1

Law and Finance in Transition Economies1

Stefka Slavova2

The World Bank 1818 H Street

Washington, D.C.,

and

Department of Economics London School of Economics and Political Science

Houghton Street, London WC2A 2AE, United Kingdom

1 I would like to thank Professor Charles Goodhart for his dedicated supervision, useful comments and practical guidance. I have also benefited from discussions with David Bernstein, Vicente Cunat, Simeon Djankov, Niko Matouschek, Anita Ramasastry and Jian Tong. Many thanks to participants in the CEPR Annual Transition Economics Summer Workshop for Young Academics, Budapest, May 1999. Thanks also go to participants in the LSE PhD Seminar in Economics, February 2000 as well as to participants in the Young Economists' Conference, 5th Spring Meeting of Young Economists, Oxford University, March 2000. I am also grateful to the Office of the General Counsel of the European Bank for Reconstruction and Development for providing me with excellent research opportunities. This research was undertaken with support from the European Union's Phare ACE Programme, Contract P96-7118-S. 2 Mailing address: Mail stop MC 9-903, Financial Sector Strategy and Policy, The World Bank, 1818 H Street, N.W., Washington, D.C., 20433, U.S.A., Tel: (+1 202) 473 2464, Fax: (+1 202) 522 2031, E-mail: sslavova@worldbank.org

2

Law and Finance in Transition Economies

Abstract Legal and financial systems are interrelated. We argue that the quality of financial law and its enforcement matter for the relative size and volume of stock markets and credit markets in the economies in transition. Using a sample of 21 countries from Central and Eastern Europe and the former Soviet Union, we determine that the effectiveness of laws, governing banking activities, is a statistically significant determinant of the ratio of bank credit to the private sector to GDP. For a sample of 19 transition economies we find that both extensiveness and effectiveness of securities laws and regulations are statistically significant determinants of stock market capitalization and stock market turnover. Journal of Economic Literature Classification Numbers: G28, K12, K22, P34. Key Words: Bank Credit; Stock Market Capitalization; Financial Regulation; Legal Rules; Legal Enforcement; Transition Economies.

3

1. INTRODUCTION

The majority of crises in transition economies are financial in their origin and

nature - failing banks, pyramid deposit schemes, collapsing investment funds. They span

from lack of investor protection to cases of sheer fraudulence. Economists and legal

scholars alike have long maintained that law is essential for sound finance. Consequently,

legal reform has occupied an integral part of political transition in Eastern Europe and

governments across the region have been delegated the laborious task of enacting new

legal rules, supportive of a market economy.

An established theoretical view is that the availability of external finance (both

equity and debt) to a country's private sector is positively correlated with the quality of

legal investor protection. 3 The main purpose of this paper is to establish whether the rule

of law determines the availability of finance to investors in transition economies.

External finance has generally been very tight in transition economies over the

last ten years. Compared to other countries with similar levels of per capita GDP the

transition economies have much lower ratios of private credit to GDP. Several

explanations of this outcome have been put forward in the literature on corporate finance

in transition. According to one of them bank lending to state-owned enterprises crowds

out lending to the private sector.4 For example, functioning banks and stock markets were

virtually non-existent at the outset of reforms in the early 1990s. At that time

liberalization of financial services and privatization gave rise to over-abundance of banks

in most of these countries. However, many of these banks continued to openly or covertly

finance their old clients - debt-ridden state-owned enterprises.

A second explanation for the low levels of private bank credit is the outstanding

stock of bad loans on banks’ balance sheets. The problem of bad loans, accumulated from

the past, was largely resolved at the beginning of transition, when many of these loans

were written off bank balance sheets or replaced by long-term government bonds or

inflation depreciation kicked in. Despite these measures, bank credit remained generally

tight, and enterprises had to resort to other forms of financing, notably through

3 See for example La Porta et al. (1997). 4 Perotti (1993) builds a model of bank lending, which explains this type of behavior.

4

accumulation of wage, tax and payment arrears and increased use of barter and trade

credit. Even to this date, the bias towards lending to state-owned enterprises, or for

politically-motivated reasons is substantial in many transition economies.

Thirdly, weaknesses in corporate governance and banking supervision create

ample opportunities for asset-stripping both in the banking and corporate sector in

transition, and thus necessitate review of the legal and financial interactions in transition.

Despite the growth of the private firms in these countries, external finance has been

largely unavailable, as documented in Pistor, Raiser and Gelfer (2000).

Fourth, the reasons for lack of external finance to private enterprises have been

linked with the method of privatization. The corporate sector in these countries has

undergone dramatic changes during the transition period. But the very nature of

privatization has proved an obstacle to bank lending. Privatization of state enterprises has

been constrained by insiders, who had assumed effective control in the years immediately

preceding and following the collapse of Communism. Powerful entrenched managers

have thus made external investors wary and finance has been scarce. This in itself

reinforces the bad equilibrium of no restructuring and asset stripping. Thus, bank finance

and stock market development are linked to the patterns of corporate ownership and

control, which have emerged as a result of privatization. In a quantitative survey of the

literature on enterprise restructuring in transition, Djankov and Murrell (2000) discuss

both corporate and bank ownership issues and institutional factors. For example, they

summarize one of the findings of the literature: weak corporate governance results in

higher ownership concentration, which in turn limits the sources of external financing.

Also, they quote evidence that state ownership of banks in transition is the critical factor

for persisting soft budget constraints.

Obviously, the interest in law and finance developments in the transition

economies is also generated by a series of banking crises that have gripped almost each of

them in recent years. Albania, Bulgaria, Croatia, the Czech Republic, Russia all had their

share of banking troubles. Perotti and Sgard (1999) present an interesting overview of the

mechanics of the Russian crisis in the summer of 1998. Their study stresses that the

Russian meltdown was the result of perverse individual incentives built on a system of

weak legal enforcement. The overwhelming incentive to strip cash out of old and new

5

Russian banks and firms led to a high outflow of capital, and the banks were both a major

channel and a leveraging tool which fed the flow. So contrary to the belief that the crisis

was triggered by the government default and devaluation due to inability to raise taxes,

the main reason for the banking collapse is thought to be the system of perverse, albeit

rational incentives to strip cash and send it abroad. The latter was generated by the failure

of the Russian institutional environment: poor enforcement of laws and lack of protection

of property rights. If property rights are not protected, then rational agents adopt short-

term strategies: ignoring payment obligations, appropriating any cash and immediately

transferring it abroad. Perotti and Sgard (1999) argue that both the banks and the

government debt market in Russia before the crisis turned into two pyramids, leaking any

assets out as capital flight, and leaving behind liabilities and empty boxes. To a large

extent, the unrestricted power of bank and firm managers and the size of related party

lending caused the ultimate collapse.

In order to answer whether legal text and enforcement explain financial structure

in transition, we test whether laws governing banking and securities markets, and

currently in operation in the region, and in particular the quality of their enforcement,

have any significant bearing upon the volumes of overall private sector bank debt and

equity finance in the 26 economies in transition. We use a cross-section of relevant

aggregate economic data and indices of extensiveness and effectiveness of financial laws

in the region, based on a survey carried out among local law firms, specializing in

financial laws and based in the transition countries.5 The number of participating law

firms varies among countries – from 20 for Russia to 2 for Armenia. The respondent law

firms were identified by the General Counsel Office of the EBRD and their participation

was on a voluntary basis.

