1. ¹Department of Economics, University of Frankfurt, D-60325 Frankfurt, Germany. E-mail feess@wiwi.uni-frankfurt.de
2. ²Tilburg University, Center for Economic Research and Department of Finance, NL-5000 Tilburg, The Netherlands. E-mail hege@kub.nl

^*We wish to thank Marcel Boyer, Dominique Demougin, Hendrik Lando, Göran Skogh and Georg Nöldeke for useful discussions and two anonymous referees for helpful remarks. Seminar participants at the EALE - Geneva Association Joint Conference in Rotterdamprovided stimulating comments. Financial support from Thyssen Stiftung is gratefully acknowledged.

Abstract

Firms will exert too little care due to a limited liability effect if damages are likely to exceed their equity. This is particularly important for environmental and product liability and motivates the current discussion about mandatory insurance and extending liability to creditors. We model the choice of the care level as a moral hazard problem that can be solved through costly monitoring. Conventional strict liability and lender liability both lead to distortions in the capital structure and to inefficiently low care. By contrast, mandatory liability coverage (financial responsibility) that can be satisfied by either an insurance contract or a lender guarantee leads to the first best allocation if managers can self-insure, and to the second best if managers cannot self-insure but choose to be monitored.