Creditor rights protection, tort claims and credit

Abstract

We use a simple lending model where environmental accidents lead to bankruptcies to study the impact of stronger protection of creditor rights. In the model, both the borrower and the creditor undertake actions—the former on accident reducing care and the latter on the screening of loan applicants. Creditor rights may not be preserved entirely due to competing claims from tort victims. The impact of better credit protection crucially depends on the structure of the informational asymmetry. For situations where only the entrepreneur’s action is privately observed, better protection of creditor rights leads to an improvement in the terms and availability of credit. When the actions of the borrower and the lender are both unobservable the results are completely reversed. The impact of better credit protection on social welfare is ambiguously dependent on the quality of borrowers.