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.

In Anglo-Continental Guano Works v Bell (Surveyor of Taxes), Mr Justice Cave summed up thus: “It seems to me... that the gains of the trade are quite independent of the question of how the capital money is found… [One] cannot take into  BIS central bankers’ speeches  5  consideration the fact that the firm or trader has to borrow some portion of the money which is employed in the business... If you did that it would land you in very extraordinary results”.12 Indeed, it might land you in the guano. But banking was about to buck this trend. In Farmer (Surveyor of Taxes) v Scottish North American Trust, Limited, Lord Atkinson referring to the Anglo-Continental case concluded: “It does not appear to me that the reasoning on which this decision is based can apply to a bank whose business is the borrowing and lending of money”.13 From early in the 20th century, debt interest became a legitimate deductible from bank profits. Where banks led, non-financial firms followed. This debt bias has persisted in the century since.14 The scale of tax-induced debt bias is generally greater the higher the rate of corporation tax and the lower the rate of personal taxation of equity. The IMF (2009) has recently estimated the scale of debt bias in a selection of developed countries. For low or tax-exempt investors, such as pension funds and non-residents, debt is typically between 30–40% cheaper than (new or retained) equity.15 For high-tax investors, the biases are smaller but still significant.