This article traces the development of the debate surrounding shareholder liability regimes in nineteenth-century British banking.Footnote ¹ Pure limited liability for commercial bank shareholders in the UK is very much a twentieth-century phenomenon as the majority of important banks in the nineteenth-century had some form of extended liability regime. Indeed, most major banks legally had to have unlimited shareholder liability during the first half of the nineteenth century, and even by the end of the century most major banks had some form of extended liability.

The motivation for examining the debate surrounding bank shareholder liability regimes in nineteenth-century Britain is threefold. First, although the US experience with double shareholder liability in banking has been well documented, relatively little is known about the British experience.Footnote ² Yet, arguably, the British experience was institutionally richer than that of the US in that British banking in the nineteenth century had a complete spectrum of shareholder liability regimes, ranging from pure limited liability, through multiple liability to joint and several unlimited liability. The wider debate surrounding limited liability in nineteenth-century Britain has been extensively covered in the secondary literature, but the banking sector, which has long been regarded as being different from other industries, is usually not singled out for analysis.Footnote ³ This article does not attempt to answer the question of why limited liability was introduced into banking and why it was introduced when it was – its purpose is simply to analyse the economic arguments of the main protagonists in the various debates on the subject of shareholder liability in banking.Footnote ⁴

Second, extended shareholder liability regimes are believed to have played a very important role in protecting depositors and generating confidence in early banking systems.Footnote ⁵ Consequently, an analysis of the debates on liability regimes is ultimately an investigation of views on how bank stability could be best achieved.

Third, there are some scholars who suggest that the removal of extended liability and its replacement with implicit or explicit deposit insurance was a backwards step in the evolution of modern banking systems because the costs of bank failure have been largely and inefficiently shifted away from shareholders to taxpayers.Footnote ⁶ An investigation of the debates on shareholder liability in Britain reveals that nineteenth-century commentators and experts largely agreed that shareholders played a very important role in assuring bank stability.

The main finding of this article is that there were two core issues addressed in the debates on bank shareholder liability regimes. The first core issue was the credibility of unlimited liability. If bank shares could be freely transferred to low-wealth or impecunious individuals then the liability regime was de facto limited, and depositor confidence was simply based on an illusion. Interestingly, the major nineteenth-century proponents of limited liability banking (Clay, Headlam, Bagehot and Rae) all held this position, but it will be suggested in this article that many of their views were erroneous. The other important core issue addressed in the debates was how to assure depositors of bank safety if unlimited liability was removed. The suggestions ranged from lesser forms of extended liability, increased shareholder capital and audited accounts.

This article is structured as follows. Section I discusses the genesis of joint-stock banking in Britain in the 1820s, and suggests that there was little controversy surrounding the fact that banks had to have unlimited shareholder liability. Nevertheless, by the mid 1830s, following several banking collapses, there were concerns about the feasibility and credibility of unlimited liability. Subsequently, William Clay, a Parliamentarian, initiated a vigorous debate on whether limited liability should be introduced into banking. Section II discusses his proposal that limited liability should be introduced into banking along with fully paid-up capital and public disclosure of financial accounts. Section III then goes on to show that Clay received little support from the experts before the select committees on joint-stock banking which convened from 1836 until 1838. Section IV suggests that the issue of liability regimes subsequently reappeared in the late 1840s and early 1850s, when Thomas Headlam (a Parliamentarian) and Walter Bagehot, the famous polymath and banking expert, argued strenuously for limited liability in banking. Section V examines the views of banking experts after the infamous City of Glasgow failure in 1878. In particular, we will see that George Rae's views on reserve liability effectively reduce to Clay's idea of limited liability, paid-up capital and publicity of financial accounts. The final section is a brief conclusion.

I

At the beginning of the nineteenth century, apart from the five state-chartered banks, banking institutions were legally restricted to the partnership form of organisation.Footnote ⁷ In England and Ireland, the charters of the two state-chartered banks placed further restrictions upon banks by capping at six the number of partners which could establish a note-issuing bank.

