Banking Relationships and Creditor Rights

Do the legal rights of creditors influence whether the firms borrow from arm’s length or relationship lenders in a country? We examine this question by exploiting the staggered adoption of legal reforms that changed creditor rights. We find that as creditor rights strengthen, firms exhibit a greater propensity to switch to relationship lenders. Conversely, firms switch to arm’s length lenders as creditor rights weaken. These results are consistent with the view that arm’s length creditors have a bias toward excessive liquidation in environments with strong creditor rights. Hence as creditor rights strengthen, firms switch to relationship lenders as they are less likely to sub-optimally liquidate the firm when continuation is more efficient.