GETTING CREDIT: HOW BANKS MAKE LENDING DECISIONS

IN ARGENTINA, PERU, AND THE WORLD,

WITH AN EMPHASIS ON SECURED TRANSACTIONS AND TRUST

by

OLE EGIL DISTAD ANDREASSEN

Suggested citation: O. Andreassen, "Getting Credit: How banks make lending decisions in Argentina, Peru, and
the World, with an emphasis on secured transactions and trust". Ph.D. dissertation, Johns Hopkins University,
Washington, DC, 2006.

Washington, District of Columbia

January, 2006

© Ole Egil Distad Andreassen 2006

All rights reserved

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Abstract

This thesis examines how legal, institutional, and social frameworks impact bank

financing of firms. It builds on theory about law and finance and about finance and

growth, drawing on financial economics, law, and political science.

The thesis uses qualitative data from field studies in Peru and Argentina to assess

how banks finance firms. It finds that banks in these two countries do not finance

innovation, that they prefer large firms in order to capture transactional business, and that

maturities are short. In fact, the banks take on investor-like behavior. They ration credit

rather than adjust the price. Several assertions in financial theory do not provide a good

description of the financing environment in Peru and Argentina. For example, banks do

not allocate resources from savings efficiently; they do not allow higher risk levels than

individual investors; they do not focus on future firm performance; they monitor closely

rather than rely on standardized contracts; and they use collateral to remedy agency

problems, not to reduce risk.

Searching for an explanation, the thesis reviews the literature on secured

transactions to see if shortcomings in the legal framework can explain observed lending

patterns. It reviews experiences from Eastern Europe, where secured transactions reform

is particularly advanced. Comparing this with Peru and Argentina, the thesis concludes

that it is unlikely that legal shortcomings provide an explanation.

When employing global cross-country data, creditor-related law appears much

less important than political stability, modern values, and social capital (trust). The

observations from Peru and Argentina, cross-country regressions, and theory indicate that

ii

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interpersonal trust and trust in institutions matter, in addition to the performance of

institutions.

The findings suggest that reforming the framework for bank financing must be

accompanied by measures designed to build trust in institutions.

Throughout the thesis, the findings from Peru and Argentina are compared to

global cross-country data. In most cases, the observations in Peru and Argentina fit with

global patterns. This suggests that the findings of the thesis can be used also when

analyzing other countries, although the thesis emphasizes the need for a thorough

understanding of any individual country before formulating policy.

iii
Acknowledgements

I would like to thank the many people who assisted me in the research for this thesis, in

particular those who gave me of their time and hospitality during my field studies in Peru

and in Argentina.

I would also like to thank Ms. Flora Paoli for her outstanding assistance in editing this work.

Remaining errors and omissions are attributable to the author alone.

iv
 ABSTRACT ...................................................................................................................................................II

ACKNOWLEDGEMENTS .............................................................................................................................. IV

I. INTRODUCTION ...............................................................................................................................1

STRUCTURE .................................................................................................................................................3

DATA...........................................................................................................................................................6

Qualitative data ................................................................................................................................................. 6

Quantitative data ............................................................................................................................................... 7

BANKING CRISES AS BACKGROUND, NOT A SUBJECT OF INVESTIGATION .....................................................9

A NOTE ON WHAT IS “SMALL,” “MEDIUM,” AND “LARGE” .........................................................................11

II. LAW, INSTITUTIONS AND GROWTH........................................................................................13

THE RELATIONSHIP BETWEEN LAW AND ECONOMIC GROWTH ....................................................................13

AN IMPEDIMENT TO GROWTH: HOW THE LEGAL FRAMEWORK ON SECURED TRANSACTION LIMITS ACCESS

TO CREDIT .................................................................................................................................................20

III. SELECTION OF CASE STUDIES .............................................................................................29

SMALL-N CASE STUDIES AND LARGE-N RELATIONSHIPS ............................................................................29

ASSESSING THE IMPACT OF LAW ON FINANCE: STUDYING BANKS ..............................................................33

IV. FROM LAW TO FINANCE: BANKS AS FINANCIAL INTERMEDIARIES. THEORY

AND EXAMPLES FROM PERU AND ARGENTINA. ..........................................................................34

THE ROLE OF BANKS ..................................................................................................................................34

BANKS AND THE CREDIT CRUNCH ..............................................................................................................42

FINANCE AND GROWTH .............................................................................................................................49

Banks mobilize savings and allocate resources ............................................................................................... 56

The financial system facilitates risk management ........................................................................................... 58

The financial system acquires information about investments ........................................................................ 61

The financial system monitors managers and exerts corporate control ........................................................... 66

v
 Monitoring: Reducing agency costs ................................................................................................................ 68

The distinction between relationship lending and close monitoring................................................................ 71

More monitoring: short-term lending substitutes for investor-like control...................................................... 73

Political stability, rule of law, trust, and the lack of long-term financing ...........................................80

Financial liberalization and financing as obstacles to doing business................................................89

Reducing monitoring costs: Using collateral and contracts to bring more lenders under the interest rate ceiling

........................................................................................................................................................................ 92

THE CONNECTION BETWEEN LAW AND FINANCE – MACRO-LEVEL EVIDENCE ............................................95

Governance and legal origin, religion, and geography.......................................................................98

HOW DO LEGAL DIFFERENCES DEVELOP? ................................................................................................105

MICRO-EVIDENCE OF LEGAL IMPACT ON FINANCE ...................................................................................111

V. MICRO-LEVEL INVESTIGATION: HOW LACK OF MOVEABLE COLLATERAL

LIMITS ACCESS TO FINANCE............................................................................................................113

THE THEORY ABOUT COLLATERAL AND ACCESS TO FINANCE ..................................................................113

PROBLEM: MOVEABLE PROPERTY CANNOT SERVE AS COLLATERAL ........................................................115

VIEWS FROM THE OPPOSITE SIDE .............................................................................................................120

THE GAPS IN THE LEGAL FRAMEWORK.....................................................................................................125

CURRENT POLICY RECOMMENDATIONS AND IMPACT OF REFORM ATTEMPTS IN PERU AND ARGENTINA ..126

LESSONS FROM PREVIOUS REFORMS: THE CASE OF CENTRAL AND EASTERN EUROPE .............................129

Perceived obstacles to doing business and secured transaction quality in EBRD countries.............143

VI. HOW DO FIRMS OBTAIN FUNDS? THE IMPORTANCE OF LAW AND

INSTITUTIONS FROM THE PERSPECTIVE OF BANKS AND FIRMS ........................................148

HOW DO FIRMS OBTAIN FUNDS? THEORY AND EXAMPLES FROM PERU AND ARGENTINA ........................148

HOW DO FIRMS OBTAIN FUNDS? A QUANTITATIVE ANALYSIS..................................................................185

Source of financing, company characteristics and legal characteristics...........................................188

The impact of company characteristics ......................................................................................................... 190

The impact of country characteristics............................................................................................................ 197

Summary ....................................................................................................................................................... 203

vi
 A PROPOSED CLASSIFICATION OF THE ELEMENTS OF A CREDIT DECISION ................................................206

ASSERTING FUTURE PAYMENT WILLINGNESS IS AS IMPORTANT AS FUTURE PAYMENT ABILITY: TRUST IS AS

IMPORTANT AS COLLATERAL. ..................................................................................................................208

VII. THE ROLE OF TRUST IN CREDIT DECISIONS ................................................................211

WHAT DETERMINES TRUST ON AN INDIVIDUAL LEVEL? ...........................................................................216

Trust and law................................................................................................................................................. 220

HOW DOES TRUST IMPACT FINANCIAL DECISIONS? ..................................................................................223

THE IMPACT OF TRUST ON BUSINESS DEVELOPMENT. ..............................................................................229

Trust in the family......................................................................................................................................... 230

Trust and firm growth – empirics.................................................................................................................. 232

Size of the SME sector and trust ........................................................................................................234

Trust and the business environment – empirics. ................................................................................236

Constraints to doing business and trust.............................................................................................237

WHAT IS THE DIFFERENCE BETWEEN TRUST IN INDIVIDUALS AND TRUST IN THE INSTITUTIONAL

FRAMEWORK? .........................................................................................................................................239

WHY WOULD TRUST IN INSTITUTIONS AND NOT ONLY THE OUTPUT OF INSTITUTIONS MATTER?..............242

The business environment and trust in institutions ............................................................................246

VIII. CONCLUSION ...........................................................................................................................250

IX. VARIABLE DESCRIPTIONS...................................................................................................257

X. APPENDICES..................................................................................................................................264

A. Legal origin ........................................................................................................................................ 265

Explanatory power of legal origin, religion, and geography on law and governance ......................265

B. Trust ................................................................................................................................................... 272

C. Family importance and trust ............................................................................................................... 273

D. Trust in institutions............................................................................................................................. 274

XI. BIBLIOGRAPHY .......................................................................................................................275

CURRICULUM VITAE ...............................................................................................................................301

vii
Abbreviations:

CEE Central and Eastern Europe

CIS Commonwealth of Independent States

EBRD The European Bank for Reconstruction and Development

GNI Gross national income

IRIS Center for Institutional Reform and the Economic Sector at the

University of Maryland

NGO Non-governmental organization

NIC Newly industrialized countries

OECD Organisation for Economic Co-operation and Development

SDC Standard Debt Contract

UCC U.S. Uniform Commercial Code

viii
 I. Introduction

Do legal characteristics matter for financial development? Is law just a component of the

broader institutional framework, and it is this framework that matter for access to

finance? Or is how firms and banks interact dependent on more fundamental societal

issues, such as culture and how much people trust each other?

We will ask these questions, focusing on bank credit to firms. There is a wide

range of literature available that suggests various explanations for firms’ business

environment and financing patterns. Recently, much of the focus has been on the

business environment – the legal and institutional framework that surrounds the lender –

borrower relationship takes place. We will therefore initially focus on the role of the legal

framework in bank financing, and we will in particular focus on a mechanism that has

been argued to have a great impact on access to credit: securing loans with moveable

collateral.

In order to sort out the assertions in the literature, we visited two Latin American

countries, Peru and Argentina, to investigate how banks make credit decisions, and to

understand more of their institutional environment. Our studies there led us to believe

there are other factors that might me more important than the legal system. In particular,

our respondents indicated that political instability, lack of trust, and cultural factors (that

we will attempt to sort out below) have more of an impact on credit than does the legal

framework.

The theoretical background for this thesis is research over the last six years that

has emphasized the importance of legal characteristics for financial development. This

1
literature, part of the ‘new comparative economics,’ is based on research that established

the importance of institutions for economic development. One of the core assertions is

that a country’s legal origin, normally acquired through colonization or deliberate

transplantation of a legal system, determines the level of creditor and investor protection.

When combining this assertion with the increasing evidence that financial development

matters for economic growth, we can discuss how institutions matter to a greater extent

than what is allowed for by the older literature on institutions.

Work to quantify legal qualities is already being undertaken. The World Bank has

taken over the pioneering research by the law firm association Lex Mundi with the

objective of quantifying the quality of a range of legal regulations regarding credit,

bankruptcy, and the business environment.1 At the same time there is a growing

realization that merely quantifying legal quality across countries does not give an

understanding of the causal mechanisms that make law a matter for finance.

In this thesis, we aim to understand one such causal channel, studying how

regulation (or lack thereof) regarding the use of moveable collateral to secure credit

impacts banks lending decisions. We study this particular mechanism because there are

strong economic arguments in the existing literature suggesting that such regulations

have a direct impact on how banks allocate credit. In studying this mechanism we

compare the behavior of banks with the existing corporate finance literature, and we

assess how secured transactions fit into the banks’ credit decisions. In doing so we do not

only look at the specific role of the secured transactions legislation but also attempt to

1
Djankov, 2003a, Courts: The lex mundi project ,Djankov, et al., 2004, Doing business in 2004 :
Understanding regulation

2
gain a wider understanding of how bank managers make credit decisions. We also

investigate the role of collateral in general, and how the economic functions of collateral

are taken into account by the bank managers. This allows us to study what could possibly

substitute for law in the cases where we find that bank managers do not use legal

considerations in making their lending decisions.

Our findings lead us to question the importance that the recent literature allocates

to legal qualities for the provision of finance. We find that broader qualities than what are

normally used in the ‘new comparative economics’ matter more than the quality of

individual regulations. For example, we find that the quality of judges is an important

concern to the banks, whereas the quality of the secured transactions legislation is less

important. We also find that factors such as the bankers’ trust in the client and the

stability of the political system are much more important to bank managers than the

quality of individual regulations.

Structure

This thesis is structured as follows: In section II we look at the rationale behind focusing

on law and bank credit. Research has shown that institutions and law are important

matters for growth. We show this relationship and discuss the hypothesis that the

framework on secured transactions is an important component in creating a more efficient

allocation of finance. We also show that when breaking the rule of law into its separate

components, such as creditor rights, the immediate relationship between the rule of law

and economic output seems to break down, and that companies are differently affected by

the rule of law according to their size.

3
 In section III we explain how we will investigate the hypothesis that a better legal

framework on secured transactions leads to better allocation of bank credit, using both

small-n case studies and large-n cross-country data. We focus on two Latin-American

countries, Peru and Argentina, whose banking sectors are in comparable situations, and

we use interviews to understand how credit decisions are arrived at. We explain why

studying banks is the correct focus for such an investigation: it is the bank managers who

ultimately allocate credit to companies, and the only way to determine the variables that

drive these credit decisions is to understand how the credit managers perceive their

environment and determine priorities.

In order to put our qualitative findings in context and to establish their relevance

for financial development and role in providing finance to companies in Latin America,

we need to understand the role of the banks in the financial system. In section IV, we

review relevant literature on banks. In doing so, we compare some central assertions in

the literature to our findings, emphasizing where our findings contradict or contribute to

new knowledge compared to the existing literature. We also review the possible channels

that lead from banks to growth, not only through secured lending, because the main

argument for reform of secured lending legislation is its potential to increase growth,

everything else being equal. If other channels substitute for the effect of collateral, then

collateral may not be as important as alleged. We focus in depth on how banks use

collateral compared to how the literature predicts collateral should be used, and on how

banks bridge the gap between investor and creditor through close monitoring and short-

term lending. We also review the literature on how law and legal and colonial origin

4
impact finance through the institutional framework, and we use our data to assess

assertions that have previously been made about legal origin and finance.

In section V, after having reviewed and discussed the literature on banks, we

discuss the assertions that have been made regarding the importance of the framework for

using moveable collateral to secure credit, focusing on Peru and Argentina. We review

why reform of the regulation of transactions secured with moveable collateral would

matter to improving access to finance. We then compare these recommendations to

lessons learned from a region that has a great deal of experience from secured

transactions reform, Central and Eastern Europe, and we use quantitative data to assess

what legal regulations are associated with patterns of company financing in these

countries.

In section VI, we close in on firms and banks, and we use our qualitative and

quantitative data to establish patterns on how firms obtain finance. Without a

comprehensive understanding of the ways banks decide to supply credit and how firms

perceive their access to credit, we cannot understand what role institutions, the legal

system, and secured transactions play in finance. We examine previously established

stylized facts from the corporate finance literature and see how these fit in with our

findings. We then establish stylized facts based on our own data and observations, and we

perform a cross-country analysis of the company, legal, governance, and culture

characteristics associated with the sources of finance of firms. Based on our findings, we

establish a classification of the elements of a credit decision.

Using our qualitative and quantitative findings, we conclude that moveable

property as collateral cannot be viewed separately from whether or not the bank manager

5
trusts the client to preserve the collateral and to repay. In fact, our findings suggest that

the trust between the bank manager and the client is more important than the framework

for secured lending. In other words, it is not the physical security through collateral that

matters more, it is the intangible security through trusting that the client will repay. In

section VII, we discuss our findings about the importance of trust in credit relationships,

and we use the existing literature on trust, or ‘social capital,’ to help interpret our

qualitative findings and to help explain how law and trust can be both complements and

substitutes in a credit relationship. We distinguish between trust in people and trust in

institutions, and we discuss one of our most consistent observations from our qualitative

studies: that political stability matters a great deal for the terms of bank loans. We sum up

our findings in section VIII.

Data

We use two types of data for this thesis, qualitative case studies from two countries,

Argentina and Peru, and qualitative data retrieved from a range of databases.

Qualitative data

Our qualitative data are obtained through personal interviews with managers in three

commercial banks in Peru and three commercial banks in Argentina. Besides

interviewing bank managers, we interviewed commercial lawyers, scholars, regulatory

authorities, venture capital managers, development institutions, and private companies.

We selected the leading banks in each country, lawyers particularly familiar with bank

financing and legal reform in that field, scholars familiar with firm finance specifically in

their country, the relevant regulators, particularly successful venture capital managers,

6
development institutions, and private companies of various sizes. In Peru we also

interviewed micro-credit financial institutions and micro-credit NGOs because micro-

credit is particularly developed as firm finance in that country. In Argentina, we

interviewed managers at a mutual guarantee agency as this is a specific mechanism that

seeks to mitigate some of the problems we discuss regarding SMEs and bank finance.

Our interviews touched, to a great extent, upon confidential business strategies

and information. A condition for the interviews was that neither the managers nor the

banks be identified in any publication. We extend the same practice to the lawyers

interviewed because these work closely with the banks. Therefore, our findings from the

interviews are referenced simply as qualitative findings. Many findings are similar

between the two countries. The country of the qualitative findings is identified where the

stylized facts we draw from the interviews differ between the two countries. Where the

interview subjects have published documents or provided manuscripts, these are

referenced in full as all other literature used in the thesis, and details are found in the

bibliography. Laws and regulations are referenced using standard abbreviations and

included in the bibliography.

Quantitative data

Our quantitative data are obtained from a large number of publicly available databases

and published literature. The main contribution of this thesis in addition to specifying and

testing models based on our qualitative findings is to combine these databases in ways

previously, to our knowledge, not done.

The three main databases we use are:

7
- The firm-level survey in WorldBank (2000), which gives detailed information

about approximately 10,000 small, medium-sized, and large firms in 80 countries

and which describes the firms’ financing and perceptions of the business

environment, in particular the obstacles the firms face in doing business.

- The World Bank’s Doing Business database in WorldBank (2004), which is the

most up-to-date database regarding legal regulation, builds on the work of the law

firm association Lex Mundi and academic researchers in Djankov (2003a). The

database covers more than 130 countries and is continuously being expanded.

- The World Values Survey in Inglehart (2000b), covering four waves of surveys of

individuals in a total of 79 countries. The survey covers demographics, beliefs,

values, and confidence in people and institutions, as representative as possible of

the general population.

- The database of country financial system characteristics contained in La Porta,

Lopez-de-Silanes et al. (2002), which covers 196 countries (although not all with

complete data).

- The database of aggregate governance indicators in Kaufmann, Kraay et al.

(2003). The database covers 173 countries and describes political stability, the

rule of law, control of corruption, regulatory quality, and other governance-related

variables.

- The database of countries small- and medium-sized enterprise sectors in Beck,

Ayyagari et al. (2003), which describes the size of the SME sector according to a

common definition and according to the individual countries’ official definitions

of SME in 76 countries.

8
These are the main data sources, but we supplement these sources with many others. The

sources not listed above are identified in the section Variable descriptions on page 257,

which also contains a detailed description of the variables with summary statistics. In

order to compare goodness-of-fit between models, we use the R-squared proposed by

McKelvey and Zavoina (1975).2

Banking crises as background, not a subject of investigation

This thesis is not an investigation into the financial crises of Latin America in the late

1990s and early 2000s. Our study will most likely not be of interest to macro-economists.

In our two case studies, Peru and Argentina, the financial crises, more recent in Argentina

than in Peru, provide a background for investigating how the banking system operates.

The crises have led to an increased and current awareness within the bank management of

what constitutes good borrowers, good collateral, and good lending practices.3 Therefore,

our interview subjects have an active relationship to the topics we discuss, and their

banks have reorganized to do away with relationship and conglomerate banking and

introduce prudent banking standards such as separate credit risk departments. The crises

are necessary to give us access to credit managers with an active approach to risk

management. It is not relevant to our study to detail the mechanisms of the crisis. One

2
Veall and Zimmermann, 1996, Pseudo-r2 measures for some common limited dependent variables , Hagle
and Mitchell II, 1992, Goodness-of-fit measures for probit and logit
3
The crises have strengthened foreign participation in the banks, in particular so that foreign banks are
regarded as models for the domestic banks as for prudential banking. Foreign participation in banks in
Latin America has been shown to impact how credit is distributed across company size. For Peru and
Argentina, the effect is the same, where foreign banks in general lend less to smaller companies see;
Clarke, et al., 2002, Bank lending to small businesses in latin america does bank origin matter? . As we will
see below, prudential lending has led to less credit to small companies, so our findings are consistent with
this previous research. We find, however, that it is the prudential lending practices inspired by the foreign
banks that restrict lending to small companies, not just whether a bank is foreign or not.

9
other important common feature of our two case studies is that macroeconomic factors

have left the banking system with a surplus of liquidity, so that funding issues do not

restrict their lending policies.

In Argentina, the Tequila crisis forced a wave of bank closures and forced the

central bank to establish increasingly more sophisticated supervisory mechanisms. The

response from banks was to bring in foreign (or foreign trained) staff, foreign risk-

management practices, and foreign capital. This gave foreign banks a more dominant

position in the market, directly through investment and indirectly through influence on

banking practices, which led to higher quality in risk management. These measures,

however, were inadequate in preparing the banking system for the crisis of 2002, created

by macroeconomic mismanagement and the subsequent end of the currency board. The

central bank suspended supervision and the Ministry of Economy started negotiating with

the banking sector, pushing the central bank aside. As the government defaulted on its

debt, a large surplus of liquidity was created.4

Peru has had more time to recover from its crisis, which was created by structural

deficiencies and in part triggered by the impact of the weather phenomenon El Niño on

agriculture in 1997-98 and, at the same time, contagion from the Asian and Russian

financial crises.5 This caused a consolidation in the banking sector, increased foreign

4
For an overview of the Argentine crisis, see Calomiris, et al., 2003, A taxonomy of financial crisis
restructuring mechanisms: Cross-country experience and policy implications , Honohan, 2003,
Recapitalizing banking systems: Fiscal, monetary and incentive implications , and Dabos and Gomez Mera,
1998, The tequila banking crisis in argentina .
5
For an overview of the Peruvian crisis, see Moron and Loo-Kung, 2003, Early warning system for
financial fragility . For an overview of the Asian financial crisis, see Corsetti, et al., 1998, What caused the
asian currency and financial crisis? Part i: A macroeconomic overview and Claessens, et al., 2000,
Corporate performance in the east asian financial crisis with references. For the cost of financial crises, see

10
government ownership, increased banking supervision, and led to the establishment of

prudential banking mechanism such as separate credit risk departments. The experiences

from the bank failures are still very much a part of the cognitive framework for the top

banking officials.

A note on what is “small,” “medium,” and “large”

Each bank we interviewed has its own definition of company size as to how it classifies

its market segments. The terms “small,” “medium,” and “large” are therefore relative

terms. When we discuss credit policy with bank managers, we discuss how they treat

companies relative to each other: how are smaller companies treated compared to larger

ones. For the purposes of this study, the variation in definitions is not a methodological

problem. We do not gather accumulated data across banks in our case studies. When we

compare firms in our cross-country analyses, we use the size definitions in the World

Business Environment Survey where a ‘small’ company has 1 to 50 employees, a

‘medium’ sized company has 51 to 500 employees, and a ‘large’ company has more than

500 employees.6 When we compare the size of countries’ SME sectors, we use either a

definition of SMEs with a cut-off at 250 employees or countries’ official SME

Carstens, et al., 2004, Banking crises in latin america and the political economy of financial sector policy .
For the internal weaknesses in the Peruvian economy, see Grupo de analysis para el desarollo, 1999, The
political economy of exchange rate policies in latin america and the caribbean and Pasco-Font and Ghezzi,
2000, Exchange rates and interest groups in peru, 1950-1996 .
6
Batra, et al., 2003a, The firms speak: What the world business environment survey tells us about
constraints on private sector development , WorldBank, 2000, World business environment survey

11
definition.7 The regulatory authorities in Peru and Argentina that have provided us with

useful knowledge about SME financing classify loan sizes, not company sizes.8 In

general, the banks in Peru use smaller cut-off sizes than the banks in Argentina.

7
Beck, et al., 2003, Small and medium enterprises across the globe: A new database
8
Superintendencia de Banca y Seguros del Perú, the Subsecretaria de la Pequeña y Mediana Empresa y
Desarrollo Regional, Ministerio de Economía Argentina, the Banco Central de la Republica Argentina.

12
 II. Law, institutions and growth

The relationship between law and economic growth

The rule of law is clearly associated with economic output, which intuitively makes much

sense: law makes transactions clear, enforces contracts, secures rights in property,

prevents extralegal enforcement and coercion, and regulates the relationship between

business and the government authorities.

If we graph a measure of the rule of law in a country against output, we obtain a

close to linear relationship.

Figure 1

Rule of law and income

fin che
sgp
aut
can
nzl aus
swe
nld dnknor
2

deu usa
irl jpn
bel
fra
chl esp are
nam omn prt
pri isr
1

bwa crihun svn twn ita

grc
Rule of law index

ury
pol
jor
tun mys czesau
tha
mar zaf lvasvk
ltu
ind
mng egy arghrv
tur pan
0

gha lka bgrdom jam

bra lbn
rom
npltza sen png chnsyr mkd mex
eth mwi zmbben
mrt arm phl
bol irnslv
mda civ per
caf bgd
uga
bfa
mdg
mli pak geo ukr ecu col
moz tgo vnm
khm
slener rwa zwe
gin alb
kaz
gtm
dza ven
bdi kgz nic yem idnhndpry
uzb bih rus
ken cmraze blr
-1

lao
nga
cog
ago
hti
-2

4 6 8 10 12
log of GNI per capita
y = -3.943473 + .5375557, R-squared = 0.76

(Data: A higher Rule of Law index means better rule of law according to Kaufmann,
Kraay et al. (2003). GNI per captita in 2002 from WorldBank (2004))

13
What this relationship does not say is what comes first. Does law create growth, or does

legal development follow economic growth? Or, do the same underlying factors that

create growth also lead to the development of legal institutions? And what do we measure

by the ‘rule of law,’ in the first place?

Rule of law is part of the institutional framework within which the agents of an

economy operate. There is a large body of research that points to good institutions

playing a role in economic growth.9 What “good institutions” means, however, or even

what kind of institutions are important for economic output, are complicated questions to

answer because the various institutions and performance indicators in an economy are

highly interrelated and correlated.10

Whether we use the rule of law, government efficiency, or regulatory quality as

measures, we obtain close to the same relationship with output. This makes intuitive

sense: regulation is the tool through which government efficiently establishes the rule of

law.11

9
North, 1990, Institutions, institutional change, and economic performance . See Aron, 2000, Growth and
institutions: A review of the evidence for a review of the literature.
10
See Kaufmann, et al., 2003, Governance matters iii : Governance indicators for 1996-2002 for a diverse
and well-documented set of institutional indicators. For a discussion of the different aspects of institutions,
see Acemoglu and Johnson, 2003, Unbundling institutions .
11
For a discussion of regulatory rules vs. discretion, see Fukuyama, 2004, State-building : Governance and
world order in the 21st century and Dworkin, 1986, A matter of principle .

14
Figure 2

Governance indices and income

2
Score on governance index
-2 0

Rule of law Rule of law fitted line

Government effectiveness Government effectiveness fitted line
Regulatory quality Regulatory quality fitted line
-4

4 6 8 10 12
log of GNI per capita
Rule of law: y = -3.943473 + .5375557, R-squared = 0.76
Governance effectiveness: y = -3.804025 + .5199521, R-squared = 0.71
Reguatory quality: y = - 2.72969 + .3889018, R-squared = 0.52

(Data: A higher score on the governance index means better governance according to
Kaufmann, Kraay et al. (2003). GNI per capita from WorldBank (2004))

We can measure the performance of the legal system by objective benchmarking to an

established standard, for example that regulations on moveable collateral should be close

to the U.S. regulations, which are generally regarded as among the best in the world on

this matter.12 Or, we can measure the performance by the economic output per person in

the economy. The first is difficult because it is difficult to determine a benchmark.13 The

12
It is the effectiveness of the laws or regulations that matters here; not whether the form of prescribing
behavior comes through a law, following a constitutional procedure, or a regulation, enacted by a
government institutions through delegated authority.
13
Fukuyama, State-building

15
second is difficult because of the many causal channels at work, which requires the

investigator to make assumptions that will invariably be contestable.14

One alternative is to see how the economic agents in the economy perceive the

institutional framework, because their confidence in the system will determine how they

relate to and rely upon the system. When we measure the confidence of people in their

justice system, we find an apparent relationship to economic output, although weaker

than the relationship between output and a traditional expert-based rule of law measure:

Figure 3

Rule of law and income Confidence in justice system and income

3
2
1

Confidence in justice system

Rule of law index

2.5
0
-1

2
-2

4 6 8 10 12 0 10000 20000 30000 40000

log of GNI per capita GNI per capita
y = -3.943473 + .5375557, R-squared = 0.76 y = 2.224344 + 0.0000134 x, R-squared = 0.38

(Data: GNI: WorldBank (2004); Rule of law index: Kaufmann, Kraay et al. (2003);
Confidence in justice system: Inglehart (2000b). There is a stronger correlation between
Kaufman’s expert-based rule of law measure and output than between peoples’
confidence in the justice system and growth.)

14
Beugelsdijk, et al., 2004, Trust and economic growth: A roubustness analysis

16
The rule of law encompasses many legal aspects, such as the tradition for law and order,

enforceability of contracts, crime, and the black market. It also encompasses the notion of

‘property rights’ – the legal implications of owning an asset. In this study, we will focus

on aspects of property rights and how this segment of the rule of law impacts finance.

One of the lessons that have reverberated most loudly in the field of property

rights is that ‘dead capital’ can be activated when that capital is formalized so that it may

be used as collateral.15 ‘Dead capital’ means assets without formal title, such as

unregistered dwellings or farmland occupied by poor farmers. Sometimes capital is

‘dead’ because there is no way of establishing title, sometimes it is ‘dead’ because

registration is too expensive, cumbersome, or inefficient for the owner. Without title, the

owner cannot transfer rights to creditors so that the land can be used to secure credit, and

he cannot claim it on his personal balance sheet in order to increase his creditworthiness.

This is an attractive notion: even immobilized assets have a value, and the gains

from its potential future sale can be discounted to a net present value, which the owner

should be able to use as collateral to obtain credit. If property rights contribute to ‘making

assets fungible,’ then they should allow for a better allocation of finance since assets may

be used to secure financing.16 Property rights are, like the rule of law, associated with

economic output, whether we use a broad index of property rights as on the left side

below (a scale of 1 – 5), or whether we focus on the risk of government repudiation of

15
Soto, 2000, The mystery of capital : Why capitalism triumphs in the west and fails everywhere else
16
“By uncoupling assets from their rigid, physical state, a representation makes the asset ‘fungible’ – able
to be fashioned to suit practically any transaction” Ibid.56

17
contracts as on the right side below (using an average of underlying measures scaled from

1 to 10).

Figure 4

Property rights index and income Contract repudiation index and incomce
Index of property rights Index of the risk of repudiation of contracts
from 1 (worse) to 5 (better) from 1 (worse) to 10 (better)

10
che
deujpn nor
aut
swe
bel
5 nld
nzl fra dnk
twnitafin
irl usa
can
sgp
aus
kor
prt
esp

8
4 pry tha mys isr
ury
alb zaf hun
png col svn
omn
mng bwachl
bgrjam mex grc
civ chn

repudiat
braven
indidn egy
tza cmr

6
3 tur
gha cri
ken dza
mar tun pol
lka
hndecu sau are
mwi
moz
bfa
ner sen
zwe
tgopak rom pan
gtm
arg
syr jor
phl
yem bol per
nic slv
eth nga irn
nam
2 cog ugabgd
gin
vnm
lbn
4

sle ago dom

zmb

mli hti
mdg

1
2

4 6 8 10 12 4 6 8 10 12
Log of GNI per capita Log of GNI per capita

(Data: Property rights indes:Kaufmann, Kraay et al. (2003); Contract reputiation index:
LaPorta, Lopez-de-Silanes et al. (2002). Both measures show a correlation with output)

The picture becomes more mixed when we look at economic growth instead of the level

of output.17 If we substitute economic growth between 1970 and 1995 for output on the

graphs above, we see that the obvious relationships disappear (and for one index it

appears actually to reverse).

17
See Aron, Growth and institutions and Gradstein, 2004, Governance and growth , who illustrate that the
links between institutions and property rights, respectively, and growth is not clear.

18
Figure 5

Property rights index and income Contract repudiation index and incomce
Index of property rights Index of the risk of repudiation of contracts
from 1 (worse) to 5 (better) from 1 (worse) to 10 (better)

10
che lux
gbr nor
jpn
aut
swe bel
5 nldisl
nzl dnk
fra
ita
fin
usa
can irl sgp
aus hkg
prt kor
esp

8
4 tha
isr mys
pry cyp
uryhun
col png
chlomn mlt
bwa
tto bgrmex grc gab
civ jam

repudiat
bra chn
indegyidn cmr
tza

6
3 cri
ken
poldza martun
hnd panecu lka
sen zwerom
gtm mwi bfa
phl paksyr sur
perbol slv
nga nam
2 bgd
gin
cog
uga

4
dom gnb

mli
sdn
1
2

-8 -6 -4 -2 0 2 -8 -6 -4 -2 0 2
Log of GNI per capita growth 1970-1995 Log of GNI per capita growth 1970-1995

(Data: Kaufmann, Kraay et al. (2003), LaPorta, Lopez-de-Silanes et al. (2002))

There are many possible explanations for this configuration. Perhaps the sources for both

economic growth and institutions lie way back in time so that the impact of institutions is

to be found on the level of output rather than current growth. Perhaps the relationship is

too subtle for a two-dimensional analysis, and we will have to control for other variables.

In order to understand more of the link between the legal implications of assets and

economic growth, we will have to look specifically at the channels through which

property rights may impact growth, and we will look at this relationship from the aspect

of finance.

19
An impediment to growth: How the legal framework on
secured transaction limits access to credit

Much of the focus on property rights and growth has been on how dead assets can be

brought alive as collateral for finance. The developed world has systems for this, and

“legal property thus gave the West the tools to produce surplus over and above its

physical assets.”18 Typically, for development purposes the focal point has been land and

real estate, and the importance of land registries. Land is the most imminent asset

available for most people, at least for those who own or have occupied farmland or a

house. Since the ability of the debtor to post collateral depends on the quality and

negotiability of his title, only formalized and registered property is useful in getting

finance. The value as security for the creditor also depends on the quality of the posted

title and the legal mechanisms for taking possession of the assets if the debtor defaults.

Focusing on real estate, however, gives a highly biased picture on the need for

and access to finance. In the same way some industries are more dependent on external

finance than others, some industries have more fixed assets in the form of real estate and

land than others.19 Service industries will typically have little real estate, agriculture will

typically have land, and industrial production will have real estate. Small companies

typically have not been able to acquire land and buildings, which large companies have

while more access to real estate collateral.

18
Soto, The mystery of capital 51
19
Rajan and Zingales, 1998, Financial dependence and growth and Beck and Levine, 2002, Industry
growth and capital allocation: Does having a market- or bank-based system matter?

20
Figure 6

Dependence on External Finance by Industry

Tobacco
Pottery
Leather
Spinning
Footwear
Non-ferrous metal
Apparel
Pet. Refineries
Non metal products
Beverages
Iron and steel
Food
Pulp, paper
Synthetic resins
Paper and products
Printing and publishing
Other chemicals
Rubber products
Furniture
Metal products
Basic chem excl fert
Wood
Transp
Pet and coal prod
Motor vehicles
Textile
Machinery
Ship
Other ind
Glass
Elect mach
Professional goods
Radio
Office computing
Plastic prod
Drugs

-1 0 1 2

Young Average
Mature

(Source: Rajan and Zingales (1998). Since dependence on external finance differs across
industries, variations in the legal framework relevant to bank credit is likely to affect
industries differently. Similarly, some industries are more than others reliant on real-
estate compared to other assets.)

These differences in financing needs across industries have real implications. A larger

banking sector makes young firms in industries dependent on external assets more likely

to be created and to grow.20 The banking sector, however, is more likely to serve large

firms in industries that have assets to secure the credit. Typically, in many countries, this

means land and real estate. Industry affiliation and company size therefore impact the

supply-and-demand for credit asymmetrically.

20
Cetorelli and Gambera, 2001, Banking market structure, financial dependence and growth: International
evidence from industry data . See Laeven, et al., 2002, Financial crises, financial dependence, and industry
growth for a similar analysis on the impact of financial crises across sectors.

21
 This does not mean that industries with little real estate have few assets. A

transportation company might have little real estate but many trucks. A service company

might have few tangible assets but valuable trademarks. An agricultural producer with

leased land has crops in various states of growth, and a cattle-owner has cattle that are

born, grown, and perhaps slaughtered, before they are sold.

For an asset to be of use both to the debtor and the creditor, the asset must remain

in possession of the debtor throughout the life of a credit. The most obvious such asset is

land. But, in theory, any asset that the debtor owns may be subject to a pledge to the

creditor. There is no economic reason that prevents an architect from pledging his

patented designs to his bank, but he cannot do so without the appropriate legal

framework.

While using land and real estate as collateral is provided for in most legal systems

and its use defined through practice, this is not the case for moveable assets. Fleisig

asserts:

Where legal and regulatory constraints make it difficult to use moveable property
as loan collateral, the cost of loans makes capital equipment more expensive for
entrepreneurs relative to their counterparts in industrial countries; businesses
either postpone buying new equipment or finance it more slowly out of their own
limited savings. Small businesses, in particular, are hit hard by the scarcity of
low-cost financing, but the whole economy suffers because the lack of new
investment dampens productivity and keeps incomes down. Estimates put
welfare losses caused by barriers to secured transactions at 5-10 percent of GNP
in Argentina and Bolivia.21

21
Fleisig, 1996, Secured transactions: The power of collateral

22
The estimated impact on GNP in the quoted text is based on the assumption that interest

rates will rise when moveable property is used as collateral as opposed to real estate in

economies where the legal quality of moveables is inferior to that of real estate.22

If the impact on GNP were consistent across countries, we might expect to see a

correlation to output similar to the one we saw when applying the rule of law in general.

The measures we have available to describe the framework for secured transactions are 1)

whether secured creditors are given priority in liquidation, a basic indication of how the

law treats secured creditors as opposed to unsecured creditors; 2) the percentage of

secured creditors that must approve a reorganization before it is valid, a more refined

proxy of how the law treats secured creditors; and 3) a composite index of creditor rights

in the legal framework on collateral and bankruptcy.23

If we transpose these measures onto our scatter plot of the rule of law versus

output there does not seem to be an immediate relationship. While the relationship

between the rule of law in general and output is clear, the relationship of secured

transactions-related law and output is not clear.

22
Fleisig, 1999, Costo economico de los defectos en el marco legal argentino para los creditos con garantia
de bienes muebles ,Fleisig, 1997, Legal restrictions on security interests limit access to credit in bolivia
23
If secured creditors do not come first in bankruptcy, the value of collateral falls dramatically. Therefore,
this is a cruder measure of creditor-friendliness than the percentage of secured creditors that have to
approve reorganization. The most refined scale is the composite index unfortunately it is not continuous.

23
Figure 7

Secured creditors first in liquidation Percent of secured creditors that must approve liquidataion
Creditors do not come first
2

2
1 Creditors come first

1
Rule of law

Rule of law
0

0
-1

-1
6 7 8 9 10 11 6 7 8 9 10 11
Log of GNI per capita Log of GNI per capita

The top left graph shows the relationship between the rule of law as measured by experts
and output per capita. The red markers show countries where secured creditors do not
come first in a liquidation, which means secured creditors are less protected than in other
countries. If we regress output per capita on the rule of law and whether creditors come
first, the priority of creditors is not significant. The size of the markers in the right graph
above shows which percent of secured creditors that has to approve a liquidation. The
higher percent the better protection for the individual secured creditor. Also here there is
no significant relationship.

Creditor rights index Creditor rights index and output growth

4

4
Creditor rights index

3
2

Creditor rights index

Rule of law

2
0

1
-2

-2

4 6 8 10 12
Log of GNI per capita
0

-8 -6 -4 -2 0 2
Rule of law Creditor rights index Log of growth of GNI per capita 1970-1995

The left graph above shows the relationship between the rule of law and output per capita
in black and between an index of creditors’ rights and output in red. There is no
significant relationship between creditors’ rights and output per capita. The right graph
substitutes growth for output per capita. Again, there is no significant relationship.

(Data: GNI:WorldBank (2004); Rule of law index: Kaufmann, Kraay et al. (2003);
Measures of priority of secured creditors, percentage of secured creditors that must
approve liquidation; creditor rights index: LaPorta, Lopez-de-Silanes et al. (1998).
Creditor rights index is an index based on assessments of the legal framework from 1 to
4, where 4 is best)

The top left graph shows, in red, the countries where creditors do not come first in

reorganization. If this were more common in countries with low output, we would expect

24
to see the red dots in the lower left corner. Though there are more red dots in the lower

left corner of the graph, the relationship is not significant. The top right graph shows, by

the size of the markers, what percentage of secured creditors must approve

reorganization. We would expect the markers to be bigger in the top right corner;

however, there is no significant relationship here either

Our most sophisticated measure is plotted on the bottom graphs. On the left graph

we show the rule of law and output, and we superimpose the creditor right index (right

axis), on a scale from 1 to 4. We would expect this scale to reflect somehow the level of

output, since creditor rights should be associated with more credit, and more credit

should be associated with more output. However, there does not seem to be such a

relationship, neither with the level of output nor, as we show in the right hand graph, with

growth.

There are, of course, many causal channels that can lead from the quality of

creditor rights to output, and because of intervening variables, such a relationship might

well exist even if it does not show up on a two-way graph. In order to close in on the

micro-level relationship between providers of finance and the companies that seek

finance, we may look at the firms themselves. If creditor rights matter for how firms

obtain financing, we would expect there to be an association between creditor rights and

how easy firms find it to obtain financing. If we plot the country average perception of

finance as a constraint to doing business as perceived by firms, against the creditor rights

25
index, there is no apparent relationship, though there is a clear relationship between the

rule of law in general and the perceived financing constraint.24

Figure 8

The graph shows a clear relationship between rule of law as measured by experts and the
constraints to financing as observed by firms (R-squared = 0.45). There is no significant
relationship between how firms perceive financing as a constraint and the index of
creditor rights.

(Data: Kaufmann, Kraay et al. (2003), LaPorta, Lopez-de-Silanes et al.), WorldBank

(2000). Financing constraint is a scale from 0 to 4 where 4 means that financing is a
major obstacle to doing business and 0 means that financing is no obstacle to doing
business)

24 Correlations of the indicators (74 observations)

| Financing Collateral Creditor Rule

| constraint constraint rights] of law
-------------+------------------------------------------
Finance | 1.0000
Collateral | 0.4979 1.0000
Creditor r. | 0.0715 -0.0338 1.0000
Rule of law | -0.6543 -0.4366 -0.1278 1.0000
Source: Kaufmann, et al., Governance matters , LaPorta, et al., 2002, Government ownership of banks , WorldBank,
Wbes

26
This has two potential implications. First, finance as a constraint to doing business might

be caused primarily by other forces than the quality of creditor rights. Second, the rule of

law in general might be a component in explaining this constraint.

If small companies suffer particularly because of an adverse legal framework,

then looking at average responses for all companies would not be appropriate.25 If we

divide up companies into size, and plot the average perception within company size

groups against the categories of creditor rights quality, we see that smaller companies

perceive finance to be a greater obstacle than larger ones. However, whereas smaller

firms face significantly more obstacles in obtaining finance, there is no indication that

smaller companies in countries with weaker creditor rights perceive finance as more on

an obstacle than do smaller companies in countries with stronger creditor rights.26

In the remainder of this study we will survey the relationship between financer

and financed and focus on how the legal framework on creditor rights affects the way

banks extend credit to companies. We will also look for substitutes for law in those cases

where we find that the impact of the legal framework is not strong, and we will try to

understand why the legal framework fails to perform.

Using qualitative studies in two countries, Peru and Argentina, and cross-country

data from a variety of databases and surveys, we will try to answer the following

25
Previous research indicates that obstacles to doing business affect companies of different sizes
significantly different; see Batra, et al., The firms speak and Pfeffermann, et al., 1999, Trends in private
investment in developing countries and perceived obstacles to doing business .
26
The strength of association between finance as a constraint to doing business and the category of creditor
rights in which the legal system in a firm’s country scores is very weak (Kramer’s V = 0.05 for 8,449 firms
in 74 countries). This is the same for small firms only (Kramer’s V = 0.06 for 3.314 firms in the same
countries). No linear relationships appear. [DATA] If we regress finance as a constraint to doing business
on size and the creditor rights index, size enters as significant but not creditor rights.

27
questions: Can we verify or strengthen the literature’s assertions regarding how banks

provide credit to firms? How does the existing legal framework in our case studies

provide for secured financing, and how do the banks use these rules? From a qualitative

assessment: what is the impact of the legal framework on collateral and bankruptcy on

access to credit? Quantitatively, what determines how firms finance themselves, and what

is the role of law? And, if the legal framework does not perform, do personal

relationships and trust substitute for the reduction of risk and facilitation of transactions

that the legal framework is supposed to provide?

28
III. Selection of case studies

Small-n case studies and large-n relationships

We are studying two Latin American countries up close, Peru and Argentina. These

countries have comparable banking sectors, and they have in the recent years started to

act upon recommendations to improve their legal framework for moveable collateral.

In Peru, a draft for newly secured transactions legislation is before congress. The

same is the case in Argentina; however, the proposal has been lost in the political process

and is considered as abandoned by its authors. Being in the same stage of reform has

created a certain level of awareness of these issues among key policymakers and policy-

influencers, and – more importantly for our study – among the banks. Furthermore, it has

made available related research on which we can build, in particular in order to formulate

hypotheses about the impact of secured transactions reform.

In addition to the framework on secured transactions being in the same stage of

reform, the banking sectors are in comparable states:

1. Both countries have recent experiences with banking crises that have

forced banks to collect and as such build a recent experience base on the

value of having transactions secured with collateral. The experiences from

these crises are fresh in the consciousness of borrowers and lenders alike,

and have led to an increased awareness of the various aspects of the

creditor-debtor relationship, both legal and in other aspects.

29
2. The banking crises have forced the banks to end relationship banking. In a

strong relationship banking-culture, legal ex ante considerations are likely

to be negligible. Following the crises, banks have established stringent

credit-approval routines. It has made the banks that survived the crises

rethink their approach and routines related to credit and to reassess

business practices. The bank managers as well as regulatory authorities

and the legal community have an active understanding of the value of

secured lending. The restructurings and consolidation following the crises

have also caused an influx of bankers with international experience, which

reduces the distortion that local customs play in the way credit decisions

are made.

3. There is a comparable understanding of the increased focus on cash flow

analysis following the work with the Basel II accord in both countries, so

that the banks are not likely to be overly reliant neither on collateral nor on

previous relationships.

4. There is ample liquidity in both systems, in Peru because of domestic

investment by pension funds, and in Argentina because of the default on

government debt obligations. This means that funding issues do not

constrain lending policies.

5. In both countries access to finance and political instability are the two

most important problems in doing business, as perceived by business

30
 executives.27 Access to finance as a problem makes the secured

transactions legislation have important policy relevance, and political

instability makes banks likely to value collateral particularly in a way that

affects the whole economy equally.

We use two components in this analysis: qualitative interviews and cross-country

regressions. We gather arguments and theories from a wide variety of disciplines, such as

law, political science, sociology and economics, and we try to integrate rather than

juxtapose these disciplines.28

Based on previous research related to the use of collateral in our two countries in

combination with corporate finance literature, we describe and develop hypotheses about

how credit decisions should be influenced by law. We use legal research on the status of

secured transactions legislation in our case-study countries. However, legal analysis is

always constrained by its limited use of sources. The legal system is just one of many

systems operating in a society, and whereas sociology and related disciplines have

become the tool for analyzing entire societies, law has remained the science of just one

small social system.29 If one wants to investigate the economic impact of law, one cannot

use only legal sources because they do not inform about the outside world’s perception of

27
Porter, et al., 2004, The global competitiveness report 2003-2004
28
Landauer, 1971, Toward a unified social science
29
We use ‘system’ as in Easton, 1957, An approach to analysis of political systems and we recognize the
many debates surrounding systems theory. However, in the countries we study, the legal system is indeed a
relatively closed system, and it may benefit from being analyzed as such.

31
the legal system.30 Using techniques from other fields, such as quantitative economics or

qualitative sociology, are ways of understanding how law works in society, which is our

goal here.31 The internal autonomy in the field of law is particularly pronounced in our

case studies; however, the ramifications outside the legal system of the activity within the

legal field are often weak, partly because of the inefficiencies of the field itself, partly

because of efficient channels of exchanging information between the judicial system and

other systems in society, and partly because of the large extrajudicial sectors in these

countries. The ‘internal politics’ of the legal profession, while heavily occupying the

lawyers, is largely ignored by agents in the financial system.32

Specifically, we interview a number of bank executives, business leaders,

government officials, and lawyers in Peru and Argentina. From these interviews, we

gather stylized facts that contribute to the understanding of how banks make credit

decisions, and how they use the legal framework on collateral in making these decisions.

Furthermore, our qualitative findings enable us to assess how theory related to our fields

fits with the ‘real world’ that we observe.

Having performed a qualitative analysis, we run cross-country regressions to see

if our conclusions hold on a multi-country basis, where the data permit and where such

analyses add to the existing literature. This is a different level of analysis than the country

case studies. We do not attempt to confirm our analysis of an individual country by

running cross-country regressions. Such analyses would simply allow us to recommend

30
For a review of the discipline of jurisprudence, see Tur, 1978, What is jurisprudence? .
31
Legal theory and sociology are related in the history of academics; see Lane and Scheppele, 1994, Legal
theory and social theory .
32
Using the perspective in Bourdieu, 1987, The force of law: Toward a sociology of the juridical field .

32
that research on a micro-level in other countries be based on hypotheses developed from

our findings in Peru and Argentina. In a cross-country analysis, one of these countries

may well be an outlier – what holds for the rest of the world, needs not hold for

Argentina, for example, or the other way around. It is, however, of value to know which

of our findings we may use for tentative generalizations, and which are likely to be

unique to our case studies.

Assessing the impact of law on finance: Studying banks

Banks are the main source of external financing for most companies on a world-wide

basis. Although there are many financial intermediaries operating in our countries, the

bulk of external financing comes from banks also in Peru and Argentina, as we will show

using firm-level data below. There are, of course, many companies that never make it to

the bank and that survive using internal financing and family-held equity. Understanding

how one may enable these firms to access external finance is one of the goals of this

research. Such external finance, given today’s financial and institutional structure, is

overwhelmingly likely to be bank finance, and hence we focus our analysis on the banks.

We will start out looking at the role banks play in financial intermediation, and we will

see how this role fits with our qualitative observations.

33
IV. From law to finance: Banks as financial

intermediaries. Theory and examples from Peru

and Argentina.

The role of banks

If banks are nothing but “financial intermediaries that issue deposits and use the proceeds

to purchase securities,” they would not be distinct from any other financial entities.33

Company financing around the world, however, is heavily dependent on banks. What

causes the special position banks hold in the financial system has been subject to much

research. For our purposes we try to understand what this special role of banks implies in

the distribution of credit to companies.

The special situation of banks in the financial system may be primarily related to

another side of their activity than extending credit. Banks manage the payment system

and transmit monetary policy. Although payment transactions are a function that

increasingly is being handled by other entities than banks, transactions as revenue

generator for the banks is becoming increasingly important, thus enabling banks to offer

credit on a cost-basis to customers in exchange for transaction management. In the same

way that the transactional function is what made banks emerge as special financial

institutions because of the classification of the regulators, transactions will continue to

make banks special lenders because of their own business models. This business model

33
Fama, 1980, Banking in the theory of finance

34
only applies to lending to corporations big enough to be attractive as transaction

customers. For the smaller companies, the banks are still in search of revenues through

the interest rate spread, largely because for the smaller companies there is no alternative

financing but the banks. Larger companies have the option of issuing tradable debt or

equity, but smaller companies do not.