The banking structures of Ireland and England were shaken to their foundations by crises in 1819/20 and 1825 respectively. The Irish crisis resulted in the collapse of 16 banks,Footnote ⁸ and 60 and 43 English banks failed in 1825 and 1826 respectively.Footnote ⁹ Such was the state of affairs in England that Huskisson, president of the Board of Trade, stated at the height of the crisis that the country ‘was within four-and-twenty hours of a state of barter’.Footnote ¹⁰ Meanwhile, in stark contrast to the English and Irish systems, the Scottish banking system was the epitome of stability.Footnote ¹¹ Thomas Joplin, a contemporary banking theorist, observed that ‘Scotch banks never fail, nor is any danger ever apprehended from them; and that in consequence, banking is carried on in that kingdom to an extent unknown.’Footnote ¹²

Most contemporary commentators were in agreement that the greater stability of the Scottish banking system was closely related to its structure. For Lord Liverpool it was the diversification benefits flowing from branch networks;Footnote ¹³ whereas for Thomas Joplin, the relative stability of the Scottish system was due to the fact that most banks were joint-stock companies, while English banks were partnerships.Footnote ¹⁴

Although it was mistakenly believed that the Scottish partnership or provincial banks were de jure joint-stock companies, Scottish partnership law effectively meant that provincial banking companies were de facto joint-stock banks. Scottish partnership law was similar to that of civil-law countries in that partnerships had aspects of separate legal personality and managerial hierarchies.Footnote ¹⁵ However, unlike the civil law, which had limited liability for sleeping partners, Scottish partnership law, similar to the common law, had joint and several unlimited liability. The privilege of having a separate legal personality enabled Scottish provincial banks to delegate managerial and contracting decisions to a managerial hierarchy. It also enabled the shares of these banks to be traded. Therefore, apart from having limited liability, Scottish partnership law effectively enabled Scottish banks to have all the legal and economic characteristics of joint-stock companies – separate legal personality, managerial hierarchy and transferable stock.Footnote ¹⁶

The question then arises as to why the quasi-joint-stock structure of Scottish banking resulted in superior stability. The main benefit of having a separate legal personality was that it enabled ownership to be separated from control, which meant that Scottish banks could draw on the capital of a large number of copartners. This had two effects. Firstly, in the event of financial distress, there was a diversified group of owners backing the liabilities of the bank. Secondly, the greater capital resources enabled these banks to branch and to diversify their assets and liabilities.

This quasi-joint-stock structure of banking in Scotland was highlighted by Irish reformers as a factor which contributed to the relative stability of the Scottish banking system.Footnote ¹⁷ Consequently, the Irish Banking Copartnership Regulation Act (1825) was enacted, permitting joint-stock banks to establish in Ireland conditional on shareholders having unlimited liability and no issuance of notes within a 50-mile radius of Dublin.Footnote ¹⁸ Subsequently, possibly having learned from this Irish legislative experiment, Parliament also granted English banks the right to constitute on a joint-stock basis, but similar to the Irish case, bank shareholders were not permitted to have limited liability, and there was an exclusion on banks issuing notes within a 65-mile radius of London.Footnote ¹⁹ According to William Clay, the Bank of England, wishing to preserve their monopoly status, would not give their assent for the passage of the joint-stock banking legislation if banks were granted limited liability.Footnote ²⁰ Although their consent wasn't necessary, their power and influence at this time gave them an effective veto. In addition, the successful privately established Scottish provincial banks had the principle of unlimited shareholder liability very much at their core. Notably, although the joint-stock banking legislation was enacted with relatively little debate on the issue of shareholder liability, this issue was to be a central theme in the debates on bank organisation and governance over subsequent decades.

II

As mentioned above, a provision within the 1826 Banking Copartnership Act restricted note-issuing banks from establishing inside a 65-mile radius around London. However, legal doubts with regard to the establishment of non-issuing joint-stock banks within this radius were removed by legislation in 1833.Footnote ²¹ In speeches made prior to the passage of this legislation, suggestions were made by Lord Althorp and Vincent Stuckey that the liability of these new deposit-issuing banks should be limited, but these views received little support.Footnote ²² By 1836 circa 136 joint-stock banks had formed in Britain, but there were growing concerns about the stability of the banking system and the absence of regulations on banks' constitutions and capital.Footnote ²³ These concerns were no doubt fuelled by the high-profile failures of the Agricultural and Commercial Bank of Ireland and Northern and Central Bank.Footnote ²⁴ Consequently, following the proposal of William Clay in the House of Commons in 1836, a Select Committee was appointed to inquire into the operation of the existing joint-stock bank legislation, with the main focus being the governance and capital of banks.

