How Law and Institutions Shape Financial Contracts: The Case of Bank Loans

This paper empirically examines how legal origin, creditor rights, property rights, legal formalism and financial development affect the design of price and non-price terms of bank loans. The paper:

• Employs a data set of loans from 60 countries to test how loan terms vary across countries in a reduced form setting;
• Argues that bank loan contracts depend on country-level variables incorporating legal and institutional factors, and on loan-level variables incorporating borrower and loan characteristics;
• Examines the basic pricing term, two non-price terms, along with three ownership variables;
• Tests how loan attributes vary with differences in creditor rights, property rights, government corruption, the functioning of the courts, and financial and economic development;
• Provides a complete characterization of how the overall ability of credit may respond to the contracting environment.

The paper finds that:

• A country's law and institutions are important in shaping private contracts;
• Private contracts reflect differences in legal protection of creditors and the enforcement of contracts;
• Loans made to borrowers in countries where creditors can seize collateral in case of default are more likely to be secured, have longer maturity and lower interest rates;
• Coasian bargaining can partially offset weak legal or institutional arrangements;
• Lenders mitigate risks associated with weak property rights and government corruption by securing loans with collateral and shortening maturity;
• The choice of loan ownership structure affects loan contract terms;
• Greater legal formalism in a borrower's country significantly alters the terms of loan contracts.