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Law, Finance, and Economic Growth

Ross Levine*University of Virginia

July 1997

Abstract: This paper examines the connection between the legal environment and financialdevelopment, and then traces this link through to long-run economic growth. Countries withlegal and regulatory systems that (1) give a high priority to creditors receiving the full presentvalue of their claims on corporations, (2) enforce contracts effectively, and (3) promotecomprehensive and accurate financial reporting by corporations have better-developed financialintermediaries. The data also indicate that the exogenous component of financial intermediarydevelopment the component of financial intermediary development defined by the legal andregulatory environment is positively associated with economic growth.

* Department of Economics, 114 Rouss Hall, University of Virginia, Charlottesville, VA 22903-3288;[email protected]. I thank Thorsten Beck, Maria Carkovic, Bill Easterly, Lant Pritchett, Andrei Shleifer, andseminar participants at the Board of Governors of the Federal Reserve System, the University of Virginia, and theWorld Bank for helpful comments.

1Does financial development affect long-run economic growth? Economists hold

remarkably different views regarding the answer to this question. At one end of the spectrum,

many argue that better financial systems -- financial systems that are better at identifying the

most worthwhile projects, exerting corporate control, mobilizing savings, providing risk

management facilities, and easing transactions -- accelerate economic growth [Bagehot 1873,

Schumpeter 1911, and Hicks 1969]. Others question the direction of causality. Robinson (1952)

asserts that economic growth creates demands for financial services and the financial system

responds to provide these services.1

Although King and Levine (1993b) show that measures of financial intermediary

development are good predictors of economic growth, these results neither settle the issue of

causality nor identify the determinants of financial development.2 As argued by Rajan and

Zingales (1996), financial markets may anticipate economic growth and respond by developing

in anticipation of greater economic activity. Thus, financial development may simply be a

leading indicator, rather than an underlying cause. Also, financial development and economic

growth may be driven by a common omitted variable. Thus, the observed positive association

may not imply a causal link.

Given the debate about whether finance causes growth and the lack of information

regarding the sources of financial development, this paper addresses two questions. First, what

are the legal and regulatory determinants of financial intermediary development? Second, is the

1 For recent formulations of the conditions under which financial intermediaries accelerate economic growth, see, for

example, Bencivenga and Smith (1991) and King and Levine (1993c). For views on bi-directional causality, seePatrick (1966), Greenwood and Jovanovic (1990), Greenwood and Smith (1997).2 King and Levine (1993b) show that financial depth in 1960 predicts economic growth over the next 30 years.

Using annual data and sophisticated time-series procedures, Wachtel and Rousseau (1995) and Neusser and Kugler(1996) find that financial development Granger-causes economic performance. These time-series studies, however,

2exogenous component of financial intermediary development the component of financial

intermediary development defined by the legal and regulatory environment positively

associated with economic growth? Answering the first question that is, providing information

on the roots of financial development -- is valuable regardless of potential links with steady-state

growth. For example, the functioning of financial intermediaries may affect business-cycles and

the level of income per capita. Policy makers, therefore, may desire information on the legal and

regulatory determinants of financial systems irrespective of the potential ties with steady-state

growth.3 Toward this end, this paper constitutes the first broad cross-country documentation of

the relationship between financial intermediary development and national legal and regulatory

characteristics. The paper complements LaPorta, Lopez-de-Silanes, Shleifer, and Vishnys

(1997) study of the legal determinants of equity and bond markets.

In terms of the second question, this paper uses the legal and regulatory determinants of

financial development as instrumental variables and examines whether an increase in the

exogenous component of financial development causes more rapid growth. Thus, this paper will

help resolve the issue of whether financial development is simply a leading indicator of

economic growth, or whether the financial system exerts a causal influence on economic

performance. This is the first study of whether the component of financial development defined

by the legal and regulatory environment is positively associated with growth.

Part I of this paper searches across a new cross-country data set to identify the

determinants of financial intermediary development. LaPorta, Lopez-de-Silanes, Shleifer, and

Vishny (1996, henceforth LLSV 1996) assemble data on the legal and regulatory treatment of

remain subject to the problems that financial development may be a leading indicator but not a cause of growth, andthey do not identify the determinants of financial development.

3creditors, the efficiency of the legal system in enforcing contracts, and accounting standards.

Since contractual arrangements form the basis of financial activities, legal systems that protect

creditors and enforce contracts are likely to encourage greater financial intermediary

development than legal and regulatory systems that impede creditors from gaining access to their

claims or that ineffectively enforce contracts. Similarly, since information about corporations is

critical for exercising corporate control and identifying creditworthy firms, accounting standards

that simplify the interpretability and comparability of corporate financial statements will tend to

ease financial activities. Moreover, LLSV (1996) show that differences in the legal treatment of

creditors, legal system efficiency, and the comprehensiveness and quality of information

disclosed in corporate annual reports are systematically linked to the countrys legal origin.

Specifically, LLSV (1996) divide the sample into countries with predominantly English, French,

German, or Scandinavian legal origins. Since most countries obtained their legal systems

through occupation and colonization and since these systems vary little over time, the legal

variables are treated as exogenous for the post-1960 period.4

Part I finds that the legal and regulatory environment influences financial intermediary

development. To measure financial development, this paper uses the King and Levine (1993b,

henceforth KL ) indicators of financial intermediary development. These indicators quantify the

size of financial intermediaries, the relative importance of commercial banks versus the central

bank in allocating credit, and the degree to which intermediaries allocate credit to the private

sector versus the government or public enterprises. The data show that countries with legal

systems that assign a higher priority to creditors extracting the full present value of their claims

3 Also, to understand economic development, economists seek information on the origins of key institutions, such as

financial intermediaries [North 1981].4 The sensitivity of this assumption are examined and discussed below.

4against corporations in the case of corporate bankruptcy or reorganization have more developed

financial intermediaries. Similarly, countries with legal systems that more effectively enforce

contracts have better developed financial intermediaries than countries where contract

enforcement is more lax. Furthermore, information disclosure matters. While less robust than

the creditor rights and legal efficiency variables, the data also illustrate a strong positive link

between financial intermediary development and the degree to which corporations publish

comprehensive and comparable information.

