Stricter enforcement of credit contracts through the courts can actually have a damaging effect
on the economy, according to research by Professor Alberto Zazzaro. The reason is that
improved enforcement standards reduce banks’ incentives to screen and monitor the firms
who want to borrow from them. This is a particular problem in less developed economies,
where there are often big differences between good and bad entrepreneurs and between the
potential returns on different projects.
When firms borrow, the lenders are entitled to a flow of payments to be paid in the future as a
reward for money lent today. In order for this transaction to be attractive, the entitlement must
be adequately protected by the law and the courts.
Starting from these simple observations, many economists maintain that there is a clear-cut
positive relationship between the efficiency of legal systems, the degree of protection accorded
to investors, and the performance of financial markets. Hence, any legal and judicial reform
that improves creditor protection should be strongly advisable.
But the empirical evidence is mixed. Some researchers find that countries and regions whose
legal and judicial systems strictly protect creditors rights have large capital and credit markets,
low credit rationing and low interest rates. Others find no statistically significant correlation
between creditor protection and non-performing loans. Indeed, in Italy, there is evidence that
the stock of pending trials is negatively correlated to the interest rates charged by banks and
the amount of non-performing loans.
How can these findings be reconciled? Are they really in conflict? Zazzaro’s research,
published in the Economic Journal, shows that some of the conflicts in the evidence may be
only apparent. They may be resolved by taking account of the simple fact that different types of
laws affect the credit market in different ways.
Zazzaro shows that laws that govern accounting standards may affect the credit market quite
differently from laws that govern the enforcement of contracts. Improving accounting standards
(for example, by tightening accounting rules and reporting rules, and having sanctions for
fraudulent reporting) makes bank screening more efficient and less costly, and improves the
allocation of credit.
Improving enforcement standards (such as the efficiency and speed of foreclosure and
bankruptcy procedures) reduces agency problems, and thus makes it easier for entrepreneurs
to secure external finance. But it also reduces banks’ incentive to screen and monitor
borrowers adequately, thus worsening credit allocation and social welfare.
In other words, banks' protection by law and courts may be a substitute for screening.
Consequently, stricter contract enforcement by courts creates negative externalities for good
entrepreneurs and therefore may be welfare diminishing.
Specifically, the economic intuition behind the adverse effect of better contract enforcement by
courts is the following. Once confronted with an improvement in courts' efficiency, banks
reduce the screening effort and, urged by competition, pass the increase in profitability to their
borrowers. This diminishing of the interest rate increases the expected utility of applicants and
social welfare.
But a worse selection of applicants by banks also increases the probability of funding lowquality
entrepreneurs and reduces the probability of funding high-quality entrepreneurs. This
creates externalities, because applicants enjoy expected gains when their project is financed.
Worse screening benefits extra bad-type applicants funded but harms those good
entrepreneurs whose applications are no longer accepted. When the sum of the latter losses
exceeds the former gains, a stricter enforcement of credit contracts will shrink social welfare,
even if achieved without cost.
The adverse welfare effect of enforcement reforms is more likely in economies where the
quality of good and bad entrepreneurs is very dissimilar and where the variance of project
returns is large. Such extreme distributions of returns are more typical of less developed
regions, where many unworthy borrowers may coexist side by side with some able
entrepreneurs.
But considering that the implementation of more efficient judicial systems is actually quite a
costly undertaking, the cases where stricter enforcement standards reduce social welfare may
be more frequent than the analysis predicts.
ENDS
Notes for editors: ‘Should Courts Enforce Credit Contracts Strictly?’ by Alberto Zazzaro is
published in the January 2005 issue of the Economic Journal.
The author is at the Dipartimento di Economia, Università Politecnica
delle Marche, Piazzale Martelli 8, 60121 – Ancona, Italy.
For further information: contact RES Media Consultant Romesh Vaitilingam on 0117-983-
9770 or 07768-661095 (email: romesh@compuserve.com); or Alberto Zazzaro on +39-71-220-
7086 (email: albertoz@deanovell.unian.it).