Penalties and Optimality in Financial Contracts: Taking Stock

50 Pages Posted: 14 Jan 2006  

Michel A. Robe

American University - Kogod School of Business

Eva-Maria Steiger

Max Planck Institute of Economics, Strategic Interaction Group

Pierre-Armand Michel

University of Liege - HEC Management School

Date Written: January 2006

Abstract

A popular view of limited liability in financial contracting is that it is the result of societal preferences against excessive penalties. The view of most financial economists is instead that limited liability emerged as an optimal institution when, in the absence of a clear limit on economic agents' liability, the development of some economic activities might have been thwarted. Viewing the institution from the perspective of optimal legal system design allows us to better understand the current debate on it.

We present a broad history of penalties in financial contracts to highlight the interactions between technology, legal environments, purpose of the financial relationship, and contractual provisions. We show that harsh monetary and non-pecuniary penalties are not mere relics from a bygone era and, at the same time, that limited liability is far from a recent institution. We then discuss trade-offs associated with legal mandates of either unlimited or limited liability, both for the contracting parties and for the rest of Society.

We identify two broad patterns. First, the toughness of liability rules and bankruptcy laws decreases as exogenous sources of uncertainty become relatively more important, and increases with the opportunity for moral hazard (related to diligence, risk taking, or deception). Second, bankruptcy laws become more lenient as the scope for labor specialization and the returns to human capital or entrepreneurship increase.

Keywords: Limited Liability, Bankruptcy, Debt Bondage, Debtors' Prison, History

JEL Classification: G32, D82

Suggested Citation

Robe, Michel A. and Steiger, Eva-Maria and Michel, Pierre-Armand, Penalties and Optimality in Financial Contracts: Taking Stock (January 2006). Available at SSRN: https://ssrn.com/abstract=875177 or http://dx.doi.org/10.2139/ssrn.875177

Michel A. Robe (Contact Author)

American University - Kogod School of Business ( email )

4400 Massachusetts Avenue NW
Washington, DC 20816-8044
United States
202-885-1880 (Phone)
202-885-1946 (Fax)

Eva-Maria Steiger

Max Planck Institute of Economics, Strategic Interaction Group ( email )

Kahlaische Strasse 10
D-07745 Jena, 07745
Germany

HOME PAGE: http://www.econ.mpg.de/english/staff/staffpage.php?group=esi&name=steiger

Pierre-Armand Michel

University of Liege - HEC Management School ( email )

B-4000 Liege
Belgium

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