Part II of this paper examines the issue of causality. Specifically, I extend the work of

KL(1993b) by using various combinations of the legal and regulatory determinants of financial

development as instrumental variables for financial development. Generalized Method of

Moments (GMM) procedures reveal that the exogenous component of financial intermediary

development the component defined by national legal and regulatory characteristics --

positively influences economic growth. These results are robust to variations in the instrument

variables, modifications in the conditioning information set, alterations in the sample period, and

changes in the measure of financial intermediary development. Tests of the overidentifying

restrictions indicate that the data do not reject the hypothesis that the instrumental variables are

uncorrelated with the error term. This implies that the instrumental variables affect growth only

through their influence on financial intermediary development. The results suggest that an

exogenous increase in financial development causes an acceleration of long-run economic

growth. Furthermore, this link is economically large. The estimated coefficients suggest, for

example, that moving a country from the lowest quartile of countries in terms of legal protection

of creditor rights to the next quartile translates into a 20 percent rise in financial development

(evaluated at the sample mean). This rise in turn accelerates long-run growth by almost one

5percentage point per year (which is about 60 percent of the standard deviation of cross-country

growth rates over the 1980s).

This paper complements recent alternative methods for addressing the issue of causality.

Using industry-level data, Rajan and Zingales (1996) show that industries that rely comparatively

heavily on external funding grow comparatively faster (than industries that do not rely heavily on

external capital) in countries with well-developed financial systems. Similarly, Demirguc-Kunt

and Maksimovic (1996) show that firms with access to better developed financial systems grow

faster than they could have grown without this access. Furthermore, Jayaratne and Strahan

(1996) show that when individual states of the United States relaxed intrastate banking

restrictions, bank lending quality improved and economic growth accelerated.

The paper is organized as follows. Part I establishes an empirical connection between

cross-country differences in banking development and cross-country differences in the legal and

regulatory environment. Part II then traces the impact of differences in the legal and regulatory

environment on banking development through to economic growth. The data indicate that the

exogenous component of financial intermediary development -- the component defined by the

legal and regulatory system -- is positively associated with economic growth.

6I. The Legal and Regulatory Determinants of Financial Development

To examine the relationship between financial intermediary development and measures of

national legal and regulatory conditions, one needs (1) measures of financial intermediary

development and (2) measures of the legal and regulatory characteristics for a cross-section of

countries. This section first describes the financial intermediary development indicators. Then,

it presents evidence regarding the links between each financial development indicator and

various indicators of (1) the legal and regulatory treatment of creditors, (2) the enforcement of

contracts, and (3) the accuracy and comprehensiveness with which information about firms is

disclosed to outsiders.

A. Financial intermediary development

Ideally, one would like to construct measures of the particular functions provided by the

financial system. That is, one would like to have comparative measures of the ability of the

financial system to research firms and identify profitable ventures, exert corporate control,

manage risk, mobilize savings, and ease transactions. Accurately measuring the provision of

these services in any single country would be extraordinarily difficult; doing it for a broad cross-

section of countries would be virtually impossible. Instead, this paper follows KL (1993b) and

uses four indicators of financial intermediary development. These indicators measure the size of

financial intermediaries, the relative importance of commercial banks versus the central bank in

allocating credit, and the degree to which intermediaries allocate credit to the private sector

versus the government or public enterprises. While there are positive features and shortcomings

associated with each measure (as discussed by KL 1993b), all four are used. Since the results are

broadly similar across the four financial intermediary indicators, this enhances the confidence

7one holds in the conclusions. These data are available for 77 countries over the 1960-1989

period.5

The first measure, LLY, measures the size of financial intermediaries and equals liquid

liabilities of the financial system (currency plus demand and interest-bearing liabilities of banks

and nonbank financial intermediaries) divided by GDP. Under the assumption that the size of

the financial system is positively correlated with the provision and quality of financial services,

many researchers have used indicators of financial system size [Goldsmith 1969]. Citizens of the

richest countries -- the top 25 percent on the basis of income per capita -- held about two-thirds

of a years income in liquid assets in formal financial intermediaries. In contrast, citizens of the

poorest countries -- the bottom 25 percent -- held only a quarter of a years income in liquid

assets.

The second measure of financial development, BANK, measures the degree to which

commercial banks versus the central bank allocate credit. BANK equals the ratio of bank credit

divided by bank credit plus central bank domestic assets. The intuition underlying this measure

is that banks are more likely to identify profitable firms, exercise corporate control, pool risk,

mobilize savings, and facilitate transactions than central banks. There are two notable

weaknesses with this measure, however. Banks are not the only financial intermediaries

providing valuable financial functions and banks may simply lend to the government or public

enterprises. BANK is greater than 90 percent in the richest quartile of countries. In contrast,

commercial banks and central banks allocate about the same amount of credit in the poorest

quartile of countries.

The third and fourth measures partially address concerns about the allocation of credit.

5 KL(1993a,b) provide data sources and summary statistics of the financial intermediary indicators.

8The third measure, PRIVATE, equals the ratio of credit allocated to the private sector to total

domestic credit (excluding credit to banks). The fourth measure, PRIVY, equals credit to the

private sector divided by GDP. Directed credit initiatives and government subsidy programs may

importantly influence the fraction of credit allocated to the private sector. The assumption

underlying these measures is that financial systems that allocate more credit to the private sector

are more engaged in researching firms, exerting corporate control, providing risk management

services, mobilizing savings, and facilitating transactions than financial systems that simply

funnel credit to the government or state owned enterprises.

B. Creditor rights and financial intermediary development

As discussed in LLSV (1996), outside creditors can influence firms to satisfy their debt

obligations in a variety of ways. For instance, a creditor may have the right to repossess

collateral or liquidate the firm in the case of default. Some legal and regulatory systems make

repossession easier than other systems. Similarly, creditors may enjoy rights regarding the

reorganization of a company since the reorganization may affect the probability of repayment.

Again, legal systems differ in the rights assigned to creditors in terms of corporate

reorganizations. Thus, legal and regulatory systems that facilitate the repossession of collateral

and that grant creditors a clear say in reorganization decisions are, all else equal, likely to

encourage the development of financial intermediaries engaged in issuing credit supported by

these laws. In terms of the specific financial intermediary indicators, legal systems that assign

strong rights to creditor are -- all else equal -- more likely to support the growth of financial

intermediaries (LLY), commercial banks relative to the central bank (BANK), and financial

intermediaries that allocate more credit to private firms as opposed to the government or public

9enterprises (PRIVATE, PRIVY) than legal systems that impede the repossession of collateral or

limit the role of creditors in reorganizations.

