Bank Quality, Judicial Efficiency and Borrower Runs: Loan Repayment Delays in Italy

Abstract

Exposure to liquidity risk makes banks vulnerable to runs from both depositors and from wholesale, short-term investors. This paper shows empirically that banks are also vulnerable to run-like behaviour from borrowers who delay their loan repayments (default). Firms in Italy defaulted more against banks with high levels of past losses. We control for borrower fundamentals with firm-quarter fixed effects; thus, identification comes from a firm’s choice to default against one bank versus another, depending on their health. This ‘selective’ default increases where legal enforcement is weak. Poor enforcement can therefore create a systematic loan risk by encouraging borrowers to default en masse once the continuation value of their bank relationships comes into doubt.