Impact of Legislation on Credit Risk. How different are the UK and Germany?

The analysis of credit risk and its impacting factors are important topics for the European Investment Fund (EIF, the Fund) as the Fund provides guarantees to financial institutions for portfolios of loans and leases to micro- and small and medium sized-enterprises (SMEs). In this context, the study also contributes to the current debate on the ongoing reform of legislation in Europe as part of the Lisbon strategy. This study investigates the link between legislation and credit risk of corporate bank debt based on a cross-country study for the United Kingdom (U.K.) and Germany.1 To this end, implied credit risk parameters (Probabilities of Default (PDs) and Loss Given Default (LGD)) reflecting the expected differences resulting from variations in legal systems are determined. These parameters are compared with empirical evidence to calculate the "net" impact of legislation, extending existing studies which found that there is an impact. We find that differences in legislation do not result in material differences in default rates, while U.K. banks would recover approximately 14 percentage points of the exposure more than German banks. The difference in LGDs resulting from legislation is mainly driven by shorter proceedings in the U.K., and, to a lesser degree, by a higher portion of out-of-court default events and slightly lower legal costs. However, German banks adjust their behaviour by demanding more credit risk mitigants than U.K. banks do and thereby finally recover only 4 percentage points less.