The paper considers three creditor rights indicators. The first two focus on the rights of

creditors in reorganizations. The third indicator measures the seniority of creditors in the case of

a defaulting firm. LLSV (1996) construct the data from bankruptcy and reorganization laws for

49 countries and list this data in the Appendix.

AUTOSTAY equals one if a countrys bankruptcy and reorganization laws impose an

automatic stay on the assets of the firm upon filing a reorganization petition. AUTOSTAY equals

0 if this restriction does not appear in the legal code. The restriction prevents secured creditors

from gaining possession of collateral or liquidating a firm to meet obligations. Thus, all else

equal, AUTOSTAY should be negatively correlated with the activities of intermediaries engaged

in providing secured credit.

MANAGES equal one if the firm continues to manage its property pending the

resolution of the reorganization process, and zero otherwise. In some countries, management

stays in place until a final decision is made about the resolution of claims. In other countries,

management is replaced by a team selected by the courts or the creditors. If management stays

pending resolution, this reduces pressure on management to meet secured creditor obligations.

Thus, MANAGES should be negatively correlated with the activities of financial intermediaries

engaged in secured transactions.

SECURED1 equals one if secured creditors are ranked first in the distribution of the

proceeds that result from the disposition of the assets of a bankrupt firm. SECURED1 equals

zero if non-secured creditors, such as the government or workers get paid before secured

creditors. In cases where SECURED1 equals zero, this certainly reduces the attractiveness of

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lending secured credit. SECURED1 should be positively correlated with activities of financial

intermediaries engaged in secured transactions, holding everything else constant.6

Tables 1-3 present results regarding the empirical connection between each of the three

creditor rights variables and the four measures of financial intermediary development. The

regressions control for the level of per capita income in these regressions of financial

development on the creditor rights variables because LLSV (1996) show the level of income per

capita is frequently correlated with creditor rights indicators even after controlling for legal

origin.

As expected, countries that prevent secured creditors from gaining possession of their

security by imposing an automatic stay on firm assets in the case of reorganization

(AUTOSTAY=1) tend to have commercial banks that allocate a relatively low amount of credit

relative to central banks (BANKS) and commercial banks that extend a relatively low amount of

credit to private firms as a fraction of GDP (PRIVY). AUTOSTAY enters negatively in all four

regressions, and is significant at the 0.01 level in the BANK regression and at the 0.09 level in

the PRIVY regression.

Similarly, countries where managers stay in control of the firm pending the resolution of

the reorganization process (MANAGES=1) tend to have less well-developed financial

intermediaries than countries where officials appointed by creditor or the courts assume

responsibility for the operation of the business during reorganization. As shown in Table 2,

6 LLSV (1996) also examine REORG, which equals one if a countrys bankruptcy and reorganization laws impose

restrictions, such as creditors consent, to file for reorganization, and one otherwise. This type of restriction mayboost creditor rights by increasing the likelihood and shortening delays in creditors getting paid. If the legal systemdoes not impose this restriction, then managers can reorganize corporations and thereby avoid or delay payingsecured creditors. While I also examined REORG, it was insignificantly related to all of the financial intermediarydevelopment indicators.

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MANAGES enters all of the regressions negatively, and is statistically significant at the 0.05

level in the LLY equation and at the 0.10 level in the PRIVATE and PRIVY regressions.

The findings are strongest for SECURED1. Countries where non-secured creditors,

such as the government or labor, are given priority in the distribution of the proceeds that result

from the disposition of the assets of a bankrupt firm (SECURED1=0) tend to have less well-

developed financial intermediary sectors than countries where secured creditors are ranked first

(SECURED1=1). As shown in Table 3, SECURED1 enters the LLY, BANK, and PRIVY

equations positively, and significantly at the 0.05 level and enters the PRIVATE equation

positively, with a P-value of 0.05.

Finally, these three creditor rights indicators are combined into an aggregate index

designed to be positively associated with creditor rights. Specifically,

CREDITOR = SECURED1 - AUTOSTAY - MANAGES, and takes on values between 1 (best)

and -2 (worst). As shown in Table 4, CREDITOR is significantly positively correlated with

LLY, BANK, and PRIVY at the 0.05 level and with PRIVATE at the 0.07 level. Countries with

legal systems that assign a high priority to secured creditors receiving their pledged claims tend

to have more well-developed intermediaries.

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C. Enforcement of contracts and financial intermediary development

The laws and regulations governing secured creditors will affect secured creditors only

to the extent that the laws and regulations are enforced. Indeed, comparatively lax creditor

rights laws in conjunction with efficient property rights enforcement may promote financial

intermediary activities more effectively than strong creditor rights laws with lax enforcement.

Consequently, two measures of the efficiency of the legal system in enforcing contracts are

included from LLSV (1996).

RULELAW is an assessment of the law and order tradition of the country that ranges

from 10, strong law and order tradition, to 1, weak law and order tradition. This measure was

constructed by International Country Risk Guide (ICRG) and is an average over the period

1982-1995. Given the contractual nature of finance, I expect a positive relationship between

RULELAW and financial intermediary development.

CONRISK is an assessment of the risk that a government will and can modify a

contract after it has been signed. CONRISK ranges from 10, low risk of contract modification,

to 1, high risk of contract modification. Specifically, modification means either repudiation,

postponement, or reducing the governments financial obligation. This measure was

constructed by ICRG and is an average over the period 1982-1995. Legal systems that

effectively enforce contracts including contracts with the government will support financial

intermediary activities. Thus, I expect CONRISK to be positively associated with financial

development.

