Make them pay…make them pay

Carried away by ever-rising real estate prices and aided and abetted by new types of financial instruments, the financial system’s overindulgence in risk has left taxpayers with a nasty hangover, a hefty tab, and a desire to make someone pay.

Commentators have blamed the financial meltdown on the attitude towards risk generated by banks’ corporate structure.  Because of limited liability, bankers and shareholders can walk away from failures, suffering the loss of their investment but no further penalty.

If manager and shareholder wealth was at risk, as it is in unlimited liability partnerships, perhaps bankers would take fewer risks and the financial system would be safer.  Those who gambled and lost would pay the price out of their personal wealth, rather than at public expense.

Partnerships have a long and honorable history on Wall Street.  For many years, investment banking firms such as Goldman Sachs and Salomon Brothers, neither of which remains a partnership today, were among Wall Street’s most respected—and secure–firms.  And Brown Brothers Harriman and Co., the largest and oldest of American partnership banks, can boast an unblemished 190-year record of financial stability.

Of course, many private banks have failed during the past two centuries, so focusing on a few with impressive histories does not provide compelling evidence.  Fortunately, American financial history provides a wealth of evidence on the subject.

For much of the nineteenth and early twentieth century, shareholders of banks chartered by many state governments—and by the federal government—were subject to an enhanced form of liability, known as “double liability.”  Under double liability, shareholders of failed banks—in addition to losing the amount invested in the shares–could be called upon by bankruptcy authorities to contribute an amount roughly equal to the purchase price of the shares.

Some states instituted triple liability and, a few, unlimited liability.  And the law frequently specified that enhanced liability provisions followed shareholders for as many as three years after they had disposed of their shares.

Was double liability successful in stabilizing the financial system?  Yes and no.

During the four decades preceding the Great Depression, banks chartered in “double liability” states held more conservative balance sheets and failed at a lower rate than banks chartered in “limited liability” states.

When the Great Depression hit, however, the situation was reversed: states with double liability saw greater failure rates than their limited liability counterparts.  This reversal occurred because states that were more vulnerable to financial crisis had already enacted double liability, so when the financial turbulence of the 1930s struck, these states were disproportionately affected.

Discredited by its inability to prevent the banking crises of the Great Depression and rendered obsolete by the enactment of deposit insurance in 1933, double liability soon fell out of favor.  By 1944, double liability, which had been the rule in more than two thirds of all states in 1930, had been rescinded virtually everywhere.

History suggests that some variant of double liability can play a constructive role in mitigating risk-taking in the post-crisis financial system.  The experience of the Great Depression, however, shows that neither enhanced liability, nor any other single reform will render our financial system crisis-proof.  Our complex financial problems require more nuanced solutions.