Saturday, October 11, 2008

Financial Fuss (9) - Limited Liability

The limited liability created by government law is an enormous issue. It allows banks and other businesses to run risks and reap all the profits without carrying the full risk of their actions. They can earn enormous dividends during the good years by taking very high risks, but limit their losses during the bad years that usually follow.

The reality is that liability cannot be limited, just as risk cannot be fully mitigated. Limited liability does not eliminate liability, it just allows the liability to be shifted to innocent parties. The shareholders of the investment banks and hedge funds who have taken enormous dividends would have put far greater constraints on their mangers, if they knew they were liable for all possible losses of their companies. The profits that they took in the good times would no longer be sheltered in the bad times.

People would have far more confidence in banks, if they knew that their owners were liable for all the liabilities of the bank, even in bankruptcy.

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