School of Economics, Finance and Management MSc Law and Economics (ECONM2027) Brief Notes on Law and Finance

1. Quick background on Legal Families

The two big legal families are: Civil Law Common Law

Primary features of civil law are: Origin based on Roman Law and Code Napoleon Historically concerned with preventing disorder extensive regulation to control it by ensuring judges follow the states objectives Developed in continental Europe Based on general abstract principles regardless of case Codified with detailed definitions

 Each rule sets out lengthy enumerations of specific applications or exceptions There are three sub families of civil law (French, German and Scandinavian)

Primary features of common law are: Origin based on traditional English Law Developed to control the power of the state (as represented initially by monarchy) Evolved in current form from 11th century onwards Doctrine of stare decisis (translation - stick to decisions, i.e., essentially precedent based) Based on reasoning from case to case Process of distinguishing (judges do not have to apply precedent if alleged precedent is significantly different from current case) Judge based law

English Common Law and French and German Civil Law have been exported throughout the world.

See Annex 1
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2. Is the distinction between the legal families significant and permanent? Balas, La Porta, Lopez-de-Silanes and Shleifer (2008 paper: The divergence of legal procedures) suggest that it is. See Annex 2, 3 and 4 (taken from their paper). They look at two examples: Bounced cheque Eviction of tenant. Uses seven measures to create an index of formalism they show that civil law has more formalism than common law. Their evidence (from 1950 onwards) shows no convergence if anything there appears to be divergence.

3. Legal origin theory Annex 5 gives La Porta, Lopez-de-Silanes, and Shleifers view of the relationship between legal origin and outcomes. Common law appears to give greater protection to outside investors and creditors relative to civil common law.

If true, what might be reasons? One strand goes back to strength of the state versus individual Another suggests that common law is better able to change to meet new situations

So what follows if it is true? Better protection leads to better developed financial markets. See Annex 6, 7 8 and 9. Less well documented but growing view that developed financial markets are good for growth. See Annex 10.
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 Ownership concentration is response to these differences in investor protection (the concentration of ownership is highest in civil law countries).

4. All the above is hotly disputed.

Specific criticisms include: Poor data Reverse causality Omitted variables Not what is written but the implementation of it See Annex 11

5. Two Alternative views 5a Endowments Theory There are arguments that it is the fundamental initial endowments that matter, e.g., Beck, Demirguc-Kunt, and Levine (2003) argue (using settler mortality and latitude as a proxy for initial endowments) that it is initial endowments that matter. See Annex 12, 13, 14, 15 and 16.

5b. Trust Franks et al (2008) disagree with underlying thesis about legal origin and claim that there is little evidence once one looks in detail. They claim dispersion came first (formal investor protection only emerged in the second half of the century), claiming 1948 was the key date and that there was little protection in UK at all until end of 1920s - yet there was significant dispersion of ownership at this time and one could argue that the biggest changes came before 1950.
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See Annex 17 They also claim protection came through statute not through common law. They claim the key issue is trust (arguing that local stock exchanges and shareholders distance from the company matter in creating trust). See Annex 18 and 19

References: (In each case you will probably need to press ctrl when you click) 1. The Economic Consequences of Legal Origins Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer Journal of Economic Literature 2008, 46:2, 285332 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1028081 Contains Annex 1, 5, 6, 7, 8, 9, 10.

2. Law, endowments, and finance Thorsten Beck, Asli DemirgucKunt, and Ross Levine. Journal of Financial Economics Volume 70, Issue 2, November 2003, Pages 137-181 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=321355 (click on NBER subscribers download)

Contains Annex 11, 12, 13, 14, 15 and 16.

3. Ownership: Evolution and Regulation, Julian Franks, Colin Mayer, and Stefano Rossi, in Review of Financial Studies (2008). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=354381

Contains Annex 17, 18 and 19.