The Economic Rationale for Lender Liability

Abstract

We develop a model that provides an economic rationale for breach-of-contract liability for financial institutions: profit seeking alone is often an insufficient incentive to exploit all economically beneficial lending opportunities. We show that liability for reneging on commitments to lend acts as as a low cost incentive for banks to screen borrowers and induces greater investment efficiency and entrepreneurial activity. Our results extend the literature on law and finance and show the need for protection of borrowers from abuses by creditors.