Litigation or Foreclosure? The Effects of Judicial Efficiency on Lending Markets

Abstract

The efficiency of judicial enforcement significantly influences credit market outcomes. We examine a bilateral lending relationship with opportunistic borrowers and imperfectly efficient courts, where lenders face a choice between costly legal proceedings and non-judicial foreclosure to enforce debt contracts. We show that improvements in judicial efficiency reduce credit constraints and increase lending. However, lenders' ex-ante preferences for court actions versus collateral recovery depend on the trade-off between judicial efficiency and collateral recoverability. More efficient courts allow lenders to offer lower upfront interest rates while increasing their expected recovery on each loan. Collateral is particularly relevant as a mechanism for managing default risk in lower-quality investments and serves as an effective repayment incentive only when its value exceeds the outstanding debt.