusion? A hope that that a united front can change perceptions and therefore reality? (see this as Tinkerbell behavior: if we all clap together, the markets won’t die).

In the last week, we’ve had the CEOs of Goldman, Morgan Stanley and JP Morgan say that they see an end in the not-too-distant future to the credit crunch. Similarly, Mark Mobius of Templeton argues that all the bad news is already priced into stocks, while private equity investor Wilbur Ross plans to spend $4 billion buying banks (although he professes to be picky)

Mind you, the optimism among the financial services leadership is far from universal. Lehman thinks recovery won’t come till 2009; Paul Calello, CEO of the investment bank Credit Suisse expressed considerable uncertainty as to when the crisis might be over. And the industry’s own analysts, who have strong incentives to argue the bull case, have been far more downbeat than industry executives. Goldman has forecast an “awful” earnings season across the board; Meredith Whitney of Oppenheimer is calling for continued large losses at banks.

I could go through a litany readers know well (and can no doubt improve upon): the housing market is continuing to deteriorate and based on precedents here and abroad, there is no reason to think it will bottom before 2010 or 2011; we are some distance from a typical bear market low of a 30% fall in the S&P (and with the severity of this crisis, we may overshoot); the US has to wean itself off its credit habit, and none of the ways out are pretty; non-government guaranteed securiization has fallen off a cliff and appears unlikely to come back any time soon, yet banks lack the equity to fill the gap with on-balance-sheet intermediation; counterparty risk in the credit default swaps market hangs over the financial services industry like a sword of Damocles.

But let’s put these long-term considerations aside. It’s bizarre to see this upsurge of cheery chatter given the counterevidence in the money markets. Widening TED spreads suggest we are on the verge of another crisis:

The overnight index swap rate has also indicated bank reluctance to lend to each other. Jeff Frankels provided an update yesterday, with a chart from the Institute of International Finance:

And the report yesterday that banks were fudging on their reporting of Libor is making maters worse. From Across the Curve:

I have related the thoughts of a money market trader at a large shop who has been modestly constructive on his market. The story in the Wall Street Journal this morning which suggetst that banks have been understating the true cost of funding and the true Libor rate has turned this veteran trader less optimisitic. My source believes that this story and the subsequent report that the British Bankers Association will mete out harsh punishment to those found dealing in untruths will lead to an excess of caution over the near term. My trader source reports that inquiry further out on the money market curve has dried up this morning and the only business he has printed is in overnight sector. He thinks the imbroglio could add 5 basis points to 10 basis points to Libor in the near term

Separately, the 5year swap spread is currrently at 92.5 basis points. It has essentially retraced the entire post Bear Stearns rally. On the Friday evening of March 14 the 5 year swap spread finished trading at the 93.75 level. In the rally which followed it reached 77 basis points. It has slowly moved wider so that it currently sits just a basis point from the pre Bear level.

Central bankers have thrown a lot of firepower at the problem of a money market seize-up, yet illiquidity persists. What more can they possibly do if we move into another acute phase?

Update 11:30 AM: Reader Scott sent this chart, showing two year US swaps, with the comments. “The concept that the Fed has stabilized the system is fantasy…..queue the Ride of the Valkyries.”

Martin Wolf, in today’s Financial Times, argues that the eurozone has done wonders for Germany by allowing it to keep the value of its currency down. With Germany’s persistent, large trade surpluses, the value of the deutschemark would eventually have risen, dampening Germany’s trade surpluses and forcing it either to accept a higher level of domestic consumption or greater unemployment.

This picture runs at odds against the stereotype of German industry, that its success is due to high levels of investment, attention to quality, a good workforce, etc. While all these things are no less true, consider: how would German businessmen have reacted if a German currency appreciated and stayed at a high level? They’d presumably shift operations to lower cost centers and reduce their level of domestic investment. They might also might be less keen to support high levels of infrastructure spending, since their operations would now make less use of it. And they might push for lower taxes to compensate for margin pressures at home.

