Law and Finance: Why Does Legal Origin Matter?

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Law and Finance Why Does Legal Origin Matter?

• Thorsten Beck, Asli Demirgüç-Kunt , and Ross
  Levine

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Legal origin matters ...

• Legal origin explains investor protection laws,
  property rights, and hence financial development
  (LLSV)
• Through these channels, legal origin helps
  account for
• corporate valuations, dividends, ownership
  concentration (LLSV Himmelberg, Hubbard, Love)
• capital allocation (Wurgler Beck/Levine,
  Claessens/Laeven, etc.)
• informational efficiency of stock prices (Morck,
  Yeung, Yu)
• financial fragility (Johnson, Boone, Breach,
  Friedman)
• Firm, industry, and country growth
  (Demirguc-Kunt/Maksimovic Rajan/Zingales
  Levine)

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But, why? Through what channels?

• Some skeptical of law and finance view
• North Stulz and Williamson (Culture/Religion)
• Berkowitz et al. (transplant process)
• Engerman/Sokoloff Acemoglu, Johnson, Robinson
  (offer alternative, though not mutually exclusive
  explanations)
• But, Beck, Demirguc-Kunt, and Levine while
  supporting AJR, still find that legal origin
  matters.
• But, why?
• Can we identify particular characteristics of the
  legal system?
• Can we identify establish a causal chain running
  from legal origin via legal system traits to
  finance?

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1. Political channel

• State power viv-a-vis individual investors (LLSV,
  1999)
• LO differ in terms of private property rights
  protection
• property rights protection is key for finance
• LO, private property rights, and powerful States
• Common law evolved to protect property rights
  (North/Weingast Mahoney)
• Courts limited kings power
• Civil law (19th century) was constructed to
  solidify State power.
• Justininan places emperor above law, breaking
  with Roman tradition
• French Revolution tried to eliminate
  jurisprudence, judicial discretion
• Place the State above the courts relegate judges
  to minor, bureaucratic role
• Like Napoleon, Bismarck unified and strengthened
  a nation through codification
• Civil law is a proxy for an intent to build
  institutions that further the power of the State,
  relative to the rights of individual investors
  (LLSV 1999) (but RZ)
• Powerful States tend to create policies that
  divert the flow savings toward favored ends,
  which is antithetical to competitive finance.

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2. Adaptability channel

• Premises
• legal systems differ in their abilities to adapt
  to changing financial conditions
• legal systems that embrace jurisprudence and do
  not rely excessively on changes in statutory law
  will tend to evolve more efficiently to changing
  conditions than legal systems that reject
  jurisprudence or require strict adherence to
  statutes.
• Common Law
• An influential, though not unanimous, literature
  holds that the common law tends to evolve
  efficiently (Posner)
• The life of the law has not been logic it has
  been experience.
• Justinian
• tried to eliminate jurisprudence, without success

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2. Adaptability Channel (continued)

• France
• In pre-Revolutionary France judge-made law was an
  important source of law
• In theory, Napoleonic doctrine made the law
  judge-free
• In practice, France has overcome many of the
  static characteristics of the Napoleonic doctrine
  over the last 2-centuries (though some claim it
  is still less efficiently flexible)
• Napoleonic doctrine crippled the judicial
  systems in many colonies (Merryman)
• Unlike UK, French rigidly imposed the Doctrine
• When the French exported their system they did
  not include the information that it really does
  not work that way, and they failed to include a
  blueprint of how it actually works.
• Low prestige of judges difficult to develop
  efficiently flexible system
• Avoid open disputations on competing statures,
  ambiguous laws, and past decisions. The
  exportation of this legal culture hindered
  efficient legal system development.
• Germany was very different
• Explicitly rejected French deviation accepted
  need for jurisprudence and sought to
  create/maintain a responsive legal system
• Long history of open disputations about legal
  interpretations

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Political vs. Adaptability

• Political
• Focus on State power vs. judicial independence
• Focus on Common vs. Civil law

• Adaptability
• Focus on process of law-making efficient legal
  system flexibility
• Focus on French vs. others (albeit not
  necessarily France!)

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This papers purpose and motivation

• This paper provides evidence concerning the
  channels through which legal origin shapes
  financial development.
• Who cares?
• Further our understanding of the sources of
  international difference in corporate governance
  finance more generally
• Relevant for policy makers who seek to improve
  growth, stability, and capital allocation
• Hopefully contribute to our understanding of the
  development of enduring and crucial institutions.

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Qualifications

• Channels are parts of law and finance theory
• not mutually exclusive
• inextricable parts? Jurisprudence less likely in
  a legal system where the State controls the
  judiciary!
• Measures of political adaptability channels are
  imperfect
• Complements Pistor et al (2000,2002) Keinan
  (2000) Berkowitz et al. (2002)
• Builds on lots of research(!), most immediately
  on Djankov, LaPorta, Lopez-de-Silanes, and
  Shleifer (2003) La Porta, Lopez-de-Silanes,
  Pop-Eleches, and Shleifer (2002)

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Data

• Finance
• Private credit
• Stock market development
• Property rights
• Legal Origin British, French, German,
  Scandinavian (LLSV)
• Political Channel (LaPorta, Lopez-de-Silanes,
  Pop-Eleches, Shleifer)
• Tenure of Supreme Court Judges (0, 1, 2)
• Less than 6 years more than 6 but less than
  lifetime lifetime
• Supreme Courts Power (0, 1)
• One if lifetime tenure and power over
  administrative cases
• Adaptability Channel
• Case law (1, 0) if judicial decisions are a
  source of law (Intl Ency. of Comp law)
• Legal Justification (0, .33, .67, 1) (Djankov, La
  Porta, Lopez-de-Silanes, and Shleifer)
• Complaint must include reference to statutes or
  case law
• Judgment must expressly state legal justification
• Judgment must be on law only, not general
  equitably arguments
• Other Latitude, Religion, Independence

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LO explains financial development (LLSV)
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Does LO explain State power and Adaptability?
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Methodology

• Preliminary Step 1
• 2nd Stage Financial Development
  ?Political Channel ?X u
• 1st Stage Political Channel
  ?3 Legal Origin Dummies ?X v
• __________________________________________________
  ___
• Preliminary Step 2
• 2nd Stage Financial Development
  ?Adaptability Channel ?X u
• 1st Stage Adaptability Channel
  ?3 Legal Origin Dummies ?X v
• __________________________________________________
  ___
• Final Step
• 2nd Stage Financial Development ?1Political
  Channel ?2Adaptability Channel ?X u
• 1st Stage Political Channel ?13
  legal Origin Dummies ?1X v1
• 1st Stage Adaptability Channel ?23 legal
  Origin Dummies ?2X v2

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Does LO operate through State power, only?
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Does LO operate through Adaptability, only?
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Does LO operate through State power,
Adaptability, or both?
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Summary

• Adaptability channel
• LO explains adaptability
• Case law main distinction is French LO vs.
  others
• Legal Just main distinction is British LO vs.
  others
• Adaptability explains financial development when
  controlling for the political channel other Xs
• Political channel
• LO explains State power over judiciary
• The main distinction is British LO vs. others
• State power over judiciary does not explain
  financial development even when not controlling
  for adaptability

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Summary

• Stronger evidence for adaptability than political
  channel
• Legal origin does not explain financial
  development beyond legal origins ability to
  explain cross-country variability in legal system
  adaptability
• Policy implications benefits of efficient legal
  system adaptability