Tables 5-6 present results regarding the empirical connection between the two measures

of legal system efficiency and the four measures of financial intermediary development. Both

RULELAW and CONRISK are positively associated with all of the financial intermediary

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development indicators at the 0.05 significance level after controlling for the level of real per

capita GDP. The results suggest that legal systems that enforce contracts including

government contracts efficiently promote financial intermediary development.7

D. Accounting standards and financial intermediary development

Information about corporations is critical for exerting corporate governance and

identifying the best investments. These activities will be facilitated by accounting standards that

simplify the interpretability and comparability of information across corporations. Furthermore,

many types of financial contracting use accounting measures to trigger particular actions. These

types of contracts can only be enforced and will only be used if accounting measures are

reasonably unambiguous. Accounting standards differ across countries and governments impose

an assortment of regulations regarding information disclosure and accounting standards. Since

accurate information about corporations may improve financial contracting and intermediation,

the paper examines a measure of the quality of information disclosed through corporate accounts

from LLSV (1996).

ACCOUNT is an index of the comprehensiveness of company reports. The maximum

possible value is 90 and the minimum is 0. The Center for International Financial Analysis and

Research assessed general accounting information, income statements, balance sheets, funds flow

statement, accounting standards, and stock data in company reports in 1990. Given the

importance of information in financial contracting, I expect ACCOUNT to be positively

7 I also examined an interaction term, CREDITOR*CONRISK, to examine whether creditor rights are less important

in the presence of an effective contract enforcement system and whether contract enforcement exerts a differentimpact on financial development depending on the legal treatment of creditors. This interaction term always entersinsignificantly.

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correlated with financial intermediary development.8 In particular, one might expect that

commercial banks will benefit more from reliable and comparable corporate financial statements

than central banks in terms of allocating credit, and accurate information on corporations is likely

to be more important for the funding of private firms than for public firms.

Table 7 indicates that while ACCOUNT is not significantly correlated with LLY and

PRIVY, ACCOUNT is positively and significantly related to BANK and PRIVATE at the 1

percent significance level. Countries with better standards of corporate reporting tend to have

financial systems where the central bank plays a smaller role in allocating credit relative to

commercial banks and where more credit flows to the private sector relative to the public sector.

Discussion

Part Is results are consistent with the view that the legal and regulatory environment

materially affect financial intermediary development. More specifically, countries with legal and

regulatory systems that assign a high priority to creditors receiving the full value of their claims

tend to have more well-developed financial intermediaries. In contrast, countries where the legal

environment does not protect potential outsider creditors against the interests of insiders tend to

have less-developed financial systems. The data also indicate -- albeit less robustly -- that

comprehensive and comparable information on corporations boost financial intermediary

development. Furthermore, the three different legal/regulatory indicators -- creditor rights,

8 This is not necessarily true and raises the need for a general conceptual qualification. An economy with perfect

information, perfect contract enforcement and perfect legal codes (i.e., and economy with essentially zero transactionand information costs) would have little reason for financial intermediaries. Put differently, market frictionsmotivate the emergence of financial intermediaries. See the review by Levine (1997), especially Boyd and Prescott(1986). Conceptually, this implies that at very high levels of legal system development and informationdissemination, a marginal increase in legal efficiency or information quality may cause a reduction in the role andimportance of financial intermediaries. To test this potential non-linearity, I included various combinations ofquadratic expressions for ACCOUNT and CONRISK. The quadratic terms never enter significantly.

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contract enforcement, and accounting information on corporations -- provide different

information. As summarized in Table 8, although ACCOUNT is highly correlated with

RULELAW and CONRISK; CREDITOR is not significantly correlated with RULELAW,

CONRISK, or ACCOUNT.

Not only is the relationship between financial development and the legal/regulatory

environment statistically significant, it is economically large. For example, the estimated

coefficient suggests that a legal or regulatory improvement that boosts the overall creditor rights

index, CREDITOR, by a value of one will increase financial depth, LLY, by a value of 0.11,

which is about 20 percent of the mean value of LLY in the 1980s (0.55). Similarly, contract

enforcement is at least as important as the formal legal and regulatory statutes. Countries that

enforce contracts effectively have better developed financial intermediaries that countries with

weaker law and order traditions and where the government frequently modifies the terms of

preexisting contracts. Again, the relationship is economically large. A one standard deviation

improvement in CONRISK (1.8) increases financial depth by 0.18, which is 32 percent of the

mean value of LLY. Finally, information matters. Countries where corporations publish

comprehensive, high-quality financial statements have more well-developed financial

intermediaries than countries where accounting standards provide less reliable information.

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II. Causality: Financial Intermediary Development and Economic Growth

This part of the paper uses the legal and regulatory determinants of financial

development examined in Part I as instrumental variables for financial development. Thus, the

paper examines whether the exogenous component of financial development is positively

associated with economic growth. To do this, KLs (1993b) cross-country study is extended to

an instrumental variable framework. After briefly describing the KL methodology, this section

summarizes the instrumental variable results.

A. Brief description of KL methodology

KL (1993b) assess the strength of the empirical relationship between growth and each of

the four indicators of the level of financial intermediary development discussed above. First,

they use data averaged over the 1960-1989 period. Let F(i) represent the value of the ith

indicator of financial development (DEPTH, BANK, PRIVY, PRIVATE) averaged over the

period 1960-1989, G represents real per capita GDP averaged over the period 1960-1989, and X

represents a matrix of conditioning information to control for other factors associated with

economic growth (e.g., income per capita, education, political stability, indicators of trade, fiscal,

and monetary policy ). They then run the following four separate regressions on a cross-section

of 77 countries:

(1) G = + F(i) + X + .

There is a strong positive relationship between each of the four financial development indicators,

F(i), and growth. Not only are all the financial development coefficients statistically significant,

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the sizes of the coefficients imply an economically important relationship. Ignoring causality for

the moment, their estimated coefficient of 2.4 on DEPTH implies that a country that increased

DEPTH from the mean of the lowest DEPTH quartile of countries (0.16) to the mean of the

largest DEPTH quartile of countries (0.70) would have increased its per capita growth rate by

almost 1.3 percentage points per year. This is large. The difference between the slowest growing

25 percent of countries and the fastest growing quartile of countries is about five percent per

annum over this 30 year period. Thus, the rise in DEPTH alone eliminates 25 percent of this

growth difference.9

B. Selecting Instruments

Given this basic framework, the paper uses the legal and regulatory determinants of

financial development examined in Part I as instrumental variables for financial development,

F(i). That is, a vector of instrumental variables Z(i) is selected for each regression equation

specified by equation (1). Assuming that E[]=0 and that E[]=, where is unrestricted,

implies a set of orthogonality conditions, E[Z]=0. This produces a nonlinear instrumental

variable estimator of the coefficients in equation (1). After computing these GMM estimates, I

use a Lagrange-Multiplier test of the overidentifying restrictions to see whether the instrumental

variables are associated with growth beyond their ability to explain cross-country variation in

financial intermediary development. For completeness, all of the equations were also estimated

using two-stage least squares. This alternative estimator does not change either the statistical

inferences or the coefficient sizes from those reported below.

