Abstract: New research suggests that cross-country differences in legal origin help explain differences in financial development. This paper empirically assesses two theories of why legal origin influences financial development. First, the “political ” channel stresses that (i) legal traditions differ in the priority they give to the rights of individual investors vis-à-vis the state and (ii) this has repercussions for the development of property rights and financial markets. Second, the “adaptability ” channel holds that (i) legal traditions differ in their ability to adjust to changing commercial circumstances and (ii) legal systems that adapt quickly to minimize the gap between the contracting needs of the economy and the legal system’s capabilities will foster financial development more effectively than would more rigid legal traditions. We use historical comparisons and cross-country regressions to assess the validity of these two channels. We find that legal origin matters for financial development because legal traditions differ in their ability to adapt efficiently to evolving economic conditions.

Prize winners disagree about the impact of the financial sector on economic growth. Some do not even consider finance worth discussing. A collection of essays by the “pioneers of development economics”—including three winners of the Nobel Prize in Economics—does not discuss finance (Meier and Seers, 1984). At the other

Major currency areas are characterized by important differences in financial structure that are clear in microeconomic data. Surprisingly, this fact is seldom discussed in the analysis of the international transmission of shocks. This paper attempts to fill this gap. First, I examine some stylized facts about financial diversity and cyclical correlations among OECD countries. Data show a negative relation between cyclical correlations and differences in financial systems. Second, using a two-country model with sticky prices, imperfect financial integration and borrowing constraints on investment, calibrated to US and euro area data, I analyze the international transmission of shocks with different degrees of financial fragility in the two economies. I find, first, that financial diversity can account for heterogenous business cycle fluctuations and reproduce the negative relation found in the data. Differential responses to shocks are shown to occur with independent monetary policies- Taylor rules or rigid inflation targets-. The result is robust under different degrees of economic and financial openness and of correlation of underlying shocks. Credible pegs help to increase synchronization of cycles. The model is successful in accounting for some international business cycle facts, like the output correlations

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We present a model of endogenous lobby formation in which wealth inequality and political accountability undermine both entry and financial development. Theelitewillseekalowerlevelofeffective minority protection than the middle class to prevent potential entrants from raising financing. The elite wins because its lobby can promise larger political contributions due to the higher rents earned by restricting entry. Entry and investor protection improve when wealth distribution becomes less unequal, and the political system becomes more accountable. Evidence across 48 countries indicates that greater accountability and lower income inequality are associated with stronger legal enforcement, even after controlling for legal origin and per-capita income. Moreover, greater political accountability increases entry in external capitaldependent industries; its inclusion makes financial development insignificant. These results suggest that lobbying protects established interests by creating entry barriers and undermining legal enforcement.

The emergence of the euro area posed new questions concerning the effects of monetary policy and the transmission of shocks among countries characterized by financial differences that are still evident in country data. Macro data show that convergence in the euro area is increasing but still not complete. I build a two-region model characterized by imperfect financial integration and differences in financial markets. Financial differences are modeled in the form of asymmetric access to credit for investment due to institutional features which are calibrated on European countries data. I evaluate the impact of monetary policy shocks under three regimes: common monetary policy, independent monetary policies and unilateral hard peg- i.e. which I label accession country regime. A differential transmission mechanism emerges but asymmetric dynamics are less pronounced under the currency area regime as opposed to the independent policies regime. A unilateral hard peg is able to reproduce the co-movements generated under the currency area regime. The transmission mechanism of shocks is deeply enriched by the presence flight to quality effects- i.e. flows of capital toward the country with more profitable investment opportunities.

Foundation for Economics and Law and The Jan Wallander and Tom Hedelius Foundation. He would also like to

This dissertation investigates the process of financial development in low-income economies. Corporate finance theory states that in an emerging market--an institutional environment characterized by high agency costs, poor minority shareholder protection and ineffective legal enforcement--firms will be reluctant to issue equity. Yet, large corporations in developing countries rely heavily on new issues to finance investments. My thesis will resolve this conflict between theory and empirical reality by considering the role of politics in the formation of financial policy. I present a model in which special interest groups use political pressure to influence the government’s choice of financial policy, which in turn affects the firm’s choice between bank debt and equity. This model will explain stylized facts about the process of financial liberalization in emerging markets. Using firm level data, I will study the structure of financial policy that emerges in the political equilibrium and the incentives of different interest groups to support a particular policy outcome. A Dynamic Theory of Financial Development

There is a growing policy interest in the role of financial structure in promoting development. However, very little is known about how different financial structures emerge and evolve. In this paper we empirically assess the political origins of financial structure. Using difference-in difference estimation and annual data, we study the effects of democratization on financial structure in a sample of 96 countries covering the period 1970 to 2005. Democratization here corresponds to the event of becoming a democracy. We find that democratization leads to a more market-based financial system. Democratic change could also be incremental rather than a one off. To identify the causal effect of incremental democratic change on financial structure we estimate a separate model and find that democracy matters. We also find that countries with substantial democratic capital are more likely to have a market-based financial structure. Our main results are robust to a variety of controls, instrumental variable estimation using commodity price and rainfall as instruments, Arellano-Bond GMM estimation, alternative measures of democracy and financial structure, and across different samples.