Explaining the Effect of Financial Development on the Quality of Property Rights

Abstract

Recent empirical evidence suggests that financial development can catalyze property rights reforms, and for such effect to materialize financial development must cross a threshold. This paper offers a theory of financial markets to explain both stylized facts defining the relationship. The explanation is based on a simple trade-off between the costs and the benefits of securing property. Securing the right to property at a cost allows agents to post collateral against loans. However, the benefits of collateral vary according to the existing credit market conditions. We include this information in the trade-off between the costs and the benefits of securing property rights along the path of financial development to explain the conditions under which financial development can create incentives for better property rights institutions.