(Editor’s Note: This post comes to us from Vikrant Vig of London Business School, Rainer Haselmann of the University of Mainz, and Katharina Pistor of Columbia University School of Law.)
In our paper, How Law Affects Lending, which was recently accepted for publication in the Review of Financial Studies, we exploit variation in legal institutions of twelve transition economies to investigate the effect of legal change on the supply of credit.
Our study focuses on twelve Central Eastern European (CEE) transition economies. We assemble a unique matched database comprising bank-level information, ownership information, and time series information of legal changes for these countries. There are several advantages of using this set of countries as a laboratory: (i) these countries have undergone major legal reforms in the 1990s; (ii) these countries form a fairly homogeneous group; (iii) there is a considerable inter-temporal variation in the timing of these reforms; (iv) the reforms are motivated by pressures from outside governing bodies such as the European Union (EU), European Bank for Reconstruction and Development (EBRD), and USAID; and (v) these are all bank-based economies; therefore, creditor rights should play an important role in these countries.
We find that banks increase the supply of credit subsequent to legal change. The economic impact of a legal change on bank lending is considerable; an improvement of our legal indicator by one implies an increase in loan supply by 13.66%. Further, we differentiate between legal rules designed to protect individual creditors’ claims outside bankruptcy (Collateral) and the collective enforcement regime bankruptcy establishes (Bankruptcy). We find Collateral to be more important than Bankruptcy. This result is in contrast to previous articles, in which measures related to collective enforcement/reorganization (LLSV index) were used to proxy for creditor rights. Further, the effectiveness of a bankruptcy regime is conditional on the existing collateral regime, i.e., the existence of a strong collateral regime is critical for the efficacy of the bankruptcy regime.
Finally, our data suggest that entrants to the market, and in particular foreign banks, respond more strongly to legal change than incumbents by increasing their lending volume. The same is true when comparing greenfield banks with incumbents. We also find that improvements in collateral law result in an increase in individual and household lending, while lending to the government remains unaffected. Finally, legal improvements also affect firms’ level of external debt and their capital structure.
The full paper is available for download here.