The Economics of Legal Uncertainty

Abstract:

In this paper, we examine how legal uncertainty affects economic activity. We develop a model that distinguishes between three types of legal uncertainty, classifying them as either idiosyncratic or systematic. We test the model’s predictions using micro-level data on bankruptcy judges and corporate loans in Korea. To compute time-varying court-level measures of legal uncertainty, we exploit random case assignment to judges and exogenous judge rotations in the judicial system. Our results show that firms are more likely to file for restructuring in courts with lower levels of legal uncertainty. We also find that higher levels of legal uncertainty result in smaller credit markets, primarily for high-risk firms. Our analysis further indicates that credit supply is less responsive to idiosyncratic legal uncertainty than credit demand since banks can diversify idiosyncratic legal uncertainty across borrowers.