Law, Finance, and Economic Growth

Ross Levine*
University of Virginia
July 1997

Abstract: This paper examines the connection between the legal environment and financial
development, and then traces this link through to long-run economic growth. Countries with
legal and regulatory systems that (1) give a high priority to creditors receiving the full present
value of their claims on corporations, (2) enforce contracts effectively, and (3) promote
comprehensive and accurate financial reporting by corporations have better-developed financial
intermediaries. The data also indicate that the exogenous component of financial intermediary
development the component of financial intermediary development defined by the legal and
regulatory environment is positively associated with economic growth.

* Department of Economics, 114 Rouss Hall, University of Virginia, Charlottesville, VA 22903-3288;

RL9J@virginia.edu. I thank Thorsten Beck, Maria Carkovic, Bill Easterly, Lant Pritchett, Andrei Shleifer, and
seminar participants at the Board of Governors of the Federal Reserve System, the University of Virginia, and the
World Bank for helpful comments.

1
Does financial development affect long-run economic growth? Economists hold
remarkably different views regarding the answer to this question. At one end of the spectrum,
many argue that better financial systems -- financial systems that are better at identifying the
most worthwhile projects, exerting corporate control, mobilizing savings, providing risk
management facilities, and easing transactions -- accelerate economic growth [Bagehot 1873,
Schumpeter 1911, and Hicks 1969]. Others question the direction of causality. Robinson (1952)
asserts that economic growth creates demands for financial services and the financial system
responds to provide these services.1
Although King and Levine (1993b) show that measures of financial intermediary
development are good predictors of economic growth, these results neither settle the issue of
causality nor identify the determinants of financial development.2 As argued by Rajan and
Zingales (1996), financial markets may anticipate economic growth and respond by developing
in anticipation of greater economic activity. Thus, financial development may simply be a
leading indicator, rather than an underlying cause. Also, financial development and economic
growth may be driven by a common omitted variable. Thus, the observed positive association
may not imply a causal link.
Given the debate about whether finance causes growth and the lack of information
regarding the sources of financial development, this paper addresses two questions. First, what
are the legal and regulatory determinants of financial intermediary development? Second, is the
1

For recent formulations of the conditions under which financial intermediaries accelerate economic growth, see, for
example, Bencivenga and Smith (1991) and King and Levine (1993c). For views on bi-directional causality, see
Patrick (1966), Greenwood and Jovanovic (1990), Greenwood and Smith (1997).

King and Levine (1993b) show that financial depth in 1960 predicts economic growth over the next 30 years.
Using annual data and sophisticated time-series procedures, Wachtel and Rousseau (1995) and Neusser and Kugler
(1996) find that financial development Granger-causes economic performance. These time-series studies, however,

2
exogenous component of financial intermediary development the component of financial
intermediary development defined by the legal and regulatory environment positively
associated with economic growth? Answering the first question that is, providing information
on the roots of financial development -- is valuable regardless of potential links with steady-state
growth. For example, the functioning of financial intermediaries may affect business-cycles and
the level of income per capita. Policy makers, therefore, may desire information on the legal and
regulatory determinants of financial systems irrespective of the potential ties with steady-state
growth.3 Toward this end, this paper constitutes the first broad cross-country documentation of
the relationship between financial intermediary development and national legal and regulatory
characteristics. The paper complements LaPorta, Lopez-de-Silanes, Shleifer, and Vishnys
(1997) study of the legal determinants of equity and bond markets.
In terms of the second question, this paper uses the legal and regulatory determinants of
financial development as instrumental variables and examines whether an increase in the
exogenous component of financial development causes more rapid growth. Thus, this paper will
help resolve the issue of whether financial development is simply a leading indicator of
economic growth, or whether the financial system exerts a causal influence on economic
performance. This is the first study of whether the component of financial development defined
by the legal and regulatory environment is positively associated with growth.
Part I of this paper searches across a new cross-country data set to identify the
determinants of financial intermediary development. LaPorta, Lopez-de-Silanes, Shleifer, and
Vishny (1996, henceforth LLSV 1996) assemble data on the legal and regulatory treatment of

remain subject to the problems that financial development may be a leading indicator but not a cause of growth, and
they do not identify the determinants of financial development.

3
creditors, the efficiency of the legal system in enforcing contracts, and accounting standards.
Since contractual arrangements form the basis of financial activities, legal systems that protect
creditors and enforce contracts are likely to encourage greater financial intermediary
development than legal and regulatory systems that impede creditors from gaining access to their
claims or that ineffectively enforce contracts. Similarly, since information about corporations is
critical for exercising corporate control and identifying creditworthy firms, accounting standards
that simplify the interpretability and comparability of corporate financial statements will tend to
ease financial activities. Moreover, LLSV (1996) show that differences in the legal treatment of
creditors, legal system efficiency, and the comprehensiveness and quality of information
disclosed in corporate annual reports are systematically linked to the countrys legal origin.
Specifically, LLSV (1996) divide the sample into countries with predominantly English, French,
German, or Scandinavian legal origins. Since most countries obtained their legal systems
through occupation and colonization and since these systems vary little over time, the legal
variables are treated as exogenous for the post-1960 period.4
Part I finds that the legal and regulatory environment influences financial intermediary
development. To measure financial development, this paper uses the King and Levine (1993b,
henceforth KL ) indicators of financial intermediary development. These indicators quantify the
size of financial intermediaries, the relative importance of commercial banks versus the central
bank in allocating credit, and the degree to which intermediaries allocate credit to the private
sector versus the government or public enterprises. The data show that countries with legal
systems that assign a higher priority to creditors extracting the full present value of their claims

Also, to understand economic development, economists seek information on the origins of key institutions, such as
financial intermediaries [North 1981].
4
The sensitivity of this assumption are examined and discussed below.