2. RECENT LITERATURE

The present paper contributes to the analysis of financial markets and legal

enforcement in transition and follows the methodology, developed in La Porta et al

(1997, 1998). The main argument in La Porta et al (1998) is that control rights attached to

5 For a more comprehensive analysis of the survey, its methodology and results see Ramasastry and Slavova (1999).

6

securities, are what managers and entrepreneurs give up in order to get finance. However,

these rights are not intrinsic. They are shaped and depend on the legal rules of the

particular jurisdiction where they arise. The concept of legal rules has two equally

important dimensions: law text or content and law enforcement. Law text and law

enforcement are what determines investor protection, which in turn drives the patterns of

corporate finance. Therefore we might reasonably expect that differences in legal

protections of investors could explain why firms are financed and owned so differently in

different countries and legal regimes. The authors test this conjecture by conducting a

comparative econometric study of investor protection and financial structure in a cross-

section of 49 countries around the world. Their main findings are that legal origin is a

significant determinant of shareholder and creditor rights. The main focus is on legal text

as the indices of shareholder and creditor rights are constructed on the basis of existing

commercial laws. Legal enforcement is also considered by compiling an index, based on

several estimates from the International Country Risk Guide, and poor enforcement is

found to accompany poor laws.

La Porta et al have built on their original work (first published in 1996) and using

the original sample of 49 countries, have produced an empirical paper, which tests

whether legal norms and enforcement have a bearing on capital structure – La Porta et al

(1997). After controlling for size of the economy and its growth, the rule of law, legal

origin and shareholder and creditor rights are found to be significant determinants of

external stock market capitalization and domestic bank credit to the private sector. Thus

legal text is found to affect external finance in developed market economies. Both studies

exclude transition economies from the analysis.

A recent paper by Glaeser, Johnson and Shleifer (2001 – QJE, forthcoming)

focuses on securities laws and regulations in two transition economies - Poland and the

Czech Republic. The authors draw a comparison between the two countries in terms of

their securities market regulation in the 1990's. They argue that government regulation of

capital markets may be preferable to private enforcement in the presence of a weak

judiciary. The authors find that stringent capital market regulations in Poland (as

encompassed in its company and securities laws) have stimulated the development of the

stock market and led to many new firms to go public. In contrast, the lax and poorly

7

enforced capital market regulations in the Czech Republic have brought about stagnation

of the stock market, delisting of a lot of privatized companies and practically no new

listings. There has in addition been rampant expropriation of external investors. Thus, the

study of only two transition economies argues that both the provisions and enforcement

of securities laws matter, and that government regulation of securities markets can be

desirable when legal enforcement is poor. In the present paper we shall be talking of both

legal norms and prudential regulations, so in that respect the attempt to look at regulation

both theoretically and in terms of the above example is very encouraging.

Berglof and Von Thadden (1999) look at the policy lessons and implications of

the La Porta et al (1997) findings for transition and developing economies. They suggest

that in an environment of strong firm insiders and inadequate judicial enforcement legal

text is likely to matter less. However, an example of the Russian corporate law, implies

that legal text in fact matters. Their argument is that strengthening bank regulation should

receive more attention in transition economies than stock market development.6

The link between legal text, legal enforcement and finance in transition

economies has been explored by Pistor, Raiser and Gelfer (2000). The authors use coded

data for shareholder and creditor rights, based on laws on the books from 1992 to 1998.7

They follow the basic approach of La Porta et al (1998) in constructing indices of

shareholder and creditor rights, and extend these indices to cover some aspects of

shareholder protection of particular concern to transition countries.8 The authors also use

6 Enforcement of contracts in transition has been the main theme of several papers. Johnson, McMillan and Woodruff (1999) focus on the means of contractual enforcement in five transition economies. Using a survey of enterprises the authors find that relational contracting is more frequently used than courts. Hendley, Ickes, Murre ll and Ryterman (1997) also survey enterprise officials in Russia. The questions concern secured lending, contract law, competition law and internal governance. They conclude that responses indicate little use of law as legal institutions are considered ineffective. Recent work by Hendley, Murrell and Ryterman (1998), based on new Russian enterprise survey data, seems to contradict their earlier findings. Somewhat surprisingly, the survey responses reject the commonly-held view that courts in Russia are used seldom and that very often agents resort to private enforcement (Mafia) instead. 7 The methodology of the codification of shareholder and creditor rights in the transition economies as well as an extensive analysis of the changes in their corporate laws is provided in Pistor (2000). 8 For example, they add to the LLSV shareholder index measures of VOICE and EXIT. The former refers to corporate control within the company and comprises all the LLSV shareholder rights measures plus other measures of the ability of shareholders to assert their control over the management. The latter pertains to the rights of shareholders to liquidate their holdings in a company when dissatisfied with the way it is managed. In addition the authors use ANTIMANAGE and ANTIBLOCK indices to determine how the legal system deals with the conflicts between management and shareholders, and blockholders and minority shareholders. For instance, cumulative voting rights, pre-emptive rights of current shareholders in case of

8

an index of stock market integrity (SMINTEGR), which covers not the individual

protection of shareholders but rather captures the presence of legal rules on insider

dealing, on an independent share registry and stock market supervision. Our variable of

stock market legal extensiveness is very similar in essence to their stock market index,

and later we report a high degree of correlation between our measures and SMINTEGR.

In the same manner, the authors augment the traditional LLSV creditor rights index. They

include measures of creditor control of the bankruptcy process, of the existence of

collateral lega l rules, and of remedies afforded to shareholders to impose sanctions on the

management ex-post.

In addition to the indices of creditor and shareholder protection Pistor et al. (2000)

employ also three alternative measures of legal effectiveness – the rule of law index

published by the Central European Economic Review, the EBRD survey-based index of

corporate and bankruptcy law (which is derived on the basis of the EBRD Legal Indicator

Survey, used for all the legal variables in our paper), and an enforcement index based on

the World Business Environment and Enterprise Performance Survey for 20 transition

economies. The econometric analysis of both stock market and banking development

reveals that legal enforcement, but not legal text, is statistically significant for explaining

stock market and private credit volume. Unlike in La Porta et al (1997) legal text in

transition is found not to affect external finance.

A related paper by Claessens, Djankov and Klingebiel (2000) focuses only on the

determinants of stock market development in the transition economies. The authors

conduct OLS regression analysis, and after controlling for income per capita and

geographical distance to Western Europe, establish that low levels of inflation, adequate

shareholder protection and the size of institutional investor assets are all significant

determinants of stock market capitalization and turnover.

In the present paper we would like to empirically test how the quality of banking

and securities laws affects the volumes of credit to the private sector and the stock market

capitalization and turnover in a sample of 26 transition economies. In short, we are

testing the La Porta et al (1997) predictions for the countries in transition. The present

new share issues, quorum requirements are all examples of indicators, ascertaining the rights of minority shareholders when strong blockholders are present.

9

study differs from Pistor et al (2000) in that it utilizes survey-based legal data, whereas

their paper employs measures of legal investor protection, derived from coding the

written laws in 24 transition economies.

The paper is organized as follows: Section 3 presents the data and discusses some

of the survey results used to quantify legal rules and enforcement regarding financial

institutions. The main regression results are presented in Section 4. Section 5 concludes.

3. DATA

3.1 Description of Economic Variables

We use as dependent variables measures of stock market and banking

development. One of the dependent variables we use is stock-market-capitalization-to-

GDP ratio for 1998. This is a frequently used measure of stock market development in

the related literature. Market capitalization data are for 1999 and are taken from the 2000

EBRD Transition Report.9

A second measure of stock market development is market turnover - the value of

traded shares divided by market capitalization. We employ a measure of stock market

turnover for 1999 from Claessens et al (2000).

