Limited liability, corporations and banks (2/2)

Limited liability, the ability to walk away from certain debts, is seen as one of the hallmarks of modern economics. In 2016, the Economist argued it is one of man’s greatest inventions that encourages investment by limiting people’s downside risk. Nevertheless, it has shortcomings. In the extreme, if people never have to own up to their debts, no-one would ever be willing to lend to them. In other words, there appears to be a trade-off.

In this research project we theoretically and empirically investigate this trade-off in the context of (non-financial) companies and banks. The central research question we ask is: What is the optimal level of limited liability that spurs economic activity?

Empirically, we know surprisingly little. In today’s world there is little variation in limited liability within a country and it is hard to make comparisons if the regime is the same for everyone. There are large differences between countries, but these may reflect deeper economic, cultural or institutional differences.

In this research project we use the 19th and early 20th century as a laboratory. During this time period rules on limited liability were introduced for the first time and subsequently underwent large changes. This provides a unique opportunity to study the effects of limited liability.

In the context of (non-financial) firms, we study the valuation and entry of firms who obtain (the option of) limited liability for their shareholders. In the context of banking, we look at the link between managers’ liability and their risk taking, and how liability rules affect financial fragility (in the form of bank runs) and the overall provision of credit in the economy. 

Keywords

Corporate governance, limited liability, corporate finance, financial history.