4
against corporations in the case of corporate bankruptcy or reorganization have more developed
financial intermediaries. Similarly, countries with legal systems that more effectively enforce
contracts have better developed financial intermediaries than countries where contract
enforcement is more lax. Furthermore, information disclosure matters. While less robust than
the creditor rights and legal efficiency variables, the data also illustrate a strong positive link
between financial intermediary development and the degree to which corporations publish
comprehensive and comparable information.
Part II of this paper examines the issue of causality. Specifically, I extend the work of
KL(1993b) by using various combinations of the legal and regulatory determinants of financial
development as instrumental variables for financial development. Generalized Method of
Moments (GMM) procedures reveal that the exogenous component of financial intermediary
development the component defined by national legal and regulatory characteristics -positively influences economic growth. These results are robust to variations in the instrument
variables, modifications in the conditioning information set, alterations in the sample period, and
changes in the measure of financial intermediary development. Tests of the overidentifying
restrictions indicate that the data do not reject the hypothesis that the instrumental variables are
uncorrelated with the error term. This implies that the instrumental variables affect growth only
through their influence on financial intermediary development. The results suggest that an
exogenous increase in financial development causes an acceleration of long-run economic
growth. Furthermore, this link is economically large. The estimated coefficients suggest, for
example, that moving a country from the lowest quartile of countries in terms of legal protection
of creditor rights to the next quartile translates into a 20 percent rise in financial development
(evaluated at the sample mean). This rise in turn accelerates long-run growth by almost one

5
percentage point per year (which is about 60 percent of the standard deviation of cross-country
growth rates over the 1980s).
This paper complements recent alternative methods for addressing the issue of causality.
Using industry-level data, Rajan and Zingales (1996) show that industries that rely comparatively
heavily on external funding grow comparatively faster (than industries that do not rely heavily on
external capital) in countries with well-developed financial systems. Similarly, Demirguc-Kunt
and Maksimovic (1996) show that firms with access to better developed financial systems grow
faster than they could have grown without this access. Furthermore, Jayaratne and Strahan
(1996) show that when individual states of the United States relaxed intrastate banking
restrictions, bank lending quality improved and economic growth accelerated.
The paper is organized as follows. Part I establishes an empirical connection between
cross-country differences in banking development and cross-country differences in the legal and
regulatory environment. Part II then traces the impact of differences in the legal and regulatory
environment on banking development through to economic growth. The data indicate that the
exogenous component of financial intermediary development -- the component defined by the
legal and regulatory system -- is positively associated with economic growth.

6
I. The Legal and Regulatory Determinants of Financial Development
To examine the relationship between financial intermediary development and measures of
national legal and regulatory conditions, one needs (1) measures of financial intermediary
development and (2) measures of the legal and regulatory characteristics for a cross-section of
countries. This section first describes the financial intermediary development indicators. Then,
it presents evidence regarding the links between each financial development indicator and
various indicators of (1) the legal and regulatory treatment of creditors, (2) the enforcement of
contracts, and (3) the accuracy and comprehensiveness with which information about firms is
disclosed to outsiders.

A. Financial intermediary development

Ideally, one would like to construct measures of the particular functions provided by the
financial system. That is, one would like to have comparative measures of the ability of the
financial system to research firms and identify profitable ventures, exert corporate control,
manage risk, mobilize savings, and ease transactions. Accurately measuring the provision of
these services in any single country would be extraordinarily difficult; doing it for a broad crosssection of countries would be virtually impossible. Instead, this paper follows KL (1993b) and
uses four indicators of financial intermediary development. These indicators measure the size of
financial intermediaries, the relative importance of commercial banks versus the central bank in
allocating credit, and the degree to which intermediaries allocate credit to the private sector
versus the government or public enterprises. While there are positive features and shortcomings
associated with each measure (as discussed by KL 1993b), all four are used. Since the results are
broadly similar across the four financial intermediary indicators, this enhances the confidence

7
one holds in the conclusions. These data are available for 77 countries over the 1960-1989
period.5
The first measure, LLY, measures the size of financial intermediaries and equals liquid
liabilities of the financial system (currency plus demand and interest-bearing liabilities of banks
and nonbank financial intermediaries) divided by GDP. Under the assumption that the size of
the financial system is positively correlated with the provision and quality of financial services,
many researchers have used indicators of financial system size [Goldsmith 1969]. Citizens of the
richest countries -- the top 25 percent on the basis of income per capita -- held about two-thirds
of a years income in liquid assets in formal financial intermediaries. In contrast, citizens of the
poorest countries -- the bottom 25 percent -- held only a quarter of a years income in liquid
assets.
The second measure of financial development, BANK, measures the degree to which
commercial banks versus the central bank allocate credit. BANK equals the ratio of bank credit
divided by bank credit plus central bank domestic assets. The intuition underlying this measure
is that banks are more likely to identify profitable firms, exercise corporate control, pool risk,
mobilize savings, and facilitate transactions than central banks. There are two notable
weaknesses with this measure, however. Banks are not the only financial intermediaries
providing valuable financial functions and banks may simply lend to the government or public
enterprises. BANK is greater than 90 percent in the richest quartile of countries. In contrast,
commercial banks and central banks allocate about the same amount of credit in the poorest
quartile of countries.
The third and fourth measures partially address concerns about the allocation of credit.
5

KL(1993a,b) provide data sources and summary statistics of the financial intermediary indicators.

8
The third measure, PRIVATE, equals the ratio of credit allocated to the private sector to total
domestic credit (excluding credit to banks). The fourth measure, PRIVY, equals credit to the
private sector divided by GDP. Directed credit initiatives and government subsidy programs may
importantly influence the fraction of credit allocated to the private sector. The assumption
underlying these measures is that financial systems that allocate more credit to the private sector
are more engaged in researching firms, exerting corporate control, providing risk management
services, mobilizing savings, and facilitating transactions than financial systems that simply
funnel credit to the government or state owned enterprises.

B. Creditor rights and financial intermediary development

As discussed in LLSV (1996), outside creditors can influence firms to satisfy their debt
obligations in a variety of ways. For instance, a creditor may have the right to repossess
collateral or liquidate the firm in the case of default. Some legal and regulatory systems make
repossession easier than other systems. Similarly, creditors may enjoy rights regarding the
reorganization of a company since the reorganization may affect the probability of repayment.
Again, legal systems differ in the rights assigned to creditors in terms of corporate
reorganizations. Thus, legal and regulatory systems that facilitate the repossession of collateral
and that grant creditors a clear say in reorganization decisions are, all else equal, likely to
encourage the development of financial intermediaries engaged in issuing credit supported by
these laws. In terms of the specific financial intermediary indicators, legal systems that assign
strong rights to creditor are -- all else equal -- more likely to support the growth of financial
intermediaries (LLY), commercial banks relative to the central bank (BANK), and financial
intermediaries that allocate more credit to private firms as opposed to the government or public