In other words, they might adopt some of the bad behaviors of American executives.

From Wolf:

So why….should Germans accept that they have an overwhelming interest in the success of the eurozone? The immediate answer is that the economy is hugely dependent on exports for demand (see chart). From 2000 to 2008 external demand generated as much as two-thirds of the growth in overall demand for German output. Germany needs both captive markets and a competitive exchange rate. The eurozone has delivered both, to an inordinate degree: the crisis in the periphery has dragged down the value of the euro; and many of Germany’s eurozone partners (who absorb two-fifths of its exports – nine times as much as China) are uncompetitive, after a decade of rising relative costs.

{click to enlarge]

More important, imagine what would have happened, in the absence of the euro. The exchange rate of the D-Mark would have exploded upwards, as currency crises savaged the European economy, as happened in the 1990s. In peripheral Europe, currency depreciations would have been at least as big as, if not bigger than, sterling’s. The absence of such shocks has greatly enhanced the prospects for the German recovery. The creation of the eurozone was, for this reason alone, much more than a favour Germany did for its partners. It was also a big economic (not to mention political) gain for Germany. German industrialists are clear on this, as is the government.

Note how a cheap currency supports activities that look virtuous – high savings, investment in capital – but require other parties to run trade deficits (which implies they import capital, which usually means borrow) and consume. Mercantilism is a great model until your trade partners wake up and realize the real costs. As Niall Ferguson points out, “China gets 10pc growth: the US gets 10pc unemployment. That doesn’t seem the basis for a happy marriage.” And partners that can’t divorce often wind up making life miserable for each other.

→ Washington’s Blog

(Videos at WashingtonsBlog.com)

A number of different chemists are finding elevated levels of toxic hydrocarbons in the bloodstream of Gulf coast residents.

What is most disturbing about these results is that people who simply live near the water are showing higher than normal levels of toxic chemicals. These are not fishermen, shrimpers, oil workers or others who work on the water.

Jerry Cope recently wrote about his test results in a must-read essay at Huffington Post.

Several Gulf coast residents described their test results in the following video:

And the Intel Hub has uploaded some of the other test reports.

The local ABC news affiliate in Pensacola, Florida – ABC3 Wear – covered the story:

Several residents of Orange Beach say the oil spill has been making them sick…and they have the test results to prove it.

Gerry Cope, Margaret Carrouth and Robin Young were all feeling the same symptoms of headaches, watery eyes, and breathing problems…

All three had blood samples taken at the beginning of August…

Tests revealed each had elevated levels of the Hydrocarbons Ethyl Benzene and Xylene.

Bob Naman, a chemist out of Mobile, analyzed the results.

“He shows three times the amount you typically find in someone’s blood.”

“These people are from different backgrounds, and from different walks of life, all showing same similar organic compounds in blood, says to me its very likely in the air.”

Background levels of these chemicals were taken from the U.S. Centers for Disease Control’s Fourth National Report on Human Exposure to Environmental Chemicals.

It is well known that oil fires can increase the levels of ethyl benzene and xylene in people’s bloodstream. For example, in studying Gulf War illness, the National Defense Research Institute
found that exposure to the Kuwaiti oil fires set by Saddam Hussein increased ethyl benzene levels in firefighters more than 10 times – from .052 to .53 micrograms per liter – and more than doubled xylene levels:

Table 3.6
VOC Concentrations in Blood in U.S. Personnel
(µg/l)

A geochemist from East Carolina University – who was awarded a grant from the National Science Foundation – says that evaporation and storms can carry toxic hydrocarbons from the Gulf oil and dispersants inland:

YouTube Video

There have been previous reports of  spill-related toxins becoming airborne. For example, as National Public Radio notes, Orange Beach city geologist Mark White and others found oil which was apparently airborne.

