Law and Finance: Why Does Legal Origin Matter?

1. Law and Finance: Why Does Legal Origin Matter? Thorsten Beck, Asli Demirgüç-Kunt , and Ross Levine

2. 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)

3. 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?

4. 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 king’s 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.

5. 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

6. 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

7. 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!) Political vs. Adaptability

8. This paper’s 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.

9. 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)

10. 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 (Int’l 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

12. LO explains financial development (LLSV)

13. Does LO explain State power and Adaptability?

14. 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 = 1[Political Channel] + 2[Adaptability Channel] + X + u 1st Stage: Political Channel = 1[3 legal Origin Dummies] + 1X + v1 1st Stage: Adaptability Channel = 2[3 legal Origin Dummies] + 2X + v2

15. Does LO operate through State power, only?

16. Does LO operate through Adaptability, only?

17. Does LO operate through State power, Adaptability, or both?

18. 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

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