9
enterprises (PRIVATE, PRIVY) than legal systems that impede the repossession of collateral or
limit the role of creditors in reorganizations.
The paper considers three creditor rights indicators. The first two focus on the rights of
creditors in reorganizations. The third indicator measures the seniority of creditors in the case of
a defaulting firm. LLSV (1996) construct the data from bankruptcy and reorganization laws for
49 countries and list this data in the Appendix.
AUTOSTAY equals one if a countrys bankruptcy and reorganization laws impose an
automatic stay on the assets of the firm upon filing a reorganization petition. AUTOSTAY equals
0 if this restriction does not appear in the legal code. The restriction prevents secured creditors
from gaining possession of collateral or liquidating a firm to meet obligations. Thus, all else
equal, AUTOSTAY should be negatively correlated with the activities of intermediaries engaged
in providing secured credit.
MANAGES equal one if the firm continues to manage its property pending the
resolution of the reorganization process, and zero otherwise. In some countries, management
stays in place until a final decision is made about the resolution of claims. In other countries,
management is replaced by a team selected by the courts or the creditors. If management stays
pending resolution, this reduces pressure on management to meet secured creditor obligations.
Thus, MANAGES should be negatively correlated with the activities of financial intermediaries
engaged in secured transactions.
SECURED1 equals one if secured creditors are ranked first in the distribution of the
proceeds that result from the disposition of the assets of a bankrupt firm. SECURED1 equals
zero if non-secured creditors, such as the government or workers get paid before secured
creditors. In cases where SECURED1 equals zero, this certainly reduces the attractiveness of

10
lending secured credit. SECURED1 should be positively correlated with activities of financial
intermediaries engaged in secured transactions, holding everything else constant.6
Tables 1-3 present results regarding the empirical connection between each of the three
creditor rights variables and the four measures of financial intermediary development. The
regressions control for the level of per capita income in these regressions of financial
development on the creditor rights variables because LLSV (1996) show the level of income per
capita is frequently correlated with creditor rights indicators even after controlling for legal
origin.
As expected, countries that prevent secured creditors from gaining possession of their
security by imposing an automatic stay on firm assets in the case of reorganization
(AUTOSTAY=1) tend to have commercial banks that allocate a relatively low amount of credit
relative to central banks (BANKS) and commercial banks that extend a relatively low amount of
credit to private firms as a fraction of GDP (PRIVY). AUTOSTAY enters negatively in all four
regressions, and is significant at the 0.01 level in the BANK regression and at the 0.09 level in
the PRIVY regression.
Similarly, countries where managers stay in control of the firm pending the resolution of
the reorganization process (MANAGES=1) tend to have less well-developed financial
intermediaries than countries where officials appointed by creditor or the courts assume
responsibility for the operation of the business during reorganization. As shown in Table 2,

LLSV (1996) also examine REORG, which equals one if a countrys bankruptcy and reorganization laws impose
restrictions, such as creditors consent, to file for reorganization, and one otherwise. This type of restriction may
boost creditor rights by increasing the likelihood and shortening delays in creditors getting paid. If the legal system
does not impose this restriction, then managers can reorganize corporations and thereby avoid or delay paying
secured creditors. While I also examined REORG, it was insignificantly related to all of the financial intermediary
development indicators.

11
MANAGES enters all of the regressions negatively, and is statistically significant at the 0.05
level in the LLY equation and at the 0.10 level in the PRIVATE and PRIVY regressions.
The findings are strongest for SECURED1. Countries where non-secured creditors,
such as the government or labor, are given priority in the distribution of the proceeds that result
from the disposition of the assets of a bankrupt firm (SECURED1=0) tend to have less welldeveloped financial intermediary sectors than countries where secured creditors are ranked first
(SECURED1=1). As shown in Table 3, SECURED1 enters the LLY, BANK, and PRIVY
equations positively, and significantly at the 0.05 level and enters the PRIVATE equation
positively, with a P-value of 0.05.
Finally, these three creditor rights indicators are combined into an aggregate index
designed to be positively associated with creditor rights. Specifically,
CREDITOR = SECURED1 - AUTOSTAY - MANAGES, and takes on values between 1 (best)
and -2 (worst). As shown in Table 4, CREDITOR is significantly positively correlated with
LLY, BANK, and PRIVY at the 0.05 level and with PRIVATE at the 0.07 level. Countries with
legal systems that assign a high priority to secured creditors receiving their pledged claims tend
to have more well-developed intermediaries.

12
C. Enforcement of contracts and financial intermediary development
The laws and regulations governing secured creditors will affect secured creditors only
to the extent that the laws and regulations are enforced. Indeed, comparatively lax creditor
rights laws in conjunction with efficient property rights enforcement may promote financial
intermediary activities more effectively than strong creditor rights laws with lax enforcement.
Consequently, two measures of the efficiency of the legal system in enforcing contracts are
included from LLSV (1996).
RULELAW is an assessment of the law and order tradition of the country that ranges
from 10, strong law and order tradition, to 1, weak law and order tradition. This measure was
constructed by International Country Risk Guide (ICRG) and is an average over the period
1982-1995. Given the contractual nature of finance, I expect a positive relationship between
RULELAW and financial intermediary development.
CONRISK is an assessment of the risk that a government will and can modify a
contract after it has been signed. CONRISK ranges from 10, low risk of contract modification,
to 1, high risk of contract modification. Specifically, modification means either repudiation,
postponement, or reducing the governments financial obligation. This measure was
constructed by ICRG and is an average over the period 1982-1995. Legal systems that
effectively enforce contracts including contracts with the government will support financial
intermediary activities. Thus, I expect CONRISK to be positively associated with financial
development.
Tables 5-6 present results regarding the empirical connection between the two measures
of legal system efficiency and the four measures of financial intermediary development. Both
RULELAW and CONRISK are positively associated with all of the financial intermediary

13
development indicators at the 0.05 significance level after controlling for the level of real per
capita GDP. The results suggest that legal systems that enforce contracts including
government contracts efficiently promote financial intermediary development.7

D. Accounting standards and financial intermediary development

Information about corporations is critical for exerting corporate governance and
identifying the best investments. These activities will be facilitated by accounting standards that
simplify the interpretability and comparability of information across corporations. Furthermore,
many types of financial contracting use accounting measures to trigger particular actions. These
types of contracts can only be enforced and will only be used if accounting measures are
reasonably unambiguous. Accounting standards differ across countries and governments impose
an assortment of regulations regarding information disclosure and accounting standards. Since
accurate information about corporations may improve financial contracting and intermediation,
the paper examines a measure of the quality of information disclosed through corporate accounts
from LLSV (1996).
ACCOUNT is an index of the comprehensiveness of company reports. The maximum
possible value is 90 and the minimum is 0. The Center for International Financial Analysis and
Research assessed general accounting information, income statements, balance sheets, funds flow
statement, accounting standards, and stock data in company reports in 1990. Given the
importance of information in financial contracting, I expect ACCOUNT to be positively

I also examined an interaction term, CREDITOR*CONRISK, to examine whether creditor rights are less important
in the presence of an effective contract enforcement system and whether contract enforcement exerts a different
impact on financial development depending on the legal treatment of creditors. This interaction term always enters
insignificantly.

