illtemper.org

“What impact did these changes have on banks’ incentive to take risks? The answer was provided in 1974, around a hundred years after the introduction of limited liability, by the Nobel Prize-winning economist Robert Merton, who showed that the equity of a limited liability company could be valued as if it were a financial option – that is, an instrument which offers rights over the future fruits of the company’s assets. This option has value – in the jargon, it is ‘in the money’ – provided a firm’s assets cover its debts. But the most extraordinary implication of Merton’s framework is that the value of those options can be enhanced by increases in the degree of uncertainty about the value of the bank’s assets. How so? Because while uncertainty increases both upside and downside risks, downside risks are capped by limited liability. For shareholders, the sky is the limit but the floor is always just beneath their feet. To maximise shareholder value, therefore, banks need simply to seek bigger and riskier bets.”