NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Strongest Capital Markets are in Common Law Countries

"...the largest companies can get access to external finance no matter where they're based, while smaller companies' ability to raise money is much more dependent on a country's legal system."

Why do some countries have vastly bigger, more vibrant capital markets than others? In Legal Determinants of External Finance (NBER Working Paper No. 5879), Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny find strong links between capital market conditions in different countries and the legal traditions followed by those countries. The most developed capital markets are in countries where English-style common law holds sway (the United Kingdom and former colonies such as the United States, Australia, India, and Singapore), while the weakest capital markets are in countries with legal systems based on France's Napoleonic Code (France, Italy, Spain, and most of Latin America). In between are countries with laws based on the German model (Germany, Japan, and a handful of others) and the Scandinavian countries, which have their own legal tradition.

In an earlier study, Law and Finance (NBER Working Paper No. 5661), La Porta, Lopez-de-Silanes, Shleifer, and Vishny found that legal protections for shareholders and creditors were strongest in the English common law countries and weakest in the countries with French-style laws, with the German and Scandinavian systems in between. (The French, German, and Scandinavian traditions all are variations on Roman law, dominated by legislator-drawn legal codes; in English common law, legal precedents are set by judges deciding specific cases, and only later incorporated into legislation.) The new study links investor protections and legal traditions to the health of capital markets by measuring the ratio of stock market capitalization to gross domestic product; the ratio of debt-to-GDP; the number of publicly traded domestic corporations per million inhabitants; and the number of initial public offerings per million inhabitants. By all of these measures, the English common law countries as a whole vastly outscore their French law counterparts. The countries with German- and Scandinavian-style laws generally are in the middle, although by one scale -- the debt-to-GDP ratio -- the bank-dominated German-style countries lead the way. The authors also try another approach, measuring the ability of individual companies to get external financing, and find a much less pronounced difference between countries with different legal traditions. But the only companies for which they could obtain such data were large, well-established ones, leading them to conclude that the largest companies can get access to external finance no matter where they're based, while smaller companies' ability to raise money is much more dependent on a country's legal system.


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