An Introduction to Islamic Finance: Theory and Practice

TABLE 17.2

Importance of institutions and legal framework for fi

nancial systems

Main Theoretical Arguments

Empirical Research

Institutions

Better protection of creditor rights increases the

breadth and depth of capital markets.

Laws and their enforcement infl

uence the extent

to which insiders can expropriate outside investors who fi

nance fi

rms. Credibly pledging

collateral reduces asymmetric information problems.

Shareholder and creditor

• rights indices (for 49 countries with publicly traded companies)

increase opportunities for external fi

nance (La Porta

et al.

1997a, 1998).

Creditor rights and law enforcement are also positively correlated with bank

development (Levine 1998, 1999), fi

rms’ ability to raise capital (Kumar

et al.

2001;

Beck

et al.

2003), effi

ciency of equity markets (Morck

et al.

2000), effi

ciency of

capital re

• allocation (Beck and Levine 2002; Wurgler 2000), corporate and bank

valuations (Claessens

et al.

2000, 2003; La Porta

et al.

2000) and ability to fund

faster

• growing fi

rms (Demirgüc

• Kunt and Maksimovic 1998), and fi

rms with less

collateral (Claessens and Laeven 2003).

Law enforcement and creditor protection also reduces credit cycles and currency and

banking crises (Johnson

et al.

2000; Galindo

et al.

2001, 2004; Boucher 2004).

Legal

framework

Alternative view: strict protection of creditor

rights (e.g. right to repossess collateral) might be ineffi

cient and may impede continuation

of effi

cient projects. Pro

• creditor rights reduce

risk

• taking incentives for entrepreneurs.
  Protection of creditors reduces their incentives to screen projects and to discourage investment by overconfi

dent entrepreneurs.

Legal framework and corporate governance: by

shaping fi

rms’ incentives, a weak protection

of creditor rights and weak law enforcement might encourage adoption of remedial rules, higher ownership concentration, and excessive reliance on tangible and liquid assets.

Extending La Porta

et al.

’s (2000) exercise by including additional macroeconomic

controls, Padilla and Requejo (2000) fi

nd that, although an effi

cient judicial system

improves the size and effi

ciency of the credit market, the effect of creditor protection

is inconclusive. By extending the sample (15 additional developing countries), Galindo and Micco (2001) fi

nd that the positive effect of creditor protection does

hold, even after controlling for macroeconomic variables.

Countries with weak laws and enforcement tend to introduce remedial rules such as

mandatory dividends and reserve requirements (La Porta

et al.

1998), display more

ownership concentration (Zingales 1994; La Porta

et al.

1998; Claessens

et al.

2000;

Himmelberg

et al.

2000; Roe 2000; Caprio

et al.

2003; Dyck and Zingales 2004),

and invest more in tangible assets (Claessens and Laeven 2003) and liquid assets (Pinkowitz

et al.

2003).

Other institutions

(trust or social capital)

Trust: increasing the perception that others will

cooperate facilitates cooperation in large and impersonal markets.

Social capital and fi

nancial development are strongly connected in Italy

, according to

household data (Guiso

et al.

2000). Beyond Italy (in a sample of 48 countries), trust

is positively correlated with the size and activity of fi

nancial intermediaries, bank

effi

ciency

, and stock and bond market development (Calderón

et al.

2001).

Source: Fergusson (2006).

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