Periodic Reporting for period 2 - HILL (One of Man’s Greatest Inventions? Historical Insights into Limited Liability)
Période du rapport: 2023-03-01 au 2024-08-31
As a legal structure, limited liability has been described as one of the greatest inventions of modern economics. On the positive side, it reduces people’s downside risk and encourages investment. On the negative side, it can create conflicts of interest between borrowers and lenders. The EU-funded HILL project investigates this trade-off in the context of entrepreneurs, non-financial companies, and banks. First introduced in the beginning of the 19th century, limited liability has existed in various forms. This project takes a historical approach and analyses how changes in limited liability affected patenting, the introduction of new technologies, migration decisions, firms' cost of capital, firm creation, and bank risk-taking and lending decisions.
In “Innovation: Patenting and the 1898 Federal Bankruptcy Act”, we show that the introduction of limited liability for entrepreneurs stimulates patenting, but only if the amount of assets that are exempted in bankruptcy are not too high. Making it harder to defraud creditors has similar effects. Similarly, in “Technology adoption: limited liability and the introduction of steam power, 1850-1880”, we find that exempting some household assets in bankruptcy makes it likelier for firms to introduce the steam engine. Overall, results suggest that a successful liability regime for entrepreneurs consist of debt forgiveness in case of failure, but with sufficient creditor protection against fraud.
In “Going for Broke: Bank Reputation and the Performance of Opaque Securities,” we find that bank reputation can help improve the quality of security issuances. Recent work on the 2000s has questioned this mechanism, suggesting bank reputation is ineffective. We argue that a necessary condition is that bank managers are held liable for their banks’ reputational losses. Similarly, in “Bank directors’ liability and security issuance”, we find that risk taking in banks can be mitigated if bank managers can be held liable for negative outcomes from their individual decisions making. In line with this evidence, in “Shareholder Liability and Bank Failure” we find that banks will be at lower risk of failure if their bank managers are held liable for the losses. These insights are new since bank managers’ liability is typically limited in today’s banks and suggest that financial crises will be less likely to happen if bank managers have more to lose.
At the same time, limited liability banks seem to benefit substantially from borrowers with unlimited liability. In “The Mortgage Piggybank: Building Wealth through Amortization”, we study banks’ mortgage lending behavior in a full recourse setting. It establishes that mortgage lending is unchanged when borrowers are forced to amortize more, suggesting amortization does not matter for mortgage terms and bank risk in full recourse settings. This insight is new as most of the literature has studied settings with limited recourse and some sort of limited liability for borrowers.
In “Going for Broke: Bank Reputation and the Performance of Opaque Securities,” we find that bank reputation can help improve the quality of security issuances. Recent work on the 2000s has questioned this mechanism, suggesting bank reputation is ineffective. We argue that a necessary condition is that bank managers are held liable for their banks’ reputational losses. Similarly, in “Bank directors’ liability and security issuance”, we find that risk taking in banks can be mitigated if bank managers can be held liable for negative outcomes from their individual decisions making. In line with this evidence, in “Shareholder Liability and Bank Failure” we find that banks will be at lower risk of failure if their bank managers are held liable for the losses. These insights are new since bank managers’ liability is typically limited in today’s banks and suggest that financial crises will be less likely to happen if bank managers have more to lose.
At the same time, limited liability banks seem to benefit substantially from borrowers with unlimited liability. In “The Mortgage Piggybank: Building Wealth through Amortization”, we study banks’ mortgage lending behavior in a full recourse setting. It establishes that mortgage lending is unchanged when borrowers are forced to amortize more, suggesting amortization does not matter for mortgage terms and bank risk in full recourse settings. This insight is new as most of the literature has studied settings with limited recourse and some sort of limited liability for borrowers.
We study the importance of limited liability using the introduction of incorporation laws in the U.S. and U.K. in the 19th century. We are currently involved in big data collection exercise of individual firm and aggregate statistics and creating a detailed compendium of law changes in different U.S. states.
At the end of the project, we will tie all different elements from the project together to come up with a comprehensive understanding of limited liability for all different types of agents in the economy.
At the end of the project, we will tie all different elements from the project together to come up with a comprehensive understanding of limited liability for all different types of agents in the economy.