14
correlated with financial intermediary development.8 In particular, one might expect that
commercial banks will benefit more from reliable and comparable corporate financial statements
than central banks in terms of allocating credit, and accurate information on corporations is likely
to be more important for the funding of private firms than for public firms.
Table 7 indicates that while ACCOUNT is not significantly correlated with LLY and
PRIVY, ACCOUNT is positively and significantly related to BANK and PRIVATE at the 1
percent significance level. Countries with better standards of corporate reporting tend to have
financial systems where the central bank plays a smaller role in allocating credit relative to
commercial banks and where more credit flows to the private sector relative to the public sector.

Discussion
Part Is results are consistent with the view that the legal and regulatory environment
materially affect financial intermediary development. More specifically, countries with legal and
regulatory systems that assign a high priority to creditors receiving the full value of their claims
tend to have more well-developed financial intermediaries. In contrast, countries where the legal
environment does not protect potential outsider creditors against the interests of insiders tend to
have less-developed financial systems. The data also indicate -- albeit less robustly -- that
comprehensive and comparable information on corporations boost financial intermediary
development. Furthermore, the three different legal/regulatory indicators -- creditor rights,

This is not necessarily true and raises the need for a general conceptual qualification. An economy with perfect
information, perfect contract enforcement and perfect legal codes (i.e., and economy with essentially zero transaction
and information costs) would have little reason for financial intermediaries. Put differently, market frictions
motivate the emergence of financial intermediaries. See the review by Levine (1997), especially Boyd and Prescott
(1986). Conceptually, this implies that at very high levels of legal system development and information
dissemination, a marginal increase in legal efficiency or information quality may cause a reduction in the role and
importance of financial intermediaries. To test this potential non-linearity, I included various combinations of
quadratic expressions for ACCOUNT and CONRISK. The quadratic terms never enter significantly.

15
contract enforcement, and accounting information on corporations -- provide different
information. As summarized in Table 8, although ACCOUNT is highly correlated with
RULELAW and CONRISK; CREDITOR is not significantly correlated with RULELAW,
CONRISK, or ACCOUNT.
Not only is the relationship between financial development and the legal/regulatory
environment statistically significant, it is economically large. For example, the estimated
coefficient suggests that a legal or regulatory improvement that boosts the overall creditor rights
index, CREDITOR, by a value of one will increase financial depth, LLY, by a value of 0.11,
which is about 20 percent of the mean value of LLY in the 1980s (0.55). Similarly, contract
enforcement is at least as important as the formal legal and regulatory statutes. Countries that
enforce contracts effectively have better developed financial intermediaries that countries with
weaker law and order traditions and where the government frequently modifies the terms of
preexisting contracts. Again, the relationship is economically large. A one standard deviation
improvement in CONRISK (1.8) increases financial depth by 0.18, which is 32 percent of the
mean value of LLY. Finally, information matters. Countries where corporations publish
comprehensive, high-quality financial statements have more well-developed financial
intermediaries than countries where accounting standards provide less reliable information.

16
II. Causality: Financial Intermediary Development and Economic Growth
This part of the paper uses the legal and regulatory determinants of financial
development examined in Part I as instrumental variables for financial development. Thus, the
paper examines whether the exogenous component of financial development is positively
associated with economic growth. To do this, KLs (1993b) cross-country study is extended to
an instrumental variable framework. After briefly describing the KL methodology, this section
summarizes the instrumental variable results.

A. Brief description of KL methodology

KL (1993b) assess the strength of the empirical relationship between growth and each of
the four indicators of the level of financial intermediary development discussed above. First,
they use data averaged over the 1960-1989 period. Let F(i) represent the value of the ith
indicator of financial development (DEPTH, BANK, PRIVY, PRIVATE) averaged over the
period 1960-1989, G represents real per capita GDP averaged over the period 1960-1989, and X
represents a matrix of conditioning information to control for other factors associated with
economic growth (e.g., income per capita, education, political stability, indicators of trade, fiscal,
and monetary policy ). They then run the following four separate regressions on a cross-section
of 77 countries:

(1)

G = + F(i) + X + .

There is a strong positive relationship between each of the four financial development indicators,
F(i), and growth. Not only are all the financial development coefficients statistically significant,

17
the sizes of the coefficients imply an economically important relationship. Ignoring causality for
the moment, their estimated coefficient of 2.4 on DEPTH implies that a country that increased
DEPTH from the mean of the lowest DEPTH quartile of countries (0.16) to the mean of the
largest DEPTH quartile of countries (0.70) would have increased its per capita growth rate by
almost 1.3 percentage points per year. This is large. The difference between the slowest growing
25 percent of countries and the fastest growing quartile of countries is about five percent per
annum over this 30 year period. Thus, the rise in DEPTH alone eliminates 25 percent of this
growth difference.9

B. Selecting Instruments
Given this basic framework, the paper uses the legal and regulatory determinants of
financial development examined in Part I as instrumental variables for financial development,
F(i). That is, a vector of instrumental variables Z(i) is selected for each regression equation
specified by equation (1). Assuming that E[]=0 and that E[]=, where is unrestricted,
implies a set of orthogonality conditions, E[Z]=0. This produces a nonlinear instrumental
variable estimator of the coefficients in equation (1). After computing these GMM estimates, I
use a Lagrange-Multiplier test of the overidentifying restrictions to see whether the instrumental
variables are associated with growth beyond their ability to explain cross-country variation in
financial intermediary development. For completeness, all of the equations were also estimated
using two-stage least squares. This alternative estimator does not change either the statistical
inferences or the coefficient sizes from those reported below.
9

