Liability Holding Companies

While excessive bank debt can impose overwhelming costs on the broader economy, some contend that there may be some benefits from debt for a firm’s corporate governance. In particular, some academics have argued that debt is useful because it disciplines bank management. The idea suggests that creditors with hard claims against the firm will monitor the firm in order to prevent bank management from misusing the free cash flows that the banks’ economic activities generate. If these benefits exist and are substantial, we may face a vexing tradeoff: Too much debt creates dramatic social costs, moral hazard, and systemic risk, while too little may have negative consequences for firm governance. The challenge is to find a way to optimize that tradeoff.
This Article engages that challenge and introduces a new kind of financial institution—a liability holding company (LHC)—that appropriately balances the social costs of excessive private leverage with the purported benefits for corporate governance that such leverage might create. Our proposal places an increased-liability version of the bank’s equity in a conjoined but separately controlled entity, the LHC, which also owns other assets to which the banks’ liabilities have recourse in the event of failure. The equity shares of the LHC—a holding company subject to a unique regulatory regime supervised by the Federal Reserve, similar to bank holding companies—are then traded in public markets. The LHC thus aims to eliminate or, at least, to greatly reduce the role of the government as the effective guarantor of the systemically important financial institutions (SIFIs), thereby reducing the distortions created by current implicit governmental guarantees. It additionally allows banks the benefits of two boards: an advising board that the bank managers may appoint and the monitoring board that is housed at the LHC and appointed by the LHC’s own public shareholders. This dual-board structure resolves some important issues raised in the longstanding debate about the role that corporate boards should play. We discuss in detail how this proposal would function within the present legal and regulatory environment particularly within the contexts of bank regulation, corporate governance, and the Dodd-Frank Act—and address counterarguments and alternative proposals.

Anat R. Admati, Peter Conti-Brown, and Paul Pfleiderer

UCLA Law Review

2012

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