Financial Law

Financial Law

1)Do you think law and legal institutions are to serve the needs of financial markets, or to govern how financial markets should operate?

A burgeoning literature finds that financial development exerts a first-order impact on long-run economic growth. Levine and Zervos (1998) show that banking and stock market development are good predictors of economic growth.1 At the microeconomic level, Demirguc-Kunt and Maksimovic (1998) and Rajan and Zingales (1998) find that financial institutions are crucial for firm and industrial expansion. While disagreements remain, the bulk of existing evidence points to a strong finance-growth nexus.

The finding that financial development influences economic growth raises critical questions, such as why do some countries have well-developed growth-enhancing financial systems, while others do not? Why have some countries developed the necessary investor protection laws and contract-enforcement mechanisms to support financial institutions and markets, while others have not?

The law and finance theory focuses on the role of legal institutions in explaining international differences in financial development (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1997, 1998, 2000a, henceforth LLSV). The first part of the law and finance theory holds that in countries where legal systems enforce private property rights, support private contractual arrangements, and protect the legal right of investors, savers are more willing to finance firms and financial markets flourish. In contrast, legal institutions that neither support private property rights nor facilitate private contracting inhibit corporate finance and stunt financial development.

The second part of the law and finance theory emphasizes that the different legal traditions that emerged in Europe over previous centuries and were spread internationally through conquest, colonization, and imitation help explain cross-country differences in investor protection, the contracting environment, and financial development today. More specifically, legal theories emphasize two inter-related mechanisms through which legal origin influences finance (Hayek, 1960). The “political” mechanism holds that (a) legal traditions differ in terms of the priority they attach to private property vis-à-vis the rights of the State and (b) the protection of private contracting rights forms the basis of financial development (LLSV, 1999). The “adaptability” mechanism stresses that (a) legal traditions differ in their formalism and ability to evolve with changing conditions and (b) legal traditions that adapt efficiently to minimize the gap between the contracting needs of the economy and the legal system's capabilities will more effectively foster financial development than more rigid systems (Merryman, 1985).

Countervailing theories and evidence challenge both parts of the law and finance theory. Many researchers accept that effective investor protection facilitates efficient corporate financing and growth-enhancing financial development, but reject the law and finance's view that legal origin is a central determinant of investor protection laws and financial development (Roe, 1994; Pagano and Volpin, 2001; Rajan and Zingales, 2003).

Alternatively, some studies do not critique the role of legal origin. Instead, although abundant evidence emphasizes the importance of investor protection laws, recent case-studies question whether changes in investor protection laws drove the evolution of corporate ownership and financial development in the United Kingdom and Italy (Franks, et al., 2003; Aganin and Volpin, ...