KL (1993b) use 77 countries. There are only legal and regulatory variables, however, for 43 of these countries.
When the KL (1993b) regressions are run for this smaller sample of countries, the results are virtually identical. The

18
I choose different instrumental variables for the different financial intermediary
indicators based on the regression results in Tables 1-7 and the correlation results in Tables 8. I
use CREDITOR and CONRISK as instrumental variables for all of the financial intermediary
development indicators. The variable CREDITOR summarizes each countries legal and
regulatory treatment of secured creditors by aggregating information on AUTOSTAY,
MANAGES, and SECURED1. It is significantly correlated with financial development as
discussed in Part I. Using SECURED1 (which is also significantly associated with all of the
financial intermediary indicators) instead of CREDITOR does not alter the results that follow. I
also wanted to include a measure of contract enforcement. CONRISK and RULELAW are both
highly correlated with all of the financial intermediary development indicators, and they are
highly correlated with each other 0.88. I select CONRISK because it has a larger correlation
coefficient with all of the financial intermediary indicators. Using RULELAW instead does not
alter the results. Finally, for PRIVATE and PRIVY, ACCOUNT is also included as an
instrumental variable because it is significantly correlated with these financial intermediary
indicators.10

only difference is that BANK becomes insignificant at the 5 percent level when a large conditioning information set
is included
10
In a two-stage least squares framework, the first stage includes more explanatory variables than those in Tables 17. In particular, the limited conditioning information set regressions also include the logarithm of income per capita
and the logarithm of secondary. The R-squares in these regressions are typically around 0.40 and the F-statistic
always rejects the null hypothesis at the 0.01 significance level that none of the cross-sectional variation in financial
intermediary development is explained by the explanatory variables.

19
C. GMM results over the 1960-1989 period
Consider first a straight application of instrumental variables over the 1960-89 period.
Table 9 summarizes two sets of results. The limited conditioning information set results use a
small X matrix that includes only the logarithm of initial real per capita GDP and the logarithm
of initial secondary school enrollment. The full conditioning information set regressions use a
large X matrix that also includes government consumption expenditures divided by GDP
averaged over the period, exports plus imports divided by GDP averaged over the period, and the
average annual inflation rate.11 I treat the X matrix as exogenous because I am focusing on
examining the question of whether the exogenous component of financial intermediary
development as defined by the legal and regulatory environment is positively associated with
economic growth.12
The results indicate a strong link between the exogenous component of financial
development and economic growth. The coefficient on financial intermediary development is
significant at the 5 percent level in seven out of the eight regressions summarized in Table 9.13
Further, the data do not reject the null orthogonality conditions; the data do not reject the
hypothesis that the instrumental variables are uncorrelated with the equation (1) error term at the
10 percent level. Put differently, the are consistent with the view that the legal and regulatory
factors affect growth only through their affect on financial intermediary development.

11

This full conditioning information set is taken from KL (1993b) for comparative purposes. As discussed in
greater detail below, using other conditioning variables does not affect the results [Levine and Renelt 1992].
12

As a sensitivity check, I used the initial values (the pre-determined values instead of the average values over the
period) of the X matrix variables. This did not alter the results.
13

Only in the BANK regression with the full conditioning information set does the financial indicator not enter
significantly (it enters with a P-value of 0.11), but this is no different from the OLS results summarized above. Thus,
the lack of significance does not reflect a simultaneity problem.

20

D. GMM results over the 1980s

Since the legal and regulatory variables are measured over the 1980s, I repeat the
analysis using data over the period 1980-89. As shown in Table 10, the results are even
stronger. In seven of eight regressions, financial intermediary development enters the growth
regression significantly at the 0.05 level and it enters the eighth regression significantly at the
0.10 level. Again, a test of orthogonality restrictions suggests that the instrumental variables
are appropriate. The data are consistent with the view that improvements in creditor rights or
the enforcement of contracts, or the information content of corporate financial statements
induce improvements in the functioning of financial intermediaries that accelerate economic
growth.
Furthermore, this relationship is economically large. Rough estimates of the influence
of an exogenous improvement in financial development on economic growth can be obtained
from the above Tables.14 Consider, for example, an improvement in creditor rights. The
estimated coefficient from Table 4 suggests that a legal or regulatory improvement that boosts
the overall creditor rights index, CREDITOR, by a value of one (which is two standard
deviations) will increase financial depth, LLY, by a value of 0.11. From Table 10, we see that
this would in turn accelerate economic growth by about one percentage point per year. This is
reasonably large considering that the standard deviation of cross-country growth rates is 1.8
percent. Also, consider an improvement in contract enforcement. From Table 6 and as
14

These approximations are not completely correct for two reasons. First, the equations are estimated using GMM,
which is a nonlinear instrumental variable procedure. I, however, use the approximate first stage linear results to
conduct the conceptual experiments. This is immaterial because the two-stage least squares results are virtually
identical to the GMM estimates. Second, I use results from Tables 1 - 7 to conduct the conceptual experiments.

21
discussed above, a one standard deviation improvement in contract enforcement (CONRISK)
causes LLY to rise by 0.18. From Table 10, we see that this would in turn accelerate economic
growth by about 1.5 percentage points per year. Thus, a one standard deviation improvement in
CONRISK induces a 80 percent of one standard deviation acceleration in economic growth.
Thus, this papers results suggest an economically large relationship between financial
development and economic growth. Legal and regulatory reforms that boost financial
development can materially affect long-run growth rates.

E. GMM results using financial development in 1960

Finally, I re-run KLs (1993b) test of whether the value of financial depth (LLY) in
1960 predicts the rate of economic growth over the next 30 years. They find that LLY in 1960
is significantly correlated with growth over the 1960-89 period. 15 Here, I instrument for the
value of financial depth in 1960 with the legal and regulatory variables (CREDITOR and
CONRISK). As shown in Table 11, the part of LLY in 1960 associated with the degree of
creditor rights and contract enforcement is strongly, positively associated with economic
growth over the next 30 years.