Whilst making this proposal, William Clay made a famous Parliamentary speech, which was subsequently printed as a pamphlet, in which he argued that the joint-stock banking legislation ‘introduced into our monetary system, an element of tremendous power; we have taken no precaution to limit or control its operation’.Footnote ²⁵ The stability of the banking system was Clay's paramount concern,Footnote ²⁶ and he firmly believed that unlimited shareholder liability was not conducive to this end as it augmented the risk of bank failure.Footnote ²⁷ Clay held this view for at least two reasons.

First, he suggested that the multitude of bank failures over the previous half-century was sufficient to demonstrate that unlimited liability and banking stability were incompatible.Footnote ²⁸ The fallacy in Clay's inference is that he placed the blame for banking instability on unlimited liability rather than on the inherent weaknesses with the partnership organisational form, such as the hold-up costs associated with the absence of a separate legal personality.Footnote ²⁹ Interestingly, Clay somewhat glibly dismisses the success of the Scottish system, where, as discussed above, partnership law enabled banks to have a separate legal personality, and effectively operate as joint-stock companies.Footnote ³⁰

Second, Clay claimed that unlimited liability attracts low-wealth shareholders and bankers, whilst repelling the wealthy.Footnote ³¹ Along these lines, he argued that ‘unlimited liability has a tendency to deter persons of fortune, intelligence, and respectability, from becoming partners or managers of joint-stock banks’.Footnote ³² Although he did concede that wealthy persons owned bank shares, he suggested that few would be willing to become owners in the future, and that one single disaster would result in the exit of all wealthy bank shareholders.Footnote ³³ Consequently, he stated that the ‘confidence of the public might thus be found to be resting on grounds altogether illusory’.Footnote ³⁴ What Clay failed to recognise, however, was that the governance structure of banks as laid down in their constitution may have rendered this possibility unlikely as directors were granted the power to vet all share transfers and exclude low-wealth individuals.Footnote ³⁵ Furthermore, a disaster wouldn't result in the exit of wealthy shareholders because of the existence of post-sale-extended liability.Footnote ³⁶ The Irish and English banking copartnerships legislation both imposed a post-sale-extended liability on shareholders of joint-stock banks, making shareholders liable for the bank's debts for three years after they had sold their shares. In Scotland, previous owners of joint-stock shares were held liable for debts incurred during their tenure if existing owners were unable to cover these losses.Footnote ³⁷

Clay's alternative to unlimited shareholder liability was to have limited liability, adequate paid-up capital and entire publicity. He believed that limited liability would ensure a proprietary consisting of the most respectable persons in the community, and that such individuals would ensure the prudent conduct of a bank.Footnote ³⁸ However, limited liability is traditionally associated with the extension of share ownership to the lower classes of society and with the separation of ownership from control.Footnote ³⁹

Clay advocated that limited liability charters should only be granted to banks on condition that they had fully paid-up capital and that their balance sheets be audited and published every six months for the benefit of the public.Footnote ⁴⁰ He believed that the banking public would monitor bank behaviour because it was in their self-interest, with the goodness of human nature resulting in honest reporting by banks.Footnote ⁴¹ However, as the famous banker Vincent Stuckey realised, the publishing of balance sheets reveals little information about a bank's true position as the secretive and discreet nature of banking prevents bankers publicly revealing the details of their loan portfolio.Footnote ⁴² In addition, Stuckey was dismissive of Clay's implicit trust in the honesty of bankers, suggesting that there would be a need for outside scrutiny of bank reporting.Footnote ⁴³ An additional weakness with Clay's position is that after books were balanced, banks could have quickly and easily reduced the volume of safe and liquid assets in their possession.

