The London Review of Books has a fascinating piece by the Bank of England’s Andrew Haldane on excessive financial-industry risk. He looks back at the history of the British financial system to help shed light on our modern-day troubles.

Until the late 19th century, Britain’s banks were all unlimited-liability companies, meaning owners were on the hook for all losses, and limiting their appetite for unnecessary risk. And until the early 20th century, most banks there had extended-liability, which put owners on the hook for a fixed amount of losses over and above their investments. Now, they’re all limited-liability corporations:

What impact did these changes have on banks’ incentive to take risks? The answer was provided in 1974, around a hundred years after the introduction of limited liability, by the Nobel Prize-winning economist Robert Merton, who showed that the equity of a limited liability company could be valued as if it were a financial option - that is, an instrument which offers rights over the future fruits of the company’s assets. This option has value - in the jargon, it is ‘in the money’ - provided a firm’s assets cover its debts. But the most extraordinary implication of Merton’s framework is that the value of those options can be enhanced by increases in the degree of uncertainty about the value of the bank’s assets. How so? Because while uncertainty increases both upside and downside risks, downside risks are capped by limited liability. For shareholders, the sky is the limit but the floor is always just beneath their feet. To maximise shareholder value, therefore, banks need simply to seek bigger and riskier bets.

The response to these incentives has been entirely predictable. Since 1880, the ratio of UK bank assets to GDP has risen roughly tenfold, and the increase has been particularly steep over the past thirty years, peaking at well over 500 per cent of GDP. The pattern in other developed countries has been similar, if less dramatic. The bets weren’t just bigger, but also riskier. During the 20th century, an alphabet soup of exotic and complex instruments, often known by three-letter acronyms, came to displace simple loans on banks’ balance sheets. These boosted banks’ returns. But if returns are high, risks are never far behind. Returns on bank assets were two and a half times more volatile at the end of the 20th century than at the beginning…

The evolution of banking as I have described it has satisfied the immediate demands of shareholders and managers, but has short-changed everyone else. There is a compelling case for policy intervention. The best proposals for reform are those which aim to reshape risk-taking incentives on a durable basis. Perhaps the most obvious way to tackle shareholder-led incentive problems is to increase banks’ equity capital base. This directly reduces their leverage and therefore the scale of the risks they can take. And it increases banks’ capacity to absorb losses, reducing the need for taxpayer intervention.

And of course, as Haldane notes, Too Big to Fail is just another way of limiting liability.

— In the wake of The New York Times disturbing iEconomy series on working conditions at Apple’s outsourced factories, the company commissioned a workplace monitor to inspect them.

Bloomberg:

The Fair Labor Association, a watchdog monitoring working conditions at makers of Apple Inc. products, has uncovered “tons of issues” that need to be addressed at a Foxconn Technology Group plant in Shenzhen, China, FLA Chief Executive Officer Auret van Heerden said.

Van Heerden made the comments in a telephone interview after a multiday inspection of the factory. Apple, the first technology company to join the FLA, said on Feb. 13 that it asked the Washington-based nonprofit organization to inspect plants owned by three of its largest manufacturing partners.

“We’re finding tons of issues,” van Heerden said en route to a meeting where FLA inspectors were scheduled to present preliminary findings to Foxconn management. “I believe we’re going to see some very significant announcements in the near future.”

— The scope of the foreclosure scandal is astonishing.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu.