70 Pages Posted: 31 Mar 2020
Date Written: March 10, 2020
Policymakers need to rediscover the organizational form of business entity as a tool of financial regulation. Recent and classic scholarship has produced evidence that financial institutions organized as alternative entity forms – including investment bank partnerships and banks and insurance companies organized as mutual or cooperatives – tend to take less risk, exploit customers/consumer less, or commit less misconduct compared to counterparts organized as investor-owned corporations. This article builds off the work of Hill and Painter on investment banks organized as partnerships, Hansmann on the history and economics of banks and insurance companies organized as mutuals and cooperatives, and other scholars. Encouraging either financial institutions to convert to alternative entity forms or more capital and business to flow to these firms can mitigate systemic risk, dampen risk-taking, and further consumer protection. Systemic risk can also be mitigated by organizing firms across a financial industry in an entity that mutualizes risk and encourages firms to police one another’s conduct. Omarova’s and Saguato’s work in this vein recalls the bank clearinghouse of the 19th century.
The entity form furthers these policy objectives without the need for policymakers to specify standards for conduct. Instead, alternative entity forms work by changing the relationships among various claimants on the firm and the firm’s management. Beyond control and liability rules, alternative organizational forms affect manager behavior by changing the identity of the residual claimant on the firm. Management behavior shifts because they are not responsive to investors whose principal interest is maximizing their return on capital.
Alternative entity forms may come with agency costs, as the residual claimants face difficulty in organizing collectively to monitor and discipline management. However, evidence from mutual insurance companies suggests that agency costs are not severe. Other costs associated with partnerships, mutuals, and collectives include limitations on the ability of firms to raise capital. However, this drawback has the benefit of creating an embedded check on the size and complexity of financial firms and providing an alternative to breaking up large financial conglomerates for too-big-to-fail and other concerns. Similarly, alternative entities better serve the interests of residual claimants when those claimants have homogenous interests, creating disincentives for firms to expand across business lines.
Policymakers could encourage financial firms to convert their organizational form or promote more capital or business flowing to alternative entities by providing or restoring historical tax incentives or creating regulatory preferences in the policy areas in which alternative entities outperform investor-owned corporations. In some cases, such as risk-adjusted deposit insurance premiums, regulators may be required to provide this treatment. Regulators and prosecutors should consider requiring financial institutions that have committed serious violations of laws to convert to an alternative organizational form as an alternative to imposing fines or revoking a charter or license.
This article was written for a Cornell symposium in memory of Lynn Stout.
Keywords: financial institutions, financial regulation, mutual, partnership, cooperative, banks, insurance, investment bank, theory of the firm
JEL Classification: G2,G21,G22,G24,G28,K22,L22,D18,D21,D22
Suggested Citation: Suggested Citation