Long Tail Risks and Endogenous Liabilities: Regulating Looting

Abstract

In an earlier article in this journal (Mason and Swanson 1996) we argued that one of the primary causes of long tail insurance risks was the system of incentives for strategic liquidation inherent within a limited liability system. In effect limited liability makes available a loophole for the appropriation of societal rents by appropriately structured firms. This argument was based upon the previous analysis of the American savings and loan crisis undertaken by Akerlof and Romer (1993) in which they stylised the use of strategic bankruptcy for the appropriation of rents as "looting". In that earlier paper we extended and generalised their analysis, and identified the structure of firms that would make the "looting strategy" available. In this paper our objective is to set forth our conclusions from this previous analysis regarding the appropriate means of regulation of firms structured in a manner to make available the possibility of strategic liquidation. That is, we are addressing the question: How does a society regulate for looting?Looting is a phenomenon with which most people are now familiar. It has taken two very noticeable forms recently. In the US, the thrifts crisis has been estimated to have generated societal losses in the amount of US$140 billion. According to Akerlof and Romer, this crisis resulted from the deliberate relaxation of the regulation system regarding the savings and loan industry when a slowdown in the housing market was causing concern about the viability of some sectors of this industry. The regulators reduced reserves requirements and relaxed monitoring, and this then produced the loophole

The Economics of Liability Insurance

“…As a practical matter, the judgement proof problem may lead to inefficiently high levels of risky activity and inefficiently low levels of care. Limited liability and tort liability law may induce strategies that attempt to shield assets from judgements and, in extreme cases, may induce planned bankruptcy (see Ringleb and Wiggins, 1990;Ackerlof and Romer, 1993;Swanson and Mason, 1998; also see LoPucki, 1996). The judgement proof problem has received substantial attention in recent years and has kindled debate over the efficiency of the traditional doctrine of limited liability, at least for corporations that own corporations or that have many diversified shareholders (see, e.g., Hansmann and Kraakman, 1991 ).…”