Judicial Risk and Creditor Expropriation: Micro Evidence from Brazilian Payroll Loans Ana Carla A Costa (Banco Central do Brasil) João M P de Mello (PUC-Rio)

General Research Question Is there micro evidence of agents responding to changing institutional setting?

Motivation The literature –Large consensus on “sound” institutions good for economic performance North –Empirical evidence on the institutions-economic performance nexus on the aggregate level La Porta et. al. [1997]: creditor protection and size equity/debt markets Acemoglu et. al. [2001]: institutions on economic growth King and Levine [1993], Levine and Zervos [1998]: financial deepening on growth

Motivation Although strong, evidence not completely convincing: –Aggregate level data: Tests only of the broad level implication –Several alternative rationalizing theories –Micro-level necessary condition not tested Endogeneity Omitted determining factors

Contribution Our paper: micro-evidence, a fortunate combination: –Court ruling regarding legality of Payroll Loans Judicial Risk, Changing Institutional Setting –Data on the relevant supply decision-making unit: banks

Payroll Loans Consumer loans with automatic interest and amortization deduction from the borrowers wage –It makes a collateral out of future income –Future income is valuable as collateral if not too volatile It exists since the beginning of 1990s: –1990s Public servants Private sector workers through association with employers or workers’ union –2003 law regulating to private sector retirees Lenders have to be franchised by the Social Security Agency

The Chronology 2001: public servant (city of Porto Alegre) sue SUDAMERIS –Contesting legality of payroll deduction Regional court (Tribunal de Justiça do Rio Grande do Sul, TJRS) rules for the plaintiff SUDAMERIS appeals to the second highest federal court (Superior Tribunal de Justiça, STJ) –Similar to na American Federal Circuit Court June 2004: STJ upholds the TJRS decision –SUDAMERIS again appeals the decision

Relevant for Market Players? Johan Ribeiro: Legal Department FEBRABAN (Valor Econômico, 07/02/2004) –“Undoubtedly there will be repercussion in terms of higher interest rates” since “…[one] of the elements that sustain the low interest rates is low risk on these loans. If the legality of these contracts is contested, the risk increases”

Relevant for Market Players? Luís Marinho (then head of CUT) reported receiving phone calls from bankers saying (Universo On Line, 07/04/2004) –“… banks would hit the break on loans, at least temporarily, until the have a better understanding of the extension of the STJ decision”

Relevant for Market Players? On the other hand, Gabriel Jorge Ferreira (former FEBRABAN head) (Universo On Line, 07/04/2004): –“…[the program] is still intact, and I do not believe there will be an upward pressure in interest rates”

The Identification Hypothesis STJ ruling increased the perceived probability of that the future income collateral becomes useless Actual change in lender behavior not obvious –Decision was not final –Opportunistic borrower behavior may not be 1 st order –Increase in competition outweigh the negative impact

Indeed...

Still... There are interesting contrafactual questions: –Is there evidence that the evolution would have been more pronounced? –Or in better terms (interest rates)?

Empirical Strategy Compare the evolution of consumers loans with payroll deduction with a similar product: –Control group: payroll loans without payroll deduction (call standard loans) –Treatment group: payroll loans with payroll deduction

Empirical Strategy: the Control Group The Control Group –Very similar product, except for the payroll deduction Personal credit for consumption finance No other collateral –Little chance that different demand movements could produce the results

Empirical Strategy: the Control Group Identifying assumption: –No re-shifting between two products in response to ruling –It would be true if two products are segmented

Empirical Strategy: the Control Group

As expected –Payroll loans are less risky, cheaper and have a higher volume on average –Payroll loans show a more pronounced For payroll loans, sub-period before ruling –Interest rates slightly above average –Risk slightly above average For standard loans, sub-period before ruling –Interest rates slightly below average –Risk slightly above average

Empirical Strategy: the Control Group Important for a good control group: –Groups could be in very different parts of a cycle (although controlled for period effects) Quantity: much more pronounced increase for payroll loans –If anything, this should make it more difficult to document an effect on quantities

Empirical Strategy: the Model Difference-in-Difference model. An observation is a product i by a bank b at a month t y is: –Average interest rates –Average risk rating –Total amount of loans

Empirical Strategy: the Model

The hypothesis tested. If the decision had an impact, the coefficient β 3 should be: –Positive when y is interest rates and risk assesment Interest rates (risk rating) increased in payroll loans relative to standard loans after the court decision –Positive when y is quantity Amount of loans decreased in payroll loans relative to standard loans after the court decision

Conclusion It appears the STJ ruling had an adverse impact on the market performance of payroll loans. This suggests that: –Expansion could have been more pronounced –At lower interest rates

Conclusion Direct test (micro evidence) that judicial risk of creditor expropriation is relevant Helps explain performance of the Brazilian credit market