Re-examining the Relationship between Creditor Rights and Corporate Leverage through a Cultural Lens

Two opposing effects govern the impact of creditor rights strengthening reforms on corporate leverage. On the one hand, the income effect states that creditor rights strengthening leads to a higher supply of loans from lenders and higher debt capacity of the borrowers, which may increase corporate leverage. On the other hand, the substitution effect states that creditor rights strengthening leads to a higher threat of bankruptcy and thus may lead to lower credit demand and lower corporate leverage. Single country studies from different countries have documented contradicting results on the impact of creditor rights on firm leverage. In this multi-country study, we postulate that national culture determines risk-taking behavior of borrowers and lenders, which in turn determines whether the income effect or the substitution effect dominates in a given country. Thus we examine how culture moderates the impact of creditor rights strengthening reforms on firm leverage. We use DIDID in a generalized s on data of over 24000 firms in 23 years from 31 countries to test our hypothesis. We find that individualism, which is associated with high risk preference, has a positive moderating effect while power distance, which is associated with low risk preference, has a negative moderating effect on the impact of creditor rights strengthening reforms on corporate leverage. We see similar results for economy-wide aggregate bank credit in the sample countries. Further, we document that firms in individualistic and low power distance countries tend to issue less equity and hold fewer cash balances in response to strong creditor rights.