As well as publicity, Clay believed that banks should have capital ready to cover depositors' funds.Footnote ⁴⁴ According to Clay, paid-up capital was to be held in a very liquid and safe form because after all ‘the business of the banker is not to lend his money, but the money of other people’.Footnote ⁴⁵ However, there is a credibility problem associated with promises to hold capital in such a form, particularly when the opportunity costs of so doing are high. For one thing, as highlighted by Stuckey, such capital could easily be lent out, in one form or another, to major shareholders.Footnote ⁴⁶

Clay supported his case for limited liability, paid-up capital and entire publicity by placing great emphasis on the successful banking laws passed in Pennsylvania, New York and Massachusetts, where banks were issued with banking charters conditional on having paid-up capital and publishing regular balance sheets.Footnote ⁴⁷ Stuckey, however, pointed out that American banks also had government inspections and regulations. Although this was the case in New York and Pennsylvania, Massachusetts didn't have government inspections until 1838. Notably, the banking system of Massachusetts experienced a crisis in 1837 with 32 out of 134 banks failing and the public experiencing severe losses as a result.Footnote ⁴⁸ One could speculate that this crisis may have undermined Clay's case for limited liability in British banking.

Although Stuckey believed that Clay's idea of limited liability would ‘go far to annihilate whatever there is of solidity in the present system’, he was not uncritical of the unlimited liability joint-stock banking system.Footnote ⁴⁹ For him, the chief defect of the system was that the public didn't know who all the partners were – whether they were men of straw or millionaires.Footnote ⁵⁰ Although he was astonished that any wealthy person would want to invest in bank shares, and even though ‘an individual who has 10s. or 20s. to spare may become a shareholder in a bank’, he admitted that the majority of joint-stock banks had wealthy shareholders, and were therefore established on a sound basis.Footnote ⁵¹ Consequently, the only change which he believed was necessary to the existing system was the publication of a quarterly shareholder return, as ‘the knowledge of who parties are in a bank, and their unlimited responsibility, are the only securities that, generally speaking, are worth a pinch of snuff’.Footnote ⁵² According to the banking theorist Gavin Bell, knowledge of every shareholder was not necessary for a secure system as all that depositors (and note-holders) needed to know was who were the directors of the bank.Footnote ⁵³ As argued above, the directors of the joint-stock banks vetted all new shareholders, and thereby effectively maintained the initial quality of the shareholder constituency. As long as the directors were wealthy individuals, then they had every incentive to ensure that other shareholders were from the wealthier classes of society.Footnote ⁵⁴

As will see in the next section, Clay's arguments for limited liability in banking were not generally supported by contributors to the Parliamentary committees on joint-stock banking. Indeed, if anything, most of the experts interviewed had views antithetical to those of Clay. However, Clay's contribution was that he formulated the key arguments against unlimited liability and for limited liability in banking to which later protagonists would return.

III

Following Clay's speech, a Select Committee was appointed to inquire into the operation of the existing joint-stock bank legislation, with the main focus being the governance and capital of banks. This committee reported in 1836, requesting more time to conduct its inquiry;Footnote ⁵⁵ further investigations were conducted in 1837 and 1838, with the main focus still being on banks' governance and capital. However, the 1837 and 1838 committees also spent a great deal of their time interviewing individuals connected with the failure of the Agricultural and Commercial Bank of Ireland, a large Irish joint-stock bank which collapsed dramatically in 1836. With regards to shareholder liability regimes, there were several issues addressed by these committees, which will be outlined below.

There was a broad consensus amongst witnesses before the 1836 Committee on Joint Stock Banks that the best security for the prudent conduct of a bank was the respectability and aggregate wealth of its proprietors.Footnote ⁵⁶ Nevertheless, there was a concern that banks having low-denomination shares were less able to attract wealthy shareholders.Footnote ⁵⁷ It was even perceived by some experts that banks having low-denomination shares would have owners from the lowest classes of society, such as servants, ladies' maids and little tradesmen.Footnote ⁵⁸ For example, it was claimed that the low paid-up value of the shares of the Agricultural and Commercial Bank of Ireland enabled ‘the petty shopkeeper, the small farmer, the catter, the travelling pedlar, the gentleman's servant, and, perhaps the most respectable of all of them, the farm labourer…. to become proprietors’.Footnote ⁵⁹ Consequently, for several commentators, low-denomination shares undermined the soundness and security of the banking system.Footnote ⁶⁰ However, not everyone believed that this was the case. For example, J. W. Gilbart, the famous banking expert, suggested that smaller-denomination shares did not, necessarily, end up in the hands of inferior individuals.Footnote ⁶¹ Indeed, W. G. Cassells, of the Northern and Central Bank, whilst conceding that small-denomination shares might attract low-wealth individuals, argued that bank directors had the responsibility and power to prevent such individuals becoming members.Footnote ⁶²

