Spare Tire? Stock Markets, Banking Crises, and Economic Recoveries

Do stock markets act as a “spare tire” during banking crises, providing an alternative corporate financing channel and mitigating the economic severity of banking crises? Using firm-level data in 36 countries from 1990 through 2011, we find that the adverse consequences of banking crises on firm profitability, employment, equity issuances, and investment efficiency are smaller in countries with stronger shareholder protection laws. These findings are not explained by the development of stock markets or financial institutions prior to the crises, the severity of the crisis, or overall economic, legal, and institutional development. The evidence is consistent with the view that stronger shareholder protection laws provide the legal infrastructure for stock markets to act as alternative sources of finance when banking systems go flat, easing the impact of the crisis on the economy.