sou · GOB311d5 · 2001-01-01 00:00:00 — Thus there is a chicken and egg problem with liquidity – people will not trade in a particular market unless they think the market is liquid, but the market will not be liquid unless they trade. This again implies that the birth of a market requires the rare event that serves to coordinate expectations. For example, the Government issued in large numbers to finance the war effort during the First World War. People who would otherwise not touch a financial security bought these bonds for patriotic reasons. Peach (1941) argues that it was the successful experience these investors had with the bonds that made them willing to invest in arms length securities issued by corporations, which then gave corporate securities markets liquidity, and led to the enormous expansion of these markets in the 1920s. generally, economic theory suggests that a market becomes liquid when, somewhat counter-intuitively, there are a large number of uninformed investors willing to grease the wheels of trade. This is because when a market consists only of informed, experienced traders, everyone is trying to second-guess the counterpartys information from the way they trade, and few trades take place. The reasoning is if you are willing to sell me this stock and I know you are smart, I keep wondering what it is you know that I do not, and am less willing to buy. The difficulty of providing uninformed investors the confidence to participate in the market when, by their very nature, they will not collect a great deal of information is one of the most important impediments to market liquidity. Investors obtain such confidence, not from a detailed scrutiny of the financial press but from word-of-mouth about salient events, and articles in the popular press. There is some evidence of this. Initial public offerings of stock that have higher first day returns in the attract more analyst following, perhaps because huge initial returns make these story stocks that are written about in the popular press attracting investor interest. These stocks also have higher trading volumes, a natural consequence of more uninformed interest.16 But there is a downside to attracting the uninformed. A broad-based unpleasant experience can equally easily drive them from the market and word of mouth about such a salient event will take a long time to die down. The bottom line is that liquidity is based on past experience, takes a long time to nurture, and could be somewhat fragile for new markets. Financial contracts also take time to perfect. There is a process of trial and error in which institutions initially, and eventually markets, 16 See and Servaes (1997). Volym D:70 Supplement 24 learn the nuances of a financial contract, how to price it, what covenants to build in, how to withstand legal scrutiny, and how to obtain effective enforcement.17 The institutions such as exchanges, audit agencies, custodial services, rating agencies, etc., that help the smooth enforcement of arms length contracts take time to set up, and more time to perfect their trade in local conditions. Financial intermediaries also take time to set up and become effective. As (1998) argues, institutions intermediate where financial contracts are incomplete, either because contingencies cannot be fully foreseen in the case of innovative transactions, or because the contingencies are too complex to describe up front. The institution uses its reputation to bond itself, and its bargaining power to achieve negotiated outcomes that are superior to those that can be obtained through direct transacting in the market place. A good reputation is crucial for an intermediary because this is what convinces to trust it when contracts do not fully protect them, but reputations take time to build, see Kreps and (1982) and (1989), for example.18 An institution may also be able to bond itself by putting its monetary capital or future rents at stake, but we have already argued that monetary capital may not be available in concentrated form in economies with primitive financial sectors. Moreover, even if available, monetary capital alone may not be particularly effective in providing to , see Boot, , and Thakor (1993). Finally, financial intermediaries take time to build for the same reasons that large industrial firms take time to build, see and Zingales (1999). It takes time for employees to learn to work with each 17See (1998). 18In every financial innovation, there are outcomes that are not anticipated up front, and have to be worked out amicably between intermediary and client. This is where the intermediary's reputation plays a part. Some intermediaries develop reputations for being un-cooperative, which hurts their business. An incident reported by Euromoney (, p. 35) is suggestive. In 1987, sought bankruptcy protection after being ordered to pay $ 10.5 billion in damages to Pennzoil. Even though was far from insolvent, the filing put it in technical default on a swap contract with . The details of the swap contract allowed either party to walk away even if they owed money when one party defaulted (this limited-two-way-payment is deservedly obsolete). owed $ 10 million on the swap. The expectation was that it would waive the default given that it was merely technical. Euromoney reports that top management looked at the situation, weighed the banks relationship with – not itself known for showing much mercy to its bankers – and took the windfall gain. has refused to deal with ever since. Politics, and Financial Development Volym D:71 other, to build relationships with , and to build routines that ensure the smooth functioning of the organization. Moreover, all this learning cannot take place instantaneously, it has to be sequenced, else it could risk overwhelming the command and control capabilities of the organization. While these factors are clearly important in explaining what triggered the birth and early steps of a financial market, it