How Does the Institutional Setting for Creditor Rights Affect Bank Lending and Risk-Taking?

Abstract

This paper investigates how the institutional setting for protection of creditor rights affects bank lending and risk-taking. An analytical model is specified to underpin banks‟ portfolio decisions, between loans and other earning assets such as government securities. The model is augmented with various metrics, which proxy the institutional setting for creditor rights, and is estimated and tested on an unbalanced three-dimensional dataset of commercial banks in 20 African countries for 1995-2008. It is found that three specific metrics induce banks to allocate a high proportion of their earning assets to loans: legal creditor rights; the efficient enforcement of creditor rights; and availability of information sharing mechanisms among banks. However, the three metrics appear to work through different channels. The enforceability of legal rights works not only through mitigating credit risks, but also through a composite effect of market competition and lower costs of information acquisition and contract enforcement. The legal rights metric and information sharing metric exclusively rely on the composite effect.