Bankers pay too low a price for high risks; The Vickers reforms won't go far enough – limited liability should be abolished for banks

Today, Sir John Vickers publishes his Independent Banking Commission’s report into the problems and solutions for the financial system. The contents of the report – a few hundred pages in total – are likely to be largely as predicted: the ring–fencing of retail banks from their investment arms, plus new capital rules.

The diagnosis of the problems with the banking system – mostly covered in the interim report early this year – can be summed up pretty succinctly, too: bankers and financial practitioners have a perverse incentive to take excessive risks.

Stop and consider this for a moment. Unlike in the normal world, where profits fall to companies with the best product or hardest workers, in banking short–term profits tend to accrue to those who take the greatest risks. So when times are good, even the most unimpressive banker can seem a hero by taking riskier trades and earning greater profits.

No matter that such risk–taking makes banks, and the wider financial and economic system, more vulnerable to crises of the sort we are still enduring.

No one from inside the industry complains because they know that the banking system has for years been a one–way bet on such behaviour. The bankers enjoy their bonuses, the shareholders partake in the windfall; and when the banks collapse, most of the eventual losses are borne by society, whose only alternative is to allow the financial foundations of the economy to collapse.

Clearly, it’s not as if those responsible for generating the risk are let off scot–free: the bankers often lose their jobs; shareholders sacrifice the value of their investments; depositors sometimes lose some of their uninsured savings. But such is the nature of the beast that these losses are never enough to compensate for all the costs.

The punishment for failure, in other words, is not commensurate with the rewards for risky behaviour. This wasn’t always the case. In the early 19th century, banks were unlimited liability partnerships. When they collapsed, the partners who owned them were liable not only for the value of their shares but for everything from their private yachts to the shirts on their backs. They were pursued until all the losses were recouped.

Of course, unlimited liability was hardly popular in the Britain of the Industrial Revolution. Being an entrepreneur isn’t a particularly attractive career choice when you know you’ll end up in a debtors’ prison if your idea fails. So eventually, in perhaps the most important policy shift in modern capitalism, the limited liability company was created, in which investors were only liable for the amount they put in.

This makes plenty of sense for normal businesses. In fact, limited liability is one of the keystones of a dynamic, innovative economy. But banking is no normal business. It has none of the facets you’d expect from a functioning market – hardly any competition, enormous barriers to entry, the complete opposite of perfect information. And that’s above and beyond the risk addiction we’ve already established.

Despite this, all but a handful of niche banks today are limited liability companies. And rather than reconsider this deeply illogical and unfair system, regulators have instead spent the past century improvising sticking–plaster solutions: regulations about the amount banks can lend out; controls over the amount of shares they should shore up their finances with; recommendations over how much cash they must keep on tap; bankers’ pay is scrutinised to try to ensure it reflects longterm performance.

Unfortunately, this pattern will continue with the ICB recommendations, which will be focused on whether to ring–fence certain types of banking activity. This is a start, but it does not go far enough. The problems lie with the limited liability model for banking: why shouldn’t banks – at the very least investment banks – be returned to unlimited liability partnerships?

Obviously, this couldn’t happen overnight: we are still in the teeth of recession. As Jeremy Warner wrote in these pages last week, any reform should be handled with caution, given that the wider economy could suffer as a result. But no one has seriously considered, let alone costed, this simplest and most elegant solution to the banking quandary.

There would be problems: regulators would need to ensure that shares in banks didn’t fall solely into the hands of those who couldn’t afford the costs of a crisis, as Walter Bagehot feared they would (and evidence from history suggests they need not).

Some shareholders would no longer want to own a stake in a bank knowing that its collapse would cost them far more than their investment. The same may apply to some of those working in the industry. But isn’t that precisely the problem with banking? For so long have its practitioners and investors been mollycoddled by a perverse ownership structure that they have deluded themselves into believing that anything else would be unfair.

Banks would be smaller. They would take fewer risks, invest more cautiously. Finally, a sense of responsibility would be re–established in the financial sector. Maybe it’s too much to expect, but at least it would mean aiming high rather than fiddling round the edges.