As banks move down the firm size scale in search of profit, the interest rate

margins deteriorate, however, and the result is a perception that also the mid-market has a

low profitability when based on spread alone. Since there is less transactional revenue to

be generated in the mid-market, this segment ends up without finance. We will return to

this issue later. For the moment, we note that part of what helped make banks special at

the outset (in the eyes of the regulator), the transactions, is now crucial for their business

(from the market’s perspective). Since they already enjoy a dominant position in the

market of transactional business, this situation is likely to continue.

The banks’ role in creating “fountain pen money” makes them subject to special

regulations.34 In particular, the banks have special access to government institutions such

as the Superintendencia de Bancos y Seguros in Peru and the Banco Central de la

Republica Argentina, which have given them better information about regulatory

processes and a louder voice in such matters than have other institutions. In addition to

the access created by the crucial role of banks in the financial system, their old and well-

organized business associations enjoy solid and long-standing ties with the authorities.

Being in a special regulatory situation with the corresponding corporative channels is

34
Tobin, 1963, Commercial banks as creators of "money" . On monetary circuit theory, see Hicks, 1989, A
theory of money and Bossone, 2000, What makes banks special? .

35
likely to contribute to institutional development. Research indicates that accessing these

channels may be more of a challenge in Latin America, where voice towards the

government is more difficult, than in the countries from which the financial, legal, and

political traditions were transplanted.35 The favored access to government again gives

market access for other products such as credit. This may explain why banks have

emerged as the most important lenders.36 It also explains why banks persist being special

in the financial system.37 It does not, however, explain why banks should retain their

special position as large lenders in the future, especially if societies become more

pluralistic.38

Part of the explanation for the privileged access banks enjoy in dealing with the

regulators may be due to the efficiency that the regulators perceive in dealing with the

banks and the confidence that the regulators enjoy in dealing with the banks. During the

financial crisis in Argentina, the banks worked closely with the authorities to get the

financial system back on track, at the request of the Ministry of Finance. Since banks are

well organized and enjoy impact in the market as a whole, scarce resources on the part of

the government (in qualified personnel and time) are better spent where they may have

more impact. This relationship created close monitoring, and this close monitoring of

banks makes banks less risky financial partners than other institutions.

35
O'donnell, 1999, Horizontal accountability in new democracies ,Hirschman, 1970, Exit, voice, and
loyalty
36
Rajan and Zingales, 2003a, Saving capitalism from the capitalists : Unleashing the power of financial
markets to create wealth and spread opportunity
37
See Rajan, 1998, The past and future of commerical banking viewed through an incomplete contract lens
for a different perspective on how the regulatory perspective preserves bank specialness.
38
For example, in Argentina there are several banking associations, in Peru only one of importance.

36
 This perceived lesser risk involved in dealing with banks reflects what has been

called the banking sector’s ‘reputational capital.’39 This reputational capital is what

allows banks to collect deposits from depositors despite the banks’ controlled balance

sheet mismatching. But it also works for the regulators. The institutionalization of a large

bank provides for the structures that allow regulators to negotiate and control millions of

deposits through relatively few points of interaction. If the reputational capital of one

bank deteriorates, it is normally not detrimental to the financial system as a whole. Unless

there is a crisis and the loss takes place overnight, the interaction between the regulators

and the bank will change according to the bank’s decline in reputation and, normally, a

reduced deposit base. However, if there is a systemic shock that shifts the level of

reputational capital across the whole banking system immediately, the banks would risk

losing their specialness. It takes a lot for this to happen. There are no signs of such a loss

of specialness in Argentina, where the banking system is just coming out from a severe

crisis, or in Peru, where the banks’ ‘relationship lending’ practices gave them an image of

political cronyism in the eighties and early nineties.

The special regulatory status of banks also provides a backup-liquidity function

for the banks.40 This is a more subtle mechanism than a lender of last resort-system where

there is an explicit or implicit guarantee that the central bank will bail out failing banks.

The favored relationship with the regulators allows for a more flexible regulatory

approach in times of crisis, as has just been the case in Argentina.

39
Bossone, What makes banks special?
40
Corrigan, 1982, Are banks special? , Corrigan, 2000, Are banks special? A revisitation

37
 Another way in which banks are special as financial intermediaries is the relative

standardization of their contractual relationships with borrowers. The debt contracts are

typically structured so that they are fixed in nominal terms, require collateral, and have

costly bankruptcy provisions. According to theory, such standard debt contracts are

optimal in taking into account ex post information asymmetries and agency costs. If we

assume that there is a cost to monitor the behavior of the borrower, the advantage of a

standard debt contract is that the banks can avoid the monitoring costs as long as the

payments come according to schedule. It is only if the borrower defaults that the bank

incurs monitoring costs. 41 The standard debt contracts have a reverse side. If one keeps

increasing the borrower’s credit, the risk of default increases and thus the risk incurred in

not monitoring the borrower during the life of the credit. This is likely to constrain firms

from obtaining credit for investments.

The theory of standard debt contracts (SDC) with costly state of verification

builds on assumptions that we will see later do not always hold in our case studies.

Rather than refrain from monitoring, the banks monitor their clients very closely, and

they use very short maturities to gain investor-like control. The only companies that are

not subject to this monitoring are the larger corporations. In this case the assumptions

hold. However, the corporations are frequently not subject to collateral requirements, and

41
Gale and Hellwig, 1985, Incentive-compatible debt contracts: The one-period problem , Bossone, What
makes banks special? , Wiliamson, 1987, Financial intermediation, business failures, and real business
cycles , Bernanke and Gertler, 1989, Agency costs, net worth, and business fluctuations, Bernanke and
Gertler, 1990, Financial fragility and economic performance , VonThadden, 1995, Long-term contracts,
short-term investment and monitoring . Note that when banks leave the ‘standard debt contract’ model and
start behaving as investors, they start incurring costs and benefits that normally would belong to owners;
see Grossman and Hart, 1986, The costs and benefits of ownership. A theory of vertical and lateral
integration and (below.)

38
they easily obtain new credit lines with other banks if one bank’s lending policies or

limits restrict it from increasing credit further.

Although one scenario could be that “as information and contract performance are

crucial to the SDC optimality result, one would expect bank specialness to fade with the

development of financial infrastructure since this provides agents with better information

and more efficient contract enforcement technologies leading investors to prefer non-

SDC contract types. Bank specialness is therefore a product of history, much like its own

disappearance at some point.”42 This might be the case elsewhere, but it does not appear

in our case studies. In fact, the banks have a superior access to information, through their

knowledge of their clients and through information sharing with other banks through

informal networks, that allows them to retain an advantage in the market, and in order to

standardize their procedures they use SDCs.43 This use is not so much for the

convenience of bridging the information asymmetries, but because they provide for a

more streamlined internal organization. A loan officer can handle a greater number of

credit lines if the process is standardized than if each client has his own contracts.

Similarly, the legal departments and collection departments in a bank are used to working

with standardized contracts, not individualized ones. When banks branch out of a

standardized contract framework, they do so in order to set up other standardized contract

frameworks, such as fideicomisos (trusts). This will happen when there is a systemic

encouragement to do so, for instance because fideicomisos are self-executing and provide

42
Bossone, What makes banks special? 7
43
The ‘informal networks’ are by no means complicated. Based on our interviews, a credit officer will pick
up the phone and call a credit officer in another bank to see if the other bank has any negative experiences
with the firm seeking credit.

39
a way of avoiding an inefficient legal system (this is the case in Peru). That the banks use

a standardized contractual framework does not prevent them from renegotiating the terms

of these contracts.44

One may test the assertion that the banks’ specialness erodes with the

development of financial infrastructure related to information and contract enforcement.

If the share of bank finance versus other private finance is inversely correlated with

financial infrastructure, then companies in countries with better financial infrastructure

should have less bank finance. We do not have cross-country data for the proportion of

private finance that is bank finance. However, we may assume that bank finance is

substituted with a portfolio of various alternative finance options that are likely to

develop as a financial system develops, and that traded equity is part of this substitution

portfolio, since we know that equity markets are associated with financial development.45

Under such assumption, better credit information and contract enforcement should be

associated with a higher ratio of equity financing to bank financing. We cannot find such

a relationship.46

44
SDCs in the organizational meaning of the word (as in our case studies) and SDC in the term meaning of
the word (as in the theory) have two different meanings. The organizational meaning is that banks use
SDCs to rationalize their credit processing. The term meaning means that the terms of bank credit contracts
are standardized. Actually, banks prove to be specialists in showing flexibility on the terms of the contracts;
see Gilson, et al., 1990, Troubled bank restructurings: An empirical study of private reorganization of firms
in default and Cantillo and Wright, 2000, How do firms choose their lenders? An empirical investigation .
45
Levine and Zervos, 1998, Stock markets, banks, and economic growth , Boyd and Smith, 1998, The
evolution of debt and equity markets in economic development
46
We a poisson regression to explain private credit/value traded by an index of the quality of public credit
registries, the procedural complexity in enforcing contracts, and GNI per capita, which yields no significant
coefficient except output per capita and a r-squared of 0.10. The simple correlations are 0.0168, 0.0168,
and -0.258, respectively.

40
 The most important specialness of banks, according to our qualitative studies,

derives from two facts. First, banks provide the only finance available to small and

medium-sized companies besides internal or family-provided financing. In this case,

there are no options for companies to change to other financial providers, so that the

‘specialness’ of banks is not threatened in the foreseeable future.47 Second, banks are

comprehensive financial institutions and are therefore well positioned in being able to

adapt to changing markets as compared to financial institutions that specialize in certain

firms or industries. They are large enough to weather business cycles and crises (at least

when we factor in their special relationship with the authorities), and they hold a

comprehensive knowledge about the credit and financial markets, as well as a superior

broad knowledge of the various sectors in an economy. For example, it would be hard to

get an overview of the credit market in a developing country studying only non-bank

credit institutions. However, studying the banking sector gives a fairly good impression

of the financial system and industrial sectors. Banks are by tradition the institution that

one first goes to in order to obtain credit, and although special entities exist for certain

functions (credit cards or leasing, for example), they are not important enough in the

credit market to gain a fundamental market share or influence. Moreover, when a credit

sector that banks have previously shunned becomes profitable and sustainable (not only

profitable or sustainable), the banks will move in. Micro-credit in Peru is one such

example.

47
Both in Peru and Argentina private equity for SMEs is in its infancy, and venture capital investors we
interviewed did not foresee a major expansion in this segment in the foreseeable future.

41
 This means that banks mobilize savings and facilitate exchange, not only

exchange of services but exchange of knowledge and exchange over time, at limited

cost.48 In doing so, funds are diversified into many projects (scope) and over time

horizons beyond the investor’s savings horizon (time). Banks pool resources together for

projects that are too large for individual shareholders to undertake (scale).49 In this way,

banks facilitate an inter-temporal exchange of technology and of human capital that

creates growth.50

We will now look at the role of banks in creating – or limiting – growth, starting

with the apparent lack of credit in Latin America.

Banks and the credit crunch

Latin America is experiencing a credit crunch, where banks respond to increased risk

through rationing credit rather than increasing interest rates.51 Theory suggests that this

takes place either because banks cannot lend (for regulatory or liquidity reasons) or do

not want to lend.52 In our case studies, the banks have ample liquidity and are free to

lend, so the first reason does not apply. On the contrary, our interviews showed that the

banks were eager to lend to any qualified borrower because of ample liquidity in the

48
This is in principle not different from Smith, 1776, An inquiry into the nature and causes of the wealth of
nations . Though one may print money and enable the exchange of goods and services, a financial
intermediary is needed to exchange innovation for funding and exchange services in different temporal
periods.
49
Bagehot, 1873, Lombard street
50
Lamoreaux and Solokoff, 1996, Long-term change in the organization of inventive activity , DeGregorio,
1996, Borrowing constraints, human capital accumulation, and growth
51
Barajas and Steiner, 2002, Credit stagnation in latin america for Latin America. See Bernanke and
Lown, 1991, The credit crunch for the United States, however, with a different definition of what a credit
crunch is.
52
Gosh and Gosh, 1999, East asia in the aftermath: Was there a crunch?

42
respective economies, provided by pension funds in Peru, and a halt in banks’ purchases

of government bonds in Argentina, which has released the liquidity that before was

soaked up by the government. 53 It is what constitutes a ‘qualified borrower’ that seems to

have contracted.

Figure 9

(Source: Barajas and Steiner (2002))

The credit crunch in Argentina and Peru has affected sizes of companies differently. The

decrease in credit in the years 1999-2000 coincides with banks’ ending their ‘relationship

banking’ approach, separating the commercial credit department from the credit risk

department. This has the effect of singling out the best borrowers, typically corporations

with exports. ‘Best borrowers’ in this context does not mean maximizing spread and

minimizing risk. Rather, for corporate clients, the banks will minimize risk because the

borrower is a larger, transparent client, and will not expect any profitable spread. The

53
Catão, 1997, Bank credit in argentina in the aftermath of the mexican crisis: Supply or demand
constrained

43
goal is to capture the client’s transactional business.54 If there is no transactional business

to be captured, the value to the bank is simply as a low-risk allocation of assets at the

bank’s own cost of capital.

Through our interviews we found the following pattern in how rates are set.

Although the banks perceive an increased risk in the market in general, they do not

increase interest rates (although such rates adjustments eventually pass through from the

banks’ cost of capital). The same appears if there is an increased risk in a sector: the bank

does not increase the interest rates to firms in that sector. The interest rates are negotiated

between the commercial credit department and the client. The commercial credit

department will give the best rate allowed by their limits, i.e., without the bank losing

money. After the credit has been negotiated, it goes to the risk department for approval. If

it is not approved, the risk department will generally ask for more collateral or shorter

terms; interest rates are a part of commercial credit department, and the risk department

does not consider it part of risk assessment at all. There is no credit rationing to the large

corporations. However, as company size decreases, the rationing becomes more apparent.

While there is less transactional business in the mid-market and the spread

becomes the main component in the profitability of the segment, rates are generally

competitively set for the companies that actually have access to credit. For the companies

where there is an increased risk, credit is rationed rather than made more expensive.55 If

54
This is somewhat the opposite effect of banks shifting credit towards larger clients when interest rates
increase, as described in Bernanke, et al., 1996, The financial accelerator and the flight to quality .
55
There is an ‘on-off’ switch for credit to this segment. If the firm is able to post acceptable collateral or
show export contracts, financing is obtained at a pre-determined rate. If the firm is not able to meet the

44
the company has no export and no acceptable collateral (we will return to what

constitutes acceptable collateral later), then there is no credit to be had even if the

marginal increase in risk could be covered with a marginal increase in interest rate. Also,

since companies are already closely monitored, there is little risk-reducing leverage in

intensifying the monitoring.56

There is product differentiation based on what the customer segment values,

however, which gives an opportunity for interest rate increase by product category rather

than by client. One example is micro-credit. While there are clear signs of rationing to

small enterprises, the micro-enterprise segment in Peru is installment-sensitive in the

same way as consumers are sensitive to installments rather than interest rates. Micro-

credit in Peru is becoming a high-profit product for the banking sector. Since the

borrowers place less importance on interest rates, the rates might be three or four times

the prime rate. The banks’ argument in setting the rate high is not risk, however: there is

still a perception in the market, seemingly ignoring cyclical, geographical, or industry

risk, that the small amounts to each lender provides for a diversification that renders the

micro-credit portfolio virtually riskless. The high interest rates are justified in the high

costs incurred by the small loan amounts, the credit assessment, and, in particular, the

costs in selling the credit, in addition to a price-to-market perspective based on the

‘installment sensitivity’ of the borrowers. Contributing to the interest rate elasticity of the

requirements, then financing is denied. The reason appears is the lack of internal flexibility to adjust
interest rates to the risk each client presents. We will discuss this further below.
56
Note that such intensified monitoring would incur costs, so that there would be two additional
components over the interest rate.

45
borrowers is how competing lenders price their credit offers by monthly rates as opposed

to annual rates.

The micro-credit segment is still developing from a NGO-driven segment into a

more sustainable for-profit segment, but the credit supply is definitely present, and there

is no credit crunch in this market. The main deterrent to getting involved in this line of

credit is the close relationships with the client and knowledge about the local markets that

are required along with the associated high costs. The segment in the middle, suffering

the most from the credit rationing, is the mid-market and the small companies. The small

companies are for the time being excluded from the micro-credit market, because of the

perceived ‘statistical hedging’ in having many even smaller borrowers. The small

company market is not perceived to constitute such a ‘statistical’ diversification. One

may question the validity of this perception. While the micro-borrowers might be less

diversified than what the lenders perceive, the small companies are currently being

considered as potential credit-card customers in Argentina, which would amount to the

same business model as what underlies commercial bank micro-credit in Peru.

Tax regulations also provide for segment-wide interest rate adjustments. Leasing

finance in Peru relies somewhat on installment-sensitivity too, in combination with the

relative lack of sophistication on the part of the borrower: tax breaks on the part of the

borrower provide for lower installments, but the bank structures the installments so that

the bank profits from the tax breaks, whereas the borrower perceives smaller installments.

All the banks we interviewed expressed that adjusting rates and maturities to

reflect individual company risk required more sophisticated models than presently in use.

This was particularly pronounced for interest rates, whereas if anything, maturities was

46
the variable that the bank would change depending on the quality of the borrower. This

completely defies the model of interest rates being a function of the level of risk. When

we pointed this out during the interviews, the response was, consistently, that such

models were too complex and that when the credit department had given its approval, the

credit was acceptable with the rate negotiated by the commercial credit department.

Several of the banks have begun taking steps to implement more sophisticated risk-

assessment measures, such as computer modeling, but nowhere had this been

implemented at the time of the interviews. The most advanced banks had started

contracting with consulting companies in order to develop such models. However, the

banks’ apparent price-taker situation in their preferred segments does not suggest that

such models will use variation in interest rate as a primary means of pricing risk into the

loans.

The current global trend in the credit risk departments is, rather than to adjust

interest rates, to implement the future cash-flow analysis recommended by the

international standardization of credit assessment in the Basel II banking regulation

process, in combination with credit ratings and collateral.57 In Peru and Argentina, the

practice appears to be that the cash flow analysis plays a minor part in the credit risk

assessment, and does not seem to help in obtaining credit if there is no collateral.

It is difficult to distinguish the supply-and-demand side of a credit crunch.58 In

Argentina, our respondents indicated that companies, in particular SMEs, are unwilling to

57
Bank for International Settlements, 2001, Principles for the management of credit risk , Bank for
International Settlements, 2004, International convergence of capital measurement and capital standards ,
Estrella, 2000, Credit ratings and complementary sources of credit quality information
58
Catão, Bank credit in argentina in the aftermath of the mexican crisis: Supply or demand constrained

47
take on credit because they have experienced a large number of bankruptcies if borrowers

were unable to repay their debts during a financial crisis. We observed similar comments

in Peru and in Argentina: that SMEs did not want debt because it reduced their financial

flexibility. For the small-business segment this problem is largely irrelevant: the banks do

not want to extend credit, so what the potential borrowers want does not affect the

market. For the medium-sized companies, however, it is relevant. Our respondents in

banks in Argentina indicated that the banking sector was targeting well-qualified

medium-sized companies for short-term credit, but these were reluctant to take on more

than the minimum needed because of the lessons from the preceding crisis. This,

however, constitutes a small segment of the market, and it is more likely to affect the size

of a company’s leverage, not whether there is leverage at all.

Further complicating the matter is that the supply-side may be dependent on a

rationing one step upstream, for instance so that the banks that would be willing to lend

are unable to do so, and the ones able are unwilling. In Argentina, smaller banks tended

to restrict lending because they themselves experience a reduction in the deposit base as

the depositors undertake a ‘flight to quality,’ which again allows the larger banks more

flexibility.59 Similarly, on the lending side, the larger banks that end up with the deposits

ration credit to the private sector in their version of a ‘flight to quality’ (as opposed to

taking advantage of the increased flexibility to lend).60 This is no longer the case neither

59
Berlin and Mester, 1999, Deposits and relationship lending
60
Braun and Levy-Yeyati, 2002, The role of banks in the transmission of shocks: Micro evidence from
argentina 1996-1999 . ‘Flight to quality’ is really not a good term: the government assets that banks were
buying ended up being riskier than debt to the private sector, which was widely discussed in the banking
system well before the default that followed after the period covered by Braun et al. See Barton, et al.,

48
in Peru nor in Argentina, so that this constraint does not affect the banks that we

interviewed.

Having established that the banks have a role in the ongoing credit crunch in Latin

America, we will now look at the functions finance performs in creating growth, and how

the banks we studied perform these functions. In particular, we will focus on the

functions that relate to, or provide a context that impacts how banks use secured lending

– or how they circumvent or substitute for secured lending in cases where the legal,

institutional, or business framework makes secured lending impractical.

Finance and growth

If banks allocate funds inefficiently through rationing credit and through collateral

requirements that only some firms of certain sizes and sectors can meet, if banks are a

key provider of finance, and if credit rationing distorts the mitigation of monetary policy,

then the banks’ rationing is likely to have adverse consequences for the economy.61 The

credit crush in Latin America that we addressed in the previous section coincides with a

slowdown in growth.62 Furthermore, research shows that in Latin America, the economy

2003, Dangerous markets : Managing in financial crises for a discussion of depositor behavior in financial
crises; for a depositor behavior study in a stable environment, see Barajas and Steiner, 2000, Depositor
behavior and market discipline in colombia . Our findings are opposite to the predictions of theories that
predict that banks will target smaller, more opaque, borrowers when forced to reduce lending as in
Dell'Ariccia and Marquez, 2001, Flight to quality or to captivity? : Information and credit allocation .
61
Bernanke and Blinder, 1988, Credit, money, and aggregate demand and Romer and Romer, 1990, New
evidence on the monetary transmission mechanism . They build on Tobin, 1969, A general equilibrium
approach to monetary theory in assuming that there is no perfect substitutability between bonds and credit
because of the role of reserve requirements.
62
Barajas and Steiner, Credit stagnation in latin america ; see the table on page 43.

49
is particularly vulnerable to credit booms.63 This leads to the question of how finance

impacts growth, because if it does not, there is little point in worrying about the concerns

of mobilizing assets to give access to finance or credit rationing to certain segments of

the market. If finance does lead to growth, then the widespread belief “in policy circles in

several countries that the slowdown in financial sector credit is an important driving force

behind the economic slump” and that “growth will only be restored once the ‘credit

channel’ becomes operative again” is accurate and a matter of immediate concern.64

The impact of the banking system on growth has been a matter of dispute at least

since Bagehot argued that the bank-based system constituted the “rough and vulgar

structure of English commerce [as] secret of its life; for it contains 'the propensity to

variation,' which, in the social as in the animal kingdom, is the principle of progress,” in

other words, mitigation of risk and the matching of funds to the best risk/return

allocation. 65 The main providers of liquidity in our case studies, the pension funds,

typically cannot invest in single projects (such as a railway project), but they can deposit

their funds to banks, which again may participate in such projects. When the pension

funds participate directly in projects, such as large fideicomisos, they need to bring in

other investors in order to mitigate the risk, spreading it over multiple investors as

63
Gourinchas, 2001, Lending booms: Latin america and the world . Se Kim, 1999, Was credit channel a
key monetary transmission mechanism following the recent financial crisis in the republic of korea? for a
similar case study on Korea.
64
Barajas and Steiner, Credit stagnation in latin america
65
Bagehot, Lombard street . Bagehot also emphasized the democratization effect of the English banking
system: “This increasingly democratic structure of English commerce is very unpopular in many quarters,
and its effects are no doubt exceedingly mixed. On the one hand, it prevents the long duration of great
families of merchant princes, such as those of Venice and Genoa, who inherited nice cultivation as well as
great wealth, and who, to some extent, combined the tastes of an aristocracy with the insight and verve of
men of business. These are pushed out, so to say, by the dirty crowd of little men.”

50
opposed to spreading the risk of one investor on multiple projects which requires a bank

to structure the deal. Note, however, that the very large undertakings, like those

addressed by Bagehot here, would most likely be financed by equity in Latin America

today – and in any case they could be financed by equity if the banks refused funding.

Also, in countries with a tendency towards a more developmental-state perspective,

definitely the case in Argentina before the privatizations of Menem and possibly a

scenario under the administration of Kirchner, the government could be the organizing

institution.66 Today’s equivalent of the Bagehot financial paradigm quoted above is the

large corporations, who have easy access to bank financing, and the smaller companies

that depend on bank financing in order to grow.

Schumpeter held that what breaks the non-profit structure of the circular flow,

with the ‘entrepreneur faisant ni bénéfice ni perte,’ is the entrepreneurial innovation

financed by credit – the entrepreneur “is the typical debtor in capitalist society; and as

such what creates leaps in growth.”67 For Schumpeter’s entrepreneurial theory, the

importance of the banks is emphasized by the tendency of financial markets to induce a

shift towards projects with higher expected returns when risk diversification is made

66
See Johnson, 1982, Miti and the japanese miracle for the Japanese developmental state; and for the
concept ‘developmental state.’ Note that given the defaults, any large-scale project where the Argentine
state would organize the financing, is likely to require offshore collateralization.
67
Schumpeter, 1934, The theory of economic development [1911] builds on Marx; see Elliott, 1980, Marx
and scumpeter on capitalism's creative destruction: A comparative restatement . An opposite perspective
comes from Lenin, who applied Marx’s economic theories on international relations: banking loans to
dependent countries and thus to local entrepreneurs are the prime mechanism for the exploitation of these
countries; see Cardoso, 1972, Dependency and development in latin america . Today, many firms
experience that credit from foreign countries comes with better terms than domestic credit. (The quote from
Schumpeter was borrowed from Walras.) Schumpeter’s warning that “capitalism is being killed by its
achievements” is alarmingly close to what several of our interview subjects in Argentina expressed; see
Schumpeter, 1950, Capitalism, socialism, and democracy .

51
easier.68 Such a shift would benefit start-ups and small companies in particular. The

Schumpeterian perspective is very attractive: it explains innovation and growth, and

credit to entrepreneurs, including non-incumbents, is at the core of ideas of

democratization of finance and of efficient capital allocation.69

Schumpeter’s theory seems, however, less well founded in our observations. The

classical entrepreneur, as described by Schumpeter, starts off with an idea and maybe a

small firm. He then needs finance to expand. But in our case studies, the small companies

are the ones with the most difficulty in obtaining finance, and small and medium

companies rarely break through the glass ceiling to becoming large.70 Our interviews

show that the conservativeness of the banks prevents them from extending credit based

on future cash flow, and only companies with a track record and collateral will obtain

credit. These companies, what the banks perceive as ‘good’ borrowers, are not the

innovative ones. Rather, they have a product in a sector that is favored at the moment and

that represents little risk, and they create a stable income based on a proven business

model. Bank finance for investment in new projects is virtually non-existent in Peru and

Argentina.

The largest deterrent from banks providing entrepreneurs with finance is that the

maturity of the loan will be too short to provide a basis for any real investment. Bank

loans financing in our case studies is for working capital, export, real estate, and in some

68
Obstfeld, 1994, Risk-taking, global diversification, and growth
69
Rajan and Zingales, 2003b, Saving capitalism from the capitalists : Unleashing the power of financial
markets to create wealth and spread opportunity
70
Later, we will see that cross-country investigations with a larger number of countries confirm that small
companies have more problems in getting access to finance.

52
cases for machinery or vehicles. Of these, only real estate loans are long-term. The loans

are also closely monitored, in particular when it comes to small companies. If an

entrepreneur obtained financing based on current products, he would most likely not be

able to use the financing to fund subsequent innovations.

It is more likely that such entrepreneurs will obtain financing, if at all, from

micro-credit agencies, which do not exist on any scale in Argentina, or from private

equity. Private equity, however, is deterred from engaging in innovative projects by the

lack of leverage from the banks and also by the entrepreneur’s reluctance to relinquish

control of his firm.71 Micro-credit is too small to allow for any scaled production – as the

head of a Peruvian U.S.-funded umbrella organization for micro-credit put it: micro-

credit exists to give a person a dignified life, not to develop companies. In any case,

financing for innovations will not come from the banks, and for the great majority of

companies it is unlikely to come from anywhere but retentions, friends, and family.

The lack of finance does not deter innovative thinking. The thought process and

knowledge production of innovation might well take place without finance, but financing

is a condition for its realization. The products manufactured during the beginning of the

Industrial Revolution may already have been invented prior to the revolution, but the

invention of liquid financial systems allowing mitigation of risk helped trigger the rapid

change in industrial production.72 If small companies cannot get finance, entrepreneurs

may still invent and then sell their innovations to corporations that would be able to

71
Although participation from a private equity firm is likely to substantively increase the prospects of
obtaining bank financing.
72
Hicks, 1969, A theory of economic history

53
obtain bank financing. This, however, makes the corporations the identifiers of

innovation, taking over the role of banks. Leaving to corporations to ‘pick winners’ rather

than banks is a substantive problem for efficient capital allocation because the selection

process will be biased towards already existing corporate strategies and product lines.

A large body of empirical research has established a correlation between finance

and growth, based on a “parallelism between economic and financial development if

periods of several decades are considered [observing that] periods of more rapid

economic growth have been accompanied, though not without exception, by an above-

average rate of financial development.”73 The direction of causality is disputed. Some

economists downplay the role of finance in growth, some believe growth leads to finance,

and some – increasingly more – believe that finance leads to growth.74

73
Goldsmith, 1969, Financial structure and development , see also McKinnon, 1973, Money and capital in
economic development .
74
Lucas, 1988, On the mechanics of economic development does not consider finance particularly
important in growth compared to human capital. Lucas discusses using subsidies to the ‘winners’ among
sectors to promote growth, a job that other theory would assign to the banks. See also Krugman, 1993,
International finance and economic development . Stern, 1989, The economics of development: A survey
and Stern, 1991, The determinants of growth do not discuss finance at all; some finance is discussed in
Goldin, et al., 2002, The role and effectiveness of development assistance: Lessons from the world bank
experience . For studies that establish various degrees of impact from finance on growth, see Demirguc-
Kunt and Maksimovic, 1998, Law, finance and firm growth, Beck, et al., 2000, Finance and the sources of
growth, Beck and Levine, Industry growth and capital allocation: Does having a market- or bank-based
system matter? , Guiso, et al., 2002, Does local financial development matter? , Laeven, et al., Financial
crises, financial dependence, and industry growth, Boissonneault, 2003, The relationship between financial
markets and economic growth: Implications for canada, Levine, 2003, More on finance and growth: More
finance, more growth? , Wachtel, 2003, How much do we really know about growth and finance? . There
also seems to be causality from financial intermediary development to poverty reduction; see Honohan,
2004, Financial development, growth and poverty: How close are the links? and Beck, et al., 2004,
Finance, inequality and poverty: Cross-country evidence . These studies present evidence contrary to
Greenwood and Jovanovic, 1990, Financial development, growth, and the distribution of income which
predicts that financial development will increase income gaps.

54
 The theory that comes closest to our observations, contrary to recent macro-level

cross-country empirical findings, is that “where enterprise leads, finance follows.”75 In

other words, it is not finance that selects promising projects in our case study countries;

finance follows types of projects already proved to be sustainable.76 Not once during our

interviews would a banker indicate that his bank would extend credit to innovations. This

does not mean that finance does not play a role in growth. Finance allows activities that

produce returns to continue and to grow (albeit in most of our observations, slowly) and

as such reap benefits of scale, and other means of finance may serve innovation.77 In our

two countries, however, these other means of finance are retained earnings, family and

friends.

The evidence not only for a parallelism between finance and growth, but for

causality from finance on growth, becomes more solid when the definition of finance is

expanded to investigate the role of commercial banks in particular.78 Also, the evidence

grows stronger when one focuses on the growth of industrial sectors relative to their

dependence on external finance.79 How this causality takes place, however, is not well

understood. Through looking at the individual functions of the financial system and

75
See Robinson, 1952, The generalization of the general theory
76
This poses a problem with the counterfactual: More finance may lead to more growth in the sectors that
are perceived by the banks as ‘secure’, and thus to more growth in the economy as a whole. It is difficult to
know if growth would have been ever higher had the banks been more adventuresome in their credit
allocation, or if part of the key to sustained growth is conservative finance.
77
In addition to more efficient production, specialization may lead to increased trade and thus to increased
growth; see Krugman, 1979, Increasing returns, monopolistic competition, and international trade , Riedel,
1984, Trade as the engine of growth in developing countries, revisited, Dollar, 1992, Outward- oriented
developing economies really do grow more rapidly: Evidence from 95 ldcs, 1976- 1985, Frankel and
Romer, 1999, Does trade cause growth? , Dollar and Kraay, 2003, Institutions, trade, and growth .
78
King and Levine, 1993a, Finance and growth: Schumpeter might be right , King and Levine, 1993b,
Finance, entrepreneurship, and growth: Theory and evidence
79
Rajan and Zingales, Financial dependence

55
comparing these with our findings, we can further understand how this mechanism takes

place and how to view our findings in the light of the contrary findings in the empirical

literature.80

If we assume that transaction and information costs and imperfections create a

necessity for financial intermediaries to facilitate the allocation of resources across space

and time in an uncertain environment, then we can, following Levine (1997), divide the

functions of the financial system’s allocation of funds into the following: the financial

system mobilizes savings and allocates resources, facilitates risk management; it acquires

information about investments, it monitors managers and exerts corporate control. We

will now review these functions and see how the banks we study fit with the theory. We

will focus on the monitoring function in particular, and for two reasons: First, this is the

function that is the closest substitute for using collateral, and second, this is where our

findings diverge from many of the assumptions about how banks differ from equity

investors.

Banks mobilize savings and allocate resources

Central in the literature on banks is the notion that banks, being able to process large

quantities of information across industry, time, and about individual borrowers, allocate

resources efficiently in maximizing returns while minimizing risk, as well as allocating

80
We take this list of functions of the financial system from Levine, 1997, Financial development and
economic growth: Views and agenda , which is one of the most important studies in moving from
parallelism to causality for growth and finance. The framework applies to all kinds of finance; here we will
only be discussing banks. Tracing the literature, Levine starts with moving away from the Arrow-Debreu
framework and adopt the raison d’être for the financial system from Merton and Brodie; see Arrow, 1953,
Le role des valeures boursieres pour la repartition la meilleure des risques , Debreu, 1959, Theory of value ,
and Merton and Bodie, 1995, A conceptual framework for analyzing the financial environment .

56
those resources in a diversified way across time and sector. This is true in a deep and

developed economy. However, our field studies in Peru and Argentina make us question

whether this is true in developing economies.

In our case-studies, banks, markets, retained earnings, and family are all semi-

efficient ways of allocating resources. Equity and bond markets have a high barrier to

entry, in particular in Latin America.81 While the continuous auction-like mechanism of

market trading provides an accurate quantification of a project’s likely success, it is

inhibited by the barriers to entry and the information imperfections. It also requires

institutions to mobilize savings towards the equity markets; a function that exists in most

economies. The exclusive nature of markets in the lack of equal access to information,

and a limited number of listings makes it a semi-efficient allocation: many good projects

are not accessible through the markets.

Family financing is likely to go either to family projects or to institutions. Since

only family companies can tap into family financing from the same family network, it is

highly unlikely that this finance will find its best allocation. Retained earnings are in the

best case allocated to the best project within the company; if that allocation ends up being

the best possible one on an intra-company level, it is due to mere luck – at least in the

short term.82

Banks may invest in projects of different scales and time horizons, and smaller

projects than markets and with longer maturities than the quarterly report-focus of equity

81
Levine, 1998b, Napoleon, bourses, and growth in latin america
82
In the long term a company may shift its entire production according to what would be the best allocation
of its resources.

57
markets. However, in our case studies, the banks limit themselves to short-term financing

of known companies, largely excluding small companies. This is a low-risk allocation of

funds, but it is not the best investment in a world of assumed perfect ex-ante knowledge

about a project’s probability for success. Although banks may bridge information gaps,

they will not use this information to undertake the best investments, nor do their policies

define best investments to be what minimizes risk and maximizes return. A project is

evaluated in light of the prudential guidelines of the bank. This will of course always be

the case, but the banks in our study have brought prudence to a level where a very small

number of companies qualify.

Banks do indeed mobilize savings and allocate resources, but this allocation is not

necessarily very close to perfect information, perfect access to contracting, and to

transaction cost efficiency.

The financial system facilitates risk management

We can divide the risk amelioration by the banks into liquidity and idiosyncratic risk.

Banks ameliorate liquidity risk in that depositors can withdraw funds at any time they

wish. This is necessary because of the illiquidity of the bank’s assets, which, in case the

individual were to undertake such an investment directly, would prevent conversion of

the asset into liquidity if the need for liquidity were to arise. This again would prevent

investors from undertaking the investment in the first place. Although this reason for the

banking system is evident, the converse side – the illiquid assets – does not play out in

full in our case studies. When the maximum term of finance is three and occasionally six

months, as we have observed, the banks do not convert long-term projects into liquidity.

Rather, the long-term investments are undertaken by individual investors in the form of

58
company owners or their friends and family. Larger companies issue bonds, and all

companies may roll over debt, but – as we shall see later – this debt is not associated with

long-term projects.

If there is no system to ameliorate liquidity risk, savers choose short-term, low-

return projects over long-term, high-return projects.83 This mechanism rests on the

assumption that a fraction of the savers experience adverse shocks after choosing the

asset (short-term or long-term), and that an individual cannot verify whether others have

received shocks or not. In effect, these assumptions are a good description of the banks’

behavior: since political instability and monitoring complications make medium-term

predictions difficult, they stick with short-term working capital and export finance,

avoiding loans to companies that could use them for longer-term investments generating

a higher level of returns.84 In fact, the assertion that “banks can offer liquid deposits to

savers and undertake a mixture of liquid, low-return investments to satisfy demands on

deposits and illiquid, high-return investments,” and thus “facilitating long-run

investments in high-return projects” does not, according to our observations, hold.85 The

banks undertake the former, not the latter.

The idiosyncratic risk that the financial system ameliorates is the diversification

in allocating the assets; they “mitigate the risk associated with individual projects, firms,

83
Diamond, 1984, Financial intermediaries and delegated monitoring
84
In other words, the banks cannot ameliorate liquidity risk through their own predictions about the
behavior of borrowers and the political contexts. One way of overcoming the banks’ risk-averseness could
be to further develop secondary markets for securitized loans, as in Bencivenga, et al., 1995, Transactions
costs, technological choice, and endogenous growth , which would provide liquidity risk reduction for the
banks themselves.
85
Levine, Financial development 693. As Levine notes, increased liquidity affects growth ambiguously; see
Jappelli and Pagano, 1992, Saving, growth and liquidity constraints

59
industries, regions, countries, etc.,” and as such “tend to induce a portfolio shift toward

projects with higher expected returns,” benefiting from “the ability to hold a diversified

portfolio of innovative projects [which] reduces risk and promotes investment in growth-

enhancing innovative activities.”86 While the banks do mitigate the risk across projects,

the two latter assertions do not always hold for the banks we interviewed. The stress-

testing of the banks’ portfolios during the preceding crises seems to have shifted the

banks’ appetite away from any “innovative activities,” and the rate of return is clearly not

geared to capturing the upside of risky projects. Rather, the banks stick with ‘high-

quality’ (meaning low risk) projects that generate only moderate spreads in the mid-

markets, and virtually no spreads in the corporate market.

The only move towards risk-taking we have observed is the development of

micro-finance in Peru. As we have noted earlier, the shift into micro-finance rests exactly

on the assumption that it is a low-risk portfolio because of the large number of

borrowers.87 While a portfolio with a micro-finance component is the only lending

strategy we have observed where the theory of a “mixture of liquid, low-return and

illiquid, high-return investment” holds, incidentally, this is also a substantial departure

from the traditional business model of the commercial banks in Peru. There is little or no

collateral, there is an intense follow-up that in some cases amounts to writing up the

financial statements for the client, the loan amounts are very low compared to the

86
Levine, Financial development 694
87
As we have noted above, this assumption is not well founded. The perception of the banks, however, is
that a micro-finance is low-risk, and their perception is what decides their behavior.

60
expenses incurred on evaluating and following up on every individual client, and the

bank works as a hybrid between a consulting firm, a lender, and an investor.

The increase in the portfolio return, except for micro-credit, comes from

consumer credit. This applies to both countries. Since credit cards can yield spreads of up

to 30% at the current stage of market development, banks see a well diversified, highly

profitable market.88 The same applies to the freshly developing home-equity market in

Argentina, where the only collateral perceived as fundamentally solid--real estate-- backs

consumer lending. The potential spread is lower than for credit cards, but the risk-rate

combination is better than any small-business lending, according to the way the banks

perceive the market. Some banks in Argentina are starting to look into expanding their

credit card business into the SME market, but there have been no concrete steps so far,

according to our interviews.

The mitigation of liquidity and idiosyncratic risk by the banks in our case studies

is far from what it should be, given the ideal picture of a banking system. The risk-

averseness prevents any long-term finance and there is no evidence of the banks

supporting high-risk, innovative projects.

The financial system acquires information about investments

The cost of acquiring information is part of the core rationale for financial

intermediaries.89 This applies both to understanding market segments and to

understanding individual companies. Banks enjoy a competitive advantage through their

88
The banks currently only target the wealthy and the upper middle class for credit cards.
89
Diamond, Financial intermediaries and delegated monitoring

61
special relationship with their borrowers. These relationships also benefit the borrowers

because the bank relationship has a quantifiable value to the firm and because different

compositions of the finance portfolio are desirable at different stages in a firm’s business

cycle.90

We can divide this information-gathering in two broad categories: one is the

information about the expected return of an investment – the ability of the borrower to

generate returns and repay the loan – and second is the willingness of the borrower to

repay, i.e. whether the borrower honors his debt with his disposable assets. Ability is

judged by the banks on a current (using collateral) and forward-looking (using cash-flow)

analysis. Willingness is judged by a backward-looking analysis (using credit information)

and by whether or not the banker trusts the borrower to repay.

If we take the Schumpeterian approach to finance, “the banker is not so much

primarily a middleman. He authorizes people, in the name of society as it were, [to

innovate],” or, in other words, “financial intermediaries may boost the rate of

technological innovation by identifying those entrepreneurs with the best chances of

successfully initiating new goods and production processes.”91 Assessing the ability to

repay involves an analysis of whether or not the client is able to pay the scheduled

installments and what interest rate the bank is able to negotiate, given the profitability of

90
Berger and Udell, 1998, The economics of small business finance: The roles of private equity and debt
markets in the financial growth cycle , Berger and Udell, 1995b, Relationship lending and lines of credit in
small firm finance , Slovin, et al., 1993, The value of bank durability: Borrowers as bank stakeholders .
Note that a long relationship with a bank can make a borrower vulnerable. If the bank breaks the
relationship, it might be difficult for the borrower to obtain financing with other investors. This might deter
firms (that have the option) from using excessive bank financing; see Rajan, 1992, Insiders and outsiders:
The choice between informed and arms length debt .
91
Schumpeter, The theory of economic development [1911] as quoted in Levine, Financial development ;
see also King and Levine, Finance, entrepreneurship, and growth .

62
the project. The forward-looking ability assessment becomes more important as the

borrower wants to use the credit for expansion, not just for working capital. However, the

banks we observed do not use cash-flow analysis to assess expansions to any significant

degree.

The willingness aspect of company information is to some extent outsourced from

the banks. While the banks’ records used to be the primary source of payment history of a

potential borrower (banks used to share and still share this information through informal

channels), more and more public and private credit registries now perform this task,

which has made the information advantage over the banks to deteriorate.92 The banks use

the credit registries more than before not only because of innovations in their own risk-

assessment but also because of the expected Basel II-recommendations.93

Cross-country quantitative studies show that smaller companies benefit from the

existence of credit registries so that when credit registries exist, financing is perceived as

less of an obstacle to doing business.94 In other words, more efficient information sharing

92
See Miller, 2000, Credit reporting systems around the globe: The state of the art in public and private
credit registries for a survey of credit registries, in particular in Latin America, and more comprehensively
Miller, 2003, Credit reporting systems and the international economy . See Jappelli and Pagano, 2000,
Information sharing in credit markets: A survey for an exposition of the role of credit information sharing
systems, and Jentzsch, 2003, The regulatory environment for business information sharing focusing on the
regulatory environment. One of the first thorough treatments of credit information sharing is Pagano and
Jappelli, 1991, Information sharing in credit markets , focusing on how to avoid adverse selection.
93
On Basel II, see Estrella, Credit ratings and Bank for International Settlements, Principles for the
management of credit risk . Bank lending is higher and lending risk lower in countries with credit
information sharing, see Jappelli and Pagano, 2002, Information sharing, lending and defaults: Cross-
country evidence . From the other side of the creditor-debtor relationship: companies in countries with
credit registries perceive less financing obstacles, see Love and Mylenko, 2003, Credit reporting and
financing constraints ; see also Galindo and Miller, 2001, Can credit registries reduce credit constraints?
Empirical evidence on the role of credit registries in firm investment decisions .
94
Love and Mylenko, Credit reporting . Their paper states that “existence of a private registry is associated
with higher average percent of bank financing in small and medium enterprises,” however, their analysis
seems to support only significance for medium sized companies. See Love, 2003, Financial development

63
about potential borrowers reduces the constraints that smaller companies perceive in

obtaining necessary financing. According to our qualitative investigation in Peru and

Argentina, the most likely explanation for this finding is that larger companies do not

need credit registries: they are known to the banks and the banking community regardless

of whether or not registries exist. This is because their financial statements are better and

more trustworthy, because they have had time to grow and thus establish a reputation

with the banks, and because the cost per lent dollar related to acquiring information is

much lower than for smaller companies.

The cross-country investigation cited shows that small companies do not benefit

from either private or public registries. This raises the question if, in a country with credit

registries, banks are retaining their risk assessment advantage despite the registry or if the

case rather is that nobody would lend to small companies, either way. The banks may

have an advantage in their informal network, but it seems unlikely that this should be the

sole explanation why credit registries do not affect small companies’ access to credit.

Rather, if the banks we interviewed overcame their reluctance to lend to small

companies, credit registries would be likely to make such lending easier. The finding that

credit registries do not matter to small companies is consistent with our qualitative

finding that banks hardly ever lend to small companies at all, and that there is no

alternative external financing. The small companies in our case studies are financed

through retained earnings, family, and supplier credit, which come from sources that do

and financing constraints: International evidence from the structural investment model for an analysis of
large firms.

64
not rely on credit registries in the first place. Therefore, the existence of credit registries

is likely to be insignificant in explaining the financing of small companies.

For the medium-sized business, however, credit registries increase the use of

domestic credit. It is also for these businesses that the banks’ information gathering may

increase access to finance, and the banks we interviewed would indeed gather substantial

information about their prospective clients in the mid-market. The banks do have an

advantage in this analysis since the credit registries typically have limited information,

whereas the banks’ more detailed records and network of informal information-sharing

still adds value.95

This firm-specific knowledge is coupled with market analyses and projections,

where banks gather experience over time in certain industries. The industry-specific

knowledge is a strategic asset for the bank, which takes time to develop; thus, a bank

cannot easily move into a new sector, and the built-up expertise may lead a bank to stay

in a sector that has lost some of its profitability. We will abandon this topic, however, and

continue to focus on the individual firm. In the banks that we interviewed, the traditional

separation between information gathering for projections and information gathering as

monitoring is unclear, especially because the banks monitor more than what theory

predicts. We will now look in detail on how the banks perform their role as monitors of

their clients.

95
Jappelli and Pagano, Information sharing has examples of what credit reports include.

65
The financial system monitors managers and exerts corporate control

It is the monitoring that plays the major part in a client relationship in the banks we

analyzed:

Potential creditors will not loan $100,000,000 to a firm in which the entrepreneur
has an investment of $10,000. With that financial structure the owner-manager
will have a strong incentive to engage in activities (investments) which promise
very high payoffs if successful, even if they have a very low probability of
success. If they turn out well, he captures most of the gains if they turn out badly,
the creditors bear most of the costs.96

But even if there are principal-agent concerns the banks will loan some, according to

theory: there are loan sizes and interest rates that, provided there are costs associated with

monitoring, will make the lender not monitor as long as the loan installments are repaid.97

Furthermore, in the cases where monitoring at a cost makes economic sense, it also

makes sense to delegate monitoring to one single institution where there is one borrower

and many lenders; this is the role of the bank.98

Some literature assumes that the borrower’s management of projects cannot be

observed even by the banker.99 However, the banks we interviewed do monitor their

borrowers very closely, with the frequency of reviews ranging from monthly to semi-

annually. These reviews occur during the duration of the credit, and always at the roll-

over of the credit, which we will see happens with very short intervals such as three

96
Jensen and Meckling, 1976, Theory of the firm: Managerial behavior, agency costs and ownership
structure
97
Townsend, 1979, Optimal contracts and competitive markets with costly state verification , Gale and
Hellwig, Incentive-compatible debt contracts
98
Diamond, Financial intermediaries and delegated monitoring . If the bank’s portfolio is well diversified,
the depositors (the first-stage lenders) do not have to monitor the bank because the bank can repay the
depositors even if one of its borrowers defaults; see Krasa and Villamil, 1992, Monitoring the monitor: An
incentive structure for a financial intermediary .
99
Stiglitz and Weiss, 1983, Incentive effects of terminations: Applications to the credit and labor markets ,
Stiglitz and Weiss, 1981, Credit rationing in markets with imperfect information

66
months. Credit is always given for a purpose (almost always for working capital and

export finance), and the banks do not accept any deviation from that purpose. Some

banks may renew credit, so that the credit becomes longer-term than was the initial

intention given the purpose of the credit, but in such cases the rolled-over credit is almost

always for a similar purpose. The short-term contracts are the main element in this

monitoring. The banks want to be able to recall a loan easily, and the most convenient

way to do so is upon termination of the contract. Short-term contracts also put pressure

on the borrower to comply with the terms. We will return to this below.

This structuring of the credit contract creates a discrepancy in the expectations of

the lender and the borrower. If the borrower successfully renews the credit multiple

times, he starts taking the credit line for granted while the lender does not. This again

creates a necessity for increased monitoring on the part of the bank to ensure that the

credit is used for the intended purpose.

The necessity to closely monitor the use of funds may explain why the banks

consistently require ‘logical’ collateral – collateral that is related to the goods to which

the finance relates. In this way, the bank monitors the use of the loan and the whereabouts

and status of the collateral in the same operation.

The exception from the ‘logical collateral’ is real estate. If the owner of the

company is not readily identifiable, the company has to pledge its real estate as collateral.

This essentially performs the same monitoring function as the owner’s home: while a

business can do without production equipment that is recovered after a default, it

generally cannot do without its real estate. Since the judicial system is generally more

used to realizing real estate than moveable property (we will return to this later), there is

67
a higher likelihood that the process of recovering pledged real estate will be successful,

while recovering leased property might take a long time and might not even be

successful.

Monitoring: Reducing agency costs

If the owner is easily identifiable, the bank often takes the owner’s real estate as collateral

(unless the company is large). This is another exception from securing the loan with

‘logical’ collateral. One explanation for this in the literature is that real estate is a

condition for obtaining credit, despite other available types of collateral.100 This does not

explain why real estate is such a condition. The explanation for this, according to our

qualitative observations, is that real estate performs a specific monitoring function.

First of all, for businesses where there is one owner or a few easily identifiable

owners (normally the case for SMEs), an owner’s home is frequently taken as collateral.

None of the managers we interviewed identified this as a mechanism of reducing the

value at risk of the credit. The home is taken as collateral in order to align the interests of

the management of the company with the interest of the bank, namely repaying the credit

according to the agreed schedule.

The main concern of the banks with regards to credit to SMEs is that the owner

might empty the firm of funds, sell off or remove the collateral, and run the company

bankrupt. The level of trust in SME owners abiding by their loan obligations is very low

in all the banks we visited. We have not been able to assess if the low level of trust is

justifiable from the banks’ experiences or if it is due to self-reinforcing myths circulating

100
Fleisig, The power of collateral

68
in the financial community.101 What is obvious is that the level of trust in SME owners is

low.