For a measure of debt finance we use domestic bank lending to the private sector

as percent of GDP for 1999. These data are available in the IMF's International Financial

Statistics (August, 2000) for all the economies in question with the exception of Bosnia

and Herzegovina, Tajikistan, Turkmenistan and Uzbekistan. For 1998 there are no

available private credit data for Georgia too.

As control variables in the regressions we use the growth of real GDP, average

inflation over the past six years and the number of years spent under communism. Real

GDP growth is average real GDP growth for 1996, 1997 and 1998 and the data come

from Transition Report 1998. Average inflation is defined as the average annual rate of

inflation over the period 1994-1999, and is based on the IMF's International Financial

9 La Porta et al (1997) exclusively look at externally raised finance by introducing a correction of market capitalization for the average fraction of insider-held equity. We do not correct for insider-raised finance for lack of data.

10

Statistics. Finally, data on years under communism are taken from Fischer and Sahay

(2000). The reasons for choosing these variables are set out briefly later in section 4.1.1.

These are the main economic variables we use in the OLS estimations. Now we

turn to our legal variables and the way they were generated.

All economic variables are presented in Table A in the Appendix.

3.2 Description of Legal Variables and EBRD Survey Results

The legal measures we use to assess the strength and viability of equity and debt

markets in Eastern Europe and the former Soviet Union are generated through a survey,

constructed by EBRD experts10 and run in the summer of 1998 as part of the work on the

Transition Report 1998 and then run again in June and July 1999 for the legal analysis in

Transition Report 1999. Therefore we have legal data on financial institutions in

transition economies for both 1998 and 1999.

As we briefly mentioned before, the participating law firms were identified by the

EBRD. Almost all of them are domestic law firms, and only in a limited number of cases

respondents were branches of foreign law firms, operating in the respective country. 11

Each country’s participating law firms were asked to fill the survey for their own

jurisdiction. They received the survey questionnaires in hard copy (and by fax or

electronically in some cases) and were asked to return the completed questionnaires by

fax to the EBRD. All respondents received instructions and sample answers to a few

questions. The number of participating law firms varies across countries, and reflects

country size and legal industry development. We show the number of law firms for each

country in Table 1.

There are two main dimensions to the quality of law in a given country which we

define as extensiveness and effectiveness. Essentially, extensiveness refers to what other

authors call rule-of- law or law-and-order. It is a measure of the presence of certain legal

norms deemed fundamental for the functioning of any legal system and in a sense gauges

the extent to which financial laws have been passed in transition countries. Effectiveness

10 The main contributor towards constructing the EBRD Legal Indicator Survey and its methodology is Anita Ramasastry.

11

on the other hand captures the essence of law enforcement or implementation. We often

find, even in relatively developed legal systems, that while laws may well exist, they are

not enforced for a number of reasons - courts are weak, agents prefer a private

arrangement, the law is outdated and business practice has evolved ways to go around it,

etc. So effectiveness here stands for enforcement. In accordance with this theoretical

distinction, we are using two indices, derived from survey responses, called EXT99 and

EFF99, which respectively measure the perceptions of legal practitioners in the transition

economies about the quality and existence of financial legal rules and the quality of their

enforcement. It must be stressed that the above indices are lumping together laws

pertaining to banks and stock markets in evaluating both extensiveness and effectiveness.

As our aim is to differentiate between stock market and banking sector development, we

employ a split version of the above two measures, which we term EXTBANK99,

EXTCAP99, EFFBANK99 and EFFCAP99. Thus, we can test how banking regulatory

norms and their implementation affect the banking industry and how much credit to the

private sector it generates, and how capital market rules and their implementation affect

stock market size and volume.

We focus on two parts of the 1999 EBRD Legal Ind icator Survey, namely

Banking and Stock Markets, which are used to derive the above legal measures.

Questions in both parts are roughly similar in number (33 for Banking, 26 for Stock

Markets) and can be related to mainly extensiveness, mainly effectiveness, or in some

cases parts of a question may be extensiveness-related, and parts of it - effectiveness-

related. Each question carries a maximum weight of 1. Many survey questions are

composed of several sub-questions. In this case the sub-question weights are chosen in

such a way as to rank the possible outcomes or combinations of outcomes, and these

intra-question weights sum up to one. Most effectiveness questions are scored, using a

scale of 1 to 5, and are also afforded a maximum score of 1. We have assigned a ranking

to this discrete scale, such that 1 carries a value of 0, 2 translates into 0.25, 3 into 0.5, 4

into 0.75 and 5 into 1 in all cases. Our final scores are in percentage terms – in all cases

we estimate what percentage of the maximum score the country achieves.

11 No respondent law firms from Bosnia and Herzegovina, Tajikistan and Turkmenistan were identified in 1999, and are excluded from our analysis.

12

Obviously, only questions or sub-questions, which relate to extensiveness of banking

laws and regulations, are captured in the EXTBANK99 index and so on. The overall index

is a simple weighted average of all question scores. Potentially a country can achieve the

absolute maximum, however only the U.S. receive a 100 % score for its overall financial

law extensiveness and effectiveness. We checked the performance of the U.K. and

Canada as two other benchmark countries in terms of financial laws and regulation and

they also scored high - around the 90 % mark. Therefore, when we say that Croatia scores

51% on stock market legal effectiveness, this means that Croatian lawyers perceive

Croatia as having 51% of the perceived stock market legal effectiveness of the United

States.

As tricky as constructing surveys and indices can be, we are quite confident about

the quality of the results. Both extensiveness and effectiveness have a high coefficient of

variation and they seem to reflect well the various stages of legal reform across countries.

We have tabulated the individual stock market question scores by country in order

to highlight cross-country variation in overall survey scores. Table 1 gives the individual

question scores. The table reports the survey results for 23 countries. However, several of

them have not developed stock markets and are omitted from our econometric analysis.

These are Albania, Azerbaijan, Belarus and Georgia. Next, we report some descriptive

statistics for individual stock market survey question scores only for the 19 countries in

our sample.

For example, if we look at the question on the enforcement powers of the

regulator we do not see significant cross-country variation. Indeed, many enforcement

powers are afforded to securities regulators. The mean of the question scores is 0.76 and

the standard deviation is 0.17. However, when we consider the effectiveness component

of this question, namely whether the regulator has undertaken any oversight or

enforcement action in the past 5 years, we find that scores are lower on average and vary

more: mean of 0.58 and a standard deviation of 0.28. In the same manner, all countries in

our sample have a Securities Regulator – mean of 0.96 and a standard variation of 0.08.

But the effectiveness question on the presence of a Regulator – i.e. whether the Regulator

has the ability to conduct on-site examinations scores lower on average and the scores

display higher variation (mean=0.77, s.d.=0.15). Again, virtually everywhere brokers and

13

dealers are regulated (mean=0.96, s.d.=0.06), but the question whether broker licenses

have been revoked in recent years scores much lower, and brings out more pronounced

differences among countries (mean=0.39 and s.d.=0.16). A high degree of variation

among the countries in our sample stems from whether the law imposes a mandatory use

of international accounting standards (question score mean is equal to 0.35 and the

standard deviation is 0.36). Insider dealing questions also reveal interesting cross-country

patterns. However, the extensiveness question on insider dealing has a higher degree of

variation than the effectiveness one, and as expected, higher scores on average. Thus,

most countries in the sample have laws prohibiting insider dealing (mean of 0.80,

s.d.=0.20), although there are notable exceptions like Kyrgyzstan and Ukraine. Still,

countries differ more in terms of presence of an insider dealing law than as to the way

this law is enforced. For instance, the question as to how often the Regulator has

undertaken enforcement action against instances of insider dealing displays much lower

scores on average and with lower variation (with a mean of 0.34 and a standard deviation

of 0.15). This probably reflects the fact that even in countries that do have explicit anti-

insider dealing laws, these laws are seldom enforced. Information provision laws also

exist across the sample region – thus the extensiveness question on the mandatory

disclosure of financial results by listed companies displays a highe r mean and lower

standard variation than the corresponding effectiveness question on how often such

disclosure is effected. By and large, most of the stock market survey questions display a

sufficient degree of variation among countries, and we observe lower average scores on

effectiveness compared to extensiveness questions. In addition, countries vary more in

terms of the effectiveness questions, although differences in variation between

extensiveness and effectiveness questions are sometimes negligible.

