Legal Origin,
Creditors’ Rights
and Bank Risk-Taking
Rebel A. Cole
DePaul University
Chicago, IL USA
Rima Turk Ariss
Lebanese American University
Beirut, Lebanon
Cole-Turk:
Legal Origin, Creditors’ Rights and Bank Risk-Taking
Summary


In this study, we examine bank operating risk,
financial risk and profitability at 1,468 banks in
99 emerging-market countries over the 20002006 period.
We find that banks take on more portfolio risk
(allocating significantly more of their assets to
loans) where:
• They enjoy English rather than French or Socialist legal
origin.
• Enforcement of debt contracts is more efficient.
• Banks enjoy fewer restrictions on their activities.
• Creditors’ rights are weaker
• The ownership share of the controlling shareholder is
larger.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Summary

We find that banks take on more financial risk
(holding significantly less equity as a percentage
of assets) where:
• They enjoy English rather than French or Socialist legal
origin.
• Creditors’ rights are stronger.
• The largest shareholder is not the State..
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Summary

Finally, we find that banks are much more
profitable (as measured by return on assets)
where:
• Banks enjoy English rather than French or Socialist legal
origin.
• Creditors’ rights are stronger.
• Banks face more restrictions on their activities.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Summary



Our primary contribution to the literature is new
evidence from bank-level data of a bank-lending
channel by which better legal protection leads to
more credit, and, consequently, better financial
development.
With better creditor protection, bankers increase
the portion of their asset portfolios allocated to
risky loans.
In aggregate, this should lead to higher levels of
private sector credit, which the “finance and
growth” literature has shown is positively related
to economic growth.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Summary


We also contribute to the growing literature on
determinants of bank risk-taking (Acharya,
Amihud and Litov 2008; John, Litov, Yeung 2008;
Laeven and Levine 2008).
Here, we provide new firm-level evidence that
banks take on more risk when their interests are
better protected by the judiciary.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
Law, Finance and Growth



Our study is based upon the “law and finance”
literature as well as the “finance and growth
literature.”
We expect that a bank will allocate more of its
asset portfolio to loans when it enjoys better
legal protection and more efficient enforcement
of contracts.
Greater bank lending should lead to higher
economic growth.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Law and Finance”




“Law and Finance” literature: essentially begins
with LLSV (1998 JPE) article “Law and Finance”
Premise: English common law provides superior
protection to investors and creditors as compared
to civil law, especially French civil law.
Finding: Countries with English legal origin enjoy
better developed capital markets than do
countries of other legal origins.
Others have challenged LLSV: is it legal origin or
is it simply English culture/heritage?
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Law and Finance”

LLSV make important distinctions
between:
• Investor protection and creditor protection
 You can protect equity holders at the
expense of debt holders, and visa versa.
• Legal rights and legal enforcement.
 You can have strong laws but they provide
little protection without enforcement.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Law and Finance”


Beck, Demirguc-Kunt and Levine (2003 JFE)
“Law, Endowments and Finance.”
Financial development as measured by the
amount of private-sector credit (scaled by GDP)
is greater in countries of English legal origin than
in countries of French legal origin.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Law and Finance”

Djankov et al. (2003 QJE) “Courts”:

Develop measures of enforcement efficiency
• How long does it take to collect on a bounced check?
 60 days in New Zealand, 645 days in Italy
• How long does it take to evict a delinquent tenant?
 49 days in U.S., 660 days in Bulgaria

Findings:
• Efficiency is greater in countries of English legal origin.
• Efficiency is associated with higher survey measures of
the quality of justice in a country.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Law and Finance”

Djankov, McLiesh and Shleifer (2007 JFE) “Private
Credit”:
• Revise and expand the earlier measure of legal
enforcement:
• How long does it take to collect on a debt
equal to half of a country’s GDP per capita?
• Find that private sector credit (scaled by GDP)
is higher in countries with stronger creditor’s
rights and more efficient enforcement in
developed, but not developing, countries.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Law and Finance”



Qian and Strahan (2007 JF):
Examine how creditors’ rights and enforcement
efficiency (as measured by collecting on a
bounced check) affect terms of loan contracts
(amount granted, rate, maturity) in 43 countries.
Findings:
• better legal protection of creditor rights is associated
with better terms of credit.
• More efficient enforcement is associated with better
terms of credit.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Law and Finance”



John, Litov and Yeung (2008 JF)
“Corporate Governance and Risk-Taking”:
Examine how differences in governance impact
risk-taking and growth of industrial companies in
38 countries from 1992-2002.
Find that companies that enjoy better legal
protection take on more risk, and that firms
taking on more risk grow faster.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Law and Finance”

