Franco Modigliani (MIT Sloan School of Management, Cambridge, MA 02139, USA) Enrico Perotti (University of Amsterdam and CEPR, Roeterstraat 11, 1018 WB Amsterdam, Netherlands)
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While excessive regulation is an obstacle to the development of financial markets, we argue that lack of basic rules or poorly enforced regulation may explain the relative importance across countries of banking and security markets in financing firms. A selective or arbitrary enforcement transforms legal rules into an exclusionary good; arm's length market exchanges become unreliable. As a result, transactions tend to become intermediated through institutions or concentrated among agents bound by some form of private enforcement. Provision of funding shifts from risk capital to debt, and from markets to institutions with long term relations.
Securities, as standardized arm's length contractual relationships, are most vulnerable to poor enforcement. We show that when small investors' rights are poorly protected, the ability of firms to raise equity capital is impaired, and as a result, profitable new ventures will be forsaken. This suggests a conflict of interest over regulatory standards between the controlling shareholders in listed firms and new entrepreneurs. More generally, fewer firms will be financed with outside equity, resulting in a low capitalization relative to GNP and a predominance of internal (unlisted) equity and bank lending over traded securities.
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Rafael La Porta & Florencio Lopez-de-Silane & Andrei Shleifer & Robert W. Vishny, 1997.
"Legal Determinants of External Finance,"
NBER Working Papers
5879, National Bureau of Economic Research, Inc.
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Other versions:
RAFAEL LaPORTA & FLORENCIO LOPEZ-de-SILANES & ANDREI SHLEIFER & ROBERT W. VISHNY, .
"Legal Determinants of External Finance,","
CRSP working papers
324, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
La Porta, Rafael & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, 1997.
" Legal Determinants of External Finance,"
Journal of Finance,
American Finance Association, vol. 52(3), pages 1131-50, July.
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