The Financial Development of a Nation - Essay Example

?Legal s matter for financial development with further implications for economic growth Introduction A significant amount of literature suggests that that financial development has a long-term beneficial effect on the economic growth of a country (Huang, 2006, 2). Financial development of a nation is measured by taking into account certain factors like efficiency, size, access, depth, effectiveness, and security of the financial system, which comprises of institutions, markets, intermediates, resources and assets, and the various associated regulations. The greater the levels of financial development in the country, the wider are the provisions of financial services that allow risk diversifications, and this in turn boosts the economic growth curve of a nation. Joseph Schumpeter first proposed the link between economic growth and financial development in the early 20th century, where he claimed that the financial intermediaries advocated technological modifications by providing economic resources for the invention of new products (Schumpeter, 1912). Levine and Zervos (1998) in their papers show that development within the stock market and banking sectors of a nation are reasonably reliable indicators of the economic growth. For industrial expansions at the microeconomic level, Rajan and Zingales (1998) and Demirguc-Kunt and Maksimovic (1998) feel that financial institutions are an essential component. Despite contentions, a majority of the research papers suggest that there is indeed a strong connection between the financial development and economic growth. In this context, certain questions that arise may ask as why some countries show financial systems that complement growth, while others fail do so? Why are there laws for the protections of the investors and mechanisms for contract-enforcement in order to back the financial institutions and markets in some countries while none in others? In fact, the differences perceived in the levels of economic growth and financial developments across cross-country data have inspired economists to identify the factors that explain these differences. Financial development as defined by the World Economic Forum comprises of “factors, policies, and institutions that lead to effective financial intermediation and markets, as well as deep and broad access to capital and financial services” (The Financial Development Report 2010, 2010, 4). Here institutions chiefly refer to laws that control and monitor the financial sector, contractual enforcement and the quality of corporate governance. The word “institution” as defined by Douglas North (1991) states that these are man-devised constraints that shape a nation’s socio-economic and political interaction. These constraints maybe informal like social taboos, sanctions, trust, social traditions and customs, social capital, and social codes of conduct; or they may also be formal like legal system, constitutions, property rights, etc. Institutions have been devised in to create an order in the society, and decrease the chances of uncertainty in various transactions and exchanges. As per economic theories, a strong and stable institutional environment is essential for decreasing the transaction and information charges (Levine, 2004).There are also a significant number of research papers that establish the close relation between financial development and a country’s institutional characteristics, especially its legal framework (Arestis, Demetriades, and Luintel, 2001). Thus, from a study of papers one can conclude that legal institutions from an essential part of the financial development of a nation, since it works towards protecting the investor interests (Barth, J., Caprio, G., and Levine, R., 1999). The law and finance theory centres on the part played by the legal institutions in analysing global differences perceived in financial development (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2000). The law and finance theory suggests that in countries that have strong legal institutions and effective legal systems that promote ‘private contractual arrangements,’ enforce the rights of private properties, and give legal protection to rights of the investors, more depositors are willing to take the risk of financing firms, owing to which the markets thrive. On the other hand, in countries where the legal institutions are ineffective or weak, and do not support the rights of private properties or help in the process of private contracts, work towards impeding corporate finance system and ultimately stunt the process of financial development. The law and finance theory also states that the various legal traditions that evolved over centuries in Europe were spread worldwide, through the processes of colonial conquests, which to a certain extent assists in clarifying the cross-country variation perceived in cases of legal mechanisms pertaining to private contracting environment, investor protection, and financial development, in the modern context. Thus, we find that legal- financial theories put stress on two interconnected processes through which the legal origin affects the financial development (Hayek, 1960). The political processes view that legal traditions of a state vary according to the antecedence given to protection of private properties in comparison to the rights of a State, and protection of rights of private contractual agreements form the foundation for financial development (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1999). One important aspect is the “adaptability” factor that holds forth the view that legal traditions vary from one state to another according to their nature of formalism and their ability to evolve with time. it also conceptualizes that the legal traditions that modify effectively to lessen the gap between the capabilities of the existent legal system and the contracting requirements of the national economy, will be able to more stimulate a better financial development, than the legal systems that are rigid and do not evolve as per the changing times and norms (Merryman, 1985). There are also contending views that argue that financial growth though benefits from investor protection, yet they dismiss the view that legal origin is the primary determinant of laws