Lender Penalty for Environmental Damage and the Equilibrium Cost of Capital

In a model of the lending relationship incorporating both adverse selection and moral hazard, we show that increasing the liability of lenders for environmental damage done by their borrowers has a qualitatively ambiguous impact upon interest rates. This calls into question the assertion of financial community representatives that such reform will necessarily driveup interest rates and have adverse macroeconomic consequences. If it is this fear which is preventing reform then that reluctance may, in the case of many classes of pollutant, be misplaced. The implications of such reform for credit-rationing are also explored.