Legal Institutions, Corporate Governance and Aggregate Activity: Theory and Evidence∗

This paper investigates the relation between the degree of creditors’ legal protection and corporate decisions and the effects of this interaction on aggregate activity, both theoretically and empirically. We develop a two country general equilibrium model with overlapping generations. We assume asymmetric information in the credit market and we allow individuals to sign collateralized credit contracts. We show that, at the steady state equilibrium, firms rely more on external financing from banks, pay a lower price for credit and have a larger size, if located in the country which better enforces the creditor right to repossess the collateral asset. While these results rationalize some recent empirical evidence in the corporate finance literature, we obtain a new prediction for the leverage ratio, that we show to be independent of the quality of legal institutions. In the empirical part, we test our predictions using a data set at the firm level for Spain. We measure the degree of legal enforcement by using statistical information on concluded trials. We document that endowing high cost judicial districts with the best degree of legal enforcement would increase the availability of external financing and the firm’s size by around 42% and 10%, respectively and would reduce the price of credit charged by banks by about one percentage point.