Risk doesn’t just disappear

08/11/2012 § 2 Comments

The Pike River Mine report has brought the issue of risk and companies’ duties back up. The report found that the company exposed the workers to unacceptable risk. There is a very important discussion to have about ex ante and ex post perceptions of risk — Monday morning quarterbacking, to use an American phrase — but I won’t do that now. Instead, I want to focus on risk allocation and companies.

These things are called limited liability company (LLC) for a good reason. They limit the liability — the responsibility for failure. The company is a legal entity separate from its shareholders, and it bears its own risk. Shareholders can lose only their investments and no more.

This has proven a useful arrangement in the modern economy. If you try something out — a new product, a new store, a new technology — you can limit your losses. We have all benefited from this. The arrangement has encouraged risk-taking and innovation, and has helped create the material world in which we are living (cue Madonna?).

But, these things aren’t perfect.

Think of it this way. There is a distribution of uncertain outcomes. We can model this as the probabilities of good and bad outcomes. Let’s say that the following graph shows the probabilities of success. There’s a reasonable probability that things will go well and you’ll make money and so one. But, there is also a positive probability that you won’t succeed. Let’s say the black line marks the difference between business success and failure. The LLC allows you to truncate the distribution of outcomes that concern you; you get to lop off the left tail.

But, there is also a non-trivial probability that things will go horribly wrong. That’s what happened with the Pike Rive Mine. Think of these situations as the tail to the left of the red line. They won’t happen often, but they will happen. The probability doesn’t disappear. The LLC structure just moves the risk from the business onto other people.

We all benefit from this legal fiction, because of a more innovative and productive economy. On the other hand, some benefit more than others. That suggests a two-prong approach to dealing with this imperfection in LLCs:

  1. when a few people bear the burden of the rare disasters, they should get help from the rest of us. After all, they have ended up in the left tail while the rest of us enjoy the bulk of the probability distribution
  2. those who benefit more — those who chop off more of the left tail than the rest of us — should pay for the privilege.

There’s not much concrete policy in those ideas, but I’m sure we can work it out later.

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§ 2 Responses to Risk doesn’t just disappear

  • Your model forgets that the corporate veil only exists for corporates. Try getting anything on credit without a personal guarantee in this economy!
    Some companies want personal guarantees signed even if you pay in advance for the goods or services you’re purchasing by way of an engagement letter or the like.
    In order to benefit from limited liability, you need to have something worth protecting in the first place. Even then, access to credit is severely restricted at this point in the cycle.
    Many businesses cannot get to the black line because they can’t get sufficient working capital without putting their entire net worth at risk.
    I would argue that the black line is on the far right of the Bell Curve as opposed to where you’ve placed it.
    I’d argue it’s because the moral hazard of limited liability is completely under-estimated and thus the rate of abuse of limited liability is far higher than estimated, calling into question its veracity as a concept.

    • Bill says:

      Yes, it is true that small businesses need to guarantee their debts personally. That does limit some of what I’m talking about. Actually, it also provides the possibility of some empirical research. Does extending the guarantee over assets not in the business affect risk taking? There must be a way to segregate businesses into those with external guarantees and those without.

      The general contention still holds, however. The damage caused by, say, leaky buildings was greater than the residual value of the construction firms. The guaranteed bank loans would have been repaid. The losses incurred by housebuyers were on the left tail, however. Construction firms could go out of business to limit the losses and shift the assets to new companies. This was convenient for them, but individual housebuyers who relied on the implicit guarantee from the central government building regulations and the sign-off of Councils have carried the losses.

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