Legal Institutions, Corporate Governance and Aggregate Activity: Theory and Evidence

Abstract

This paper investigates the interaction between legal institutions and financial arrangements and the effects that these have on corporate decisions and aggregate activity, both theoretically and empirically. We develop a two country general equilibrium model with overlapping generations and asymmetric information in the credit market. We show that, at the steady state equilibrium, firms located in the country providing tighter legal enforcement to the creditors' rights receive a larger amount of external finance at a lower price and have a larger size. While these results rationalize some recent empirical evidence in the corporate finance literature, we obtain a new result for the leverage ratio that we show to be independent of the quality of legal institutions (i.e. it is the same across firms located in the two countries). At the aggregate level, we show that countries with higher creditors' protection enjoy a larger aggregate output level and a bigger capital stock. The driving force behind our results is that improvements in the legal protection of creditor rights to repossess a collateral asset, increase the investment rate of return, by tempering the inefficiencies due to asymmetric information. In the empirical part, we provide evidence that confirms our theoretical predictions by using new data sets at firm and regional level for Spain and Italy. Unlike the already existing literature, we proxy the degree of legal enforcement by using statistical information on the performance of judicial districts, i.e. measures based on the number of backlogs, the number of concluded trials and the average length of trials.