On information, extended liability and judgment proof firms

Abstract

We use a simple lending model with endogenous screening to compare the impact of improvements in the cost of acquiring information and increases in the liability of lenders for environmental harm caused by their borrowers. In the model, judgment proof borrowers have private information about their underlying risk (represented by the probability of an accident). Screening enables lenders to receive a noisy signal about their borrowers’ risk type ex ante. We show that a decrease in the cost of information exacerbates credit rationing. By contrast, an increase in lender liability leads to a reduction in the extent to which credit is rationed. The impact on social welfare crucially depends on the mix of borrower-type in the population: an increase in extended liability is likely to improve social welfare if there is an abundance of good borrowers in the population; improvements in the information system are likely to enhance social welfare if the proportion of good risks is sufficiently low.