Acharya, Amihud and Litov (2008 working paper)
“Creditor Rights and Corporate Risk-Taking”:
• Propose a “dark side” to strong creditors rights: they
induce firms to engage in risk-reducing investments


Shareholders want to avoid inefficient liquidation of
assets.
Managers want to preserve their private benefits of
control.
• Finding: firms in countries with strong creditors rights
engage in more diversifying mergers, reduce operating
risk as measured by Std. Dev. of ROA
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Background:
“Finance and Growth”



Levine (1999 JFI)
Financial Institutions are better developed in
countries with better legal protection
Portion of Financial Institution development
(private sector credit scaled by GDP) explained
by legal protection is positively related to
economic growth.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Research Question


At the firm level, rather than at the country level,
how do lenders respond to differences in
governance regimes? (With exception of Qian and
Strahan, all of these previous studies are at the
country level rather than at the firm level)
Specifically, how do banks in emerging countries
respond to differences in legal origin, creditors
rights, and efficiency of contract enforcement?
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Hypotheses


Risk-taking behavior of banks is affected by a
country’s legal tradition, creditor protection, and
prevailing institutions ( such as more “openness
in banking practices”).
The superior legal protection and enforcement
available from the institutions in countries of
English legal origin encourages banks:
• to take on more operating risk (i.e. extend more loans)
• to take on more financial risk (i.e., hold less capital).

To the extent that they increase their overall level
of risk, we also should observe higher levels of
returns.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Data

Bank-level data over the period 2000-2006,
• 7,374 bank-year observations on 1,468 banks located in
99 emerging-market countries from 9 world regions
(Latin America, East Asia, Eastern, Northern, Central
and Southern Europe, MENA and GCC). (Source:
BankScope).
• Financials:

Total Assets, Total Equity, Total Loans, Net
Income
• Ownership:

Percentage, type of owner (Domestic
Private, Foreign Private, State)
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Data


Legal Origin: Identifies the legal origin of the
company law or commercial code of each country
(English, French, Socialist).
(Source: Djankov et al. 2007).
GDP per capita: commonly used as a control of
the level of economic development in a country.
(Source: IFS).
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Data

Banking Activity Restrictions: an indicator of relative
openness of banking & financial system with a
higher score indicating more restrictions on banking.
(Source: Heritage Foundation).
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Data

Creditors’ Rights : Index is based upon four separate
rights (Source: Djankov et al. 2007, but first used on
a smaller set of countries by LLSV 1998):
1. Existence of restrictions, such as creditor consent, when a
debtor files for reorganization.
2. Ability to secured creditors to seize collateral after a
reorganization petition is approved (no automatic stay on
ability to seize collateral).
3. Secured creditors are paid first out of the proceeds of
liquidating a bankrupt firm.
4. Responsibility for running the business during the
reorganization falls upon an administrator, and not
management, i.e., management is replaced.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Data

Legal Formalism: An estimate of the number of
days necessary to collect an unpaid debt equal to
50% of the country’s GDP per capita,) Source:
Djankov et al. 2007.
• Higher values indicate greater “procedural formalism”
and greater inefficiency in judicial enforcement.
• Conversely, lower values indicate greater judicial
efficiency.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Methodology

We merge all data sets together and:
• calculate univariate statistics
• conduct random-effects regressions. (Note: As pointed out
by LLSV, we cannot conduct fixed-effects regressions
because legal origin and creditors’ rights are constant
across our time series.)

