Should courts enforce credit contracts strictly?

Abstract

The intimate linkages between law and finance are currently the centre of wide-ranging empirical investigations. This article presents a simple banking model with information asymmetries concerning borrowers' entrepreneurial talent. It is shown that improvements in the enforcement of contract by courts reduce agency problems but can also reduce the bank's incentive to screen borrowers adequately, thus worsening credit allocation. A stricter enforcement of credit contracts, therefore, may be socially harmful even if costlessly achieved. Improvements in accounting standards, however, always make bank screening of borrowers less costly and improve credit allocation and social welfare. © Royal Economic Society 2005.