And New Orleans news channel WDSU noted in July:

Smith’s team has also conducted air monitoring tests. What they found [were] high levels of chemicals like benzene and hexane coming from dispersants.

And even BP admitted back in June elevated levels of ethyl benzene and xylene offshore. See this and this.

In addition, as I noted last week, scientists have found that applying Corexit to Gulf crude oil releases 35 times more toxic chemicals into the water column than would be released with crude alone.

Is it possible that the massive application of Corexit dispersant is creating a situation analogous to ongoing oil fires: ongoing release of large quantities of toxic components of crude oil?

It is important not to be alarmist about the dangers of the oil/dispersant mixture to human health, but it is equally important to fully study the issue, and not to let politics get in the way of science.

The end of the US summer holiday period is upon us, and with it, a return to reality. The markets are again concerned re Eurobanks, as the fears registered in EU periphery country bond spreads are now registering with investors in other markets. Per Bloomberg:

The gaps between 10- year German bond yields and those of Irish and Portuguese debt climbed to all-time highs, while the German-Greek yield spread increased to the widest since May.

“Widening spreads are like a canary in a coal mine,” said Quincy Krosby, chief market strategist for Newark, New Jersey- based Prudential Financial Inc., which oversees $690 billion. “It’s a signal that debt concerns are mounting. In order for the stock market to move higher, investors will have to see a solid package of data suggesting that we’re avoiding a double- dip recession.”

Gold has traded up to $1258 an ounce, near its recent highs but the euro is still within its recent 1.27 to the dollar trading range. The big impetus for the gold spike earlier this year had been European investors selling euros to buy gold. That may revive if rattled nerves and with it, funding stress rises, but it is also possible that investors may look to a more diverse menu of “safety” trades this go round.

Study examines association between urban living and psychotic disorders PhysOrg

Freakonomics: The Movie Out Today on iTunes Only Freakonomics

Money Can Buy Happiness, Study Finds — But Only Up To $75,000 Associated Press. Even though the Nobel Prize winner Daniel Kahneman was involved in this study, the idea of using survey research to reach this sort of conclusion gives me the willies. However, past studies have found repeatedly that happiness levels quit rising once someone reaches an income level at which he can meet basic needs and have a margin for safety. Thus, the $75,000 figure is also suspect, since it’s a lot cheaper to live in, say, Oklahoma than in San Francisco.

Obama slams wealthy critics: ‘They talk about me like a dog’ Raw Story

German banks try to fend off Basel III Financial Times

Bankruptcy Court Is Latest Battleground for Traders Wall Street Journal

Happy Fuckin’ Labor Day! Michael Moore (hat tip reader Frank A)

Obama’s Economic “Plan”: Ten Times Less Than Adequate and Far, Far Too Late Friedoglake

Caixin Online: China’s census to include empty housing MarketWatch

Citi under fire over deferred tax assets Financial Times

The Blitz Continues: Obama Will Let Businesses Write Of 100% Of Plant Investments Clusterstock

Greece Default Risk Is `Substantial,’ Pimco’s Bosomworth Says Bloomberg

Europe’s Banks Stressed By Sovereign Debts Regulators Ducked Bloomberg

Europe’s Bank Stress Tests Minimized Debt Risk Wall Street Journal. Repeat after me: Bank stress tests are PR exercises.

Ultra-Rich in Finance Are Meaner Than Rest of Us Matthew Lynn, Bloomberg

Antidote du jour:

Wow, the EU is increasingly taking steps to force foreign, meaning US and UK firms, to play by its rules or not have access to its investors. The first salvo occurred over private equity funds and hedge funds, where the EU will limit its investors to funds located in the EU, and is also limiting the ability of foreign funds to acquire firms in the EU.

The latest development is that the EU is implementing a rule called 122(a) which will have a significant impact on the private securitization market. EU investors will be penalized (via much higher capital requirements) if they invest in asset backed securities that they cannot understand. And of course, to understand them, the issuer has to make pretty complete disclosure (you can’t assess in a vacuum). That disclosure in turn happens to be higher than the norm pre crisis.

