Law enforcement and firm financing: Theory and evidence

Abstract

This paper investigates the economic effects on firms' policies of differences in law enforcement. We find that injudicial districts where trials are longer, bank financing is more costly and firms are smaller. However, we do not find any significant relation between law enforcement and firms' leverage ratio. We rationalize our results within a two- region dynamic general equilibrium model with asymmetric information and collateralized credit contracts. We find that a stronger enforcement of creditors' rights not only improves credit conditions (partial equilibrium effect), but also fosters individual capital accumulation (general equilibrium effect). In line with this theoretical prediction, we find a positive relation between individual savings and quality of legal enforcement. (JEL: E20, K40, G32) © 2010 by the European Economic Association.