Creditor Rights, Systemic Risk and Bank Regulations: Evidence from Cross-country Study

In our paper entitled “Creditor rights, Systemic Risk and Bank Regulations: evidence from cross-country study”, we investigate the extent to which creditor rights protection in bankruptcy induces banks to take more risk, leading to a higher level of systemic risk in the financial system. We apply ∆CoVaR, introduced by Adrian and Brunnermeier (forthcoming, 2016), as the measure of systemic risk. Our sample uses 744 listed commercial banks and covers 34 countries. Our work shows that more legal protection of creditors leads to a higher level of systemic risk. This result supports the “dark side” of strong creditor rights in bankruptcy. We further find that developed countries contribute to the increase of systemic risk, while we find neutral impact for developing countries. We finally find that not only laws in the books matter but the enforcement of these laws has also an impact on investor protection.

The recent financial crisis has led bank regulators to rethink the rationale of banking regulation. In fact, Basel I and Basel II concentrated on the individual aspects of limiting banks’ exposure to risk. The global financial crisis of 2008/2009 led regulators and governments to adopt macro-prudential approaches that focus on the well-being of the banking system as a whole, with a main interest on inter-linkages between financial stability and the real economy (Borio 2011, Tobias and Boyarchenko 2012). Thus, as the crisis of 2008 shows, the contagion in the financial system as a whole through inter-linkages between banks worldwide enhances the probability of systemic risk.

We suspect that creditor rights protection could have an impact on the behavior of banks and their contribution to systemic risk. More precisely, the level of creditor rights protection could influence bank systemic risk in different ways. In a first scenario, more creditor rights could lead to low level of bank systemic risk. As argued by Acharya, Amihud and Litov (2011), firms invest less and take low levels of risk when creditor rights are well protected. Banks could impose repayment or grab the collateral, which increases the recovery if firms default. In a second scenario, we identify two channels through which more creditor rights lead to a higher level of systemic risk. On the one hand, banks may be less worried about the default of firms and may be willing to lend more to a wider set of borrowers. This effect will increase the average expected default rate in the bank’s portfolio. If the higher expected recovery rates in default fail to offset the higher expected default rates, stronger creditor rights would be associated with increased systemic risk.  On the other hand, lower demand of credit from borrowers may lead to asset substitution; banks could choose a different business model based on investments in derivatives and other risky projects that increase bank systemic risk (Brunnermeier, Dong and Palia (2012)). Facing low credit demand from borrowers, banks have more liquidity to invest in financial markets with projects having higher risk than loans provided to firms.  If the negative effect of the second scenario of strong creditor protection outweighs its positive effect of the first scenario, we should find that more creditor rights lead to an increase in systemic risk at the bank level. To our knowledge, no other paper has studied the link between the level of systemic risk and creditor rights.  

This paper contributes to the literature in at least three ways. First, we add to the law and finance literature by demonstrating new evidence from bank-level data, according to which better legal protection leads to a higher level of systemic risk. Far from a neutral effect, we argue that these institutional features have a pronounced influence on bank systemic risk. Second, our study contributes to the literature that explores the determinants of bank systemic risk. In fact, our paper adds to the existing literature by revealing an important determinant for bank systemic risk. Finally, in addition to laws in the book, we tested law enforcement by applying different measures for creditor rights protection.

 Frédéric Lobez is a Professor of Finance and Christian Haddad is a doctorate student, both at Université de Lille SKEMA Business School.