III. Sensitivity Analyses and Discussion

However, the real first stage regressions include all of the X variables. This is also immaterial, because the size of
the relevant coefficient in the conceptual experiments is not altered much by the inclusion of the other instruments.
15
There are too few observations on BANK, PRIVATE, and PRIVY to replicate this exercise for these financial
development indicators. Furthermore, KL (1993b) also use pooled cross-section, time-series procedures, with the
data pooled over the three decades. They then use measures of all four financial development indicators at the
beginning of each decade and find that financial development predicts decade growth rates. When using this papers
instrumental variables in the KL (1993b) pooled cross-sectional analyses, one still finds that the exogenous
component of financial intermediary development the component defined by the legal and regulatory environment
is positively and significantly correlated with long-run economic growth.

22
A. Sensitivity results
One risk with pure cross-country analyses concerns country-fixed effects.16 That is,
the regression may omit an important explanatory variable that is really driving the results and
that is highly correlated with the financial intermediary development indicators. Thus, besides
the X variables discussed above, I experimented with a wide-array of additional explanatory
variables that other researchers have identified as importantly related to long-run growth.
Specifically, I included the following eight variables to test the robustness of the results to
changes in the conditioning information set. First, the black market exchange rate premium is a
general index of price, trade, and exchange rate distortions [Dollar 1992]. Second, the number
of assassinations per capita is one general index of political instability [Banks 1994]. Third, the
number of revolutions and coups is another commonly used indicator of political instability,
and is frequently found to be negatively associated with economic growth [Banks 1994].
Fourth, Barro and Lee (1995) construct a general index of political rights. Fifth, the degree of
civil liberties is one frequently used measure of political freedom [Gastil 1990]. Sixth, the
degree to which the regulatory environment obstructs commerce is a general indicator of
bureaucratic efficiency [Mauro 1995]. Seventh, the degree of ethnic diversity, which equals the
probability that two randomly selected individuals in a country belong to different
ethnolinguistic group, tends to induce poor policies that slow growth [Easterly and Levine
16

One could apply the dynamic-panel procedures developed by Holtz-Eakin, Newey, and Rosen (1988) and
Arrellano and Bond (1991). This dynamic-panel approach would be a valuable complement to this papers analysis
since dynamic-panel techniques can virtually eliminate the potential inconsistency arising from country-specific
effects that are omitted from pure cross-country regressions. When applied to growth regressions, however, dynamic
panel applications typically average the data over five years to have a sufficient time-series dimension. Yet, five
year aggregation may still capture business-cycle relations and thereby misrepresent the relationship between finance
and steady-state growth. Moreover, even using five-year averaged data, there are typically only five or six time
observations, which can make the parameters very unstable with regard to changing the lags of the instrumental
variables. In contrast, this paper uses data averaged over a minimum of 10 years to abstract from business-cycle

23
1997]. Finally, I consider a measure of corruption, which many argue influences economic
development [Mauro 1995; Shleifer and Vishny 1993]. Each of these variables is used to
examine the robustness of this papers results by controlling for bad government, bad
institutions, bad policies, and political instability. 17 Including these additional explanatory
variables does not alter this papers finding that the exogenous component of financial
intermediary development that part of financial development defined by each countrys legal
and regulatory environment -- is strongly, positively correlated with economic growth.
A second potential area of concern is the exogeneity of the instruments. As noted
earlier, national legal systems derive largely from four legal origins English, French, German,
and Scandinavian, and these legal systems were disseminated via occupation and colonization
[LLSV, 1996]. Moreover, it is worth emphasizing that the creditor rights variables are not
general indexes of the efficiency of the legal system. They measure the legal rights of secured
creditors. As shown above, these creditor rights variables strongly influence financial
intermediary development. But, other legal variables, such as laws governing minority
shareholder rights, do not strongly influence financial intermediary development. Thus, the
instrumental variables measure particular characteristics of the legal system that influence
financial intermediary development.
Nevertheless, the exogeneity of the general indexes of contract enforcement, such as
the rule of law variable, RULELAW, and the contract risk variable, CONRISK may be subject
to greater doubt since they are subjective evaluations of the security of contracts. While LLSV
(1996) show that these indexes of contract enforcement are closely associated with legal origin,

frequencies in examining whether the exogenous component of financial intermediary development positively
influences long-run growth.

24
I evaluated the sensitivity of the results to alterations in the instrument set. Specifically, the
regressions were re-run (a) omitting CONRISK as an instrumental variable and instead using
the LLSV (1996) dummy variables for legal origin, i.e., English, French, German,
Scandinavian, and (b) substituting the underlying legal code variables for CREDITOR, namely
SECURED1, AUTOSTAY, and MANAGES. These alternative instruments lead to the same
conclusions as exemplified in Table 12: the legal environment importantly affects financial
intermediary development, and the exogenous component of the financial system the
component of the financial system defined by the legal environment is positively and
significantly associated with economic growth.
Finally, to further gauge the robustness of the results, I used a conglomerate index of
banking development that incorporates information on the size of intermediaries, who is
conducting the intermediation, and the allocation of credit. Specifically, this measure equals
credit allocated by commercial and deposit-taking banks to the private sector divided by GDP
[Levine and Zervos 1997]. These data are only available since 1976. This conglomerate
banking index incorporates information from BANK, PRIVATE, and PRIVY and is called
BANK-TO-PRIVATE. This banking indicator yields similar conclusions to those reported
above: the legal and regulatory environment affects banking development, and the component
of the banking system defined by the legal and regulatory environment is positively and
robustly correlated with long-run economic growth. Table 13 shows that the exogenous
component of BANK-TO-PRIVATE remains significantly correlated with growth when
altering the conditioning information set. Moreover, the strong link between long-run
economic growth and the exogenous component of BANK-TO-PRIVATE is not sensitive to
17

See Knack and Keefer (1995) for a comprehensive and careful examination of the relationship between economic

25
alternations in the instrumental variables.
B. Perspectives and interpretation
In many respects, this papers results can be viewed as a merger of KL (1993b) with
LLSV (1996). I combine the KL (1993b) data on financial intermediary development with the
LLSV (1996) data on legal and regulatory indicators. The paper then (1) examines the legal
and regulatory determinants of financial intermediary development and (2) tests whether the
exogenous component of financial intermediary development as defined by the legal and
regulatory environment is positively associated with economic growth. The paper can also be
viewed as an extension of LLSV (1997) along two dimensions. First, LLSV (1997) examine
the legal determinants of equity and bond markets. This paper examines the legal determinants
of financial intermediaries. Second, this paper then traces the affect of differences in the legal
environment on the financial system through to differences in long-run economic growth rates.
The papers results are consistent with the arguments made by Bagehot, (1873),
Schumpeter (1911), and Hicks (1969): exogenous improvements in financial intermediary
development cause an acceleration in long-run growth rates. The papers results are also
consistent with arguments made by Patrick (1966), Greenwood and Jovanovic (1990), and
Greenwood and Smith (1997): the direction of causality runs in both directions. Namely, the
paper does not show that growth does not cause finance. Rather, this paper shows that the
component of financial intermediary development associated with the legal and regulatory
environment is strongly linked with long-run growth rates.

growth and array of institutional and political indicators.