The agency problems are similar to the classic situation of a company’s

management acting in ways not conforming to the interests of the shareholders.102 Banks

anywhere in the world are fully aware of the problems posed by the separation of

ownership and management; the agency problem relating to debt is largely the same as

the agency problem between owner and management, and as with the owner-management

relationship it is likely to vary in effect around the world.103

There are no incitements built into the standard loan contracts that may bridge this

divergence of interests as there may be in management employment contracts with stock

options or other performance incentives.104 Though managers face both ‘carrots,’ i.e.

economic and career incentives, and ‘sticks,’ i.e. potential negative sanctions like civil

and criminal liability or adverse effects on their careers in their relationship with

shareholders, there are only ‘stick’ and no ‘carrot,’ available in the owner-bank

relationship. Likewise, the ‘soft stick’ available to shareholders through changing

101
The findings in Glen, et al., 1995, Dividend policy and behavior in emerging markets , that dividend
payouts in developing countries have gone down, suggest that this view might not be accurate. However,
the low levels of trust remain. We do not have the data to redo Glen’s analysis on SMEs.
102
Berle and Means, 1932, The modern corporation and private property , Jensen and Meckling, Theory of
the firm
103
See LaPorta, et al., 2000a, Agency problems and dividend policies around the world . Schleifer and
Vishny, 1997, A survey of corporate governance argues that the fundamental agency problem is between
outside investors and controlling shareholders. Note that the agency dynamics might work in the banks’
favor. As Glen and Pinto, 1994, Debt or equity? How firms in developing countries choose points out,
management’s desire for control may be a factor pushing towards debt where the cost of equity would be
lower. This is likely to make owners of small family firms choose debt rather than equity.
104
Diamond and Verrecchia, 1982, Optimal managerial contracts and equilibrium security prices

69
directors, selling the firm, forcing dividends, or measured amounts thereof, are not

available to banks.105

Since the banks have an ‘informal network’ of information sharing, whereby a

bank manager may call up another bank to check on a prospective clients history, one

may hypothesize that banks are subject to the same ‘free rider’ problem as found in

markets. In markets, the share price is a signal of performance, and participants may

assume that the share price is set by informed participants.106 Likewise, clients who have

been able to obtain loans in one bank under certain conditions might be able to obtain

loans more easily on another bank, the second bank assuming that the first has performed

a thorough credit evaluation.

According to our interview subjects, this used to be the situation before the

financial systems underwent stress. When the last financial crises hit in Argentina and

Peru, the banks discovered that relationship banking had led to low standards of credit

evaluation, which again made it easier for clients to ‘shop around’ using the reputation

they had built up with other banks.107 The crises made the banks stop relying on other

banks’ credit evaluations, and checking on a client by calling other banks is now just one

step in preparing the credit decision. This suggests that without a recent experience with a

105
Hart, 1995, Firms, contracts, and financial structure: Clarendon lectures in economics . Banks lack the
‘residual control rights’ associated with ownership. The lien on a company’s property may, of course,
reduce the rights of the owner; see Demsetz, 1998, Firms, contracts, and financial structure: Clarendon
lectures in economics. Book review . The strength of the legal system determines this limitation, and in our
case-studies the banks have little confidence in their ability to pursue legal claims. For a discussion of a
dividend model that shows how legal rights may affect claimholders to the company’s profits, see LaPorta,
et al., Agency problems . Their highest-dividend option is not available to banks, which resemble the
lowest-dividend model.
106
Stiglitz, 1985, Credit markets and the control of capital
107
Several interview subjects expressed surprise that the lenders did not remember previous crises but
allowed an escalation of bad debt.

70
financial crisis, or at least a level of awareness of the problem within the banking system,

the free-rider problem may affect bank credit as well, although with a much slower

dissemination than in a market where the asset price is constantly updated.

Recent research showing that small firms are less likely to pledge collateral as

their history with the bank grows longer substantiates the finding that collateral performs

a role as a monitoring tool rather than as a means to recover the value of the loan.108

Were the collateral only there to recover value in case of default, one would expect it to

be a standard routine upon every new line of credit. However, if it exists to reduce the

uncertainty related to corporate governance, there is less reason to ask the client to pledge

collateral as the bank becomes more confident in the borrower’s conduct and repayment

willingness.

The distinction between relationship lending and close monitoring

The banks in our case studies were, before the banking crises that led to consolidation,

engaged in what is referred to as ‘relationship lending.’ The definition varies from one

interview subject to another, but at the core is a lack of a credit-risk assessment procedure

separate from the sale and negotiation of commercial credit. Common for all the banks

we interviewed is that, following the financial crisis, they initiated a separate credit

approval department, or that they made the existing credit approval department

independent. In many cases (and in all Peruvian cases), this process started before the

Bank for International Settlements initiated the work with Basel II.109 The relationship

108
Berger and Udell, Relationship lending and lines of credit in small firm finance
109
Basel Committee, 1999, A new capital adequacy framework

71
lending led to bad debt accumulation, which again became problematical for the banks

during the respective crises. After the crises, the banks, largely through bringing in

foreign partners and expertise, set up credit or ameliorated risk departments that had to

review and approve the credit lines negotiated by the credit managers.

Before this change in methodology, the credit manager who sold the credit would

monitor the client. Strong personal ties between the relationship manager and the client

provided a control of how the credit was used. Today, there is an equally close

relationship between the bank and the client, and this is what preserves the information

asymmetry that is to the competitive advantage of the bank.110 What differentiates this

model from the previous one is the role of the credit risk department in the approval of

new credit lines. The new ‘arm’s length’ financing is not as new as it sounds. Far from

being ‘arm’s length,’ the relationship remains close, only with the new, more objective,

intervention by the credit risk department during the credit approval.

The real difference from before in how the monitoring works during the life of the

credit is the incitement to repay on terms in order to obtain future credits. While

previously new terms could be negotiated with the relationship manager during the life of

the credit, such new terms, if conceded today, due to a lack of willingness or ability to

pay, would be a negative element in a future approval process in the credit-risk

department.

This is not without exceptions. In both countries, borrowers had to renegotiate

their obligations following the crises. The way they renegotiated this became an element

110
See, for example, Dell'Ariccia and Marquez, Flight to quality or to captivity? : Information and credit
allocation .

72
in the way they are assessed as customers, so that willingness to negotiate in good faith in

a time of systemic crisis is seen as an indication of future willingness to repay. A

renegotiation that during stable times would count negatively towards a company’s future

prospects of obtaining credit becomes an asset for future credit approval when the system

is in distress.

More monitoring: short-term lending substitutes for investor-like control

The banks we interviewed all hold most of their portfolios with very short maturities.

Most commercial loans are 3 to 6 months, and very few loans are over one year.

Financing over three years hardly exists. When banks lend with very short maturities,

they in effect gain investor-like control.111 In lending short-term, the banks may obtain

the following additional powers compared to longer-term financing:

1. Frequent exit opportunities. Like a shareholder who may sell the asset if he

believes the risk is too high, rolling over short-term financing allows the bank to

relatively quickly dispose of assets whose prospects decline or which do not fit

with the bank’s current strategies.

2. Frequent adjustment of terms. Like a shareholder that may elect to sell an asset if

it does not give the sufficient return, rolling over short-term financing gives the

bank the power to adjust terms to reflect increased or decreased risk associated

with the company. The adjustment may not only be risk-related but also

111
Schleifer and Vishny, A survey of corporate governance . The findings for SMEs in the United States in
Ortiz-Molina and Penas, 2004, Lending to small businesses: The role of loan maturity in addressing
information problems are consistent with our findings.

73
 competitive: the banks interviewed reduce the interest rates to match competitors

who target their clients.112

3. Close monitoring. When the bank has the discretion to renew or cancel the credit

frequently, it becomes in the interest of the management of the borrower to let the

bank monitor. During a credit with fixed terms that is not about to be renewed, the

management has no such interest. This is the primary reason cited by the bank

managers we interviewed for preferring rolling over short-term credit rather than

extending longer-term loans.113

This puts into questions theories that build on a minimal amount of monitoring by the

banker.114 In fact, the loan contract is closely monitored, and collateral is no longer the

only monitoring mechanism.

What constitutes a monitoring opportunity for the banks is perceived as an

obstacle to doing business by the borrower. If we compare the lack of long-term

financing to other financial obstacles as perceived by firms, we find that, with the

exception of high interest rates, the lack of access to long-term financing is the most

important obstacle to doing business in every region surveyed except for the OECD

112
According to our findings, interest rate adjustments are almost never due to changes in risk perceptions;
they are almost always due to the competitive environment (including the funding costs that the bank
faces).
113
Note that short-term lending also allows for more incremental assessment of the borrower’s reputational
capital; see Hellmann and Murdock, 1998, Financial sector development policy: The importance of
reputational capital and governance .
114
Such as Stiglitz and Weiss, Credit rationing, Stiglitz and Weiss, Incentive effects of terminations and
the Costly State Verification models, as in Townsend, Optimal contracts, Webb, 1992, Two-period
financial contracts with private information and costly state verification .

74
countries.115 In Latin America and the East Asia newly industrialized countries and

China, collateral requirement and bank bureaucracy are in a tie with the lack of access to

long-term financing as the most important obstacle to doing business.

East
Figure 10 Asia
NIC+ East Asia South Latin
Financing Constraints: China Developing Asia America OECD CIS CEE
High interest rates 40.3 72.5 83.9 87.6 47.8 80.6 79.5
Lack-access to long-term loan 31.2 52 65.1 63.1 20 58.7 67
Collateral requirements 30.1 43.6 58.5 65.1 35.7 49.7 52.2
Bank paperwork 29.9 34.6 56.6 63 38.9 52.9 48.3
Inadequate credit info. on clients 27 48.4 46.7 46.1 23.5 40.1 41.6
Special connections 26.3 39.6 44.5 46.5 26.5 35.1 43.1
Banks lack money to lend 20.6 52.2 35.1 39.1 14.3 37.4 46.8
Access to specialized export finance 15.1 33.7 36.4 34.7 16.5 35.5 38.8
Access to non-bank equity 13 32.6 34.9 35.6 18.1 38.3 42
Access to lease finance 13.1 34.9 32.9 34.1 19.3 32.7 48.9
Access to foreign banks 11.7 41.5 33.9 35 11.1 35.3 40.4
Corruption of bank officials 19 45.1 28.9 18.6 5.7 24.3 29.3
(Source: Batra, Kaufmann et al. (2003a). Boxes show top obstacles except high interest
rates as reported by firms in the respective regions.)

The reason for the short-termism may be volatility (economic or political), a weak

legal system, lack of information/presence of agency problems, or the financial culture.

Our interview subjects frequently expressed a very low trust in that the borrowing

management would use the funds for their intended purpose, which would explain

monitoring as the prime cause of short-termism. Interestingly, this applied also to the

international managers that had experience from other emerging markets or from the U.S.

We are not able to determine whether the international managers’ perception of the

115
Note that there are no data for MENA and Africa. For East Asia, there is a tie with “Banks lack money
to lend.” Note, however, that this response should be dealt with carefully. The surveyed companies are not
banks; and their perception of banks not having money to lend could easily have other causes, and the
perspective from the banking sector regarding this obstacle to doing business may be quite different.

75
trustworthiness of the borrowers was caused by the transfer of experience from their

locally based colleagues, by the adoption of local prejudices, imported from their

previous stations of duty, or formed by their own local experience.

Market and political volatility was a major concern expressed by our interviewees

when discussing the short terms of credit.116 The interviewees related this volatility to

political cycles more frequently than they related it to market cycles. However, the time

perspectives of market and political volatility would suggest longer maturities than the

existing ones; market cycles are longer than six months, and the interview subjects tied

political volatility to electoral cycles.

The short-termism might also be due to the legal system. When the legal

framework does not provide an efficient way of recovering debt so that the legal

framework in reality discourages intermediaries, the banks may tend to move towards an

investor-like behavior where they can exercise control over the borrower before legal

action is needed.117 That the legal framework discourages credit does not mean that

markets will develop. Developing equity and debt markets requires the active, skilled,

and measured participation of a state, a combination which is not easily found.118 The

bankers interviewed consistently had very low confidence in the ability of the judicial

116
Political volatility could be expected to lead to inflation, which again would help borrowers and hurt
lenders. Our respondents, however, did not express any desire to return to eras of high inflation. Rather,
they consistently expressed a wish for a stable political environment. For them, instability is caused by
never knowing which business environment – i.e., laws, regulations, and taxes – to expect, which makes
long-term planning difficult.
117
Coffee, 1999, The future as history: The prospects for global convergence in coporate governance and
its implications
118
Rajan and Zingales, 2001, The great reversals: The politics of financial development in the 20th century
, Rajan and Zingales, Saving capitalism ,Djankov, et al., Doing business ,Fukuyama, State-building ,
WorldBank, 1997, World development report 1997 the state in a changing world

76
system to enforce their debt contracts. When the two different outcomes of a debt

contract (default/payment) may be verified at the end of the term (payment/bankruptcy),

there might be an interest rate that makes it economically optimal not to monitor, as we

have discussed above. However, if the observation of the negative outcome is costly

(default without bankruptcy or bankruptcy on other terms than agreed, i.e., non-recovery

or partial recovery of the collateral), such a model becomes much more complicated.

Although one may find it feasible to adapt a non-monitoring credit model to such a more

complex potential outcome, this would be far beyond the levels of sophistication of the

banks in our case studies. For the banks, close monitoring is easy, and although the cost

is high, the cost is also known, as is the methodology.

How the political, legal, and trust factors rank in causing short-term credit is

difficult to determine. We cannot perform a direct quantitative analysis since we do not

have data on average maturities on bank credit per country.119 We do, however, have data

that describe the quality of the relevant laws, the quality of the legal system, the political

stability, and the level of trust in a country.

Figure 11
Correlation of legal indices, trust, and governance indicators

| Bankruptcy Court Proc. Creditor Trust Law Stability

-----------------------------+--------------------------------------------------------------------
Bankruptcy index | 1.0000
Courtpowers index | -0.3084* 1.0000
Procedural complexity index | -0.3066* 0.4321* 1.0000
Creditor rights index | 0.1399 -0.1608 -0.0739 1.0000
Lack of trust | -0.4056* 0.2516* 0.3251* -0.0858 1.0000
Rule of law index | 0.5961* -0.3937* -0.2966* 0.0334 -0.4664* 1.0000
Political stability index | 0.5101* -0.2488* -0.1549 -0.0143 -0.4198* 0.8264* 1.0000

* = significant correlation at the 5% level. Pairwise correlations, 87-162 observations.

119
Note that we cannot use such standard measures as private credit over output because we are not
analyzing banks’ willingness to lend, just the duration of the credit.

77
 Data: Kaufmann, Kraay et al. (2003), WorldBank (2004), Inglehart (2000b),
Globalbarometer (2004)

In order to gain some preliminary knowledge about the causes of short-termism, we may

look at these variables, which we would use to explain short-termism according to our

qualitative observations. The relatively high correlation between rule of law and political

stability suggests that we might have problems separating the two variables’ effect on

maturities. Trust is significantly correlated to rule of law at the 5% level (r = 0.47); the

bankruptcy index is significantly correlated to the former variables ranging from r = 0.41

to 0.60, while the indices specific to how the legal system treats creditor rights and the

courts’ power in bankruptcy are less correlated to the trust, rule of law, and political

stability. We should therefore be able to explain the maturities on a cross-country basis,

provided the average maturities were available.

One possible proxy variable we may use for loan duration is how much

businesses regard the lack of long-term loans as a constraint to doing business. This

variable has the weakness of measuring only the client side of the loan contract, and a

variable measuring the actual maturities in the financial system would be better. On the

other hand, since economies differ, the perception of the businesses is likely to be a good

measure of the impact of the lack of long-term finance on their ability to do business and

to expand. Looking only at how much the bank policies are an obstacle to doing business

for the companies also allows us to avoid the complication of constructing a supply-and-

demand model.

78
 Looking at how the lack of long-term finance poses an obstacle for a firm, we see

that our qualitative findings in Peru and Argentina are largely supported by the cross-

country relationships; see Figure 12.

79
Figure 12

Political stability, rule of law, trust, and the lack of long-term financing

The ordered probit regression estimated is: Lack of access to long-term financing as an obstacle to doing business = α + β Political
stability index + β Trust in people in general (mean per country) + β Traditional value scale (mean by country) + β Family important
(mean by country) + β Court Powers Index + β Procedural Complexity Index + β Public Credit Registry Index + β Creditor Rights
Index + β GNI per capita + β Industry + β Firm age + β Foreign ownership dummy + β Sales + β Multinational dummy + β
Government ownership dummy + β Size of company + β Rule of law index + β Degree of financial liberalization + u.
The regressions allow for error terms clustered by country. R-squared are McKelvey and Zavoina (1975). We use ordered
probit because the dependent variable is ordered categorically between 1 and 4, where 1 is ‘no obstacle’ and 4 is ‘major obstacle’

(1) (2) (3) (4) (5) (6)

Long-term finance obstacle
Political -0.263 -0.339 -0.282 -0.304
stability index
(2.04)** (2.88)*** (4.42)*** (5.75)***
Lack of trust 1.296 1.173 0.798 0.694
(2.64)*** (2.59)*** (1.64) (1.73)*
Traditional -0.178 -0.207 -0.283 -0.204
values
(0.85) (1.11) (1.57) (1.04)
Family not 1.231 0.628 4.073 3.284
important
(1.24) (0.64) (3.61)*** (2.26)**
Court power index 0.002 0.001 0.000 0.000 0.004 0.001
(0.60) (0.37) (0.12) (0.08) (1.91)* (0.75)
Procedural -0.000 -0.002 -0.004 -0.007 0.001 0.005
complexity index
(0.08) (0.56) (0.86) (2.66)*** (0.71) (2.12)**
Credit registry 0.002 0.003 0.002 0.003 0.011 0.009
index
(0.59) (1.19) (0.67) (1.16) (6.87)*** (4.82)***
Creditor rights 0.036 0.072 -0.056 0.011 -0.558 -0.534
index
(0.42) (0.84) (0.82) (0.15) (7.62)*** (8.25)***
GNI per capita -0.000 0.000 -0.000 0.000 0.000 0.000
(0.97) (0.60) (1.65)* (1.17) (4.88)*** (6.06)***
Service industry -0.189 -0.187 -0.121 -0.107
(5.11)*** (4.87)*** (2.67)*** (2.29)**
Other industry -0.222 -0.211 -0.095 -0.018
(not manuf.)
(1.45) (1.38) (0.40) (0.08)
Agriculture 0.073 0.044 -0.033 -0.016
(0.50) (0.28) (0.18) (0.09)
Construction 0.077 0.086 0.213 0.236
(0.97) (1.08) (2.43)** (2.70)***
Firm age -0.001 -0.001 -0.003 -0.003 -0.001 -0.002
(0.87) (0.96) (2.04)** (2.37)** (0.70) (1.25)
Foreign ownership -0.241 -0.236 -0.211 -0.202 -0.278 -0.276
(4.42)*** (4.26)*** (3.44)*** (3.20)*** (2.38)** (2.36)**
Sales $mn -0.000 -0.000 -0.000 -0.000 -0.000 -0.000
(1.81)* (2.41)** (1.24) (1.55) (2.22)** (1.95)*
Multinational 0.015 0.010 -0.026 -0.037 -0.121 -0.133
(0.25) (0.18) (0.39) (0.52) (1.03) (1.12)
Government -0.097 -0.096 -0.087 -0.049 0.096 0.119
ownership
(1.04) (1.01) (0.73) (0.42) (0.68) (0.87)
Small company 0.144 0.152 0.210 0.230 0.069 0.081
(2.22)** (2.38)** (3.06)*** (3.45)*** (0.64) (0.74)
Medium-sized 0.045 0.038 0.103 0.105 0.118 0.123
(0.83) (0.69) (2.07)** (1.99)** (2.46)** (2.47)**
Savings ratio -2.453 -3.469
(avg60-92)
(2.42)** (3.87)***
Rule of law index -0.392 -0.548
(3.27)*** (4.82)***
Financial -0.057

80
liberalization 92
(1.61)
Financial -0.158
liberalization 95
(2.06)**
R-squared 0.185 0.193 0.261 0.253 0.179 0.181
Countries 38 38 26 26 9 9
Observations 4123 4123 2516 2516 926 926
LR Chi2 653.42 687.65 588.58 616.33 149.483 151.292
Robust z statistics in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%

Our dependent variable is how much of an obstacle a firm considers the lack of long-term

financing to be (from 1, no obstacle, to 4, major obstacle).

Political stability, a measure based on polls and surveys of experts, managers, and

citizens, is significant at the 1% level in decreasing access to long-term finance as an

obstacle to doing business. This corresponds with our findings in Peru and Argentina.

Using a general measure of the rule of law instead of political stability provides for a

slightly better fit (improves R2 from 0.185 to 0.193), but since the legal aspects that in

particular govern bankruptcy and creditor rights are captured in other variables, and since

political stability definitely must remain part of the model, we retain political stability.120

Lower trust in a country makes the lack of long-term financing more likely to be

an obstacle to doing business. We measure trust by the average number of the population

in a country that says people in general can be trusted. Recognizing the caveat that trust

in general in a society is only one factor in the trust relationship between the lender and

the borrower, we also assume that the general level of trust has an impact on the average

trust in creditor-debtor relationships. If there is little trust in the principal-agent

relationship, one is likely to require more monitoring and more exit-options, which is

120
We cannot use both variables; they are highly correlated governance variables.

81
reflected in shorter-term financing. This cross-country result supports our qualitative

observations in Peru and Argentina.

There are certain firm characteristics that impact how long-term financing is

perceived as an obstacle to doing business. Long-term financing is less of an obstacle for

foreign companies. Our interviews in Peru and Argentina suggest that this is because

foreign companies can shop around for financing in several countries. They also in some

cases have access to offshore revenues that may be used as collateral. Our interviews also

indicate that being a foreign company also may have an impact on the ability to get

financing at all, as offshore revenues used as collateral are directed through the lending

bank’s payment services, and thus are one of the few actual alternatives to real estate as

collateral that we have encountered.

Long-term financing is more of an obstacle for small companies (50 employees or

less), but interestingly: being a medium-sized company (51-500 employees) does not

decrease this obstacle significantly.121 This is puzzling compared to our qualitative

observations. While small companies cannot really expect to obtain long-term financing

in the current credit environment, and were described by the banking managers as not

seeking long-term financing, the mid-market segment is the one described by our

interviewees as wanting but not getting longer-term financing.

Another quantitative finding that contradicts our qualitative findings is that being

in the service industry as opposed to the manufacturing industry significantly decreases

long-term financing as an obstacle to doing business. The banks we interviewed in Peru

121
That financing obstacles are dependent on firm size is also explored in Beck, et al., 2002b, Financial and
legal constraints to firm growth: Does size matter?

82
and Argentina are generally skeptical of the service industry because of the lack of

tangible assets. This result is likely due to the nature of our dependent variable, which

captures the borrower side of the credit relationship only. If the service industry has

become used to operating without long-term financing because of the lack of tangible

assets to post as collateral, then the lack of financing over time – the expectation of

financing over time – might not be perceived as such an obstacle. The manufacturing

industry is more fixed asset-intensive, and has not learnt to do without long-term

financing, which could explain why there is a significant difference to the service

industry. Furthermore, investments in assets requiring long-term financing is not so much

of a concern in the service industry compared to the manufacturing industry, so that the

service industry is likely to demand less long-term finance and hence perceive it as less

of an obstacle.

The short-termism of the banks might also be caused by balance-sheet

matching.122 If we use the savings ratio (domestic savings as a percentage of GDP) in a

country as a proxy for the liquidity of the banking system and assume that savings take a

portfolio distribution on terms, then savings ratio is a crude proxy for time-deposits in the

banks. We use the historical savings ratio (1960 to 1992) because we assume that the

banking system generally responds slowly to macroeconomic changes in making lending

122
Bossone, What makes banks special? . The banks we observed engage in balance sheet matching on
their own initiative, and do not need incentives to engage in ‘narrow banking’ as would be required in
situations where banks hold long-term assets while there is an unsatisfied demand from the public for safer,
shorter-term assets; see Goodhart, 1987, Why do banks need a central bank? .

83
policies less conservative.123 Adding this variable provides for a model that better

explains the variance of the lack of long-term finance as an obstacle to doing business

(our R2 improves from 0.185 to 0.261).

We see that a higher savings ratio significantly reduces the obstacle posed by the

lack of long-term finance. This suggests that when the liquidity in a financial system

improves, firms get increased access to long-term financing. When we hold savings ratio

constant, medium-sized firms also experience more problems associated with the lack of

long-term financing than large firms, and small-firm experience even more problems than

medium-sized firms. This has two implications: it substantiates our qualitative finding

from Peru and Argentina that medium-sized firms do not easily get long-term financing,

and it puts into question the assertion from the bankers we interviewed that small firms in

general do not seek long-term financing. A more likely story is the one we encountered in

interviews with other actors in the financial system: that the managers of small

companies do not even approach the banks because they know their requests will be

turned down.

When we hold the savings rate constant, we also see that the age of the firm

becomes significant so that older companies have easier access to long-term financing.

This is coherent with the strong assertion from the bankers we interviewed that a

company’s payment history is a crucial element in getting finance. This element is likely

123
This is an assumption that does not hold in times of booms, especially where there are domestic
opportunistic actors with less prudent lending policies, such as in Peru and Argentina before the financial
crises of the late 90s and early 2000s. However, for a cross-country investigation we use a variable that
captures the average over time, assuming that it takes time to change banking culture. On the persistence of
cultural variables, see Inglehart, 1999a, Trust, well-being and democracy .

84
to apply stronger to long-term finance than to finance in general, since extending a longer

term loan means that the bank takes on more risk everything else being equal.

We also find that the construction sector finds long-term financing more of an

obstacle than what is perceived by the manufacturing sector. Since the construction

business generally is able to post real estate as collateral, this business should, according

to our qualitative findings, generally be favored in getting credit. However, these two

findings are compatible taking into account the production cycle of the construction

business and remembering that our dependent variable is the perceived obstacle posed by

the lack of long-term financing. While the typical turn-around time for export credit for a

manufacturer is three to six months, construction typically requires longer-term financing

and will not be helped at all with short-term working capital loans (unless these are rolled

over into what is in effect long-term financing). The lack of long-term financing is

therefore likely to be more of a problem to the construction business compared to

manufacturing, access to credit being equal. Since the construction business is highly

cyclical, the bankers we interviewed asserted that they would give credit in upward

cycles but not in downward cycles. This might mean that the construction business is

regularly starved for credit, creating an impression of long-term finance being more of an

obstacle. We do not have data to investigate this further.

Holding savings rate constant shows a more specific impact of trust patterns.

Increased family importance is associated with long-term finance being more of an

85
obstacle to doing business.124 This is even more aligned with our qualitative findings than

trust in general being important for financing. Family importance, which causes a special

version of agency problems, shields the company from influence by other potential

investors. Ironically, such companies are more dependent on bank finance while our

qualitative studies in Peru and Argentina show that the banks are skeptical of tightly-held

family companies because of their lack of transparency.125

It is not only the liquidity available at various maturities that affects the

availability of long-term funds. The ability of the financial system to turn over these

funds is also likely to impact the way banks match their balance sheets. Previous research

has established that with financial liberalization in Latin America and East Asia, banks

have tended to lend more short-term.126 From existing empirical research we know that

financial liberalization tends to reduce financing constraints for relatively smaller firms,

and increase them for relatively larger firms.127 We can perform an empirical

investigation of this hypothesis on long-term debt using a limited number of countries.128

The measure of financial liberalization that we use is based on interest rate regulations,

124
This measure is the country average of respondents’ ranking of how important family is in their life on a
scale from 1 to 4.
125
When we interact family importance with company size, the interaction is not significant.
126
Schmuckler and Vesperoni, 2001, Globalization and firms' financing choices: Evidence from emerging
economies . Argentina is part of their sample, Peru is not.
127
Laeven, 2000, Does financial liberalization relax financing constraints on firms? . Note that their
definition of small firms is a firm smaller than the sample median of net sales. Since the firms in their
sample tend to be listed, this is not a definition of a small firm that is comparable to our definition.
128
We retain Argentina, Brazil, Chile, Indonesia, Malaysia, Mexico, Pakistan, Peru, and the Philippines.
This gives us a total of 9 firms. The measure of financial liberalization is available from 1988 to 1998. We
use the level of financial liberalization in 1992 and 1995 because these years have useful variance in the
measure for financial liberalization. The year 1995 is the latest year with a useful variance in the measure.
The level of financial liberalization in 1992 does not have significant impact while the level of financial
liberalization in 1995 does.

86
entry barriers in the banking industry, reserve requirements and credit controls,

government control of banks, and prudential regulation.

The level of financial liberalization five years before the firm-level survey is

associated with smaller obstacles from the lack of long-term financing for all types of

firms. We do not know from the empirical data whether the significance is due to banks

extending more long-term loans or firms finding other sources of financing in a

liberalized system so that the banks’ unwillingness to supply long-term credit poses less

of an obstacle. Our qualitative research in Peru and Argentina suggests that financing

options such as leasing and supplier credit have become increasingly available to SMEs,

while corporations can borrow abroad and thus are less constrained by local banks’

policies.

Holding the level of financial development five years before the survey constant,

we see that it is the medium-sized companies that experience problems obtaining credit

long-term compared to larger companies. This corresponds with our qualitative findings

from Peru and Argentina: medium-sized companies experience a ‘glass-ceiling’ where

they are unable to obtain the long-term financing that is required in order to grow into a

large company.

The financial development variable does not take into account the quality of

creditor rights, the quality of the legal system, or the development of credit registries.

Holding financial development constant, the legal variables take on significance. In our

sample of countries with measures for financial development, long-term finance is less of

an obstacle when creditor rights are better, as one would expect. (We measure creditor

rights by how creditors are treated in bankruptcy or default-triggered reorganization).

87
 The effect of better information is ambiguous. Holding financial liberalization

constant, better public credit registries make it more difficult for firms to obtain long-

term financing. However, a higher degree of financial liberalization is likely to lead to

several channels of information dissemination, such as more accurate financial

statements, accounting standards, and higher transparency, so that there might be

substitutes for the lack of credit registries. The credit rights index, on the other hand, is a

fairly constant measure across time because of its reliance on the legal origin of a legal

system.129 This variable is therefore shielded from the relatively short-term financial

liberalization dynamics, and it is consistent with our expectations that better creditor

rights give increased access to long-term financing.

Holding the degree of financial liberalization constant, increasing procedural

complexity in enforcing debt contracts leads to more problems associated with obtaining

long-term finance. When the terms of a loan are longer, the risk associated with the loan

is higher, everything else being equal, the capacity of the courts to enforce the contract in

case of default becomes increasingly important. For short-term contracts, the banks are

willing to take the risk associated with a slow or inefficient legal system, but less so over

longer terms.130 This is consistent with what our interviewees expressed.

129
LaPorta, et al., 1998, Law and finance , Beck, et al., 2002a, Law and finance: Why does legal origin
matter? ,Djankov, et al., Doing business
130
When we use a general financing constraints measure as the dependent variable in the same model,
procedural complexity is not significant while the governance variable rule of law remains significant.

88
 Previous research has shown that financial liberalization makes it easier for

smaller firms to obtain long-term financing, while it gets more difficult to obtain such

financing for large firms. 131 We use our dataset to investigate this, as shown in Figure 13.

Figure 13

Financial liberalization and financing as obstacles to doing business

The ordered probit regression estimated in (1) and (3) is: Lack of access to long-term financing as an obstacle to doing business = α +
β Political stability index + β Court Powers Index + β Procedural Complexity Index + β Public Credit Registry Index + β Creditor
Rights Index + β GNI per capita + β Firm age + β Foreign ownership dummy + β Sales + β Multinational dummy + β Government
ownership dummy + β Degree of financial liberalization in country + β Interaction between firm size and the degree of financial
liberalization + u.
The ordered probit regression estimated in (2) and (4) is: Lack of access to financing in general as an obstacle to doing
business = α + β Political stability index + β Court Powers Index + β Procedural Complexity Index + β Public Credit Registry Index +
β Creditor Rights Index + β GNI per capita + β Firm age + β Foreign ownership dummy + β Sales + β Multinational dummy + β
Government ownership dummy + β Degree of financial liberalization in country + β Interaction between firm size and the degree of
financial liberalization + u.
R-squared are McKelvey and Zavoina (1975). We use ordered probit as the dependent variable is ordered categorical from
1 to 4.

(1) (2) (3) (4) (5) (6)

L-t finance Finance is L-t finance Finance is L-t finance Finance is
obstacle obstacle obstacle obstacle obstacle obstacle
Political -0.302 -0.257 -0.302 -0.257 -0.302 -0.257
stability index
(3.20)*** (3.20)*** (3.20)*** (3.20)*** (3.20)*** (3.20)***
Court power index 0.002 -0.003 0.002 -0.003 0.002 -0.003
(0.62) (1.92)* (0.62) (1.92)* (0.62) (1.92)*
Procedural 0.005 0.004 0.005 0.004 0.005 0.004
complexity index
(1.32) (1.15) (1.32) (1.15) (1.32) (1.15)
Credit registry 0.009 -0.001 0.009 -0.001 0.009 -0.001
index
(3.78)*** (0.39) (3.78)*** (0.39) (3.78)*** (0.39)
Creditor rights -0.537 -0.197 -0.537 -0.197 -0.537 -0.197
index
(5.99)*** (4.32)*** (5.99)*** (4.32)*** (5.99)*** (4.32)***
GNI per capita 0.000 0.000 0.000 0.000 0.000 0.000
(3.31)*** (1.48) (3.31)*** (1.48) (3.31)*** (1.48)
Firm age -0.002 -0.000 -0.002 -0.000 -0.002 -0.000
(0.96) (0.16) (0.96) (0.16) (0.96) (0.16)
Foreign ownership -0.275 -0.239 -0.275 -0.239 -0.275 -0.239
(2.70)*** (2.83)*** (2.70)*** (2.83)*** (2.70)*** (2.83)***
Sales $mn -0.000 -0.000 -0.000 -0.000 -0.000 -0.000
(2.62)*** (1.39) (2.62)*** (1.39) (2.62)*** (1.39)
Multinational -0.131 -0.157 -0.131 -0.157 -0.131 -0.157
(1.31) (1.83)* (1.31) (1.83)* (1.31) (1.83)*
Government 0.120 0.095 0.120 0.095 0.120 0.095
ownership
(0.58) (0.59) (0.58) (0.59) (0.58) (0.59)
Financial -0.152 -0.074 -0.175 -0.095 -0.157 -0.041
liberalization 95

131
Laeven, Financial liberalization finds that large firms face increasing long-term financing constraints as
a country liberalizes whereas small firms face fewer financing constraints.

89
 (1.76)* (1.10) (2.00)** (1.41) (1.83)* (0.63)
Financial -0.005 0.033 0.018 0.054
liberalization 95
* small firm
(0.26) (1.94)* (0.82) (2.60)***
Financial -0.023 -0.021 -0.018 -0.054
liberalization 95
* large firm
(1.14) (1.13) (0.82) (2.60)***
Financial 0.023 0.021 0.005 -0.033
liberalization 95
* medium sized
firm
(1.14) (1.13) (0.26) (1.94)*
Observations 926 1113 926 1113 926 1113
R-squared 0.181 0.083 0.181 0.083 0.181 0.083
Countries 9 10 9 10 9 10
LR Chi2 151.137 79.726 151.137 79.726 151.137 79.726
Absolute value of z-statistics in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%

We do not find such effect when interacting firm size with long-term financing

constraints, on the contrary: Financial liberalization makes all firms perceive fewer

obstacles related to long-term financing, but there is no significant interaction effect by

company size.132

When it comes to finance as an obstacle in general, the interaction with firm size

is significant, although this model has a much lower fit than when explaining the lack of

long-term loans as an obstacle to doing business. Smaller firms perceive larger obstacles

related to finance in general as financial liberalization increases compared to large and to

medium-sized firms. When comparing medium and large firms to small firms, we

observe that both categories have fewer problems with finance in general as a country

liberalizes its financial sector. This fits our observations in Argentina. While the state-

132
Note that we discuss both a different situation and different data than Ibid.. Their analysis is time-series
the effect of liberalizing over time, our analysis is static, i.e., the relationship to the level of financial
liberalization five years before. Our model explains a very small portion of the variance while using the
general financing constraint as a dependent variable, whereas the model fits well its intended purpose, i.e.,
explaining the access to long-term finance as an obstacle. The data used in Laeven, Financial liberalization
suffer from being drawn from a database that focuses on listed, and thus large firms. Our model has the
advantage that it uses data that span a wide range of companies; the model in Laeven, Financial
liberalization has the advantage of a time-series.

90
owned Banco de la Nación Argentina was an ‘SME-bank’ before the liberalization of the

economy in the 90s, it is now in a process of ridding itself of the bad debt, and has much

higher standards for the evaluation of SME lending than it had before. The other banks

we interviewed in Argentina do not lend much to small companies, and in Peru the small

companies that are too large for micro-finance are in the same situation as their

counterparts in Argentina.

According to the theory reviewed above, financial liberalization should enable

entrepreneurs to start companies. If this is true, and our observation that there is a glass

ceiling through which companies have a problem breaking (either because they want to

stay small or because they cannot get the finance to expand) is correct, or if entrepreneurs

start companies and not all of them make it big because not all inventions merit large-

scale production, we would expect the SME sector to increase as a country liberalized its

finance. It does not, however, appear to be any significant relationship between these two

variables.

Figure 14
90

financial liberalization in 1995

financial liberalization in 1993 chl
SME sector part of labor force
80

idn
70

arg arg
twn per per
phl phl
60

bra bra
50

mex mex

1 2 3 4 5 6
Degree of financial liberalization

(Data: Laeven (2000), Beck, Ayyagari et al. (2003))

91
We have reviewed how banks use non-legal mechanisms to monitor their borrowers.

Now, we will move on to the legal instruments that banks use to monitor their loans.

Reducing monitoring costs: Using collateral and contracts to bring more lenders under
the interest rate ceiling

In much financial literature, banks are assumed to use collateral and contract design to

reduce the risk associated with their portfolio, and to increase the interest rate to reflect

the risk of a credit line. We have reviewed some of this literature related to Standard Debt

Contracts earlier, and we found that banks use SDCs not because they allow non-

monitoring, but because they allow for organizational streamlining.

If interest rates were perfectly flexible, all firms would be able to obtain credit at

some cost. But, as our qualitative research in Peru and Argentina has shown, many firms

are excluded from bank financing. Banks prefer to keep rates low, for example in order to

meet a perceived competitive rate, and ration credit.133 One reason for this, as we have

described elsewhere, is that banks do not have the tools to match interest rates and risk.134

Rather, the banks are rate-takers, where a rate per business segment (mid-size market,

corporations) is established in the market, and banks use other terms, such as maturities

133
Williamson, 1986, Costly monitoring, financial intermediation, and equilibrium credit rationing
134
This explains findings such as the ones in Wyznikiewicz, et al., 1995, Coping with capitalism: The new
polish entrepeneurs , where the main obstacle to doing business for small entrepreneurs is access to finance,
independent of interest rate. It also explains why smaller companies face higher financing obstacles in
WorldBank, Wbes , see Beck, et al., 2002, Financial and legal constraints to firm growth : Does size
matter? , and is contrary to one assertion we encountered interviewing an economist at a Washington, D.C.-
based IFI, that special development programs for SMEs were pointless because increased risk associated
with smaller companies would be passed on to the borrower through the interest rate.

92
and collateral (both mainly as monitoring mechanisms), to balance the risk. This would

explain the credit rationing to industries and firm sizes that we have observed.

In such a state, reducing the risk associated with the loan portfolio would be likely

to give more firms access to credit, and this leaves us with the other two means

introduced earlier: the use of collateral, and the design of contracts.135 When the borrower

has higher net worth, there is likely to be less of an agency problem because part of the

net worth can be used as collateral which makes banks face less risk associated with this

part of their portfolio.136 If banks in general are able to reduce the agency costs across

their portfolio, the average risk will decrease, and fewer firms are likely to face credit

rationing. Similarly, if banks are able to design optimal contracts with the appropriate

monitoring, and if these contracts correspond with the perceived competitive interest rate,

the banks’ risk profile is reduced.137

This perspective assumes that collateral is a way for banks to reduce the risk

associated with their lending portfolio. However, our qualitative findings in Peru and

Argentina indicate that banks use collateral rather as a monitoring mechanism of the

management or the owner of the borrowing firm. It does not appear that the banks

interviewed expect to recover much if any of their collateral in the case of default, and

they expect to recover only a small fraction of moveable collateral. Neither do they

expect to be able to enforce the debt contracts in court unless there is real estate as

135
That the use of collateral brings more firms under the credit umbrella is a version of the argument made
in Fleisig, The power of collateral , but rather than provide access to finance based on moveable collateral,
the availability of collateral reduces the impact of credit rationing.
136
Bernanke and Gertler, Agency costs, net worth, and business fluctuations
137
VonThadden, Long-term contracts, short-term investment and monitoring

93
collateral, in which case they expect to recover around 50% of the collateral’s market

value. Since the bankers expect funds to SMEs be diverted unless they are closely

monitored, there is substantial monitoring. Contract design to minimize monitoring,

primarily using the payment of installment, interests, and default as the information about

the borrower, is relevant for corporate lending, but the corporate clients have an abundant

choice of financing.

In Peru and Argentina, collateral requirements seem more of a requirement to

obtain finance than a real reduction of portfolio risk, at least as the banker who makes the

lending decision is concerned. Generally the information prior to entering into the loan

agreement regarding the value of collateral after a future default is so weak that it plays

only a minor role in risk assessment, if any role at all. Collateral is important as a way of

obtaining bargaining power over the borrower and is generally a requirement for

obtaining financing. These observations do not correspond well with theories that

emphasize the regulatory framework on collateral as a major determinant of bank

lending.

Such theories that base the development of finance on the legal framework have

become increasingly popular and sophisticated. From assertions based on the legal origin

of a country as an explanation for the quality of the legal framework, the literature in its

current state uses narrowly defined variables to describe aspects of the financial legal

framework. We will look at some of this literature and see how its assumptions fit with

our observations. In particular, we will look at how the different perspectives on

institutions (law is part of the institutional framework) lead to different perspectives on

bank lending. Then we will look at the bankers, and companies, financing patterns in

94
order to judge whether the theories that predict impact from law onto banking decisions

are a good description of reality according to our analysis.

We start with theories about how the legal origin of a country determines its legal

environment, because the use of legal origin has had profound impact in the field and is

responsible for the revival of the use of law in the analysis of finance. We will also

compare this to other governance-related variables because we believe that this early

literature is more descriptive of governance than of financial legislation. Then we will

look at micro-level research and reforms in the framework for secured lending to see if

this can help us understand how the framework for secured transactions affects credit

decisions. We will review our findings based on other literature and qualitative research

in Peru and Argentina about how firms finance themselves and see how they fit with this

theory, and we will use cross-country investigations to see if our findings are likely to be

a good description for a larger sample of countries.

Lastly we will suggest alternative explanation of bankers’ behavior in the use of

legal frameworks in making credit decisions. In this section, which is based on our

interviews in Peru and Argentina, we will focus much more on mechanisms that

substitute for law than on law itself, and we will test our findings empirically.

The connection between law and finance – macro-level

evidence
Recent research on finance has focused strongly on the impact of legal and regulatory

quality on financial development, financial structure, and growth. The differences in legal

quality is traced to the origin of the legal framework, building on how four major legal

systems, English, French, German, and Socialist through colonies and alliances, came to

dominate the world’s legal systems. In addition there is the hybrid Scandinavian legal

95
system, which is considered apart from the others. Dividing countries into these five

categories has allowed explaining differences in how different countries protect investors

and creditors, as well as other legal characteristics.138

There are problems, however, in using legal origin as an explanatory variable.

First, the quality of the legal system is strongly correlated to other governance

variables.139

Figure 15
| Voice Stability Effic. Law Corruption
-------------------------------+-------------------------------------------------
Voice and accountability index | 1.0000
Political stability index | 0.7012 1.0000
Government efficiency index | 0.7262 0.8244 1.0000
Rule of law index | 0.7451 0.8254 0.9382 1.0000
Control of corruption index | 0.7159 0.7926 0.9321 0.9363 1.0000
161 observations
(Data: Kaufmann, Kraay et al. (2003))

This comparison makes it difficult to distinguish between which parts of a country’s

standard of governance relate to the legal system and which parts relate to other

governance aspects using cross-country empirics. This is not only a question of

quantitative methodology. Law forms the regulatory basis for governance, and

governance is what decides the regulatory process. In the real world, there is considerable

interaction between various governance variables such as the rule of law, political

stability, government efficiency, voice and accountability, and the control of corruption.

Asserting that colonial origin has led to transplantation of the legal system, which again

has led to certain legal qualities, it is hard to distinguish from asserting that colonial

origin has led to transplantation of bureaucratic and political culture which again has led

138
LaPorta, et al., Law and finance
139
Kaufmann, et al., Governance matters

96
to certain regulatory outcomes. Institutional quality can hardly be separated from

regulatory quality, because institutions are what enact regulations and prepare and

enforce law – the one is largely pointless without the other. Legal institutions also

interact with the power-struggle to control institutions.140 Furthermore, what is covered

by the concept ‘institutions’ is frequently not clear.141 One may categorize institutions in

various ways, but whatever the classification, the interaction makes it difficult to isolate

the various categories quantitatively.142

While it is clear that institutions affect development, it is far from clear that the

transplantation of institutional and bureaucratic culture is influenced mainly by colonial

origin. It may very well, for instance, be influenced by trade, geography, traditional

values, or religion.143 For example, if we regress governance variables on legal origin,

religion, and geography, we see that geography is at least as good a predictor of

governance quality as legal origin; see Figure 16.144 Here we obtain a typical result from

legal origin-based regressions: that French and Socialist legal origin have a high impact

140
Glaeser and Shleifer, 2002, Legal origins
141
The work of North, 1981, Structure and change in economic history encompasses many different
aspects of institutions. Glaeser and Shleifer, 2003, The rise of the regulatory state show how political and
legal institutions may develop in parallel and may complement or substitute for each other.
142
Acemoglu and Johnson, Unbundling institutions divides institutions into ‘contracting institutions’ and
‘property rights institutions’ in order to obtain quantitative estimates.
143
Hattenhauer, 1999, Europäische rechtsgeschichte , Engerman and Sokoloff, 1996, Factor endowments,
institutions, and differential paths of growth among new world economies: A view from economic
historians of the united states , Acemoglu, et al., 2001a, The colonial origins of comparative development:
An empirical investigation, Acemoglu, et al., 2001b, Reversal of fortune: Geography and institutions in the
making of the modern world income distribution , Inglehart, 1997, Modernization and postmodernization :
Cultural, economic, and political change in 43 societies , Keefer, et al., 2002, Social polarization, political
institutions, and country creditworthiness .
144
An additional complication that we do not address here is that institution-building may be influenced by
the level of social equality in the colonies; see Engerman and Sokoloff, 2002, Inequality before and under
the law: Paths of long-run development in the americas .

97
on regulatory (governance) output. Note that religion is not significant in explaining these

governance variables.145

Figure 16

Governance and legal origin, religion, and geography

The OLS regression estimated is: Governance quality variable = α + β Legal orgin + β Region + β Share of religion + β
Latitude + u

(1) (2) (3) (4)

Control of Political stability Rule of law index Government
corruption index effectiveness
French -0.462 -0.279 -0.587 -0.456
(-0.220)*** (-0.148) (-0.293)*** (-0.231)***
German -0.054 0.193 -0.013 0.012
(-0.017) (0.068) (-0.004) (0.004)
Socialist -1.150 -0.583 -1.093 -1.067
(-0.320)*** (-0.181)* (-0.319)*** (-0.316)***
Europe Central Asia -1.465 -1.307 -1.410 -1.423
(-0.545)*** (-0.542)*** (-0.551)*** (-0.565)***
Middle East North -0.631 -0.725 -0.338 -0.585
Africa
(-0.188)** (-0.241)** (-0.106) (-0.186)*
Sub-Saharan Africa -0.774 -0.753 -0.689 -0.634
(-0.312)*** (-0.339)*** (-0.292)*** (-0.273)***
South Asia -1.254 -1.515 -1.157 -1.173
(-0.232)*** (-0.312)*** (-0.225)*** (-0.231)***
East Asia Pacific -0.592 -0.205 -0.347 -0.019
(-0.165)* (-0.063) (-0.101) (-0.006)
Muslims/ population -0.001 0.001 -0.001 0.001
(-0.045) (0.039) (-0.024) (0.049)
Catholics/ -0.003 -0.001 -0.001 0.000
population
(-0.094) (-0.045) (-0.054) (0.011)
Protestants/ 0.002 -0.003 0.000 -0.002
population
(0.038) (-0.058) (0.007) (-0.034)
Latitude 3.236 3.039 3.200 3.340
(0.586)*** (0.613)*** (0.609)*** (0.645)***
Constant 0.126 -0.119 0.102 -0.107
(0.119) (-0.126) (0.102) (-0.108)
Observations 127 127 127 127
R-squared 0.66 0.59 0.67 0.62
F-stat 18.06 13.47 19.52 15.77
Prob > F 0.000 0.000 0.000 0.000
Normalized beta coefficients in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%

145
Barro and McCleary, 2002, Religion and political economy in an international panel, Barro and
McCleary, 2003, Religion and economic growth find impact of religious attitudes on economic growth,
and Guiso, et al., 2003a, People's opium? Religion and economic attitudes finds impact of specific
religions on conditions for economic growth.

98
Rather than to be treated as an explanatory variable, legal origin is better used as a

classifying variable that correlates to certain legal and/or institutional features; thus, legal

origin may successfully be used as an instrumental variable in regressions. Drawing

conclusions based on a direct causality from a country’s legal origin to such dependent

variables as growth is not convincing because no research we have reviewed has

succeeded in delivering an argument about causality from legal origin that is robust

against impact from other governance-related factors.

Another problem in using legal origin to explain outcomes such as financial

development is that legal origin is vague as a concept. Legal origin may best be perceived

as a broader cultural-historical variable that captures certain aspects of a country’s

institutional history. There is no causal effect directly from legal origin to any measurable

output. There may be a causal effect from such provisions as protection of creditors (this

would make it more attractive to be a creditor) to the level of financing, but the face that

a country has a specific legal origin has no immediate consequences on the behavior of

economic agents, which has led to a large effort to quantify legal qualities in greater

detail.146 There is now available a large array of variables describing specificities of legal

systems, which are likely to have a relatively immediate causal impact on behavior.

Furthermore, legal origin is useless for policy formulation. A country cannot

change its legal origin. It can, however, change the quality of its legal system through

changing the way courts operate, the laws on the books, access to courts, and the

146
Djankov, et al., Doing business , Djankov, Courts

99
reliability of judges.147 Identifying which variables have more impact in each country is,

however, dependent on a micro-level, case-by-case study. Cross-country correlates can

give only an idea about where to start looking.

The availability of specific governance and law variables has given rise to the

‘new comparative economics,’ where the focus is to understand how “efficient

institutions, the consequences of colonial transplantation, and the politics of institutional

choice” affect economic development.148 This ‘comparative economics’ has become

increasingly sophisticated as more data have become available. The residual criticism of

the ‘new comparative economics’ seems to occasionally be based on misconceptions

about what ‘legal origin’ means and possibly a failure to recognize the nature of broad,

categorical variables.149 Since one cannot determine what lies in ‘legal origin,’ and since

legal origin is likely to encompass an institutional culture based on colonial past, it may

be used to explain, quantitatively, relationships that do not have substantiated theory

behind them. This is the same result as one would encounter if using one governance

variable (such as political stability) in the place of another highly correlated variable

(such as corruption), where one would obtain acceptable results to explain a model that,

to be consistent with the theory, requires the use of the first variable (corruption, in our

example).

147
Beck, et al., 2001c, Law, politics, and finance
148
Djankov, et al., 2003, The new comparative economics
149
See as an entertaining example West, 2002, Legal determinants of world cup success who explains
Soccer World Cup success using legal origin. He finds that French legal origin explains success in soccer,
quite naturally since both Latin Europe and Latin America excel in soccer and make up the majority of
countries with French legal origin. The essay illustrates the pitfalls of using broad categorical dummy-
variables as causal explanations. West also finds that the rule of law has a significant impact. He does not
seem to agree that governance might be significant in developing nation-wide team-sports.

