Do Court Delays Distort Capital Formation?

20 May 2020

Pantelis Koutroumpis and Farshad R. Ravasan
View Journal Article / Working Paper

Weak enforcement of financial contracts often distorts the incentive to invest and delays efforts to catch up with the technology frontier. We study how longer bankruptcy trials affect the cost, structure and allocation of corporate capital across different regions in Italy. We take advantage of an exogenous change in local court efficiency caused by the reorganization of judicial districts under the legislative reform of 2012. Using an instrumental variable strategy, we find that the change in length of bankruptcy proceedings had a strong impact on firm-level outcomes. Our estimates show that the interquantile reduction in the length of bankruptcy trials lowers the marginal cost of capital by 11.5% and increases the firm’s capital stock and capital intensity of production by 9.7% to 11.5%. Significantly, our results show that poor enforcement of financial contract lead firms to under-allocate capital in their intangible assets. Moreover the effects are stronger in sectors that depend
more on external finance and firms with high leverage.