Template-Type: ReDIF-Paper 1.0
Author-Name:  Michel A. Robe
Author-X-Name-First: Michel A.
Author-X-Name-Last: Robe
Author-Name:  Eva-Maria Steiger
Author-X-Name-First: Eva-Maria
Author-X-Name-Last: Steiger
Author-Name:  Pierre-Armand Michel
Author-X-Name-First: Pierre-Armand
Author-X-Name-Last: Michel
Title:  Penalties and Optimality in Financial Contracts: Taking Stock
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.
Length:  47 pages
Creation-Date:  2006-02
File-URL: http://sfb649.wiwi.hu-berlin.de/papers/pdf/SFB649DP2006-013.pdf
File-Format: Application/pdf
Number: SFB649DP2006-013
Classification-JEL: G32, D82
Keywords: Limited Liability, Bankruptcy, Debt Bondage, Debtors' Prison, History
Handle: RePEc:hum:wpaper:SFB649DP2006-013