Univariate statistics:
• We split our sample into groups of high and low levels of
governance indices, and conduct simple t-tests for
difference in means of bank credit risk exposure,
capitalization level and profitability.
• Idea is to provide some broad evidence on the importance
of legal origin and creditor protection on bank conditions
and performance.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Univariate Results
Obs. Statistic
All
Loans to
Assets
Equity to
Assets
ROA
7,214 Mean
Std.Error
0.4831
(0.0023)
0.1465
(0.0015)
0.0127
(0.0003)
Panel A: By Legal Origin
English
1,618 Mean
Std.Error
0.4837
(0.0044)
0.1070
(0.0025)
0.0151
(0.0006)
French
2,895 Mean
Std.Error
0.4606
(0.0039)
0.1459
(0.0024)
0.0115
(0.0005)
Socialist
2,701 Mean
Std.Error
0.5067
(0.0036)
0.1709
(0.0026)
0.0124
(0.0004)
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Univariate Results
Panel B: By Creditors Rights
Low
5,769 Mean
Std.Error
High
1,445 Mean
Std.Error
Panel C: By Legal Formalism
Low
3,605 Mean
Std.Error
High
3,609 Mean
Std.Error
Panel D: By Financial Freedom
Low
3,269 Mean
Std.Error
High
3,945 Mean
Std.Error
TL/TA
0.4919
(0.0025)
TE/TA
0.1453
(0.0017)
0.4477
(0.0053)
0.1514
(0.0035)
0.0151
(0.0006)
0.5048
(0.0032)
0.1498
(0.0021)
0.0144
(0.0004)
0.4613
(0.0032)
0.1433
(0.0022)
0.0109
(0.0004)
0.4894
(0.0033)
0.1512
(0.0023)
0.0138
(0.0004)
0.4778
(0.0032)
0.1426
(0.0019)
0.0117
(0.0004)
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
ROA
0.0121
(0.0003)
Multivariate Regressions
Yi,t = β Xj + δ Cj + η Zj,t + εi,t





Yi,t measures bank operating risk-taking (total loans to total
assets), financial risk (total equity to total assets), or
profitability (net income to total assets or to total equity)
for bank i during year t;
Xj are dummy variables describing the legal origin of
country j;
Cj are structural/governance variables for country j;
Zj,t are controls for the level of economic development for
country j;
εi,t is a random error term for bank i during year t.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Random-Effects Regression:
Loan to Assets
(1)
-0.075 a
(0.0125)
-0.030 b
(0.0130)
0.060 a
(0.0035)
French Legal Origin
Socialist Legal Origin
ln (GDP per Capita)
ln ( Legal Formalism)
Creditors' Rights Index
(2)
-0.096
-0.0137
-0.039
-0.013
0.062
-0.0035
-0.057
-0.0099
-0.035
-0.0057
Financial Freedom
a
a
a
a
a
(3)
-0.098
(0.0139)
-0.034
(0.0131)
0.057
(0.0037)
-0.054
(0.0101)
-0.035
(0.0058)
0.048
(0.0144)
a
b
a
a
(4)
-0.082
(0.0140)
-0.050
(0.0134)
0.060
(0.0037)
-0.054
(0.0100)
a
a
a
a
(5)
-0.0672 a
(0.0141)
-0.0167
(0.0149)
0.0483 a
(0.0048)
-0.0504 a
(0.0101)
a
a
CR1: Creditor consent required for re-org
CR2: Creditors can seize collateral first in re-org
CR3: Creditors paid first in liquidation
CR4: Mgt. does not stay in re-org
ln (Bank Assets)
Government Size
Ownership Share of Largest Shareholder
Largest Shareholder is the State or a Public Authority
Largest Shareholder is Foreign
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
0.052 a
(0.0148)
-0.034 a
(0.0106)
-0.101 a
(0.0114)
0.009
(0.0103)
-0.002
(0.0110)
0.0534
(0.0148)
-0.0383
(0.0106)
-0.0858
(0.0118)
0.0003
(0.0104)
0.0145
(0.0114)
0.0133
(0.0028)
0.045
(0.0177)
-0.0475
(0.0136)
-0.0321
(0.0174)
-0.0034
(0.0112)
a
a
a
a
b
a
c
Random-Effects Regression:
Equity to Assets
(1)
0.0416 a
(0.0084)
0.084 a
(0.0094)
-0.0211 a
(0.0025)
French Legal Origin
Socialist Legal Origin
ln (GDP per Capita)
ln ( Legal Formalism)
Creditors' Rights Index
(2)
0.0493
(0.0089)
0.0869
(0.0095)
-0.0218
(0.0026)
0.0129
(0.0070)
0.0111
(0.0035)
Financial Freedom
a
a
a
c
a
(3)
0.0518
(0.0091)
0.0864
(0.0096)
-0.0215
(0.0026)
0.0134
(0.0070)
0.0115
(0.0035)
-0.0177
(0.0099)
a
a
a
c
(4)
0.0484 a
(0.0087)
0.089 a
(0.0100)
-0.0221 a
(0.0026)
0.0097
(0.0070)
(5)
0.0039
(0.0080)
-0.0067
(0.0113)
0.0261 a
(0.0038)
0.0027
(0.0060)
-0.0222 b
(0.0102)
-0.009
(0.0075)
0.0377 a
(0.0085)
-0.0095
(0.0072)
0.0223 a
(0.0072)
-0.024
(0.0092)
-0.0021
(0.0066)
0.0109
(0.0083)
0.0216
(0.0064)
-0.0264
(0.0068)
-0.0474
(0.0027)
-0.0001
(0.0117)
0.0155
(0.0091)
0.0439
(0.0120)
0.0003
(0.0074)
a
c
CR1: Creditor consent required for re-org
CR2: Creditors can seize collateral first in re-org
CR3: Creditors paid first in liquidation
CR4: Mgt. does not stay in re-org
ln (Bank Assets)
Government Size
Ownership Share of Largest Shareholder
Largest Shareholder is the State or a Public Authority
Largest Shareholder is Foreign
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
a
a
a
a
c
a
Random-Effects Regression:
ROA
French Legal Origin
Socialist Legal Origin
ln (GDP per Capita)
(1)
-0.0069 a
(0.0013)
-0.0055 a
(0.0014)
0.0020 a
(0.0005)
ln ( Legal Formalism)
Creditors' Rights Index
(2)
-0.0052
(0.0013)
-0.0051
(0.0014)
0.0018
(0.0005)
-0.0006
(0.0011)
0.0016
(0.0006)
Financial Freedom
a
a
a
a
(3)
-0.004
(0.0014)
-0.006
(0.0014)
0.0026
(0.0005)
-0.0017
(0.0012)
0.002
(0.0006)
-0.0143
(0.0028)
a
a
a
(4)
-0.004
(0.0013)
-0.0054
(0.0015)
0.0022
(0.0005)
-0.0022
(0.0012)
a
a
a
c
(5)
-0.0028
(0.0013)
-0.0028
(0.0016)
0.0013
(0.0006)
-0.002
(0.0011)
b
c
b
c
a
a
CR1: Creditor consent required for re-org
CR2: Creditors can seize collateral first in re-org
CR3: Creditors paid first in liquidation
CR4: Mgt. does not stay in re-org
ln (Bank Assets)
Government Size
Ownership Share of Largest Shareholder
Largest Shareholder is the State or a Public Authority
Largest Shareholder is Foreign
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
-0.0159
(0.0031)
-0.0011
(0.0011)
0.0068
(0.0014)
-0.0027
(0.0011)
0.0046
(0.0010)
a
a
b
a
-0.0153
(0.0031)
-0.0016
(0.0011)
0.0077
(0.0014)
-0.0034
(0.0012)
0.0059
(0.0012)
0.0013
(0.0003)
0.0014
(0.0029)
-0.0021
(0.0015)
-0.0036
(0.0021)
-0.0016
(0.0012)
a
a
a
a
a
c
Conclusions