14

Table 1

Cross-country comparison of individual survey question scores for stock markets

Questions on Stock Markets

Alb

ania

Arm

enia

Aze

rbai

jan

Bel

arus

Bul

gari

a

Cro

atia

Cze

ch R

epub

lic

Est

onia

FYR

Mac

edon

ia

Geo

rgia

Hun

gary

Kaz

akhs

tan

1. Securities laws amended or new ones enacted 1.00 1.00 1.00 1.00 0.94 0.89 1.00 1.00 1.00 1.00 1.00 1.00 2. Presence of a regulator of securities operations 1.00 1.00 1.00 1.00 0.88 1.00 1.00 0.86 1.00 1.00 1.00 1.00 3. Ability of regulator to conduct on-site examinations and whether it regulates shares and bonds issues

0.94 0.50 0.28 1.00 0.84 0.69 0.90 0.79 1.00 1.00 0.95 0.90

4. Other mechanisms for trading of securities 0.06 0.50 1.00 0.25 0.36 0.44 0.62 0.50 0.42 0.17 0.63 0.80 5. Listed companies required to provide disclosure of fin. results 1.00 1.00 0.67 1.00 0.81 0.89 0.92 1.00 0.67 1.00 1.00 1.00 6. How often is such information provided 0.50 0.25 0.25 0.50 0.56 0.72 0.56 0.82 0.50 0.25 0.71 0.65 7. Mandatory use of international accounting standards 0.46 0.00 0.00 0.00 0.17 0.76 0.06 1.00 1.00 0.33 0.60 0.33 8. Functioning clearance and settlement system for shares and bonds 0.13 1.00 0.50 1.00 0.63 0.44 0.77 1.00 0.67 0.33 0.81 0.60 9. Type and form of information to be filed with Regulator prior to selling securities

0.88 0.63 0.75 0.63 0.74 0.77 0.86 0.82 0.75 0.88 0.77 0.95

10. How often does the Regulator review filed information before public offerings 1.00 0.50 0.67 0.75 0.72 0.83 0.65 0.75 0.75 0.67 0.75 1.00 11. Enforcement powers of the Regulator 0.88 0.65 0.11 1.00 0.71 0.64 0.85 0.58 0.49 0.88 0.93 0.53 12. Has the Regulator undertaken any oversight or enforcement action in the last 5 years

0.21 1.00 -0.11 1.00 0.58 0.54 0.68 0.40 0.22 0.33 1.00 0.37

13. Insider dealing prohibited 0.75 1.00 0.33 1.00 0.75 0.89 1.00 0.86 0.67 1.00 1.00 0.60 14. Types of normative acts prohibiting insider dealing 0.25 0.20 0.13 0.20 0.25 0.36 0.46 0.54 0.27 0.33 0.55 0.20 15. How often does the Regulator use enforcement powers against insider dealing 0.19 0.25 0.00 0.50 0.17 0.39 0.35 0.25 0.42 0.33 0.56 0.50 16. Presence of a functioning stock exchange 0.25 1.00 0.00 -0.17 0.80 1.00 1.00 1.00 1.00 0.33 1.00 1.00 17. Regulation of brokers and dealers 0.29 1.00 0.83 1.00 0.91 0.83 1.00 0.89 1.00 1.00 1.00 0.95 18. Have brokers and dealers had their licenses revoked 0.00 0.75 0.17 0.25 0.23 0.39 0.40 0.43 0.25 0.25 0.46 0.50 19. Collective investment schemes authorized and their types 0.50 0.50 0.50 0.33 0.31 0.48 0.77 0.71 0.50 0.33 0.54 0.50 20. Separate rules and regulations for collective inv. Schemes 1.00 1.00 1.00 1.00 0.58 0.65 1.00 0.86 1.00 -0.06 1.00 0.77 21. Do they disclose information to the public 0.25 0.13 0.00 0.50 0.28 0.44 0.60 0.57 0.50 0.00 0.71 0.45 22. Do they disclose information to the investor 1.00 1.00 0.22 1.00 0.36 0.67 0.83 0.67 0.28 -0.11 0.73 0.77 23. Existence of an investor compensation scheme -0.08 1.00 0.00 -0.17 0.16 -0.02 0.06 0.26 0.22 -0.11 0.60 -0.07 24. Recent failures of securities markets intermediaries 0.75 -0.17 0.28 0.00 0.39 0.43 0.13 -0.05 -0.11 0.28 -0.01 0.13 25. How often have investors received compensation 0.00 0.00 0.00 0.00 0.14 0.06 0.21 0.21 0.17 0.00 0.42 0.10 26. Provision of professional custodial services 0.38 1.00 0.83 1.00 0.69 0.61 0.85 0.71 0.83 0.67 0.85 1.00 Number of participating law firms per country 4 1 3 1 16 9 13 7 3 3 13 5

15

Cross-country comparison of individual survey question scores for stock markets

Questions on Stock Markets K

yrgy

z R

epub

lic

Lat

via

Lith

uani

a

Mol

dova

Pola

nd

Rom

ania

Rus

sian

Fed

erat

ion

Slov

ak R

epub

lic

Slov

enia

Ukr

aine

Uzb

ekis

tan

1. Securities laws amended or new ones enacted 1.00 1.00 1.00 1.00 1.00 0.83 1.00 1.00 1.00 1.00 1.00 2. Presence of a regulator of securities operations 1.00 1.00 1.00 1.00 1.00 0.83 0.95 0.89 1.00 0.75 1.00 3. Ability of regulator to conduct on-site examinations and whether it regulates shares and bonds issues

0.78 0.71 0.78 0.75 0.89 0.83 0.83 0.67 0.47 0.69 0.56

4. Other mechanisms for trading of securities 0.50 0.63 0.25 0.44 0.54 0.21 0.60 0.58 0.83 0.63 0.50 5. Listed companies required to provide disclosure of fin. results 1.00 1.00 1.00 0.71 1.00 1.00 0.95 0.89 0.67 0.60 0.71 6. How often is such information provided 0.33 0.63 0.75 0.31 0.86 0.63 0.61 0.75 1.00 0.41 0.63 7. Mandatory use of international accounting standards -0.06 0.21 -0.06 0.25 0.57 -0.08 0.03 0.78 0.67 0.19 0.21 8. Functioning clearance and settlement system for shares and bonds 0.67 0.75 0.67 0.63 1.00 0.75 0.73 0.78 0.83 0.75 0.50 9. Type and form of information to be filed with Regulator prior to selling securities

0.63 0.94 0.96 0.78 0.74 0.92 0.86 0.89 0.96 0.73 0.88

10. How often does the Regulator review filed information before public offerings 0.67 0.69 0.92 0.94 0.82 0.83 0.84 0.72 0.67 0.69 1.00 11. Enforcement powers of the Regulator 1.00 0.79 1.00 0.79 1.00 0.83 0.90 0.86 0.49 0.69 0.74 12. Has the Regulator undertaken any oversight or enforcement action in the last 5 years

