Does Structural Matching between Finance and Law Promote Economic Development?

Abstract

Financial systems generally operate under two different models: one where capital markets play a primary role in financial transactions and resource allocation (market-oriented model), and another where banks are the central institutions for these activities (bank-oriented model). The degree of investor protection afforded by the legal system varies across these systems. What is the most efficient alignment between financial structure and investor protection? This paper attempts to quantify the structural matching relationship between the financial structure and investor protection in various countries, and examines empirically the impact of this relationship on economic development. Using a sample of cross-country panel data, it finds that the degree of structural matching was positively related to economic development. Both the combination of a securities market and strong investor protection and the combination of a banking system and weak investor protection can contribute to promoting economic development. It extends the law and finance theory framework, enhances the analysis of scenarios with weak alignment between financial structure and investor protection, explains the growth path of developing countries, and highlights the diversity and the dynamic nature of the optimal financial structure.