Limited liability is the real issue with banks

Steve Cecchetti at the Bank for International Settlements hits the nail on the head in this speech on financial regulation [pdf]:

The fundamental problem is that the private interests of banks and bankers can diverge from those of society at large. This is especially true when it comes to the stability of the system and the direct or indirect burden on taxpayers. The source of this conflict is limited liability: the fact that owners and employees are not held financially accountable beyond their actual investment. What this means is that the bank’s owners and managers have a call option on the firm.

I’ve argued repeatedly that one of the fundamental weaknesses in the efforts to regulate finance is that they have stopped short of re-examining whether it really is right to allow investment banks to incorporate themselves as limited liability companies – thus shielding their investors from the full cost of their collapse. Bringing back unlimited liability for banks may not be practicable (in that it would be an enormous revolutionary step which would naturally terrify anyone with a share in a bank) but it’s only right to step back and think about what went wrong in the ownership structures of banks that brought us to this pretty pass.