Importance of Judicial Efficiency in Capital Structure Decisions of Small Firms: Evidence from Pakistan

Empirical evidence to identify factors that are responsible for the sluggish development of bond and capital markets in Pakistan remains scanty. This paper is a step forward in this direction. Specifically, this paper draws on the recent developments in the area of law and finance to formulate several propositions on how judicial efficiency can have a differential impact on corporate capital structures of small and large firms. These propositions are tested using data of 370 firms listed at the Karachi Stock Exchange (KSE) and 27 districts high courts of Pakistan. The results indicate that leverage ratio decreases, when judicial efficiency decreases; however, this relationship is not statistically significant. This is due to the composition effect. Allowing judicial efficiency to interact with the included explanatory variables, the results show that worsening judicial efficiency increases leverage ratios of large firms and decreases leverage ratios of small firms, which is an indication of the fact that creditors shift credit away from small firms to large firms in the presence of inefficient judicial system. Results also indicate that the effect of inefficient courts is greater on leverage ratios of firms that have fewer tangible assets as percentage of total assets than on leverage ratios of firms that have more tangible assets. The results indicate that under inefficient judicial system creditors reduce their lending to small firms and firms with little collateral and redistribute the credit to large firms. This is why judicial inefficiency does not change volume of credit, but changes distribution of the credit. These results highlight the importance of judicial efficiency for small firms in the determination of their capital structures.