When Do Laws and Institutions Affect Recovery Rates on Collateral?

By Hans Degryse, Vasso Ioannidou, Jose Maria Liberti, and Jason Sturgess

The effect of bankruptcy laws and institutions governing enforcement on firm borrowing, investment, and growth has been studied extensively in the economics and finance literature using mainly country-level data. Due to the lack of micro-level data, the same literature has been silent on the underlying economic channels through which weak laws and institutions affect debt contracting.

In order to fill this gap, we study how laws and legal institutions that shift bargaining power between creditors and debtors in the event of default affect expected recovery rates on assets pledged as collateral in secured lending transactions. In particular, we study empirically the determinants of expected recovery rates on different types of collateral using a detailed loan-level dataset of secured loans made by a single bank across emerging market countries. We are able to pin-point the actual mechanism through which better law and stronger enforcement of secured loans can translate into lending: the effect of creditor rights and asset types on the bank’s expected recovery rates.  Our results suggest collateral that is movable (machinery, equipment, inventory, and accounts receivable), more asset specific, more susceptible to agency concerns, or faster to depreciate exhibits lower expected recovery rates since they are more vulnerable to laws and institutions.

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