How do creditor rights matter for debt finance?

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In the history of famous feuds, there are the Hatfields and the McCoys, the Montagues and the Capulets and, sometimes it seems, lawyers and economists. 
 
As a lawyer, I often find myself in heated debates with my economist friends and colleagues. Where they use data, we use words; where they have faith in rational actors, we know that humans are, sadly, often deeply irrational; and where they want to connect different data points to illustrate a trend, we want to highlight the infinite nuance between those data points that insists against a simple narrative.
 
Yet, despite our seemingly fundamental differences, we do seem to be coming together around the notion that law does matter for finance.  Specifically, that certain kinds of laws (those around creditor rights and insolvency) matter for certain kinds of finance (debt).

In a new paper, published by the European Bank for Reconstruction and Development, my colleague Antonia Menezes and I partnered with two Oxford University scholars, John Armour and Kristin van Zwieten, to show how financial infrastructure laws influence debt finance.

In the interest of full disclosure, I will tell you that all four of us are lawyers. However, John and Kristin are leading academics at the intersection of economics and law in Oxford’s Law and Finance program, and both have advanced degrees in economics.  They can talk the talk and walk the walk!

In the paper, we find that, perhaps paradoxically, strengthening the rights of creditors – including sometimes at the expense of debtor rights – can improve access to credit at reasonable rates for those very debtors.  The predictability generated by more efficient and transparent insolvency and movable collateral regimes, in particular, seem to have the effect – both in cross-country and, crucially, in within-country studies – of reducing the cost of borrowing for firms and increasing their access to finance.
 
Of course – as any good lawyer will tell you – caution should be used in drawing conclusions from one legal system and applying them to another one. But the evidence from a variety of different countries, across income levels and legal origins, all seems to be pointing in the same direction.
 
Could this herald a détente in the feud? Maybe. (Still, if I ever run into those Freakonomics guys on the street, I’m going to give them a piece of my mind. . . . )
 
Our full paper is available in Research Handbook on Secured Financing in Commercial Transactions.
 

Authors

Mahesh Uttamchandani

Practice Manager, Financial Inclusion, Infrastructure & Access in the Finance, Competitiveness, and Innovation Global Practice, World Bank Group

Waleed Malik
August 11, 2015

Interesting findings as they make the case for WBG's support to developing countries in improving the business climate via financial/justice sector reforms.
Did you also see whether the predictability generated by more efficient and transparent insolvency and movable collateral regimes, also translates into better outcomes (e.g. reduced cost of credit) for small businesses and low income households.

Mahesh Uttamchandani
August 14, 2015

Most of the literature does not disaggregate data by business size but, given the disproportionate dependence of small businesses on credit, and their disproportionate lack of immovable assets, we would expect to see a larger positive effect for small businesses.  For consumers/households, the evidence that improved personal insolvency laws lead to greater entrepreneurship and risk-taking is quite compelling.