9 KL (1993b) use 77 countries. There are only legal and regulatory variables, however, for 43 of these countries.

When the KL (1993b) regressions are run for this smaller sample of countries, the results are virtually identical. The

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I choose different instrumental variables for the different financial intermediary

indicators based on the regression results in Tables 1-7 and the correlation results in Tables 8. I

use CREDITOR and CONRISK as instrumental variables for all of the financial intermediary

development indicators. The variable CREDITOR summarizes each countries legal and

regulatory treatment of secured creditors by aggregating information on AUTOSTAY,

MANAGES, and SECURED1. It is significantly correlated with financial development as

discussed in Part I. Using SECURED1 (which is also significantly associated with all of the

financial intermediary indicators) instead of CREDITOR does not alter the results that follow. I

also wanted to include a measure of contract enforcement. CONRISK and RULELAW are both

highly correlated with all of the financial intermediary development indicators, and they are

highly correlated with each other 0.88. I select CONRISK because it has a larger correlation

coefficient with all of the financial intermediary indicators. Using RULELAW instead does not

alter the results. Finally, for PRIVATE and PRIVY, ACCOUNT is also included as an

instrumental variable because it is significantly correlated with these financial intermediary

indicators.10

only difference is that BANK becomes insignificant at the 5 percent level when a large conditioning information setis included10

In a two-stage least squares framework, the first stage includes more explanatory variables than those in Tables 1-7. In particular, the limited conditioning information set regressions also include the logarithm of income per capitaand the logarithm of secondary. The R-squares in these regressions are typically around 0.40 and the F-statisticalways rejects the null hypothesis at the 0.01 significance level that none of the cross-sectional variation in financialintermediary development is explained by the explanatory variables.

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C. GMM results over the 1960-1989 period

Consider first a straight application of instrumental variables over the 1960-89 period.

Table 9 summarizes two sets of results. The limited conditioning information set results use a

small X matrix that includes only the logarithm of initial real per capita GDP and the logarithm

of initial secondary school enrollment. The full conditioning information set regressions use a

large X matrix that also includes government consumption expenditures divided by GDP

averaged over the period, exports plus imports divided by GDP averaged over the period, and the

average annual inflation rate.11 I treat the X matrix as exogenous because I am focusing on

examining the question of whether the exogenous component of financial intermediary

development as defined by the legal and regulatory environment is positively associated with

economic growth.12

The results indicate a strong link between the exogenous component of financial

development and economic growth. The coefficient on financial intermediary development is

significant at the 5 percent level in seven out of the eight regressions summarized in Table 9.13

Further, the data do not reject the null orthogonality conditions; the data do not reject the

hypothesis that the instrumental variables are uncorrelated with the equation (1) error term at the

10 percent level. Put differently, the are consistent with the view that the legal and regulatory

factors affect growth only through their affect on financial intermediary development.

11 This full conditioning information set is taken from KL (1993b) for comparative purposes. As discussed in

greater detail below, using other conditioning variables does not affect the results [Levine and Renelt 1992].12

As a sensitivity check, I used the initial values (the pre-determined values instead of the average values over theperiod) of the X matrix variables. This did not alter the results.13

Only in the BANK regression with the full conditioning information set does the financial indicator not entersignificantly (it enters with a P-value of 0.11), but this is no different from the OLS results summarized above. Thus,the lack of significance does not reflect a simultaneity problem.

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D. GMM results over the 1980s

Since the legal and regulatory variables are measured over the 1980s, I repeat the

analysis using data over the period 1980-89. As shown in Table 10, the results are even

stronger. In seven of eight regressions, financial intermediary development enters the growth

regression significantly at the 0.05 level and it enters the eighth regression significantly at the

0.10 level. Again, a test of orthogonality restrictions suggests that the instrumental variables

are appropriate. The data are consistent with the view that improvements in creditor rights or

the enforcement of contracts, or the information content of corporate financial statements

induce improvements in the functioning of financial intermediaries that accelerate economic

growth.

Furthermore, this relationship is economically large. Rough estimates of the influence

of an exogenous improvement in financial development on economic growth can be obtained

from the above Tables.14 Consider, for example, an improvement in creditor rights. The

estimated coefficient from Table 4 suggests that a legal or regulatory improvement that boosts

the overall creditor rights index, CREDITOR, by a value of one (which is two standard

deviations) will increase financial depth, LLY, by a value of 0.11. From Table 10, we see that

this would in turn accelerate economic growth by about one percentage point per year. This is

reasonably large considering that the standard deviation of cross-country growth rates is 1.8

percent. Also, consider an improvement in contract enforcement. From Table 6 and as

14 These approximations are not completely correct for two reasons. First, the equations are estimated using GMM,

which is a nonlinear instrumental variable procedure. I, however, use the approximate first stage linear results toconduct the conceptual experiments. This is immaterial because the two-stage least squares results are virtuallyidentical to the GMM estimates. Second, I use results from Tables 1 - 7 to conduct the conceptual experiments.

21

discussed above, a one standard deviation improvement in contract enforcement (CONRISK)

causes LLY to rise by 0.18. From Table 10, we see that this would in turn accelerate economic

growth by about 1.5 percentage points per year. Thus, a one standard deviation improvement in

CONRISK induces a 80 percent of one standard deviation acceleration in economic growth.

Thus, this papers results suggest an economically large relationship between financial

development and economic growth. Legal and regulatory reforms that boost financial

development can materially affect long-run growth rates.

E. GMM results using financial development in 1960

Finally, I re-run KLs (1993b) test of whether the value of financial depth (LLY) in

1960 predicts the rate of economic growth over the next 30 years. They find that LLY in 1960

is significantly correlated with growth over the 1960-89 period. 15 Here, I instrument for the

value of financial depth in 1960 with the legal and regulatory variables (CREDITOR and

CONRISK). As shown in Table 11, the part of LLY in 1960 associated with the degree of

creditor rights and contract enforcement is strongly, positively associated with economic

growth over the next 30 years.