pertaining to investor protection and financial development of a country (Pagano and Volpin, 2001; Rajan and Zingales, 2003). There are also arguments that tend to disagree on the nature of the legal system that would work best to advocate the appropriate evolution of the state legal system (Rubin, 1982). This article will examine the view the various contending legal financial theories and will examine various evidences to find out whether legal institutions matter for financial development with further implications for economic growth. Discussion Law, Enforcement, and Financial Development within the legal theories of financial development: Law and finance theory (first part): legal institutions are bodies or a system that monitor, control the social and trade relationships, and reduce the chances of risks or uncertainties. In recent years, starting with the pioneering research work of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998), the different legal systems and their influences on financial development of a country has undergone thorough investigations. The basic notions behind the law and finance theory are based on the firm belief that legal institutions affect the finance and the financial development of corporate firms (ibid). As La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000) in their papers opine that the law and finance theory has evolved from the theory of corporate finances during the last 50 years. Jensen and Meckling (1976) in their papers state that a country’s statutory laws and the degree to which the state courts administer the provided laws construct the contract types used for addressing agency problems. Modigliani and Miller (1958) in their papers have observed that equity and debt are legal claims on any organisation’s cash flow. Hart in 1995 observed that the recent research scholars, in the field of finance, largely focus on the control rights of the owners on their financial securities, and the effect of different laws on the nature of corporate control. Thus from this viewpoint, one may observe finance as a series of contracts. In that case, rights of the securities holders and the financial operational systems are determined by the nature of a state’s contract, the company, and laws that guarantee securities and the effective administration. Within organisations, firm managers and the leading shareholders are often in a bearing where they can appropriate the minority shareholders and creditors rightful dues. It is in such situations that the state’s legal institutions play all important role in identifying the degree and nature of the embezzlement. Instances of appropriation may vary from transfer pricing, thievery, hiring of own family members, asset stripping, and other forms of ‘perks’ that aim at benefitting the leading shareholders and managers, at the expense of the creditors and the minority shareholders (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2000). The law and finance theory also observes that the perceived cross-country differences arise from certain factors: the priority given by a state’s legal systems on protecting private property rights, contract, securities laws, organisation, and bankruptcy factors, and (iii) if a state’s law enforcement is appropriate and effective, it works towards alleviating the levels of embezzlements, and hence the boosts the confidences of the depositors, and stimulates them to purchase securities and take active part in the financial markets. Within the broad spectrum of the influence of the legal institutions on the nature of functioning of the corporate finances and the financial development, there are various contending notions. Some scholars are of the view that the legal systems should work towards only supporting the private contractual arrangements, while other feel the legal system should have specific laws as regards the shareholder and creditor rights. Ronald Coase (1960) in his papers opines that the legal system should be allowed to administer only the private contracts. Effective legal institutions make way for the experienced participants within a financial market to create a large number of elaborate private contracts to mitigate the complicated agency problems (Easterbrook and Fischel, 1991). In such cases, however the courts must administer the private contract agreement in a neutral manner; while it must also possess the competency and also the willingness to decipher intricacies that are seen in contracts, while also verifying the technically complex clauses that initiate categorical actions (Glaeser, Johnson, and Shleifer, 2001, 853). Since the administration of complicated private contracts is exceeding difficult, it is far advantageous for the state to develop bankruptcy, company, and securities laws that in turn would create a framework for coordinating financial transactions and safeguarding the creditors and the minority shareholders. Here, it must be noted that regularising the whole system may increase its efficient functioning by decreasing the transactions costs; however, the encumbrance of a too stringent and rigid framework may abbreviate informal and interpersonal dealings and hinder in the process of efficient contracting. in this approach whether one assuming the viewpoint of Coase on courts administering only the intricate private contracts, or an approach that extends the protection of private contracts to the bankruptcy, company, and securities laws, the law and finance theory establishes that the fact that the level of protection accorded to private investors is an important determinant of financial development. Law and finance theory (second part): The law and finance theory as conceptualised by La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) in its second part stresses that a state’s legal tradition also frames its approach to private contract agreements, property rights, protection of the investor, and ultimately the country’s financial development. The legal processes of many countries worldwide originate from the English or French laws. This owes to the widespread colonialism followed by these two countries during the seventeenth, eighteenth, and nineteenth centuries. The legal systems based on the England laws are delineated as belonging to the category of the common law tradition; while