The cost of enforcing contracts is a key determinant of market performance. We document this point with reference to the credit market in a model of opportunistic debtors and inefficient courts. According to the model, improvements in judicial efficiency should reduce credit rationing and increase lending, with an ambiguous effect on interest rates that depends on banking competition and on the type of judicial reform. These predictions are supported by panel data on Italian provinces and by cross-country evidence. In Italian provinces with longer trials or large backlogs of pending trials, credit is less widely available. International evidence also shows that the depth of mortgage markets is inversely related to the costs of mortgage foreclosure and other proxies for judicial inefficiency.

A borrower may default on a loan because he is unable (accidental default) or because, though potentially solvent, he is unwilling to repay (strategic default). Besides being intrinsically different, inability and unwillingness to repay depend on totally different factors. A borrower is unable to repay if his project fails, which may in turn depend on bad luck, incompetence, poor effort in managing the project, or a combination of all three factors. A solvent borrower may be unwilling to repay if the gain from defaulting is greater than the perceived cost of the presumed sanctions. The perceived cost of these sanctions does not depend only on the lender’s willingness to inflict them, but on the entire set of institutional arrangements governing the credit market. The law and its enforcement by the judiciary are central to these arrangements. Historically, countries have developed different legal systems, which feature varying degrees of protection of creditors’ rights. But even countries with similar legal rules may enforce them to a differing extent, depending on the efficiency and honesty of their judiciary. And even within the same country, the efficiency of courts can vary a great deal, depending on the allocation of resources and the geographical distribution of the “demand for contract enforcement.