26
III. Conclusions
This paper focuses on identifying a connection between the legal and regulatory
environment and financial development, and then tracing this link through to long-run
economic growth. First, the paper shows that the legal and regulatory environment matters for
financial development. Specifically, this papers findings are consistent with Shleifer and
Vishnys (1997) argument that cross-country differences in legal systems affect the relationship
between entrepreneurs and creditors. Countries with legal and regulatory systems that give a
high priority to creditors receiving the full present value of their claims on corporations have
better functioning financial intermediaries than countries where the legal system provides much
weaker support to creditors. Moreover, contract enforcement matters as much as the formal
legal and regulatory codes. Countries that impose compliance with laws efficiently and enforce
contracts including government contracts effectively tend to have much better developed
financial intermediaries than countries where enforcement is more lax. Finally, the paper
shows that information disclosure matters for financial development. Countries where
corporations publish relatively comprehensive and accurate financial statements have betterdeveloped financial intermediaries than countries where published information on corporations
is less reliable.
Second, the paper uses the legal and regulatory indicators of creditor rights, contract
enforcement, and information disclosure as instrumental variables for financial development.
The data indicate that the exogenous component of financial intermediary development the
component defined by the legal and regulatory environment is positively associated with
economic growth. The results indicate that legal and regulatory changes that boost financial
intermediary development will induce a rapid acceleration in long-run economic growth.

27

28

Table 1: Financial Intermediaries and AUTOSTAY: 1980s

Dependent Variable
LLY

BANK

PRIVATE

PRIVY

-1.05
(0.007)

-0.46
(0.037)

-0.47
(0.096)

-1.36
(0.000)

Logarithm of
Income per capita

0.19
(0.000)

0.16
(0.000)

0.13
(0.001)

0.21
(0.000)

AUTOSTAY

-0.12
(0.151)

-0.13
(0.009)

-0.06
(0.362)

-0.11
(0.088)

0.22

0.42

0.28

0.38

44

39

39

44

R2
Observations

AUTOSTAY=1, if reorganization procedure imposes a stay on firm assets.

Prevents secured creditors from gaining possession of their security.
AUTOSTAY=0, otherwise.
(Heteroskedasticity consistent P-values in parentheses)

29

Table 2: Financial Intermediaries and MANAGES: 1980s

Dependent Variable
LLY

BANK

PRIVATE

PRIVY

-1.41
(0.004)

-0.44
(0.089)

-0.63
(0.041)

-1.46
(0.000)

Logarithm of
Income per capita

0.25
(0.000)

0.15
(0.000)

0.15
(0.000)

0.23
(0.000)

MANAGES

-0.26
(0.026)

-0.09
(0.151)

-0.12
(0.091)

-0.13
(0.091)

0.32

0.36

0.33

0.39

44

39

39

44

R2
Observations

MANAGES=1, if management stays in control of property pending

the resolution of the reorganization process.
MANAGES=0, otherwise.
(Heteroskedasticity consistent P-values in parentheses)

30

Table 3: Financial Intermediaries and SECURED1: 1980s

Dependent Variable
LLY

BANK

PRIVATE

PRIVY

-1.03
(0.007)

-0.35
(0.080)

-0.50
(0.041)

-1.32
(0.000)

Logarithm of
Income per capita

0.16
(0.000)

0.12
(0.000)

0.12
(0.000)

0.18
(0.000)

SECURED1

0.22
(0.014)

0.13
(0.031)

0.14
(0.051)

0.19
(0.014)

0.27

0.40

0.35

0.41

45

40

40

45

R2
Observations

SECURED1=1, if secured creditors are ranked first in the distribution

of the assets of a bankrupt firm
SECURED1=0, otherwise.
(Heteroskedasticity consistent P-values in parentheses)

31

Table 4: Financial Intermediaries and CREDITOR: 1980s

Dependent Variable
LLY

BANK

PRIVATE

PRIVY

-1.35
(0.001)

-0.58
(0.022)

-0.66
(0.035)

-1.54
(0.000)

Logarithm of
Income per capita

0.23
(0.000)

0.16
(0.000)

0.15
(0.000)

0.23
(0.000)

CREDITOR

0.11
(0.002)

0.07
(0.011)

0.06
(0.066)

0.08
(0.004)

0.31

0.45

0.35

0.43

44

39

39

44

R2
Observations

CREDITOR = SECURED1 - AUTOSTAY - MANAGES

(Heteroskedasticity consistent P-values in parentheses)

32

Table 5: Financial Intermediaries and RULELAW: 1980s

Dependent Variable
LLY

BANK

PRIVATE

PRIVY

0.10
(0.810)

0.19
(0.445)

0.20
(0.454)

-0.42
(0.140)

Logarithm of
Income per capita

0.01
(0.841)

0.05
(0.194)

0.02
(0.630)

0.06
(0.118)

RULELAW

0.05
(0.012)

0.03
(0.007)

0.04
(0.017)

0.04
(0.003)

0.21

0.39

0.34

0.37

47

42

42

47

R2
Observations

RULELAW = assessment of the law and order tradition of the country.

Scale from 0 to 10; 10 equals most tradition of law and order.