Thomas Joplin, an advocate of low-denomination shares, suggested that such shares were more likely to be widely distributed, and banks, as a result, would have a more numerous proprietary, which would result in increased security to the banking public.Footnote ⁶³ As one anonymous commentator concurred, the number of shareholders in a joint-stock bank is its real security.Footnote ⁶⁴ Furthermore, Joplin also argued that ‘nothing can be more desirable than that the poorer classes, who are the authors of panics, should be induced to hold shares in Banks. The more interest they have in the public institutions of the country, the better for the country.’Footnote ⁶⁵

Despite Clay's hostility to unlimited liability in banking, only General Austin (managing director of North of England bank), amongst the witnesses before the parliamentary committees, gave any support to Clay's thesis. He argued that ‘unlimited liability discourages a great many wealthy persons from taking shares. A party reasons with himself very justly, why should I, who have property, subject my property to loss on the chance of trifling dividends I can obtain in a bank? If the liability was limited, he would not so view it; there would be a better class of shareholders.’Footnote ⁶⁶ As an alternative, he proposed that bank shareholders should face double liability requirements.

The majority opinion on unlimited liability in banking, held by individuals such as Paul James (the manager of Birmingham Banking Co.) and Vincent Stuckey, was that it didn't discourage wealthy individuals from becoming bank shareholders.Footnote ⁶⁷ Indeed, one bank director persuasively argued that unlimited liability was a better security to the banking public than limited liability as it provided directors with more incentives to behave prudently and circumspectly.Footnote ⁶⁸ Concomitantly, Simon Martin and Samuel Gurney (two private bankers) argued that limited liability would tend to make bank managers more reckless and adventurous.Footnote ⁶⁹ Notably, similar arguments had been published three years previously by the banker Hugh Watt.Footnote ⁷⁰

No immediate legislation or recommendations resulted from these Parliamentary inquiries,Footnote ⁷¹ although several joint-stock banks voluntarily consolidated their share issues. However, the debate on the credibility of unlimited liability and the feasibility of limited liability had begun.

IV

Although there was extensive political debate regarding the right of free incorporation and limited liability prior to the 1844 Companies Act, it appears that there was little public debate regarding limited liability in banking from the late 1830s until 1849, when Thomas Headlam, a Parliamentarian, attacked the status quo, arguing that the tendency of unlimited liability was to render bank failures more probable.Footnote ⁷² Headlam argued that at the inception of joint-stock banking, many wealthy individuals naively became bank shareholders, but as these owners gradually died, ownership and control of banks came into the hands of poorer individuals, who tended to be more speculative.Footnote ⁷³ Consequently, widespread bank failure was inevitable unless banks converted to limited liability.Footnote ⁷⁴ Headlam's views are very similar to those of Clay, and he was also in agreement with Clay in that he believed that the Bank of England was the chief opponent of limited liability in banking.Footnote ⁷⁵ Another similarity to Clay is that Headlam appealed to the practice of other nations, stating that ‘our law is an exception to the universal policy of mankind, and we have experience to prove that it has not been successful’.Footnote ⁷⁶ However, he was overstating the case because, apart from several colonies or former colonies, limited liability joint-stock banking was still uncommon.Footnote ⁷⁷

