Understanding Creditor Rights and Their Impact

Understanding Creditor Rights and Their Impact

February, 26 2025 | By Giulio Trigilia

Creditor rights are often seen as a key driver of investment and economic growth, but research suggests the reality is more complex. While stronger protections can improve borrowing conditions in competitive markets, they may stifle business dynamism in concentrated lending environments. In this blog, Professor Giulio Trigilia explores how lender competition shapes the impact of creditor rights reforms—and why one-size-fits-all solutions may fall short.

Creditor rights refer to the legal protections granted to creditors when a debtor defaults on their obligations. These rights vary significantly across economies and markets. In fact, there is a positive correlation between the strength of creditor rights and both economic development and growth trajectories. Moreover, creditor rights appear to have real, independent effects on growth beyond differences in capital asset availability across economies.

Renowned Peruvian economist Hernando De Soto underscored this idea:

"Most of the poor already possess the assets they need [...] But they hold these resources in defective forms [...] Because the rights to these possessions are not adequately documented, these assets cannot readily be turned into capital, cannot be traded outside of narrow local circles where people know and trust each other, cannot be used as collateral for a loan, and cannot be used as a share against an investment."

The proposed solution? Reforms that strengthen property title security, formalize business operations, and improve creditor rights enforcement.

The Reality of Creditor Rights Reforms

Despite decades of global reform efforts, particularly in developing economies, empirical evidence reveals significant shortcomings in De Soto’s vision. Research shows low demand for titling and formalization among firms in developing economies, calling into question the cost-effectiveness of such initiatives. Additionally, attempts to strengthen creditor rights in these regions have led to unexpected consequences, including reduced business investment and growth.

This raises a crucial question: Why do creditor rights reforms produce varied effects across markets? In other words, what omitted factors might explain the correlation between creditor rights, investment, and growth? Unfortunately, neither theoretical nor empirical research has provided a clear answer. Most theoretical models suggest that stronger creditor rights should unambiguously encourage investment, while it has proven hard to find causal real-world evidence on the deep roots of the creditor rights vs. growth nexus. 

Interestingly, however, recent financial research within the U.S. has provided causal evidence that enhanced creditor rights can have negative effects on startup investment and business dynamism and, especially in the riskier corporate segments. These findings suggest that, even within relatively more developed economies, creditor rights might not necessarily benefit all firms, but rather they might have effects that differ across corporate sectors.

The Role of Lender Competition

 In my recent research, conducted jointly with Dan Bernhardt and Kostas Koufopoulos, we identify a common factor that may connect startup financing in the U.S. with capital raising in developing economies: a lack of competition among potential financiers. Indeed, both environments feature lending markets with limited depth, where the market power of few big players is relatively more pronounced. While this is just one of many differences between economic contexts, our novel theoretical findings suggest that lender competition can significantly alter the effects of creditor rights reforms, even if well-intended.

Our study reveals that the impact of creditor rights on real outcomes depends on the level of lender competition:

• High competition: Strengthened creditor rights improve firms' access to borrowing, supporting conventional economic theories.

• Low competition: Stronger creditor rights can harm firms by reducing entrepreneurial effort. The monopolistic lenders may raise interest rates and tolerate higher default rates to maximize profitability, ultimately eroding firm value and economic growth. Importantly, even if interest rates fall firm value and investment can still decrease. This is because enhanced creditor rights allow lenders to recover more from defaults, leading them to prioritize profitability over fostering sustainable business growth. As a result, our research casts doubt on using interest rates or nominal values as sole indicators of the success of creditor rights reforms—a common practice in empirical studies.

Policy Implications and Future Research

Our study highlights the deep connection between creditor rights and competition regulation. Reforms aimed at strengthening creditor rights may produce vastly different outcomes depending on the competitiveness of the financial market. For the De Soto agenda to be effective, policymakers must carefully evaluate financial market conditions and ensure adequate competition among lenders. Without addressing competition, efforts to enhance titling, formalization, and creditor rights may fail to deliver their intended benefits or even produce harmful consequences.

Additionally, our analysis suggests that lenders have strong incentives to push for greater creditor rights in markets with low competition, where they stand to capture a larger share of the benefits. In perfectly competitive markets, however, lenders have little interest in such reforms, as they already operate with minimal abnormal profits.

Moving forward, further research should explore the relationship between financial market competition and creditor rights, as well as the regulatory conditions necessary for successful creditor rights reforms.

Full Article with Sources
 

Giulio Trigilia is an Assistant Professor of Finance at Simon Business School 

Follow the Dean’s Corner blog for more expert commentary on timely topics in business, economics, policy, and management education. To view other blogs in this series, visit the Dean's Corner Main Page.