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Creditor Protection and Credit Volatility

The implications, for the efficiency of financial markets, of laws and regulations that protect creditors have been amply debated in the literature. Several authors have argued that protecting creditors has important benefits since it allows credit markets to provide funds at a low cost. When creditor rights are protected bylaw, outside investors are willing to pay more for financial assets-as equity and debt. Legal protection assures that more of firms profits would comeback to investors as interest or dividends.

Rules and regulations that protect creditors and are properly and efficiently enforced lead to larger credit market and lower interest margins. This idea has been formalized by To wnsend (1979), Aghion and Bolton (1992), and Hart and Moore (1994,1998).

Recent papers by La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997 and 1998) and Djankov, McLiesh and Shleifer (2004) have given new impetus to the discussion of the importance of regulations surrounding credit markets for the development of financial markets, by providing valuable data on the state of legal protections to investors around the world and their enforcement.

Based on this data the impact of creditor protection on credit markets has been tested. Empirical evidence shows that countries with poor investor protection as measured by the quality of rules as well as their enforcement, tend to have narrower debt and equity markets.

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Creditor Protection and Credit Volatility