On the Role of Bank Liability in Protecting against Environmental Pollution

By extending the basic framework of Boyer and Laffont (1997) to an incomplete contracting model, where a bank with "lender liability" and a firm under an unlimited liability constraint play bargaining games in using option contracts, we show that environmental damages as externalities caused by the firm can be reduced to the socially desirable level through the provision of monitoring, insurance and credit by the bank interacting with the financial market.