Creditor Rights and Aggregate Factors in Loan Terms

Abstract

Weak creditor rights introduce contracting frictions and magnify conflicts of interest between borrowers and creditors. We examine the effects of creditor rights on the sensitivity of bank lending terms to aggregate relative to firm-specific information. We formulate two competing hypotheses. On the one hand, weaker creditor rights can amplify the bank’s screening and monitoring role, increasing the value of firm-specific information for the pricing of default risk. On the other hand, weaker creditor rights increase the incentives and ability of solvent borrowers to default strategically, particularly when aggregate performance is weak. Empirically, we find that loan spreads become more sensitive to aggregate factors and less sensitive to firm-specific fundamentals when creditor rights are weaker, consistent with the second prediction. Our findings suggest that weak creditor rights reduce the ability of borrowers with strong fundamentals to raise bank debt, lead to more correlated bank lending decisions, and may decrease allocative efficiency.