Banking must return to '19th century' principles

Regulators should embrace historic principles of banking to prevent new financial failures, according to a report from the Adam Smith Institute.

The reintroduction of rules similar to the “double liability” system of 19th century American banks would lower the failure rate and discourage risky behaviour, according to the think-tank.

Under the double liability system, bank executives and shareholders faced a bill in the event of a lender’s failure for twice the value of their investment, making managers and investors far more careful about the risks their institutions took.

“I believe that effective regulation should focus on incentivising managers to behave in the interest of their firms’ key stakeholders, rather than focus on the institution level capital adequacy-based frameworks,” said Mikko Arevuo, the report’s author.

Mr Arevuo proposes that banks should create a new class of “employee shares” that would convert into ordinary shares after five years. However, should the bank collapse before the shares vest the holders of the shares would liable for losses up to the value of their shares on the day they were awarded.

Alternatively, he suggests bringing in a “claw-back” clause on executive bonus payments that would allow banks to take back any awards up to 10 years after they were granted to make managers think more about longer-term risks.

Mr Arevuo argues that his reforms of the incentive systems are better than tougher and more complex and costly regulations that he says are ultimately “a poor tool for changing managerial behaviour”.