1. 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)

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

3. 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

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

5. 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

6. 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

7. 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) June 2004: STJ (2º class) upholds the TJRS decision –Decision applied only to the case at hand, but could signal a direction for subsequent rulings

8. 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”

9. 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”

10. 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”

11. The 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

12. Indeed...

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

14. 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

15. 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

16. Empirical Strategy: the Control Group Similarities S1: Personal Loans, consumer finance S2: Not revolving S3: No other formal collateral Differences D1: Wage Collateral D2: Mostly through Union/Employer intermediation D3: Demographics: more state employees, retirees (later periods)

17. Empirical Strategy: the Control Group Identifying assumption: –No re-shifting between two products in response to ruling Conceivable movement: worse payroll borrowers to standard loans –It would be true if two products are segmented Mostly due to D2 Bias would be against

18. Empirical Strategy: the Control Group

19. As expected: –Payroll loans are less risky –Payroll loans show a more pronounced increase Higher volume on average is a particular feature of the sub- sample 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

20. 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: more pronounced increase for payroll loans –If anything, this should make it more difficult to document an effect on quantities

21. 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 –Volume of loans

22. Empirical Strategy: the Model

23. 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 –Negative when y is quantity Amount of loans decreases in payroll loans relative to standard loans after the court decision

24. Dependent Variable: dummy for average risk above median Sub-Sample: month > Feb/04 and < Dec/04 Sub-Sample: month > Feb/04 Sub-Sample: month > Sep/03 and month < July/04 Sub-Sample: month > July/04‡ (1)(2)(3)(4) Payroll Loan- 0.184-0.220*-0.386**0.153 (0.137)(0.120)(0.176)(0.116) Judicial Decision-0.391**-0.590***-- (0.172)(0.154)-- Payroll LoanxJudicial Decision0.357***0.166-- (0.078)(0.128)-- Log(Number of Operations)-0.154**-0.017-0.309*0.068 (0.071)(0.050)(0.181)(0.060) Log(Average Size Operation)0.071-0.056**0.102-0.020 (0.061)(0.026)(0.157)(0.026) Dummy Robust---0.607***-0.296* --(0.175)-0.184 Payroll LoanxDummy Robust---0.455***-0.563*** --(0.122)(0.181) Number of Observations 543993626667

25. FGLS IV 1.41 percent increase

26. 3.77 percent decrease

27. 5.34 percent increase

29. Conclusions 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

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