Quality of Institutions, Credit Markets and Bankruptcy

This paper begins with an observation of the economic equilibrium following firm bankruptcies in Western and Eastern Europe. In an attempt to explain the observations, this paper poses two questions:

• How do institutions influence the incentive of creditors to liquidate defaulting debtors?
• Which are the institutions that matter for this decision?

The paper analyzes the effects of bankruptcy by setting up a bank-firm relationship model to understand the incentive of a bank to liquidate its defaulting customers. It studies:

• Interdependence between law and finance;
• Creditor passivity;
• Information exchange through credit bureaus.

The paper is organized in three sections:

• The first section develops a credit market game and studies the impact of corporate bankruptcy on interest rates; it explains the credit model and contract, and establishes that the size of the rent depends on the adverse selection between banks;
• The next section analyzes the bank's incentive to liquidate a defaulting borrower; it presents three propositions that assess various scenarios effecting banks decision to liquidate firms;
• The concluding part states that bankruptcy decisions can be made more efficient by improving institutions and reducing the adverse selection problem; institutions can be improved by bettering the legal framework, while the adverse selection problem can be mitigated by:
  • Increasing credit access to firms that have not had access to finance in the past;
  • Improving screening skills of the bank staff;
  • Fostering bank competition in the market.