09 November 2016

Legislating instability

Adam Smith, Free Banking, and the Financial Crisis of 1772

Tyler Beck Goodspeed
2016, Harvard University Press, 208 pages,
ISBN 9780674088887

Reviewer: William A Allen, Economic & Financial Consultant

In 1765, an Act of Parliament imposed a minimum denomination on notes issued by Scottish banks, and prohibited the practice of banks issuing notes carrying an option enabling them to delay payment of the note for 6 months, subject to paying interest at 5% per annum (the legal maximum at the time) on the outstanding amount. Goodspeed’s book claims that the act of 1765, which was supported by Adam Smith, was ill-considered, and that it was responsible for the financial crisis of 1772 in which a large bank failed. Douglas, Heron and Co. had been established only in 1769 and had grown very quickly. The shareholders, who had unlimited joint and several liability, were able to meet the liabilities by borrowing against the security of their personal assets. For each £500 share, the average partner was liable for nearly £3,000, so the bank must have lost a colossal amount of money in a very short time.

The book is a work of history, but its main purpose is not to describe and explain what happened, but to argue that the 1765 Act was a misconceived reaction to the over-issue of notes by certain banks. The reader is invited to extrapolate from 18th century Scotland to the financial world of the 21st century and, presumably, to conclude that it would be better today if there were ‘free banking’: no bank regulation, unlimited liability, and no too-big-to-fail banks.

The unlimited liability partnership model certainly has attractions as a means of containing the risks to society posed by financial companies. Had it been more widely used in the last two decades, some outrageously negligent corporate misgovernance would have been avoided. Until 1986, partners in Stock Exchange member firms were required to have unlimited liability; and Lloyds underwriters had it until the 1990s. These were exceptional cases, however. In the middle of the nineteenth century, limited liability became generally available to companies as a right, and in the case of banks, unlimited liability went seriously out of fashion after the collapse of the City of Glasgow Bank in 1878. No creditors lost money, but most of the shareholders were bankrupted, many of them not having understood that their liability was unlimited.

Unlimited liability, if it to be a sustainable form of corporate organization, depends on the existence of a group of investors who are not only very wealthy, but are also known to be sufficiently wealthy to support the activities of the bank. They must also be able to oversee the affairs of the company either personally, or through trusted relatives or close associates. To give an idea of the scale of wealth that would be required, the richest person in the world, Bill Gates, is said to be worth $87 billion. The equity capital and total liabilities of the medium-sized Lloyds Banking Group are about $55 billion and $990 billion respectively. Mr Gates could perhaps afford to assume unlimited liability for Lloyds Banking Group, provided he contributed not only his wealth but also his time and close attention.  He certainly could not afford HSBC (equity capital $198 billion, liabilities $2,212 billion), even if accompanied in joint and several liability for the enterprise by other people of comparable wealth, whom he would have to trust. So a financial world of unlimited-liability partnerships would be a world of much smaller financial companies owned and managed by wealthy people, a world in which people would want to boast about their wealth, and a world in which family and personal connections would be more important than they are now. And it would be a world in which those who were known, or at least believed, to be very wealthy, could earn superior returns by virtue of their reputations. Too bad about equal opportunities.

There is a strong case for many financial companies being structured as unlimited liability partnerships, particularly those taking big trading risks. But for some financial companies, like banks, size matters, if only because there are important economies of scale.  For them, a return to unlimited liability is completely unrealistic.

Goodspeed’s presentation of the case against the Act of 1765 reads rather like a prosecuting counsel’s opening statement. It would have been nice to have heard the case for the defence, or, best of all, the judge’s balanced summary.