The buck stops here: The economic role of limited liability in finance theory and regulatory policy

Noe, Thomas and Smith, Stephen (1997) The buck stops here: The economic role of limited liability in finance theory and regulatory policy. Federal Reserve Bank of Atlanta. Economic Review, 82 (1). pp. 46-56.

Abstract

In modern societies personal limited liability is the norm, given such conditions as finite wealth and the elimination of debtors’ prisons. In fact, over the last few centuries, many societies have taken this principle further by passing laws that allow investors in banks and other business enterprises to limit their losses to either their initial investment (pure corporate limited liability) or some multiple of their initial capital contribution. This latter liability structure might call for an additional infusion of funds on the part of investors up to some maximum (say, two times the investment) should an enterprise fail to meet its obligations from available resources. Bank shareholders, for example, were once routinely required to post at least some additional funds in the event of a bank failure. This practice ceased only after the substitution of public capital, in the form of government deposit insurance, for the private capital formerly used to support the system. Overall, changes in liability provisions, by many accounts, have been among the major influences on both the level and distribution of contemporary economic output as well as the allocation of financial resources in today’s financial markets.

This article reviews a large and growing literature on
the role of personal and corporate limited liability in the
economy. As early as Adam Smith’s ([1776] 1994) criticism of the emerging joint stock corporations of the eighteenth century and Walter Bagehot’s ([1873] 1991) analysis of the reasons for and consequences of the incorporation of the Bank of England in the seventeenth century, economists have been aware that liability structures, almost by definition, influence decisions made by households, businesses, and government agencies. This review attempts to provide a more thorough understanding of incentive structures under alternative liability regimes and, in doing so, should help policymakers better understand the possibly unintended effects of certain policies and programs.

Item Type: Article
Keywords: limited liability; economics; finance theory; regulation
Subject(s): Finance
Centre: Faculty of Finance
Date Deposited: 29 Mar 2012 15:30
Last Modified: 23 Oct 2015 14:07
URI: http://eureka.sbs.ox.ac.uk/id/eprint/2897

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