0.22 0.71 0.61 0.17 0.86 0.83 0.89 0.76 0.67 0.27 0.21

13. Insider dealing prohibited 0.33 0.75 1.00 0.75 1.00 0.67 0.85 0.89 1.00 0.38 0.75 14. Types of normative acts prohibiting insider dealing 0.07 0.35 0.40 0.40 0.34 0.37 0.44 0.44 0.47 0.08 0.40 15. How often does the Regulator use enforcement powers against insider dealing 0.08 0.38 0.17 0.31 0.54 0.63 0.31 0.39 0.33 0.25 0.13 16. Presence of a functioning stock exchange 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 0.85 1.00 17. Regulation of brokers and dealers 1.00 1.00 1.00 1.00 1.00 0.89 0.98 1.00 1.00 0.91 0.83 18. Have brokers and dealers had their licenses revoked 0.00 0.44 0.33 0.44 0.54 0.42 0.46 0.33 0.50 0.41 0.19 19. Collective investment schemes authorized and their types 0.50 0.63 0.11 0.46 0.79 0.83 0.73 0.94 0.50 0.48 0.04 20. Separate rules and regulations for collective inv. Schemes 1.00 1.00 0.67 1.00 1.00 1.00 0.85 1.00 1.00 0.88 0.21 21. Do they disclose information to the public 0.25 0.44 0.25 0.31 0.79 0.54 0.49 0.58 0.50 0.47 0.00 22. Do they disclose information to the investor 0.61 0.42 0.67 0.42 1.00 0.83 0.78 0.78 0.61 0.56 0.46 23. Existence of an investor compensation scheme -0.06 0.13 0.61 0.17 0.86 0.11 0.25 0.17 0.28 0.19 -0.04 24. Recent failures of securities markets intermediaries -0.06 -0.04 -0.06 -0.04 0.29 0.14 -0.01 0.07 0.00 -0.06 0.21 25. How often have investors received compensation 0.17 0.44 0.00 0.25 0.32 0.08 0.20 0.11 0.42 0.16 0.00 26. Provision of professional custodial services 0.50 0.75 1.00 0.75 0.86 0.67 0.95 0.94 0.67 0.94 0.50 Number of participating law firms per country 3 4 3 4 7 6 20 9 3 8 4

16

Table 2: Law on the books and perceptions of legal extensiveness and effectiveness (Correlation coefficients)

Coded legal indices from Pistor, Raiser and Gelfer (2000) Legal indices based on LIS

1999

pistorsh pistorcr voice exit anti_man anti_bl smintegr

credcon collat remedy

EXTBANK99 0.31 0.51* -0.05 0.37* 0.15 0.55* 0.57* 0.26 0.14 0.34

EFFBANK99 0.27 0.34 -0.04 0.21 0.26 0.33 0.57* 0.18 -0.08 0.37*

EXTCAP99 -0.10 -0.15 -0.42* -0.07 -0.31 0.23 0.38* 0.04 -0.13 -0.18

EFFCAP99 0.23 0.28 -0.09 0.34 -0.03 0.41* 0.34 0.43* -0.13 0.08

EXT99 0.39* 0.43* 0.02 0.39* 0.19 0.64* 0.67* 0.17 0.27 0.26

EFF99 0.46* 0.45* 0.13 0.44* 0.30 0.58* 0.61* 0.30 0.12 0.31

Source: Pistor, Raiser and Gelfer (2000), and author’s compilations. Note: Asterisks indicate that the coefficient is statistically significant at the 10% level.

Next we compare our legal extensiveness and effectiveness measures to the Pistor

et al (2000) indices of shareholder and creditor protection. Table 2 shows the correlation

coefficients between each of the Pistor et al (2000) variables of shareholder and creditor

protection and our survey-based indices of legal extensiveness and effectiveness of

banking and stock markets. It is apparent that the Pistor index of stock market integrity

(SMINTEGR) exhibits the highest degree of statistically significant positive association

with our legal measures. This is hardly surprising, bearing in mind that our indices

strongly reflect the regulations of banking and securities operations. The anti-block

holder index is also significantly positively associated with the survey indices of capital

market effectiveness. It must be noted that the aggregate indices of financial

extensiveness and effectiveness (EXT99 and EFF99) show high levels of significant

association with the aggregate shareholder and creditor indices by Pistor et al (2000) as

well as with several of the component variables – the indices of exit, anti-blockholders,

stock market integrity, etc.

All the legal variables are presented and described in Table B in the Appendix.

17

4. REGRESSION RESULTS

4.1 Stock Market Capitalization Regressions

4.1.1 Extensiveness of Securities Laws and Regulations as a Determinant of Stock

Market Capitalization and Turnover

The relevant measures for stock market development that we shall be using

throughout this paper are stock market capitalization and stock market turnover. It could

be argued that market capitalization might not be a good indicator of stock market

development in transition countries as it depends to a large extent on the depth of the

privatization effort, and higher capitalization might simply reflect more privatized

companies rather than companies going public to raise external finance. This is why we

employ an alternative measure of stock market development – market turnover. It gives

us a better idea about stock market liquidity as it measures the value of traded stocks as

percentage of capitalization. In many transition stock exchanges it is common that only

few stocks are traded.

We do a series of regressions of the stock-market-capitalization-to-GDP ratio and

of stock market turnover for a cross-section of 19 countries, excluding the ones for which

data are not available. We control for GDP growth, as it is accepted in the related

literature that growing economies have usually higher valuations of shares, deeper stock

and credit markets and higher proportion of credit to the private sector. Thus for example

Greenwood and Jovanovic (1990) explore the causality between economic growth and

financial development. Their argument is that growth promotes investment in

organizational capital and creation of markets. The latter in its turn increases the

equilibrium economic growth rate as financial intermediaries allow a larger fraction of

credit in the economy to be directed to activities with high social returns. Causality is

allowed to run in both directions. Other authors also address the impact of growth on

financial structure.12

In addition we control for average inflation over the period 1994-1999 and for the

number of years spent under communism. Inflation is employed as a standard measure of

macroeconomic stability. High rates of inflation lower the real rates of return to both

12 There is a substantial body of empirical research on finance and growth. See for example King and Levine (1993), Rajan and Zingales (1998), Greenwood and Smith (1997).

18

equity and deposit investors, and thus erode the deposit base for banks and lower the

demand for stocks.

Years under communism is employed as a measure of historical memory of

markets. The idea that the historical memory of markets and institutions matters, has been

put forward in a number of empirical studies of transition economies. Shared historical

past with Western European countries and experience with laws and market institutions

like banks and stock markets prior to the onset of communism in some of these countries

might be reflected in the present degree of banking and stock market development and

regulation. In other words, it is very likely that historical memory would be a strong

determinant of the way markets function and the effective application of financial laws.

The number of years under communism could serve as a useful proxy for the memory of

market institutions. In this respect the transition economies could be divided into three

main groups: those, which spent a low number of years under communism (40-45 years),

those with a high number of years under communism (70-75), and the medium-range

countries (51-52 years). Among the first group are most of the Central and Eastern

European countries; the three Baltic countries and Moldova fall into the intermediate

range, and all the other former Soviet republics are at the high end of the scale. We have

conducted simple analysis of differences in means of legal effectiveness for these three

groups of countries. The results are presented in Table 3.

Table 3: Years Under Communism and Legal Effectiveness.