those originating from the French laws are distinguished as belonging to the category of the tradition of civil or Roman laws. The two aforementioned forms of legal systems function in two different ways. The French form of the civil law is dependent on the written notes and records, legal codes and professional judges; while the English common law depends on a wide spectrum of legal principles, judges, and strong oral arguments (Glaeser and Shleifer, 2002, 3). The civil law tradition is categorised into the French, Scandinavian, and German systems. As already mentioned, the common and civil legal heritage have spread across the globe through the processes of imperialism, colonial conquests, straightforward borrowing, and duplication. Between the two legal traditions, the French form of the civil law is the older in age and tradition, weaves greater influence and is the most widely distributed tradition around the world (La Porta, Lopez-de-Silanes, Shleifer, and Vishny , 1998). According to the law and finance theory of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998), the level of variation noticed within the legal protections accorded to the creditors and investors; and the effectiveness of the enforced laws help in analysing why there are differences in the financial development amongst the various countries. As regards these differences, the authors opine that: creditors and shareholders are acceded protection in most of the countries that follow the English common law; while in the countries that follow the in French civil law, the creditors and the shareholders are acquiesced very little (minimal) protection least; some countries like Germany and the Scandinavian countries have a slightly different civil law come somewhere in the between as regards the level of the accorded protection the law enforcement can be ranked as the of the highest quality in German and Scandinavian civil law countries, followed by the countries that follow the English common law; while the countries that follow the French civil law show the poor law enforcement results (ibid). A large number research papers suggest that legal systems affect the financial development of a state through two main channels, the political processes, and the adaptability factor. The political processes that form the inert aspect in the realms of law and finance, emphasizes on the fact that legal traditions vary on the basis of level of priority attached with the notions of the private property rights, which in turn forms the foundation for financial development, versus the state rights. as for example if we take a look at the French form of the civil law tradition we will find that it gives greater priority to the state power. The civil law was primarily framed to remove the increasing corruption levels amongst the judges and the courts. In order to establish and fortify the general level of trust of the judiciary, the legislature framed the laws with clear and precise wordings. This was done with the aim to remove the necessity for translation of the laws by the judges. With this type of codification, the legal system has developed systematic traditions that focus of protecting the power of the state, rather than delivering the rights of the investors. Thus, it is very clear that under the French civil laws the judges function in a bureaucratic order while elevating the power of the state (Mahoney, 2001; Meryyman, 1985; Beck, Asli Demirg? and Levine, 2003). A look at the English common law on the other hand will show us that it evolved to guarantee protection to private property rights against the tyrannical crown. The English common law primarily developed in this manner owing to the fact that in England during the Middle –Ages, the landed aristocrats, and wealthy merchants wanted the legal system to operate in manner that would accord strong protections for their individual properties and contract agreement rights and restraint the monarchic powers to intervene in market matters. The crown tried to advocate its feudal authority by trading monopolies in order to acquire revenues (Mahoney, 2001). The British Parliament, which comprised of mainly of the wealthy merchants and landowners along with the judges of the courts, supported the property owners against Monarchy (Beck and Levine, 2003). Thus, it is clear that the English legal tradition places greater priority on the protection of individual rights than on the state powers. thus, from the view of an investor, that the English common law is better than the French civil law, owing to the differing assumptions on the rights and roles of the individual, and the state (Hayek, 1960). In general, Hayek was of the opinion that the English common law meant with less restrictions by the state on a country’s economy, and other liberties (Mahoney, 2001). In their papers La Porta, Lopez-de-Silanes, Pop-Eleches, and Shleifer, (2003) found that in the countries that followed the French civil law the State is will not be likely to permit tenure for the judges, disallow the legal jurisdiction over cases pertaining to the matters of government activities, or even allow a judicial review of the authority of the existent laws. La Porta, Lopez-de-Silanes, Shleifer, and Vishny, (1999) in their papers observe that in a civil legal heritage, the institutions are built primarily with the intentions to elevate and establish the State power, in any cases where the government is involved (231–2). Here it is easy to derive that a powerful State with a supporting civil law will look towards diverting the stream of social resources toward a more favourable (for the state) ends, which is directly in contradiction to the effective function of a highly competitive market scenario. Additionally a state that is powerful will find it extremely difficult to commit with credibility of its non-interference in the country’s financial markets, which in turn work towards hampering the overall financial development and economic growth. Thus, the law and finance theory claims that the countries following the Civil law system will tend to have feeble property rights protection and will show low degrees of financial development. On the other hand, we find that the English Common law has always sided with the rights of the private property owners against the