The quality of the legal system matters for firms’ access to bank loans: Strong creditor and property rights and a rigorous judicial enforcement system with short, cheap and simple proceedings create favourable conditions for bank lending.

Bank loans are a primary source of financing for firms. Banks will, however, only be willing to grant a loan if they can control the borrower risk and promptly recover on the loan in the case of a borrower default. The certainty of the law and the opportunity to enforce legal rights in court support banks in dealing with delinquent customers: Strong creditor rights protect the banks’ interests by enabling them to force repayment, repossess collateral or gain control of the debtor firm. In addition, rigorous judicial enforcement increases the bank’s recovery rate and reduces both time and efforts required to gain possession of their collateral. In countries with strong creditor protection and rigorous judicial enforcement, banks will find it easier to control borrower risk and, thus, be more willing to lend ex ante, thereby reducing credit constraints. At the same time, banks in countries with poor creditor protection and feeble law enforcement will be exposed to a greater legal risk and, thus, be reluctant to lend.

In our European Central Bank (ECB) Working Paper[1], we explore the effect of creditor protection (i.e. the strength of creditor and property rights) and judicial enforcement (i.e. the time to resolve a dispute, its costs and the number of procedures required) on firms’ credit access in eleven European countries. In distinction to previous papers, we employ an objective measure of credit constraints, which is based on the number of successful loan applications and not on the firms’ perceptions of difficulties in their access to finance or proxies for credit constraint, such as the price and non-price terms of loans. We rely on the Survey on the Access of Finance of Enterprises (SAFE) from the ECB, which collects information directly from firms about their access to credit, the use of different sources of finance and liquidity and finance constraints. We integrate this data with information on legal systems by the World Bank and the Heritage Foundation and end up with a dataset of 48,950 observations between 2009 and 2012, of which 12,504 observations are about firms which applied for a loan in that period. We use traditional Logit regression and re-test our findings by using Heckman selection to address potential selection bias as well as different controls and estimation techniques.

Our findings show that stronger creditor protection and better judicial enforcement lower the probability that firms do not obtain the requested loan at all and that firms obtain only a fraction of the requested loan. Thus, a strong legal system characterised by high creditor and property rights protection and a rigorous judicial enforcement system with short, cheap and simple proceedings creates favourable conditions for bank lending and supports credit access for firms. Even though all countries in our sample are member countries of the European Union, our results suggest a considerable economic impact of the legal system: the probability to obtain credit is up to 30% higher in countries with a better legal system; with regard to property protection the difference is smaller (around 19%) but nevertheless economically relevant. The table below reports the economic impact of the quality of the legal system on the probability to obtain a bank loan.

Source: Moro, Maresch and Ferrando (2015)

These findings have considerable implications for both firms and banks. Firms located in countries with weak creditor protection and feeble law enforcement might face a competitive disadvantage, since the more difficult access to bank loans constrains their development and growth. The context of our research, i.e. the single market policies pursued by the European Union, implies that firms cannot be protected via trade barriers. As a consequence, firms might be motivated to move to countries where the legal system allows for easier access to finance, which would impact the countries’ GDP growth and job creation. This aspect is particularly important, as there is some consistency in terms of creditor protection and judicial enforcement at country level: Finland ranks in the top in three out of five dimensions, whereas Italy ranks last in four out of five dimensions.

Banks might also be at a competitive disadvantage when they are located in a country with a low-quality legal system, as they might be less confident to retrieve the loan in case of a borrower’s default. From a policy point of view, our results suggest that credit access for firms can be facilitated by improving the quality of the laws and reducing the length, costs and required proceedings for judicial enforcement. Even though it might be difficult to change legal codes and improve the quality of the judicial enforcement system, the economic returns of such improvement might be worth the trouble.

ENDNOTES

[1] Andrea Moro, Daniela Maresch and Annalisa Ferrando (2015) Creditor Protection, Judicial Enforcement and Credit Access, ECB WP series 1829. https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1829.en.pdf.

The preceding post comes to us from Andrea Moro, Annalisa Ferrando and Daniela Maresch. Andrea Moro is a Senior Lecturer in Finance at Cranfield University (UK). Annalisa Ferrando is a Principal Economist at the European Central Bank. Daniela Maresch is an Assistant Professor at the Institute for Innovation Management (IFI) at the Johannes Kepler University Linz. The opinions expressed are those of the authors and do not necessarily reflect those of Cranfield University, the European Central Bank, or Johannes Kepler University Linz. The post is based on the authors’ article, which is entitled “Creditor Protection, Judicial Enforcement and Credit Access” and available here.