"Creditor Rights and Corporate Bond Market" (with Oskar Kowalewski), Wharton Financial Institutions Center Working Paper #14-20, 7th International IFABS Conference Paper (June 2015 in Hangzhou, China)
This study investigates how laws and legal institutions affect the development of corporate bond markets relative to that of equity markets using a sample of 42 developed and developing countries over the period of 1978 to 2011. In the study, we employ several different measures as proxies for creditor and shareholder protections. We also control for other legal factors, such as country legal origins, debt contract enforcement and bond contract covenants. The existing research indicates that these legal factors are correlated with financial system development, and the link remains robust after controlling for religious composition and other national characteristics (Beck, Demirgü?-Kunt, and Levine, 2003). Lastly, we investigate the effects of financial crises on the relationship between law and capital market development (Allen, Gu, and Kowalewski 2012).
Our initial empirical strategy is to run cross-country regressions to determine the effects of creditor and shareholder rights on the development of the corporate bond market relative to that of the equity market. We control for macro-economic country characteristics that are likely to affect capital market development. We also employ a natural experiment with a generalized difference-in-difference (diff-in-diff, henceforth) estimator to explore whether financial reforms in past decades have any effect on the association between the law and the development of the structure of the capital market within a country. This diff-in-diff strategy avoids the econometric concern that institutional factors such as creditor or shareholder rights are endogenous, and it presents an alternative to the instrumental variable techniques that have been criticized by Djankov et al. (2007).
Our results support the logic underlying the finance literature and the law literature, which have linked investor protection to the development and structure of financial systems. First, we find that countries with stronger creditor rights tend to have a more developed corporate bond market relative to the equity market. Moreover, the results indicate that restrictive bond covenants, which serve as an alternative ex-post mechanism to protect the bondholder, are primarily negatively associated with the development of the bond market relative to that of the stock market. Additionally, we demonstrate that countries that have stronger debt contract enforcement have a more developed bond market than stock market, but generally, information sharing is more helpful for equity market development. In addition, we find some evidence that shareholder protection predicts the development of the equity market relative to that of the corporate bond market.
Second, we find that financial reforms improve the development of corporate bond markets more than that of equity markets in countries that have stronger creditor protections. In contrast, our results indicate that financial system reforms in countries with stronger shareholder protections enhance the development of the equity market more than that of the corporate bond market. The results suggest that the effect of financial reforms is strongly dependent on a country's legal system. For instance, in countries with stronger creditor protection, financial reforms play a more important role further corporate bond market development. Additionally, we document that greater information disclosure improves the effect of financial reforms on the development of capital markets.
Third, the relationship between law and the structure of the capital market is not as significant during crisis periods as it is during normal periods. We find that in many advanced economies, the bond market develops faster than the equity market but only in the short term during a crisis period. Additionally, during a crisis period, we do not find significant evidence that indicates that in countries with stronger creditor rights, the bond market is developing faster than the equity market. Moreover, we find similar results for emerging economies. Consequently, the observed association between the legal system and the structure of the capital market is partly offset during a crisis period. Indeed, our results are in line with the findings of Allen et al. (2012), who documented significant short-term reversals in the development of financial system structures during a financial crisis. However, they indicated that after a crisis, the financial system reverts to its previous structure. Thus, we also assume that after a financial crisis, the legal system still largely determines the structure of the capital market.
Overall, our results document that legal factors are important in explaining the development of corporate bond markets versus that of equity markets across countries. We argue that in countries with stronger creditor rights, the corporate bond market is more developed than the stock market during normal periods. Moreover, the effects of financial reforms on the capital market development also tend to depend on the legal system, particularly the investor protections in the country.
