The Composite Effect of Stock Markets, Bank Stability and Country-Level Institutional Factors on Leverage

Abstract

This paper analyzes the relation between firms' leverage, financial development and firm-level characteristics. I find financial development, measured as stock market turnover ratio or stock market capitalization, is negatively related to firm leverage while financial development, measured as the stability of a country's commercial banking system, is positively related to firm leverage. As stock markets become more developed, leverage decreases. This decrease is more pronounced for smaller firms as compared to larger firms. As banks become more stable, leverage increases and this increase is more pronounced for larger firms as compared to smaller firms. I also find that leverage is lower for firms in politically unstable and more corrupt countries. Conversely, firms are more levered in countries with stronger protection of creditor rights. A higher restrictiveness on foreign direct investment significantly increases leverage ratios of firms.