100
 In order to understand what explains various legal and governance characteristics,

we can look at how these variables correlate with the categorical variables that have been

used as explanatory in previous research.150 We compare indices describing legal

qualities and indices describing the quality of governance.

150
Below we include Credit registry index, which, strictly speaking, is not a legal or governance index.
However, since it belongs to the same group of data as the other indices and since we use this variable in
some of our analysis, we include it for clarity’s sake.

101
Figure 17

Legal origin Religion Geography

French English German Scandi. Socialist Protestant Muslim Catholic Latitude

Bankruptcy -0.3704* 0.1566 0.1513 0.3118* 0.0388 0.3859* -0.1548 -0.0197 0.4689
index 0 0.0799 0.0909 0.0004 0.6661 0 0.0836 0.8264 0
126 126 126 126 126 125 126 126 126

Courtpowers 0.3733* -0.3380* -0.0073 -0.1786* -0.0247 -0.2810* 0.1912* 0.0415 -0.2454
index 0 0.0001 0.9355 0.0454 0.7835 0.0015 0.032 0.6446 0.0056
126 126 126 126 126 125 126 126 126

Hiring 0.3642* -0.4307* -0.0832 0.0537 0.0852 -0.1509 -0.0165 0.2217* 0.0286
index 0 0 0.3483 0.5459 0.3373 0.0891 0.8532 0.0116 0.7479
129 129 129 129 129 128 129 129 129

Employment 0.3195* -0.4075* 0.0257 -0.3401* 0.2352* -0.4482* -0.0178 0.2667* 0.0172
index 0.0002 0 0.7724 0.0001 0.0073 0 0.8412 0.0022 0.8466
129 129 129 129 129 128 129 129 129

Firing index 0.2663* -0.3135* -0.1251 -0.0774 0.2045* -0.2061* -0.0849 0.2463* -0.1239
0.0023 0.0003 0.1579 0.3834 0.0201 0.0196 0.3389 0.0049 0.1617
129 129 129 129 129 128 129 129 129

Labor law 0.4285* -0.5175* -0.0832 -0.1689 0.2376* -0.3681* -0.0486 0.3309* -0.037
index 0 0 0.3486 0.0556 0.0067 0 0.5843 0.0001 0.677
129 129 129 129 129 128 129 129 129

Procedural 0.5588* -0.4458* -0.0766 -0.1683 -0.0975 -0.3755* 0.0647 0.3518* -0.172
index 0 0 0.3959 0.0606 0.2793 0 0.4732 0.0001 0.0551
125 125 125 125 125 124 125 125 125

Credit 0.3661* -0.2868* 0.0796 -0.167 -0.1841* -0.2847* 0.0288 0.3138* -0.0933
registry 0 0.0012 0.3773 0.0626 0.0399 0.0013 0.75 0.0004 0.3005
index 125 125 125 125 125 124 125 125 125

Creditor -0.3414* 0.1963* 0.2184* -0.0278 0.0563 0.1142 -0.1247 -0.0788 0.1114
rights 0.0001 0.0264 0.0133 0.7558 0.5277 0.2012 0.1609 0.3768 0.2105
index 128 128 128 128 128 127 128 128 128

Voice & -0.1575 -0.0312 0.2819* 0.3046* -0.1857* 0.3824* -0.5053* 0.3433* 0.4214
account. 0.077 0.7278 0.0013 0.0005 0.0366 0 0 0 0
127 127 127 127 127 173 175 175 175

Political -0.1257 -0.0875 0.2607* 0.2854* -0.1193 0.2786* -0.2391* 0.1454 0.4778
stability 0.1575 0.3263 0.003 0.0011 0.1798 0.0004 0.0022 0.0649 0
128 128 128 128 128 160 162 162 162

Gov't -0.1367 0.0418 0.2227* 0.3093* -0.2657* 0.2972* -0.1941* 0.1081 0.4604
efficiency 0.124 0.6391 0.0115 0.0004 0.0024 0.0001 0.0103 0.1555 0
128 128 128 128 128 172 174 174 174

Rule of -0.2202* 0.1077 0.2278* 0.3480* -0.2500* 0.3444* -0.2176* 0.0964 0.4779
law 0.0125 0.2264 0.0097 0.0001 0.0044 0 0.0038 0.2044 0
128 128 128 128 128 173 175 175 175

Control of -0.1684 0.0581 0.1955* 0.3979* -0.2577* 0.4042* -0.2635* 0.1112 0.4804
corruption 0.0574 0.5149 0.027 0 0.0033 0 0.0004 0.144 0
128 128 128 128 128 172 174 174 174

Pairwise correlations with significance and number of observations. * = significant at the 5% level.
Note that there are only four countries with Scandinavian legal origin in the sample.
(Data: LaPorta, Lopez-de-Silanes et al. (1998), Kaufmann, Kraay et al. (2003), LaPorta, Lopez-de-Silanes et al.
(2002))

102
Looking at correlations between legal origin and legal and governance indicators (Figure

17), we see that French and English origin is significantly correlated to the legal indices.

For Latin America in particular, the Napoleonic code is said to offer weak shareholder

and creditor protection and causes uninformative financial statements.151 German legal

origin, however, is only significantly correlated to the governance indicators, and

Scandinavian legal origin mostly to the governance indicators. In fact, the share of

Protestants and Catholics is more significantly correlated to the legal indices than what

are German and Scandinavian legal origin, and Protestantism and Islam are significantly

correlated to both legal and governance indices. Geography is higher correlated than any

other measure to the governance indicators, but not significantly correlated to the legal

indices. This suggests the following: French legal origin is explanatory for legal qualities,

German and Scandinavian legal origin is explanatory for governance, and religion might

be as good an explanation of legal and governance qualities as legal origin is.152

To try to understand what ‘legal origin’ explains, we may look at the variance

legal origin accounts for in the legal and governance indicators when the latter are

regressed on legal origin; see Figure 18. To compare legal origin with other

historically/culturally oriented variables, we perform the same operation substituting

religion and latitude for legal origin.

151
Levine, Napoleon and LaPorta, et al., Law and finance
152
Stulz and Williamson, 2001, Culture, openness, and finance finds that legal origin is more important in
explaining laws protecting equity holders, and religion is more important in explaining laws protecting
creditors. Such results should inspire further research to find the true causal channels.

103
Figure 18

Legal/institutional index: Which model explains the index best: What element of legal origin contributes to the
explanation:
Dependent variable R-squared when using… Legal origin significant at the 95% level
Index Legal Religion Geography French German Scandi Socialist
origin
Bankruptcy index 0.20 0.15 0.23 ‡ X X
Court power index 0.10 0.06 0.22 ‡ X X
Hiring flexibility index 0.22 ‡ 0.07 0.00 X X X
Employment law index 0.33 ‡ 0.25 0.00 X X X X
Layoff flexibility index 0.16 ‡ 0.10 0.02 X X
Labor regulation index 0.37 ‡ 0.23 0.00 X X X
Procedural complexity 0.35 ‡ 0.26 0.03 X X
index
Credit registry index 0.19 ‡ 0.17 0.01 X X
Creditor rights index† 0.14 ‡ 0.05 0.01 X
Voice/Account index 0.20 0.34 ‡ 0.18 X X
Political stability index 0.16 0.11 0.23 ‡ X X
Government effectiveness 0.21 0.11 0.22 ‡ X X
Rule of law index 0.25 ‡ 0.14 0.24 X X X
Control of corruption 0.26 ‡ 0.19 0.24 X X
This table reports R-squared for regressing the various legal and governance indices on legal origin, religion, and geography,
respectively. The individual regressions are in Appendix A. We only report R-squared as this is what allows us to compare OLS and
ordered probit. The purpose is to see which of the sets of the broad explanatory variables (legal origin, religion, or geography) that
provides a better explanation for each of the detailed legal and governance measures (Bankruptcy index, Court power index, etc.)

† is ordered probit and R-squared is McKelvey and Zavoina (1975), the other regressions are OLS. English legal origin is dropped.
‡ marks the best explanatory variable for an index. Note that there are only four countries with Scandinavian legal origin in the
sample.

If we look at the variance measured through R squared, we see that legal origin is better

at explaining the legal indices. When we get to the governance indices, however, the

picture is more mixed. Religion is the better explanatory variable for Voice and

Accountability, and Geography is better for Political Stability. As for Government

Efficiency, Rule of Law, and Corruption, geography and legal origin are virtually in a tie.

Looking at which legal origins are significant in the different specifications, we

see that French legal origin consistently explains legal indices and not governance

indices. German legal origin explains some legal indices, Voice and Accountability, and

Political Stability; Socialist legal origin is significant for labor law, Government

Efficiency, Rule of Law, and Corruption.

104
 These inconsistencies in which legal and governance indices are explained by

legal origin suggest that there are underlying variables that would better explain legal

quality and governance than legal origin, religion, and geography. This is in particular

strengthened by regressing the various indices on legal origin, religion, and geography

simultaneously, which causes a large loss of significance for the explanatory variables

see Appendix A. Legal origin retains significance only as explanatory variables for

Political Stability, Government Effectiveness, Rule of Law, and Corruption. If we

remove the four Scandinavian countries from the sample, legal origin as a general

explanatory variable loses significance except for Socialist legal origin, which impacts all

governance variables at the 1% significance level, which suggests that there are variables

that explain the legal indices better than does legal origin.153

How do legal differences develop?

Finance impacts growth. The debate used to focus on whether bank- or market-based

financial systems were better for growth. It now appears that there are underlying

characteristics that impact growth, such as regulatory quality, rather than simply if a

country has developed the bank or market side of its financial system.154 With the recent

availability of variables that describe, on various levels, characteristics about a regulatory

153
Generally throughout these regressions it appears that the explanatory variable is rather French legal
origin than legal origin in general. Socialist legal origin explains labor-related law, except that the
significance of legal origin is scattered. This means that when investigating one single legal variable we
may say that certain legal origins explain this variable, which is different from saying that legal origin in
general explains legal and governance quality. Empirically Levine, 1998a, The legal environment, banks,
and long-run economic growth shows that legal origin and selected specific legal variables give similar
results in explaining banking development.
154
Beck, et al., 2000, Financial structure and economic development: Firm, industry, and country evidence
, Levine and Zervos, Stock markets, banks, and economic growth , Demirguc-Kunt and Maksimovic, Law,
finance and firm growth , Rajan and Zingales, Financial dependence

105
framework that seem to have a causal impact on finance, the question becomes how this

causality works.155

One may divide the law and finance theories into 1) the “law and finance” view,

which holds that legal traditions decide the comparative rights of individuals versus the

state, and that this power relationship impacts financial development; 2) the “dynamic

law and finance” view, which emphasizes the ability of different legal traditions to adapt

to change; and 3) the “politics and finance” view, which focuses on political influence on

financial development rather than law.156

The two main components of the “law and finance” view holds that “in countries

where legal systems enforce private property rights, support private contractual

arrangements, and protect the legal right of investors, savers are more willing to finance

firms and financial markets flourish,” and that differences in how countries do this

occurred because of colonial transplants.157 The legal systems that subsequently were

able to adapt to changing circumstances generated more financial development.158

There is debate over whether legal origin has had a significant impact on creditor-

related laws and thus financial development. Some theories rather stress the political

development and the competition for power among various stakeholders throughout

history, especially between incumbents and challengers.159

155
Beck, et al., 2003, Law, endowments, and finance
156
Beck, et al., Law, politics ,Beck, et al., Law and finance: Why does legal origin matter?
157
Beck and Levine, 2003b, Legal institutions and financial development
158
Merryman, 1985, The civil law tradition: An introduction to the legal systems of western europe and
latin america
159
Rajan and Zingales, Saving capitalism, Rajan and Zingales, 2003c, The great reversals: The politics of
financial development in the twentieth century . For a contemporary analysis, see Zingales and Rajan,
2003, Banks and markets: The changing character of european finance .

106
 Looking at the historical development of Europe’s various legal systems, one may

trace the political developments that led to the various legal systems’ distinctions, such as

the French Revolution ultimately leading to less discretion on the part of judges or the

German universities’ work to develop broad and flexible legal principles after

Bismarck.160 However, if such historical events were important in developing these legal

systems, then, given that colonial expansion had been underway for over a century, one

would expect other country-specific events to be equally important within each separate

colony, so that the common legal origin should be of less importance. The Scandinavian

legal system scores high on creditor protection, although Scandinavia has a culture of

statism; at the same time statism is blamed for the French legal system’s failure to

provide creditor protection.161

For Latin-America in particular, the transplantation of French law is argued to

have had particularly crippling consequences, making the colonies worse off than the

European countries with French legal systems. The reason is that what was transplanted

was the law on the books and not the legal culture and jurisprudential subtleties that are

crucial for a flexible application of the law.162 Countries with French legal origin

consistently score the lowest among non-socialist societies on most measures of legal

160
Beck and Levine, 2003a, Legal institutions and financial development . For a discussion of how
principles impact jurisprudence, see Dworkin, A matter of principle . Dworkin’s theory suggests that legal
systems based on principles are more flexible in creating regulations than legal systems based on more
defined rules (“policies”). This may explain the success of common law-systems in adapting to changing
circumstances and as such promoting financial development.
161
For the Scandinavian case, Coffee, 2001, Do norms matter? A cross-country examination of the private
benefits of control argues that social cohesion has caused the low level of expropriation from Scandinavian
firms by controlling share holders. Where crime is high, social cohesion low, and political disruption high,
as in Brazil, the private benefit for controlling shareholders is high.
162
Merryman, 1996, The french deviation

107
quality and governance, and the French legal origin dummy is the most important one in

regressions where legal origin is used to explain legal quality.163 The explanation for this

is that when the French legal code was in conflict with local codes, the local code got

transplanted without a parallel transplantation of the jurisprudential knowledge of how to

apply it flexibly, and the legal culture that arose was adverse to open debates about the

interpretation of the law.164

In the theory, the proposed link between legal origin and financial development

builds on the legal systems of common law being biased towards protecting private

property law, whereas civil-law countries, like France and thus Latin America, are biased

towards favoring the state.165 Further, legal systems with more discretion, i.e., common

law, are assumed to adapt more flexibly to changing needs in society.166 The assertion is

that “if statutes are constantly playing ‘catch-up,’ this will hinder efficient corporate

finance and financial development.”167 This broad assertion based on the fundamental

characteristics of civil versus common-law systems breaks down when we close in on

countries in detail, however, which again suggests that the legal origin-view is not

163
LaPorta, et al., Law and finance and our Appendix A.
164
Beck and Levine, Legal institutions . Regarding the transplanted law as a given, non-questionable fact is
strikingly similar to the reception of Roman law in Europe in the middle ages (see Hattenhauer,
Rechtsgeschichte ), although the situations are too different to be used for a fruitful comparative study.
165
Rajan and Zingales, The great reversals
166
As in Pistor and Xu, 2002, Incomplete law: A conceptual and analytical framework , Pistor, 2003,
Evolution of corporate law and the transplant effect: Lessons from six countries , Pistor and Xu, 2003, Law
enforcement under incomplete law: Theory and evidence from financial market regulation . Note that law is
always incomplete and is gradually completed through legal discourse in any system. The relevant
argument here is how favorable the legal system is to such discourse.
167
Beck and Levine, Legal institutions 15

108
nuanced enough to explain financial development, and at least not to draw policy

consequences from the research.168

Using cross-country regression, there is evidence that the “law and finance” view

along with the ‘endowment’ theory, holding that settlers built sustainable institutions in

places where the environment was favorable to physical survival, is the view that best

describes financial development.169

The controversies around this research, however, suggest that a more thorough

micro-level research is needed to establish how the legal and institutional environment

affects economic behavior. This can be done through studying the actions of economic

agents. Cross country studies say nothing about why legal origin impacts financial

development, nor why certain legal characteristics impact economic growth. When one

studies one country, historical details and patterns may account for financial development

in a way that makes formal legal investor protection seem largely unimportant.170 The

historic processes that a country undergoes seem too complex to catch in a dozen

variables describing certain legal characteristics.

168
Lamoreaux and Rosenthal, 2002, Organizational choice and economic development: A comparison of
france and the united states during the mid-19th century shows that the French civil system might be more
flexible than the U.S. legal system, contrary to conventional wisdom.
169
Beck, et al., Law, politics , Beck, et al., 2001b, Law, endowments and finance , Easterly and Levine,
2003, Tropics, germs, and crops: How endowments influence economic development , Acemoglu, et al.,
The colonial origins of comparative development: An empirical investigation, Acemoglu, et al., Reversal of
fortune: Geography and institutions in the making of the modern world income distribution , Levine, The
legal environment, banks, and long-run economic growth
170
Notably Franks, et al., 2003, The origination and evolution of ownership and control , Aganin and
Volpin, 2003, The history of corporate governance in italy and similar studies accessible through the
European Corporate Governance Institute covering, in addition to Italy, Canada, China, Germany, Great
Britain, Japan, the Netherlands, Sweden, and the U.S.;see European Governance Institute, 2004, History of
corporate ownership: The rise and fall of great business families .

109
 One possible explanation for this complexity is that certain legal characteristics

develop due to the same causes that create certain financial environments. This does not

mean that the legal characteristics cause certain financial environments; neither does it

mean that the same causes underlie similar legal characteristics. Public administration,

the quality of courts, entrepreneurial and risk-taking disposition, political dynamics,

incumbent protectionism, interdependence through trade, may all cause certain

environments to develop, diverge, and converge. Similarly, financial development may

be related to the colonial origin in the first place but later may become more dependent

on other factors.171

Another view is that financial development, at least financial behavior, is

dependent on other factors that are more important than the legal system and legal

qualities. Open media and competitive markets may exert better control mechanisms on

controlling shareholders than any law.172 Informal norms and confidence in counterparts

and in people in general may be more important than the standards of the legal system.173

It is nothing new that informal enforcement may be as efficient as formal enforcement,

although not always desirable from an ethical point of view.174

In other words, the question is how agents go about allocating finance. In this

decision legal mechanisms are just pieces of a much more complex puzzle. In order to

answer the how question, we need to go inside the ‘black box’ where bank managers and

171
Palepu, et al., 2002, Globalization and similarities in corporate governance: A cross-country analysis .
Ethnic fractionalization may cause institutional development that has little to do with legal traditions nor
bureaucratic culture; see Easterly and Levine, 1997, Africa's growth tragedy: Policies and ethnic divisions .
172
Dyck and Zingales, 2004, Private benefits of control: An international comparison
173
Guiso, et al., 2003b, The role of social capital in financial development
174
Franks, et al., The origination and evolution of ownership and control

110
entrepreneurs make their decisions on how to allocate finance and produce.175 We will

now look at theories about the use of collateral in the allocation of finance, investigate

these qualitatively, and see how this harmonizes with cross-country data.

Micro-evidence of legal impact on finance

The cross-country findings indicating that their law impacts financial development do not

answer how this impact takes place. Since each country’s history is unique, even if some

started out with some of the same institutional or natural endowments, there are endless

opportunities for the framework around the financial system to evolve.176

At the end of the day, economic agents allocate finance. Investors take a

multitude of information into consideration before investing, and their opportunities are

limited to the projects proposed by entrepreneurs, who again take a multitude of

information into account before embarking upon a venture. What happens in this ‘black

box’ of decision-making is described in case studies and industry analyses.177 These

analyses, again, have the disadvantage of their small-n paradigm.

Examining theory from local, micro-level observations allows us to gain an

understanding of how financial actors actually take the regulatory framework into

consideration. Building on these findings, we may use cross-country data to see if our

175
Santiso, 1999, Analysts analyzed: A socio-economic approach to financial and economic markets,
Santiso, 2003, The political economy of emerging markets: Actors, institutions and financial crises in latin
america
176
Using quantitative variables to compare legal characteristics across countries is a simplification which
might not be justifiable because legal systems and practices are highly diverse by nature; see Dahan, 2000,
Secured transactions law in western advanced economies: Exposing myths . This is a further case for not
using cross-country studies unless they are accompanied by micro-level investigations.
177
See, for example Leeds, 2003, Financing small enterprises in developing nations : Learning from
experience .

111
findings are likely to be repeated in other countries. This is not the end of the research, at

least not if we want to build policy on it. That correlations indicate our findings to be fit

for generalizations is nothing more than an indication: micro-level analysis will be

needed in every country where one is to undertake reform work. The only way to

substantiate cross-country empirical findings with variables as vague as the ones

describing governance and law is through micro-level analysis. A legal characteristic may

just be, depending on the variable, the wording of a legal code. Enforcement by the courts

may be selective, so that the code does not apply equally or so that only certain parts of

the code are enforced.

We will start with a theory holding that the lack of legal provisions and

understanding about collateral deprives firms from obtaining finance. Then we will

examine, through interviewing the participants in the financial system in the two

countries, whether the legal framework is or would be applied as the theory holds. We

will try to understand how firms obtain funds, and how this corresponds with what our

theory says. We will attempt to explain parts of what goes on inside the ‘black box’ of

bank managers’ decisions. And, based on our findings, we will explore effects that may

be more important than what our initial theory holds.

112
 V. Micro-level investigation: How lack of moveable

collateral limits access to finance

The theory about collateral and access to finance

In Hernando De Soto’s book The Mystery of Capital, which has become the standard

reading about formalizing capital so that its full value may be realized, we read about

‘dead capital’ (informal capital):

Dead capital exists because we have forgotten (or perhaps never realized) that
converting a physical asset to generate capital – using your house to borrow
money to finance an enterprise, for example – requires a very complex process.

In the West, which has mastered that process,

[these assets] lead a parallel life as capital outside the physical world. They can
be used to put in motion more production by securing the interests of other
parties as ‘collateral’ for a mortgage, for example, or by assuring the supply of
other forms of credit and public utilities.178

Development efforts related to these ideas have mainly focused on real estate. Once the

formal title to a real estate entity exists, most legal systems have the necessary legal

framework to secure mortgages in it, although there is often much to be done on the part

of the accuracy of the land registries and the efficiency of realizing claims on mortgaged

property through the courts.179

178
Soto, The mystery of capital 39-40. See also Soto, 1989, The other path: The invisible revolution in the
third world
179
In Lima, Hernando De Soto’s Institute for Liberty and Democracy undertook a reform of the land
registries; see Lastarria-Cornhiel and Barnes, 1999, Formalizing informality: The praedial registration
system in peru . See also for an overview Lastarria-Cornhiel and Melmed-Sanjak, 1999, Land tenancy in
asia, africa, and latin america: A look at the past and a view to the future .

113
 What many legal systems lack, however, is the ability to cope with moveables as

collateral. Registering charges on moveable assets such as vehicles, machinery,

inventories, invoices, and unpaid checks requires a more sophisticated legal framework

and more sophisticated courts than does the traditional mortgage.180 In particular, it

requires clear rules about the priority of secured creditors in bankruptcy, since such assets

often will have much shorter durability than real estate.181

One organization that has focused on promoting the reform of the framework for

secured transactions, in particular regarding moveable assets, is the Center for the

Economic Analysis of Law (CEAL) in Washington, DC, a World Bank spin-off.182 The

Center has analyzed the potential for secured transaction reform in several countries,

including Argentina and Peru. Its main argument is, in accordance with the De Soto

study, that making the legal framework able to deal with secured transactions based on

moveable property would give increased access to finance to entities that have such

property – which is most businesses in all sectors and of all sizes. This would enable

entities without real estate to post collateral and obtain finance, and it would allow

entities that have already depleted the collateral value of their real estate to obtain more

credit.

180
There is increasing activity to introduce such legal frameworks around the world. The Organization of
American States recently approved a Model Inter-American Law on Secured Transactions (February,
2002); see www.oas.org/juridico/English/cidip_annex.doc. The European Bank for Reconstruction and
Development enacted its model law in 1994; see www.ebrd.com/pubs/sectrans/modellaw/model.pdf.
181
For an international comparison of how secured creditors are treated during bankruptcy, see Djankov, et
al., Doing business . Latin America scores among the worst regions in this. In Peru, secured creditors get
paid third, in Argentina second, while ideally they should be paid first.
182
www.ceal.org

114
 We will review some of the assertions made by CEAL. We will compare the

assertions about the benefits of secured transactions reform with our qualitative findings

in the financial system in Peru and Argentina. This comparison will allow us to

understand whether enabling the legal system to recognize moveable property as

collateral is likely to give broader access to finance. Having established this, we will

investigate how banks distribute credit, and we will assess whether this is likely to

change with a change in the legal framework.

Problem: Moveable property cannot serve as collateral

In his article The Power of Collateral, Fleisig sets out the fundamental problem of

secured lending as he sees it:

Private lenders in developing countries rarely make loans secured by moveable

property unless at least one of two conditions is satisfied: borrowers must own
real estate that can be attached if they do not pay, or borrowers must place the
moveable property under the physical control of the lenders, as in a pawnshop or
warehouse financing.183

This leads to two main consequences: 1) without satisfying the conditions above there is

no access to credit; and 2) because of the shortcomings in the legal system regarding the

use of moveable property as collateral, provided there is real estate to accompany it, there

is an adverse economic impact whereby interest rates increase the reflect the increased

risk posed by borrowers without assets that can be used for collateral.

183
Fleisig, The power of collateral

115
 This is based on the premise that any right to an asset (material or immaterial) that

a person or business has should be possible to transfer, in part or in whole.184 Limiting

this principle, because the law is not in place to allow it or because the laws in place

prohibit it, causes economic harm. For example: laws that are in place to avoid usury and

protect the homestead from seizure following defaults, actually harm the poor and their

small businesses because they lead to credit rationing and to banks not accepting the only

assets available to the poor as collateral.185 Although there are non-economic reasons not

to allow every asset to be used as collateral, we will, in the following, assume that it is

desirable to be able to collateralize as much of one’s property as possible.186

The effects of the lack of regulation to allow moveable assets as collateral are

especially adverse on micro-, small- and medium-sized enterprises, as well as on those

industries in which enterprises generally do not have much real estate to offer as

collateral.187 Large companies also have the advantage of having more means to negotiate

ways around legal shortcomings than do smaller companies. 188

184
This is the principle behind several model laws on secured transaction, which we describe below. It is an
ideal that few countries’ legal systems achieve.
185
Fleisig, 1995, The right to borrow . Another illustrative example is collateral auction laws that require a
certain percentage of the market value of an asset to be obtained for the law to recognize a realization of the
asset, see Kipiani, 2001, Recent trends in secured transactions under georgian law .
186
In fact, the Scandinavian legal system, which scores the highest on bankruptcy indices, does not allow
all assets to be used as collateral. Unless an asset class is specifically designated to be used as collateral by
law, an agreement to use it to secure claims is void. The Nordic countries also have exemptions for certain
personal assets, such as a home and the necessary means to sustain an acceptable standard of living and to
engage in business; see Braekhus, 1994, Omsetning og kreditt 2. Pant og annen realsikkerhet and Andenas,
1999, Konkurs . For a classification of bankruptcy systems, see Djankov, et al., Doing business .
187
Even worse a situation exists when only offshore collateral is recognized as a good by the lenders.
While there are few countries in Latin America (with the exception of Cuba) where the situation is black
and white on this matter, the nuances certainly affect credit distribution. Offshore credit is generally
considered the safest. For an example from a recent transition country, see Kroll, 2000, Taking security
over offshore foreign currency accounts of a russian borrower .
188
Beck, et al., Financial and legal constraints to firm growth .

116
 In particular, the legal shortcomings affect companies’ prospects of term finance:

Although operators of small industrial operations may find it possible to finance

“plant”—real estate—with a mortgage, it may be impossible for them to get medium term
loans for working capital or equipment. The reason is not the loan maturities—the same
lenders happily make longer-term loans secured by real estate—but the underlying
collateral (equipment and inventory) that is unacceptable to lenders.189

Having established that micro-enterprises in Latin America pay on average 28%

for credit as opposed to 5.8% for similar types of companies in the U.S., CEAL asserts

that “most of the difference in credit terms between large and small borrowers in Latin

America arises entirely from the inability to realize the economic benefits of collateral:

either directly, in secured lending, or indirectly, as a method of refinancing unsecured

loans” rather than issues related to country risk and financial intermediation.190 There is

no allowance made for interest rate differentials due to information, country, systemic,

cultural, governance, or business efficiency. The alleged economic benefit from mending

these shortcomings is thus very large.191

When many forms of assets can serve as collateral, Fleisig et al. assert, the

financing obstacles faced by small firms become similar to those faced by large

companies, and the financing disadvantage of being small disappears. The empirical

evidence that is presented is based on how much easier it is for a US-based micro-

enterprise to obtain financing than for one based in Latin America.192

189
Fleisig, The power of collateral
190
Fleisig and Pena, 2003, Should the bank and the fund support the reform of secured transactions?
191
CEAL estimates the welfare loss from the lack of such legal framework to be 5-10
percent of GNP in Argentina and Bolivia; see Fleisig, The power of collateral .
192
Fleisig and Pena, 2002a, Microenterprises and collateral and Fleisig and Pena, 2002b, Smes and
collateral . The same argument is used for both SMEs and for Micro-enterprises.

117
 One problem we frequently encountered during our studies in the field is that the

micro-lending business (in Peru; it is virtually absent in Argentina) is mainly run by

NGOs with corporate governance issues resulting from a NGO’s willingness to take on

more risk and forsake profits compared to a for-profit institution, such as a bank.

As for the private non-NGO, lenders, Fleisig et al. note:

Private lenders only lend when they think that borrowers will pay them back.
Over the years, credit markets have developed two successful lending systems:
unsecured lending and secured lending. Unsecured lending relies on the
borrower’s reputation and the lender’s assessment of the borrower’s future
demand for access to credit. Secured lending relies, in addition, on the lender’s
ability to seize and sell property to satisfy an unpaid loan. Both systems reflect
sound economic logic and both attempt to address the main features of credit
markets: adverse selection, moral hazard, asymmetric information, and
uninsurable risk. As the borrower’s needs for credit grows[sic], collateral will
better address these problems of the lending market. However, Latin American
SMEs cannot easily graduate to obtain secured loans because the property of
Latin American SMEs cannot serve as good collateral under Latin American
law.193

This assertion is in tune with the development in Peru. Even commercial micro-lenders

do not focus on collateral, whereas when a company ‘graduates’ from micro-lending to

formal bank lending, collateral becomes a requisite. Behind the quote above lies the

assumption that secured lending is better than unsecured lending because the credit is

available to more companies, more credit is available to each company, and the credit is

cheaper. Unsecured lending is not an imperfection by any means, but it is not appropriate

for all types of credit lines. Because of this, the investment financing that is dependent on

security is absent.

In many developing countries, where legal and regulatory constraints make it

difficult to use moveable property as loan collateral, the cost of loans makes
capital equipment more expensive for entrepreneurs relative to their counterparts

193
Fleisig and Pena, Smes

118
 in industrial countries; businesses either postpone buying new equipment or
finance it more slowly out of their own limited savings. Small businesses, in
particular, are hit hard by the scarcity of low-cost financing, but the whole
economy suffers because the lack of new investment dampens productivity and
keeps incomes down.194

The conclusion is that the lack of mechanisms for secured lending depresses economic

activity in developing countries.

The argument restated in this section builds on many assumptions, and to start our

inquiry into whether the argument holds, it might be of value to examine the opposite

view of some of these assumptions. Central to the argument is that law matters in lending

and that regulations may be enforced. These are not insignificant assumptions.

For law to matter in lending, the law has to be taken into account by those making

the lending decisions in such a way that were the law different, their decisions would be

different. It may seem obvious to observers in developed countries that legal regulations

are enforced so that agreements made in accordance with those regulations may be

executed by a legal system with authority above and beyond that of private parties, but it

is one of the most significant problems in dealing with legal systems in developing

economies. Part of the enforcement problem is the cost of enforcement, where regulations

exist that may be enforced. In Peru, the bankruptcy procedure costs on average 8% of the

estate value, which is close to the OECD average of 7%. However, the outcome based on

the current regulation is not particularly efficient. In Argentina, where the outcome is

efficient, the cost of the bankruptcy procedure is on average 18% of the estate value.195

We will now look at some theories that question the assumptions necessary to gain

194
Fleisig, The power of collateral
195
Djankov, et al., Doing business

119
economic benefits from improving the rules and regulation governing moveable

collateral.

Views from the opposite side

There is ample theory arguing that law does not matter in the context of corporate

finance. The core of this perspective is that since firms are free to enter into any

contractual agreement, any law can be done away with using contracts. One view is that

“most organizations are simply legal fictions which serve as a nexus for a set of

contracting relationships among individuals.”196 This means that it is the many

contracting relationships of a firm that have legal consequences, not the firm per se.

Since firms are always free to change these relationships, the law on the books is just a

default starting point.197 The focus of this theory is corporate law; the argument can be

made for any legal relationship between private parties, so that any law that affects the

relationship between two parties may be eliminated or changed by a contract inter partes.

In the real legal world there are mandatory rules that one cannot contract away.198

This is the case for corporate law and for other legal disciplines, in particular where a law

is meant to protect, or protect from, a third party. While the parties to a creditor-debtor

relationship may contract away the rights the creditor has versus the debtor, according to

law, provided these rights are not mandatory, these two parties cannot contract away the

rights belonging to a third party. This may be the right to priority in bankruptcy or the

196
Jensen and Meckling, Theory of the firm
197
Easterbrook and Fischer, 1991, The economic structure of corporate law
198
Eisenberg, 1989, The structure of corporation law

120
right to register a charge on an asset belonging to one of the parties that has previously

not been charged.199

The exception to the ability to contract away law in that any agreement that is

intended to bind a third party will require law to become binding for someone who is not

party to the original agreement, has consequences for laws regarding secured lending in

particular. If a bank registers a charge on a borrower’s asset, that charge only excludes

later charges by a third party if there are laws regulating priorities and is practicable only

if there a registry in which the charge may be registered and if there are legal

consequences of the agreement and registration in that registry. Two parties cannot agree

that an asset pledged as collateral may be recovered from a buyer that bought the asset in

good faith unless there is a law available to solve the conflict about who gets the asset.

The problem with these rules is that if they do not work or fit the needs of a

sufficiently large segment of the market, informal behavior is likely to appear.200 Even if

there are laws regulating the situation described above, a bank may require physical

control of the asset if it does not trust the legal system to enforce its rights according to an

agreement with the borrower (especially if that agreement is contracting away a law).

This is a distorted version of the law-does-not-matter theory described at the beginning of

this section.201 First, law may not matter if one contracts away from it. Second, neither

199
A party may, of course, agree not to enter into a subsequent agreement making further charges on the
asset. However, if he so does despite the agreement, the right of the third party is not governed by the
agreement between the two first parties unless law so prescribes. Such a law would normally exist in
connection with a public registry or another way of making the contract visible to third parties.
200
Loayza, 1997, The economics of the informal sector : A simple model and some empirical evidence
from latin america
201
And it is the converse of a large body of economic literature that assumes contracts are enforced. Much
of this literature builds on Coase, 1960, The problem of social cost .

121
the law nor the subsequent contracts matter if these rights cannot be enforced. If the

courts cannot enforce the rules, neither the contracts nor the rules have meaning. 202

If the economic agents themselves do not know the rules, or how to apply and

benefit from the rules, any reform of the law on the books has little impact. A study from

Russia found that

Russian enterprises make little use of law and legal institutions in structuring
their relationships. Lawyers are usually peripheral actors in the enterprise.
Formal contracts are used, but as a matter of routine rather than of strategy, the
form of the contracts changing little in response to circumstance a basic theme
running through much of the ensuing discussion is the inertia of enterprises in
those activities that involve the use of law and legal institutions, despite the
enormous institutional changes that have taken place. Old contractual practices
and forms continue. Legal knowledge lags. The use of courts appears to be based
on routine behaviors.

Specifically regarding secured lending, the experience was that

Only one-half of enterprise lawyers knew that, according to the 1995 Civil Code,
pledges of moveable assets do not have to be notarized; their responses, in short,
were consistent with random guessing. Only 50 percent of enterprise lawyers
knew that the creditor who secured the loan at the earlier date has priority claim
to an asset that has been used to secure two loans. Most importantly, enterprise
officials are not aware of the fact that the 1995 Civil Code assigns secured
creditors priority over the government in claiming the assets of a liquidated
company. 203

The more one closes in on agent’s specialty the more that agent is likely to know about

the matter. The quoted study from Russia interviewed corporate officers and lawyers. In

our research in Peru and Argentina, we interviewed bank managers. As we review our

findings later, we will see that the bank managers generally know the law – whether it

enters significantly into their decision-making is a matter to which we will return.

202
Pistor, et al., 2000, Law and finance in transition economies, Pistor, 2001, Law as a determinant of
equity market development: The experience of transition economies , Solomon and Foglesong, 2000,
Courts and transition in russia
203
Hendley, 1997, Observations on the use of law by russian enterprises

122
 If one operates in a complex environment, the discretion of the court itself may

create inefficiencies.204 A court is constrained by the fact that its procedural rules as well

as the principles governing its reasoning and values apply to a wide range of cases and

decisions and not only the specific contract that the parties are disputing.205 Although

laws instruct the court on how to handle a specific contract, the principles according to

which the court operates may originate from or interact with principles from the

outside.206 This has to do with the legitimacy of a legal system: legitimacy is anchored in

all parts of society, not only the financial system, and although decisions may be highly

technical in certain financial cases in the judicial system, the way the courts operate and

their basic values must be based on a much broader set of disciplines. If other parts of

society require the courts’ attention, the technical subtleties of transaction law might

suffer from neglect likewise, and values from other political controversies, such as ‘social

justice,’ may interfere with rules that at the outset would appear clear and concise.207

If the agents in a system do not believe in the system’s legitimacy, then they will

not adhere to it and they will construct their own substitute systems.208 The legal system

must carry legitimacy beyond that of private contract enforcement in order to have

relevance for private economic agents. The formal rules in a legal system along with the

exercise of control over actions in society can be seen as drivers of a system’s legitimacy

204
Hay, et al., 1996, Toward a theory of legal reform
205
Luhmann, 1975, Legitimation durch verfahren
206
Dworkin, 1985, A matter of principle
207
As we will see later, our respondents in Argentina indicated that courts outside of the greater Buenos
Aires area would rule in favor of local interests when there was a dispute over exercising collateral, and
that the tendency among legal scholars and lawyers following the financial crisis was to favor social goals
rather than financial efficiency.
208
One example is to use fideicomisos in order to avoid the legal system, as is increasingly happening in
Peru and Argentina.

123
or what creates the legitimacy that is necessary for the system to preserve itself.209

Without both components, rules and control, the system will fail. That legitimacy of

‘rules and control’ is based on the values that the legal system incorporates.210 Formal

rules and control are less flexible than values, so if the legal system does not build on the

values in society, it risks becoming rigid and archaic.211

There are normative and functional aspects to legitimacy. If the system is not

worthy of recognition by moral standards, then it has no legitimacy.212 Before the

colonial era, moral legitimacy alone – the desirability of a set of laws according to some

moral standard, in the Western world the Christian religion – could make laws binding.213

With the end of rational natural law towards in the last colonial century, legitimacy

became equated with actual political power, and thus a potential victim to the rigidities of

a legal system legitimized by political power and not by shared values.214

There are, in other words, many hurdles that the literature on the collateralization

of moveable assets does not take into account. The theories and arguments in this section

inject problems into the proposition that legal reform of the framework for collateral is

likely to alter credit behavior, at least to the extent proposed by the CEAL literature. The

appropriateness of the provisions enforced by the system is a matter of legal efficiency.

The ability of the legal system to enforce contracts is a matter of legal effectiveness. Most

209
Luhmann, 1988, Macht . See also Kelsen, 1955, Foundations of democracy .
210
Luhmann, 1993, Das recht der gesellschaft .
211
This is frequently the criticism of the French legal system as transplanted to Latin America, see Beck, et
al., Law, politics .
212
Habermas, 1976, Zur rekonstruktion des historischen materialismus defines legitimacy as die
Anerkenningswürdigkeit einer politischen Ordnung.
213
Hattenhauer, Rechtsgeschichte .
214
Luhmann, 1983, Rechtssoziologie . The Napoleonic legal system’s rigidity is one of the proposed
reasons for its poor performance compared to other legal systems; see Beck, et al., Law, politics .

124
of the arguments by CEAL address the former; most of the views we have used to

illustrate the opposite perspective stress the latter. Our first question, then, is what to

mend in order to improve the framework that allows more collateralized lending. Later,

we will address whether there is any point in doing so, or if fixing the law on the books is

likely to be futile.

The gaps in the legal framework

The legal reforms that CEAL proposes are divided into three:

In the creation of security interests there are “gaps in coverage [that] exclude

some lenders, some borrowers, and some property.” The law is also ambiguous about the

priority of lenders’ rights in the collateral. The public registries are “primitive, making

the practical determination of a lender’s priority difficult or impossible.” Also, the

enforcement is “slow and expensive”:

Repossession can take two or three years; lenders know this length of time far exceeds
the economic life of much moveable property that SMEs can offer as collateral. Once
repossessed, sale of collateral often requires complex, judicially-mandated procedures
that ultimately put most of the proceeds of a sale into the hands of the auctioneer,
appraiser, participating lawyers and officers of the court. Even hybrid security interests
in Civil Code jurisdictions -- such as leasing, the trust and the sale with retention of
title -- cannot fully solve the enforcement problem. Even though they can bypass
judicial sale, they must still initiate enforcement with troublesome procedural laws that
require judicial action to take possession of the leasehold or trust collateral from the
debtor. By these features, Latin American law makes the otherwise valuable capital
stock of the SME useless to lenders as collateral.215

Remembering the general problems regarding creation, priority, and enforcement, we

will look at the state of the reform work in Peru and Argentina, and then move on to the

215
Fleisig and Pena, Smes

125
experiences from a region that has undertaken substantial reform of these three

mechanisms and of the framework for secured transactions in general.216

Current policy recommendations and impact of reform

attempts in Peru and Argentina
“Reforms that make it easier for borrowers to use moveable property as collateral

would,” Fleisig asserts, “give comfort to lenders, stimulate investment, and boost

productivity and growth.”217 Not only are these reforms important for access to credit and

increased investment: they are also important for the stability of the financial system

itself:

The literature on recent financial crises is littered with tales of extraordinary asset
price inflation – real estate prices driven up to fantastic heights by credit
expansion. The cases of Korea, Japan, Thailand, Indonesia, and the Philippines
have stimulated a microindustry of "bubble literature." These reports document
the cycle of how rises in property values fuel further increases in mortgage-based
lending. This lending fuels further increases in property values. The problem of
asset inflation is enormously aggravated by a poor legal framework for secured
transactions.218

These reforms are not being supported to a measurable extent by the organizations that

could make them come through: the World Bank and the IMF have still not included

secured transactions legal reform for moveable property in any major initiative, in fact,

hardly in any initiative at all, according to Fleisig et al.219

In fact, the the work of Fleisig et al. has started to have legislative impact both in

Peru, and similar work is underway in Argentina. In Peru, a commission with a mandate

216
For the specific analysis of the legal framework in our case-study countries, see Fleisig and Peña, 1997,
Peru : How problems in the framework for secured transactions limit access to credit , Fleisig and Pena,
1997, Argentina: Como las leyes para garantizar prestamos limtan el acceso a credito , Fleisig, et al., 1998,
Argentina: Anteproyecto de ley de garantias reales muebles , Fleisig, Costo economico .
217
Fleisig, The power of collateral
218
Fleisig and Pena, Should the bank and the fund support the reform of secured transactions?
219
Ibid.

126
to “rediseñar un sistema de garantías reales eficiente, que reduzca los costos de

transacción y que permita una rápida y efectiva recuperación de los créditos” delivered its

report to the Ministry of Economics and Finance on June 6, 2001.220 Their proposal for a

law for moveable collateral is currently in front of the Peruvian Congress.221 The law is to

a very high degree inspired by the work of CEAL and complies with most principles

advocated in the works of Fleisig and de la Peña.222

In Argentina, a draft law for secured transactions was passed to Congress in

1998.223 The legislation embodies all the major modern principles of secured transactions

law. It is not based on any work by CEAL, but has striking similarities.224

In both countries, however, the legislative effort has stalled. In Peru, the proposal

is not scheduled to appear before the legislative assembly. In Argentina, the proposal

disappeared in the congressional committee and appears to have stalled completely. In

neither country is it likely that anyone will make the effort to push the reform through,

although the author in Peru if he so chose might be able to muster the political capital to

do so. In Argentina, the current political environment is adverse to any new “neo-liberal”

legal reform, and a collateral reform clearly falls into this category. In the current

220
Interview with the chair of the drafting committee, Jorge Avedaño. The commission’s report is in
Ministerio de Economia y Finanzas de Peru, 2001, Facilitando el acceso al credito mediante un sistema
eficaz de garantias reales .
221
Avedano Valdez, 2003, Anteproyecto de ley de la garantia mobiliaria . The draft law is unpublished.
222
Based on interviews with the chairman of the commission, Jorge Avedano. An illustrative example is
that five out of nine bibliographic references in the reports point to work by CEAL or its affiliates.
223
Kelly and Sigman, 1998, Propuesto de ley de derechos de garantia and interview with the chair of the
drafting committee, Julio A. Kelly.
224
The similarities between the proposals seen together with reform work in Eastern Europe and by the
IRIS center at the University of Maryland, as discussed elsewhere, show that the principles behind secured
transactions legislation are fairly well established in the global legal community and that problems in
enacting such reforms are not due to drafting difficulties. Both the CEAL proposals, the Argentine
proposals, and the IRIS proposals (reviewed above) are based on U.S. Uniform commerical code article 9 -
secured transactions }.

127
political environment, sending any credit-related law to Congress is a game of hazard.

One of the major international financial institutions gave up its attempts to pass a new

bankruptcy law for fear it would be so perverted that it would end up creating a situation

less favorable to resolving bankruptcies than exists today.225 In Peru, the weakness of the

current administration has essentially created an inability to pass any major reforms, and

collateral reform ranks very low on any lawmaker’s list of priorities. If a new

administration with a presidential candidate more inclined to favor property rights were

elected, the proposal may come through.

It is likely that the work of CEAL will bear more fruit in the years to come. The

year 2005 is designated by the U.N. as the “international year of micro-credit,” and at the

G-8 summit in June, 2004, the member countries decided to

…work with the MDBs and other organizations to facilitate the establishment of
the fundamental components of mortgage markets, including property rights, title
transfer, credit risk management, legal and regulatory frameworks, funding
sources, and the operational capacity of mortgage lenders [and to] assist
developing countries to improve their legal and institutional frameworks for
micro-finance so it can become sustainable and more widely available.226

We will now look at the experiences from a region that successfully, as opposed to Peru

and Argentina, has been able to pass reforms on secured transactions. This will allow us

to assess whether secured transaction reform in Peru and Argentina has potential to

improve access to finance. Having looked at the European Bank of Reconstruction and

Development’s efforts in Eastern Europe, we will investigate how the banks in Peru and

Argentina actually make credit decisions, and the place of secured transactions in these

225
Interview with Buenos Aires-based lawyer that assisted the international financial institution.
226
G-8, 2004, G-8 action plan: Applying the power of entrepreneurship to the eradication of poverty , G-8,
G-8 action plan

128
decisions, which will, in turn, allow us to place the use of secured lending in perspective,

and thus evaluate the potential effects of reforming these regulations.

Lessons from previous reforms: The case of Central and

Eastern Europe
The legal framework that comes closest to the CEAL ideal world for secured transactions

is the European Bank for Reconstruction and Development’s Model Law on Secured

Transactions. This model law has been one of the pillars of the EBRD’s work on secured

transaction reform.227

The EBRD framework follows principles that may be criticized as too

simplistic. Its basic tenets, that the legal framework should leave it to the parties to

contract what to use as collateral and to keep the rules simple, does not take into

consideration the many concerns arising from a complete freedom of contract.228 The

Center for Institutional Reform and the Informal Sector at the University of Maryland has

developed a model law based on its own experiences in consulting for developing

countries.229 This law is more restrictive and focuses more strongly on the U.S.

regulation, citing as its advantage the comprehensive catalogue of potential conflicts with

solutions, in that “Article 9 contains the world’s most comprehensive catalog of potential

conflicts over moveable collateral, and offers proven solutions. Its balance of economic

227
Although the laws resulting from the reform work vary based on national traditions and legislative
priorities, the model law embodies the principles that have been advocated by the EBRD; see EBRD, 2004,
Core principles for a secured transactions law .
228
Welsh, 2003, Secured transactions law: Best practices and policy options . For an example of where
simplification has led to interpretation problems in a new law, see Sallustio and Sims, 2000, New albanian
law on securing charges .
229
Welsh, 2004, The iris model law on secured transactions with commentary: A model law on obligations
secured by movable property

129
incentives and legal rights fosters economic activity and deters litigation.”230 Although

the transplantation of common law into civil law countries is a frequent source of

confusion when the law is to be applied, IRIS asserts that in the field of secured

transactions law, transplants have been successful across different types of legal

systems.231 The difference between countries that have adopted Article 9 and those who

have not is not that great, however: “the core policy issue remains the priority given to

ownership versus that given to a security interest. Within jurisdictions that have

apparently embraced the same system as inspired by Article 9, substantive rules vary

depending on the jurisdiction’s position on publicity and priority.”232

The implementation of the EBRD model law provides an excellent base of

experience from which one can learn about the effects of, and potential pitfalls in,

enacting such reforms.233 Grouping countries by their level of reform, we see that the

framework for secured transactions in general has improved with the reform effort. This

does not seem to be the case with the bankruptcy legislation.

230
Ucc art 9 , Welsh, Secured transactions law 2. The principles in the IRIS and EBRD proposals are,
however, very similar; see EBRD, Core principles and Welsh, Secured transactions law .
231
Welsh, The iris model law . We encountered concerns about mixing the two systems from a well known
bankruptcy lawyer in Argentina.
232
Dahan, Exposing myths . These variations are small. This may be seen in the similarities of the current
proposals for secured transactions in Peru and Argentina, which are based on differing literature.
233
It is, strictly speaking, wrong to say that the EBRD model law has been “implemented.” Rather, the law
served as a benchmark in many national legal reforms. It encompasses, however, the principles that came to
be defining for judging whether the reforms were appropriate or not. For the model law, see EBRD, 1994,
Model law on secured transactions . For the core principles embedded therein, see EBRD, Core principles ,
also in Simpson, 2000, Ten years of secured transactions reform .

130
 Figure 19

EBRD assessment of legal problems by reform level

Advanced reform

Deficient reform

Major reform

Minor reform

Unreformed

0 1 2 3

Scope Inventory
Immovables Receivables
Insolvency ranking Insolvency procedure
1 = no significant problem, 3 = major problems

(Data: Dahan, Kutenicova et al. (2004). Data from 26 countries in the EBRD’s zone of
operation)

If we combine the level of reform as determined by the EBRD with available firm-level

data on the source of financing, we see that there has been more of an impact on equity

than on domestic credit, although there is a clear correlation with reduced reliance on

retained earnings in more reformed countries. Companies in reformed countries thus

seem to rely more on external finance, although it is not clear if the preference of bank

credit versus markets shifts within the domestic system. We see that reliance on foreign

financing seems to drop as there are domestic reforms. If we look at SMEs only, we find

the same patterns.

131
Figure 20

Source of credit by EBRD reform level - SMEs

69.5238
8.9881
Unreformed 4.46429
3.60714
4.64286

68.8056
4.10494
Deficient reform 1.19136
.987654
4.77161

63.4238
8.76972
Minor reform 3.19558
.88959
7.05678

61.4739
7.15529
Major reform .38822
9.40696

3.93574

38.2075
6.68868
Advanced reform 1.46226
11.5377

5.33019

0 20 40 60 80

Retained earnings Domestic credit

Equity Foreign banks
Supplier credit

Source of credit by EBRD reform level - all sizes

63.949
12.6122
Unreformed 5.35714
5.42857
4.13265

68.1729
3.89049
Deficient reform 1.4755
1.0951
4.73487

62.8246
8.65682
Minor reform 3.50048
1.35939
7.12965

60.8172
7.1393
Major reform .595771
9.62438

3.91045

37.7778
7.21296
Advanced reform 1.43519
12.25

5.23148

0 20 40 60 80

Retained earnings Domestic credit

Equity Foreign banks
Supplier credit

132
 (Data for preceeding graphs: Dahan, Kutenicova et al. (2004), WorldBank (2000))234

One possible reason for the reduced reliance on internal financing is that owners are

extracting more from their companies in order to invest elsewhere (or consume). We do

not have reliable data for dividends, especially from small companies, but the level of

investment and expected investment over the coming years by a company is a good proxy

for the owners’ intentions to expand the company. If companies retain their earnings to

use for investment rather than pay dividends, then they are not extracting cash. If

companies expect to be able to obtain more financing and thus expand their companies,

their expected investment would grow, even though they extract cash in the form of

dividends. If retained earnings are decreasing as well as investment, then it is likely that

more funds are being extracted from the companies and are not expected to be replaced

with external financing.

