Working Paper: CEPR ID: DP6307
Authors: Viral V. Acharya; Krishnamurthy Subramanian
Abstract: Do legal institutions governing financial contracts affect the nature of real investments in the economy? We develop a simple model and provide evidence that the answer to this question is yes. We consider a levered firm's choice of investment between innovative and conservative technologies, on the one hand, and of financing between debt and equity, on the other. Bankruptcy code plays a central role in these choices by determining whether the firm is continued or liquidated in case of financial distress. When the code is creditor-friendly, excessive liquidations cause the firm to shy away from innovation. In contrast, by promoting continuation upon failure, a debtor-friendly code induces greater innovation. This effect remains robust when the firm attempts to sustain innovation by reducing its debt under creditor-friendly codes.Employing patents as a proxy for innovation, we find support for the real as well as the financial implications of the model: (1) In countries with weaker creditor rights, technologically innovative industries create disproportionately more patents and generate disproportionately more citations to these patents relative to other industries; (2) This difference of difference result is further confirmed by within-country analysis that exploits time-series changes in creditor rights, suggesting a causal effect of bankruptcy codes on innovation; (3) When creditor rights are stronger, innovative industries employ relatively less leverage compared to other industries; and (4) In countries with weaker creditor rights, technologically innovative industries grow disproportionately faster compared to other industries. Finally, while overall financial development fosters innovation, stronger creditor rights weaken this effect, especially for highly innovative industries.
Keywords: Creditor rights; Entrepreneurship; Financial development; Growth; Law and finance; R&D; Technological change
JEL Codes: G3; K2; O3; O4; O5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Creditor-friendly bankruptcy codes (G33) | Less innovation (O39) |
| Creditor-friendly bankruptcy codes (G33) | Increased likelihood of liquidation (G33) |
| Increased likelihood of liquidation (G33) | Discourages risk-taking (D81) |
| Debtor-friendly bankruptcy codes (K35) | Promote innovation (O35) |
| Debtor-friendly bankruptcy codes (K35) | Allow firms to continue operations in financial distress (G33) |
| Allow firms to continue operations in financial distress (G33) | Incentives for investment in innovative technologies (O31) |
| Stronger creditor rights (G33) | Lower leverage for innovative industries (O39) |
| Stronger creditor rights (G33) | Adversely affect growth rates of innovative industries (O25) |
| Stronger creditor rights (G33) | Negative correlation with innovation intensity (O39) |
| Creditor rights (G33) | Influence financing decisions of firms (G32) |
| Effect of creditor rights on innovation is magnified in high propensity industries (O31) | Exacerbate disparity in innovation rates (O39) |