Unless a client has an exceptional credit history, banks generally demand security before they grant a loan. Such collateral security reduces the risk of banks' lending operations. In industrialized economies, like the U.S., the procedure for taking control of collateral in the event of default is quite standardized. However, in countries with weaker financial institutions, the enforcement of collateral, once a borrower has defaulted, is by no means guaranteed. Furthermore, if no centralized agency exists with which to register an asset that has been pledged as collateral, it is difficult to prevent an asset being used as collateral with more than one bank. Therefore, weak financial institutions cause uncertainty for banks and increase lending risk. This relationship suggests a connection between the willingness of banks to grant credit and the institutional environment in which they operate.

Haselmann, Pistor and Vig (2006) analyze this relationship by examining the loan supply of banks in twelve eastern European transition economies. These economies represent an ideal laboratory for examining this relationship since, for each economy, the institutional systems were generally weak before the onset of the transition period (the 1990's) and reforms of the collateral and bankruptcy regimes were undertaken during the transition period. Thus, the authors can examine differences in loan supply, not only between economies, but also before and after legal reforms. The authors find that banks clearly react to changes in the institutional environment by expanding their loan supply. Further analysis reveals that a change in collateral law is a more important influencing factor on bank lending than a change in bankruptcy law. The authors argue that this does not mean bankruptcy legislation is unimportant to banks; rather, effective collateral law is a precondition for effective bankruptcy law.

Furthermore, a change in legislation does not affect all banks in the same way. Banks that are new entrants to the market - for example, foreign banks - respond more strongly to legal changes than incumbent banks, domestic banks. The authors explain this finding by arguing that collateral is especially useful to those banks with limited information about the creditworthiness of clients. In general, foreign banks find it harder to gather information about the creditworthiness of clients than domestic banks. Therefore, improvements in legislation that promote the usage of collateral are especially beneficial for foreign banks. The work by Haselmann, Pistor and Vig (2006) provides a useful example to illustrate how institutional changes transmit to the economy.