Using a sample of 49 countries, we show that countries with poorer investor protections, measured by both the character of legal rules and the quality of law enforcement, have smaller and narrower capital markets. These findings apply to both equity and debt markets. In particular, French civil law countries have both the weakest investor protections and the least developed capital markets, especially as compared to common law countries.
Why do some countries have so much bigger capital markets than others? Why, for example, do the United States and the United Kingdom have enormous equity markets, while Germany and France have much smaller ones? Why do hundreds of companies go public in the United States every year, while only a few dozen went public in Italy over a decade (Pagano, Panetta, and Zingales (1995))? Why do Germany and Japan have such extensive banking systems, even relative to other wealthy economies? If we look at a broader range of countries, why in fact do we see huge differences in the size, breadth, and valuation of capital markets? Why, to take an extreme example, do Russian companies have virtually no access to external finance and sell at about one hundred times less than Western companies with comparable assets (Boycko, Shleifer, and Vishny (1993))?
In our earlier article (La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1996), henceforth LLSV (1996)), we have conjectured that the differences in the nature and effectiveness of financial systems around the world can be traced in part to the differences in investor protections against expropriation by insiders, as reflected by legal rules and the quality of their enforcement. We presented evidence indicating that legal rules protecting investors and the quality of their enforcement differ greatly and systematically across countries. In particular, these rules vary systematically by legal origin, which is either English, French, German, or Scandinavian. English law is common law, made by judges and subsequently incorporated into legislature. French, German, and Scandinavian laws, in contrast, are part of the scholar and legislator-made civil law tradition, which dates back to Roman law (David and Brierley (1985)). Most countries have adopted their legal systems through occupation or colonization by one of the European powers to which they owe the origin of their laws. Some other countries, such as those in Latin America, have adopted their legal systems after attaining independence, but have still typically chosen the laws of their former colonizers.