A second element is that Rule 122(a) will also require issuers to retain 5% of their new issues. From Institutional Risk Analyst:

There is a five percent (5%) retention requirement for the issuer regardless of the type of underlying asset. Even as this article was being written, there is still debate between the regulators and the industry as to the form of the retention. For example, the retention could be a vertical or horizontal slice of the deal.

Much more important than the retention requirement is the disclosure requirement. Issuers are required under Paragraph 7 of Article 122a to “ensure that prospective investors have readily available access to all materially relevant data on the credit quality and performance of the individual underlying exposures, cash flows and collateral supporting a securitisation exposure as well as such information that is necessary to conduct comprehensive and well informed stress tests on the cash flows and collateral values supporting the underlying exposures.”

This appears similar to, but less comprehensive than an FDIC proposal earlier this year which was very much in keeping with what investors needed and therefore died on the vine. IRA contends implementation would not be difficult:

Issuers and the servicers involved in the daily billing and collecting of the underlying exposures are easily able to report all the data fields that they track in their data systems on an observable event basis. Issuers are in the best position to explain each structural element of a security and how they work together. In addition, the information technology exists to provide both the underlying exposure data and the structural features at very low cost. As a result, compliance is easy and several issuers are likely to comply to gain a competitive advantage over those issuers who do not comply and also to ensure ongoing access to the capital markets for funds.

The fact that the EU is muscling the US is a sign of both the US’s weakening authority and a lack of strategic vision. As strange as it may seem now, the reason the US has had the deepest capital markets wasn’t simply the size of our economy, but the perception that we had the most open and fairest regime for investors. The US markets are badly tarnished, yet the authorities continue to take their cues from the very same industry incumbents who created this mess.

The Japanese often would speak of “foreign pressure” as in using foreigners as an excuse to do things that the elite bureaucrats actually wanted to happen but found difficult politically. The worst is our top regulators still seem unable to believe that they can and must be much tougher with their charges.

John Cassidy, and following him, Felix Salmon. took aim at Ben Bernanke’s testimony last week at the Financial Crisis Inquiry Commission explaining why the central bank and Treasury stood aside in Lehman’s extremis. The problem is that both get two fundamental, and critical facts wrong, and that error makes the rest of their claims dubious.

As Cassidy reads Bernanke’s testimony, he made what Cassidy deems to be a new rationale for not saving Lehman:

“Any attempt to lend to Lehman would be futile and would only result in a loss of cash,” Bernanke said in explaining what he and his colleagues were thinking. “It wasn’t just a question of legality. It was a question of whether there was any conceivable option that would work.” The conclusion reached was “there is no way…. If I could have done anything to save it, I would have saved it.”….

Bernanke has shifted the debate onto the issue of whether saving Lehman would have been a practical option. Here, I fear, he is on much shakier ground…

Recall that right up until Sunday night, Barclays, the big British bank, was ready to take over and stabilize Lehman in the same way that, six months earlier, J. P. Morgan had taken over and stabilized Bear Stearns. The official story is that this option fell through because Barclays needed to obtain shareholder approval for such a takeover, which would have taken at least a few days, and the British government refused to waive this requirement. With the markets about to open in Asia, there wasn’t time to wait for Barclays to do what it needed to do in Britain.

But what if the Fed and the Treasury had made a public announcement that they had approved a takeover by Barclays and were willing to provide Lehman with bridging finance until the deal could be completed?Wouldn’t that have been enough to reassure the firm’s creditors and counterparties? It isn’t immediately obvious that the answer is no.

Erm, this discussion considerably overstates where Barclay’s really was. The first serious error is Barclays was NOT ready to take over and stabilize Lehman. Its senior management wanted to do that, but any deal depended on shareholder approval.

The second error is that approval would take “a few days.” But approval under the UK regime was expected to take thirty to sixty days.

