Many but not all firms have the freedom to choose liability rules. In some countries, service professions have unlimited liability rules imposed by government; historically, banks in some countries faced unlimited liability. Why do governments impose unlimited liability? This is the question we address. With a simple model, we illustrate the agency conflicts in firms. Limited liability solves these conflicts efficiently. Unlimited liability raises the cost of capital; inefficiently small firms result. But under some conditions, selectively applied unlimited liability rules protect rents. We test several propositions with data on Scottish banking and U.S. law firms

Many, but not all, firms have the freedom to choose liability rules. In some countries, service professions have unlimited liability rules imposed by government; historically, banks in some countries faced unlimited liability. Why do governments impose unlimited liability? This is the question the authors address. With a simple model, they illustrate the agency conflicts in firms. Limited liability solves these conflicts efficiently. Unlimited liability raises the cost of capital; inefficiently small firms result. But under some conditions, selectively-applied unlimited liability rules protect rents. The authors test several propositions with data on Scottish banking and U.S. law firms.