By the end of the 1930s, there were only six British banks left with reserve liability. In the US, a similar process was underway. Systemic bank failure during the Great Depression was taken as evidence of the inadequacy of extended liability in protecting depositors. As in the UK, making a call on shareholders was deemed likely to make a bad situation worse. It was quickly replaced with Federal deposit insurance in 1934. With reserve liability gone, so too did the rationale for shareholder vetting. So by the 1930s the governance and balance sheet structure of banks was unrecognisable from a century earlier. Ownership and control were amicably divorced. Ownership was vested in a widely dispersed set of shareholders, unvetted and anonymous. Their upside payoffs remained unlimited, but their downside risks were now capped by limited liability. The pool of reserve capital had largely evaporated. Later in the 20th century, these governance and balance sheet features spread across the financial system. During the 1990s, many of the larger global investment banks abandoned their private partnership status to become limited liability public companies. In the UK, a number of mutually-owned building societies followed suit and turned public. The rationale was familiar from a century earlier – the desire to break their balance sheet chains. By the end of the 20th century, joint stock banking was pre-eminent. What impact did these governance changes have on banks’ risk-taking incentives? Finance theory here is admirably clear.

Due to unlimited liability, control rights were exercised by investors whose personal wealth was literally on the line. That generated potent incentives to be prudent with depositors’ money. Nowhere was this better illustrated than in the asset and liability make-up of the balance sheet. The market, amorphously but effectively, exercised discipline. It was given a helping hand by market-based prudential safeguards. Directors of a bank had the capacity to vet share transfers, excluding owners without sufficiently deep pockets to bear the risk. Shareholders also maintained their liability after the transfer of their shares. This put shareholders firmly on the hook, a hook they then used to hold in check managers. Managers monitored shareholders and shareholders managers. In this way, the 19th century banking model aligned risk-taking incentives. But the global environment was changing. During the first half of the 19th century, rich countries were becoming hungry for capital to finance investment in infrastructure, including railways. As long as capital in banks was restricted to a small number of unlimited liability partners, credit was constricted. In 1826, the 6-partner restriction on UK banks was lifted, allowing banks to operate as joint-stock companies. No longer was ownership and control vested in a single agent. But pressures were building to liberalise further. Unlimited liability became the next target. In the words of British parliamentarian William Clay, “unlimited liability has a tendency to deter persons of fortune, intelligence and respectability from becoming partners or managers”.3 Shareholder discipline was proving rather too effective as a brake on risk-taking.