(Average Scores for Each Country Group)

Years under

communism

EFFBANK99 EFFCAP99 EFF99

40-45 69.08 57.16 62.15

50-55 61.60 55.43 58.02

70-75 54.89 47.91 50.83

T-test 40-45 / 50-55 0.1003 0.3464 0.1016

T-test 40-45 / 70-75 0.0199 0.0488 0.0104

T-test 50-55 / 70-75 0.1895 0.0577 0.0622

Note: The table reports average scores for each category, as well as the probabilities of rejecting the null

hypothesis of equal means. One-tailed t-tests are reported.

19

Evidently, countries with a low number of years under communism do better in

terms of banking and stock markets legal effectiveness than both other groups. The

difference between the low and high duration countries is statistically significant across

the effectiveness measures, while the difference between the low and intermediate

duration countries is only marginally significant in terms of banking legal effectiveness

and insignificant in terms of stock market legal effectiveness. Interestingly, the difference

in banking legal effectiveness between the intermediate and high-duration countries is not

statistically significant, whereas the difference between the same two groups in terms of

stock market legal effectiveness is significant. On the whole, countries with lower

number of years under communism fare better in terms of financial legal effectiveness.

Extensiveness of stock market laws and regulations - EXTCAP99 - is found to be

significant at the 1 % level as a determinant of market capitalization relative to GDP. The

coefficient has the expected positive sign. We control for average inflation and GDP

growth, as well as for years under communism. None of the other variables are

significant. Inflation has the expected negative sign, whereas growth and time under

communism coefficients get the wrong sign. In regression specifications controlling for

growth and inflation only and growth and years under communism only13 we obtain

similar results – EXTCAP99 is significant, while the controls are always insignificant.

However, overall financial extensiveness (EXT99) appears insignificant in a regression

specification, controlling for growth, inflation and time under communism. As before,

none of the controls is significant.

We also test the same regression specification, but use instead of our stock market

legal extensiveness variable the measure of stock market integrity from Pistor et al

(2000). Their index is the closest in content to our stock market indices. We find similar

results, but the stock market integrity index explains less of the variation in market

capitalization. We also find that other Pistor et al measures of shareholder rights perform

in a similar way. All SMINTEGR, PISTORSH, ANTI_MAN and ANTI_BL indices are

significant at 5% in specifications controlling for growth, inflation and time under

communism. The VOICE variable is significant at 10%. All these specifications explain

less of the variance of STOCK_99 compared to EXTCAP99.

20

We run the same regressions using stock market turnover relative to GDP as the

dependent variable. In the turnover regressions both stock market extensiveness

(EXTCAP99) and overall financial law extensiveness (EXT99) are found significant at

1%. Among the controls, only GDP growth appears significant at 10%, albeit with the

wrong sign. Controlling for growth and inflation only, and growth and years under

communism only does not change the results.

We again run the same regression specification, using in the place of our legal

measure each of the Pistor et al measures. In the turnover regressions neither the stock

market integrity index, nor the other indices appear significant.

4.1.2 Effectiveness of Securities Laws and Regulations as a Determinant of Stock

Market Capitalization and Turnover

Another regression specification is testing for the significance of effectiveness of

capital market regulation. As before, we use two measures of implementation of

securities market regulatory rules - effectiveness of laws, pertaining to capital markets

only - EFFCAP99 and overall financial law effectiveness - EFF9914.

Stock market legal effectiveness is found highly significant at the 1% level for

market capitalization over GDP. The same controls as above have been employed in the

regression specification. All inflation, growth and years under communism are

insignificant. Overall financial law effectiveness (EFF99) is also significant at 1% for

market capitalization. In the latter specification average inflation appears significant at

5% and has the expected sign. Years under communism is significant at 10% and has the

wrong sign.

13 Years of communism and average inflation are highly correlated (coefficient of 0.73), which warrants leaving one of them out of the regression. 14 An earlier version of the paper presented robustness checks using 1998 legal and financial data. We found that the regression results for 1998 were consistent with the results for 1999. The 1998 data differs in terms of legal effectiveness, as effectiveness questions were modified in the 1999 version of the survey. In the present paper the results of these robustness checks are not presented for brevity.

21

Table 4: OLS Estimation of Stock Market Capitalization and Turnover, 1999

Dependent Variables: Stock Market Capitalization as Percent of

GDP and Stock Market Turnover.

Independent Variable

STOCK_99 TURNOVER_99

EXTCAP99 1.4682*** 2.6461***

EXT99 4.1114***

EFFCAP99 0.9302***

EFF99 1.4735*** 2.1715**

GDP_GR -1.1215 -0.1034 -0.9718 -3.1876** -2.2440 -2.5555

AV_INFL -0.0217 -0.0435 -0.0799** -0.0107 -0.1457***

YR_COMM 0.4545 0.3057 0.5184* -0.3994 -0.2737

INTERCEPT -118.5** -52.7** -95.6*** -136.1 -214.9** -79.9

Number of Observations 19 19 19 19 19 19

Adjusted R2 0.45 0.43 0.45 0.62 0.66 0.46

Note: *** denotes significance at 1%, ** denotes significance at 5%, * denotes significance at

10%.

Results are based on White's heteroscedasticity-adjusted standard errors.

This result is consistent with Glaeser, Johnson and Shleifer's (2000) findings

regarding regulation in the mid-1990's in Poland and the Czech Republic. Indeed, they

claim that the significantly better performance of the Polish stock market can be

explained in terms of differences in corporate laws, but also by markedly different

approaches towards securities regulation in the two countries. Our paper finds evidence in

support of this view.

Effectiveness of stock market laws and regulations is found marginally significant

in the turnover regressions, controlling for inflation and growth only. EFFCAP99 is

significant at 10% and inflation – at 5%. However, when we replace inflation with years

under communism, the latter becomes the only significant variable (at 1%) and has the

correct sign. Overall financial effectiveness (EFF99) is significant at 5% in a

specification, controlling for growth and inflation. Here inflation is significant at 1%.

Again, once we substitute for inflation with years under communism, effectiveness loses

significance. Thus, the link between legal effectiveness and stock market turnover

appears less robust.

22

The results of the stock market regressions are presented in Table 4.

4.2 Banking Sector Activity Regressions

4.2.1 Extensiveness of Banking Laws and Regulations as a Determinant of Private

Sector Credit

In these regressions we use domestic bank credit to the private sector as percent of

GDP as a measure of banking sector activity and we are trying to establish whether

overall financial laws and banking laws in particular have a significant impact on the

lending ratio. It is a well-known fact that banks in transition economies serve as quasi-

fiscal agents to the government and as such their lending to the private sector in relative

terms is much lower than for countries with comparable levels of GDP per capita. At the

same time, as government bond markets began to operate, banks started investing a lot of

funds in Treasury bills for safe returns. That again impedes the lending activity to the

severely under-financed private sector.

We are interested in testing what the impact of extensiveness and effectiveness of

laws and regulations, pertaining to banking activity only, is.

We run several regressions, using banking legal extensiveness - EXTBANK99, as

well as overall financial law extensiveness - EXT99.

Table 5: OLS Estimation of Domestic Bank Credit to the Private Sector, 1999

Dependent Variables: Private Sector Credit as Percent of GDP. Independent Variable DEBT_99 DEBT_98

EXTBANK99 0.0196

EXT99 0.4391

EFFBANK99 0.1676 0.2386*

EFF99 0.4882* 0.4902***

GDP_GR 0.3887 0.4897 0.6932 0.8742* 0.8718** 0.8463*

AV_INFL -0.0001

YR_COMM -0.6097*** -0.4719** -0.4103*** -0.3115** -0.3120** -0.4598***

INTERCEPT 50.1* 15.3 26.6 2.9 2.8 22.7

Number of Observations 22 22 21 21 21 20

Adjusted R2 0.35 0.37 0.49 0.60 0.60 0.53

Note: *** denotes significance at 1%, ** denotes significance at 5%, * denotes significance at 10%. Results are based on White's heteroscedasticity-adjusted standard errors.