power of the State. Instead of just existing as a State tool, the Common law acts a powerful counteraction that supports the private property rights. Rajan and Zingales (2003) observe that governments in countries having Civil Law were generally more competent and effective, than the countries having a government within a Common Law setting, and the authors feel that the former type of legal tradition was created while expanding the state role at the expense of financial development, during the Great Wars of 1919–1939. Thus, according to the law and finance theory it is the English form of Common law that supports greater financial development and economic growth than the Civil law system. The second process that connects the legal origin with a country’s financial development is the adaptability factor that has been created on two main fronts. First, the legal systems vary in their nature of adaptation to the changing socio-economic and cultural scenarios. Secondly, if the legal systems of a country adjust very slowly to the transforming socio-economic conditions, then will be large open clefts between the actual financial requirement of a country’s economy and the capability of the existing legal system to endorse those requirements. In the context of the adaptability factor, Rubin (1977) and Priest (1977) hold the view that the English common law mechanisms are more competent than the ‘statutory-based’ legal systems, because in the former, the laws that are ineffective are regularly appealed and disputed in the courts that ultimately lead to the creation of laws that more effective in nature. On the other hand we find that Posner (1973) and Bailey and Rubin (1994) contend that ‘statutory’ based legal systems evolve slowly, thus making them more subjective to pressures from the inefficient political circles than the Common law systems. If statutes are made to constantly undergo changes then it will hinder the effective function of the corporate finances and the overall financial development. Thus, one can conclude in this context that the adaptability factor claims that the countries having the French form of civil law, (this does not necessarily refer to France itself), generally tend to have lower chances of developing and effective and malleable financial system when compared to the English common law followers or even the German civil law followers. The adaptability factor is of the view that the English Common law is invariable more progressive in nature as it responds by making itself suitable to each individual case, and adapts itself fast to the changing needs of society. This limits the chances for opening of large fissures between the society and economic demands and the legal system. La Porta, Lopez-de-Silanes, Pop-Eleches, and Shleifer (2003) in their papers have observed that the counties with the English common law will tend to acknowledge the decisions made by the judiciary as the prime source of law. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1999) in their papers also show that countries with low investor protections (French civil law), measured as per the character of the existent set of laws, and the nature of the effectiveness of law enforcement, tend to procure narrow and cramped capital markets. In their papers, the authors’ also present evidences, which show that civil law, especially the French civil law, accords the weakest investor protections, while also showing capital markets that are minimally developed. In another paper, La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998), reported that the countries with English common law accorded the firms with better equity finance access than their counterpart civil law countries, (especially the French civil law countries). The various researches undertaken by Beck, Asli Demirg? and Levine (2001), lend a considerable support to the law and finance theory. Furthermore, the authors also show that the variations in the legal origin of the countries help to explain the differences in financial development as are perceived between different countries, even today, after considering all regional dummy variables, controlling for the level of economic development, religious and ethnic diversity, degree of globalisation, initial legacies, and the political order. In another study, Beck, Asli Demirg and Levine (2003), contends that while the factor of legal adaptability gives an answer for the cross-country variations in financial development, political channel provides no such answer. Law and Azman-Saini (2008) reaffirms the importance for the rule of law in assessing the banking sector development. Their research findings were in tune with La Porta et al. (1998). However, they also confirmed that institutional quality variables, like the variables for the rule of law, were statistically important causal factors for the stock market development, and hence suggested that the economic development must therefore reach a certain threshold value for the stock market to grow and develop. Djankov, et al. (2003a) emphasize the fact that variations in legal formalism also tend to affect the law adaptability factor. They observe that countries with common law generally have a lower degree of legal formalism as regards evidence regulation, collection, and presentation. They also require less extensive judicial processes, and refrains from insisting on written records at every step of the process, and while also avoiding setting up of stringent procedures and requirements on the party communication. In contrast, the French civil law tends to have a lack of faith on the judiciary and thus shows a dependence on the judicial formalism. This creates a hindrance in the adaptability factor of the legal system in many of the countries that follow the French legal system, with negative implications on the overall financial development. Many other legal experts observe that the German law is closer to the English Common law, in terms of greater adaptability factor. The German law rejects the doctrines in the French civil law system and maintains its own tradition and culture in the arena of its legal jurisprudence. While adaptability and political processes are interconnected parts of the law and finance theory, and both indicate that the legal origin frames the financial