234
The graphs with financing details and the stage of legal reform exclude countries where the latest
recorded reforms were enacted in the year 2000 or later. The sources for recorded reforms are country
surveys for 27 countries on the EBRD’s website. These graphs comprise nine countries and 2,866 firms.

133
Figure 21

Change in investment by EBRD reform level

Unreformed

Deficient reform

Minor reform

Major reform

Advanced reform

0 20 40 60 80
Average change in investment past three years - all companies
Average change in investment past three years - SMEs
Estimated average change in investment next three years - all
Estimated average change in investment next three years - SMEs

(Data: Dahan, Kutenicova et al. (2004), WorldBank (2000))

If we look at the financing prospects in the year 2000 of firms surveyed in the EBRD

countries, we see that the higher the level of reform, the lower the level of expected

investments, except for advanced reform countries, where the level is somewhat higher

than in the countries with some reform. For deficient and minor reform countries,

projected future investment is higher than past investment. This might be explained by

optimism that the reforms will have an impact on financing.

If companies are losing funds for the right reason, this pattern is not a problem.

The right reason would be that entrepreneurs find more efficient use for funds that were

previously trapped in less productive firms because of financial or business infrastructure

or the lack of better investment opportunities. If the funds are leaving for the wrong

reasons, there are reasons for concern, such as if entrepreneurs wanted to keep the
134
companies small and to channel dividends into less productive ventures or new ventures

that would be comparatively less productive than increasing the scale of the original

operation. As we will see, these are concerns voiced by bank managers in our case study

countries, Peru and Argentina.

Comparing the EBRD data and the financing data on a company level, the view

that secured transaction reform leads to increased domestic credit is not clear. The value

of the relationship between measured reform level and reported financing sources,

however, is significantly reduced by the fact that most of the reforms are relatively

recent, so that there might not have been time for the impact of the new legal

opportunities to drizzle through to the financial and business community.235

If we look at specific experiences from the EBRD’s reform work on secured

transactions, and from its client countries, we may gain some understanding about the

specific mechanisms of the impact of reform on finance. The experience in the EBRD’s

area of operation is extensive: In 1990 none of the 26 countries of EBRD operations had

any “workable laws permitting non-possessory security over moveable assets”; now 22 of

those countries have such laws.236 The work was based on an approach that needed to be

compatible with civil law but drawing on the strengths of the common law systems in the

field of secured lending, similar to the situations in Latin America.

The first and most important lesson is that enforcement of the collection of debt is

possible to reform. A survey of 26 countries ranked the secured transactions legislation

235
This is a particularly important factor in countries where legal awareness is weak, as discussed in the
previous section,
236
Simpson, Ten years of secured transactions reform

135
and institutions through the ability to recover debt secured with machinery and

inventory.237 If we compare the results to the level of reform of the secured transactions

legislation and the related institution, we see a pattern where the reformed countries

generally perform better.

237
The question asked in the survey was directed to a cooperation law firm: “We are a bank registered in
your country. One of our customers, a local privately owned limited company in manufacturing, has failed
to repay a loan of €100,000. There was no invalidity to the underlying loan agreement: the default is due to
cash flow problems. The debtor thus has no comeback for the non-payment of the loan. Our customer has
given us security over €120,000 worth of: (i) production equipment and machinery used in its factory; and
(ii) inventory consisting of finished products. We now ask you for advice on how we can enforce our rights
over the assets given as security in order to recover our claim.” For detailed country surveys describing the
legal situation in the EBRD operation countries, see Fairgrieve and Andenas, Ibid.Securing progress on
collateral law reform: The ebrd's regional survey of secured transactions laws .

136
Figure 22

Efficiency versus reform level

Countries ranked by efficiency in recovering charged assets
Hungary
Latvia
Slovak Republic
Czech Republic
Lithuania
Estonia
Bulgaria
Croatia
Slovenia
FYR Macedonia
Kazakhstan
Serbia and Montenegro
Ukraine
Belarus
Kyrgyz Republic
Romania
Albania
Russia
Moldova
Poland
Georgia
Azerbaijan
Uzbekistan
Turkmenistan
Bosnia and Herzegovina
Armenia

0 1 2 3 4 5
mean of reform

The countries have been ranked in the order of actual efficiency in recovering charged
assets. The bars describe the level of reform of secured transactions legislation. In
general, countries with reformed secured transactions legislation and institutions do better
in how efficiently assets are recovered.

(Data: Dahan, Kutenicova et al. (2004).

There is a discrepancy, however, which may well be explained by the fact that the

process of a legal outcome is influenced by many other factors than just the legal

provisions and institutions pertaining to the specific topic. For example, the bankruptcy

provisions are likely to impact how individual debt recovery takes place in the courts and

hence how the secured transactions regulation is used by creditors. The correlation

between the EBRD’s ranking of secured transaction framework versus bankruptcy

137
framework shows everything but correlation between the two sectors, although they are

intimately related in practical legal life.238

Figure 23

Insolvency versus secured transactions ranking

insolvency secured
Bulgaria
Slovakia Kyrgizstan
Hungary Macedonia
Czech Rep Poland
Uzbekistan Albania
Turkmenistan Croatia

Slovenia Latvia

Estonia Lithuania

Belarus Serbia
Armenia Azerbaijan
Ukraine Georgia
Russia Romania
Moldova Bosnia Herzegovina
Kazakhstan

(Data: Dahan, Kutenicova et al. (2004))

Another important realization by the EBRD research is that banks are influenced not only

by the legal framework but also by their internal policies.239 Investigating the same

claims as we find in the CEAL literature, that banks pose excessive collateral

requirements and restrictions on what collateral is acceptable, the findings from the

238

Ranking of insolvency and collateral enforcement qualities in EBRD countries

| Inventory Immoveabl Moveabl Quality Procedure

---------------------+------------------------------------------------
Inventory | 1.0000
Immoveables | 0.4513 1.0000
Receivables | 0.3864 0.3368 1.0000
Insolvency quality | 0.1125 0.2229 0.2314 1.0000
Insolvency procedure | 0.0458 -0.2941 -0.0881 0.2257 1.0000
26 observations. (Data: Dahan, et al., 2004, Enforcing secured transactions in central and eastern europe: An
empirical study )
239
Muent and Pissarides, 2000, Impact of collateral practice on lending to small and medium-sized
enterprises . Ramastry, 2002, Ebrd legal indicator survey: Assessing insolvency laws after ten years of
transition notes that the efforts put into effective implementation of the insolvency system is more
important that what kind of system is put in place.

138
EBRD are that, contrary to the literature, collateral requirements are more or less the

same across company size, and that overcollateralization exists but not excessively.240

The EBRD’s findings are consistent with our findings in Peru and Argentina, except that

we find that large companies in many cases are not required to post collateral. The EBRD

finds that banks do not necessarily identify smaller enterprises as riskier than larger ones,

that the level of collateral requirements does not accurately reflect the risk associated

with particular types of borrowers, and that SMEs are not systematically discriminated

against across the region by banks with regards to collateral requirements. Except for the

discrimination against SMEs, this is consistent with our qualitative findings. According

to the EBRD, the time it takes to register assets and the existence of a central registry

does not explain higher collateral requirements, contradicts the basic assumptions in

literature that a more efficient legal and institutional system reduces risk and thus

collateral requirements. The survey found some evidence of higher collateral

requirements because of long expected realization times in the case of default; this was

the only significant correlation at the 5%-level in the data collected. This makes sense as

holding collateral is costly for the seizing creditor.

240
The average collateral requirements as a percentage of total loan size were: For loans less than US$
25,000: 147%; for loans between US$ 25,000 and 200,000: 148%; for loans over US$ 200,000: 145%
(Muent and Pissarides, 2000, Impact of collateral practice on lending to small and medium-sized
enterprises )

139
Figure 24
Variables descriptive of legal provisions in EBRD countries’ secured transactions law

| Large Medium Small Immov. Mov. Pool Delays Market Value

--------------------------+-----------------------------------------------------------------------------------
Collateral |large | | 1.0000
Requirements|medium |loans| 0.8773* 1.0000
for |small | | 0.7295* 0.9520* 1.0000
Days to | immoveables | 0.7056* 0.8357* 0.7096* 1.0000
Enforce | moveables | 0.5626 0.6202 0.4363 0.8427* 1.0000
| pooling | 0.1975 0.3425 0.4038 0.2039 0.4470 1.0000
Problems | delays | 0.2023 0.5338 0.6430 0.5421 0.3728 0.4452 1.0000
with | marketability | -0.2353 -0.3921 -0.4853 -0.2148 -0.0466 -0.3935 -0.1121 1.0000
collateral| valuation | -0.2385 -0.0844 0.1069 -0.1527 -0.3688 0.2612 0.3046 -0.6321 1.0000

Pairwise correlations. Data collected from Muent and Pissarides (2000). 19 observations (country averages). * =
significant at the 5%-level.

The table shows pairwise correlations between variables describing aspects of the
regulatory framework in 19 countries of EBRD operation. Collateral requirements are
the average collateral requirements in terms of loan value for loans over USD 200,000,
between USD 25,000 and 200,000, and less than USD 25,000. Days to enforce is the
average period from start of proceedings to sale for immoveable and moveable collateral.
Problems with collateral is the average rating among banks in each country on a scale
from 1 to 3 related to a) collateral being pooled into the estate at bankruptcy so that the
creditor cannot liquidate it; b) delays in the realization of collateral; c) marketability of
collateral when the bank needs to liquidate the asset; d) valuation of the collateral. There
are significant correlations at the 5% level between the collateral requirements for the
various loan sizes, between days to enforce immoveable collateral and the collateral
requirements for all loan sizes, and between days to enforce moveable and immoveable
collateral. The correlations are illustrated in Figure 26.

Figure 25

Days to enforce movable collateral and level of collateralization Days to enforce immovable collateral and level of collateralization
Small loans Small loans
200

200

Medium loans Medium loans

Large loans Large loans
% collateralization

% collateralization
150

150
100

100

0 100 200 300 400 500 0 100 200 300 400 500
Days to enforce movable collateral Days to enforce movable collateral

140
 Problems of collateral being pooled Problems of delays in bankruptcy
into a bankrupt estate and level of collateralization
and level of collateralization
Small loans

200
Small loans Medium loans

200
Medium loans Large loans
Large loans

% collateralization
% collateralization

150
150 100

100
1 1.5 2 2.5 1.5 2 2.5 3
Problem ranking 1 (little importance) to 3 (very important) Problem ranking 1 (little importance) to 3 (very important)

Problems concerning marketability of collateral Problems in valuation of collateral

and level of collateralization and level of collateralization
Small loans Small loans
200

200
Medium loans Medium loans
Large loans Large loans
% collateralization

% collateralization
150

150
100

100

1.5 2 2.5 3 1 1.2 1.4 1.6 1.8 2

Problem ranking 1 (little importance) to 3 (very important) Problem ranking 1 (little importance) to 3 (very important)

(Data: Muent and Pissarides (2000))

Plotting the time to enforce collateral and the problems cited with the

marketability and valuation of collateral, as well as the problems with collateral being

pooled into a bankruptcy estate and the time to complete a bankruptcy, shows no

apparent relationship with the level of collateralization for any type of company (except

for realization time), see

Figure 25.241

241
More specifically with the type of loans, not the type of company, since the data are classified by loan
size, not borrower size. We assume that small loans are associated with small companies and large loans
with large companies.

141
 We can use existing firm-level survey data to see how the banks’ assessment of

the collateral framework affects firms’ perceived obstacles to doing business, under the

assumption that the banks’ assessment of the collateral framework shapes their internal

policies, which again affects companies’ access to finance (Figure 26).

142
Figure 26

Perceived obstacles to doing business and secured transaction quality in

EBRD countries
The ordered probit regression is:
(1) Collateral requirements as a perceived obstacle to doing business by the firm = α + β Size of company + β Industry + β
Firm age + β Foreign ownership dummy + β Sales + β Multinational dummy + β Government ownership dummy + β Export dummy +
β Export dummy + β Days of enforcement of immoveable collateral + β Days of enforcement of moveable collateral + β Banks’
perception of problems related to collateral being included in bankruptcy estate + β Banks’ perception of problems concerning the
marketability of collateral + β Banks’ perception of problems concerning the valuation of collateral + u; and
(2) Financing as a perceived obstacle to doing business by the firm = α + β Size of company + β Industry + β Firm age + β
Foreign ownership dummy + β Sales + β Multinational dummy + β Government ownership dummy + β Export dummy + β Export
dummy + β Days of enforcement of immoveable collateral + β Days of enforcement of moveable collateral+ β Banks’ perception of
problems related to collateral being included in bankruptcy estate + β Banks’ perception of delays in enforcement as problematic + β
Banks’ perception of problems concerning the marketability of collateral + β Banks’ perception of problems concerning the valuation
of collateral + u
R-squared are McKelvey and Zavoina (1975). The dependent variable is ordered categorical between 1 and 4, so we use
ordererd probit.

(1) (2)
Collateral is obstacle Finance is obstacle
Small company 0.138 -0.138
(0.92) (0.96)
Medium-sized 0.044 0.010
(0.33) (0.08)
Service industry -0.172 -0.265
(1.93)* (3.16)***
Other industry (not manuf.) 0.002 0.131
(0.00) (0.16)
Agriculture 0.264 0.145
(2.45)** (1.37)
Construction -0.084 0.119
(0.66) (0.99)
Company age -0.004 -0.001
(1.58) (0.46)
Foreign ownership -0.215 -0.462
(1.53) (3.47)***
Sales $mn -6,965.013 -36,240.408
(0.61) (3.49)***
Multinational -0.034 0.022
(0.21) (0.15)
Government ownership 0.034 0.088
(0.35) (0.94)
Exporter dummy -0.011 0.214
(0.12) (2.32)**
Days to enforce immoveable collateral -0.015 -0.005
(3.88)*** (1.44)
Days to enforce moveable collateral -0.010 -0.008
(3.25)*** (2.58)***
Problem: Collateral pooled 0.269 0.475
(1.74)* (3.29)***
Problem: Collateral marketability 0.132 -1.092
(0.54) (4.74)***
Problem: Collateral valuation 0.802 -0.318
(1.90)* (0.79)
Observations 1081 1190
Countries 6 6
R-squared 0.057 0.184
LR Chi-squared 51.62 204.38
Absolute value of z-statistics in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%

143
We have two measures of the obstacles that firms perceive: first, the perceived obstacle

that collateral requirements pose for businesses, and second, the perceived obstacle that

financing in general poses for businesses. We see in the regression above that the

entanglement of secured debt in a bankruptcy estate is correlated to collateral as being

more of a problem, and even more to finance as being a general obstacle to doing

business. Problems in valuating assets make collateral requirements more of a problem to

business. This is in line with findings that companies need to be able to post specific asset

types as collateral when there are problems with the realization of other asset types. This

means that durable assets, typically real estate, is the only accepted collateral by banks.

We obtain some initially puzzling signs in this analysis. Collateral requirements

are perceived as less of an obstacle to doing business than the number of days required to

enforce collateral increases, and finance as a general obstacle to doing business goes

down as the number of days to enforce moveable collateral goes up.

However, while banks are selective regarding the types of collateral they accept,

creating problems for companies in coming up with the appropriate collateral,

enforcement time does not. On the contrary, when banks struggle with realizing

collateral, the less problem the companies face. Banks will always ask for collateral when

extending credit no matter how easy it is to realize it; when the realization time comes, it

is to the company’s advantage that enforcement time be longer (it is not to the company’s

advantage that the assets get entangled in a bankruptcy estate because the company is no

longer able to use the assets). Longer enforcement time does not therefore create more

obstacles to doing business.

144
 Furthermore, as banks have more problems in selling seized collateral, the

companies perceive fewer obstacles to finance in general. This suggests that the

companies, and the banks, are quite different. As banks cannot market collateral, it gives

the companies more leverage in their relationship with the bank. It is logical that our

results indicating that collateral requirements are perceived to be more less of an obstacle

when banks encounter marketability issues regarding the collateral. It is problematic to

find collateral that works, but once posted, the banks will want to avoid realization more

than if it is easier to sell off the collateral, thus handing bargaining power over to the

borrower. Collateral naturally poses less of a problem to companies if the realization time

is longer, provided the banks do not take realization time into account to a significant

extent when making the lending decision.242

We see that our model explains financing as a general obstacle much better than it

explains collateral requirements as an obstacle to doing business, this reflecting that

collateral requirements are just a small part of bank lending and how companies obtain

finance, and further, that the legal institutions cannot easily be separated into individual

functions. Elsewhere, we address the interconnectivity of the parts of the legal system,

and how splitting up functions too finely might assume that legal processes are

independent from each other, an assumption that is likely to be incorrect.

242
Note that in real life there are instances where customs develop that are not recognized under the law but
are used by most economic agents, such as marking chattels instead of physically transferring them or
simply not registering charges on moveables; see Schorling, 2000, Secured transactions in the czech
republic - a case of pre-reform and Muent and Pissarides, Impact of collateral practice . These practices
can only be investigated at a micro-level.

145
 One lesson from the EBRD’s work is that “legal education reform is clearly the

single most important reform undertaking for the region. If law students are not taught

how to think critically, question authority, and be guided by law and ethics in their

formative years, it is difficult to see how they cannot be effective and honest advocates,

prosecutors and judges when they begin their professional lives.”243 In order to become

independent and attain the sophistication required by a modern legal system, the human

capital on the part of the judicial agents, such as lawyers, prosecutors, auditors, and

judges, needs substantial education. Where the legal system does not have the human

capacity to interpret, give advice on, and apply the legislation, it does not matter how

sophisticated the legislation is: the law will remain ignored, or even worse, evaded by the

economic agents. One may avoid the consequences of a poor legal education to a certain

extent, for example through extra-judicial enforcement, but this cannot replace the formal

legal system.244 Not only are lawyers in need of education. Designing and implementing

reforms “in countries where the state administration has not been reformed or reorganised

and where state officials are expected to support reforms and build institutions for a

market economy – tasks for which they are ill-prepared or resent in principle” is an uphill

struggle.245 Even where reform starts, “early winners”, i.e., groups benefiting from initial

reform become incumbents who oppose further reforms – and are in a position of power

to do so.246

243
Dietrich, 2002, Three foundations of the rule of law: Education, advocacy and judicial reform
244
Schorling, 2000, Secured transactions in the czech republic - a case of pre-reform
245
Mathernova, 2002, A reformer's lessons learned: The case of the slovak republic
246
See Ibid., which provides an account of the political, donor, and incumbent dynamics of the
implementation of collateral legislation in the Slovak Republic Rajan and Zingales, Saving capitalism

146
 As we have seen, the experiences from collateral reform in the EBRD countries –

much more thorough and well-documented than anywhere else – provide a good base on

which to build hypotheses of the likely impact of collateral reform in Peru and Argentina.

Their experiences suggest that much more subtle and complex dynamics are at play than

what is advocated in the CEAL literature, and it suggests the need for a broad analysis,

not only of the legal framework’s opportunities and deficiencies, but of how banks go

about extending credit to companies in general. Only through a comprehensive analysis

can we understand how collateral factors into the banks’ lending decisions. The following

section describes our analysis of how firms obtain finance, how banks make credit

decisions, and how secured transactions are part of these decisions.

,Mitra and Selowsky, 2002, Transition - the first ten years : Analysis and lessons for eastern europe and the
former soviet union ,Shleifer and Treisman, 2000, Without a map : Political tactics and economic reform in
russia .

147
VI. How do firms obtain funds? The importance of
law and institutions from the perspective of banks
and firms
How do firms obtain funds? Theory and examples from Peru

and Argentina

If one takes the theoretical view that a firm is a collection of investment projects that

create cash flows and that debt and equity are claims to these cash flows, the financing

structure of a company is largely irrelevant.247 However, tax advantages, market

segmentation, and the impact of financing on risk make firms optimize their financing

portfolio.248 Frequently, companies’ financing choices are viewed as a ‘pecking order,’

where firms choose the available types of financing from a set scale of preferences.249

Empirical studies have proposed stylized facts about financing patterns. If we

combine two studies, one older and one new, we get the following characteristics of firm

financing:

(1) Retentions are the dominant source of finance in all countries, and banks are the

dominant force of external finance in all countries. There are some market

variations in self-finance among countries. These ratios are greater in the Anglo-

Saxon countries than elsewhere. Small and medium-sized firms are considerably

247
Modigliani and Miller, 1958, The cost of capital, corporation finance and the theory of investment,
Modigliani and Miller, 1961, Dividend policy, growth and the valuation of shares .
248
Glen, 1994, An introduction to the microstructure of emerging markets . Older literature reviews are
found in Miller, 1988, The modigliani-miller propositions after thirty years and Harris and Raviv, 1991,
The theory of capital structure .
249
Myers, 1984, The capital structure puzzle , Myers and Majulf, 1984, Corporate financing and investment
decisions when firms have information that investors do not have .

148
 more reliant on external finance than large firms, and a smaller proportion of

small – rather than large – company finance comes from securities markets.

(2) Corporations do not raise a substantial amount of finance from the stock market in

any country. Bank finance is particularly pronounced in France, Italy and

Japan.250

(3) There is strong inverse relation between the proportion of expenditure financed

from retentions and from bank credit.251

Using recent survey data about over 10,000 firms worldwide, we can investigate these

stylized facts and compare to our qualitative findings. We will then continue to use our

qualitative findings to develop further stylized facts. We will compare these facts to our

quantitative findings. Lastly, we will see how the results strengthen or weaken the theory

about moveable collateral.

Retentions are the dominant force of financing, banks are the dominant force of external
finance, and SMEs are more reliant on external finance

Looking at the total of available financing data, we see that retentions are indeed the

dominate source of financing. This also applies to large companies, contrary to literature

suggesting that for large firms, external finance is the more important (in particular when

250
Other studies frequently mention Germany as a country where bank finance is particularly important.
251
This list is from Mayer, 1988, New issues in corporate finance, Mayer, 1990, "financial systems,
corporate finance, and economic development" , discussed in Singh, 1995, Corporate financial patterns in
industrializing economies , and Allen and Gale, 2001, Comparing financial systems . Allen and Gale,
Comparing financial systems use the methodology from Mayer, New issues in corporate finance, Mayer,
"financial systems, corporate finance, and economic development" .

149
they are expanding).252 Banks are the dominant force of external financing, only matched

by family funding for small companies. The assertion that SMEs are more reliant on

external finance does not seem to hold; on the contrary, smaller companies use a larger

proportion of internal financing.

252
Singh and Hamid, 1992, Corporate financial structures in developing countries and Singh, Corporate
financial patterns in industrializing economies . These studies use listed firms. The problem with studying
listed firms because of the availability of data is that there is a self-selection: the listed firms may well list
because they have a financing strategy that relies heavily on external funds and in particular markets. Also,
these firms may well use performance cycles tailored to the stock market, which makes the equity
investor’s expectation of return on capital the benchmark for the company internally.

150
 Figure 27

7.46% 5.42%
5.815%

13.02%
3.192%

52.42%
55.61%

11.33%
15.22%

4.91% 5.173%
5.173%
Small companies Medium sized companies
Ret. earnings Equity Local comm. bank Dev. bank Foreign bank Family Ret. earnings Equity Local comm. bank Dev. bank Foreign bank Family
Money lender Supplier credit Leasing Public sector Other Money lender Supplier credit Leasing Public sector Other

6.301%
4.278%

1.303%

7.554%
46.74%

5.19%
18.87%

Large companies
Ret. earnings Equity Local comm. bank Dev. bank Foreign bank Family
Money lender Supplier credit Leasing Public sector Other

Source of financing of companies (Data: WorldBank (2000))

Small companies have 50 or fewer employees; medium sized companies have between 50
and 500 employees; large companies have over 500 employees.

Our qualitative findings in Peru and Argentina support the cross-country data. Smaller

companies are more restricted from bank financing, more dependent on retained earnings

and family investment, and they do not have access to foreign banks.

Corporations do not raise a substantial amount of finance from the stock market, and
bank finance is pronounced in France

From the section above, we see that the stylized fact that corporations do not raise a

substantial amount of finance from the stock market holds on a cross-country level. Large

firms are normally the only companies to be listed on the stock exchanged in emerging

151
markets, and thus they have the opportunity to raise such financing there, as opposed to

SMEs. Whether they elect to use this opportunity is a different question.

Figure 28

TUR
IND
Value traded over private credit in 2000
4

FIN
3

USA
PAK
ESP
2

GRC
SWE
KOR
CHE
HKG
NLD
CAN
GBR
FRA
ITA
HUN
ZAF
SGP
1

CYP
DNK
AUS
MEX
CHN
MYS
JPN
DEU
NOR
BRA
IDN
PRT
POL
ISL
PHL
KWT
CZE

ISR
EGY
BEL
LVA
SAU
NZL
THA

IRN
SVK
LTU
CHL
ROM

IRL
PER
ARG
BGD
SVN
BWA

JOR
NGA

LUX
BGR

TUN

VEN
AUT
MUS

TTO
HRV

JAM
OMN
NAM

SLV
LKA
COL
SWZ

MAR
GTM

NPL
KEN
PAN
ECU
BRB
BOL

CIV
0

Countries ranked by value traded over private credit.

5

TUR TUR
Value traded over private credit in 2000

Value traded over private credit in 2000

IND IND
4

4
3

USA USA
PAK PAK
2

ESP ESP
SWE SWE

CAN CAN
FRA GBR ITA ITA GBR
FRA HUN
1

HUN
SGP SGP
MEXCHN
MYS MYS MEX CHN
PRT IDN DEUBRA PRT BRA DEU
IDN
POL POL
CZE PHL THACHL THACHL PHL CZE
LTUSVK
ROM PER LTU
PER SVK
BGD
BGR VEN ARGSLV
ECUSVN HRVGTM COL
BOL TTO
PAN TTO BGD
COL
PANGTM SLV
ECU ARG
HRV VEN ROM
SVN
BGR
BOL
0

0 10 20 30 40 0 20 40 60 80
Bank credit financing Retained earnings financing

152
 5
TUR

Value traded over private credit in 2000

IND

3 4
USA
PAK

2
ESP
SWE

CAN
ITA FRA GBR

1
HUN SGP
MEX
CHN MYS
IDN BRA PRT DEU
POL
CZEPHL THA
CHLSVK
PER ROM
ARG
SVN LTU BGD
BGR
COL
BOL
GTM VEN
PANECUSLV
HRV TTO

0
0 10 20 30
Equity financing

Financing from bank credit (left), retained earnings (right), and equity (bottom), all
compared to the ratio of value traded to private credit.
(Data: Beck and Demirguc-Kunt (1999), WorldBank (2000))

If we look at the level of financing from various sources and stock market development

as measured by value traded versus private credit, we see that there appears to be no

relationship with the use of bank financing or equity as stock markets become more

important relative to bank financing.253 Only between private credit over GDP and

retained earnings is there a negative correlation that is significant, but still low, at the 5%

level (r = -0.32).

The stylized fact that bank finance is particularly pronounced in France comes

from a study focusing on Europe. If we expand our sample of countries, we would expect

bank financing to be particularly pronounced in countries influenced by French legal

origin.

253Correlations
(data from year 2000) | Value Capital Private Bank Equity Retained
------------------------+-------------------------------------------------------------
Value traded to GDP | 1.0000
Stock market cap to GDP | 0.6992* 1.0000
Private credit to GDP | 0.2207* 0.6742* 1.0000
Bank credit financing | 0.0276 -0.0107 0.1989 1.0000
Equity financing | 0.0689 0.1110 0.1562 0.1563 1.0000
Retained earnings | -0.1944 -0.1644 -0.3213* -0.4562* -0.3078* 1.0000
Source: Beck and Demirguc-Kunt, 1999, A new database on financial development and structure , WorldBank, Wbes .
Pairwise correlations. 52 observations for the significant relationship between privat~p and Retained earnings;
41-119 observations in the set. Country level. * = significant at the 95% level.

153
 Figure 29

Source of finance by legal origin

60
Average percentage of financing
20 0 40
French UK German Scandinavian Socialist
Bank finance (domestic and foreign) Equity
Family Retained earnings
All companies

(Data: WorldBank (2000))

If we do this, however, we see that companies in countries with UK legal origin are the

heaviest users of bank finance, followed by French, Scandinavian, German and Socialist,

which seems to contradict the conventional wisdom that French and German companies

are more reliant on bank financing than UK companies. The stylized fact that French

companies are more reliant on bank finance therefore seems not to be caused by the

French legal or institutional system. However, the ratio of bank-to-equity financing is

larger in countries of French legal origin than any other. This would suggest that in

choosing between options of external finance, French legal origin is associated with bank

finance rather than equity finance.

We also see that Scandinavian and Socialist legal origin is associated with heavy

reliance on retained earnings, and that German legal origin has the strongest association

with equity financing. The latter observation is particularly interesting, as it suggests that

the notion that German firms are more reliant on banks than the global average do not

come from the German legal or institutional system, but from other factors.

154
There is a strong inverse relation between retentions and bank financing

The stylized fact that there is a strong inverse relation between retentions and bank

financing seems to hold in our data.

Figure 30
Correlations in sources of financing, by company size

Small firms | Equity Debt
-------------+------------------
Equity | 1.0000
Debt | -0.3186 1.0000
Medium firms | Equity Debt
-------------+------------------
Equity | 1.0000
Debt | -0.4149 1.0000
Large firms | Equity Debt Foreign
-------------+---------------------------
Equity | 1.0000
Debt | -0.3748 1.0000
Foreign debt| -0.2536 -0.0739 1.0000

Obs: 3153 Obs: 3071 Obs: 1192

Data: WorldBank (2000). 62 countries. Correlations at the firm-level.

This is also coherent with our qualitative findings in Peru and Argentina, in particular for

SMEs. The only source of financing open to SMEs besides family equity is often

retentions, as they have problems obtaining bank financing. This is the explanation for

the slow growth rates of SMEs mentioned by our interview subjects. SMEs offered

access to bank finance experience that bank finance is their only alternative to internal

finance; bank finance is thus necessarily negatively correlated to retained earnings.

The picture is not so clear for large firms, according to our qualitative studies in

Peru and Argentina. In these countries, corporations can issue stocks, bonds, or take on

debt according to what gives the lowest cost of funds and the best maturity structure. If

these observations hold for our entire global sample, we would expect the correlation

between retained earnings and domestic credit to have a lower absolute value. This is the

case when comparing large firms to medium-sized firms. Small firms, however, have an

even lower correlation than large firms. From our qualitative studies in Peru and

Argentina we know that small firms frequently have no alternative to bank financing.

This might lead smaller companies to increase their balance sheets when given access to

155
finance rather than substitute credit for other funding sources. If larger corporations

substitute and smaller companies accumulate, then the lower correlation for smaller

companies would be explained. This, however, does not explain why medium-sized

companies have a higher correlation than both small companies and large companies. If

medium-sized companies have less of a propensity to invest in growth than small

companies, i.e., there is a ‘glass ceiling’, a notion to which we will return below, then we

would expect increased substitutability between retained earnings and credit for medium-

sized companies compared to small and large companies.

We will now leave the stylized facts from the literature and move on to establish

stylized facts that follow from our qualitative findings based on interviews in Peru and

Argentina.

There is a glass-ceiling that medium-sized companies have problems breaking through

In our global sample, small companies grow less than medium companies, which again

grow less than large companies. At the same time that finance as a constraint to doing

business applies is perceived stronger by SMEs than by large companies, as illustrated in

figure 33.

156
 Figure 31

Average sales growth Average financing as perceived constraint

Percent of sales Average on scale from 1 to 4
20 15 10 5 0 1 2 3

Small Small

Medium Medium

Large Large

(Data: WorldBank (2000))

During our interviews in Peru and Argentina, we frequently encountered the observation

by our interview subjects that there is a lack of companies breaking through the barrier

from small to large. This may simply be a consequence of the limited number of

interviews in the qualitative study; for the best companies to grow big, many lesser

quality companies must fail.254 On the other hand, our interview subjects have built on

solid experience, so that the number of companies in total that have contributed to this

observation is a multiple of our number of interviews. When pursuing explanations for

254
As in Friedman, 1953, The methodology of positive economics .

157
this ‘glass ceiling,’ we frequently received complaints that entrepreneurs do not want to

expand their companies; they will rather prefer to set up multiple small companies. The

reasons for this lack of willingness to grow a firm are related to other factors than

financing. Conversely, the banks are not willing to risk deploying capital in order to

develop companies – financing beyond the three-year term is hardly available to anyone

and for small companies it is not available at all.255 This means that even if entrepreneurs

wanted to expand their companies, they would be unlikely to find the finance to do so.

Some respondents indicated that entrepreneurs would prefer to stay small in order

to keep their business outside the formal sector; this, however, was not consistent. If this

were the case, we would expect to see less growth in small companies in countries with a

larger informal sector. Looking at simple correlations, this does not seem to be the

case.256

255
An exception to this is in Argentina, where state-owned banks have a history of extending credit to
SMEs. Due to the red tape involved in obtaining such credit as well as increased risk management in those
state banks, this source of funding does not seem to be sustainable. Also, this source of credit is drying up
as the state banks are under increased pressure to improve their lending standards.
256
Growth by firm size, the size of the informal sector, and the size of the SME sector
| Small Medium Large Informal SME
----------------+---------------------------------------------
| small | 1.0000
Growth | | 80
| medium | 0.6965* 1.0000
| | 80 80
| large | 0.2055* 0.1530 1.0000
| | 80 80 80
Informal / GDP | -0.0960 -0.0754 -0.0209 1.0000
| 71 71 71 108
SME /total labor| -0.1510 -0.0669 0.1214 -0.5920* 1.0000
| 40 40 40 49 53
Data: WorldBank, Wbes , Beck, et al., Sme database . Pairwise correlations. Observations in table. * =
significant at 90% level.

158
Figure 32

Log of firm growth over the last three years

Firm growth and the informal sector Firm growth and the SME sector

Log of firm growth over the last three years

4.5

4.5
4

4
3.5

3.5
3

3
2.5

2.5
2

2
0 20 40 60 80
Size of the informal sector 0 20 40 60 80
Size of the SME sector
Small companies Fit for small companies
Medium sized companies Fit for medium companies Small companies Fit for small companies
Large companies Fit for large companies Medium sized companies Fit for medium companies
Large companies Fit for large companies
For large companies: y = 2.728034 + .0094675, R-squared = 0.07, significant at the 90% level

Size of the SME sector and the informal sector

chl grc tha
80

esp
prt ita
vnm
jpn pan
fra twn belarg
irl dnk col phl per
aut
cze pol kgz
Size of the SME sector

nld swe turhrv

60

deufin bra
svk
ecu
gha
bgr
mex
hun
40

rom zmb
ken gtm tza
20

cmr civ
nga
zwe
rus
geo
blr ukr aze
0

0 20 40 60 80
Size of the informal sector

(Data: WorldBank (2000), Beck, Ayyagari et al. (2003)

If there are countries where SMEs run into a ‘glass ceiling’ one would expect the SME

sector to increase and company growth among SMEs to be low. We find no such

evidence in simple correlations (Figure 32) except a significant relationship where large

companies grow more, the larger the size of the informal sector. This supports the

hypothesis that in countries where there is a large informal sector, SMEs stay under the

‘radar screen’ and only formal, large companies grow. It does not support the thesis that

there is a glass ceiling for SMEs in general. However, since the size of the SME sector is

affected by many other factors, the lack of such a correlation is not enough to falsify the

hypothesis that there exists a ‘glass ceiling.’

159
 There is, however, a strong negative correlation between the size of the formal

SME sector and the size of the informal sector (r = -0.59). One explanation for this, that

would be consistent with the qualitative observations in our case studies, is that lack of

formality affects SMEs rather than large companies. ‘Hiding’ large companies is

difficult, and large companies are in a better position to work around inconvenient

regulations, as we have noted heretofore. Therefore, more SMEs than large companies

are informal.

As more companies are formal, the barrier of ‘going formal’ becomes less

important and it is likely to be easier to grow from small to large. We do not have

sufficient data on a cross-country level to investigate this relationship quantitatively.

Medium-sized companies need a history with the bank in order to get financing or they
need to have survived a crisis or in good faith renegotiated their debt. Small companies
generally have little access to credit.

Our two case studies are countries that recently have been under stress, which has

provided for a real test of collection and security mechanisms. It has also given the local

banks experience in what secured transactions are worth when there are defaults. It is a

consistent qualitative finding that SMEs that survived the crisis while negotiating in good

faith with their creditors have built substantial goodwill with banks. This goodwill is a

strong positive element in the credit decision. In Argentina, companies that were clients

during the last crisis had to be cooperative during renegotiations in order to be eligible for

new credit; in Peru such renegotiation performance is one element in the credit decision

but not a requirement. It appears from our interviews that the time lapsed since the crisis

reduces the emphasis on companies’ renegotiation performance.

160
 Furthermore, the managers of such companies must have a history with the banks,

or at least in the financial system. This has the paradoxical implication that innovative

companies set on exploiting the market conditions generated by the preceding crisis (in

Argentina typically the improved terms-of-trade) generally have problems obtaining bank

finance. The exception to this is export credit.

In addition to a track record with the bank, or with other banks in the same

system, credit registries play a significant role in determining credit. The same goes for

word of mouth, and the banks have much experience to learn about credit applicants’

previous behavior.

Small companies only obtain finance with sufficient collateral, which means

substantial overcollateralization. This finance is on very short term and with close

monitoring. In Peru, the best financing prospects for small companies is micro-finance.

Micro-finance is the only real option for small companies. It is installment-sensitive and
costly.

In Peru, small companies without sufficient track record or real estate are left to the

micro-finance market, which is rapidly expanding on a commercial level. In Argentina,

such a market has yet to be developed to a significant extent.

Micro-finance in Peru, as in many countries in Latin-America, was pioneered by

NGOs, which still dominate the market.257 Following some early commercial movers, the

commercial banks we interviewed are now all entering or planning to enter the micro-

257
For an overview of micro-finance in Latin America, see Berger, 2000, Microfinance: An emerging
market within the emerging markets . Development organizations also help commercial banks enter the
micro-finance market; see Berger, et al., 2003, The second story: Wholesale microfinance in latin america .

161
credit market. The market segment varies considerably among the participants, both in

size, geography, and industrial sector. For the commercial banks, however, the micro-

segment is delimited by the beginning of the small company segment. This creates the

problem that small companies, which have little access to finance through the banks’

commercial lending departments, typically are too large to qualify for micro-credit.

The micro-finance industry in Peru is one of the most developed in Latin

America, but is still suffering from issues in the transition from non-profit to profit

making. The largest and best known micro-finance bank in Lima recently experienced a

management revolt against perceived governance issues related to its non-profit policies,

specifically that the risk and quality management was not meeting the standards of a for-

profit institution. This is descriptive of the observations of several micro-finance actors

that we interviewed. Since the micro-finance business has its roots in NGOs, it suffers

from lack of risk management and profit targets.

The micro-finance business depends on heavy client monitoring and relationship

building, as we have noted elsewhere. In order to stay profitable, and, in particular, if the

lending is going to cover the increased risk associated with micro-finance, which

currently is not being done, the return on assets needs to be high. Informal and small

commercial micro-lenders, normally in the form of pawn shops, charge interest rates well

over 100% per year. For the banks now entering the micro-finance business, rates

between 30% and 60% were quoted as targets. What allows the banks to charge such

rates is the installment-sensitivity of the borrowers. If the borrower’s cash-flow can cover

the repayments, the borrower puts less emphasis on the number of installments that have

162
to be made in order to repay the debt, according to the bank managers and micro-lenders

we interviewed.

It is not clear whether or not micro-credit will allow sustainable growth in the

small-business sector. For a business to consistently rely on micro-finance, the average

income to cover the weighted cost of capital will need to be unrealistically high, in

particular given the experiences with small-business growth in Peru and Argentina.

Figure 33

Average sales growth Average sales growth

in percent from 1997 to 2000, World Latin America, by company size

Small 13.8686 1.81465 Small

Medium 15.5778 8.56271 Medium

Large 17.8463 13.6221 Large

20 15 10 5 0 5 10 15
percent percent

(Data: WorldBank (2000))

If we look at Latin America as a whole, small companies grew substantially less than

medium- and large companies in the period 1997-2000, and the difference is much more

pronounced than the world average. While the sales of small companies in the world

grew by almost 14% from 1997 to 2000, the sales of the Latin American subsample grew

163
1.8% in the same period. This further puts into question the sustainability of debt at the

cost of, for example, 30% per year.

Small and medium business owners will keep equity within the family and prefer to use
bank financing; they do not want to lose control of their company. This makes private
equity difficult.

Although potentially favorable to the banking sector if one considers banks as competing

to provide finance, the desire to keep family control of the business was unanimously

regarded negatively by the banking respondents. First, it prevents a balanced financing

portfolio on the side of the companies. Respondents in private equity firms indicated that

the most important obstacle to invest was not the lack of good projects but the

unwillingness of owners to share control. In both Argentina and Peru the respondents in

the banks and the private equity funds indicated that there exist cultures of distrust in

outside shareholders. This culture only applies to SME owners; the large companies have

to a much larger extent learned to relate to outside shareholders.

The consequence of the lack of equity is that the cushion of high-risk capital that

is supposed to take the first hit in case of a default or in a time of distress does not exist.

This again drives up the banks’ demand for collateral. When the demand for collateral

goes up per dollar financed, the total financing available to companies is reduced as it

pledges all acceptable assets.

The distrust from founders towards outside equity holders seems to have its

counterpart in the distrust the banks show towards the SME borrowers. The distrust from

the insiders towards the outsiders in the equity relationship is the inverse of the situation

164
normally discussed in the agency problem literature.258 Similarly, the distrust the banks

show towards the borrowers breaks with the assumptions in the theory behind standard

debt contracts, as we have reviewed above. Looking at the banks as outside investors,

however, shows the same relationship that the agency problem literature normally assigns

to shareholders, not lenders. Unless these trust barriers are bridged, either through the

development of the financial culture or through institutional substitutes, it is not easy to

see how one can improve the financial systems in Argentina and Peru. We will return to

the role of trust below.

Corporations have access to any finance at the most competitive rates; they are used by
the banks as a low-risk portfolio.

Corporations experience a credit buyer’s market in both countries. Since there is an

excess of liquidity, banks have an incentive to allocate as much credit as possible within

prudential limits. The preceding crises have configured the banks institutionally for a

prudent rationale by doing away with relationship banking. Since corporations represent

economies of scale in approving and monitoring credit, and since they are the most

transparent, in most cases over the best staffed entities and have the best accounting

standards and scrutiny, they have substantially easier access to credit than any other

companies.259 Because of the competition among the banks to attract the corporate

clients, there is almost no spread to produce revenue in lending to large companies;

258
Schleifer and Vishny, A survey of corporate governance
259
Fleisig and Peña, Peru suggests that banks also allocate the portfolio so that their aggregate provisions
will be minimized. We did not find any evidence of this during our interviews, even though we specifically
investigated this through our interviews.

165
unanimously, our respondents cited getting transactional business as the commercial

reason for being in the large-company segment.

We can investigate these findings empirically for our case-study countries. The

percentage of companies in a size category that report a relationship with a commercial

bank is a good indicator of whether the banks see that category as worthwhile for

business. If we look at the companies that report no relationship with a domestic

commercial bank, there are as many small as large companies in Peru with no

relationship, whereas there are more small than large in Argentina with no relationship

(Figure 34). Of the companies that have a relationship with a bank, there are as many

small as large in Argentina, but fewer small than large in Peru. These relationships are

just indications of whether our qualitative findings hold; they are not independently

statistically significant.

There is a significant relationship on a world-wide level, where companies

without domestic credit are 23 percentage points more likely to be small than large, and

companies with domestic credit are an equal number of percentage points more likely to

be large than small.260

260
For Argentina and Peru, the relationship in the table is not significant. For the world, it is significant
beyond the 1% level with a weak, but existing, strength of association (Cramer’s V = 0.17).

166
Figure 34
Use of foreign credit by company size
ARGENTINA | WORLD |
| Small Medium Large| Total | Small Medium Large| Total
-----------+---------------------------------+---------- -----------+---------------------------------+----------
No use| 15 15 5| 35 No use| 2,281 1,857 640 | 4,778
Use | 18 31 16 | 65 | 56.32% 46.07% 33.23%| 47.75%
-----------+---------------------------------+---------- ------------+---------------------------------+----------
Total | 33 46 21 | 100 Use | 1,769 2,174 1,286 | 5,229
| 43.68% 53.93% 66.77%| 52.25%
PERU | -----------+---------------------------------+----------
| Small Medium Large| Total Total | 4,050 4,031 1,926 | 10,007
-----------+---------------------------------+---------- | 100.00% 100.00% 100.00%| 100.00%
No use| 17 9 16 | 42
Use | 17 25 24 | 66
-----------+---------------------------------+----------
Total | 34 34 40 | 108
Source: WorldBank (2000). Note that there are too few companies surveyed in Peru and Argentina for the results to be statistically
significant.

The effect of the competitiveness of the corporate segment is that the corporate credit

market is saturated in both countries. Because of the strong credit risk measures in place

and the separation of commercial credit and credit risk departments with relatively

impermeable divides, the excess liquidity in the banks does not push up supply to smaller

companies. Furthermore, the banks do not seem to have invented techniques for approval

and monitoring that allow them to transfer the economies of scale down through the size

segments. This means that two mechanisms that one would expect to take place from a

profit-maximizing point of view are being prevented by the internal organizational

structure in the banks.

We also note that there is a discrepancy in how the regulatory agencies and the

financial sector in Peru and Argentina define large companies. The banks in Peru

consistently have a lower threshold for what constitutes a ‘corporation’ than their peers in

Argentina. This makes sense because of the difference in economic output. The official

definition of an SME, however, is the same in both countries.

167
Figure 35

80
lux

prt
esp
fra
60

pan
can ita
hun per jpn dnk
arg
SME share of GDP

gbr
nld pol
usa
slv
deu
40

bgr swe col

svk
rom nld
phl
tur grc
aus vnm
20

ecu
svn

rus
blr
ukr
0

0 20 40 60 80
Part of labor force in SMEs (as defined by official sources)

Globally, there is a relationship between the SME share of GDP and the size of the SME
sector. Between Peru and Argentina, however, this relationship is reversed.

(Data: Beck, Ayyagari et al. (2003). What constitutes the ‘official definition’ of SME in
each country is specified in Appendix 1 in Beck, Ayyagari et al. (2003))

Argentina has a larger share of the labor force in the formal SME sector than Peru, while

the official SME sector accounts for more of GDP in Peru than in Argentina. Note that on

a global level the relationship is the reverse: the contribution of the SME sector to total

output increases as Gross National Income (GNI) per capita increases.261 Both countries

261
SME share of GDP = - 26.50764 + 7.669034 log of GNI per capita, significant at the 99% level, R-
squared = 0.32

168
have official programs in place to help SMEs. Peru has Prompyme and Argentina has a

section at the Ministry of Finance, Sepyme, headed by a subsecretary.

Figure 36

100 GNI per capita and size of SME sector

SME as part of labor force
80

per arg
20 40 0 60

0 10000 20000 30000 40000

GNI per capita
o = SME defined as less than 250 employees
x = official definition of SME

For official definition: R-squared = 0.19, 68 observations. Function: y = 41.16646 + .0009549 * x

For SME=<250 employees: R-squared = 0.22, 50 observations. Function: y = 42.77723 + .0011784 * x

The graph shows the relationship between the SME sector’s share of output in the sample
countries and output per capita. There is a relationship between the two, whether one
defines SME as firms with 250 employees or les or use the definition of the countries’
authorities. We do not attempt to explain this relationship – it could be due to a number
of underlying variables, such as richer economies demanding more services, which are
often provided by SMEs.

(Data: Beck, Ayyagari et al. (2003))

In spite of this, the banking sector in Peru seems much more directed towards business

development for the SME sector than the banking sector in Argentina. Traditionally, the

SMEs have been serviced by the Banco de la Nacion Argentina, which is state-owned.

Lax lending policies on the part of the bank, however, have created a significant bad-debt

problem, and the bank is now increasingly conservative. A substitute mutual guarantee

169
agency owned by the largest banks and the government, Garantizar, is converting

collateral into guarantee letters, but its impact is so far limited.

This suggests that there is a disconnect in how the private sector in Argentina

relates to the SME sector – it should be focusing stronger on this sector, given the size of

the economy and the size of the SME sector; it is, however, lagging behind the banking

sector in Peru in the development of credit products to the segment.

What is in any case clear from our qualitative investigation is that the banks use

corporations as a low-risk allocation of funds from which they do not expect to make

profits in the form of spreads. They lend to corporations in order to attract other business

from the corporate clients, such as handling their transactions.

Companies are either over- or underleveraged

The combination of banks herding for the safe, normally large companies while staying

away from riskier, normally smaller companies, means, according to our respondents in

Peru and Argentina, that companies are either over- or underleveraged. The reason is that

good clients have an abundance of credit offers whereas lesser clients receive no credit

offers at all. This is a finding that appears in interviews with both bankers and other

participants in the financial system, and the finding is consistent. If this is the case, we

should be able to observe, in accordance with what our interviewees pointed out, that

companies are either over- or underleveraged.

This oversupply to some firms and undersupply to others does not harmonize with

the observation that bank managers perceive reluctance on the part of companies to take

on too much debt in order to prevent problems in case of an economic downturn, and due

170
to a general conservativeness regarding growth (the latter is more of a concern in Peru),

in other words a diminishing demand as leverage increases.

We cannot find a pattern of either over- or underleverage in Peru and Argentina

when using quantitative survey data (see Figure 39). While large companies in Argentina

seem to be less leveraged than large companies in Peru and medium-sized companies in

Argentina seem to be more leveraged than in Peru, there is no consistent pattern that

indicates either under- or overleverage for all companies If we look at companies in

countries with French legal origin, these seem to have the level of leverage concentrated

somewhat more around either low or high leverage compared to countries with English

legal origin.

171
Figure 37

Leverage by company size: Argentina and Peru Leverage: Argentina

.02
Mean of leverage by country and size
40

.015
30

Density
.01
20

.005
10 0

Small Medium Large Small Medium Large

0
Argentina Peru 0 20 40 60 80 100
Only firms with more than 0% leverage Credit from domestic banks as percentage of total financing

Leverage: World Leverage: Peru

.025
.02

.02
.015

.015
Density

Density
.01

.01
.005

.005
0

0 20 40 60 80 100 0 20 40 60 80 100
Credit from domestic banks as percentage of total financing Credit from domestic banks as percentage of total financing

Leverage: UK legal origin Leverage: French legal origin

.02

.02
.015

.015
Density

Density
.01

.01
.005

.005
0

0 20 40 60 80 100 0 20 40 60 80 100
Credit from domestic banks as percentage of total financing Credit from domestic banks as percentage of total financing

The graphs show the level of leverage for firms in Argentina and in Peru, Medium sized
firms in Argentina are more leveraged and large firms in Peru are more leveraged. If
firms in general were either over- or underleveraged, we would expect the distribution
density diagrams to show peaks at either ends. We cannot see such a pattern. If we
compare firms in countries with UK legal origin to firms in countries with French legal
origin, we see that the French-based countries seem somewhat more clustered around
low- or high leverage.