And that leads us to the third error, that the Fed merely needed to lend to Lehman, or per Salmon, to guarantee the deal (Salmon provides a link to a Bloomberg story with an in passing reference to a Fed guarantee of liabilities; I don’t see any reference to this guarantee on the Fed’s Board of Governors or NY Fed websites).

JP Morgan, before trading opened in Asia on the weekend when the Bear deal was hammered out, agreed to guarantee Bear Stearns’ trades. For instance, from the analyst conference call of March 16 (Sunday) at 8:00 PM:

We are also effective immediately providing a JP Morgan guarantee to all of the trading obligations of Bear Stearns so all counter-parties facing off against Bear Stearns should understand they are dealing with JP Morgan Chase on that basis.

That’s confirmed by later documents on the JP Morgan website. There was no question of approval by JP Morgan shareholders; the guarantee to Bear was structured as the lesser of time to shareholder approval or twelve months. Note neither the call nor the announcements mention any Fed guarantee beyond the $29 billion loan to what was later called Maiden Lane, the vehicle which held some expected to be bad Bear Stearns assets.

By contrast, on Sunday morning of the Lehman weekend, after the bank consortium had agreed to take $40 billion of toxic Lehman assets and Barclays management was ready to go, the FSA indicated it would be unlikely to waive the shareholder vote requirement. Even more important, the FSA indicated that the US would need to cover Lehman’s debts, which would include its trading obligations, prior to an acquisition, and indicated if that would happen, they might look favorably upon a deal.

Now let’s see how this plays out. The problem with dealing with a trading troubled operation is you have a very basic decision to make: whether to halt trading and settle up with everyone as best you can, or to get it into stronger hands who can (somehow) enable the operations to continue trading. The sheer volume of transaction and money flows forces binary choices You have a bankruptcy or collapse with the former; some sort of assumption of the trading operations with the latter.

Remember, approval of the acquisition is not certain and AIG was hitting the wall then too. A lot of investors would presumably decide to take a bird in the hand. There is not reason to think they would not take advantage of the Fed backstop. The market would know of the selling, and with it, continued to the Lehman franchise. The odds were real that the bleeding would continue. And what if Barclays’ shareholders turned down the deal? No one would want it. Fuld had flogged his firm anywhere and everywhere and Barclays was the last taker. The US government would own a sick investment bank.

Oh, and this mess would culminate around the time of the Presidential elections.

Hindsight is always 20/20. We now know that the hole in Lehman’s balance sheet may be as large as $150 billion (the swing from a reported positive equity to losses most recently reported at $130 billion. But at the time of the Lehman implosion, the banks who had cobbled together a backstop were assuming losses of $40 to $50 billion on bad assets. The Fed and Treasury probably believed that they would have to absorb that, plus any collateral damage resulting from the market selling into their de facto unlimited backstop on Lehman.

As readers know well, I am no fan of Bernanke. But the big failing was not in the battlefield decisions the Fed and Treasury made that weekend, but the abysmal failures to act on a number of fronts in the months and years prior to the crisis. By Lehman weekend, he had few degrees of freedom due to the Fed and Treasury’s longstanding neglect.

Update 3;00 Am: Andrew Ross Sorkin has a story at the New York Times that focuses on Lehman’s final hours, highlighting e-mails among some of the authorities at the Fed (Warsh, Kohn) stating serious political opposition to any rescue. While Sorkin intimates these messages are damaging, the fact is the officialdom was broadcasting loud and clear there would be no rescue for Lehman before the terminal slide started. In addition, the messages that Sorkin highlights were not from people who were deeply involved in the negotiations (given how frantic the rescue efforts were, I would imagine that communication, even to those normally in the inner circle, was intermittent and incomplete).