III. Sensitivity Analyses and Discussion

However, the real first stage regressions include all of the X variables. This is also immaterial, because the size ofthe relevant coefficient in the conceptual experiments is not altered much by the inclusion of the other instruments.15

There are too few observations on BANK, PRIVATE, and PRIVY to replicate this exercise for these financialdevelopment indicators. Furthermore, KL (1993b) also use pooled cross-section, time-series procedures, with thedata pooled over the three decades. They then use measures of all four financial development indicators at thebeginning of each decade and find that financial development predicts decade growth rates. When using this papersinstrumental variables in the KL (1993b) pooled cross-sectional analyses, one still finds that the exogenouscomponent of financial intermediary development the component defined by the legal and regulatory environmentis positively and significantly correlated with long-run economic growth.

22

A. Sensitivity results

One risk with pure cross-country analyses concerns country-fixed effects.16 That is,

the regression may omit an important explanatory variable that is really driving the results and

that is highly correlated with the financial intermediary development indicators. Thus, besides

the X variables discussed above, I experimented with a wide-array of additional explanatory

variables that other researchers have identified as importantly related to long-run growth.

Specifically, I included the following eight variables to test the robustness of the results to

changes in the conditioning information set. First, the black market exchange rate premium is a

general index of price, trade, and exchange rate distortions [Dollar 1992]. Second, the number

of assassinations per capita is one general index of political instability [Banks 1994]. Third, the

number of revolutions and coups is another commonly used indicator of political instability,

and is frequently found to be negatively associated with economic growth [Banks 1994].

Fourth, Barro and Lee (1995) construct a general index of political rights. Fifth, the degree of

civil liberties is one frequently used measure of political freedom [Gastil 1990]. Sixth, the

degree to which the regulatory environment obstructs commerce is a general indicator of

bureaucratic efficiency [Mauro 1995]. Seventh, the degree of ethnic diversity, which equals the

probability that two randomly selected individuals in a country belong to different

ethnolinguistic group, tends to induce poor policies that slow growth [Easterly and Levine

16 One could apply the dynamic-panel procedures developed by Holtz-Eakin, Newey, and Rosen (1988) and

Arrellano and Bond (1991). This dynamic-panel approach would be a valuable complement to this papers analysissince dynamic-panel techniques can virtually eliminate the potential inconsistency arising from country-specificeffects that are omitted from pure cross-country regressions. When applied to growth regressions, however, dynamicpanel applications typically average the data over five years to have a sufficient time-series dimension. Yet, fiveyear aggregation may still capture business-cycle relations and thereby misrepresent the relationship between financeand steady-state growth. Moreover, even using five-year averaged data, there are typically only five or six timeobservations, which can make the parameters very unstable with regard to changing the lags of the instrumentalvariables. In contrast, this paper uses data averaged over a minimum of 10 years to abstract from business-cycle

23

1997]. Finally, I consider a measure of corruption, which many argue influences economic

development [Mauro 1995; Shleifer and Vishny 1993]. Each of these variables is used to

examine the robustness of this papers results by controlling for bad government, bad

institutions, bad policies, and political instability. 17 Including these additional explanatory

variables does not alter this papers finding that the exogenous component of financial

intermediary development that part of financial development defined by each countrys legal

and regulatory environment -- is strongly, positively correlated with economic growth.

A second potential area of concern is the exogeneity of the instruments. As noted

earlier, national legal systems derive largely from four legal origins English, French, German,

and Scandinavian, and these legal systems were disseminated via occupation and colonization

[LLSV, 1996]. Moreover, it is worth emphasizing that the creditor rights variables are not

general indexes of the efficiency of the legal system. They measure the legal rights of secured

creditors. As shown above, these creditor rights variables strongly influence financial

intermediary development. But, other legal variables, such as laws governing minority

shareholder rights, do not strongly influence financial intermediary development. Thus, the

instrumental variables measure particular characteristics of the legal system that influence

financial intermediary development.

Nevertheless, the exogeneity of the general indexes of contract enforcement, such as

the rule of law variable, RULELAW, and the contract risk variable, CONRISK may be subject

to greater doubt since they are subjective evaluations of the security of contracts. While LLSV

(1996) show that these indexes of contract enforcement are closely associated with legal origin,

frequencies in examining whether the exogenous component of financial intermediary development positivelyinfluences long-run growth.

24

I evaluated the sensitivity of the results to alterations in the instrument set. Specifically, the

regressions were re-run (a) omitting CONRISK as an instrumental variable and instead using

the LLSV (1996) dummy variables for legal origin, i.e., English, French, German,

Scandinavian, and (b) substituting the underlying legal code variables for CREDITOR, namely

SECURED1, AUTOSTAY, and MANAGES. These alternative instruments lead to the same

conclusions as exemplified in Table 12: the legal environment importantly affects financial

intermediary development, and the exogenous component of the financial system the

component of the financial system defined by the legal environment is positively and

significantly associated with economic growth.

Finally, to further gauge the robustness of the results, I used a conglomerate index of

banking development that incorporates information on the size of intermediaries, who is

conducting the intermediation, and the allocation of credit. Specifically, this measure equals

credit allocated by commercial and deposit-taking banks to the private sector divided by GDP

[Levine and Zervos 1997]. These data are only available since 1976. This conglomerate

banking index incorporates information from BANK, PRIVATE, and PRIVY and is called

BANK-TO-PRIVATE. This banking indicator yields similar conclusions to those reported

above: the legal and regulatory environment affects banking development, and the component

of the banking system defined by the legal and regulatory environment is positively and

robustly correlated with long-run economic growth. Table 13 shows that the exogenous

component of BANK-TO-PRIVATE remains significantly correlated with growth when

altering the conditioning information set. Moreover, the strong link between long-run

economic growth and the exogenous component of BANK-TO-PRIVATE is not sensitive to

17 See Knack and Keefer (1995) for a comprehensive and careful examination of the relationship between economic

25

alternations in the instrumental variables.