(Data: WorldBank), WorldBank (2004). Observations: Peru n = 53, Argentina n = 56, UK

legal origin n = 685, French legal origin n = 1153, World n = 2696)

172
We cannot empirically confirm the qualitative observation of under- and overleverage.

We received this observation only from respondents in banks, not in companies, one

explanation for which may be that the respondents in the banks pursue the same clients so

that their impression is created by the oversupply of credit to certain client segments. If

this supply is not met by demand, the quantity of credit actually supplied does not need to

be too high.

Other stylized facts

The stylized facts above relate to findings in previous literature and attempt to add new

knowledge to existing topics in corporate finance and banking. There are, however, other

stylized facts we can draw from our qualitative investigations in Peru and Argentina. We

will list these facts here and use the list as a basis for our cross-country investigation.

The preferred lending is for export finance

The banks we interviewed prefer short-term credit to a project with a guaranteed cash

flow. The perfect fit for this is working capital for export where the borrower already has

a committed buyer. The banks handle the transaction so that the payment reimburses the

bank loan. This type of credit favors exporting industries over others. It seems that the

reason banks favor this structure over a domestic working capital-with-settlement product

is that they do not trust the borrowers to comply with their settlement obligations where

the buyer is also domestic.

Banks finance working capital, not investment capital

The second type of credit on the banks’ pecking order of preferred business is also short

term, but without committed buyers and in the domestic market. Banks give working

173
capital from three to six months, following a rationale that we have described above.

They do not finance investment capital, and the maximum credit cited by the banks both

in Peru and in Argentina is three years, with some exceptions running up to five years for

particularly profitable clients.

Certain industries are in favor; some industries are excluded from credit.

The banks all have their lists of industries and sectors that are in favor and in disfavor.

These seem to vary among the banks, and what exists of commonalities is more

determined by a sector’s business cycles, not by the industry-average levels of collateral.

Real estate companies were, for example, not in favor among the banks in Lima at the

time of our interviews because the commercial real estate sector was perceived to suffer

from over-capacity. In Argentina, construction and real estate were among the most

favored borrowers. There do not seem to be general guidelines for what industries are in

favor beyond industry-specific business cycles.

There is only real margin in lending to small and micro companies.

Bank both in Peru and Argentina only look for profits through spreads in lending to

SMEs and, in Peru, to micro enterprises. There is such competition in the corporate

segment that the spreads are negligible. Profits from corporate clients come from the

handling of transactions and, a relatively new business in both countries, the management

of fideicomisos (trusts).

Credit is very closely monitored, and collateral is ‘logical.’

As we have explored in depth above, credit is monitored very closely, despite what the

literature would suggest. Furthermore, the collateral that banks take is ‘logical,’ i.e., the

174
assets that are related to the activity that is financed are used as collateral. There is no

theoretical reason for this from an economic point of view; any collateral should be able

to serve as security for any lending, according to the theory. Rather, the reason seems to

be organizational. Since the banks monitor the part of the borrower’s activity that is

related to the credit, they also monitor the collateral. As one of the banks’ major concerns

is that the collateral disappears, such cost efficiencies in the monitoring make sense. The

only exception from the ‘logical’ collateral is using real estate. We have reviewed the

reasoning behind this above.

Interest rates are set by the markets.

Economic theory predicts that the banks will adjust interest rates to reflect the risk of a

particular credit line. This is not the case in any bank we have interviewed, neither in

Argentina nor Peru. The commercial credit departments do not measure the risk involved

in the potential borrowers to whom they market credit. Only after a tentative agreement

has been reached between the loan officer and the client will the proposal go to the credit

risk department which assesses the risk. The interest rate will already have been

negotiated by the loan officer based on the bank’s general guidelines, because the

potential borrower will have shopped around among banks to find the best interest rate.

This is particularly pronounced in Peru and Argentina, as the banks flock to the high-

quality borrowers, so that there is a disproportionate interest in a limited number of firms.

The credit risk department cannot adjust the interest rate; rather, it requires

collateralization and limits the term of the credit line.

Small companies with high margins limit growth.

175
The bank managers interviewed, in both countries but particularly in Peru, frequently

criticized entrepreneurs for not wanting to expand their companies. Rather, the bank

managers claimed that entrepreneurs extract high profits from a small company that they

again use to found other small companies. The explanations offered for this practice

varied during our interviews. Some explanations were that the entrepreneurs wanted to

stay ‘off the radar screen,’ others (in Peru) that there is a practice of ‘one-purpose

corporations’ where a company will be set up for one project, in particular in

construction, without an intent or a plan for a sustainable business. Another explanation

was that this is a way for entrepreneurs for retaining control of their ventures, and to

diversify in case one industry experiences adverse shocks. This could be interpreted as

placing a higher value on risk diversification through a larger set of companies rather

than gaining the benefits of economies of scale.

Since the companies are not intended to grow, there is little reinvestment of

profits into retained earnings. This requires the entrepreneur to create new companies in

order to increase his own income; this entrepreneurial activity is funded by high

dividends.

Small and medium-sized companies need to post real estate as collateral.

As a matter of procedure, SMEs must post real estate as collateral in order to obtain

financing. This requirement seems to have more to do with monitoring than with securing

the credit, as we have discussed above. SMEs without real estate do not seem to have

access to credit, with the exception of micro-credit in Peru and through the mutual

176
guarantee agencies in Argentina.262 Corporations are in a buyer’s market and do not have

to post real estate as collateral for credit.263

Micro-finance does not normally use collateral.

Micro-credit is perceived to be low-risk because of the large number of borrowers. We

have discussed the weakness of this perception above. Because of this misconception,

collateral is not much used in micro-finance, and in cases where it is used, the asset used

is normally real estate. Micro-finance relies on close client monitoring, so the monitoring

function performed by real estate in SME credit is not as necessary as in traditional bank

financing. There are a great number of types of micro-finance, and some compare better

to small-business credit than to traditional microfinance.264 The focus of the industry,

however, is on a business model that is distinct from commercial banking, and without

collateralization. As the commercial banks enter the micro-finance market, the divide

between commercial credit and micro-finance can be expected to disappear. For the

moment, however, the Peruvian banks regard micro-finance as a distinct product from

SME finance.

Small companies, micro-finance, and leasing are installment sensitive.

262
There is only one mutual guarantee agency that is not industry specific: Garantizar. This agency is
founded on the initiative of the government and owned jointly by a number of banks. There are a number of
private mutual guarantee agencies set up by companies outsourcing agricultural production or relying on a
large number of agricultural suppliers.
263
This is a recent development. In Argentina the banks indicated that up until the last crisis, corporations
also were expected to post various forms of collateral. The crisis, however, accentuated the corporations’
unique position in the credit market.
264
For an overview that according to our observations still seems to be representative of the underlying
seems structure in the market (except the entry of the commercial banks) see Taborga and Lucano, 1998,
Tipologia de instituciones financieras para la microempresa en america latina y el caribe and the
adaptation in Almagro Herrador and Fiestas Clapes, 2001, New tendencies in latin american microfinance .

177
Part of the attraction banks see in small companies and micro-finance is that they

perceive such clients to be installment-sensitive rather then interest rate-sensitive. Such

borrowers will look to their cash flow’s ability to service a loan rather than to the total

cost of the loan (the number of installments). This is in particularly true for micro-

finance. Some interview subjects mentioned this as for leasing, although the actual

finding is less consistent,265 which allows the banks to price loans to these segments

much higher than they can price credit to medium-sized companies and large companies.

10-50% of collateral is recovered, and the process takes six months to several years.

Both in Argentina and Peru, banks have special regulations that allow a faster realization

of collateral than for other lienholders. Even given this, the process for realizing

collateral takes from six months to many years. There is, to our knowledge, no systematic

data collection on recovery times for different forms of collateral in Latin America as

there is in Eastern Europe.266 The subjective perception about whether the current

realization times are ‘sufficiently fast’ is mixed. We received many complaints about

collection time, but so would we, probably, were we interviewing Japanese banking

managers, where collection time is six years.

When the case ends up in the collection department of the banks, it seems to live a

separate life, and the measure on which the collection department judges its performance

is the percent of the collateral that is recovered, not the time it takes to recover, according

265
The attraction in leasing seems rather to lie with tax incentives, which gives the banks an opportunity to
structure the credit in order to capture the value of the incentive.
266
Muent and Pissarides, Impact of collateral practice . The time it takes to close a bankrupt business is a
related measure. In Argentina it takes 2.8 years, in Peru 2.1 years; the Latin American average is 3.7 years,
and the OECD average is 1.8 years; see WorldBank, 2004, Doing business .

178
to our interviews with managers in the banks’ legal departments. A much greater and

highly consistent concern to the managers we interviewed was that moveable collateral

would easily disappear even before the bankruptcy. In these cases, the collection time

becomes irrelevant. The second concern was that perishable collateral, such as some

inventory, or collateral that needs maintenance such as vehicles, would not survive a

collection process. Time therefore becomes a measure relative to the nature of the

collateral, not to the policies of the bank.

Shortcomings in legal efficiency make the banks perceive the legal system as of little value.

Judicial enforcement enters into the daily decision-making process in the banks in a

marginal way. The level of trust in the capabilities of the legal system and in the

willingness of judges to provide an efficient framework for business was very low among

our respondents, and the world of bankers seems to be distinctly separate from the

judicial system both in Peru and in Argentina. The impression is that the legal system is

slow and that the judges do not understand the financial legislation. We also encountered

the observation, in both countries, that judges would take extrajudicial concerns into

consideration. Examples given were that judges would refuse to recover collateral from

individuals, and that judges in the provinces in Argentina would rule in favor of local

commercial or political interests rather than in favor of the bank, even if the bank’s case

were clear.267 All the interview subjects in the banks to whom we addressed legal

concerns stated that they would do everything possible to avoid the legal system.

267
Note that the assertion from a part that his case is clear cannot be trusted. However, we are here
discussing the perception by the banks of the judges, not individual cases.

179
Fideicomisos are the newest way to avoid judicial enforcement.

Both in Peru and Argentina, the banks are developing fideicomisos (trusts) as a way of

avoiding the legal system to the greatest extent possible.268 Fideicomisos become direct

owners of the assets transferred thereto, so that they, upon completion of the project (or

credit), self-execute according to their statutes. This eliminates the threat of a situation

where the borrower takes judicial measures in order to stall the recovery procedure.

Fideicomisos suffer from two problems in both countries. First, the courts are not used to

dealing with the legal issues that fideicomisos represent so that there is a legal uncertainty

related to their use (one cannot avoid the legal system completely), and second, the costs

related to setting up fideicomisos are too large for this structure to be used for SMEs.

Both these concerns are likely to diminish as the courts get used to the structure and as

the banks set up standardized procedures for creating trusts.

A borrower needs contacts in the form of reputational capital.

Although much less of a deterrent now than during the times of relationship lending,

companies still need to develop contacts in the financial system. The best way of

synthesizing our qualitative findings is to distinguish between ‘personal capital’ and

‘reputational capital.’ The difference with the previous system of relationship lending is

that before, the contacts were dependent on personal (or ‘social’269) capital, while now

268
For Peru, see Flor Matos, 1999, El fideicomiso: Modalidades y tratamiento legislativo en el peru and
Lazo Navarro, 2003, La titulizacion de activos como medio para el desarollo de negocios . For Argentina,
see Kelly, 1998, Fideicomiso de garantia and Fernando Games and Americo Esparza, 1997, Fideicomiso y
concursos .
269
We use the term ‘personal’ capital rather than ‘social’ capital in order to avoid confusion with the
numerous more or less established definitions of ‘social’ capital already proposed in the literature. We

180
the weight has shifted to reputational capital. Reputational capital emphasizes the

borrower’s performance; personal capital emphasizes the borrower’s connections such as

personal networks and family and, thus, his ‘goodwill’ with the lender. The reputational

capital may spread as banks check with other banks in assessing a client’s past behavior

and reputation; the personal capital is more deeply founded in social and family ties that

take time to establish, and that are restricted often to people being born into certain

families or social circles with high barriers to entry.

Political uncertainty restricts maturities.

Consistently across our interviews in both countries, bank managers stated that a major

cause of the lack of long-term funding was political uncertainty. In Argentina there exists

a common myth that there is a crisis every ten years. The interview subjects did not link

the uncertainty to any political dynamics in particular. The issue seems to be related to

uncertainties about what proposals might come from members of Congress at any time,

and that the populism in politics has a tendency to single out the financial system as

culprit for the country’s social and economic problems. One example offered is how

reforms of the bankruptcy legislation were put on hold because a rational outcome from

Congress was not necessarily probable.270 Another example was how the judicial

community is currently experiencing a tendency to favor debtor over creditor, while

before the recent crisis, the financial community saw opportunities to structure their own

return to discussing social capital below. Our use of ‘reputational’ capital is not necessarily the same as in
other literature.
270
This example came from a Buenos Aires-based lawyer who worked for one of the International
Financial Institutions on reforming the bankruptcy code.

181
enforcement mechanisms much like the special banking courts that the Peruvian banking

association is currently designing.271

In Peru, the interview subjects identified the cause of political uncertainty much

more specifically than in Argentina. Lenders stated that they look to election cycles when

deciding on credit. Since there is no guarantee what the financial and legislative policies

of any new government will be, and since there is considerable electoral uncertainty, the

banks will not commit assets beyond the electoral horizon. The bank managers

interviewed did not believe any government can commit the state beyond its term. There

is therefore little prospect of medium-term commercial lending unless the trust in the

regulatory stability is improved.

There is a cost for the borrower in defaulting.

A frequent observation was the assertion that there used to be no cost in defaulting for a

client, since the collateral would be sold off, the collection process could be stalled in the

judicial system indefinitely, and the bankruptcy legislation allowed for restructuring that

would penalize the banks, not the borrower. The latter was a more frequent observation in

Peru, where INDECOPI is the state-controlled organization that governs restructurings,

than in Argentina.

This is no longer the case. There seems to be an increased awareness at

INDECOPI in Peru that also debtors, not only creditors, may be to blame in bankruptcies,

271
This was a general observation from several sources, both lawyers and bankers.

182
so that renegotiations are more balanced.272 Both in Peru and Argentina bank managers

believed that borrowers no longer regarded bankruptcy proceedings as a shelter from

creditors and that borrowers would no longer use bankruptcy to ‘blackmail’ creditors.

Corruption is not an issue in particular.

None of our interview subjects mentioned corruption as a problem, including corruption

of the judiciary. The complaints about the judiciary related to bias against creditors, lack

of capabilities to process and understand financial issues, and high cost and durations for

solving conflicts. The only corruption-related issue that surfaced was of some Argentine

interview subjects who suspected judges of accepting bribes when solving cases.

There exists a ‘culture of backwardness.’

A frequently mentioned problem in the discussions with our Peruvian subjects, and which

also surfaced in Argentina, was a perceived ‘culture of backwardness’ in the SME

community. It proved difficult to arrive at a more detailed description of the problem.

Consequences of this ‘culture’ that were mentioned are:

- Entrepreneurs go with proven business-models and do not innovate;

- Business owners do not really want to expand;

- Business owners do not want to relinquish control over their company;

- There is a fear of transparency and outside auditing;

- There is a tendency to ‘stay under the radar screen’;

272
The past history of INDECOPI as being biased towards the debtor has caused at least one of the major
commercial banks in Lima to consistently vote against any renegotiation proposal during proceedings as a
matter of policy, and INDECOPI officials had mixed perceptions of the banks’ willingness to negotiate.

183
 - There is a fear of new technology and financing methods;

- SME owners are risk-averse.

When asked about specific examples, however, the respondents were generally vague in

their replies. Given the conservativeness of the banks, it is difficult to determine whether

this ‘culture of backwardness’ is a phenomenon in the SME sector or a consequence of

the conservative pressure applied by the banks themselves. The findings from the

qualitative studies based on our interviews in Peru and Argentina are therefore

inconclusive. We will return to this in our quantitative investigation below.

These are the stylized facts we draw from our field studies in Peru and Argentina.

We will now investigate whether or not these findings are descriptive across a larger

sample of countries. We will construct a model taking our findings into account, and

apply them on a database compiled from an array of different data sources.

184
How do firms obtain funds? A quantitative analysis.

Based on our stylized facts, we can construct a model of financing sources for companies.

As dependent variables we use the percentage of a firm’s balance sheet made up of

retained earnings, equity, domestic credit, family, supplier credit, and state funding,

respectively. The independent variables come from a cross-sectional firm-level survey of

around 10,000 companies world-wide (The World Business Environment Study). The

interviews were carried out between 1998 and 2000. For our analysis, we retain between

1,916 and 3,137 companies in 39 countries.

We select dependent variables based on our qualitative observations (the variables

and sources are described in detail in the Appendix). According to our qualitative studies

of Peru and Argentina the source of financing is dependent on the following variables:

From The World Business Environment Study:

- The company size. In our dataset, a small company is defined as having 50 or

fewer employees; a medium sized company has between 51 and 500 employees,

and larger companies have over 500 employees. We specify the model so that it

compares small- and medium sized companies to the default, large companies.

- The company’s industry. We classify the firms into manufacturing, which is the

default, and services, agriculture, and construction.

- The company’s age. We use a linear measure of age, although all the

specifications have also been tested with a non-linear measure.

185
- Whether the company has foreign ownership or not. We use a dummy variable for

this.

- The company’s growth rate. This is the percentage growth of sales over the past

three years.

- Whether the company has operations in foreign countries or not, measured

through a dummy variable.

- Whether the company has government ownership (a “state-owned enterprise”).

- Whether the company is an exporter, measured through a dummy variable.

From the Doing Business database:

- The quality of creditor rights in the country’s legal system. This is an index

ranging from 0 to 4 where a higher value means better creditor rights. The index

measures the priority of creditors’ interests in bankruptcy and reorganization.

- The quality of bankruptcy legislation in the country. This measure, based on the

cost, time, and efficiency of the bankruptcy process in a country, ranges from 0 to

100.

- The information available about the companies’ past credit performance through
public credit registries. This measure, from 0 to 100, is composed of how the
collection, distribution, and access of information through the registries, as well as
the quality of information contained in the registries.
- The flexibility in labor management. We use the flexibility in firing employees as
a proxy for this. This index, ranging from 0 to 100, is based on procedures for
dismissal of employees.

186
 - The level of political stability in the country. This standardized measure is based

on a compilation of a broad variety of indicators and measures of political

stability.

From The World Values Survey:

- The level of ‘backwardness’ (proxied by the level of traditional values in the

country). This measure is a standardized factor scale that describe traditional

versus secular-rational values, averaged by country. A higher score means more

traditional values.

- The importance of the family. The average in a country of answers to how

important family is to the respondent, between 1 and 4, with a lower value

meaning family is more important.

We control for geographic region and national output per capita. When we run the model

with these independent variables, we obtain the results in Figure 38.

187
Figure 38

Source of financing, company characteristics and legal characteristics

The ordered probit regression estimated is: Percentage of financing from the financing source = α + β Size of company + β Industry +
β Firm age + β Foreign ownership dummy + β Sales growth + β Multinational dummy + β Government ownership dummy + β Export
dummy + β Creditor Rights Index + β Bankruptcy Index + β Public Credit Registry Index + β Court Powers Index + β Procedural
Complexity for New Entries Index + β Lay-off Flexibility Index + β Political stability index + β Rule of law index + β Traditional
value scale (mean by country) + β Family important (mean by country) + β GNI per capita + β Geographical region dummy + u.
We use an ordered probit model following Love and Mylenko (2003), who investigates the same dependent variables. In
this specification, we divide the share of financing into ten categories, by decile of financing obtained from the source.
Specification (1a) excludes companies that use retained earnings for more than 80% of their financing. R-squared are
McKelvey and Zavoina (1975). The standardized versions of significant coefficients are reported in the text.

(1a) (1b) (2) (3) (4) (5) (6)

Retained Retained Equity Domestic Family Supplier State
earnings earnings credit credit
Small company -0.153 0.119 -0.251 -0.294 0.973 -0.026 -0.622
(1.79)* (1.71)* (2.53)** (3.92)*** (7.19)*** (0.29) (4.34)***
Medium-sized -0.034 0.016 -0.065 0.018 0.483 0.156 -0.007
(0.46) (0.27) (0.78) (0.28) (3.74)*** (2.02)** (0.07)
Service -0.124 -0.074 0.081 -0.068 0.079 -0.062 0.197
industry
(2.10)** (1.60) (1.18) (1.31) (1.14) (1.06) (2.10)**
Other industry -0.455 -0.583 0.555 0.015 0.615 -0.068 0.360
(not manuf.)
(1.46) (2.24)*** (1.69)* (0.05) (1.86)* (0.20) (0.92)
Agriculture 0.061 -0.065 -0.145 -0.004 0.143 -0.150 0.735
(0.56) (0.78) (1.01) (0.04) (1.16) (1.40) (5.86)***
Construction -0.080 -0.016 0.205 -0.032 0.048 -0.144 0.115
(0.84) (0.22) (1.89)* (0.38) (0.44) (1.40) (0.73)
Company age -0.000 0.001 -0.000 -0.001 -0.001 -0.001 0.004
(0.27) (0.83) (0.21) (1.14) (0.69) (0.49) (3.26)***
Foreign -0.116 0.029 0.214 -0.113 -0.436 -0.153 -0.228
ownership
(1.59) (0.49) (2.71)*** (1.78)* (3.79)*** (2.00)** (1.77)*
Company growth 0.000 -0.000 0.001 0.000 -0.000 0.000 -0.000
last 3 years
(0.84) (0.85) (3.37)*** (1.04) (0.22) (0.51) (0.66)
Multinational -0.012 -0.069 -0.023 -0.109 -0.022 0.080 -0.253
(0.16) (1.16) (0.27) (1.68)* (0.21) (1.05) (1.85)*
Government -0.150 -0.019 -0.116 -0.098 -0.667 -0.028 0.882
ownership
(1.88)* (0.30) (1.27) (1.38) (4.87)*** (0.34) (9.39)***
Exporter dummy 0.004 -0.074 0.137 0.178 -0.118 0.123 -0.078
(0.06) (1.59) (2.04)** (3.46)*** (1.63) (2.07)** (0.84)
Creditor rights -0.014 -0.046 0.050 0.045 -0.052 -0.031 0.114
index
(0.38) (1.52) (1.18) (1.33) (1.15) (0.78) (1.79)*
Bankruptcy 0.005 0.004 -0.002 -0.001 -0.006 -0.003 -0.005
index
(2.64)*** (2.32)** (0.85) (0.91) (2.48)** (1.69)* (1.48)
Credit registry -0.001 -0.002 -0.002 0.001 -0.000 -0.005 0.004
index
(1.22) (2.14)** (1.48) (0.93) (0.34) (3.59)*** (2.30)**
Procedural 0.008 0.005 -0.000 -0.004 -0.003 0.003 -0.008
complexity
index
(3.42)*** (2.74)*** (0.05) (1.92)* (1.01) (1.44) (2.19)**
Layoff -0.000 0.001 0.002 -0.004 -0.014 0.003 0.005
flexibility
index
(0.11) (0.44) (0.80) (2.64)*** (6.32)*** (1.37) (1.67)*
Political -0.270 -0.239 0.439 0.207 -0.346 0.037 -0.277
stability index
(5.20)*** (5.77)*** (7.19)*** (4.50)*** (5.38)*** (0.69) (3.36)***
Traditional 0.662 0.705 -0.743 -0.148 -0.039 0.058 -0.032

188
values
(6.60)*** (8.85)*** (6.71)*** (1.69)* (0.31) (0.59) (0.20)
Family not -1.103 -1.388 1.660 0.478 2.222 1.854 -0.530
important
(2.24)** (3.66)*** (2.92)*** (1.11) (4.00)*** (3.81)*** (0.65)
GNI per capita 0.000 0.000 0.000 0.000 0.000 0.000 0.000
(4.35)*** (2.08)** (1.35) (0.04) (0.07) (1.97)** (2.13)**
Latin America 1.057 0.848 -0.691 0.179 0.003 0.564 -0.471
(6.28)*** (6.20)*** (3.81)*** (1.25) (0.01) (3.42)*** (1.67)*
Europe & 0.856 0.762 0.132 -0.326 -0.262 0.043 -0.054
Central Asia
(5.05)*** (5.47)*** (0.71) (2.21)** (1.11) (0.25) (0.20)
East Asia 0.784 0.724 -0.433 -0.059 -0.267 0.456 -0.747
Pacific
(4.71)*** (5.40)*** (2.39)** (0.41) (1.13) (2.73)*** (2.29)**
South Asia 0.908 0.034 0.124 0.117 0.125 0.219 -0.708
(4.26)*** (1.91)* (0.52) (0.62) (0.44) (0.81) (1.61)
Observations 1916 3128 3137 3127 3120 2994 2965
R-squared 0.090 0.125 0.172 0.172 0.292 0.070 0.304
LR Chi2 150.81 366.81 265.85 309.49 389.14 113.51 375.53
Absolute value of z-statistics in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%

Our model, which includes 38 to 40 countries, explains reasonably well financing from

retained earnings, equity, domestic credit, family, and the state (with R squared of 0.125,

0.172, 0.172, 0.292, and 0.304, respectively). These dependent variables are categorical

from 0 to 10, and they describe the proportion of funding to a firm that comes from each

of the sources. Zero means no funding comes from the source, 1 means that up to 10% of

funding comes from the source, 2 means between 10.01 and 20% of funding comes from

the source, and so on. We assume that firms that are solely reliant on one source of

funding will not be in the market for other types of financing, and we would like to

exclude such firms from the sample where relevant. In practice, this is only the case for

retained earnings. We therefore use two samples in our analysis of retained earnings, one

excluding firms that have more than 80% of their financing from retained earnings, and

one that includes all the firms in the sample. We will report results from the sample that

excludes firms only funded by retained earnings unless otherwise is stated, and we use

the full sample to control the robustness of our findings.

Or analysis gives us the following results:

189
The impact of company characteristics

Company size matters

Small companies are 0.27 standard deviations less likely to be financed by domestic

credit than large companies. These observations match our qualitative findings in Peru

and Argentina, which indicate that small companies have limited access to bank credit.

We do not find such a relationship for medium-sized companies. Small companies are

also less likely to be financed by equity than large companies; this effect is almost as

strong as domestic credit (0.23 standard deviations). This would be consistent with large

companies having access to borrowing, and small companies being adverse to opening up

to outside shareholders.

The smaller a company gets, the more likely it is to be financed by family: a

medium sized firm is 0.40 standard deviations more likely to be financed by family than a

large one, and a small firm is 0.82 standard deviations more likely to be financed by

family than a large firm. This is consistent with our qualitative findings in Peru and

Argentina, and it suggests that those findings could be generalized to a global level.

Everything else being equal, small firms finance themselves less by retained earnings (-

0.15 standard deviations compared to large firms). This is consistent with the

observations from some of our respondents in Peru and Argentina that small firms are

used to generate and extract cash rather than to reinvest in growth.

Medium-sized companies are more likely (by 0.15 standard deviations) to be

financed by supplier credit than large companies. This makes sense compared to our

findings in Peru and Argentina, where it normally is large companies that finance their

190
suppliers using supplier credit. The state finances small firms less than large firms, by

0.52 standard deviations). There is no significant effect on medium sized firms.273

Industrial sector matters.

We find a pattern across industrial sectors in our analysis. Compared to manufacturing,

the service industry is less likely to be financed by retained earnings and more likely to

be financed by the state (by -0.12 and 0.16 standard deviations, respectively).

This could indicate that owners of service companies take out more profit in the

form of dividends and that the government puts more money into service companies. This

again could mean that the financing from the government goes into the pockets of the

owners of the service companies rather than to help these companies grow. In order to

test this hypothesis, we introduce an interaction term between government ownership and

the service industry dummy variable, so that our new variable denotes a service firm that

is owned by the government. Adding this variable to the model does not change the fit (R

squared remains at 0.30). It shows that it is indeed the government-owned service firms

that are financed more by the government (being a government-owned service firms

increases the likelihood of being financed by the government by 0.14 standard deviations,

significant at the 5% level). However, whether a service firm is more or less financed by

retained earnings is not determined by whether or not it is owned by the government.

This indicates that the government is not financing non-governmental owners’ extraction

of cash from service firms.

273
Note that this variable captures the percentages of the funding posts on a company’s balance sheet and
not the total government funding in an economy. Therefore, we cannot say that the governments in our
sample on aggregate fund large companies more than small ones.

191
 Agricultural companies compared to manufacturing are more likely to be financed

by the public sector, by 0.49 standard deviations. As opposed to the service sector, all

agricultural businesses receive more financing from the public sector, not only firms

owned by the government. If we introduce an interaction term for agribusiness owned by

the government, our fit increases marginally (R-squared improves to 0.31 from 0.30), and

we find that everything else being equal, being in the agricultural business increases state

financing by 0.72 standard deviations. If a firm is in the agricultural business and owned

by the government, however, its chance of being financed by the government is only 0.37

standard deviations higher. This suggests that, as opposed to the service business, state

financing is directed to the agricultural sector as a whole, and in particular to privately

owned agricultural firms.

In Argentina, we observed that the construction business is favored by the banks,

and in Peru we found that the banks stayed out of the construction business. This

illustrates the problem with credit patterns and sectors that we observed during our

qualitative studies. We found that the sectors which are on the banks’ list of favored or

disfavored clients are strongly dependent on local business cycles, and that these lists

change frequently. In line with this cyclicality, we do not find any significant impact

from being a construction firm on the source of financing (as we would expect cycles to

vary among the countries in our sample).

Age matters for financing from the public sector.

The older a company gets, the more likely it is to receive more financing from the public

sector (a one standard deviation increase in age increases this financing by 0.09 standard

deviations). This relationship is linear; if we introduce a non-linear age term, it is not

192
significant for any source of financing. None of our qualitative observations in Peru or

Argentina help us to explain this effect. It could indicate that the state props up old firms.

If this were the case, we would expect to see less financing from non-state sources, but

cannot find such an effect.

An alternative explanation could be that these firms are firms with institutional or

infrastructural functions, such as large scope manufacturing distributors, cooperative-like

supplier- and distribution firms, or privatized utilities. We do not have the data, neither

from our quantitative sources nor from our interviews in Peru and Argentina, to pursue

these hypotheses.

Foreign ownership matters.

A company with foreign ownership is less likely to be financed by domestic credit (-0.11

standard deviations), less likely to be financed by family (-0.37 standard deviations), and

less likely to be financed by the state (-0.19 standard deviations). There are indications

that such firms are more likely to be financed by equity and less by supplier credit.274

Foreign companies have access to foreign banks they can shop around in a larger

credit market than the domestic one, which would explain why they are less financed by

domestic credit. If the terms of financing are better in its home country, a foreign owned

firm would be able to finance its foreign operation through its own treasury.

It is also to be expected that foreign owned are less financed by the government, since

one would expect a government to support its domestic business for political reasons. In

274
The model for supplier credit has a poor fit. Within this models, the effect is strong: A foreign-owned
firm is significantly at the 5% level 0.15 standard deviations less likely to be financed by supplier credit.

193
most cases, establishing a presence in a foreign country is most likely easier through

incorporation. This means we would expect funding from shares to be more important for

foreign owned firms, which is consistent with the quantitative findings.

Firm growth matters little.

The growth of a firm over the last three years before the survey only affects equity (a one

standard deviation increase in growth increases reliance on equity by 0.08 standard

deviations). It is intuitively surprising that there is no effect of growth on other financing

sources. In particular, we would expect a fast-growing company to be able to easier

obtain bank finance.

Our qualitative observations in Peru and Argentina strongly suggest that banks are

conservative in their credit assessment, and they equally strongly suggest that firms are

not able to use banks for growth. This is consistent with our global quantitative finding

that growth is not significantly correlated to domestic credit, which gives us reason so

suspect that banks do not play a large role in funding firm growth.

It is natural that a growing firm is funded more by equity than are other firms. A

growing company represents a better investment opportunity for shareholders, and the

shorter time horizon an equity investor has, the more attractive a fast-growing company

will be.

Operations in foreign countries matter.

Our model indicates that companies that have operations in other countries are less likely

to be financed by domestic credit market and the state. Operations in other countries lead

to a decrease in financing from these sources of 0.11 and 0.21 standard deviations,

respectively (both are significant at the 10% level only).

194
 These findings make sense for the same reasons that foreign-owned companies

are less likely to be financed from the same sources. In particular, such firms are more

likely to be able to use their foreign operations to shop around for financing outside the

domestic market. Also, it is less likely that the government will finance the part of a firm

which operates abroad, so that any government financing of such a firm will take up

proportionally less of the balance sheet than would be the case for firms with domestic

operations only.

Government ownership matters.

A government owned firm receives more financing from the public sector (0.73 standard

deviations), as would be expected.275 Interestingly, government owned firms with mixed

financing are also less likely to be financed by retained earnings (-0.14 standard

deviations).

This could mean that government firms are less likely to be financially self-

sufficient than other firms, in being less profitable, and that the public sector keeps these

firms alive. It could also mean, however, that public credit to these firms is measured to

fit the firms’ financing needs, and that they are not expected to retain earnings for

financing. It could also mean that profits are extracted from the companies rather than

reinvested. We do not have the data to identify which of these explanations are more

probable.

275
By nature, it is less likely to be financed by family (-0.56 standard deviations).

195
Being an exporter matters.

Consistent with our qualitative findings in Peru and Argentina, exporters are more likely

to be financed by equity, domestic credit, and supplier credit. Being an exporter increases

the reliance of these sources of financing by 0.12, 0.17, and 0.12 standard deviations,

respectively.

The banks we interviewed in Peru and Argentina regarded exporters as less of a

credit risk than companies relying on domestic sales, and they also qualify for export

finance products for example, which are favored by the banks. All the banks had export

credit as a permanent product, and all expressed that firms with exports would be able to

obtain export financing regardless of the size. This is consistent with our qualitative

findings. Exporters are also frequently able to show banks proof of their export contracts,

so that the banks know that there will be cash flow coming in. This lowers the risk and

should in itself make an exporter obtain more bank credit than other firms, everything

else being equal.

Our models for equity and supplier credit are less reliable, but the results make

sense for much the same reasons as for bank credit: suppliers are likely to obtain finance

if their sales are guaranteed through export contracts, and firms that can diversify to

export markets can be a better investment for shareholders.

196
The impact of country characteristics.

Better creditor rights are not associated with how firms obtain financing, but the quality
of the bankruptcy legislation is.

The quality of creditor rights in a country does not matter for how firms obtain

financing.276 This is surprising, given the literature we have reviewed above. One would

believe that better creditor rights would lead to banks extending credit more easily to

firms. It is possible that this happens even with our results, but under the unlikely

assumption that all the other sources of financing we review here also increase

proportionately much. This finding is consistent with our qualitative findings from Peru

and Argentina: that the legal framework on creditor rights does not enter into

consideration at a high priority when banks make credit decisions.

The better bankruptcy legislation a country has, the more likely firms are to be

financed by retained earnings (0.09 standard deviations for each standard deviation

increase in the bankruptcy index) and the less likely are they to be financed by family (-

0.09 for each standard deviation increase in the bankruptcy index).

The bankruptcy index differs from the creditor rights index in that it does not

focus on specific claimants to the firms assets; it simply looks at how efficient it is

(measured through cost, time, observance of absolute priority of claims, and efficiency of

outcome). The creditor rights index focuses on the standing of secured creditors. This

further strengthens our qualitative observations in Peru and Argentina: the legal

276
This holds also if we group all external financing mechanisms together (equity, domestic credit, and
supplier credit) or both credit financing mechanisms (domestic credit and supplier credit).

197
framework for secured transactions does not enter significantly into the banks’ credit

allocation process.

Firms in countries with better bankruptcy laws do, surprisingly, not obtain more

external finance.277 This is contrary to theory that suggests that better bankruptcy

procedures should reduce risk for external financiers and hence lead to more external

finance. It is, however, consistent with our findings in Peru and Argentina: rarely to never

do the banks take into account the bankruptcy legislation when making credit decisions.

What we do find in our cross-country sample, is that firms are less likely to be

financed by family. This makes sense. The family is the insider and the bank or

shareholders are the outsiders. Better bankruptcy legislation reduces the likelihood of

agency problems because the insiders cannot use the threat of bankruptcy court to act

against the interests of outside shareholders and the banks. This means that families

would be expected to lock in fewer funds in a family enterprise that, given bad

bankruptcy legislation, would be protected against the outsiders. This is consistent with

our interviews in Peru and Argentina, where bankers expressed concern that insiders

would use the bankruptcy institutions to shield assets from outside creditors.

This mechanism would also explain why firms in countries with good bankruptcy

protection are more likely to be financed with retained earnings, everything else being

equal. The more efficient the bankruptcy procedures, the less willing insiders would be to

use external finance because the outsiders could more easily recuperate their investment.

This means that the more the bankruptcy legislation counteracts agency problems, the

277
This holds also if we group external finance together into one variable.

198
more likely are the insiders to finance the company with the source of funding that they

themselves control, i.e. retained earnings.

Better contract enforcement is associated with less retained earnings.

When it is more complex to enforce a contract, companies rely more on retained earnings

and less on domestic credit (0.10 and -0.05 standard deviation change with a one standard

deviation increase in the procedural complexity index, respectively).278

This is consistent with the theory we have reviewed, as outsiders are dependent on

being able to enforce their claims in case the agents of the firm do not repay. When

procedural complexity is high, firms have to rely more on internal sources of finance. It

does not necessarily fit well with our qualitative observations in Peru and Argentina,

where bank managers rarely considered recovery in court as a realistic option in

extending credit, in particular to small- and medium-sized firms.

More flexible labor regulations are associated with more domestic credit and family
financing. Less flexible labor regulations are associated with more government
financing.

Flexible labor regulations are a component of the ease for a company to adjust to

changing business cycles, which is reflected in our findings. With a one standard

deviation increase in worker protection, the share of domestic credit as firm financing

falls by 0.08 standard deviations, and the share of family financing falls with 0.24

standard deviations.

278
The impact on domestic credit is significant with a probability of 0.001 and 0.055, respectively.

199
 It makes sense that family financing is more sensitive to this than bank financing.

Family investment in a firm often (but not always) constitutes an undiversified

investment, with the welfare of family members directly tied to the risk the firm presents.

If labor regulations prevent the firm from adjusting to market conditions or to get rid of

unproductive workers, the risk to the family increases. Banks have more options of

diversification among its clients, and the link between the risk posed by an unproductive

worker and the overall risk structure of the bank is much weaker than the link between

the worker and the family investor.

Consistent with intuition, firms in countries with a high level of worker protection

are more often financed by the government (0.09 standard deviations increase with a one

standard deviation increase in the worker protection index).

Political stability is associated with more external finance.

There is a strong association between political stability and external finance. With a one

standard deviation increase in our political stability measure,

- Reliance on retained earnings decreases by 0.20 standard deviations;

- Reliance on equity increases by 0.31 standard deviations;

- Reliance on domestic credit increases by 0.15 standard deviations;

- Reliance on family financing decreases by 0.23 standard deviations;

- Reliance on public sector financing decreases by 0.18 standard deviations.

All the coefficients are significant at the 1% level.

This is highly consistent with our qualitative observations in Peru and Argentina.

The major concern among our respondents in both countries was that political instability

prevented long-term financing, and long-term projects in general. The regression reported

200
here suggests that a lack of political stability forces the insiders (a firm’s managers and

family owners) to provide the financing themselves (through retained earnings and family

finance) because outsiders cannot cope with the uncertainty created by lack of political

stability in assessing the risk of the venture. Insiders have more information about how

they can handle unexpected political developments, and they do in any case have a

personal interest in keeping the business alive.

Traditional values are associated with internal finance.

To test the suggestion from our Argentine and Peruvian interview subjects that a ‘culture

of backwardness’ impacts financing, we use as our proxy a variable describing the

prevalence of traditional values in a country (as opposed to modern values). This variable

is a factor scale based on values in mainstream preindustrial societies and is intended to

capture the difference between a society that is culturally preindustrial and one that is

culturally industrial. For further details, we refer to Inglehart (2000a). There is of course

a substantive difference between these two measures: ‘backwardness’ has a negative

connotation; traditional values are a neutral concept. For research purposes, a value

neutral concept is preferable.

Our quantitative findings support our qualitative observations from Peru and

Argentina. A one standard deviation increase in the traditional value scale is associated

with a 0.34 standard deviation increase in reliance on retained earnings. It is also

associated with a 0.36 standard deviation decrease in reliance on equity financing and a

0.07 standard deviation decrease in reliance on domestic credit. It seems from this that

traditional values, institutional and legal performance, output per capita, geographical

201
region, and the other variables being held equal, is associated with less reliance on

external finance and hence financial institutions.

This is also consistent with our finding from our interviews that insiders will risk

less (i.e., less family ownership) and that they are skeptical towards outside shareholders

and bankers, while they develop companies slowly using retained earnings.

Family importance in a society is associates with more retained earnings and more state
finance.

We find similar associations if we look at how important the family is in a country. The

importance of the family is not a part of the traditional values factor. The less importance

residents of a country assign to the family, the more equity and family financing firms

use, and they use less retained earnings. Specifically, as the measure of family

importance decreases by one standard deviation, the share of equity increases by 0.13

standard deviations, the share of family financing increases by 0.17 standard deviations,

and the share of retained earnings decreases by 0.09 standard deviations.

From our interviews in Peru and Argentina, we would expect that where the

family is less important, outsiders would be allowed in. This is consistent with equity

financing increasing in our quantitative study. Some of our respondents in Peru and

Argentina also suggested that firms were being used to extract cash. From this, we can

propose the explanation that family financing of firms goes down when family is more

important, because one wants to shield the family’s income from the firm that created it.

This is a form of risk diversification that is consistent with placing a higher value on

supporting the family and hence being averse to the risk posed by reinvesting funds in

family businesses. However, one would have to conduct further research to assess

whether this hypothesis holds.

202
 There is no significant effect of family importance on domestic bank credit. Our

interviews with bank managers found that banks regard family orientation as a problem.

It might be that the family importance in each individual company has impact on credit

decisions; the average level of family importance in a country does not seem to result in

less total bank financing of firms.

Summary

Our quantitative findings using a global database support to a large extent our qualitative

findings from Peru and Argentina. From this quantitative investigation, we can extract the

following general observations.

Firm size matters, principally through small firms having less external financing

than large firms and being more likely to be financed by family. Industrial sector also

matters, in particular through the public sector financing agriculture. Surprisingly, a

firm’s age does not seem to help it get external finance from anybody but the

government. Firm growth is associated with more reliance on equity financing.

Ties to other countries help in obtaining external finance. Firms that have foreign

ownership or operate in several countries rely less on domestic credit markets, which we

interpret to mean they have access to financing in other countries. Exporters, which can

perfectly well be domestically owned firms with domestic only operations, have easier

access to external financing.

Institutions matter more than law. The quality of creditor rights do not help

explain how firms obtain funds. The quality of bankruptcy legislation is associated with

how firms structure their internal financing, which can be explained from agency theory,

but does not help firm obtain more external finance. An easier environment for enforcing

203
contract is associated with more domestic credit. Flexible labor legislation is associated

with more domestic credit and family financing; in countries with strong labor protection

it appears that the government plays a bigger role in funding business.

Political stability is strongly associated with more external and less internal

finance. The same, interestingly, is our cultural variable, which expresses the level of

preindustrial norms still present in a country.

We have reviewed our qualitative findings and compared these to cross-country

data. As a whole, we find that many of the observations we found on a local level fit

global patterns. We will now see how our findings fit the theory about moveable

collateral, and what explains how the legal infrastructure makes it through to the actual

credit decision.

In all our findings we do not find that moveable collateral plays an important part

in banks’ lending decisions. Based on cross-country studies, creditor protection does not

seem to be associated with more bank credit. In our analysis of countries in Eastern

Europe, the marketability and valuation of collateral, and the enforcement of moveable

collateral, do not impact the level of credit. According to our qualitative interviews,

moveable collateral does not determine access to credit, and is indeed discounted as close

to worthless by the bank managers.

This is despite the obvious economic advantages that such collateral would

provide, as asserted in the CEAL literature we reviewed initially. Why is this? What is it

that happens in the banks that blurs this obvious economic mechanism so thoroughly?

Obviously there is an interaction inside the ‘black box’ of the manager that makes the

204
credit decision that makes the ‘input’ of the economic logic of moveable collateral to not

make it to the ‘output,’ i.e., the lending decision.

205
A proposed classification of the elements of a credit decision

According to our observations, we may divide the variable a bank manager takes into

account about his client into the following framework based on the ability to pay, the

willingness to pay, and the infrastructure surrounding the credit relationship:

Figure 39

ABILITY WILLINGNESS INFRASTRUCTURE

PAST Lack of past ability because…
…systemic: not negative
…management: negative
…agency problems: negative
…industry: negative or not
negative
PRESENT Collateral shows present
ability to repay and is a
monitoring mechanism; lack of
collateral is negative
FUTURE Projections of cash flow show
future ability to repay; lack
of sufficient projections is
negative. Valuation and
marketability of collateral
determines ability to repay;
uncertainty about this is
negative.279
Lack of past willingness… Lack of infrastructure…
…is always negative …may be an excuse for lack of
past ability if there is no
lack of past willingness
Present willingness to pay Lack of present infrastructure
cannot be asserted to enter into contract is
negative
Undeterminable Lack of future infrastructure
to recover debt should be
negative according to theory
but according to qualitative
and quantitative data, it is
not

One lends to a client who is willing and able to repay. The willingness and ability can be

asserted across three dimensions: the past, the present, and the future. In addition, there

must be an infrastructure (legal and institutional) that allows contracting with the client

and enforcing those contracts. Different parts of the infrastructure are important across

the temporal dimension.

First, the infrastructure to contact with the borrower must be in place. Part of this

infrastructure is internal for the bank in the form of standardized debt contracts. If the

infrastructure for the particular type of borrower (size, sector) is not in place, the

279
Uncertainty about the marketability and value of collateral determines what asset classes are acceptable
according to our qualitative studies. According to the EBRD’s quantitative data, reviewed above, this
uncertainty does not reduce the level of domestic credit.

206
individual manager cannot enter into a debt contract with a borrower. Part of the

infrastructure is institutional. For a debt contract to be enforced in the future, it must not

be too cumbersome to enforce the contract. There must be political stability so that rules

and regulations will not change during the life of the loan. There must be bankruptcy

regulations and courts that are efficient and competent enough to apply the rules in a

timely way and accurately. We know from our cross-country analysis that procedural

complexity and rigid labor markets are associated with less credit, from our qualitative

and quantitative analysis that political stability is associated with more credit, and from

our qualitative analysis that banks are concerned with the incompetence of judges. Both

our qualitative and quantitative analysis suggest, however, that this is not a concern in the

individual credit decision.

After infrastructure, the second consideration of a bank manager whether the

prospective borrower is able to repay the loan. The ability may be assessed in part from

the borrower’s past credit behavior. We have both qualitative and quantitative evidence

for that better payment history information in the form of credit registries which increase

the use and availability of domestic bank credit. Past inability to pay may be due to

management failure or to some insiders’ diverting cash flow so that it cannot be used for

repayment. Past inability to pay may be excused, however. If past defaults on payments

are due to a systemic or exogenous crisis, such as the recent crises in Argentina and Peru,

this affects all companies alike, and negotiations in good faith can make the banks accept

past deficiencies in the payment record. If an industry as a whole is particularly hit, such

as agriculture in Peru following the El Niño phenomenon in 97-98, the same

considerations apply.

207
 Looking at a company’s balance sheet, the bank manager can assess the present

payment ability. Taking collateral gives the bank a claim to part of the balance sheet,

reserving it for repayment of the debt. It also gives the bank a means of monitoring

during the credit and negotiation leverage in the future. The future ability to pay is

assessed from cash flow projections.

Ability to pay must be accompanied by willingness to pay. Lack of willingness in

the past comes to the bank’s knowledge through either the credit history, the borrower’s

reputation, or through checking up on the borrower through another bank. The lack of

past willingness to pay cannot be excused. If a borrower has not acted in good faith with

banks in the past, he is shut out from credit in the future, according to our interviews.

Present willingness to pay is impossible to ascertain. When a client interacts with

a bank, he will always do his uttermost to demonstrate a willingness to pay, and it is the

premise for the negotiations in the first place. The question is how the bank determines

the client’s willingness to pay in the future.

Asserting future payment willingness is as important as future

payment ability: Trust is as important as collateral.
In the qualitative research for this thesis, as well as in the literature we have reviewed, we

have frequently noted expressions of the importance of trust. Owners lack trust in outside

shareholders, so companies are overleveraged and do not grow. Banks lack trust in their

borrowers, and hence require collateral that cannot be removed, and which they monitor

closely. The private sector does not trust the legal system to enforce its rights. The lack of

trust in the rule of law creates informal markets. Lack of trust in politicians makes banks

lend short-term. This leaves one with the impression that the lack of trust in politicians,

when accumulated through all these mechanisms, must have an impact on the workings

208
of the financial system. We will now look at how trust comes into play in the financial

system, how it is created, and how it affects finance, and we will compare these factors to

our qualitative findings.

The first role for trust is in asserting the future willingness to pay. We can fit trust

into the table in Figure 39 on page 206 as follows:

Figure 40

ABILITY WILLINGNESS INFRASTRUCTURE

PAST Lack of past ability because…
…systemic: not negative
…management: negative
…agency problems: negative
…industry: negative or not
negative
PRESENT Collateral shows present
ability to repay and is a
monitoring mechanism; lack of
collateral is negative
FUTURE Projections of cash flow
shows future ability to
repay; lack of sufficient
projections is negative.
Valuation and marketability
of collateral determines
ability to repay; uncertainty
about this is negative.280
Lack of past willingness… Lack of infrastructure…
…is always negative. …[may be an excuse for lack of
past ability if there is no
lack of past willingness.]
Present willingness to pay Lack of present infrastructure
cannot be asserted. to enter into contract is
negative, but rarely an actual
problem.
The credit manger must Lack of future infrastructure
trust the borrower’s to recover debt should be
willingness to repay in negative, according to theory,
the future; no trust is but according to qualitative
strongly negative in the and quantitative data, it is
credit decision. not.

The lender will lend only if he expects to be repaid, as the CEAL literature we reviewed

initially asserts.281 But, contrary to this literature, we find that what creates this

expectation is not the collateral that the lender has, it is whether he trusts that the

borrower will repay or not.

Trust is a decisive factor in the ‘black box’ of the credit decision. The question

then becomes: what is trust? What determines the level of trust of an individual, and how

does this trust come into play is a lending decision and other financial decisions. What is

280
Uncertainty about the marketability and value of collateral determines asset classes that are acceptable
according to our qualitative studies. According to the EBRD’s quantitative data, reviewed above, it does
not reduce the level of domestic credit.
281
Fleisig and Pena, Smes

209
the difference of the general level of trust in a society, the trust that lenders have in a

borrower, and trust in individuals and in the system? And lastly, can we quantify the

impact of trust, or will we have to settle with our qualitative findings?

210
VII. The role of trust in credit decisions

Trust is often called ‘social capital,’ and numerous studies show that the levels of trust in

a country determine how people relate to and work with each other. The definitions of

social capital are many, and in order to integrate trust in our analysis, we will start out

looking at some of the various perspectives.

Bourdieu, one of the first major writers on social capital, starts at the individual

level when defining social capital:

Social capital is an attribute of an individual in a social context. One can acquire

social capital through purposeful actions and can transform social capital into
conventional economic gains. The ability to do so, however, depends on the
nature of the social obligations, connections, and networks available to you.282

Fukuyama defines trust not on the individual level but on the group level:

Social capital can be defined simply as an unsubstantiated set of informal values

or norms shared among members of a group that permits them to cooperate with
one another. If members of the group come to expect that others will behave
reliably and honestly, then they will come to trust one another. Trust acts like a
lubricant that makes any group or organization run more efficiently.283

Putnam’s perspective lies between Bourdieu and Fukuyama:

…Social capital refers to connections among individuals – social networks and

the norms of reciprocity and trustworthiness that arise from them. A society of
many virtuous but isolated individuals is not necessarily rich in social capital.284

282
Bourdieu, 1986, Forms of capital . The first reference on social capital frequently cited in the literature
is Hanifan, 1920, The community center , revived through Coleman, 1984, Introducing social structure into
economic analysis .
283
Fukuyama, 1999, The great disruption : Human nature and the reconstitution of social order 16
284
Putnam, 2000, Bowling alone : The collapse and revival of american community 19. Durlauf, 2002, On
the empirics of social capital notes how these two definitions “mix a number of disparate ideas. One such
combination is the mixing of functional and causal conceptions of social capital.”