But the Sorkin article puts the spotlight on a different issue: the abject failure to prepare for bankruptcy. Not enough attention has been given to something made clear in his book: no one talked to a bankruptcy attorney about what a bankruptcy filing would entail. While Lehman had retained Harvey Miller, he was out of the loop and stunned when told to file. In addition, due to the utter lack of preparation, Lehman didn’t simply file for bankruptcy, it filed on a thin form, meaning it went bankrupt in the most disorderly fashion possible. A more complete filing would have been less disruptive; this badly flawed process is remains a not-well-recognized self-inflicted wound.

An interesting paper at VoxEU provides some empirical support for a commonsensical observation: that the pervasive use of limited liability structures for virtually all financial services activities creates “heads I win, tails you lose” dynamics. If you have no downside and can earn more by taking risk, then why not? While bad incentives like these typically produce bad outcomes, they are particularly problematic in the banking arena, where leveraged institutions are fragile to begin with, and the extensive safety nets under the banking system means that taxpayers bear the cost of reckless behavior. Indeed, in the past, not only were banks much more strictly regulated out of recognition of their quasi-public role, but in some states, even arm’s shareholders were subject to double or even triple liability (ie, they could be assessed a multiple of the amount they invested) in the event of firm failure.

As we and other have noted, in the days of investment banking partnerships, which were unlimited liability structures (meaning the partners could lose everything), the owners of the firm were more cautious, not simply about the nature of their day to day exposures, but also about the firm’s franchise. Most private securities firms were conservative in their promotion choices and concerned about the long-term value of their franchise.

Richard S. Grossman and Masami Imai, both members of the economic faculty at Wesleyan, used a data sample that is sufficiently old (1878 to 1912) that some might dispute its relevance, but how much has human nature changed?

From VoxEU:

One of the striking features in the buildup to the global crisis was the extent of risk taken on by highly leveraged financial institutions. This column blames such behaviour on the limited liability status of these institutions. Using data on British banks from 1878 to 1912, it finds that the banks with greater liability for their debts took on less risk.

From the enactment of the first commercial banking codes in the nineteenth century through the adoption of the Basel and Basel II accords in recent years to the anticipated adoption of Basel III, policymakers have argued that holding increased amounts of capital promotes bank “soundness and stability” (Basel Committee on Banking Supervision 1988, 2004). Even before governments began to mandate explicit minimum capital requirements, law, custom, and market forces led to alternative means for providing sufficient levels of capital, primarily though extended shareholder liability (Berger et al. 1995).

The oldest and most well-known system of extended liability is unlimited liability, under which partners bear liability for all the obligations of a failed firm. In England and Sweden, banks that issued currency during the nineteenth century were typically subject to unlimited liability. In the US, state law often mandated that banks chartered under their authority be subject to “double” liability. In case of the bank’s failure, shareholders would be liable for twice the amount they had originally paid for their shares; some states mandated “triple” liability. The theoretical argument underlying these arrangements is simple. With more “skin in the game,” shareholders will be less willing to undertake excessive risk.

A formal analysis of liability: Uncalled capital

Although the recent crisis has encouraged economists to consider the policy implications of adopting various forms of extended liability (see Kashyap et al. 2008 and Flannery 2009 on “contingent capital”), there have been relatively few systematic attempts to examine this historical experience with extended liability. Exceptions include Esty (1998) and Grossman (2001) who demonstrate that such strict liability rules played an important role in reducing moral hazard problem in the US banking sector during the half-century or so prior to the Great Depression.

In recent research (Grossman and Imai 2010), we consider another mechanism for imposing contingent liability upon shareholders which was common in Britain during the late nineteenth and early twentieth century: uncalled capital. Under this system, firms issued equity with a nominal value, all or part of which might have been required to be paid in by subscribers at the time of the initial offering. Shares which were only partly paid carried with them a contingent liability for the unpaid portion of the share and could be called in by the firm at the management’s discretion.