B. Perspectives and interpretation

In many respects, this papers results can be viewed as a merger of KL (1993b) with

LLSV (1996). I combine the KL (1993b) data on financial intermediary development with the

LLSV (1996) data on legal and regulatory indicators. The paper then (1) examines the legal

and regulatory determinants of financial intermediary development and (2) tests whether the

exogenous component of financial intermediary development as defined by the legal and

regulatory environment is positively associated with economic growth. The paper can also be

viewed as an extension of LLSV (1997) along two dimensions. First, LLSV (1997) examine

the legal determinants of equity and bond markets. This paper examines the legal determinants

of financial intermediaries. Second, this paper then traces the affect of differences in the legal

environment on the financial system through to differences in long-run economic growth rates.

The papers results are consistent with the arguments made by Bagehot, (1873),

Schumpeter (1911), and Hicks (1969): exogenous improvements in financial intermediary

development cause an acceleration in long-run growth rates. The papers results are also

consistent with arguments made by Patrick (1966), Greenwood and Jovanovic (1990), and

Greenwood and Smith (1997): the direction of causality runs in both directions. Namely, the

paper does not show that growth does not cause finance. Rather, this paper shows that the

component of financial intermediary development associated with the legal and regulatory

environment is strongly linked with long-run growth rates.

growth and array of institutional and political indicators.

26

III. Conclusions

This paper focuses on identifying a connection between the legal and regulatory

environment and financial development, and then tracing this link through to long-run

economic growth. First, the paper shows that the legal and regulatory environment matters for

financial development. Specifically, this papers findings are consistent with Shleifer and

Vishnys (1997) argument that cross-country differences in legal systems affect the relationship

between entrepreneurs and creditors. Countries with legal and regulatory systems that give a

high priority to creditors receiving the full present value of their claims on corporations have

better functioning financial intermediaries than countries where the legal system provides much

weaker support to creditors. Moreover, contract enforcement matters as much as the formal

legal and regulatory codes. Countries that impose compliance with laws efficiently and enforce

contracts including government contracts effectively tend to have much better developed

financial intermediaries than countries where enforcement is more lax. Finally, the paper

shows that information disclosure matters for financial development. Countries where

corporations publish relatively comprehensive and accurate financial statements have better-

developed financial intermediaries than countries where published information on corporations

is less reliable.

Second, the paper uses the legal and regulatory indicators of creditor rights, contract

enforcement, and information disclosure as instrumental variables for financial development.

The data indicate that the exogenous component of financial intermediary development the

component defined by the legal and regulatory environment is positively associated with

economic growth. The results indicate that legal and regulatory changes that boost financial

intermediary development will induce a rapid acceleration in long-run economic growth.

28

Table 1: Financial Intermediaries and AUTOSTAY: 1980s

Dependent Variable

LLY BANK PRIVATE PRIVY

C -1.05 -0.46 -0.47 -1.36(0.007) (0.037) (0.096) (0.000)

Logarithm of 0.19 0.16 0.13 0.21 Income per capita (0.000) (0.000) (0.001) (0.000)

AUTOSTAY -0.12 -0.13 -0.06 -0.11(0.151) (0.009) (0.362) (0.088)

R2 0.22 0.42 0.28 0.38

Observations 44 39 39 44

AUTOSTAY=1, if reorganization procedure imposes a stay on firm assets.Prevents secured creditors from gaining possession of their security.AUTOSTAY=0, otherwise.

(Heteroskedasticity consistent P-values in parentheses)

29

Table 2: Financial Intermediaries and MANAGES: 1980s

Dependent Variable


C -1.41 -0.44 -0.63 -1.46(0.004) (0.089) (0.041) (0.000)


MANAGES -0.26 -0.09 -0.12 -0.13(0.026) (0.151) (0.091) (0.091)

R2 0.32 0.36 0.33 0.39


MANAGES=1, if management stays in control of property pendingthe resolution of the reorganization process.MANAGES=0, otherwise.


30

Table 3: Financial Intermediaries and SECURED1: 1980s

Dependent Variable


C -1.03 -0.35 -0.50 -1.32(0.007) (0.080) (0.041) (0.000)


SECURED1 0.22 0.13 0.14 0.19(0.014) (0.031) (0.051) (0.014)

R2 0.27 0.40 0.35 0.41


SECURED1=1, if secured creditors are ranked first in the distributionof the assets of a bankrupt firmSECURED1=0, otherwise.


31

Table 4: Financial Intermediaries and CREDITOR: 1980s

Dependent Variable


C -1.35 -0.58 -0.66 -1.54(0.001) (0.022) (0.035) (0.000)


CREDITOR 0.11 0.07 0.06 0.08(0.002) (0.011) (0.066) (0.004)

R2 0.31 0.45 0.35 0.43


CREDITOR = SECURED1 - AUTOSTAY - MANAGES


32

Table 5: Financial Intermediaries and RULELAW: 1980s

Dependent Variable


C 0.10 0.19 0.20 -0.42(0.810) (0.445) (0.454) (0.140)


RULELAW 0.05 0.03 0.04 0.04(0.012) (0.007) (0.017) (0.003)

R2 0.21 0.39 0.34 0.37


RULELAW = assessment of the law and order tradition of the country.Scale from 0 to 10; 10 equals most tradition of law and order.


33

Table 6: Financial Intermediaries and CONRISK: 1980s

Dependent Variable


C -0.00 0.14 -0.02 -0.47(0.993) (0.482) (0.933) (0.025)

Logarithm of -0.02 0.02 0.03 0.06 Income per capita (0.756) (0.461) (0.435) (0.028)

CONRISK 0.10 0.06 0.05 0.08(0.024) (0.001) (0.022) (0.002)

R2 0.25 0.44 0.33 0.42


CONRISK= assessment of the risk that the government will modifya contract.Scale from 1 - 10; 10 equals least amount of risk


34

Table 7: Financial Intermediaries and ACCOUNT: 1980s

Dependent Variable


C -0.92 -0.47 -0.62 -1.27(0.088) (0.032) (0.025) (0.006)


ACCOUNT 0.00 0.01 0.01 0.00(0.961) (0.000) (0.006) (0.129)

R2 0.15 0.52 0.44 0.32


ACCOUNT = index of the comprehensiveness of annual reports.Scale 0 - 90; 90 equals the most comprehensive annual reports.


