The ex-ante Effect of Law and Judicial Efficiency on Borrower Discouragement: An International Evidence

We investigate whether cross-country differences in the legal system influence demand-side credit constraints. We explore the notion of discouraged borrowers — firms that choose not to apply for bank credit because they anticipate rejection. Employing survey data from 46 economies, we find that rapid and less costly court proceedings, lower procedural complexity in court processes, and higher recovery rates under bankruptcy lead to the lower likelihood of borrower discouragement. These results are more pronounced in countries with strong creditor protections in relation to company reorganization and liquidation. The results corroborate the supply-side view that strong creditor rights and their efficient enforceability alleviate banks’ participation constraints in the loan market, thereby encouraging small and medium-sized enterprises to apply for credit in the first place. We also find that differences in institutional settings, such as higher regulatory quality, better control of corruption, and the rule of law, lead to lower rates of credit self-rationing in the loan market.