development, they make contrasting observations on the German vs. French civil law countries. The political process holds that the Civil law tradition, including both the German and French laws, tends to focus upon and aggravate the power of the state and is therefore more careful while taking a stand in favour of the free financial developing systems than the English Common law. On the other hand, we find that the adaptability factor emphasises that the countries having the English Common law and the German civil law have markedly more adaptable legal systems than the countries with the French civil law system. The two processes also make varying observations as regards the processes through which the legal systems affect the financial development of a country. The political process claims that when judiciary is controlled by the State power then it tends to create a system that always centres upon the State authority and less on the rights of the private contracting agreements of the investors; which is in complete contrast to a legal system that is characterized by a judiciary independent from the State control. Thus, the political process observes that differences in cross-country records, as regards the independent judiciary are also important for analysing the variations noted in the financial development across the world. The adaptability factor emphasises that the variations noted in cross-country readings in the malleability of the legal systems are importance for explaining the cross-country variations in financial development as observed globally. One can overemphasize the differences between the political and adaptability channels, however. Here one can focus on differences between the two processes and find that the political channels always highlight the State power, while the adaptability process focuses on the variations in the competence of the legal systems to change and adapt with the changing conditions. Jurisprudence will be less likely in a legal system that is dominated by the State power than in a judiciary where the legal systems enjoys more freedom (Glaeser and Shleifer, 2002). Contending views to the law and finance theory: Many well scholars, legal experts, and economists, express doubt over the underlying notions expressed in the law and finance theory. There are contentions regarding the comparative malleability factor of the English Common law and the French Civil law traditions. There are also doubts about the notion that the English common law gives greater priority on the protection of private property rights than the French Civil law, while scepticism is also expressed about categorising a country by the origins of its legal systems. there are various questions the authenticity of linking a country’s legal origins and legal institutions to the financial development and economic growth of that country, while doubts are expressed on the actual role of the laws that protect the investors in supporting financial development. Backhaus (1997), argue that antecedence can block an efficient evolution of the legal systems within a country. Rubin (1982) in his papers provide a large number of examples that included evolution of laws pertaining to the rights of property (during 19th century), and the presence of various ‘private clauses’ in the private contracts, when statutory law modifications were required to achieve better results in the United States. Here he cites an example where the English Common law has stuck on the principle, which states, “only a person who is a party to a contract can sue on it.” (ZK. 1998, p. 468) In contrast, the countries with the French civil law through statutory modifications permit more rights to the third parties. Furthermore, Lamoreaux and Rosenthal (2002) on their papers also present a detailed correlation of the laws related to partnerships and incorporation in France and the United States. in their papers they contended that the French civil law system showed more response while evolving effectively to the changing economic conditions, than did the U.S common law system, which was based on the English laws. in this context it can be said that while acknowledging the limitations of the law and finance theory’s capability in explaining all the ‘intertemporal’ changes in levels of the financial development across various countries, recent researches have shown that a number of validity checks regarding the connection between the legal institutions and financial development. Levine, 2004; Levine, Zervos, 1998; and Beck 2000 in their various researches reaffirms that the legal origin helps indeed help to analyse the cross-country variations observed in financial development. This is especially noted in the countries that follow the French civil law countries, (not France itself) where statistical figures have shown these countries tend to have significantly low range of development in the equity market. These researchers suggest that legal institutions and financial development are so closely inter-connected that the competitive market securities depend more on the nature of the legal institutions in a country than even on the banks. These reports are very consistent with the ideologies that propose a strong connection between the legal institutions and the financial development and economic growth of a country. Conclusion: There are a growing number of researches that explore and study the part played by the legal institutions while trying to analyse a country’s financial development. The law and finance theory proposes that (a) differences that originate from historically determined legal tradition affects a state’s perspective and approach towards protecting the private property rights, the backing for the private contractual agreements, and the creation and administration of investor protection laws; and (b) the resulting legal institutions that are created as per the legal traditions work towards shaping the willingness of depositories to invest their money in various business firms, the competency of the corporate governance, and the levels of financial development and the economic growth. There is every indication from the above discourse that legal institutions and financial developments are two closely interrelated subjects. 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