is a satisfactory explanation for todays differences in financial development across countries that we reviewed in the previous section. It is hard to argue that the French financial system today is underdeveloped relative to the English one because the amount of funds that need to be intermediated in the French economy is not sufficient to pay for the initial set-up costs. And while liquidity reasons can explain the enduring prominence of , they can explain why some late-movers progressed so rapidly and others did not. For example, in the equity market capitalization is of GDP and of the funds invested (Gross Capital Formation) are raised through equity issues. By contrast, in (a country with a per capita income almost six times as big), the equity market capitalization is equal to of GDP and only of the funds invested (Gross Capital Formation) are raised through equity issues. Volym D:72 Supplement 24 3 The Nature of the The third potential explanation for why the demand for financing does not automatically generate its own supply is the need for an enabling infrastructure. Since contracts lie at the heart of almost any financial arrangement, there is a growing consensus amongst economists that the law – which dictates permissible contracts, their interpretation, and the ease with which they can be enforced – must matter for financial development. Clearly, specific laws make a difference to financial systems. For example, the great variety of financial institutions in the – ranging from traditional commercial banks to modern venture capitalists or boutiques specializing in trading derivative securities – is probably an outcome of the Glass Steagall Act of 1933, and other legislation introduced during the Great Depression. These laws, reflecting the age- old suspicion among the people of the Western frontier states of the of bankers, effectively curtailed the power of large financial institutions and prevented them from dominating any part of the financial sector.19 The different legal protection granted to minority shareholders has been shown to affect the value of corporate of control.20 Similarly, a study of G-7 countries found that perhaps the best determinant of the amount large firms borrowed was the degree to which bankruptcy laws favored creditors. Countries like the and that had relatively severe bankruptcy laws favoring creditors were where large firms borrowed the least.21 While these early studies suggest that laws can affect finance, they leave unanswered broader questions such as why financial markets seem to have so much easier a time emerging in some countries but not in others. Perhaps a better starting point is not specific laws but the legal system – the way laws are formed and then enforced. Let us first describe how legal systems broadly differ across countries. 19See (1994). 20Zingales (1995). 21See and Zingales (1995). Politics, and Financial Development Volym D:73 3.1Legal Systems: Common and Civil Most modern legal systems in market economies can be classified as either belonging to the Common law tradition or the Civil law tradition. The main difference between the two systems lies in who makes the law. In the Common law system, past judgements by higher courts have enormous weight. Statutes passed by legislators are, therefore, considerably refined, and even modified, by precedent set in cases by judges. By contrast, in the Civil law tradition, law is really made by legal theorists with the aim of achieving (at least theoretically) the end of . The proposed statutes are enacted by legislators, and become . Judicial decisions do not create law, because that task, in the Civil law system, belongs solely to the legislative body. The judge tries to interpret logically the intent of the legislator in arriving at a just solution. But in practice, the courts are not completely at ease unless they can invoke one or more texts of enacted law to justify or support their judgement.22 While this is the main difference, there are related systematic differences in the two systems. Common evolved in , and was never based on a code of laws even though the Romans had ruled , and Roman law is the source code of most Civil codes. time, judges obtained enormous power because of their knowledge of precedent, and their ability to make law, and they resisted codification, which would force them to cede power to legislators and theorists. Of course, it also helped in that while the Common law system was evolving, there were countervailing powers to the King such as rich nobles, who supported a judicial system that was not under the kings thumb. As a result, the judicial system became a bulwark against the arbitrariness of the king. This is reflected in the kinds of cases that were initially tried under the common law system – matters relating to royal finances, ownership and possession of land, and serious criminal matters affecting the peace of the kingdom.23 The emphasis in the Common law system is in following due process. emerges from following the formalistic principles laid down such as the selection of the correct form of action or writ by which the court can be seized, convincing the court it has jurisdiction, and following the adversarial process of argument before a jury. The English attitude is that if a fair procedure is followed, a just solution 22David and (1979, p. 23David and (1979, p. Volym D:74 Supplement 24 The emphasis on procedure is natural in a country where there was no prior body of law to refer to, and judges empirically created law.24 As a result, Common law is very open to any kind of question that can arise. Since it emphasizes method, answers to new questions can be found by starting with already enumerated rules and discovering the legal rule – perhaps a new one – which deserves to be applied in the specific case at hand. The facts of the case are very important, and if the judge arrives at a different decision from that suggested by precedent, it