Creditor rights, information sharing, and bank risk taking

Abstract

Looking at a sample of nearly 2,400 banks in 69 countries, we find that stronger creditor rights tend to promote greater bank risk taking. Consistent with this finding, we also show that stronger creditor rights increase the likelihood of financial crisis. On the plus side, we find that stronger creditor rights are associated with higher growth. In contrast, we find that the benefits of information sharing among creditors appear to be universally positive. Greater information sharing leads to higher bank profitability, lower bank risk, a reduced likelihood of financial crisis, and higher economic growth.

Introduction

A growing literature dating back to La Porta et al., 1998, La Porta et al., 1999 demonstrates the important connections between legal systems, investor protections, and the development of capital markets. Research in this area generally finds that stronger investor protections help promote capital market development, which in turn is often correlated with economic development. These important insights have spurred further exploration into the various channels in which the legal system influences the formation of capital and economic growth.

In this spirit, a number of more recent papers have specifically examined both the effects of stronger creditor rights in bankruptcy, and the role of information sharing among creditors. In a study of 129 countries over a 25-year time period, Djankov, McLiesh, and Shleifer (DMS, 2007) find that the ratio of private credit to gross domestic product is positively related to stronger creditor rights, stronger legal protections, and information sharing among creditors. John, Litov, and Yeung (2008) find that stronger corporate governance is correlated with greater corporate risk taking. At the same time, Acharya, Amihud, and Litov (2009) find that stronger creditor rights lead to reduced corporate risk taking in the form of diversifying acquisitions. Claessens and Klapper (2005) find that the various components of the popular creditor rights indexes have a differential effect on the likelihood of bankruptcy, while Brockman and Unlu (2009) find that companies are less likely to pay dividends in countries with weaker creditor rights. Another strand of the literature has examined the role of credit information sharing in enhancing credit availability (Pagano and Jappelli, 1993; Padilla and Pagano, 1997; Djankov, McLiesh, and Shleifer, 2007; Brown, Jappelli, and Pagano, 2009), in lowering the cost of credit (Brown, Jappelli, and Pagano, 2009), in reducing default rates (Japelli and Pagano, 2002), and in corruption in lending (Barth, Lin, Lin, and Song, 2009).

Noticeably absent in this recent literature is an examination of the links between creditor rights, information sharing, and bank risk taking. Perhaps the most closely related paper is the recent work by Cole and Turk-Ariss (2008) who find that banks have higher loan ratios in countries with English legal origin and weaker creditor rights. The limited research in this area is somewhat surprising given the importance of bank lending in promoting economic development (see, for example, Beck, Levine, and Loayza, 2000; Levine, 2005), and given the impact that creditor rights and information sharing are likely to have on both the relative importance of bank lending and the level of bank risk taking across different countries.¹ Arguably, the recent global financial crisis has further intensified interest in understanding the various factors that affect both bank risk taking and the likelihood of financial crisis.

This paper attempts to fill this gap by exploring in detail the interactions between the level of creditor rights, information sharing, and risk taking among banks in 69 countries. We further explore how creditor rights and information sharing affect both the likelihood of a financial crisis in the country's banking system and the level of industry growth. Most notably, we find that stronger creditor rights are correlated with higher bank risk taking. We also find that information sharing among creditors reduces bank risk taking, and also has an interactive effect which mitigates the effect that creditor rights have on bank risk taking. These conclusions are extremely robust with respect to alternative measures of risk taking, different control variables, and different estimation techniques. Moreover, we find that stronger creditor rights increase the likelihood of financial crisis, whereas information sharing reduces the likelihood of crisis. Finally, we observe that stronger creditor rights and information sharing are both correlated with higher industry growth.

Our study controls for bank characteristics, country characteristics, a variety of measures of investor protection used in the law and finance literature, as well as the structure of national bank regulations. In this regard, our study complements a number of recent papers including Laeven and Levine (2009) who find that ownership structure and national bank regulations influence bank risk taking, Qian and Strahan (2007) who find that creditor protection influences the pricing and structure of bank loan contracts, and Kroszner, Laeven, and Klingebiel (2007) who find that banking crises have a more pronounced effect on sectors that are heavily dependent on external finance.

While our study is not able to directly answer the larger questions regarding optimal risk taking, our findings provide interesting insights into the channels in which creditor rights and information sharing among creditors influence bank lending decisions, which in turn affect the level of growth and the likelihood of financial crisis. In particular, our results suggest that there is both a “bright” side and “dark” side to enhanced creditor protections. Simply put, stronger creditor rights appear to encourage banks to take on more risks which helps provide valuable capital to private firms which enhances overall economic growth. On the downside, the “dark” side of greater risk taking is that it significantly increases the likelihood of financial crisis. In this respect, our findings complement the recent work of Rancière, Tornell, and Westermann (2008) who look more broadly at the connection between systemic crises and growth. While their study does not consider the effects of creditor rights (or information sharing), they do demonstrate that countries that have experienced a financial crisis tend to have higher growth rates relative to countries with more stable financial conditions.

In contrast to these conflicting effects regarding creditor rights protections, information sharing among creditors appears to be universally beneficial. Specifically, information sharing reduces information symmetries and enhances transparency—which reduces bank risk taking and the likelihood of crisis, while at the same time promoting economic growth.

This paper contributes to the literature in at least three important ways. First, we add to the law and finance literature by further demonstrating the significant and interactive effects of creditor rights and information sharing. Far from having a neutral effect, we show that these institutional features have a profound influence on the level of bank risk taking, the level of economic growth, and the likelihood of financial crisis. Second, our research contributes to the literature that explores the determinants of bank risk taking (e.g., Saunders, Strock, and Travlos, 1990; Houston and James, 1995; Laeven and Levine, 2009). Given the significance of bank lending (particularly in developing countries), it is important to understand how the legal, regulatory, and institutional environment influences banks’ willingness to lend and take risk. Third, we add to the literature that focuses on the determinants of financial crisis (e.g., Demirgüç-Kunt and Detragiache, 2002; Beck, Demirgüç-Kunt, and Levine, 2006; Kroszner, Laeven, and Klingebiel, 2007). Here we find compelling evidence that stronger creditor rights increase the likelihood of financial crisis, whereas information sharing reduces the likelihood of financial crisis. While these issues are always important, there is obviously renewed interest in these questions given the magnitude of the recent global financial crisis.

The rest of the paper proceeds as follows. Section 2 reviews the various components of creditor rights and information sharing and discusses the various channels in which they are likely to affect bank risk taking. Section 3 describes the data and presents summary statistics. Section 4 reports the key results relating bank risk taking to measures of creditor rights and information sharing, while Section 5 reports the results that relate these measures to the likelihood of financial crisis and the level of industry growth. Section 6 concludes.