Nevertheless, Headlam was soon to have his wish. Banks were initially excluded from the provisions of the Joint Stock Companies Act (1856),Footnote ⁷⁸ which permitted businesses to adopt limited liability by simply registering. However, a financial crisis in 1857 accompanied by the failure of the Western Bank of Scotland, a major unlimited liability joint-stock bank, resulted in Headlam proposing the removal of this exclusion.Footnote ⁷⁹ At this stage, his proposal failed, but within a year, a further piece of legislation was enacted, permitting banks to adopt limited liability on condition that their share denomination was greater than £100.Footnote ⁸⁰ Very few banks established or adopted limited liability until this minimum share denomination of £100 was subsequently eliminated by the Companies Act of 1862.Footnote ⁸¹ The 35-year battle for limited shareholder liability in banking had been won. Even the chief opponent of limited liability in banking, the Bank of England, had relented. Interestingly, the Bank's suggestion of a large extended liability backing up the paid-up capital was ignored.Footnote ⁸²

One of the main proponents of limited liability in banking during this final push was Walter Bagehot. Bagehot is renowned for Lombard Street, his treatise on the English banking system and the responsibilities of the Bank of England. However, Bagehot, in a series of essays from 1856 to 1862, argued vigorously that shareholder liability should not be unlimited. Bagehot was ultimately concerned with the stability of the banking system, and to this end he suggested that the solvency of joint-stock banks was secured by their paid-up capital as well as the means and standing of their shareholders.Footnote ⁸³ However, he expressed doubt on several occasions as to the aggregate resources of bank owners.Footnote ⁸⁴ For example, in 1856 he wrote: ‘we enact that every person joining a bank shall be liable for every sixpence contained in it, to his last acre and shilling. The consequence is, that persons who join banks have very commonly but few acres and shillings.’Footnote ⁸⁵ Bagehot's argument is close to that of Clay; and similar to his predecessor, he believed that many banks still had a wealthy proprietary, but that this was unlikely to continue much longer.Footnote ⁸⁶

According to Bagehot, the absence of wealthy individuals from bank shareholder lists was the consequence of an agency problem, whereby wealthy individuals would have insufficient control over those managing the bank.Footnote ⁸⁷ Consequently, the absence of wealthy (and competent) shareholders from the proprietary resulted in a small pool of suitable individuals to act as directors.Footnote ⁸⁸

Another problem that Bagehot had with unlimited shareholder liability was the high legal and administrative costs associated with collecting funds from bank shareholders during bankruptcy proceedings. Bagehot, in his inimitable way, noted that ‘the failure of any bank is a recognised way of adding to the wealth of Boulogne’.Footnote ⁸⁹

Consequently, Bagehot, as with Clay, believed that the only way to secure the stability of the banking system was to limit shareholder liability. The chief reason for his advocacy of limited liability was that such banks would attract a better quality of shareholders from which could be elected superior directors, and better-qualified men would be more likely to offer themselves as directors because they wouldn't face unlimited liability.Footnote ⁹⁰ However, Bagehot too easily dismisses the different incentives that exist for directors under the two liability regimes. Under an unlimited liability regime, the wealthiest shareholders would have actively participated in the management of the bank as they had the most to lose. Furthermore, such directors would be more circumspect than directors of a limited liability bank, who face minimal downside risk in the event of bank failure.

Unlike Clay, Bagehot didn't advocate that paid-up capital and publicity would be enough to assure depositors of bank safety. As an alternative, he suggested that liability should be extended to two or three times paid-up capital, believing that this system of limited but extended liability would result in a larger pool of shareholders who were answerable for a bank's debts.Footnote ⁹¹ Notably, despite Bagehot (and the Bank of England) advocating limited but extended liability, the legislation which extended the freedom to adopt limited liability to banks didn't require or even provide mechanisms for banks to have extended liability.

V

After the passage of the liberalising legislation of the late 1850s, it was generally hoped that ‘unlimited liability…will soon become a definition of the past, and be obliterated from the code of our banking laws’.Footnote ⁹² Yet significantly, the majority of the established banks did not adopt limited liability status at this time.Footnote ⁹³ Several small banks established on a limited liability basis, but even by the late 1870s, the vast majority of commercial banking in Britain was conducted by unlimited banks. This was despite continuing propaganda, which suggested that limited liability secured a better class of shareholders and, as a result, directors.Footnote ⁹⁴

