We examine whether differences in legal protection affect the size, maturity, and interest rate spread on loans to borrowers in 48 countries. Results show that banks respond to poor enforceability of contracts by reducing loan amounts, shortening loan maturities, and increasing loan spreads. These effects are both statistically significant and economically large. While stronger creditor rights reduce spreads, they do not seem to matter for loan size and maturity. Overall, we show that variation in enforceability of contracts matters a great deal more to how loans are structured and how they are priced.
The extent to which property rights are protected in a country is an important consideration in determining what loans are offered to firms, how these loans are structured, and how they are priced. Property rights protection affects a lender’s incentives to monitor and its ability to recontract. Declining credit quality often results in lenders raising interest rates, demanding more collateral, shortening loan maturity, and further restricting future activities. This recontracting is costly when property rights are poorly enforced. Poor enforcement lowers recovery rates and increases the time spent in repossessing collateral following default.
In addition to enforcement, the legal rights that lenders have in reorganization and liquidation procedures are also important. Differences in creditor rights matter to loan contracting because laws determine who controls the insolvency process and who has rights to the property of a bankrupt firm. How do differences in creditor rights and contract enforceability affect the amount banks lend to firms, the maturity of the loans they make, and the interest rate spreads they charge? Are laws and enforcement equally important to the loan contracting process? Bhattacharya and Daouk (2002, 2005) argue that it is the enforcement, not the existence, of laws that matters. Qian and Strahan (2007) suggest that it is creditor rights, not the protection of property rights, that matter.
The recent case of Asia Pulp and Power (APP), controlled by Indonesia’s Widjaja family, illustrates the difficulty of recontracting in weak property rights environments. In 2003, the company owed almost US$14 billion to foreign banks, fund managers, and various credit agencies. The foreign banks that lent to APP found it difficult to reschedule debt payments. The media reported that the Indonesian courts had not been very helpful in enforcing loan contracts and that the family had snubbed their foreign lenders, often not turning up for scheduled meetings to discuss debt repayments. Citing other examples from Indonesia, Bloomberg (April 28, 2003) stated that “the lack of a credible legal infrastructure makes enforcing rights in Indonesia’s courts almost impossible.” Indonesia scores high on creditor rights but low on property rights protection.
This paper examines the effects of creditor rights and property rights protection on loan contracts. Banks are expected to charge higher interest rate spreads when they lend to firms operating in countries with weak creditor rights and poor enforcement. However, as risks increase, instead of increasing interest rates, banks ration some borrowers (Stiglitz and Weiss (1981)). Thus, loan amounts shrink as legal risks increase. Loan maturities also respond to higher legal risks. Diamond (2004) suggests that in legal systems with expensive or ineffective contract enforcement, more short-term debt will be issued. Short-maturity debt allows lenders to review their lending decisions more frequently and to restrict borrower flexibility to increase the riskiness of assets. We examine all three aspects of loan contracting – loan size, loan maturity, and loan spreads. In relating these loan variables to law and enforcement measures, we control for other factors that are likely to affect loan contracting, including loan syndicate structure and composition, agency participation in loans, loan purpose and type, priority structure, borrower risk characteristics, country sovereign risk, measures of financial and economic development, borrower industry, and year and country effects. Our results are based on a fairly large sample of loans (over 63,000 loans worth US$13 trillion) to firms in 48 countries during 1994 to 2003.