(Heteroskedasticity consistent P-values in parentheses)

33

Table 6: Financial Intermediaries and CONRISK: 1980s

Dependent Variable
LLY

BANK

PRIVATE

PRIVY

-0.00
(0.993)

0.14
(0.482)

-0.02
(0.933)

-0.47
(0.025)

Logarithm of
Income per capita

-0.02
(0.756)

0.02
(0.461)

0.03
(0.435)

0.06
(0.028)

CONRISK

0.10
(0.024)

0.06
(0.001)

0.05
(0.022)

0.08
(0.002)

0.25

0.44

0.33

0.42

47

42

42

47

R2
Observations

CONRISK= assessment of the risk that the government will modify

a contract.
Scale from 1 - 10; 10 equals least amount of risk
(Heteroskedasticity consistent P-values in parentheses)

34

Table 7: Financial Intermediaries and ACCOUNT: 1980s

Dependent Variable
LLY

BANK

PRIVATE

PRIVY

-0.92
(0.088)

-0.47
(0.032)

-0.62
(0.025)

-1.27
(0.006)

Logarithm of
Income per capita

0.17
(0.007)

0.11
(0.001)

0.10
(0.007)

0.17
(0.003)

ACCOUNT

0.00
(0.961)

0.01
(0.000)

0.01
(0.006)

0.00
(0.129)

0.15

0.52

0.44

0.32

39

35

35

39

R2
Observations

ACCOUNT = index of the comprehensiveness of annual reports.

Scale 0 - 90; 90 equals the most comprehensive annual reports.
(Heteroskedasticity consistent P-values in parentheses)

10.77
(0.003)
{3.93}

{0.04}

{4.29}

{0.21}
6.89
(0.001)

BANK
7.71
(0.110)

LLY
9.14
(0.036)

{3.81}

11.70
(0.001)

{2.21}

PRIVATE
8.84
(0.002)

Financial indicator in regression

{LM-test of overidentifying restrictions in brackets}

(Heteroskedasticity Consistent P-values in parentheses)

limited conditioning information set

full conditioning information set

Regression equation

{0.12}

8.89
(0.001)

{0.74}

PRIVY
9.70
(0.004)

Dependent variable: Per Capita GDP Growth, 196089

Table 9: Finance and Growth, Instrumental Variables: 1960-1989

11.02
(0.026)
{2.47}

{1.47}

{2.39}

{1.28}
8.68
(0.003)

BANK
8.50
(0.025)

LLY
10.81
(0.095)

{3.15}

10.77
(0.008)

{2.45}

PRIVATE
9.11
(0.008)

Financial indicator in regression

{LM-test of overidentifying restrictions in brackets}

(Heteroskedasticity Consistent P-values in parentheses)

limited conditioning information set

full conditioning information set

Regression equation

{2.01}

12.18
(0.001)

{1.28}

PRIVY
14.64
(0.013)

Dependent variable: Per capita GDP Growth, 198089

Table 10: Finance and Growth, Instrumental Variables: 1980s

Table 11: Finance and Growth, Instrumental Variables: 1960

Dependent variable: Per capita GDP Growth, 1960-89
Independent variable
1

3.32
(0.024)

2.42
(0.160)

-0.03
(0.989)

LRGDP in 1960

-2.20
(0.010)

-2.43
(0.004)

-2.01
(0.022)

LSEC in 1960

1.35
(0.024)

1.36
(0.010)

2.11
(0.017)

GOV in 1960

3.13
(0.651)

3.72
(0.695)

PI in 1960

0.09
(0.224)

0.05
(0.520)

TRD in 1960

-0.73
(0.598)

-1.94
(0.373)

CIVL

0.69
(0.141)

REVC

3.96
(0.300)

ASSASS

-1.30
(0.215)

LLY in 1960

7.40
8.81
12.86
(0.014)
(0.007)
(0.017)
LM-Test
0.57
0.20
0.01
LM-test is distributed Chi-square. Critical values: 10% 2.71; 5%=3.84.
Observations=36,35,35, respectively
(Heteroskedasticity consistent P-values in parentheses)
Estimated using Generalized Method of Moments
Instruments: all right-hand variables excluding LLY60, plus CREDITOR AND
CONRISK

Table 12: Finance and Growth, Alternative Instrumental Variables: 1960

Dependent variable: Per capita GDP Growth, 1960-89
Independent variable
1
2
3
C
3.99
3.27
2.39
(0.000)
(0.013)
(0.119)
LRGDP in 1960

-1.89
(0.003)

-2.03
(0.000)

-1.65
(0.001)

LSEC in 1960

1.38
(0.002)

1.31
(0.002)

1.52
(0.010)

GOV in 1960

3.57
(0.468)

5.26
(0.321)

PI in 1960

0.06
(0.247)

0.04
(0.442)

TRD in 1960

-0.08
(0.936)

-0.62
(0.654)

CIVL

0.25
(0.346)

REVC

1.72
(0.473)

ASSASS

-0.51
(0.430)

LLY in 1960
LM-Test

5.27
(0.013)
3.23

5.31
(0.001)
2.69

5.60
(0.003)
2.49

Observations=36,35,35, respectively
Critical values for LM-Test (5 d.f.): 10% = 9.24; 5% = 11.07
(Heteroskedasticity consistent P-values in parentheses)
Estimated using Generalized Method of Moments
Instruments: all right-hand variables excluding LLY60, plus SECURED1, MANAGES,
AUTOSTAY, and dummy variables for English, French, and German legal origin
GOV-Government consumption expenditures divided by GDP; PI=Rate of inflation;
TRD=Ratio of exports plus imports to GDP; LLY=Financial Depth.

2
Table 13: Banking and Growth with Alternative Instruments: 1976-1993
Dependent variable: Per Capita GDP Growth, 1976-1993
Banking indicator in regressions
A. Basic Instruments
limited conditioning information set

BANK-TO-PRIVATE
7.19
(0.001)
{0.383}

full conditioning information set

11.08
(0.006)
{0.37}

B. Alternative Instruments
limited conditioning information set

6.00
(0.001)
{1.52}

full conditioning information set

4.26
(0.039)
{2.77}

{LM-test of overidentifying restrictions in brackets}

(Heteroskedasticity consistent P-values in parentheses)
Critical values for LM-Test (5 d.f. for alternative instrument set): 10% = 9.24; 5% = 11.07
Critical values for LM-Test (1 d.f. for basic instrument set): 10% = 2.71; 5% = 3.84
Basic instrument set: The relevant conditioning information set plus CREDITOR and CONRISK
Alternative instrument set: The relevant conditioning information set plus
manages, secured1, autostay, and dummy variables for English, French, and German legal origin.
number of observations: 40
limited conditioning information set: other regressors include a constant,
logarithm of initial real per capita GDP and the logarithm of secondary school enrollment.
full conditioning information set: other regressors include the limited conditioning information set, plus
government dividided by GDP, exports plus imports divided by GDP, and inflation.
Bank-to-Private = Deposit money bank credit to the private sector divided by GDP

3
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