The reluctance of banks to convert to limited liability appears to have been mainly due to concerns about depositor safety. For example, an 1862 article in The Bankers' Magazine suggested that the opaque nature of banking business and the absence of tangible assets made banks different from other types of firms, necessitating unlimited shareholder liability in order to protect depositors from expropriation.Footnote ⁹⁵ Concurring with this view, a banking expert, writing in the 1870s, stated that unlimited liability was ‘thought by the shareholders more conducive to profit, and by the depositors, more likely to give safety’.Footnote ⁹⁶

The eventual demise of unlimited liability in banking was ultimately brought about not by persuasive rhetoric, but the dramatic failure of the City of Glasgow Bank in October 1878. The City of Glasgow Bank was a prominent unlimited liability Scottish bank, which by the mid 1870s had 123 branches and had amassed some £8,489,000 in deposits. Although the failure of the bank did not result in any losses for depositors or note-holders, there were significant losses for shareholders, with only 254 of the 1,819 shareholders remaining solvent after the bank's liquidation.Footnote ⁹⁷ Wilson, a prominent advocate of banking reform, commented on the failure and its aftermath that ‘it was a calamity so unlooked for, so huge and disastrous, that it riveted men's gaze and made their hearts stand still, and we shall all remember it to our dying day as a landmark in the history of our generation’.Footnote ⁹⁸

As a result of the City of Glasgow failure, there was a general concern that shares in unlimited banks would be off-loaded to impecunious individuals.Footnote ⁹⁹ This view was clearly expressed in a communication to the Editor of The Bankers' Magazine, where the author argued that wealthy individuals would no longer hold shares in unlimited banks, and as a result, depositor confidence in such banks would inexorably and rapidly deteriorate.Footnote ¹⁰⁰The Economist also entered the debate by arguing that once wealthy bank shareholders realised the size of potential calls, they would sell their shares, thereby seriously undermining the power of a body of bank shareholders to meet calls.Footnote ¹⁰¹ Echoing the views of Clay and Bagehot, The Economist believed that the limited liability of the wealthy was a better security to bank depositors than the unlimited liability of the impecunious.Footnote ¹⁰² Furthermore, the old arguments of Clay and Bagehot resurfaced, with several commentators arguing that the superior class of shareholders which would emerge under limited liability would ultimately result in better corporate governance.Footnote ¹⁰³

According to George Rae, a renowned banker, the terror surrounding the City of Glasgow failure was exaggerated, but its failure led shareholders ‘to ask themselves whether it was not an act of insanity, to continue owners of a description of property, the holding of which had brought even wealthy men to the ground, and hundreds of the well-to-do to privation or beggary, with as little warning as an earthquake gives’.Footnote ¹⁰⁴ However, the concern that wealthy individuals were rapidly dumping shares may have been greatly exaggerated. A recent empirical study suggests that there is no evidence to suggest that wealthy shareholders exited unlimited liability banks or that bank stock was dumped in the aftermath of the City of Glasgow collapse.Footnote ¹⁰⁵ Nevertheless, the general perception at the time was that unlimited liability ‘might thus become in time the mere shadow if itself – a husk without a kernel’.Footnote ¹⁰⁶ As a result, the hysteria surrounding the City of Glasgow failure resulted in Parliamentary intervention in the form of the 1879 Companies Act.Footnote ¹⁰⁷

The main stumbling block towards the widespread adoption of limited liability had been the lack of viable alternatives for providing depositors with protection.Footnote ¹⁰⁸ However, the 1879 Companies Act contained Rae's concept of reserve liability, which enabled banks to set aside a fixed portion of their capital as an inalienable fund with the sole purpose of protecting depositors.Footnote ¹⁰⁹ Reserve liability could only be called up in the event of bank failure unlike uncalled capital, which was callable at the discretion of directors. As noted above, Bagehot had suggested replacing unlimited liability with extended liability, but Rae's innovation was to have it included in company legislation, which would have assured depositors of its credibility and simultaneously protected shareholders from unwanted and unnecessary calls from directors. Reserve liability appears to have been immediately accepted by depositors and shareholders as an acceptable alternative to unlimited liability, resulting in the vast majority of banks adopting limited liability in the early 1880s.Footnote ¹¹⁰ By 1884, 80 of the 138 British joint-stock banks had converted from unlimited to reserve liability, and nine still had unlimited liability, and of those banks which had reserve liability, the average and median reserve liability as a multiple of paid-up capital was 3.0 and 2.8 respectively.Footnote ¹¹¹