211
The group-level analysis reflects a common observation encountered during our

interviews: that trust can be excluding, favoring established relationships through a form

of ‘bonding’ within a group and reinforcing old relationships rather than trusting

strangers. If one does not trust strangers, one will not ‘bridge’ group borders to form new

relationships. This is a common observation. In Russia, a post-transition study found that

a large number of transactions appeared to be based on ties inherited from Soviet times,

where all parties used the legal structure and contracted the group of managers whom

they were used to from the pre-transition era.285 This observation highlights another

aspect of trust: it is not just expectations about how others will behave; it is an

expectation that is justified through established networks, i.e., a bond that has been

created.

Woolcock et al. illustrate the ‘bonding’-‘bridging’ mechanism as follows:

Figure 41

This figure is copied from Woolcock and Narayan-Parker (2000). The key message is
that a welfare-enhancing social capital materializes when people trust strangers rather

285
Hendley, Observations on the use of law by russian enterprises .

212
 than only people they know (moving up and right on the graph). This openness to
creating new relationships releases the potential for increased efficiency and new
synergies. If one trusts people in general, rather than only people within specific groups,
there is potential to create new relationships.

(Source: Woolcock and Narayan-Parker (2000))

‘Bonding’ typically results in financing being reserved for people one knows, or people

from familiar social groups, rather than being directed towards the commercially most

viable project. This is the ‘downside’ of social capital – what we may call ‘excluding’ or

‘restricted’ social capital.286 The “Defense/Getting by” dimension means trusting people

from one’s own groups, the “Getting ahead” dimension equals forging new relationships,

i.e. trusting people outside the group and giving finance to people outside the established

networks. Below, we use people’s willingness to trust other people in general in order to

measure this dimension.

Both mechanisms may be self-reinforcing. If the participants in one system in

society, say the financial system, have low levels of trust in borrowers (or certain groups

of borrowers), they may further alienate those borrowers. This would increase the levels

of cohesion within the group of lenders and within the group of borrowers, but it would

also decrease the trust level between those two groups (bonding). In order to explore the

significance of trust for financial relationships, we will need to understand better what

decided trust on an individual level.

286
Portes and Landholt, 1996, The downside of social capital . The first literature on ‘bad’ social capital is
Smith, An inquiry into the nature and causes of the wealth of nations claiming that social interaction
among “people of the same trade” leads to “a conspiracy against the public” or “some contrivance to raise
prices.”

213
 The individual and group dimensions of trust create a methodological problem. A

society consists of many groups, or social subsystems, in which the levels of trust may

vary.287 Reducing trust to a country-wide variable is not something we can do without

hesitation. Using one variable to describe a common trait of a country’s population

assumes one intrinsic character trait in that population that is commonly expressible and

measurable.

287
Bourdieu, 1990, The logic of practice , Luhmann, 1995, Social systems

214
Figure 42

Quantile of trust
0 .2 .4 .6 .8
0 bra
pry
uga
tza
phl
mli
rom
Peru per
col
bol
zwe
dza
bwa
prt
zaf
mkd
ecu
slv
mda
sgp
bih
.25 Argentina arg
svk
ven
tur
zmb
lva
pan
pol
geo
aze
hrv
mlt
fra
ury
svn
mex
hun
pri
mar
chl
isr
est
bgd
grc
.5 Russia rus
alb
cze
arm
lux
hnd
nga
ltu
dom
bgr
ukr
ukr
kor
cri
jor
gbr
bel
gtm
pak
nam
nic
ita
aut
.75 irl
esp
USA usa
che
can
deu
egy
twn
aus
ind
isl
vnm
mwi
blr
jpn
nzl
idn
chn
fin
nld
nld
nor
irn
1 swe
dnk

This quartile plot shows the ranking of countries based on average responses to the
question: “Generally speaking, would you say that you can trust most people, or that you
can never be too careful when dealing with others?”

(Source: Inglehart (2000b), Globalbarometer (2000))

Reducing trust to one country-wide variable is necessary to bring this measure to the

same level of analysis as the country-wide financial variable with which we work. At the

same time reducing trust in this way is a problem prima facie: trust is measured

individually through surveys, and there may be many determinants of the level of trust

associated with one specific individual that are more common to other individuals in

215
other countries rather than to fellow citizens. For the remainder of this work, we will

assume that the general level of trust impacts the trust in the financial system. We will

also assume that the level of family importance, a proxy for trust in the family, represents

the tendency to ‘bonding’ so that economic actors are skeptical of outsiders. We do this

because the family is the ultimate ‘insider’ group; the relationships are created when one

is born. Before we look at the impact of trust on finance, we will analyze what determines

trust on an individual level and whether we can safely use trust measures on a country

level.

What determines trust on an individual level?

Trust may be best investigated at an individual level, at a group level, or at a country

level. If one can analyze trust on a country level, we would be able to investigate

relationships with other country-wide variables. A well known example, Bowling Alone

by Putnam (1995), is essentially a description of a nationwide regression towards the

“Defense” area of Woolcock’s diagram.

The case for grouping trust by country is best made on the basis of an underlying

relationship made up of culture, institutional or legal tradition, or economic development.

Typically, if one explains cultural development by processes that are, at least somewhat,

delimited by country borders, and if one assumes that trust is something that develops

over time, the country level will be the right level of analysis.288 Trust is not a ‘residual’

in the same way as culture easily becomes when comparing countries, in that the residual

288
Landes, 1998, The wealth and poverty of nations : Why some are so rich and some so poor

216
variance is attributed to the variable by the lack of other explanatory variables.289 When

we measure trust, it is based on survey data that ask specifically about an individual’s

willingness to trust strangers or about his confidence in a range of institutions.290

The development of trust may depend more on the cultural group than the nation

or national culture.291 For example, in a country with sharp ethno-linguistic divisions,

trust in one group might be more similar to the same ethnic group in a country nearby

rather than to other ethnic groups in the same country.292 Related to this approach is

understanding trust as a consequence of demographic variables. People from different

socio-economic strata in a society develop different levels of trust; trust changes by age

or by what era a person grew up in, by family size, by education, by gender, or it may

289
Lane, 1992, Political culture: Residual category or general theory?
290
Inglehart, 2004, World values surveys and european values surveys, 1999-2001 user guide and
codebook icprs version
291
Cultural explanations for trust appear in most works on social capital but in varying forms and depth. In
Inglehart, 2000a, Modernization, cultural change, and the persistence of traditional values trust is one of
five components in the ‘survival vs. self-expression values’ factor scale so that survival values (non-
modern values) are characterized by a lack of trust in people in general. The historical-cultural explanations
for the development of trust are many and diverse; much of the literature on what develops trust originates
in Weber and Parsons, 1930, The protestant ethic and the spirit of capitalism ; see Fukuyama, 1995, Trust :
The social virtues and the creation of prosperity . Many quantitative works on trust go through a small
exercise in explanation (for example LaPorta, et al., 1997, Legal determinants of external finance ), but this
rarely goes into depth. More comprehensive treatments are found in Putnam, 1993, The prosperous
community: Social capital and public life and Landes, The wealth and poverty of nations : Why some are
so rich and some so poor ; for recent empirical work on a solid theoretical basis, see Inglehart, 1999b,
Trust, well-being, and democracy , Stulz and Williamson, Culture, openness, and finance , Guiso, et al.,
The role of social capital in financial development , and Guiso, et al., People's opium? Religion and
economic attitudes – the latter work contains references to most existing empirical studies.
292
See, for example Easterly and Levine, Africa's growth tragedy . Easterly, 2001, The elusive quest for
growth : Economists' adventures and misadventures in the tropics offers data on the impact of ethno-
linguistic fractionalization on various financial, governance, and growth variables. His qualitative evidence
appears to fit well into theories of trust; for example, the comparison between Easterly’s assertion that
stability in the U.S.A. is due to institutions that bridge the ethnic cleavages fits well with Fukuyama, Trust ,
Huntington, 2004, Who are we: The challenges to america's national identity , and Putnam, The prosperous
community, Putnam, 1995, Bowling alone: America's declining social capital .

217
depend on a person being a leader or the chief wage earner in the household.293

Demographic variables are more likely to be common within groups of people, but not

within countries.

Yet another approach is that an individual’s trust parallels of that individual’s

other values and preferences.294 This approach implies that the individual builds trust

from interactions and experiences, and that trust is not associated with the social groups

that the person belongs to, but rather to that person’s actions. An indication that this

might be a good way of explaining individual trust comes from Inglehart (1997 and

2000a), who constructs two factor scales, where trust falls in the quadrant of self-

expression and secular-rational authority, the opposites of which are survival and

traditional authority, respectively. Plotting countries according to these factor scales

(averaged over a country) shows a relationship between the scales, and between the

scales and regional and economic development.

293
Putnam, Bowling alone: America's declining social capital relates social capital to time; Fukuyama,
Trust 336 describes the relationship between family values and education: “If familism is not accompanied
by the strong emphasis on education that exists, for example, in Confucian or Jewish cultures, then it can
lead to a stifling morass of nepotism and inbred stagnation.”
294
The implicit choice behind exit or voice in Hirschman, Exit, voice, and loyalty assumes that an
individual’s confidence in others or in the institutions is developed on an individual level, as an individual
basis for decisions. His concept on ‘social energy’ in Hirschman, 1984, Getting ahead collectively :
Grassroots experiences in latin america is more group-oriented.

218
Figure 43

Inglehart (2000a)

The survival-well-being scale is highly correlated to the postmaterialist-index, a

variable based on how the respondent values order, voice in government, inflation, and

freedom of speech. Being comfortable within the social context may build trust, which

means that the cluster of variables close to trust on Inglehart’s factor scales may explain

the variation in trust. However, when we look at what is behind the factor scales, i.e. the

drivers behind self-expression and secular rationality , the variables are likely to be

heavily influenced by group and nation, not only by the individual himself.

If we make an empirical attempt at describing trust, we find that we are able to

explain 17% of the variance in trust using simply the country a person lives in as the

regressor.295 If we use a combination of legal (institutional) origin and religion, we are

295
Probit regression, 79 countries, 113371 observations, McKelvey and Zavoina R-squared = 0.166.

219
able to explain 5% of the variance in trust.296 Using demographic variables, we are able

to explain 10% of the variance in trust in people in general; see Appendix B.

We are aware and note, however, that empirical studies trying to describe trust

have been heavily criticized.297 In particular, making assumptions about causal directions

is difficult because of the probable interaction between the explanatory variables.

Trust and law.

One of these causal interferences is particularly interesting to us: law. To use an example

from the literature: “Is the level of trust a New Yorker exhibits in her daily economic

behavior the result of good law enforcement or the product of a high level of social

capital?”298

When the legal system does not provide for lowering transaction and monitoring

costs, and in particular reducing the risk of the non-compliance of contracts, other social

systems are necessary as substitutes.299 Our interview subjects in Peru and Argentina

consistently displayed a very low confidence in the abilities of the judicial system to

enforce their contracts. This means that the alternative to trust in judicial enforcement,

296
Probit regression, 79 countries, 110466 observations, McKelvey and Zavoina R-squared = 0.054.
297
Beugelsdijk, et al., Trust and economic growth shows how the results in Knack and Keefer, 1997, Does
social capital have an economic payoff? A cross-country investigation are highly dependent on their
conditioning variables; Durlauf, On the empirics of social capital , Woolcock and Narayan-Parker, 2000,
Social capital: Implications for development theory, research, and policy , and Knack and Keefer, Does
social capital have an economic payoff? ; Levine and Renelt, 1992, Sensitivity analysis of cross- country
growth regressions criticizes many of the variables that have been found to impact growth; see the
variables surveyed in Barro and Sala-i-Martin, 1995, Economic growth .
298
Guiso, et al., The role of social capital in financial development
299
Fukuyama, Trust 27 notes: “People who do not trust one another will end up cooperating only under a
system of formal rules and regulations.” We discuss the opposite: people who have less formal operational
rules and regulations need to trust each other in order to cooperate (or find other substitutes for a defunct
legal system).

220
namely, trust in the voluntary compliance by the borrower, becomes all the more

important.

The interaction between law and trust can take on three shapes. First, trust may

develop independently from law, with law having only at best a marginal impact on

business relationships, where “businessmen often fail to plan exchange relationships

completely, and seldom use legal sanctions to adjust these relationships.”300 The latter

part of this assertion is in particular confirmed during our qualitative research, where the

prospect of legal sanctions carries little importance in the credit relationships.

Second, trust may be reduced by the legal system through excessive legalism and

‘battle of contracts’ “where both contractors try to force their one-sided advantages upon

the other.”301 This stands in contrast to the example of the United States, which is

considered highly legalistic yet enjoys comparatively high levels of trust and relatively

frictionless business interactions.302

The opposite view of this is that law builds trust, since repeated business

relationships that initially are sanctioned by law develop into relationships based on trust.

This is the mechanism that takes place between two business partners who, at first, use

extensive legal contracts to determine their relationship but after successfully having

repeated transactions, trust that the other will comply with his obligations and thus reduce

300
Macaulay, 1963, Non-contractual relationships in business: A preliminary study . This is a mechanism
confirmed by the observations in Hendley, Observations on the use of law by russian enterprises and in
Rose, 1998, Getting things done in an anti-modern society : Social capital networks in russia .
301
Lane and Bachmann, 2000, Trust within and between organizations : Conceptual issues and empirical
applications and Sako, 1992, Prices, quality, and trust : Inter-firm relations in britain and japan .
302
See Figure 42 and Kagan, 2001, Adversarial legalism : The american way of law , Axelrad and Kagan,
2000, Regulatory encounters : Multinational corporations and american adversarial legalism , and Lipset,
1996, American exceptionalism : A double-edged sword .

221
transaction cost. On a macro level, as a business environment or an economy becomes

increasingly comfortable with the rules of the game, the legal culture spills over into the

business culture, and trust substitutes for law. Some literature that emphasizes trust rather

than formal rules builds on a situation where law never was particularly relevant in the

first place, and where social networks play the role of contract enforcement, risk

reduction, and monitoring. This is the foundation of the Japan-inspired management

literature that has now run into problems in trying to define the difference between trust

and cronyism.303

This view that law leads to trust embodies two perspectives. One perspective is

that trust may substitute for law, i.e., as relationships and ways of doing business develop

within a business community, law becomes less important. The other perspective is that,

over time, assumptions develop about others people’s future behavior and that these

assumptions fill a function that is comparable to formal rules. These assumptions reduce

the complexity in assessing potential outcomes of interpersonal action (contracting) and

thus reduce uncertainty in that it predicts outcomes of such relationships. 304 This

reduction of complexity can be a requirement for contracting because it makes it

intellectually possible to forecast outcomes, or it can be efficiency-enhancing is that it has

a less marginal cost per relationship than engaging in formal risk-reducing mechanisms,

such as contracts.

303
See Johnson, Miti , Asher, 1996, What became of the japanese 'miracle'? , and Haggard, 2000, The
political economy of the asian financial crisis .
304
See Backmann, 2001, Trust, power and control in trans-organizational relations discussing Luhmann,
1968, Vertrauen : Ein mechanismus der reduktion sozialer komplexität . Luhmann writes: “[Vertrauen]
dient der Überbrückung eines Unsicherheitsmomentes im Verhalten anderer Menschen, das wie die
Unvorhersehbarkeit der Änderungen eines Gegenstandes erlebt wird.” See also Luhmann, 1979, Trust and
power .

222
How does trust impact financial decisions?

Trust in other people’s compliance with their contractual obligations determines how

economic agents allocate their money and how they use financial intermediaries, because

the intermediary can be seen as a ‘bridge of trust’ between economic agents. For

example, an investor who does not trust an entrepreneur to comply with his obligation to

repay in the future may deposit his money in a bank which selects trustworthy

borrowers.305 This is the effect we described above: the bank will only lend to clients it

trusts to repay in the future. If the bank trusts more people to repay, it lends to more

clients. If trust is lower, it gives less access to credit.306

The controversy about social capital in economics has largely focused on whether

or not social capital is ‘capital’ in a sense comparable to physical and human capital.307

This is the assumption behind work on how social capital impacts growth.308 The

perspective of social capital as ‘capital’ in the growth economics sense has the

advantages of easy incorporation into growth models and easy application to

development policy.309 Empirical studies seem to indicate that social capital as ‘capital’

305
Bossone, 1999, The role of trust in financial sector development .
306
Guiso, et al., The role of social capital in financial development .
307
Typically Grootaert, 1998, Social capital : The missing link? . See Solow, 1995, Trust: The social
virtues and the creation of prosperity (book review) in response to Putnam and in particular the overview
in Sobel, 2002, Can we trust social capital? . Glaeser, et al., 2000, The economic approach to social capital
and Stiglitz, 2000, Formal and informal institutions advocate the capital analogy; Arrow, 2000,
Observations on social capital and Solow, 2000, Notes on social capital refute it.
308
Putnam, et al., 1993, Making democracy work : Civic traditions in modern italy emphasizes how social
capital enables the individual to participate in production of public goods. See also Durkin, 2000,
Measuring social capital and its economic impact and Glaeser, et al., The economic approach to social
capital . Coleman, 1988, Social capital in the creation of human capital has a ‘public good’-approach to
social capital as capital.
309
See the definition of sustainable development in Serageldin, 1996, Sustainability as opportunity and the
problem of social capital , where future generations receive as much or more capital per capita as the

223
has an economic payoff in economic growth.310 It does in any case seem to be related to

the level of output.

Figure 44

40000 30000 Output and trust

GNI per capita
10000 20000
0

0 .2 .4 .6 .8
Trust
R-squared = 0.30

(Data: WorldBank (2004), Inglehart (2000b), Globalbarometer (2004))

The discussion of whether social capital is ‘capital’ or not stems in a large part from the

fact that social capital is a highly diverse concept that cannot be easily reduced to one

perspective. Rather, what aspects of social capital one chooses to include in a theory

needs to be adapted to the purpose of the investigation.311

We will now look at the aspects of trust that are likely to impact the financial

system and companies’ access to finance.

current generation has. Grootaert, Social capital : The missing link? is a paper that attempts to
operationalize the theory of social capital to development work, with a capital perspective.
310
Knack and Keefer, Does social capital have an economic payoff? ,Whiteley, 2000, Economic growth
and social capital , Zak and Knack, 2001, Trust and growth .
311
See the essays in Dasgupta and Serageldin, 2000, Social capital : A multifaceted perspective and
Backmann, Trust, power and control for some of the uses.

224
Trust reduces risk.

Trusting someone is to believe they will comply with common norms, common

assumptions, or common statements that have been exchanged, explicitly or implicitly,

such as trusting someone to repay pursuant to a debt contract as we described in Figure

40 (page 209). Such a common understanding needs an origin. This origin may be

experience or it may be culture, culture being a collective experience across individuals,

groups, and time. If one gets this origin wrong, trust becomes a risky engagement.312 A

stronger origin of the assumption about compliance with contractual obligations leads to

higher trust. If the origin is weaker, it is less likely that someone will trust another – there

is little first-mover advantage in trusting. As a result, the development of trust is unlikely

to be pioneered by a small group of people.

Believing that the debtors’ behavior will follow pre-conceived patterns (repay,

negotiate in good faith) reduces the range of probable outcomes of the credit relationship,

and thus it reduces risk. If the typical dichotomous outcome of a standardized debt

contract, repayment or default, becomes rather repayment or renegotiation in good faith,

the probability distribution of the present value of the repayment is a more limited range

with a higher mean. Trust does not reduce the systemic risks; we will return to this below.

Trust substitutes for monitoring.

During the life of the credit, monitoring adjusts the assertions made at the time of the

credit decision. Monitoring relates to two aspects of the project’s performance: the

external environment and the company’s response to that environment. For the latter,

312
Luhmann, Trust and power .

225
specifically for creditors, the bank monitors if the company’s decisions are in the interest

of the company and the creditor, or in the interest of the agents personally.

Trust makes the bank assume that the company’s agents perform as promised, i.e.,

in honoring the company’s obligations towards the bank, which reduces the need for

monitoring. For example, the most important concern voiced by our respondents

regarding moveable collateral was that the collateral would be removed by the company’s

management in the case of default. The trust channel also applies between the company’s

owners and its management. If the management acts in the best interest of the company

and thus of the shareholders, then the company is likely to perform better and thus

bemore likely to fulfill its obligations.313

Trust substitutes for sanctions and enforcements

Social capital can be seen as “a measure of the capacity for self-enforcement — or

voluntary group enforcement — as contrasting to third party-enforcement.”314 There are

two conditioning forces that govern choices in the business relationship: the latent threat

of legal sanctions and the latent threat of sanctions from a group. It is not the actual

sanction that matters, since in the presence of an actual threat it is unlikely that the

313
A problem arises when the company runs into difficulties if a situation arises where the management
must side either with the major shareholders, the minority shareholders, or the creditor. This situation is
laid out in Schleifer and Vishny, A survey of corporate governance . For a legal analysis based on ‘new
comparative economics,’ see LaPorta, et al., 2000b, Investor protection and corporate governance . For an
empirical investigation of business performance and trust, see Sako, Prices, quality, and trust : Inter-firm
relations in britain and japan, Sako, 1998, Does trust improve business performance? . For the impact of
trust on business, see Lane and Bachmann, Trust within and between organizations : Conceptual issues and
empirical applications .
314
Paldam and Svendsen, 2000, An essay on social capital: Looking for the fire behind the smoke

226
contract would be agreed upon in the first place.315 There is a self-reinforcing mechanism

based on sanctions remaining latent (and not exercised) where “the structure of the trust

relationship requires that such calculation should remain latent, purely a reassuring

consideration.”316 In this perspective the real effect of sanctions is latent, and as opposed

to theory with paths of punishment, such paths never materialize except in extraordinary

cases.317 The effects of the latent legal sanctions become indistinguishable from the latent

social sanctions. It is virtually impossible to say whether a person does not perform an

action because of latent legal sanctions or latent social sanctions.

When the banks we interviewed have little confidence in legal sanctions, the

latent social sanctions on which the trust level builds become even more important. This

would suggest that trust has more significance in countries where the legal system is

weak.

Trust lowers transaction costs.

The analogy of social capital as capital does not seem to catch the most central aspect of

most of the social capital literature: the willingness to commit. Social capital means to

trust other people to behave in a certain way that makes a person more likely to commit

to depending on the other person’s actions. If the person were less trusting, he would

acquire more information about the counterpart and would have to rely on formal

enforcement mechanisms such as law. When a business person can trust counter parties

315
The exception from this is an ongoing business relationship where one party is in default but where the
other party or parties are constrained for any number of reasons in choosing alternative counterparties.
316
Luhmann, Trust and power 36). For a good overview of Luhmann see Backmann (2001).
317
Abreu, 1988, On the theory of infinitely repeated games with discounting .

227
to perform in accordance with contracts and established norms, it is easier to outsource,

sell, borrow, or lend to such counter parties. “Social capital reduces the cost of co-

ordination and, consequently, impacts directly on the boundaries of the firm, by placing

the firm in a better position than its competitors to outsource and specialize still further,

and to appropriate the excess rents flowing from the resulting deepening of the division

of labor,” and even through the sharing of information and specialization of tasks to

increase the ability to innovate.318 If one shares assumptions about behavior with the

business partner, less effort is needed to clarify and specify the contract, and less is

required to assess whether the other part will follow his contractual obligations.319 The

knowledge-based economy relies on such frictionless interchange, so that a society with

easier transactional dynamics will be in a better position to make this shift.320

The theory behind the impact of trust on financial decisions seems to provide an

adequate basis for understanding the observations during our qualitative studies. Because

of the inefficient legal systems which suffer low confidence among the bank managers,

there is the need for a substitute. This substitute seems to be the trust in that borrowers

will not remove assets pledged as collateral, that they will negotiate in good faith and not

318
Maskell, 2001, Social capital, innovation and competitiveness . On innovation, see DeBresson and
Andersen, 1996, Economic interdependence and innovative activity : An input-output analysis .
Schumpeter, The theory of economic development [1911] accepts the postulate that “the entrepreneur’s
function is to combine productive factors, to bring them together.” The creation of value is to reduce the
barriers to cooperation between owners of different forms of capital, gathering those forms of capital
together by buying them (see pp. 76, 116).
319
A similar view is found in Williamson, 1985, The economic institutions of capitalism : Firms, markets,
relational contracting .
320
See Carter, 1994, Measuring the performance of a knowledge-based economy . When SME business
clusters emerge based on logistics and knowledge-sharing, trust is one of the factors that explains such
developments see Sengenberger, et al., 1990, The re-emergence of small enterprises : Industrial
restructuring in industrialised countries .

228
‘blackmail’ – a term frequently encountered – the bank using antiquated or inefficient

bankruptcy mechanisms, that they want to build a good relationship with the bank and

reputation in the financial system in general, and that they will perform so that the bank

does not need to monitor so closely that the cost of maintaining the relationship becomes

too high.

The impact of trust on business development.

One observation that is consistent during interviews in Peru and Argentina is that small

and medium-sized companies have difficulties obtaining finance; this is an observation

that appears when interviewing bankers, entrepreneurs, or private equity managers. It is

also consistent with a large body of literature, as we have reviewed it earlier.

During our interviews, the most frequently cited reasons for directing finance to

the corporate sector rather than SMEs are cost, long-standing relationships, transparency,

and creditworthiness. Normally, when pursuing a deeper explanation, the lack of trust in

the managers of SMEs appears as an important reason: managers and owners of smaller

companies cannot be trusted to act in the interests of their firm or its creditors; they

generally will drain the company for funds and dispose of assets that have been pledged

as collateral.

This amounts to a question about trust as monitoring. The fixed cost of getting to

know a company in proportion to the potential revenues from issuing credit increases

inversely compared to company size. If there are no other mechanisms to monitor

managers or align the managers’ interests and those of the creditors, the substitute tends

to be trust. Trust in this perspective is both ‘formal’ and ‘informal.’ Through a formal

credit history with the bank it is ‘reputational’ in the financial system, and it is ‘informal’

229
as the credit manager or senior staff at the bank has a reason to personally trust the

manager or owner of the company. If this trust lacks, the cost of monitoring is too high,

and there is a credit shortage to the smaller companies.

Trust in the family.

Trust impacts financial relationship but what kind of trust are we talking about? The bank

managers’ complaints are related to an agency problem: owners and managers of

borrowing firms will rather enrich themselves than pay back debt. The trust level in a

business subgroup of society might not correlate perfectly with the trust level in general;

it is the trust by the bank manager in the borrower that impacts the credit decision, not the

level of trust in society in general – unless these two measures are interdependent.

Conversely, if the level of trust in the family is high in the economy in question, the

borrower is likely to favor his family over the creditor. Since this often will be a conflict

of interests with the bank, the higher the level of trust in the family, the less the level of

credit that we would expect to observe.

Trust in the family is associated with the ‘bonding’ dimension of the bonding-

bridging dichotomy from Figure 43 (page 219), because the family is the ultimate insider

group. Trust in people in general is associated with the ‘bridging’ dimension, because

people in general are the ultimate ‘outsider’ group. Consequently, trust in general tends to

be perceived as desirable and trust in the family as problematic.321 Trust in people in

321
La Porta, 1997, Trust in large organizations

230
general may replace the family as a mechanism of cooperation and, and when the area of

cooperation expands, it is more likely that larger organizations develop.322

But as opposed to what the bonding-bridging dichotomy suggests, trust in the

family and trust in general are not interchangeable.

Figure 45

Trust in general and in the family

Averages by country
.8

dnknorswe irn
Trust in people in general

nld
.6

fin
chn
idn
nzl

blr vnm jpn

aus ind isl
.4

deu twn che egy

esp irl can usa
aut ita
bel pak
gbr
kor jor
ltu ukr
bgr dom nga
est rus grc cze arm lux alb
chlbgd
svn hun ury mar
fra pri
mex
mlt
hrv aze
.2

lva pol geo

mdasvk arg sgp slv turvenbih
prt zaf mkd
per
rom col dza zwe
uga tza phl
bra
0

2.6 2.7 2.8 2.9 3

Family important
Linear relationship: y = 1.4573 - 0.4094 x, R-squared = 0.06

(Source: Inglehart (2000b))

A country may have both high trust in the family and in people in general (e.g.,

Scandinavia, Iran), it may have little trust in both (e.g., the Baltic states), it may place

high value on the family but not on people in general (the Philippines) or vice versa

(China). The lower right quadrant represents the “amoral familism” where a high level of

322
Fukuyama, Trust

231
trust within the family is associated with low levels of trust in general.323 For the

distribution of responses on an individual level, see Appendix C.

We see this lack of dichotomy in our quantitative studies of the sources of

financing and the determinants of long-term financing (Figure 38, page 188 and Figure

12, page 80). In both these regressions, trust in general and in the family have different

effects and are clearly not interchangeable.324

Trust and firm growth – empirics.

Previous work has made progress towards empirically confirming the thesis that trust

favors firm growth. La Porta et al. (1996) show that higher levels of trust in a country

favors the development of larger companies. They find that the ratio of sales of the top 20

publicly traded firms to GNP increases with trust in people, and decreases with trust in

the family. 325

Their analysis is limited by the small number of observations (26) and by only

looking at the largest firms. Also, their set of control variables is limited beyond what our

qualitative investigation suggests should be included. Our interviewees indicate that the

glass ceiling to growing big is encountered long before a company reaches the size

analyzed by La Porta et al. The story we most frequently encountered was the one of a

company growing to just before reaching a mid-sized level, and then stalling and not

323
Banfield, 1958, The moral basis of a backward society .
324
When trust in general is not included in the specifications of the two regressions, it is because it does not
contribute to explaining the variance in the dependent variable.
325
The World Values Survey (that both LaPorta et al. and we use) does not have a direct question that
addresses trust in the family, but the question “indicate how important [family] is in your life” is used as a
proxy.

232
making it to the mid or larger than mid-sized level; the definitions of which depend on

the established segmentation in the economy.

We can use cross-country data to further investigate our qualitative findings from

Peru and Argentina and test whether the findings of La Porta et al. hold for a larger

sample that includes all sizes of companies by combining our measures of trust the World

Business Environment Survey (WBES),326 the World Bank’s SME database,327 and the

World Bank’s Doing Business database328 (Figure 46).

326
WorldBank, Wbes . For a presentation of the data, see Batra, et al., 2003b, Investment climate around
the world : Voices of the firms from the world business environment survey and Pfeffermann, et al.,
Trends in private investment in developing countries and perceived obstacles to doing business .
327
Beck, et al., Sme database
328
WorldBank, Doing business . For a presentation of the data, see Djankov, et al., Doing business .

233
Figure 46

Size of the SME sector and trust

The OLS regression estimated in (1) is: The average general financing constraint by country = α + β Trust in people in
general (You cannot trust people) + β Family importance (Family is not important) + β GNI per capita + β The ratio of informal GNI
to GNI + β Creditor rights index + β Bankruptcy index + β Procedural complexity index + β Political stability + u
The OLS regression estimated in (2) and (3) is: The size of the SME sector in the total labor force = α + β Trust in people
in general (You cannot trust people) + β Family importance (Family is not important) + β GNI per capita + β The ratio of informal
GNI per capita to GNI per capita + β Creditor rights index + β Bankruptcy index + β Procedural complexity index + β Political
stability + β Interaction between the country’s income level and family importance + u
Regression (3) is robust.

(1) (2) (3)

Finance is Size of SME(=<250) Size of SME(=<250)
obstacle(med) sector sector
Lack of trust 0.116 22.329 14.284
(0.28) (0.80) (0.54)
Family not important 1.628 -92.648 -83.583
(2.90)*** (2.21)** (2.12)**
GNI per capita -0.000 0.000 -0.001
(2.40)** (0.66) (0.84)
Informal economy 0.073 -191.379 -263.884
(0.06) (2.42)** (1.75)*
Creditor rights index -0.057 -3.084 -2.700
(1.17) (1.13) (0.81)
Bankruptcy index -0.002 0.049 0.030
(0.49) (0.26) (0.18)
Procedural complexity index -0.005 0.319 0.306
(1.36) (1.30) (1.61)
Political stability index -0.167 10.620 5.197
(1.83)* (1.87)* (0.64)
Low income * Family not important -17.398
(0.77)
Lower middle income * Family not -25.961
important
(2.55)**
Upper middle income * Family not -18.139
important
(2.02)*
Constant 1.545 125.856 150.980
(1.81)* (2.04)** (2.29)**
Observations 48 40 40
R-squared 0.61 0.66 0.71
F-stat 7.57 7.59 7.00

Absolute value of t-statistics in parentheses.

* significant at 10%; ** significant at 5%; *** significant at 1%.

We see that the less bonding social capital measured proxied through family being less

important (the higher the value of “Family not important”), the smaller the formal SME

sector holding the size of the informal sector constant. This is consistent with the findings

in La Porta (1996). We also see that the larger the informal sector, the smaller the formal

SME sector, which we would expect, since larger companies are more likely to be formal

234
than small companies.329 We also notice that with trust levels and the size of the informal

sector being held constant, increased political stability leads to a larger SME sector.330

When we interact family importance with the country’s income category, we see

than lower middle and upper middle-income countries have significantly higher SME

sectors than high income countries as the family becomes more important. The

explanation for this that we encountered in our qualitative studies in Peru and Argentina

is that family ties make owners less likely to accept the outside control required for a

company to gather the funds to grow large. This is coherent with another of our

qualitative findings: family oriented companies are reluctant to take on finance if they

have to relinquish control, which reduced their demand for finance, not only the supply of

finance.

This observation is supported by another quantitative finding. The SME definition

we use here has a cut-off at 250 employees. If we look at the financing constraint

experienced by companies with a workforce from 50 to 500, we see that this category of

companies perceives the general financing constraint to be significantly higher in

countries where the family is less important. This suggests that as the family becomes

less important (as bonding social capital decreases), firms seek finance but do not get it,

i.e., the demand increases (firms want finance) but the banks and investors do not supply

it (firm cannot get finance), and the consequence is that now the perceived constraint to

doing business posed to the companies by the lack of finance increases. We do not have

329
Note that the study in La Porta, 1996, Trust in large organizations looks only at formal firms since all
listed companies are formal.
330
This effect disappears in specification (3).

235
the data to specify a model that would investigate this supply and demand dynamics in

greater detail on a cross-country basis, but this interpretation is supported by our

qualitative findings in Peru and Argentina.

Trust and the business environment – empirics.

Our data allow us to investigate further the effects on the business environment by the

level of trust in a society. Above we used the constraints to financing as perceived by

medium-sized companies. Here we will include all companies and look at three perceived

obstacles to doing business: finance, political instability, and corruption (Figure 47). We

include the latter two because our qualitative studies and the literature suggest they are

related to trust.

236
Figure 47

Constraints to doing business and trust.

The ordered probit regression estimated is: Constraint to doing business = β Firm size + β Value of sales squared + β Foreign
ownership + β Age of company + β Multinational + β Government ownership + β Exporter + β Level of trust in people in general in
country + β Family importance in country + β GNI per capita + β Political stability index + β Creditor rights index + β Credit
registries index + β Procedural complexity index + β Change in real GDP fromthree years before performing survey + β Industry + u
R-squared are McKelvey and Zavoina (1975). The dependent variable is ordered categorical, and we use probit.

(1) (2) (3)

Finance is obstacle Instability is obstacle Corruption is obstacle
Small company 0.209 0.046 0.367
(3.71)*** (0.82) (5.48)***
Medium-sized 0.142 0.044 0.115
(2.85)*** (0.88) (1.90)*
Sales $ squared -0.000 -0.000 0.000
(3.97)*** (0.14) (2.36)**
Foreign ownership -0.368 -0.095 -0.115
(7.38)*** (1.91)* (1.90)*
Company age -0.002 0.001 -0.003
(2.63)*** (1.17) (2.82)***
Multinational -0.091 0.041 -0.052
(1.74)* (0.79) (0.83)
Government ownership 0.194 -0.113 -0.066
(3.81)*** (2.25)** (1.07)
Exporter dummy 0.054 -0.012 0.005
(1.33) (0.30) (0.11)
Lack of trust 0.006 0.382 0.660
(0.04) (2.29)** (3.24)***
Family not important 1.279 0.385 0.399
(6.13)*** (1.84)* (1.65)*
GNI per capita -0.000 -0.000 -0.000
(2.98)*** (3.05)*** (0.04)
Political stability index -0.123 -0.287 -0.432
(3.69)*** (8.50)*** (10.84)***
Creditor rights index -0.040 -0.090 0.095
(1.77)* (3.95)*** (3.59)***
Credit registry index 0.001 -0.005 0.002
(0.62) (6.21)*** (2.36)**
Bankruptcy index -0.003 -0.007 0.002
(2.57)** (5.35)*** (1.04)
Procedural complexity index -0.003 0.002 0.001
(2.16)** (1.25) (0.82)
Real GDP change last 3 years 1.480 2.005 -0.095
(5.76)*** (7.76)*** (0.32)
Service industry -0.223 -0.084 0.062
(5.66)*** (2.14)** (1.34)
Other industry (not manuf.) -0.351 0.264 0.255
(1.99)** (1.50) (1.23)
Agriculture 0.326 0.246 0.105
(4.49)*** (3.42)*** (1.23)
Construction 0.119 0.076 0.135
(1.80)* (1.14) (1.77)*
Observations 4626 4594 3947
Countries 40 40 40
R-squared 0.150 0.177 0.166
LR Chi2 625.64 764.10 479.31

Absolute value of z-statistics in parentheses

* significant at 10%; ** significant at 5%; *** significant at 1%

Trust in general does not impact access to finance, contrary to what we would believe. It

does, however, impact the perceived constraints resulting from political instability and

237
corruption, so that less trust leads to higher constraints. When we hold the level of trust

constant, we find that the less family importance, the higher the constraint to obtaining

finance, as discussed in the previous section. The less important the family, the more

political instability is a constraint, which makes sense given that the arena of business

organization supplied by family ties is less important and thus the company must rely

more on the formal arena which is governed by the state. The less important the family,

the more problems are encountered with corruption, which indicates that companies,

when relying on connections other than family, must buy support from officials.

We see that, consistent with previous literature, smaller companies suffer more

strongly from constraints due to access to finance and due to corruption.331 They do not

suffer more from political instability than large companies, which makes sense since

corporations depend on interaction with authorities. Companies with foreign ownership

suffer less from all constraints, whereas age only helps in getting easier entrance to

finance and suffering fewer problems related to corruption. Operating in other countries

is associated with lower constraints from finance, corruption, and political instability, and

government-owned companies suffer less from political instability but also have more

problems arriving at finance.

In the regression above we see that political stability helps on all constraints. We

have also discussed, above, that the level of trust in general in a society is a crude

measure of social capital, since trust can vary within groups (such as the family) and also

331
Pfeffermann, et al., Trends in private investment in developing countries and perceived obstacles to
doing business , Beck, et al., Financial and legal constraints to firm growth : Does size matter? , Batra, et
al., Investment climate .

238
within institutions. Political stability is likely to be related to the trust in institutions, and

we will now look at trust in institutions rather than trust in the family, and in people in

general.

What is the difference between trust in individuals and trust

in the institutional framework?
Whether trust among financial actors is a substitute for law, a complement for law, or

both, financial relationships take place within an institutional framework. This

institutional framework matters for economic growth.332 It also matters for how trust

plays out in financial decisions. If actors rely on trust rather than on law, they also steer

away from the institutional framework, since law and institutions are inseparable –

without institutions law remains theoretical, and without law institutions have no

foundation.

The institutional framework establishes rules for transactions, defines the legal

implications of titles to assets, compartmentalizes risk, and is crucial to enable synergies

between state and society.333 If one is to achieve the bridging of social capital from social

subgroups into a society-wide trusting environment, a formal institutional framework is

332
There is a large literature on the subject. For our topics, see Ritzen, et al., 2000, On "good" politicians
and "bad" policies : Social cohesian, institutions, and growth , Stiglitz, Formal and informal institutions ,
Keefer, et al., Social polarization, political institutions, and country creditworthiness , Beck, et al., 2001a,
Financing patterns around the world: The role of institutions , Olson, 1982, The rise and decline of nations :
Economic growth, stagflation, and social rigidities , Barro and Sala-i-Martin, Economic growth, Barro,
1997, Determinants of economic growth , Alesina and Rosenthal, 1995, Partisan politics, divided
government, and the economy , Kaufmann and Kraay, 2002, Growth without governance and Soto, The
other path: The invisible revolution in the third world, Soto, The mystery of capital .
333
For the latter, see Evans, 1996, Government action, social capital, and development: Reviewing the
evidence on synergy .

239
needed to supply the ‘institutional links’ from the state to business and civil society.334

The patterns of trust in a society need to include institutions in order to keep a society

together as it moves from a traditional society towards a postmodern society.335 The state

provides such a framework. If one accepts the notion that the state is more than a medium

for exchange and more than just a set of regulations, the autonomous activity of the state

depends on confidence among the economic agents in order to interact in a beneficial

way.336 For the state to be providing rather than only controlling, the economic agents

outside of the state must trust the state to rely on the same values as the ones they

themselves rely on – for instance, that the state wants to uphold contracts, promote

business growth, and ensure a level playing field for all actors. When the state gets

captured by incumbents that divert its resources to one or a few social groups, the broader

trust in the state’s institutions breaks down and the state becomes controlling rather than

providing.337

There are many ways in which the state can fail. The most obvious is

corruption,338 but state failure, or weak state performance, is not necessarily a result of

malicious intent.339 The governance issue that our interviews identified as the by far

334
Evans, 1989, Predatory, developmental, and other apparatuses: A comparative analysis of the third
world state .
335
The ‘anomie’ from Durkheim, 1933, The division of labor in society ; see also Olson, 2000, Power and
prosperity : Outgrowing communist and capitalist dictatorships and Inglehart, Modernization, cultural
change, and the persistence of traditional values .
336
Evans, et al., 1985, Bringing the state back in , North, Structure and change in economic history ,
Burnside and Dollar, 2000, Aid, policies, and growth , Knack and Keefer, 1995, Insitutions and economic
performance: Cross-country tests using alternative institutional measures
337
Rajan and Zingales, Saving capitalism .
338
Mauro, 1995, Corruption and growth ,Shleifer and Vishny, 1993, Corruption .
339
See Ritzen, et al., On good politicians for an overview and for a presentation of many of the variables
we use in this work, and further about state performance: Acemoglu, et al., The colonial origins of
comparative development: An empirical investigation, Acemoglu, et al., Reversal of fortune: Geography

240
most significant is political instability. We addressed others, such as bureaucracy,

corruption, weak registries and weak protection of property rights, and slow and

inefficient courts. These other obstacles to financial relationships ranked far below

political instability in importance during all our interviews with representatives from the

financial sector.

This is interesting for two reasons: first, political instability is of a different

character than bureaucratic failures such as weak legal protection of property rights or

weak regulators. Instability of the political system means instability of the core of the

system that provides the basis for all other functions of the state. Corruption, bad property

rights, high levels of red tape, and other specific issues may be contained and remedied,

but political instability affects all outputs of the state.

Second, while one can adapt to corruption and weak property rights through

substitute mechanisms (an accepted level of bribery to ‘grease the wheels’;340

fideicomisos to compensate for the weaknesses of moveables as collateral), political

and institutions in the making of the modern world income distribution, Acemoglu and Johnson,
Unbundling institutions , Hall and Jones, 1999, Why do some countries produce so much more output per
worker than others? , Fukuyama, State-building , WorldBank, Wdr 1997 .
340
Huntington, 1968, Political order in changing societies 68 writes: “Corruption may be one way of
surmounting traditional laws or bureaucratic regulations which hamper economic expansion,” but it also
“naturally tends to weaken or perpetuate the weakness of the government bureaucracy”. Note that
Kaufmann, et al., 2000, Does "grease money" speed up the wheels of commerce? refutes the ‘grease the
wheels’-theory empirically. Wade, 1990, Governing the market : Economic theory and the role of
government in east asian industrialization
governing the market 328 notes of the Japanese bureaucracy: “The relative prestige of officials and
business people gives officials an internalized sanction against accepting bribes. Civil servants are,
however, much interested in jobs after their retirement, a considerable source of satisfaction, which can be
promoted by corrupt use of discretionary powers.” Corruption is one way of the state-elite relationship that
Evans, Predatory apparatuses addresses. It can be handled by the actors because it is systemic but
confined. That it allocates society’s resources less than efficiently and contributes to economic demise is a
different matter. Furthermore, it obscures the incentives and allegiances that apply to officials and private
sector actors, so that governance reform and rule of law become severely restricted.

241
instability is a weakness at the center of the system for which there is little remedy. The

administration decides on laws and regulations, as well as top civil servants, so that

political instability is, in theory, an insurmountable obstacle to financial stability.

Our qualitative interviews suggest that political instability is detrimental to the

provision of long-term and widespread finance. In all of our quantitative cross-country

studies in this investigation where we include political stability, it enters significantly in

favor of better economic efficiency. It is unlikely, therefore, that any reforms of the

secured transactions legal framework will have much impact unless the financial system

can operate in a somewhat stable environment. Without more data we cannot investigate

what the minimum level, if determinable, of political stability is.341

Why would trust in institutions and not only the output of

institutions matter?
We would expect the output from institutions to form trust, so that if the institutions

perform well they create trust, and if they perform badly they reduce trust. This does not

seem to be the case, however: Trust in institutions does not seem to reflect the objective

output of those same institutions.342 If we compare the trust in the justice system, political

parties, the government, the civil service, and parliament to governance indicators

describing voice and accountability, political stability, government efficiency, rule of

341
We could imagine a study similar to Przevorski, et al., 1996, What makes democracies endure? , who
established a threshold of economic development after which democracy is likely to endure. Note that Putnam, et
al., Making democracy work 153 identifies previous political development as more important than the level of
economic output for economic growth: “Like a powerful magnetic field, civic conditions seem gradually but
inexorably to have brought socio-economic conditions into alignment, so that by the 1970s socio-economic
modernity is very closely correlated with civic community.”
342
Objective as in “assessed by experts”; see Kaufmann, et al., Governance matters .

242
law, and the control of corruption, we find only weak linear relationships (for

correlations, see Appendix D).

243
Figure 48

Linear relationships between confidence in institutions and governance indicators

y

Voice and Accountability

4
Political Stability
Government Effectiveness

Quality of governance indicator

2
Rule of Law
Control of Corruption

0
Voice and Accountability
Political Stability

-2
Government Effectiveness
Rule of Law

-4
Control of Corruption 2
<-more
2.5
Confidence in the Justice System less->
3
4

4
Quality of governance indicator

Quality of governance indicator

2

2
0

0
-2

-2
-4

-4

1.5 2 2.5 3 3.5 1 1.5 2 2.5 3 3.5

<-more Confidence in Political Parties less-> <-more Confidence in Government less->
4

4
Quality of governance indicator

Quality of governance indicator

2

2
0

0
-2

-2
-4

-4

1.5 2 2.5 3 3.5 1 1.5 2 2.5 3 3.5

<-more Confidence in the Civil Service less-> <-more Confidence in Parliament less->

(Data: Inglehart (2000b), Globalbarometer (2004), Kaufmann (2003))

We see that the most apparent linear relationships are between confidence in the justice

system and, respectively, control of corruption (R2 = 0.38) and rule of law (R2 = 0.34).

The fit is poor between other governance variables and confidence in various institutions,

244
which raises the question whether it is the confidence in institutions or the objectively

measured output of the institutions, or both, that matters for the business environment,

and in particular the financial environment.

If we hypothesize that both the output of institutions and trust in institutions

matter for the obstacles that firms face, the model we have used earlier to show

associations with obstacles to doing business gives results as in Figure 49.

245
Figure 49

The business environment and trust in institutions

The ordered probit regression estimated is: Constraint to doing business = β Firm size + β Value of sales squared + β Foreign
ownership + β Age of company + β Multinational + β Government ownership + β Exporter + β GNI per capita + β Governance index
(see table below) + β Creditor rights index + β Credit registries index + β Procedural complexity index + β Change in real GDP since
three years before performing survey + β Industry + β Level of trust in people in general in country + β Family importance in country
+ β Confidence in institution (see table below) + u
R-squared are McKelvey and Zavoina (1975). The dependent variable is ordered categorical.

The sets of governance indices and confidence in institutions as regressors are:

Specification Business constraint Measure of trust Measure of objective output

(1) Confidence in the justice system Rule of Law
(2) Access to finance Confidence in the civil service Government Efficiency
(3) Confidence in the civil service Control of Corruption
(4) Confidence in the justice system Rule of Law
(5) Confidence in political parties Voice and Accountability
(6) Political instability Confidence in political parties Political Stability
(7) Confidence in the civil service Government Efficiency
(8) Confidence in the civil service Control of Corruption

(1) (2) (3) (4) (5) (6) (7) (8)

Finance is obstacle Instability is obstacle
Small company 0.187 0.185 0.201 -0.004 0.057 0.076 0.016 0.037
(2.58)*** (3.24)*** (3.50)*** (0.05) (0.78) (1.05) (0.27) (0.65)
Medium-sized 0.182 0.127 0.136 0.060 -0.031 -0.048 0.030 0.045
(2.85)*** (2.51)** (2.68)*** (0.94) (0.48) (0.75) (0.59) (0.88)
Sales $ -0.000 -0.000 -0.000 0.000 -0.000 -0.000 -0.000 -0.000
squared
(5.07)*** (3.91)*** (4.63)*** (1.34) (0.24) (0.12) (0.47) (0.52)
Foreign -0.426 -0.359 -0.357 -0.090 -0.026 -0.031 -0.079 -0.082
ownership
(6.57)*** (7.13)*** (7.07)*** (1.39) (0.41) (0.49) (1.56) (1.62)
Company age -0.002 -0.002 -0.002 0.000 -0.000 -0.001 0.001 0.001
(2.53)** (2.71)*** (2.10)** (0.55) (0.38) (0.64) (0.84) (1.09)
Multinational -0.065 -0.105 -0.101 0.014 -0.064 -0.066 0.056 0.051
(0.97) (1.99)** (1.91)* (0.21) (1.00) (1.03) (1.05) (0.97)
Government 0.122 0.180 0.190 -0.124 -0.146 -0.111 -0.158 -0.124
ownership
(2.06)** (3.51)*** (3.71)*** (2.12)** (1.85)* (1.41) (3.11)*** (2.46)**
Exporter 0.105 0.062 0.083 0.018 0.005 0.005 0.002 -0.001
dummy
(2.10)** (1.51) (2.03)** (0.35) (0.09) (0.09) (0.04) (0.02)
GNI per 0.000 -0.000 0.000 -0.000 -0.000 -0.000 0.000 -0.000
capita
(2.66)*** (1.49) (1.12) (1.87)* (1.09) (2.85)*** (1.29) (0.41)
Rule of law -0.360 -0.344
index
(6.04)*** (5.80)***
Voice/Account -0.341
index
(5.95)***
Political -0.161
stability
index
(3.16)***
Government -0.165 -0.449
effectiveness
(4.20)*** (11.28)***
Control of -0.274 -0.332
corruption
(7.77)*** (9.44)***
Creditor 0.097 -0.054 -0.052 -0.136 -0.045 -0.062 -0.094 -0.114
rights index
(3.42)*** (2.33)** (2.26)** (4.69)*** (1.27) (1.72)* (4.05)*** (4.96)***

246
Credit 0.000 0.000 0.002 -0.008 -0.001 0.001 -0.005 -0.005
registry
index
(0.36) (0.38) (2.15)** (7.40)*** (0.98) (1.17) (6.22)*** (5.63)***
Bankruptcy -0.006 -0.003 -0.003 -0.015 -0.006 -0.003 -0.007 -0.007
index
(3.36)*** (2.68)*** (2.45)** (9.01)*** (3.14)*** (1.40) (5.78)*** (5.53)***
Procedural -0.006 -0.004 -0.005 0.001 -0.001 -0.003 -0.000 -0.003
complexity
index
(2.95)*** (2.35)** (2.95)*** (0.63) (0.70) (1.97)** (0.26) (2.09)**
Real GDP 2.831 1.643 1.310 3.701 1.595 1.180 2.429 2.168
change last 3
years
(8.34)*** (6.53)*** (5.12)*** (10.86)*** (4.80)*** (3.63)*** (9.50)*** (8.38)***
Service -0.221 -0.222 -0.216 -0.082 -0.070 -0.076 -0.077 -0.072
industry
(4.61)*** (5.58)*** (5.43)*** (1.72)* (1.28) (1.40) (1.94)* (1.81)*
Other -0.441 -0.327 -0.281 0.423 0.310 0.329 0.294 0.357
industry (not
manuf.)
(2.00)** (1.85)* (1.59) (1.95)* (1.01) (1.07) (1.66)* (2.01)**
Agriculture 0.362 0.295 0.308 0.189 0.136 0.156 0.159 0.209
(4.35)*** (4.01)*** (4.20)*** (2.29)** (1.10) (1.27) (2.19)** (2.89)***
Construction 0.106 0.121 0.121 0.077 0.162 0.156 0.066 0.070
(1.36) (1.83)* (1.82)* (0.99) (1.76)* (1.70)* (0.99) (1.05)
Lack of trust 0.012 -0.220 -0.199 -1.419 0.719 0.732 -0.170 -0.216
(0.04) (1.36) (1.23) (5.18)*** (2.93)*** (2.79)*** (1.05) (1.34)
Family not 0.204 1.128 0.826 -0.083 -0.706 -0.447 -0.295 -0.646
important
(0.62) (5.11)*** (3.67)*** (0.25) (1.68)* (0.97) (1.34) (2.87)***
Less 0.324 -0.147
confidence in
justice
system
(2.36)** (1.07)
Less 0.051 0.080 0.334 0.478
confidence:
Civil service
(0.60) (0.95) (3.95)*** (5.75)***
Less 0.678 0.513
confidence:
Parties
(6.78)*** (5.35)***
Observations 3292 4560 4560 3262 2423 2423 4528 4528
R-squared 0.181 0.154 0.163 0.206 0.193 0.183 0.200 0.190
Countries 26 46 46 26 31 31 46 46
LR Chi2 546.98 633.18 675.97 646.31 446.62 421.13 858.58 819.98
Absolute value of z-statistics in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%

For finance as a constraint to doing business, both the rule of law objectively measured

and the confidence in the justice system matter (Specification (1)). Better rule of law

leads to fewer financing constraints. Holding the rule of law constant, less confidence in

the judicial system leads to higher financing constraints. This is parallel with our

qualitative studies.