is because the facts are different.25 Thus Common law, according to legal theorists and , is an open system. By contrast, the Civil law system originates from the code of , laid down at a time when there was a need to obtain some uniformity in the system of across a very diverse empire. It is quite suited to a centralized system because any legislation modifying the law cannot be altered by judges, who instead have to find just solutions within the confines of the statutes laid down by legislators. While this makes the law more responsive to central command, it adapts much more slowly to local conditions, especially to the idiosyncrasies of the particular case. Unlike the judge under Common law who looks for factual exceptions so as to break from precedent, the judge under Civil law looks for statutes the judgement can conform to. As a result, the Civil law system is much more of a closed system. Within the broad Romano-Germanic Civil law tradition, we can distinguish three further subcategories. The German tradition is a more flexible than the French tradition because the German tradition allows judges to override specific legislation if it contravenes general principles of the law.26 The French tradition, however, frowns on this, perhaps because the past French experience with unruly parlements or courts of law in the 17th century convinced them that allowing judges to interpret articles would, in the end, subvert the legislative order created by the French Civil Code, largely enacted under in the early nineteenth century.27 In fact, the French may have been a more convinced than others that their code was the perfection of reason and the best way to reach was simply to follow the code.28 Finally, the Scandinavian countries have their own Civil code which is distinct from the German or French tradition. 24David and (1979, p. 25David and (1979, p. 26David and (1979, p. 27David and (1979, p. 28David and (1979, p. Politics, and Financial Development Volym D:75 In drawing out the salient features of each legal tradition, we may have caricatured them a bit. This is the price we pay for brevity. But the caricature seems to match well with differences in dominant philosophy – Common law corresponds to the empirical tradition of Locke and Hume while Civil law relates to the rationalist tradition of . Furthermore, abstraction from detail also has permitted economists to classify different countries in the world according to which tradition they most resemble. Countries adopt a particular legal system either because they developed it themselves, imitated the salient features of another countrys code, or because they were conquered or colonized, and the passed its system on. It is useful to see how differences in legal system affect financial development, and perhaps more important, analyze why they might have an influence. Volym D:76 Supplement 24 4Does the Really Matter for Financial Development? There are three direct channels through which a legal system can affect financial development. In what follows we will discuss the sources of these effects as well as discuss the evidence on their empirical relevance. A financial contract is more than a promise to repay some money in the future. The value of this promise depends crucially on the speed and efficiency with which courts provide remedies for breach. It is not only important whether a certain sum is repaid, it is also important when this sum is repaid and how reliable the expectation of repayment is. While efficient enforcement benefits all financial contracts, it benefits most arms length contracts, which lack alternative ways of enforcement. By contrast, contracts written in the context of repeated relationships do not rely solely on the courts, and can be enforced by the threat of interrupting the relationship. Thus, inefficient enforcement should especially jeopardize the development of financial markets vis-à-vis other financial institutions like banks.29 There is doubt that law enforcement is important for financial development. La Porta et al (1997) find that a countrys law and order tradition (as compiled by International Country Risk Guide) contributes to explaining the relative size of its financial markets. But this is far from being the whole story. , for instance, scores near the top in all the index of efficiency of the judicial system and contract enforcement. In spite of that (and of its high level of economic development), it has a fairly minuscule market. Smaller than the one of a country like , which scores near the bottom of the list in all these measures. importantly, contract enforcement is, by a large extent, a policy variable. Thus, an explanation of financial development based entirely on the efficiency of contract enforcement would beg the question of why some countries enforce the law better than others. An explanation in this 29 See and Zingales (1998) for a development of this argument. Politics, and Financial Development Volym D:77 sense can only be found moving to a political view of financial development, avenue that we will pursue in Section 4. The traditional legal approach to Corporate was positing that contract enforcement is all that is needed for financial development. Rational investors will write in financial contracts all the necessary to protect themselves. only role, then, would be to enforce these contracts in a prompt and just . When it comes to public markets, however, two problems emerge. First, dispersed buyers find it impossible to bargain on the specific legal details of a security. They are just left with the option to buy a financial instrument as is or not to buy it. In this situation, a set of prespecified rights granted by the law can reduce contracting costs. Second, dispersed investors find it costly to enforce their rights. By standardizing the rights, explicit laws may facilitate enforcement. Thus, it is possible that better laws designed to protect investors might