Limited Liability and Banking
By Arnold Kling
Tyler Cowen says that they do not go well together.
If a shareholder invests a dollar in a big bank, why not make that shareholder liable for the first $1.50 — or more — of losses as insolvency approaches? In essence, we would be making the shareholders liable for the costs that bank failures impose on society, and making the banks sort out the right mixes of activities and risks.
This sounds good in principle, but I wonder how it would work in practice. Suppose that you sell your shares in Shakee Bank to me today, and tomorrow Shakee has to be taken over by the FDIC. Am I liable for losses, which probably were caused by decisions made before I bought my shares? Suppose that Shakee has accumulated $8 billion in losses, and all its shareholders of record obtained their shares for a collective $0.10. What happens then?
Without more explanation, this idea seems even less workable than my proposal to increase the liability of managers of failed banks by putting them in jail.