When Do Laws and Institutions Affect Recovery Rates on Collateral?
55 Pages Posted: 2 Feb 2016 Last revised: 8 Jul 2016
Date Written: July 7, 2016
We examine how law and institutions affect banks’ expected recovery rates on collateral using a novel dataset of secured loans made by a single bank across 16 countries, which includes a detailed description of the underlying assets pledged as collateral and the bank’s ex-ante appraised liquidation value. On average, expected recovery rates are higher where laws and institutions grant creditors stronger enforcement rights and bargaining power in the event of default. Using within-borrower estimation to compare recovery rates on different assets for the same borrower, we find that movable collateral that is less redeployable, more susceptible to agency problems, or faster to depreciate exhibits recovery rates that are lower and more vulnerable to laws and institutions. Further, the bank compensates for lower recovery rates in economies with weak performance by charging higher interest rates. The results shed light on one of the underlying economic channels through which weak laws and institutions undermine countries’ financial and economic development.
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