Environmental risks and bank liability

Abstract

Many governments have introduced or are considering introducing laws to recover from the liable parties the cleanup costs caused by pollution damages. In particular, the banks who finance the firms causing environmental damages may be considered liable. In various court cases in the US and elsewhere, banks have been found liable, while they have been exempted in others. We develop a model in which the insurance sector may insure the firm for the pollution risk and the bank may lend money for investment. Under complete information of the bank about the firm's activities, the limited liability of the firm induces excessive investment and insufficient care but full liability of the bank creates the appropriate internalization of the environmental risk. This rationalization of the laws on lender liability must be qualified because in general the banks suffer from agency problems (adverse selection and moral hazard) in their relationships with firms. In the adverse selection case, full liability of the bank leads to underinvestment. Partial liability is better but may fail to implement the optimal second-best allocation. In the case of moral hazard, full responsibility is killing the project too often while still leading to low care too often. Partial responsibility may achieve the second-best optimal allocation but in some cases the level of responsibility necessary to induce the proper level of care is too high for the project to be financed by the bank. We conclude with a discussion of the implications of our results with regards to liability laws for environmental damages.