Tabl

e

9: F

ina

nce

an

d G

row

th, I

nstru

me

nta

l Var

iabl

es:

196

0-19

89

De

pend

ent v

aria

ble

: Pe

r Ca

pita

GDP

Gro

wth

, 196

0-89

Re

gres

sion

equ

atio

nFi

nanc

ial i

ndic

ato

r in

regr

essi

on

LLY

BAN

KPR

IVAT

EPR

IVY

full

con

ditio

nin

g in

form

atio

n s

et

9.14

7.71

8.84

9.70

(0.03

6)(0.

110)

(0.00

2)(0.

004)

{0.21

}{4.

29}

{2.21

}{0.

74}

limite

d co

nditio

nin

g in

form

atio

n s

et

6.89

10.7

711

.70

8.89

(0.00

1)(0.

003)

(0.00

1)(0.

001)

{0.04

}{3.

93}

{3.81

}{0.

12}

{LM-te

st o

f ove

riden

tifyin

g re

stric

tion

s in

br

ack

ets}

(He

tero

sked

astic

ity Co

nsi

sten

t P-v

alu

es

in pa

ren

thes

es)

1Tabl

e 10

: Fin

ance

and

Gro

wth

, Ins

trum

enta

l Var

iabl

es:

198

0s

Depe

nden

t va

riabl

e: Pe

r capi

ta G

DP G

row

th, 1

980-

89

Re

gres

sion

equ

atio

nFi

nanc

ial i

ndic

ato

r in

regr

essi

on

LLY

BAN

KPR

IVAT

EPR

IVY

full

con

ditio

nin

g in

form

atio

n s

et

10.8

18.

509.

1114

.64

(0.09

5)(0.

025)

(0.00

8)(0.

013)

{1.28

}{2.

39}

{2.45

}{1.

28}

limite

d co

nditio

nin

g in

form

atio

n s

et

8.68

11.0

210

.77

12.1

8(0.

003)

(0.02

6)(0.

008)

(0.00

1)

{1.47

}{2.

47}

{3.15

}{2.

01}

{LM-te

st o

f ove

riden

tifyin

g re

stric

tion

s in

br

ack

ets}

(He

tero

sked

astic

ity Co

nsi

sten

t P-v

alu

es

in pa

ren

thes

es)

Table 11: Finance and Growth, Instrumental Variables: 1960

Dependent variable: Per capita GDP Growth, 1960-89Independent variable

1 2 3C 3.32 2.42 -0.03

(0.024) (0.160) (0.989)

LRGDP in 1960 -2.20 -2.43 -2.01(0.010) (0.004) (0.022)

LSEC in 1960 1.35 1.36 2.11(0.024) (0.010) (0.017)

GOV in 1960 3.13 3.72(0.651) (0.695)

PI in 1960 0.09 0.05(0.224) (0.520)

TRD in 1960 -0.73 -1.94(0.598) (0.373)

CIVL 0.69(0.141)

REVC 3.96(0.300)

ASSASS -1.30(0.215)

LLY in 1960 7.40 8.81 12.86(0.014) (0.007) (0.017)

LM-Test 0.57 0.20 0.01LM-test is distributed Chi-square. Critical values: 10% 2.71; 5%=3.84.Observations=36,35,35, respectively

(Heteroskedasticity consistent P-values in parentheses)Estimated using Generalized Method of MomentsInstruments: all right-hand variables excluding LLY60, plus CREDITOR ANDCONRISK

1Table 12: Finance and Growth, Alternative Instrumental Variables: 1960Dependent variable: Per capita GDP Growth, 1960-89

Independent variable1 2 3

C 3.99 3.27 2.39(0.000) (0.013) (0.119)

LRGDP in 1960 -1.89 -2.03 -1.65(0.003) (0.000) (0.001)

LSEC in 1960 1.38 1.31 1.52(0.002) (0.002) (0.010)

GOV in 1960 3.57 5.26(0.468) (0.321)

PI in 1960 0.06 0.04(0.247) (0.442)

TRD in 1960 -0.08 -0.62(0.936) (0.654)

CIVL 0.25(0.346)

REVC 1.72(0.473)

ASSASS -0.51(0.430)

LLY in 1960 5.27 5.31 5.60(0.013) (0.001) (0.003)

LM-Test 3.23 2.69 2.49Observations=36,35,35, respectivelyCritical values for LM-Test (5 d.f.): 10% = 9.24; 5% = 11.07 (Heteroskedasticity consistent P-values in parentheses)Estimated using Generalized Method of Moments

Instruments: all right-hand variables excluding LLY60, plus SECURED1, MANAGES, AUTOSTAY, and dummy variables for English, French, and German legal originGOV-Government consumption expenditures divided by GDP; PI=Rate of inflation;TRD=Ratio of exports plus imports to GDP; LLY=Financial Depth.

2Table 13: Banking and Growth with Alternative Instruments: 1976-1993Dependent variable: Per Capita GDP Growth, 1976-1993

Banking indicator in regressionsA. Basic Instruments

BANK-TO-PRIVATElimited conditioning information set 7.19

(0.001)

{0.383}

full conditioning information set 11.08(0.006)

{0.37}

B. Alternative Instruments

limited conditioning information set 6.00(0.001)

{1.52}

full conditioning information set 4.26(0.039)

{2.77}

{LM-test of overidentifying restrictions in brackets}(Heteroskedasticity consistent P-values in parentheses)

Critical values for LM-Test (5 d.f. for alternative instrument set): 10% = 9.24; 5% = 11.07Critical values for LM-Test (1 d.f. for basic instrument set): 10% = 2.71; 5% = 3.84Basic instrument set: The relevant conditioning information set plus CREDITOR and CONRISKAlternative instrument set: The relevant conditioning information set plus manages, secured1, autostay, and dummy variables for English, French, and German legal origin.number of observations: 40limited conditioning information set: other regressors include a constant,

logarithm of initial real per capita GDP and the logarithm of secondary school enrollment.full conditioning information set: other regressors include the limited conditioning information set, plus

government dividided by GDP, exports plus imports divided by GDP, and inflation.Bank-to-Private = Deposit money bank credit to the private sector divided by GDP

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