In this study, we extend the literature on “law and finance”
by using firm-level data to analyze how lenders respond to
differences in legal origin, creditors’ rights and legal
formalism in the enforcement of debt contracts.
Using a random-effects model that controls for bank
heterogeneity, we find that bankers allocate significantly
higher portions of their assets to loans:
• Where
origin.
• Where
• Where
• Where
larger.
they enjoy English rather than French or Socialist legal
enforcement of debt contracts is more efficient.
banks enjoy fewer restrictions on their operations.
the ownership share of the controlling shareholder is
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Conclusions

We also find that banks hold less capital
per dollar of assets:
•
•
•
•
Where
Where
Where
Where
they enjoy more financial freedom
creditors’ rights are stronger.
banks are larger in asset size.
the controlling owner is not the State.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Conclusions

And we find that banks are more profitable
as measured by ROA:
• Where they enjoy English rather than French or
Socialist legal origin.
• Where creditors rights are stronger.
• Where they enjoy less banking freedom.
• Where banks are larger in asset size.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Conclusions
• In total, these results suggest that bankers
increase both operating risk and financial risk
when they enjoy superior creditor protection.
• Previous studies have shown that more privatesector credit leads to higher growth.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Conclusions



These results document one channel by which
legal protection leads to financial sector
development, which has been documented at the
country level by numerous researchers.
With better legal protection, lenders increase the
portion of their asset portfolio allocated to loans.
Countries with inefficient enforcement should be
able to increase private sector credit and,
therefore, economic growth by improving their
enforcement mechanisms, which should lead
their bankers to make more loans.
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending
Directions For Further Research



Do the greater operating/financial risks that are
substituted for expropriation risk lead to more
financial fragility of a country’s banking system?
Do these results hold for developed countries as
well as developing countries?
How are different categories of loans affected,
e.g., unsecured vs. secured; or C&I vs. Consumer
vs RE? (We will need better data from Bankscope
or other sources.)
© 2008 Cole-Turk Ariss:
Legal Origin, Creditors’ Rights and Bank Lending