The Economics of Legal Uncertainty

We examine how legal uncertainty affects economic activity. We develop a model that distinguishes three types of legal uncertainty, classified as idiosyncratic or systematic, and test its predictions using micro-level data on bankruptcy judges and corporate loans in Korea. Exploiting random case assignment and exogenous judge rotations, we construct time-varying court-level uncertainty measures. We find that higher legal uncertainty results in smaller credit markets, primarily for high-risk firms. Moreover, credit supply is less responsive to idiosyncratic legal uncertainty than credit demand because banks can diversify risk across borrowers. Thus, both the level and nature of legal uncertainty shape credit markets.