Bankers only listen to laws.(BRIEFLY NOTED)

Some government intervention in the marketplace is necessary, but it will only work well if policymakers get the laws right. For confirmation of this, we need only look at the history of banking, where laws that granted limited liability to bank ownership underwrote risk-taking that escaped all public control.

The limited liability corporation is an extremely valuable social invention. It appeared in Britain and the United States in the 1860s, and was adopted by the rest of Europe in the following decade. By saving investors from having all their wealth at stake if a business were to fail, this type of shareholding made it possible both for higher risks to be taken in investing and for the risks to be spread over portfolios.

Initially, banks did not benefit from this legal innovation. In 1782, the Irish Parliament passed the first act permitting general limited liability partnerships. This contributed to a remarkable period of productive investment and prosperity in the country. Significantly, however, the privilege was explicitly denied to investment in businesses that dealt in any form of money. Banks were similarly excluded from the benefits of the first British acts that gave limited liability to shareholders in companies.

Because of this, the 1878 collapses of the City of Glasgow Bank and Caledonian Bank did not harm the depositors; it was the owners in both cases who suffered the losses because, as partners, their liability was unlimited. The same happened in 1890, when Barings Bank became overextended in South America. The Bank of England persuaded the other banks to help it provide enough liquidity to save Barings, but this was only on condition of great cost to the Baring family members who owned the bank in partnership.

RECKLESS TRADING When the law was changed to extend the privilege of limited liability to bank shares, Barings incorporated in 1905. The eventual result was that the second time the bank could not meet its liabilities--this time in 1995, following outrageous risk-taking in the Far East--the fortunes of its owners (other than their actual shares in the bank) were protected. Instead, it was the depositors who lost. It is highly doubtful that, if the owners had still been liable for losses up to the entire limit of their wealth, they would have allowed such reckless trading with the bank's money.

The current financial crisis is the same thing on a global scale. Limited liability was a necessary condition of the development of professional management in every industry. But in the financial sector, without any effective control from a multiplicity of shareholders, it left managers free to develop a range of instruments for the expansion of credit. In the process, they earned vast profits for their firms and correspondingly inflated bonuses for themselves, until the burst of the bubble for which they were responsible. Firms like Lehman Brothers, Bear Stearns, and Morgan Stanley survived the Great Depression of the 1930s as partnerships, but collapsed as public companies in 2008.

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