Government efficiency and control of corruption matter in reducing the obstacle

access to finance poses to doing business (2 and 3). For these two government outputs,

247
however, it is the actual performance that matters for finance as an obstacle to doing

business, not the confidence in the civil service that produces the outputs. When we hold

the output constant, there is no significant impact of the confidence on the civil service.

For political instability as a constraint to doing business, we find that the rule of

law matters. When we hold the rule of law constant, confidence in the justice system does

not enter significantly (4). We find that the level of voice and accountability matters, and

that when holding this constant, more trust in political parties is associated with fewer

business obstacles related to political instability (5).

We find a similar effect for the objective level of political stability, which reduces

the business constraints related to political instability. When we hold the level of political

stability constant, more trust in political parties is associated with fewer political

obstacles to doing business (6).

Government effectiveness objectively measured reduces the constraint to doing

business. When we hold government effectiveness constant, more trust in the civil service

reduces the constraint further (7).

Finally, we find that the better the control of corruption, the less of a constraint to

doing business is political instability. When holding the control of corruption constant,

more confidence in the civil service reduces political instability as an obstacle to doing

business (8).

In this quantitative analysis, we see that the output of the institutions (as measured

by the rule of law, political stability, government efficiency, and the control of

corruption) matters for the obstacles that firms perceive related to the access to finance

and to political stability. We also find that the confidence in the related institutions (the

248
justice system, the civil service, and the political parties) matters. This supports the

theory that patterns of trust in institutions matter for how financial actors and political

actors arrive at their decisions.

249
VIII. Conclusion

This thesis started out with the notion that law is important economic output in general

and for finance in particular. As we started to explore the link between law and finance,

we discovered that the relationship was not as clear as one would believe. While law was

clearly associated with economic output, it was not associated with growth. We also saw

that creditor rights, despite the importance the literature ascribes to it, were not associated

with output.

In order to better understand how legal rules related to creditors would affect

credit, we visited Peru and Argentina, two countries we selected because of their

comparability and conduciveness to our research topic. There, we looked at banks as

credit providers. We discovered that the banks in Peru and Argentina do not finance

growth and innovations, contrary to what we would believe from reviewing the literature

on the economic role of banks.

Corporations – large companies – in these two countries have ample access to

credit on such good terms that banks do not make a profit from lending them money.

Rather, the banks try to capture transactional business from these firms and use credit to

corporations as a low-risk, low-yield allocation of capital. We found that small firms are

virtually excluded from credit and that banks mainly lend to SMEs for export financing

and short term working capital. In Peru and Argentina, banks certainly do not allocate

capital to its most productive use. That is, banks do not facilitate risk management, as the

theory had led us to believe. They did perform other core functions that the literature

250
assigns to banks, such as collecting information, monitoring managers, and mobilize

savings.

In fact, we found that banks behave very much like shareholders. They lend short

term so that they can exit quickly from a bad investment. They monitor the management

closely (even if they have done away with previous practices of ‘relationship lending’

and introduced better risk management). The same agency problems that the literature

assigns to the relationship between shareholders and managers can be used to describe

the relationship between banks and managers in Peru and Argentina. The standardization

of debt contracts in the banks is an organizational matter, not a matter of coping with

imperfect information. We found that banks do not adjust interest rates to reflect the risk

of projects. Rather, they adjust the maturities of debt.

We started looking for explanations for this divergence between the role banks

should theoretically play and their actual function in Peru and Argentina. In searching for

such explanations, we expanded our inquiry to using global cross-country data. Recent

literature on legal origin seemed to have a good potential to help us understand bank

behavior. However, when we examined this literature more in depth, we found that legal

origin could not be separated from institutional origin and that the great number of

underlying variables made it difficult to establish probable theories of causality.

Following existing literature, we narrowed our investigation to look at a legal

institute that should improve access to credit: moveable collateral. We reviewed the

literature that suggests moveable collateral should increase access to credit as well as the

opposing literature. In Peru and Argentina, reform work on moveable collateral has

stalled, and in order to better understand if such reforms could help increase access to

251
bank finance, we looked at a large experience base of reform work on the framework for

moveable collateral from Central and Eastern Europe.

The experience from Central and Eastern Europe taught us several lessons. It is

possible to reform laws so that a legal assessment of the framework for secured

transactions after the reforms would indicate a successful transition to a more efficient

regime. But we also learned that these reforms do not seem to have had a clear impact on

bank credit or on how firms perceive problems related to collateral as obstacles to doing

business. We also learned that lawyers must be made aware of legal reforms for such

reforms to have effect. In sum, the work in Central and Eastern Europe suggested to us

that improving access to firm finance is a much more subtle project than simply

reforming laws such as secured transaction legislation.

Looking back at our findings in Peru and Argentina we remembered that bank

managers did not seem to actively consider moveable collateral or the likely result of

future bankruptcies when making credit decisions. They did not take any collateral except

the ‘logical’ collateral given the purpose loan, and then more as a monitoring mechanism

than as security. We found this surprising, because any valuable collateral would help

secure debt, not only the collateral directly linked to the purpose of the loan.

We also observed that bank managers did not place much value on moveable collateral.

Not because of the legal framework, but because they assumed the collateral would

disappear before any recovery proceedings would start – they did not trust the borrowers

to maintain the collateral. They also did not trust that loans would be used for the agreed

purposes. And very frequently political stability and various culture-related causes for

lack of finance (both short and long term) would be mentioned by the people we

252
interviewed in Peru and Argentina. We encountered indications that there is a glass-

ceiling that firms have problems breaking through, so that small firms stay small. We

found limited evidence of this glass ceiling, both on the demand and on the supply side.

These findings led us to believe that the lack of access to credit is due to more

complex issues than the legal framework, and we set out to identify the causes. We used

the qualitative observations from Peru and Argentina to construct a model of what

decides how firms are financed, and we tested this model on global cross-country data.

To a large extent, our quantitative analysis suggested that our observations in Peru

and Argentina could be representative of global patterns. The cross-country data showed

us that smaller firms have more problems obtaining finance, that industry matters, as do

ties to other countries in the form of foreign ownership or export. Consistent with what

we observed in Peru and Argentina, firm growth does not matter for bank financing, but

it does matter for equity financing.

We also found that institutions matter more than law. The quality of creditor

rights did not help us explain how firms are financed. Bankruptcy legislation tells us

something about how firms structure their internal financing, consistent with agency

literature. In countries with strong labor protection it appears that the government plays a

bigger role in funding business.

Political stability, which was consistently mentioned by our interviewees in Peru

and Argentina, turned out to be strongly associated with more external and less internal

finance on a global level. We also found that our cultural variables, describing the level

of preindustrial norms and ‘bonding’-type social capital, took on importance also on a

global level.

253
 Although our cultural variables were based on substantive data sources, we were

reluctant to accept their significance even after both our interview subjects and our cross-

country regressions had indicated cultural factors were indeed an explanation of lack of

finance.

In order to build a theoretical foundation for these cultural causes, we relied on

the literature on ‘social capital’ We used this literature to review our data, and we found

that the ‘good’ social capital, so called ‘bridging’ social capital, did not have a significant

impact on how firms perceive their environment. But we did find that the ‘bad’ social

capital, so called ‘bonding’ social capital, did have an impact. The less bonding there is in

a society, the more political instability and corruption are perceived as an obstacle to

doing business. When one relies less on established personal networks, one is more

dependent on a fair and efficient institutional framework to conduct business.

This led us to try to understand the impact on business of how people relate to the

institutions in a country. We used our cross-country data to investigate the impact on how

firms perceive their business environment of attitudes towards institutions, holding the

quality of the framework constant. We found that, holding the quality of the legal system

constant, less confidence in the judiciary was associated with higher constraints to

obtaining financing. We found that peoples’ attitudes towards political parties are

associated with the political obstacles firms perceive and that trust in the civil service is

associated with a better business environment. These findings are consistent with what

we observed in Peru and Argentina.

From our research, we can draw several policy lessons:

254
Banks must learn to profit from supporting growth. They need to learn how to adjust

interest rates to risk, and they need to learn how to allocate capital not only to export

finance or working capital, but also to projects promising growth. They have to learn how

to extend longer term finance. In this way, banks will fulfill their role in fuelling the

economy and contribute to economic growth.

People must learn to trust their institutions. In the same way it does not help

rewriting laws if lawyers do not know about the reforms, it does not help reforming

institutions if people do not trust the institutions. Institutions matter for growth, but

institutions are irrelevant if they are not used by the people that create growth in the first

place. The first step in reform is to improve how institutions work, the second is to

educate people about their improved institutions.

Political stability is crucial. Many shortcomings can be remedied by targeted

reforms of the public sector or through innovations in the private sector. But political

stability lies at the core of any society. Without it, long term planning on the part of

banks, business, and investors is very difficult, and projects with great economic potential

may never be undertaken. Political instability promotes a ‘bonding’ form of social capital

– cohesion within social groups – because a business can not trust the institutional

framework it needs when it wants to open up and rely on society rather than on its peers.

Indicators must be used with caution. Whereas broad explanatory variables such

as legal origin can be seductive in their ability to explain a lot of variation in difference

performance variables, it is difficult to establish causality. Other historical institutional

variable could be the correct ones to use, whereas the researcher often would use

whatever variable that is available. Indices must be specifically tailored to what one

255
wants to measure. As we have seen, indices do not always explain what we believe they

would. One can have a perfect legal framework, scoring high on indices, but it will not

help if practicing lawyers do not know how to use it. And any reform work – or

identification of where to consider reform – must be based on a thorough understanding

of the country in question, not solely on performance indices.

We also found many avenues for more research. In order to further test the

robustness of our findings, micro-level studies in other countries beyond Peru and

Argentina would be necessary. On the cross-country level, a natural extension to this

thesis is to try to understand what impacts credit maturities, in particular across

industries. A further extension would be to model both the demand and supply side of

sources of financing, for long and short term projects. Common for these two topics is

that more data would need to be gathered.

An extension to the ‘new comparative economics’, in particular to its reliance on

legal origin as an explanatory variable, would be historical country case studies to assess

what exactly are the causal paths from a country’s institutional culture to its economic

success. In particular, we would like to know what are the necessary levels of political

stability and /trust in institutions for a country to prosper.

More generally, we believe historical case studies would allow us to better

understand what the key success factors are a successful financial system, to successful

institutions, to the rule of law, and to economic and social development in general.

256
IX. Variable descriptions
Variable Explanation Level Source
Summary statistics: Observations Mean Std.dev. Min Max
Employment “Conditions of employment cover working time requirements, Country WorldBank
conditions including mandatory minimum daily rest, maximum number of (2004)
hours in a normal workweek, premium for overtime work,
restrictions on weekly holiday, mandatory payment for nonworking
days, (which includes days of annual leave with pay and paid time
off for holidays), and minimum wage legislation. The constitutional
principles dealing with the minimum conditions of employment are
also coded.”
128 70.40625 17.95727 22 95
Collateral Average collateral requirements for large loans (over USD 200,000) Banks’ responses Muent and
Requirements in percentage of loan value (Central and Eastern European countries averaged by Pissarides (2000)
for Large only) Country
Loans 1266 130.5545 18.75114 100 200
Collateral Average collateral requirements for medium loans (between USD Banks’ responses Muent and
Requirements 25,000 and USD 200,000) in percentage of loan value (Central and averaged by Pissarides (2000)
for Medium Eastern European countries only) Country
Loans 1266 132.0387 19.89397 100 213
Collateral Average collateral requirements for small loans (under USD Banks’ responses Muent and
Requirements 25,000) in percentage of loan value (Central and Eastern European averaged by Pissarides (2000)
for Small countries only) Country
Loans 1266 131.5719 23.61647 100 192
Days to Average period of days for collateral enforcement (from start of Banks’ responses Muent and
Enforce proceedings to sale) for immovable assets averaged by Pissarides (2000)
Collateral – 1266 114.4968 45.30604 30 525 Country
Immovables
Days to Average period of days for collateral enforcement (from start of Banks’ responses Muent and
Enforce proceedings to sale) for movable assets averaged by Pissarides (2000)
Collateral – 1266 86.57741 46.82045 30 450 Country
Movables
Pooling Average rating (1 = of little importance, 3 = very important) of Banks’ responses Muent and
problem collateral enforcement problems with regards to their impact on averaged by Pissarides (2000)
collateral requirements: Problem of collateral being pooled into a Country
bankrupt estate.
1266 1.443839 .4063108 1 2.5
Realization Average rating (1 = of little importance, 3 = very important) of Banks’ responses Muent and
problem collateral enforcement problems with regards to their impact on averaged by Pissarides (2000)
collateral requirements: Problem of delays in realization of Country
collateral
1266 1.966746 .4204928 1.6 3
Marketability Average rating (1 = of little importance, 3 = very important) of Banks’ responses Muent and
problem problems concerning marketability and valuation of collateral with averaged by Pissarides (2000)
regards to their impact on collateral requirements: Problems Country
concerning marketability of collateral
1266 2.421248 .4519596 1.8 3
Valuation Average rating (1 = of little importance, 3 = very important) of Banks’ responses Muent and
problem problems concerning marketability and valuation of collateral with averaged by Pissarides (2000)
regards to their impact on collateral requirements: Problems ion Country
valuation of collateral
1266 1.310032 .3315583 1 2
Age (firm) Firm age Firm WorldBank
8047 18.67479 25.16768 0 599 (2000)
Age (person) Answer to the question “This means you are __ years old?” Individual Inglehart (2000b)
117447 40.93284 16.30004 15 101
Autonomy This index is an Achievement Motivation Scale that measures if the Individual Inglehart (1997),
index respondent would raise children to be independent or obedient. A appendix
higher value means more independence.
113573 -.1120337 1.187553 -2 2

Bankruptcy “The measure documents the success in reaching the three goals of Country WorldBank
index insolvency, as stated in Hart (1999). It is calculated as the simple (2004), LaPorta,
average of the cost of insolvency (rescaled from 0 to 100, where Lopez-de-Silanes
higher scores indicate less cost), time of insolvency (rescaled from et al. (1998), Hart

257
 0 to 100, where higher scores indicate less time), the observance of (2000)
absolute priority of claims, and the efficient outcome achieved. The
total Goals-of-Insolvency Index ranges from 0 to 100: a score 100
on the index means perfect efficiency (Finland, Norway, and
Singapore have 99), a 0 means that the insolvency system does not
function at all.”
129 50.31783 22.98606 8 99
Catholic Catholics as share of total population in 1980 Country LaPorta, Lopez-
188 31.90745 36.15775 0 97.3 de-Silanes et al.
(2002)
Chief wage Answer to the question: “Are you the chief wage earner?” Yes is 1, Individual Inglehart (2000b)
earner 0 is no
108117 .4680763 .4989821 0 1
Collateral as Answer to the question: “Please judge on a four point scale how Firm WorldBank
obstacle problematic are these different financing issues for the operation (2000)
and growth of your business - Collateral requirements of
banks/financial institutions” from 1 to 4 where 1 is “No obstacle”
and 4 is “Major obstacle”
8964 2.497434 1.165581 1 4
Confidence in Answer to the question: “How much confidence [do you have in] Individual Inglehart (2000b)
armed forces the armed forces”? scale from 0 to 3, where 3 is “A great deal” and
0 is “None at all”
108475 1.727864 .9145031 0 3
Confidence in Answer to the question: “How much confidence [have you] in…” Individual Inglehart (2000b)
government on a scale from 1 to 4, where 4 is “A great deal” and 1 is “None at
all”
66594 1.484113 .9787563 0 3
Confidence in Answer to the question: “How much confidence [have you] in…” Individual Inglehart (2000b)
justice system on a scale from 0 to 3, where 3 is “A great deal” and 0 is “None at
all”
62612 1.390277 .8599453 0 3
Confidence in Answer to the question: “How much confidence [have you] in…” Individual Inglehart (2000b)
parliament on a scale from 0 to 3, where 3 is “A great deal” and 0 is “None at
all”
108737 1.275619 .9265619 0 3
Confidence in Answer to the question: “How much confidence [have you] in…” Individual Inglehart (2000b)
political on a scale from 0 to 3, where 3 is “A great deal” and 0 is “None at
parties all”
67557 1.06923 .9101796 0 3
Confidence in Answer to the question: “How much confidence [do you have] Individual Inglehart (2000b)
the church in…” on a scale from 0 to 3, where 3 is “A great deal” and 0 is
“None at all”
110803 1.876375 1.022219 0 3
Confidence in Answer to the question: “How much confidence [do you have] Individual Inglehart (2000b)
the civil in…” on a scale from 1 to 4, where 4 is “A great deal” and 1 is
service “None at all”
106126 1.364934 .861923 0 3
Confidence in Answer to the question: “How much confidence [do you have] in … Individual Inglehart (2000b)
the Justice the justice system” on a scale from 1 to 4, where 1 is “A great deal”
System and 4 is “None at all”
61086 2.61068 .8669837 1 4
Control of A standardized measure describing control of corruption Country Kaufmann, Kraay
corruption 173 .0303468 1.033113 -1.76 2.54 et al. (2003),
Kaufmann, Kraay
et al. (1999)
Country “Income group: Economies are divided according to 2002 GNI per Country WorldBank
income capita, calculated using the World Bank Atlas method.” The groups (2004)
category are: low income (Inc_l=1, 0 otherwise), $735 or less; lower middle
dummies income, $736 - $2,935 (Inc_lm=1, 0 otherwise); upper middle
income, $2,936 - $9,075 (Inc_um=1, 0 otherwise); and high income,
$9,076 or more (Inc_h=1, 0 otherwise).
Court power “The measure documents the degree to which the court drives CoFuntry WorldBank
in insolvency insolvency proceedings. It is an average of three indicators: whether (2004), LaPorta,
proceedings the court appoints and replaces the insolvency administrator with no Lopez-de-Silanes
restrictions imposed by law, whether the reports of the administrator et al. (1998), Hart
are accessible only to the court and not creditors, and whether the (2000)
court decides on the adoption of the rehabilitation plan. The index is
scaled from 0 to 100, where higher values indicate more court
involvement in the insolvency process.”

258
 129 58.1938 25.26178 0 100
Creditor An index from 0 to 4 where 4 is better based on four elements: County WorldBank
Rights - Restrictions on entering reorganization: whether there are (2004), LaPorta,
restrictions, such as creditor consent, when a debtor files for Lopez-de-Silanes
reorganization-as opposed to cases where debtors can seek et al. (1998)
unilateral protection from creditors' claims by filing for
reorganization.
- No automatic stay: whether secured creditors are able to seize their
collateral after the decision for reorganization is approved, in other
words whether there is no "automatic stay" or "asset freeze"
imposed by the court.
- Secured creditors are paid first: whether secured creditors are paid
first out of the proceeds from liquidating a bankrupt firm, as
opposed to other parties such as government (e.g., for taxes) or
workers.
- Management does not stay in reorganization: Whether an
administrator is responsible for management of the business during
the resolution of reorganization, instead of having the management
of the bankrupt debtor continue to run the business.
132 1.909091 1.044466 0 4
Education Level of education of respondent on a scale from 1 to 5, where 1 is Individual Inglehart (2000b)
1 = Inadequately completed elementary education
2 = Less than complete secondary school
3 = Complete secondary school
4 = Some university/higher education without degree
5 = University/higher education with degree
116677 2.738037 1.163404 1 5
Exporter 1 if the company exports, 0 otherwise Firm WorldBank
dummy 9463 .3564409 .4789729 0 1 (2000)
Family Answer to the question: “Indicate how important [family] is in your Individual Inglehart (2000b)
important life”, averaged by nation, on a scale from 1 to 4, where 1 is “Very
important” and 4 is “Not very important”
116914 1.122671 .3831205 1 4
Finance Based on the variables _fn_*, _fn_*o is a scale from 1 to 10, where Firm WorldBank
(ordered) 0 means the source of finance accounts from 0 percent (2000)
1 means the source of finance accounts from >0 and <=10 percent
2 means the source of finance accounts from >10 and <=20 percent
3 means the source of finance accounts from >20 and <=30 percent
4 means the source of finance accounts from >30 and <=40 percent
5 means the source of finance accounts from >40 and <=50 percent
6 means the source of finance accounts from >50 and <=60 percent
7 means the source of finance accounts from >60 and <=70 percent
8 means the source of finance accounts from >70 and <=80 percent
9 means the source of finance accounts from >80 and <=90 percent
10 means the source of finance accounts from >90 and <=100
percent
Finance: The share of the responding firm’s financing coming from local Firm WorldBank
Domestic commercial banks in percent of total financing (2000)
credit 7480 13.27086 23.98216 0 100
Finance: The share of the responding firm’s financing coming from family or Firm WorldBank
Family friends in percent of total financing (2000)
7485 6.461857 19.59485 0 100
Finance: The share of the responding firm’s financing coming from foreign Firm WorldBank
Foreign bank banks (2000)
7485 2.582766 11.7865 0 100
Finance: The share of the responding firm’s financing coming from retained Firm WorldBank
Retained earnings in percent of total financing (2000)
Earnings 7487 49.27635 40.41697 0 100
Finance: 100% - The share of the responding firm’s financing coming from Firm WorldBank
Retained retained earnings in percent of total financing (2000)
Earnings 7487 50.72365 40.41697 0 100
inverst
Finance: The share of the responding firm’s financing coming from Firm WorldBank
Share equity/sale of stock in percent of total financing (2000)
7497 4.729759 16.09546 0 100
Finance: State The share of the responding firm’s financing coming from the Firm WorldBank
public sector (2000)
6892 3.35592 15.27275 0 100
Finance: The share of the responding firm’s financing coming from supplier Firm WorldBank

259
Supplier credit in percent of total financing (2000)
credit 7274 6.334067 15.97073 0 100
Financial This index “focuses on changes in the degree of financial Country Laeven (2000)
liberalization liberalization within a country. The figure indicates the number of
index measures that has been implemented with respect to six different
types of financial sector liberalization. The index ranges thus from
0-6, with 6 indicating the highest level of financial liberalization.
The six reform measures we focus on are: interest rates deregulation
(both lending and deposit rates), reduction of entry barriers (both
for domestic and foreign banks), reduction of reserve requirements,
reduction of credit controls (such as directed credit, credit ceilings),
privatization of state banks (and more generally reduction of
government control), and strengthening of prudential regulation
(such as independence of the Central Bank or adoption of capital
adequacy ratio standards according to the Basle Accord
guidelines).”
1992: 12 2.75 1.658312 0 5
1995: 12 4.583333 1.240112 2 6
Financing Answer to the question: “Please judge on a four point scale how Firm Batra, Kaufmann
constraint as problematic [financing is] for the operation and growth of your et al. (2003a),
obstacle business.” from 1 to 4 where 1 is “No obstacle” and 4 is “Major WorldBank
obstacle” (2000)
9229 2.809188 1.12084 1 4
Flexibility of “Flexibility of firing covers workers' legal protections against Country WorldBank
firing workers dismissal, including grounds for dismissal, procedures for dismissal (2004), Djankov
index (individual and collective), notice period, and severance payment. (2003b)
The constitutional principles dealing with protection against
dismissal are also coded.” A higher value denotes more worker
protection.
133 37.84211 17.46375 1 74
Flexibility of “The flexibility of hiring index covers the availability of part-time Country WorldBank
hiring and fixed-term contracts.” (2004)
128 49.29688 17.23865 17 81
Foreign 1 if the company has foreign ownership, 0 otherwise WorldBank
ownership 9673 .1881526 .3908542 0 1 (2000)
dummy
Gender 1 if respondent is male, 0 if female Individual Inglehart (2000b)
117744 .4765763 .4994531 0 1
GNI per GNI per capita in 2002 Country WorldBank
capita 132 5975.909 9212.437 90 37930 (2004)
GNP per “The annual rate of GNP per capita growth for the period 1970- County LaPorta, Lopez-
capita growth 1995. Because of the short period for which there is data de-Silanes et al.
available, the variable is not constructed for those countries in our (2002) and World
sample which emerged as a result of a breakup of another Bank Indicators
country (i.e. Czech Republic, Slovak Republic, Croatia, Slovenia,
Russia and Kazakhstan).”
161 .0669747 2.527387 -14.06627 7.537846
God important Answer to the question: “How important is God in your life?” Scale Individual Inglehart (2000b)
from 1 to 10 where 1 is “Not at all” and 10 is “Very”
111454 7.50541 3.131431 1 10
Government A standardized measure describing government effectiveness County Kaufmann, Kraay
Effectiveness 178 .0150562 1.01335 -2.58 2.48 et al. (2003)
Government 1 if the government owns part or all of the company, 0 otherwise Firm WorldBank
ownership 9645 .1219285 .3272201 0 1 (2000)
dummy
Industry Company sector: 1 = manufacturing, 2 = service, 3 = other, 4 = Firm WorldBank
agriculture, 5 = construction (2000)
9141 2.102068 1.23709 1 5
Informal share Informal_gnipc/gnipc Country
of GNI
Labor law “The index of employment regulation is a simple average of the Country WorldBank
flexibility-of-hiring index, the conditions of-employment index, and (2004)
the flexibility-of-firing index.”
128 52.77344 12.87506 20 79
Large 1 if the company has over 500 employees, 0 otherwise Firm WorldBank
company 10007 .1924653 .3942562 0 1 (2000)
dummy
Latitude The absolute value of the capital’s latitude/90 Country LaPorta, Lopez-
187 .2896108 .189355 0 .7222222 de-Silanes et al.

260
 (2002)
Legal origin Leg_fr, leg_en, leg_ge, leg_sc, leg_so are 1 if the country’s legal Country WorldBank
origin is French, English, German, Scandinavian, and Socialist, (2004)
respectively, 0 otherwise
Legal origin Describes the country’s legal origin. 1) French 2) English 3) Country WorldBank
German 4)Scandinavian 5)Socialist (2004)
Log GNI per Log of GNI per capita in 2002 County WorldBank
capita (2004)
Log of GNP See Gnpcagav County
per capita
growth
Long term Answer to the question: “Please judge on a four-point scale how Firm WorldBank (2000;
loan problematic are these different financing issues for the operation Batra, Kaufmann
constraint and growth of your business. Lack access to long-term loans” et al. (2003b)
7024 2.634539 1.264914 1 4
Medium 1 if the company has 51 – 500 employees, 0 otherwise Firm WorldBank
company 10007 .402818 .4904893 0 1 (2000)
dummy
Multinational 1 if the country has operations in other countries, 0 otherwise Firm WorldBank
dummy 9668 .181837 .3857301 0 1 (2000)
Muslim Muslims as share of total population in 1980 Country LaPorta, Lopez-
188 22.34489 35.23536 0 99.9 de-Silanes et al.
(2002)
Nationalism Answer to the question: “How proud are you to be [country]?” Individual Inglehart (2000b)
Scale from 1 to 4 where 1 is “Very proud” and 4 is “Not at all
proud”
113275 1.553529 .7635873 1 4
People in Answer to the question: “How many people, including yourself, are Individual Inglehart (2000b)
household currently living in your household? Aged 18 and over”
40589 2.351401 1.113706 1 33
Political A standardized measure describing political stability County Kaufmann, Kraay
stability index 166 .0000602 .9999185 -2.83 1.73 et al. (2003),
Kaufmann, Kraay
et al. (1999)
Post- An index based on the responses in the World Values Survey that Individual Inglehart (1997),
materialist describes the respondents’ ranking on a scale from Materialist to appendix343
index, 12 item Post-Materialist values, where a higher number is Postmaterialist.
Please refer to Inglehart (1997) for a detailed description.
64092 1.958544 1.199283 0 5
Post- An index based on the responses in the World Values Survey that Individual Inglehart (1997),
materialist describes the respondents’ ranking on a scale from Materialist to appendix
index, 4 item Post-Materialist values, where a higher number is Postmaterialist.
Please refer to Inglehart (1997) for a detailed description. This
index has fewer items than Y001 and is available for more
respondents.
108259 1.808801 .6303062 1 3
Procedural “This index measures substantive, and procedural statutory Country WorldBank
complexity in intervention in civil cases in the courts, and is formed by averaging (2004), Djankov
contract the following subindices: (1) Use of professionals: This subindex (2003a)
enforcement measures whether the resolution of the case provided would rely
mostly in the intervention of professional judges and attorneys, as
opposed to the intervention of other types of adjudicators and lay
people. (2) Nature of action: This subindex measures the written or
oral nature of the actions involved in the procedure, from the filing
of the complaint to enforcement. (3) Legal justification: This
subindex measures the level of legal justification required in the
process of dispute resolution.
Statutory regulation of evidence: This subindex measures the level
of statutory control or intervention of the administration,
admissibility, evaluation and recording of evidence. (4) Control of
superior review: This subindex measures the level of control or

343
For a discussion of this index, see Hansen and Tol, 2003, A refinded inglehart index of materialism and
postmaterialism .

261
 intervention of the appellate court's review of the first instance
judgement. (5) Other statutory interventions: This subindex
measures the formalities required to engage someone into the
procedure or to hold him/her accountable for the judgement. The
Procedural Complexity Index varies from 0 to 100, with higher
values indicating more procedural complexity in enforcing a
contract.”
128 57.6875 13.649 29 90
Property An index of property rights in each country (on a scale from 1 to 5). County LaPorta, Lopez-
Rights The more protection private property receives, the de-Silanes et al.
higher the score. The score is based, broadly, on the degree of legal (2002)
protection of private property, the extent to which the Political Risk
government protects and enforces laws that protect private property, Services (1996)
the probability that the government will expropriate
private property, and the country’s legal protection to private
property.
157 3.490446 1.101385 1 5
Protestant Protestants as share of total population in 1980 Country LaPorta, Lopez-
186 13.48656 22.1902 0 99.8 de-Silanes et al.
(2002)
Public Credit Scores can range from 0 to 100, where higher values indicate that County WorldBank
Registry index the rules of the public credit registry are better designed to support (2004), LaPorta,
credit transactions. The overall index of the extensiveness of public Lopez-de-Silanes
credit registries is a simple average of the collection, distribution, et al. (1998)
access, and quality indices.
129 24.07752 25.89088 0 70
Region reg_lac reg_eca reg_eap reg_sasia; 1 if the country is in Latin Country WorldBank
dummies America and the Caribbean, Europe and Central Asia, East Asia and (2004)
Pacific, South Asia, respectively, 0 otherwise.
Regulatory A standardized measure describing regulatory quality County Kaufmann, Kraay
Quality 179 .0156983 1.012675 -3.57 2.27 et al. (2003),
Kaufmann, Kraay
et al. (1999)
Risk of An index of ICRG’s assessment of the “risk of a modification in a County LaPorta, Lopez-
Repudiations contract taking the form of a repudiation, postponement, de-Silanes et al.
or scaling down” due to “budget cutbacks, indigenization pressure, (2002)
a change in government, or a change in government Political Risk
economic and social priorities.” Average of the months of April and Services (1996)
October of the monthly index between 1982 and 1995.
Scale from 0 to 10, with lower scores indicating higher risks.
125 6.179932 2.009161 1.821429 10
Rule of Law A standardized measure describing the quality of the rule of law County Kaufmann, Kraay
179 .0146927 1.012943 -2.31 2.22 et al. (2003),
Kaufmann, Kraay
et al. (1999)
Savings ratio Index of total gross domestic savings as a percentage of GDP for Country LaPorta, Lopez-
the period 1960-1992. Gross domestic savings are calculated as the de-Silanes et al.
difference between GDP and total consumption. (2002)
77 .2466066 .0824956 .03513 .61113
Size of SME The share of the SME sector in the total official labor force when Country Beck, Ayyagari et
sector, 250 250 employees is taken as the cutoff for the definition of an SME al. (2003)
Size of SME The share of the SME sector in total official labor force when the Country Beck, Ayyagari et
sector, official official country definition of SMEs is used, with the official al. (2003)
country definition varying between 100 and 500 employees.
Size of the “Output in the informal economy as a share of gross national Country WorldBank
informal income (GNI).” (2004)
sector 108 32.68333 14.11332 3 67.3 Schneider (2002)
Size of town Size of town where the interview was conducted on a scale from 1 Individual Inglehart (2000b)
to 8, where 1 is under 2000 and 8 is over 500,000.
82906 4.946795 2.464121 1 8
Small 1 if the company has 50 or fewer employees, 0 otherwise. Firm WorldBank
company 8047 18.67479 25.16768 0 599 (2000)
dummy
Stable Answer to the question: “Whether you are married or not: Do you Individual Inglehart (2000b)
relationship live in a stable relationship with a partner?” Yes is 1, No is 0
42109 .6768862 .4676713 0 1
Supervisor Answer to the question: “In your present job, do you supervise Individual Inglehart (2000b)
anyone who is directly responsible to you?”
18908 .2513222 .4337849 0 1

262
Traditional Traditional/secular rational value factor scale, averaged by nation, Individual Inglehart (2000b),
value scale composed of the variables (1) God is very important in respondent’s Inglehart (2000a)
life, (2) It is more important for a child to learn obedience and
religious faith than independence and determination, (3) Abortion is
never justifiable, (4) Respondent has strong sense of national pride,
(5) Respondent favors more respect for authority. Higher score is
more traditional values.
76747 -.0895141 .9821006 -2.01261 3.94149
Trust Answer to the question: “Generally speaking, would you say that Country Inglehart (2000b),
you can trust most people, or that you can never be too careful when Individual Globalbarometer
dealing with others?”. Average by country. 1 is distrust, 0 is trust. (2004)
93 .7271016 .1484788 .3346856 .9719545
Trust 1 - __tc, so that 0 is distrust and 1 is trust Country
Individual
Value of sales Value of the company’s sales in 1,000,000 USD Firm WorldBank
G 9087 975.093 8943.727 0 100000 (2000)
Voice and A standardized measure describing voice and accountability Country Kaufmann, Kraay
accountability 174 -.0474138 .9884037 -2.12 1.64 et al. (2003),
Kaufmann, Kraay
et al. (1999)
Wage scale Answer to the question: “Here is a scale of incomes and we would Individual Inglehart (2000b)
like to know in what group your household is, counting all wages,
salaries, pensions and other incomes that come in. Just give the
letter of the group your household falls into, after taxes and other
deductions.” Scale varies by country, from 0 (lowest) to 10
(highest)
102194 4.543515 2.43068 1 10

263
X. Appendices

264
 A. Legal origin

Explanatory power of legal origin, religion, and geography on law and governance

The regression estimated is: Index of law or governance = α + β Legal origin + β Religion + β Distance from the Equator
Regressions are OLS except †, which are ordered probit. (56) – (60) exclude countries with Scandinavian legal origin. R squared for ordered probit regressions is McKelvey and Zavoina
(1975), and for ordered probit LR Chi squared is reported instead of F-stat.

Please refer to the variable explanations above for details about the variables.

(1) (2) (3) (4) (5) (6) (7) (8) (9)

Index_ Index_ Index_ Index_ Index_ Index_ Index_ Index_ Index_
bcy bcy bcy Court Court court flexhire flexhire flexhire
powers powers powers
Leg_fr -14.952 23.823 18.958
(3.24)*** (4.80)*** (5.70)***
Leg_ge 2.503 14.065 8.918
(0.40) (2.07)** (1.93)*
Leg_sc 33.282 -9.685 17.712
(2.98)*** (0.81) (2.16)**
Leg_so -2.513 14.701 16.758
(0.34) (1.86)* (3.11)***
protmg80 0.448 -0.296 -0.083
(3.98)*** (2.40)** (1.02)
muslim80 -0.039 0.120 0.043
(0.55) (1.56) (0.78)
catho80 -0.010 0.062 0.117
(0.16) (0.89) (2.36)**
no_cpm80 0.000 0.000 0.000
(.) (.) (.)
lat_abst 57.510 -30.639 2.151
(5.99)*** (2.72)*** (0.27)
Constant 56.968 47.407 32.744 42.935 55.807 67.233 36.788 45.325 48.633
(15.11)*** (11.02)*** (9.32)*** (10.60)*** (11.86)*** (16.29)*** (13.66)*** (13.62)*** (16.73)***
Observations 125 124 125 125 124 125 128 127 128
R-squared 0.20 0.15 0.23 0.19 0.10 0.06 0.22 0.07 0.00
F-stat 7.72 7.09 35.94 7.01 4.47 7.39 8.68 2.98 0.07

265
 (10) (11) (12) (13) (14) (15) (16) (17) (18)
Index_ Index_ Index_ Index_ Index_ Index_ Index_ Index_ Index_
condemp condemp condemp flexfire flexfire flexfire laborlaw laborlaw Laborlaw
Leg_fr 18.323 13.944 17.042
(5.72)*** (4.04)*** (7.65)***
Leg_ge 13.643 3.692 8.631
(3.07)*** (0.77) (2.79)***
Leg_sc -21.621 1.765 -0.795
(2.74)*** (0.21) (0.14)
Leg_so 24.788 18.515 20.000
(4.78)*** (3.31)*** (5.54)***
protmg80 -0.388 -0.155 -0.209
(5.07)*** (1.92)* (3.74)***
muslim80 -0.018 -0.007 0.008
(0.36) (0.12) (0.21)
catho80 0.102 0.115 0.112
(2.21)** (2.36)** (3.32)***
no_cpm80 0.000 0.000 0.000
(.) (.) (.)
lat_abst 0.498 -12.855 -3.541
(0.06) (1.62) (0.59)
Constant 58.121 71.708 70.253 29.485 36.703 42.451 41.545 51.226 53.866
(22.40)*** (23.05)*** (23.19)*** (10.56)*** (11.21)*** (14.79)*** (23.02)*** (22.56)*** (24.84)***
Observations 128 127 128 128 127 128 128 127 128
R-squared 0.33 0.25 0.00 0.16 0.10 0.02 0.37 0.23 0.00
F-stat 15.33 13.73 0.00 5.73 4.71 2.64 18.21 12.03 0.35

266
 (19) (20) (21) (22) (23) (24) (25)† (26)† (27)†
Index_procplx Index_procplx Index_procplx Index_pcr Index_pcr Index_pcr Index_cr Index_cr Index_cr
Leg_fr 18.200 22.437 -0.773
(7.43)*** (4.33)*** (3.30)***
Leg_ge 7.691 17.606 0.223
(2.29)** (2.48)** (0.71)
Leg_sc -2.250 -11.394 -0.545
(0.38) (0.90) (0.98)
Leg_so 6.477 -1.394 -0.176
(1.66) (0.17) (0.48)
protmg80 -0.195 -0.269 0.002
(3.21)*** (2.29)** (0.43)
muslim80 0.076 0.103 -0.006
(1.91)* (1.29) (1.78)*
catho80 0.155 0.244 -0.005
(4.37)*** (3.39)*** (1.62)
no_cpm80 0.000 0.000
(.) (.)
lat_abst -11.922 -11.469 0.585
(1.89)* (0.95) (1.20)
Constant 47.250 52.888 61.338 11.394 16.609 27.571
(23.87)*** (21.96)*** (26.47)*** (2.75)*** (3.44)*** (6.20)***
Observations 124 123 124 124 123 124 127 126 127
R-squared 0.35 0.26 0.03 0.19 0.17 0.01 .143† .047† .012†
F-stat 16.04 14.24 3.56 6.98 8.01 0.89 17.736† 5.476† 1.443†
†)LR Chi2

267
 (28) (29) (30) (31) (32) (33) (34) (35) (36)
VA00Est_ VA00Est_ VA00Est_ PS00Est_ PS00Est_ PS00Est_ GE00Est_ GE00Est_ GE00Est_
Leg_fr -0.098 0.019 -0.206
(0.55) (0.10) (1.07)
Leg_ge 0.718 0.789 0.509
(2.86)*** (2.94)*** (1.87)*
Leg_sc 1.572 1.635 1.623
(3.60)*** (3.51)*** (3.43)***
Leg_so -0.482 -0.193 -0.876
(1.68)* (0.63) (2.82)***
protmg80 0.015 0.013 0.015
(4.31)*** (3.01)*** (3.55)***
muslim80 -0.008 -0.003 -0.001
(3.50)*** (1.00) (0.39)
catho80 0.006 0.003 0.003
(2.84)*** (1.25) (1.27)
no_cpm80 0.000 0.000 0.000
(.) (.) (.)
lat_abst 2.208 2.576 2.495
(6.18)*** (6.99)*** (6.96)***
Constant -0.029 -0.223 -0.687 -0.117 -0.171 -0.768 0.160 -0.212 -0.681
(0.20) (1.53) (5.55)*** (0.77) (0.97) (5.85)*** (1.03) (1.21) (5.50)***
Observations 126 172 174 127 159 161 127 171 173
R-squared 0.20 0.34 0.18 0.16 0.11 0.23 0.21 0.11 0.22
F-stat 7.69 28.56 38.22 5.95 6.43 48.83 7.91 6.62 48.46

268
 (37) (38) (39) (40) (41) (42)
RL00Est_ RL00Est_ RL00Est_ CC00Est_ CC00Est_ CC00Est_
Leg_fr -0.405 -0.283
(2.14)** (1.43)
Leg_ge 0.419 0.439
(1.56) (1.56)
Leg_sc 1.750 2.220
(3.74)*** (4.55)***
Leg_so -0.955 -0.926
(3.11)*** (2.89)***
protmg80 0.017 0.019
(4.12)*** (4.88)***
muslim80 -0.001 -0.002
(0.56) (0.89)
catho80 0.003 0.003
(1.16) (1.23)
no_cpm80 0.000 0.000
(.) (.)
lat_abst 2.608 2.666
(7.31)*** (7.39)***
Constant 0.272 -0.221 -0.713 0.153 -0.243 -0.739
(1.77)* (1.28) (5.80)*** (0.95) (1.43) (5.93)***
Observations 127 172 174 127 171 173
R-squared 0.25 0.14 0.24 0.26 0.19 0.24
F-stat 10.10 8.85 53.43 10.64 12.94 54.57

269
 (43) (44) (45) (46) (47) (48) (49) (50)†
Index_bcy Index_courtpowers Index_flexhire Index_condemp Index_laborlaw Index_procplx Index_pcr Index_cr
Leg_fr -2.851 0.816 -15.965 20.765 -2.266 8.342 17.839 0.616
(0.36) (0.09) (1.27) (1.74)* (0.28) (1.88)* (1.85)* (0.70)
Leg_en 14.894 -25.159 -31.107 7.492 -14.951 -5.228 3.520 1.310
(1.82)* (2.72)*** (2.64)*** (0.67) (1.98)* (1.14) (0.36) (1.58)
Leg_ge 1.000 3.324 -23.174 17.183 -7.017 1.671 18.781 1.536
(0.13) (0.38) (1.90)* (1.49) (0.90) (0.38) (1.99)** (1.80)*
Leg_sc 9.814 -8.877 0.000 0.000 0.000 14.497 19.835
(0.56) (0.45) (.) (.) (.) (1.52) (1.01)
Leg_so 0.000 0.000 -14.660 29.238 6.006 0.000 0.000 1.269
(.) (.) (1.13) (2.37)** (0.72) (.) (.) (1.39)
protmg80 0.190 -0.064 -0.143 -0.201 -0.152 -0.242 -0.305 0.009
(1.19) (0.35) (1.29) (1.92)* (2.14)** (2.84)*** (1.82)* (1.19)
muslim80 0.009 0.098 0.011 -0.007 -0.000 0.031 0.068 -0.002
(0.14) (1.31) (0.21) (0.14) (0.01) (0.81) (0.81) (0.60)
catho80 0.107 -0.057 0.065 0.080 0.086 0.073 0.137 -0.000
(1.64) (0.76) (1.23) (1.59) (2.51)** (1.94)* (1.65) (0.08)
lat_abst 57.624 -42.814 -4.055 2.952 -7.809 -4.991 -4.140 0.021
(4.61)*** (3.02)*** (0.41) (0.31) (1.22) (0.72) (0.27) (0.03)
Constant 24.435 76.829 69.869 52.262 59.424 55.297 9.950
(2.82)*** (7.82)*** (5.11)*** (4.02)*** (6.76)*** (11.34)*** (0.94)
Observations 124 124 127 127 127 123 123 126
R-squared 0.37 0.29 0.24 0.37 0.44 0.43 0.24 0.17†
F-stat 8.51 5.81 4.71 8.71 11.71 10.64 4.40 20.602†
†)LR Chi2

270
 (56) (57) (58) (59) (60)
VA00Est_ PS00Est_ GE00Est_ RL00Est_ CC00Est_
Leg_fr 0.902 0.070 0.148 0.111 0.247
(3.64)*** (0.27) (0.58) (0.46) (0.97)
Leg_en 1.134 0.176 0.479 0.597 0.608
(4.43)*** (0.64) (1.72)* (2.27)** (2.21)**
Leg_ge 0.851 0.000 0.000 0.000 0.000
(3.44)*** (.) (.) (.) (.)
Leg_so 0.000 -0.843 -1.242 -1.234 -1.176
(.) (2.75)*** (4.02)*** (4.23)*** (3.84)***
protmg80 0.007 0.004 0.005 0.008 0.009
(1.56) (0.75) (0.90) (1.51) (1.61)
muslim80 -0.007 -0.001 -0.001 -0.001 -0.002
(3.50)*** (0.53) (0.38) (0.24) (0.78)
catho80 0.004 0.003 0.004 0.003 0.003
(2.10)** (1.31) (1.39) (1.28) (1.30)
lat_abst 2.933 3.267 3.385 3.630 3.645
(7.53)*** (6.76)*** (6.96)*** (7.90)*** (7.57)***
Constant -1.808 -1.107 -1.187 -1.298 -1.414
(6.61)*** (3.45)*** (3.68)*** (4.26)*** (4.43)***
Observations 121 122 122 122 122
R-squared 0.55 0.38 0.41 0.48 0.46
F-stat 20.06 9.93 11.44 14.92 13.66

Absolute value of t statistics in parentheses

* significant at 10%; ** significant at 5%; *** significant at 1%
† Absolute value of z statistics in parentheses, R squared is McKelvey & Zavoina

271
 B. Trust

Trust and demographic variables

The probit regression estimated is: Trust = α + β Age + β Income + β Town size + β Educational level + β Gender + β
Chief wage earner dummy + β Post-materialist index + β Autonomy index + β GNI per capita + β Elements of traditional-rational
index + β Rule of law + β Traditional secular values index + u
R-squared is McKelvey and Zavoina (1975). The dependent variable is binary.

Trust
Age 0.003
(8.10)***
Wage scale 0.035
(12.89)***
Size of town -0.019
(7.11)***
Education 0.044
(7.63)***
Male 0.003
(0.21)
Chief wage earner 0.067
(4.62)***
Post-materialist values 0.044
(4.35)***
Autonomy index -0.093
(13.65)***
GNI per capita 0.000
(1.87)*
Thinks homosexuality is justifiable 0.039
(15.45)***
Feels happy -0.081
(7.75)***
Would sign a petition -0.063
(7.40)***
Rule of law index in country 0.059
(4.92)***
Traditional values -0.111
(10.39)***
Europe Central Asia -0.201
(5.69)***
Middle East and North Africa 0.219
(5.32)***
Latin America -0.286
(7.72)***
Sub-Saharan Africa 0.089
(1.67)*
South Asia 0.208
(4.73)***
East Asia Pacific 0.092
(2.20)**
Constant -0.906
(15.16)***
Observations 50706
R-squared 0.103
LR Chi2 3148.69
Absolute value of z-statistics in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%

272
 C. Family importance and trust
+-------------------+
| Key |
|-------------------|
| frequency |
| column percentage |
+-------------------+
| MOST PEOPLE CAN BE
| TRUSTED
FAMILY IMPORTANT | MOST PEOP NEED TO B | Total
| CAN BE T. CAREFUL |
---------------------+----------------------+----------
VERY IMPORTANT | 27,039 72,401 | 99,440
| 88.30 89.09 | 88.87
---------------------+----------------------+----------
RATHER IMPORTANT | 3,088 7,634 | 10,722
| 10.08 9.39 | 9.58
---------------------+----------------------+----------
NOT VERY IMPORTANT | 394 965 | 1,359
| 1.29 1.19 | 1.21
---------------------+----------------------+----------
NOT AT ALL IMPORTANT | 101 267 | 368
| 0.33 0.33 | 0.33
---------------------+----------------------+----------
Total | 30,622 81,267 | 111,889
| 100.00 100.00 | 100.00

Pearson chi2(3) = 14.4365 Pr = 0.002

Cramér's V = 0.0114

Data: Inglehart (2000b)

273
 D. Trust in institutions

| Parliament Civil Government Parties Justice Voice Stability Effect Law Corruption
-------------+----------------------------------------------------------------------------------------------
Confidence in| 1.0000
Parliament | 78
|
Confidence | 0.7484* 1.0000
Civil service| 77 77
|
Confidence | 0.8701* 0.7207* 1.0000
Government | 46 45 46
|
Confidence | 0.8912* 0.7293* 0.8034* 1.0000
Parties | 46 45 46 46
|
Confidence | 0.6471* 0.6222* 0.4655 0.4895 1.0000
Justice sys. | 47 46 15 15 47
|
Voice/Account| 0.2335* 0.2040 0.4274* 0.3045* -0.3809* 1.0000
Index | 76 75 44 44 47 175
|
Political | -0.0187 0.1080 0.0978 -0.0110 -0.4689* 0.7012* 1.0000
Stability | 77 76 45 45 47 161 162
|
Government | -0.0637 -0.0080 0.1339 0.0439 -0.5699* 0.6964* 0.8249* 1.0000
Effectiveness| 77 76 45 45 47 173 162 174
|
Rule of law | 0.0011 0.0221 0.2144 0.1487 -0.5840* 0.7351* 0.8264* 0.9302* 1.0000
Index | 77 76 45 45 47 174 162 174 175
|
Control of | 0.0182 0.0585 0.2545 0.1827 -0.6166* 0.7124* 0.7937* 0.9214* 0.9314* 1.0000
Corruption | 77 76 45 45 47 173 162 174 174 174

Source: Inglehart (2000b), WorldBank (2004). * = significant at 95% level. Observations below correlations.

274
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