Rae's reserve liability, however, did come in for some criticism. The Economist, for example, argued that once liability was defined and no longer joint and several, shareholders and directors would no longer have incentives to ensure that shares were not transferred to individuals unable to pay calls made in the event of bankruptcy.Footnote ¹¹² Rae realised that this was a potential problem, but he believed that directors would still exercise a vetting function under a reserve liability regime.Footnote ¹¹³ However, Rae fails to acknowledge that incentives to vet dramatically reduced once liability was pro rata and defined.Footnote ¹¹⁴

As an alternative to Rae's proposals, The Economist suggested that there should be a compulsory reserve fund invested in securities beyond the bank.Footnote ¹¹⁵ As this fund was to be equal to the total reserve liability, this proposal would have effectively required banks to double, treble or even quadruple their paid-up capital overnight if they desired to convert to limited liability. Levi, a law professor, was also sceptical as to the credibility of reserve liability, but, unlike The Economist, he simply suggested that limited liability banks would need to increase their paid-up capital.Footnote ¹¹⁶ Although this was costly for bankers, he realised that public confidence in banks was correlated with the amount of capital that existed to meet unforeseen exigencies.Footnote ¹¹⁷

One reason as to why Rae didn't defend the credibility of reserve liability is that he believed that ‘it will be impossible humanly speaking, that shareholders in any bank will ever be called upon to find a sixpence on account of their reserved liability’ because it takes more than one year for a bank to squander its paid-up capital and shareholder reserves, and independent auditors, as required under the 1879 Companies Act, would detect a deteriorating capital position.Footnote ¹¹⁸ Ultimately, therefore, in Rae's opinion, depositors were assured by published balance sheets certified by independent auditors.Footnote ¹¹⁹ Notably, the banking reformer Wilson also argued that publication of audited accounts should be a prerequisite before liability is limited. However, audited accounts do not inform depositors about the riskiness or even the various constituents of a bank's loan portfolio.Footnote ¹²⁰ Indeed, as mentioned above, the very nature of banking is such that banks cannot reveal this private information. Furthermore, a sufficiently large exogenous shock could reduce bank capital to zero in less than one year.

VI

This article has traced the debate on shareholder liability regimes in British banking. William Clay can be credited with defining the parameters of this debate in 1836. Firstly, as with his intellectual descendents, most notably Walter Bagehot, he argued that unlimited liability attracts low-wealth individuals and repels wealthy individuals, eventually resulting in unlimited liability becoming de facto limited. However, Clay and his descendents failed to realise that bank constitutions as well as the post-sale-extended liability clause in the banking copartnership legislation rendered such an outcome highly unlikely.

Secondly, Clay realised that in order to assure depositors of banking stability, an alternative to unlimited shareholder liability was required. His proposals of bank capital and biannual audited accounts were rejected by contemporaries as being inadequate. Surprisingly, the introduction of limited liability into banking in the late 1850s didn't place requirements in terms of capital or publicity upon banks. Furthermore, shareholder liability was of the pure limited variety even though Bagehot and the Bank of England had argued for an extended liability regime such as double or treble liability. Despite this liberalisation, the vast majority of established banks maintained unlimited liability until George Rae suggested that reserve liability be enshrined into company law. Ultimately, however, Rae, responding to critics of reserve liability, believed that it was unnecessary and would never be tapped because regular publication of audited accounts would ensure that no more than paid-up capital would ever be lost. Therefore, it appears that Rae's position was simply Clay's ‘limited liability, paid-up capital and entire publicity’.

Although this article has focused on the nineteenth century, several banks had extended shareholder liability into the twentieth century. However, the amalgamation movement resulted in the virtual extinction of extended shareholder liability from British banking by 1920.Footnote ¹²¹ By the late 1930s, only six relatively small British banks had reserve liability, with the Deputy Governor of the Bank of England being sceptical as to its value, arguing that it was ‘a survival from the time when banks were smaller and numerous; to-day a bank could not in a crisis make a call on shareholders without aggravating the crisis’.Footnote ¹²²