We investigate the effect of judicial efficiency on banks’ lending spreads for a large cross-section of countries. We measure bank interest rate spreads for 106 countries at the country level and for 32 countries at the level of individual banks. We find that judicial efficiency and inflation rates are the main drivers of interest rate spreads across countries. Our results suggest that improvements in judicial efficiency and judicial enforcement of debt contracts are critical to lowering the cost of financial intermediation for households and firms.

An efficient judiciary that enforces legal contracts is generally thought to enhance a country’s investment climate, lead to lower interest rates, and thereby improve the performance of a country’s economy. A transparent and efficient court system is likely to provide better protection of creditors’ rights and may improve the amount and speed of loan recovery. A larger amount of recovery and a shorter time to repossess collateral in the event of loan default allows banks to reduce lending rates and extend credit to previously rationed customers. While prior research has found a positive correlation between judicial efficiency and the supply of external finance – both across countries (see, for example, La Porta et al., 1997, Demirguc-Kunt and Maksimovic, 1998, and Galindo, 2001) and across states within countries (see, for example, Bianco, Jappelli, and Pagano, 2001, Castelar, Pineiro, and Cabral, 2001, and Cristini, Moya, and Powell, 2001) – there exists mixed evidence of the effect of judicial reform on the cost of finance.