Working Paper

The Law-Finance Paradox

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The global financial crisis led to the rediscovery of ‘fundamental uncertainty’. Incorporating uncertainty into the analysis of financial markets alters our understanding of how these markets operate and expose the two-faced role of law in finance.

Instead of helping markets to approximate their idealized efficient state as assumed in standard accounts of law and finance, under conditions of fundamental uncertainty law can be destructive and hasten its demise. This is the essence of the Law-Finance Paradox:

Legal commitments lend credibility to financial contracts and help transform relational finance into large-scale markets; yet, enforcing all contracts ex post as written ex ante irrespective of intervening change can lead to the system’s self-destruction; further, suspending or relaxing the full force of law to rescue the system undermines the credibility of legal commitments needed to support market development.