Law and finance in transition economies

This paper offers a first comprehensive analysis of legal change in shareholder and creditor rights protection in transition economies and its impact on the propensity of firms to raise external finance. The paper uses the investor rights indices developed by La Porta et al. (1998) as a starting point, but expands them to capture a greater range of potential conflicts between different stakeholders of the firm.It supplements the analysis of the law on the books with an analysis of the effectiveness of legal institutions (legality). For assessing financial market development we use common measures of stock and credit market development. We find that external finance is still very underdeveloped in transition economies, despite legal change that has substantially improved shareholder and creditor rights. The only legal index with a significant positive impact on capital market development is the index that codes securities legislation (SMINTEGR). There is also some indication that credit market development benefited from improvements in the law on the books. The effectiveness of legal institutions (legality) has a much stronger impact on external finance than the law on the books. This is true especially for debt, but also for equity finance. This finding contrasts with studies in market economies showing that the quantitative effect of the law on the books is greater than legality at least for capital market development (La Porta et al. 1997; Levine 1998). Instead, it supports the proposition that legal transplants and extensive legal reforms are not sufficient for the evolution of effective legal and market institutions (Berkowitz, Pistor and Richard, 1999).