How do differences in laws and their enforcement affect the amounts bank lend to firms, the maturity of the loans they make, and the interest rates they charge? In a recent paper, Vidhan K. Goyal of HKUST and his co-author Kee-Hong Bae examine the extent to which creditor rights and contract enforceability affect what loans are offered to firms, how the loans are structured and how they are priced.

The study shows in countries with poor enforceability of contracts, banks make smaller loans, of shorter duration and at higher interest rate spreads. And while better creditor rights can help to reduce the impact on spreads, they do not have much impact on loan size and maturity.

"Banks are expected to charge higher interest rate spreads when they lend to firms operating in countries with weak creditor rights and poor enforcement. However, as risks increase, instead of increasing interest rates, banks ration some borrowers. Loan amounts shrink as legal risks increase. Loan maturities also respond to higher legal risks and lenders may issue more short-term debt so they can review their lending decisions more frequently and restrict the borrowers' flexibility to increase the riskiness of their assets," they say.

The authors look at what happens to three aspects of loan contracting ?loan amounts, loan maturity and interest rate spreads - across 48 different countries with varying levels of enforceability and creditor rights.

Their study covers 63,000 loans worth US$13 trillion from 1994-2003. It factors in data on property rights protection and creditor rights in the country where the loan is made, as well as the borrowers' characteristics such as size and profitability and whether they are part of a syndicate.

"Our results show that, all else equal, the average loan amount will increase by about $57 million if a borrower moves from a country in the sample with the weakest protection of property rights [in this study, Columbia] to one with the strongest [Finland, Germany, the Netherlands and Norway]. This suggests lenders impose size restrictions in response to uncertain legal environments," they say.

"Similarly, the average loan maturity will increase by 2.5 years, which suggests banks want to review their lending decisions more frequently and restrict the flexibility of borrowers to expropriate creditors."

"The average loan spread declines by 67 points, which suggests that additional compensation is needed when there is greater contract enforceability risk. Loan spreads also respond to variations in creditor rights, declining by a smaller 41 basis points if the borrower moves from the country scoring worst on creditor rights to the one scoring best."

Having got these findings, the authors then look at the response to the East Asian financial crisis in 1997-98, which sharply reduced expected rates of return on investments. They find loan maturities significantly declined for borrowers and that loan spreads increased, although the latter was lower for firms in countries with strong property rights enforcement.

"The response of loan contracts to variations in creditor rights and contract enforceability is significantly higher during financial crises when monitoring and recontracting costs are of particular importance to lenders," they say.

The authors conclude that property rights protection results in more efficient contracting.

"Banks lend more, offer longer maturities and charge lower spreads on loans to borrowers in countries where property rights are well protected. We find creditor rights matter only for loan spreads," they say.