We investigate the consequences of uncalled liability by analysing bank balance sheet and share price data from British banks during 1878-1912. At the time of establishment, company promoters declared the nominal amount of the firm’s capital, the number of shares into which it would be divided, and the portion of each share that would be paid-in by subscribers. There were no statutory requirements for the amount of uncalled capital, which was determined by a variety of factors, including common practice within an industry and current opinion as to what share characteristics were conducive to promoting financial stability (Jefferys 1946).

Figure 1 demonstrates the extent of uncalled capital in a variety of sectors during 1870-1913. The figure reports data for only a few sectors, including banks, insurance companies, trusts, and land, mortgage, and financial companies. These sectors maintained a high amount of uncalled capital relative to the market as a whole. The high proportion of uncalled capital can be seen as a market-imposed requirement to engender confidence in sectors where leverage was high and the physical assets were either meagre or inaccessible to creditors.

Figure 1. Ratio of uncalled to market capital, selected

We measure bank risk in two ways:following Saunders et al. (1990) and Esty (1998), we use the volatility of share prices;the ratio of loans to total assets, under the assumption that loans are riskier and less liquid than other balance sheet assets.

We regress these measures against bank capital-to-asset ratios, a dummy variable for limited liability, a measure of the amount of uncalled liability, plus interaction terms between capital and unlimited liability and capital and contingent liability. The interaction terms are included to capture the possibility that extended liability is less relevant when banks are more adequately capitalised.

The results based on share price volatility are generally not significantly different from zero. Those based on the loan-to-asset ratio, however, are less ambiguous and more robust. The coefficient on contingent liability is negative and significant, meaning that higher levels of contingent liability are associated with less risk-taking. These effects are economically important. Comparing a bank with no contingent liability with a bank with contingent capital equal to the total amount of paid-in capital (i.e., the amount put up by shareholders in at the IPO), the latter’s loan-to-asset ratio is, on average, 16 percentage points less than that of the former. Further, the effects of contingent capital are stronger for banks operating with lower capital-to-asset ratios than with well-capitalised banks, suggesting that contingent capital may act as a brake on risk-taking for banks that are, in fact, in greatest danger of failure.

Do stricter liability rules encourage prudence?

Our results suggest that, at least prior to World War I, British banks which operated under more strict liability rules – particularly more highly leveraged banks – undertook less risk than those operating with lower levels of contingent liability. These results are consistent with both the predictions of economic theory as well as the findings of empirical literature that focuses on the consequences of double liability in the US (Esty 1998, Grossman 2001, Grossman 2010).

Of course, as shown in Grossman (2001), state-chartered banks in US states that imposed extended liability during the Great Depression fared worse than banks in limited liability states, suggesting that the benefits of extended liability may be of limited use in the face of a financial tsunami. Nonetheless, our results have an important implication for today’s policymakers. Extending bank shareholders’ liability can protect taxpayers by directly reducing the taxpayer’s share of bank resolution costs and, more importantly, by altering the risk-shifting incentives of banks.

Reading Arabic ‘hard for brain‘ BBC

Rare colour footage of Blitz unearthed Telegraph

What America Has Lost Fareed Zakaria, Newsweek (hat tip reader Paul S)

Religious Outlier New York times (hat tip reader John D)

The Death of Cash? All Over the World Governments Are Banning Large Cash Transactions Lew Rockwell (hat tip reader John D). Yes, I know he tends to, ahem, extreme stories, but this appears to be reasonably factual (and is not an extreme claim). So reader input encouraged.

Sellers Cut Prices on 50% of Homes Housing Watch (hat tip reader John D)

Holding Wal-Mart Accountable American Prospect

Bank capital ratios and standing on tippy-toes John Hempton

Dangerous Defeatism is taking hold among America’s economic elites Ambrose Evans-Pritchard, Telegraph. His diagnosis is sound, I’m not as keen about his remedy.

Delusions Of Recovery Paul Krugman.

How huge houses consume fortunes John Dizard, Financial Times

Antidote du jour: