Type: Working Paper, 2019
In this paper, I discuss the interaction between legal reforms in bankruptcy resolution and judicial capacity through the enforcement of creditor rights in trial courts on credit allocation in local markets. Poor creditor rights constrain the functioning of credit markets, that subsequently affects the availability of credit for productive uses. Can well-functioning courts facilitate the enforcement of creditor rights? How does this affect credit allocation? To study this, I use a difference in difference research design by comparing districts with high judge occupancy and those with low occupancy, before and after the 2016 national legislation on bankruptcy resolution in India that increased the rights of the creditors over stressed assets. There are three key findings. First, banks reduce lending towards unproductive uses such as lending to defaulting firms and increase lending based on capital efficiency in districts with better judicial capacity. Second, improved creditor rights coupled with better judicial capacity increases repayment. Third, banks are more likely to initiate and witness resolution of debt recovery related litigation in districts with better judicial capacity after the bankruptcy reform, suggesting that enforcement of creditor rights in well functioning trial courts plays an important complementary role. Finally, the paper concludes by examining credit misallocation, showing that good quality formal institutions are insufficient to fully address existing misallocation.