Banking Relationships and Creditor Rights

Abstract

Do the legal rights of creditors influence whether firms borrow from arm’s length or relationship lenders in a country? We examine this question by exploiting the staggered adoption of legal reforms that changed creditor rights. We find that as creditor rights strengthen, firms exhibit a greater propensity to switch to relationship lenders. Conversely, firms switch to arm’s length lenders as creditors rights weaken. These results are consistent with the view that arm’s length creditors have a bias towards excessive liquidation in environments with strong creditor rights. Hence as creditor rights strengthen, firms switch to relationship lenders as they are less likely to sub-optimally liquidate the firm when continuation is more efficient.

Keywords: banking relationships, creditor rights, liquidation bias, arm’s length creditors

JEL Classification: D23, G21, G32, K42