23

EXTBANK99 appears insignificant in a specification which controls for GDP

growth, average inflation and years under communism. The overall financial law

extensiveness index (EXT99) performs better, but is also insignificant. Years under

communism is significant in all specifications at 5%, inflation – in the first set of

regressions (for EXTBANK99) - at 10%. So it seems that banking law on the books has no

impact on the volume of private credit. This result echoes the findings of Pistor et al

(2000). Macroeconomic stability as captured by the rate of average growth and inflation

together with the number of years spent under communism overwhelm the effects of the

presence of formal banking laws and regulations. The same results carry through if we

use DEBT_98 as a dependent variable, as well as when we use the Pistor et al measures

of creditor rights like PISTORCR, CREDCON, COLLAT AND REMEDY.

4.2.2 Effectiveness of Banking Laws and Regulations as a Determinant of Private

Sector Credit

We test for the significance of banking law effectiveness on the relative volume of

credit to private enterprises.15 In contrast to the banking legal extensiveness regressions,

we find evidence that banking legal effectiveness is a statistically significant determinant

of private credit. Again, we employ the measure of banking law effectiveness

(EFFBANK99) and of aggregate financial law effectiveness (EFF99). Somewhat

surprisingly, banking law effectiveness is found insignificant in a specification

controlling for growth and inflation, whereas aggregate financial law effectiveness is

significant at 10% in the same regression. If we control for years under communism and

growth only, banking law effectiveness is marginally insignificant, and aggregate

effectiveness is significant at 1%. Furthermore, banking law effectiveness and overall

financial effectiveness are found significant for private credit in 1998. Thus, we find

evidence that financial and to a lesser extent banking law effectiveness have a significant

15 We exclude the Czech Republic from the banking effectiveness regressions as an outlier. The Czech Republic has the highest ratio of private credit to GDP (66.9%) among the countries in our sample. At the same time its banking effectiveness score is rather low (58.99). This low index reflects many of the problems, which plagued the Czech banking industry in 1997-1998. Also it is known to have a poor company law and loose banking and securities regulation. Some of the latter issued are well described by Glaeser, Johnson and Shleifer (2000).

24

positive impact on the volume of domestic bank credit to the private sector. This outcome

closely matches the findings in Pistor et al (2000) about the impact of legal enforcement.

The results of all the banking regressions are presented in Table 5.

5. CONCLUSIONS

The main objective of this paper is to test whether financial laws and regulations

matter for the relative size of bank credit and stock markets in most of the economies in

transition. Using different regression specifications, we observe that our legal indices -

namely overall extensiveness and overall effectiveness as well as securities legal and

regulatory extensiveness and effectiveness - are statistically significant determinants of

stock market capitalization, and stock market turnover. Stock market effectiveness

appears insignificant for turnover in some of the regression specifications. In contrast,

banking legal and regulatory effectiveness is significantly and positively associated with

the volume of domestic bank credit to the private sector. In some specifications banking

legal effectiveness is marginally significant. However, laws and regulations as

encompassed in the banking and overall financial extensiveness are found insignificant

for the volume of private credit. Thus, our work suggests that both legal text and legal

enforcement matter for stock markets in transition. In contrast, only legal enforcement

matters for the volume of private credit. Legal text does not appear to affect banking

sector performance in transition. These results appear consistent with the findings of the

related literature – Pistor at al (2000) and Claessens et al (2000).

It must be noted that all the legal variables involved in the paper are indicative of

respondents' perceptions rather than being a measure of the precise state of law, therefore

caution must be taken when interpreting them.

The bottom-line of this discussion is that legal effectiveness seems to have a

stronger impact on financial outcomes in transition than legal extensiveness does. In

addition, stock markets seem more responsive to better laws and regulations than banks.

25

REFERENCES

Berglof, Erik, and von Thadden, Ernst-Ludwig, ''The Changing Corporate Governance Paradigm: Implications for Transition and Developing Countries.'' Mimeo, SITE, Stockholm School of Economics, 1999. Claessens, Stijn, Djankov, Simeon, and Klingebiel, Daniela, “Stock Markets in Transition Economies”, Financial Sector Discussion Paper No. 5, The World Bank, September 2000. Demirguc-Kunt, Asli, and Maksimovic, Vojislav, ''Law, Finance and Firm Growth.'', Journal of Finance 53, 6:2107-2137, December 1998. Djankov, Simeon, and Murrell, Peter, “Enterprise Restructuring in Transition: a Quantitative Survey”, mimeo, The World Bank and University of Maryland, November 2000. European Bank for Reconstruction and Development, Transition Report, Various issues. London: EBRD. European Bank for Reconstruction and Development, Transition Report Update. London: EBRD, April 1999. Glaeser, Edward, Johnson, Simon, and Shleifer, Andrei, ''Coase v. the Coasians'', mimeo, MIT and Harvard University, Forthcoming, Quarterly Journal of Economics, 2001. Greenwood, Jeremy, and Jovanovic, Boyan, ''Financial Development, Growth and the Distribution of Income.'' Journal of Political Economy 98, 5, Part 1:1076-1107, October 1990. Greenwood, Jeremy, and Smith, Bruce D., ''Financial Markets in Development, and the Development of Financial Markets.'' Journal of Economic Dynamics and Control 21, 1:145-181, January 1997. Hay, Jonathan R., Shleifer, Andrei, and Vishny, Robert W., ''Toward a Theory of Legal Reform.'' European Economic Review 40, 3-5:559-567, April 1996. Hendley, Kathryn, Murrell, Peter, and Ryterman, Randi, ''Law, Relationships and Private Enforcement: Transactional Strategies of Russian Enterprises.'' The William Davidson Institute Working Paper No. 72, University of Michigan Business School, November 1998.

26

Hendley, Kathryn, Ickes, Barry W., Murrell, Peter, and Ryterman, Randi, ''Observations on the Use of Law by Russian Enterprises.'' Post-Soviet Affairs, 13, 1:19-41, January-March 1997. Johnson, Simon, McMillan, John, and Woodruff, Christopher, ''Contract Enforcement in Transition.'' Centre for Economic Policy Research Discussion Paper No. 2081, February 1999. King, Robert G., and Levine, Ross, ''Finance and Growth: Schumpeter Might Be Right.'' Quarterly Journal of Economics 108, 3:717-737, August 1993. La Porta, Rafael, Lopez-de-Silanes, Florencio, Shleifer, Andrei, and Vishny, Robert W., ''Law and Finance.'' Journal of Political Economy 106, 6:1113-1155, December 1998. La Porta, Rafael, Lopez-de-Silanes, Florencio, Shleifer, Andrei, and Vishny, Robert W., ''Legal Determinants of External Finance.'' Journal of Finance 52, 3:1131-1150, July 1997. La Porta, Rafael, Lopez-de-Silanes, Florencio, Shleifer, Andrei, and Vishny, Robert W., ''Investor Protection and Corporate Governance'', Journal of Financial Economics, 58, 1-2: 3-27, 2000. Modigliani, Franco, and Perotti, Enrico, ''Protection of Minority Interest and the Development of Security Markets.'' Managerial and Decision Economics 18, 7-8:519-528, November-December 1997. Perotti, Enrico, “ Bank Lending in Transition Economies”, Journal of Banking and Finance 17, 5: 1021-1032, September 1993. Perotti, Enrico, and Sgard, Jerome, “Bank ing Regulation under Extreme Legal Underdevelopment: Lessons from the Russian Meltdown”, Forthcoming, Economic Policy, 2001. Pistor, Katharina, “Patterns of Legal Change: Shareholder and Creditor Rights in Transition Economies”, European Business Organization Law Review 1, 1: 59-108, 2000. Pistor, Katharina, Raiser, Martin, and Gelfer, Stanislaw, “Law and Finance in Transition Economies”, Economics of Transition 8, 2: 325-368, August 2000. Rajan, Raghuram G., and Zingales, Luigi, ''What Do We Know about Capital Structure? Some Evidence from International Data.'' Journal of Finance 50, 5:1421-1460, December 1995. Rajan, Raghuram G., and Zingales, Luigi, ''Financial Dependence and Growth.'' American Economic Review 88, 3:559-586, June 1998.

