An agency cost channel from creditor rights reforms to leverage

The paper investigates the influence of creditor rights reforms on leverage. Based on a partial equilibrium agency cost model, we propose a novel channel running from the owner/manager’s private bankruptcy costs to leverage. Such costs mitigate the firms’ agency problem toward creditors, thereby increasing credit limits and leverage. The proposition is tested with data from India 2011–2020, a period that saw the strengthening of creditor rights. We find that the reform caused leverage to fall, which is indicative of a decrease in owner/manager’s bankruptcy costs. We also find evidence of a decline in credit limits as predicted by the proposed theory.