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The Economics of Legal Uncertainty

  • Jiwon Lee Princeton University
  • David Schoenherr Princeton University
  • Jan Starmans Stockholm School of Economics.
In this paper, we examine the impact of legal uncertainty on economic activity. We develop a simple model that distinguishes between two types of legal uncertainty: idiosyncratic (diversifiable) and systematic (nondiversifiable), both of which can reduce economic activity. We test the model’s predictions using micro-level data on bankruptcy judges and corporate loans in Korea. Exploiting random assignment of cases to judges and exogenous judge rotations in the judicial system, we compute time-varying court-level measures of debtor-friendliness and legal uncertainty as perceived by debtors and creditors. Our results show that firms tend to file for restructuring in courts with high levels of debtor-friendliness and low levels of legal uncertainty. We also find that higher legal uncertainty decreases the size of credit markets, predominantly for high-risk firms. Our analysis further indicates that credit supply is less sensitive to idiosyncratic sources of legal uncertainty than credit demand, as banks can diversify idiosyncratic legal uncertainty, whereas firms cannot.

  • Jiwon Lee
  • David Schoenherr
  • Jan Starmans
In this paper, we examine the impact of legal uncertainty on economic activity. We develop a simple model that distinguishes between two types of legal uncertainty: idiosyncratic (diversifiable) and systematic (nondiversifiable), both of which can reduce economic activity. We test the model’s predictions using micro-level data on bankruptcy judges and corporate loans in Korea. Exploiting random assignment of cases to judges and exogenous judge rotations in the judicial system, we compute time-varying court-level measures of debtor-friendliness and legal uncertainty as perceived by debtors and creditors. Our results show that firms tend to file for restructuring in courts with high levels of debtor-friendliness and low levels of legal uncertainty. We also find that higher legal uncertainty decreases the size of credit markets, predominantly for high-risk firms. Our analysis further indicates that credit supply is less sensitive to idiosyncratic sources of legal uncertainty than credit demand, as banks can diversify idiosyncratic legal uncertainty, whereas firms cannot.
Bankruptcy,law and economics,legal uncertainty,uncertainty.