Is There a Relationship Between Shareholder Protection and Stock Market Development?

Does the quality of legal and other institutions make a difference to economic development and growth? In their very well-known studies of the relation between law and finance, Andrei Shleifer and his collaborators (in particular Rafael La Porta and Simeon Djankov) found evidence to support this claim. Their econometric analysis showed that higher levels of shareholder and creditor protection were correlated with increased financial development. This work became highly influential among researchers and policy-makers. Since the mid-1990s, it has been believed that strengthening shareholder and creditor rights will lead to improved financial outcomes.  This view became a mainstay of global policy initiatives, including the World Bank’s Doing Business Reports and the OECD’s Principles of Corporate Governance, and of many national law reform programmes, particularly those in developing countries.  However, later empirical research has cast doubt on the claim that law matters for finance. We use newly available data on laws relating to shareholder protection to assess the impact of legal and regulatory changes on stock market development in 28 countries. We also use time-series and panel data econometric techniques to investigate the existence of a reverse-causal relationship, in other words, the possibility that it may have been changes in finance which drove legal reform, rather than the law driving financial development.

Since 1990 shareholder rights have been  strengthened around the world and particularly in middle income countries, with Russia and China taking the lead in adopting pro-shareholder reforms.  Our econometric analysis indicates only equivocal evidence of a positive impact of shareholder protection on the most widely used measures of stock market development at country level, that is to say, stock market capitalization as a proportion of GDP, the volume of shares traded, and the turnover ratio.  The evidence is equivocal because we use a number of different regression models to deal with the uncertainties inherent in a large, cross-national panel dataset, and do not consistently see a positive and statistically significant sign in the resulting correlations.  Some effects are negative (for example, the impact of pro-shareholder laws on the number of listed companies).  We also see evidence of reverse causality, in the sense of stock market development at country level generating changes in shareholder protection law. This effect outweighs its opposite, the impact of law on financial development. 

For policy makers, the main take away from our research is that legal reforms driven by global standards such as those of the World Bank and OECD do not straightforwardly translate into improved financial outcomes at country level. Where changes to the laws of a given country are triggered by external factors such as the influence of international standard-setting bodies, the presence of endogenous demand for investor protection, coupled with complementary institutions at country-level, will make a difference to the effectiveness of the law in practice, and hence to financial outcomes.