July 01, 2009

Much like Richard Posner, Martin Wolf is not a very big fan of Obama's proposed restructuring of the financial regulatory structure. But rather than focus on the fallibility of regulators as Posner does, Wolf focuses on the incentives at the heart of the financial system:Lucian Bebchuk and Holger Spamann of the Harvard Law School make the big point in an excellent recent paper.* Its focus is on the incentives affecting management. These are hugely important.

Still more important, however, is why a limited liability bank, run in the interests of shareholders, is so risky.In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses.