The Original Sinn
By Arnold Kling
The lack of equity resulted largely from the concept of “limited liability,” which provided an incentive for excessive leveraging. Earnings left inside a financial institution can easily be lost in turbulent times. Only earnings taken out in time can be secured.
Sinn does not mention this, but reducing dividend taxes may have exacerbated the problem. Double taxation of dividends encourages firms to retain more earnings, reducing the incentive to live on the edge.
Sinn argues that limited liability is a fundamental cause of financial instability. Equity-holders have a huge incentive to take risks, because they gain on the upside but leave others with losses on the down side. On the other hand, I would argue that this creates a countervailing incentive for debt-holders to monitor firms really closely and to restrict their risk-taking. The question is why the countervailing incentives do not operate effectively.
Sinn argues that home-buying in the U.S. has a similar asymmetry. If you home gains in value, you win. If it loses value, the bank loses. Your personal assets cannot be tapped by the bank.
The way to counter limited liability in home buying is to require a large down payment. The emergence of mortgages with low down payments as the dominant form of housing finance is a key element in the crisis.
Thanks to Mark Thoma for the pointer.