financial development. The direction of causality, however, is not clear. advanced financial markets have more experience on what it is needed to protect investors. They are, thus, more likely to pass laws in this direction. To try to disentangle the direction of causality, La Porta et al. investigate whether the degree of investor protection differs as a function of the family of origin of a countrys legal system. Countries adopted a particular legal system centuries ago, mostly as a result of an invasion or colonization. If, more than a century later, the type of system adopted has an effect on the level of investor protection and financial development, then – the authors claim – there is a strong case that legal families, as expressed in the legal rules, actually affect outcomes. In a series of influential papers, La Porta et al. show that indeed Common countries protect investors better. This is true not only for equity investors, but also for creditors. They then go on to relate cross- country differences in financial development with the family of origin of a countrys legal system. In discussing Table 1, we have already pointed out that the U.K and its former colonies, which are Common countries, have a much larger ratio of the size of stock market to GDP. The evidence presented by La Porta et al. (1997) is much more detailed. Common law countries have many more listed firms per million people and more initial public offerings per million people. 30 La Porta, et al. (1998, p. Volym D:78 Supplement 24 has 8 listed firms per million people in 1994 while has only 5. By contrast, the has 36, the 30, and an astonishing 128. This diversity in listed firms is also reflected in initial public offerings (IPO) of stock. In 1995-96, common law countries average 2.2 initial public offerings per million people while countries belonging to the French civil law tradition averaged 0.2 of an IPO, to the German tradition, 0.12 of an IPO, and Scandinavian countries 2.1 IPOs. Specifically, during that year had 7 IPOs, 10, the 803, and 1114.31 These findings suggest that firms in common law countries tend to raise far more equity finance from public investors than do firms in civil law countries. They are especially striking because they hold across countries with dramatic differences in per capita GDP. For instance, has more IPOs per million of population than any country following the French or German civil law tradition. Moving to debt markets, countries from a German civil law tradition tend to have deeper debt markets than common law countries (on average, the private sector debt to GDP ratio is 0.97 in 1994). However, common law countries have larger debt markets (debt to GDP ratio of 0.68) than countries from a French (debt to GDP ratio of 0.45) or Scandinavian civil law tradition (debt to GDP ratio of 0.57).32 Some of the differences in debt ratios may be because what is regarded as debt differs across countries. For example, unlike in the , fully funded pension liabilities show up as debt in German balance sheets which gives the impression that German companies are highly indebted when, in reality, they are not. Moreover, more of the debt is borrowed from financial intermediaries in compared to the where public corporate debt markets are quite large. Therefore, it may well be that countries from a common law tradition typically have both deeper public equity and debt markets. A final piece of evidence; accounting standards have been used in other studies as a good proxy for financial development.33 Unlike measures of financial development based on market size, this measure of financial development is useful because it is not mechanically correlated with the amount of finance raised – which may be a function of the kinds of industries present in a country. Common countries again seem to be more financially developed than all but the Scandinavian countries because their rating on accounting standards is uniformly higher (on 31La Porta, et al. (1997, p.1137). 32La Porta, et al. (1997, p. 33See and Zingales (1998). Politics, and Financial Development Volym D:79 average, 70) than French origin (average 51) and German origin (average 63) civil law countries. In summary, these authors find separately that Common countries protect investors better and financial markets are better developed in these countries. The natural conclusion is that these are cause and effect. But the theme of their work, and Finance hints at a broader idea, that it is the legal system more than any other difference between the countries that leads to the differences in financial development. 4.3Measurement Ahead of Theory Even before looking at some new evidence, there are theoretical reasons to be cautious about drawing any conclusions, natural as they may seem. One has to make strong assumptions even to go from one finding to the other. For instance, while it may seem self-evident that more investor protection would lead to deeper capital markets in – Lukoil trades at a fraction of the multiple of reserves that Western oil firms trade at because investors fear expropriation – it is by no means true that this principle extends to more developed economies. In fact, in earlier work we show that borrowing by large corporations is the least in the two G-7 countries, and the U.K., which have the strongest creditor rights.34 The reason may simply be that stronger creditor protection leads to inflexibility and potentially higher bankruptcy costs. This could lead to lower effort and investment incentives for managers. Therefore, the objective of a sophisticated legal system is not necessarily that of extending maximal and unconditional protection to all investors, but to ensure that various stakeholders' cash flow and control rights in the firm vary in such a contingent way as to maximize total output. This suggests a more nuanced line of causality from protection to financial development than that investigated by La Porta et al.