Market- vs. Bank-Based Financial Systems: Do Rights and Regulations Really Matter?

Abstract

Why are common-law countries market-dominated and civil-law countries bank-dominated? This paper provides an explanation tied to legal traditions. Civil-law courts have been less effective in resolving conflicts than common-law courts because civil-law judges traditionally refrain from interpreting the codes and creating new rules. Therefore, they are not very effective in extending their reach to matters that are not defined in the laws of the country. In a civil-law environment, where potential conflicts between borrowers and individual lenders inhibit the development of markets because the courts are unable to penalize defrauding borrowers, I show that banks can induce borrowers to honor their obligations by threatening to withhold services that only banks can provide. In other words, banks emerge as the primary contract enforcers in economies where courts are imperfect. Therefore, one would expect the civil-law countries to be bank-dominated. The empirical evidence presented in this paper supports this argument. Legal scholars argue that courts, acting as contract enforcers, need the guidance of laws to settle disputes. However, if there are alternative institutions in an economy, such as banks as described in this paper, that can enforce contracts without court intervention, I conjecture that there is relatively little need for investor rights compared to countries where the courts are the primary contract enforcers. In support of this argument, I show that creditor rights play no role in bank-development in civil-law countries but they promote banking growth in common-law countries where courts are more efficient. This paper also reveals that some of the earlier analyses that used a pooled sample of common-law and civil-law countries to test the effect of investor rights on bank development are misspecified. Therefore, in this analysis, common-law and civil-law countries are analyzed separately. I also show that prevailing economic conditions and legal traditions jointly determine the financial structure of a country. Therefore, although a country's legal tradition is permanent, the organization of its financial system may fluctuate over time between a bank-dominated structure and a market-dominated structure. These results agree with the findings of Rajan and Zingales (2000) who showed that France and Germany were more market-friendly than U.S. and U.K. at the turn of the 20th century.