In many developing countries and transition economies, the quality of formal judicial institutions is poor. Cases in court are subject to long delays, judges and court officials are corrupt, or the courts are captured by the elite.1 As a result, economic agents cannot depend on courts for the protection of their property rights, leading to high transactions costs and other contracting problems (Williamson 1985). A large and growing body of theory suggests that in such situations some welfare-improving transactions will not be undertaken (Mookherjee 1999).
Improving the quality of formal judicial institutions and more generally “getting the institutions right” (North 1990) may thus allow the achievement of superior economic outcomes. For instance, it has been shown that entrepreneurs’ confidence in a country’s institutions, including the judicial system, predicts levels of investment and rates of economic growth (Knack & Keefer 1995, Mauro 1995), and that the nature of a country’s laws and the efficiency of its judiciary can explain the concentration of share-holding and the extent of external long-term financing that firms receive (Demirgüç-Kunt & Maksimovic 1998, La Porta et al. 1998). However the literature provides very little evidence of the micro-level mechanisms through which judicial quality influences economic development.2 This paper seeks to contribute in filling that void.
This paper investigates the effects of a particular improvement in the judicial institutions that process debt recovery cases in India. In 1993 the Indian government passed a national act that allowed for the establishment of Debt Recovery Tribunals (DRTs) across India. These tribunals are a new quasi-legal institution set up to process legal suits filed by banks against defaulting borrowers. They follow a streamlined legal procedure that emphasizes speedy adjudication of cases and swift execution of the verdict. By March 31st 2003 they had disposed claims worth Rupees 314 billion (roughly 4 percent of total bank credit to the commercial sector in 2002-03) and recovered Rupees 79 billion (Government of India 2003).
Two aspects of this reform are particularly relevant. One, the monetary threshold for claims to be filed in a DRT is Rupees 1 million (approximately US$ 20,000). Two, there is variation in the timing of tribunal establishment in different states. Neither the monetary threshold nor the timing of DRT placement appears to be correlated with other factors which may influence the ability or willingness of borrowers to repay their loans. Therefore these two features allow a differences in differences strategy to identify the effects of the DRTs.
The data used to implement this strategy consist of loan level records that I collected from a large private sector bank with a national presence. I observe detailed information about the contractual terms of the loans, their repayment schedule and actual repayment in each quarter when an installment becomes due. I utilize the two sources of variation described above to examine the effect of DRTs on borrowers’ repayment behavior.
Loans that are late on repayment of more than Rupees 1 million at the time of the legal reform are potentially treated by DRTs. Therefore I compare the change in the repayment behavior of these loans after DRTs are established, to the change in the repayment behavior of other loans (those with less than Rupees 1 million overdue). The difference can be attributed to the DRTs. To address possible concerns that other factors may be driving these results, I conduct several robustness checks. I control for state-level time-varying unobservable factors (by including state × quarter fixed effects), and allow different time-varying unobservables for loans above and below the Rupees 1 million threshold. I find robust evidence that for loans with more than Rupees 1 million overdue, the establishment of a tribunal increases the likelihood that an installment is paid on time. Furthermore, this effect holds within loans as well: for the same loan, installments that become due after a tribunal is established are more likely to be paid up on time than installments that become due before.
As evidence of the economic impact of this reform, I find further that the establishment of a DRT leads to a change in the contractual terms of new loans given out subsequently. While the size of an average loan does not change significantly, the interest rate on new loans tends to be lower than that on comparable older loans by 1 to 2 percentage points. This suggests that improved repayment behavior lowers the risk of default and allows the bank to provide cheaper credit.
The paper is organized as follows. Section 2 provides some background on the factors leading to the DRT Act, and details of the act and its implementation. Section 3 presents a theoretical framework to explain the phenomenon studied here. Section 4 describes the data. Section 5 presents the empirical strategy. Sections 6, 7 and 8 present the empirical results. Section 9 concludes the paper.
