ENVIRONMENTAL RISKS AND BANK LIABILITY

Many governments have introduced or are considering introducing laws t o recover from the liable parties the cleanup costs caused by pollutio n damages, In particular, the banks who finance the firms causing envi ronmental damages may be considered liable. In various court cases in the US and elsewhere, banks have been found liable, while they have be en exempted in others. We develop a model in which the insurance secto r may insure the firm for the pollution risk and the bank may lend mon ey for investment. Under complete information of the bank about the fi rm's activities, the limited liability cf the firm induces excessive i nvestment and insufficient care but full liability of the bank creates the appropriate internalization of the environmental risk. This ratio nalization of the laws on lender liability must be qualified because i n general the banks suffer front agency problems (adverse selection an d moral hazard) in their relationships with firms. In the adverse sele ction case, full liability of the bank leads to underinvestment. Parti al liability is better but may fail to implement the optimal second-be st allocation. In the cast: of moral hazard, full responsibility is ki lling 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 th e bank. We conclude with a discussion of the implications of our resul ts with regards to Liability laws for environmental damages.