Banks and Firms: Evidence from a legal reform altering contract design

Banks are unique in designing loan contracts. Contract design determines liquidation and continuation decisions of firms. Smaller firms are often the weaker party when interacting with their banks. We study a legal reform that aims to improve small firms’ bargaining position by altering the contractual environment. The new law gives small firms the right to prepay loans against a contractually specified penalty and requires banks to offer firms’ best-suited loan type. Using this quasi-natural experiment, we show that, while the legal reform increases overall credit availability, banks dampen the effect of the act by tilting their credit supply to loans that are unaffected by the legal change, i.e., credit lines. Using bank-firm-credit-type data, we show that banks reduce the supply of term loans by 0.7% while credit lines increase by 4%. This effect is more pronounced for borrowers with longer relationships. Our results show that reforms generate unintended consequences since banks strategically try to undo part of the regulation.