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? In this paper, we examine this question by exploiting the staggered adoption of legal reforms that changed creditor rights. We show that as creditor rights strengthen, firms have a greater propensity to switch to relationship lenders. Conversely, firms switch to arm's length lenders as creditors rights weaken. The results are consistent arm's length creditors having a bias towards excessive liquidation in environments with strong creditor rights. Relationship lenders are less likely to sub-optimally liquidate a firm when continuation is more efficient. We find further support for this interpretation in results that show more pronounced effects for firms expected to suffer a greater value loss from inefficient liquidation.