Rule of Law, Risk Sharing, and the Cost of Funds

Abstract

This paper shows that the quality of laws, by affecting the cost of investment for outside investors, has an effect on risk sharing and, through it, on the availability of external finance to firms. If, because of high investment costs, the provision of finance to projects is concentrated in few risk-averse individuals, the risk premium rises steeply with the amount of funds firms demand. As a consequence, in countries where the financial system does not favor risk sharing, the larger the demand for external funds of a firm, the costlier external finance becomes. Empirical evidence of this effect is also provided. The cost of debt is higher for firms demanding larger loans, even after controlling for leverage and other firm characteristics. Not surprisingly, the scale of the loans matters especially in countries where creditor rights are less protected.