27

Rajan, Raghuram G., and Zingales, Luigi, ''The Politics of Financial Development.'' Mimeo, University of Chicago and NBER, August 1999. Ramasastry, Anita, and Slavova, Stefka, ''Market Perceptions of Financial Law in the Region - EBRD Survey Results.'' Law in Transition, 24-34, Spring 1999. Shleifer, Andrei, ''Government in Transition.'' European Economic Review 41, 3-5:385-410, April 1997. Shleifer, Andrei, and Vishny, Robert W., ''A Survey of Corporate Governance.'' Journal of Finance 52, 2:737-783, June 1997. Weller, Christian E., ''The Connection Between More Multinational Banks And Less Real Credit in Transition Economies.'' Working Paper B8, Center for European Integration Studies, University of Bonn, 1999. Zingales, Luigi, ''The Value of the Voting Right: A Study of the Milan Stock Exchange Experience.'' Review of Financial Studies 7, 1:125-148, Spring 1994.

29

APPENDIX: DATA TABLES

Table A: Description of Variables

Variable Description

STOCK_99 Stock market capitalization as percent of GDP for 1999.

TURNOVER_99 Stock market turnover for 1999. (in percent)

DEBT_99 Domestic bank credit to the private sector as percent of GDP for 1999.

DEBT_98 Domestic bank credit to the private sector as percent of GDP for 1998.

GDP_GR Average growth rate of real GDP for 1996, 1997 and 1998.

AV_INFL Average rate of annual inflation over the period 1994-1999.

YR_COMM Number of years spent under communism.

EXTBANK99 Extensiveness of banking laws and regulations for 1999.

EFFBANK99 Effectiveness of banking laws and regulations for 1999.

EXTCAP99 Extensiveness of capital market laws and regulations for 1999.

EFFCAP99 Effectiveness of capital market laws and regulations for 1999.

EXT99 Overall financial laws extensiveness index for 1999.

EFF99 Overall financial laws effectiveness index for 1999.

30

Table B: Transition Economies by Economic Variables and Number of Years Spent under Communism.

Country STOCK_99 TURNOVER_99 DEBT_99 DEBT_98 GDP_GR AV_INFL YR_COMM

Albania n. a. n. a. 3.6 2.7 3.7 14.8 45

Armenia 1.3 15 9.2 8.3 5.0 324.2 74

Azerbaijan n. a. 13 3.4 3.3 4.6 312.0 75

Belarus n. a. n. a. 9.7 0.004 6.1 456.6 75

Bosnia & Herzegovina n. a. n. a. n. a. n. a. 30.0 n. a. 44

Bulgaria 6.0 4 14.6 13.3 -2.6 175.2 43

Croatia 13.8 5 36.7 40.9 5.6 3.0 44

Czech Republic 23.1 61 66.9 64.7 1.3 7.6 43

Estonia 37.1 44 26.2 27.2 6.8 17.7 51

FYR Macedonia 0.2 45 22.5 19.0 2.4 11.0 44

Georgia n. a. n. a. 6.1 n. a. 10.2 1095.1 70

Hungary 35.7 103 25.2 22.3 3.4 18.2 41

Kazakhstan 16.5 2 8.6 6.2 1.2 213.1 75

Kyrgyzstan 0.3 2 5.1 3.6 5.9 39.3 75

Latvia 6.3 21 16.2 14.7 4.6 12.6 51

Lithuania 10.7 13 13.0 11.4 4.5 17.5 51

Moldova 3.6 81 11.9 8.6 -1.4 38.0 52

Poland 20.0 62 23.8 18.8 6.1 16.9 42

Romania 3.1 58 8.4 10.3 -2.6 65.5 43

Russian Federation 44.4 27 11.7 6.0 -2.6 81.2 74

Slovak Republic 3.8 48 37.2 42.5 6.0 8.4 43

Slovenia 11.9 28 35.9 32.5 3.6 10.1 44

Tajikistan n. a. n. a. n. a. n. a. 0.1 395.2 75

Turkmenistan n. a. n. a. n. a. n. a. -9.7 516.4 75

Ukraine 4.6 12 8.7 5.5 -4.4 112.0 75

Uzbekistan 0.9 2 n. a. n. a. 2.0 256.9 75

Sources: Transition Report 2000, International Financial Statistics, August 2000, Transition Report 1999, Claessens, Djankov and Klingebiel (2000), Fischer and Sahay (2000).

31

Table C: Banking and Capital Market Legal Indices, 1999 and 1998.

Country EXTBANK99 EFFBANK99 EXTCAP99 EFFCAP99 EXT99 EFF99

Albania 58.39 74.07 71.59 39.23 63.00 53.81

Armenia 55.69 82.80 72.27 54.90 61.48 66.58

Azerbaijan 54.85 59.52 59.80 30.44 56.58 42.62

Belarus 38.70 38.36 77.58 50.00 52.28 45.13

Bosnia & Herzegovina n. a. n. a. n. a. n. a. n. a. n. a.

Bulgaria 65.80 69.84 65.48 49.46 65.69 57.99

Croatia 55.88 69.79 74.78 51.75 62.48 59.3

Czech Republic 62.06 58.99 82.23 57.37 69.10 58.05

Estonia 64.31 73.40 84.26 57.20 71.28 63.99

FYR Macedonia 57.62 72.24 81.97 42.27 66.12 54.82

Georgia 32.66 22.09 72.22 35.60 46.47 29.95

Hungary 67.76 73.08 86.68 69.37 74.37 70.92

Kazakhstan 61.89 64.55 75.00 57.60 66.47 60.51

Kyrgyzstan 59.19 63.34 66.26 40.87 61.66 50.28

Latvia 57.93 62.96 76.86 53.43 64.54 57.42

Lithuania 54.09 51.81 71.82 60.63 60.28 56.94

Moldova 72.80 58.23 73.90 50.45 73.19 53.71

Poland 62.29 67.57 85.69 75.17 70.46 71.99

Romania 61.19 60.58 72.78 60.04 65.24 60.27

Russian Federation 50.52 56.69 77.33 65.46 59.88 61.79

Slovak Republic 62.44 73.59 85.86 61.16 70.62 66.36

Slovenia 59.62 71.03 78.23 65.76 66.12 67.97

Tajikistan n. a. n. a. n. a. n. a. n. a. n. a.

Turkmenistan n. a. n. a. n. a. n. a. n. a. n. a.

Ukraine 47.98 49.73 61.86 54.36 52.82 52.42

Uzbekistan 58.13 56.91 59.89 41.95 58.74 48.21

Source: EBRD Legal Indicator Survey, 1999