How 'Law and Finance' transformed scholarship, debate

By Steven Neil Kaplan,  Luigi Zingales   
March 05, 2014

From: Magazine

Photo by Getty.

It has been 15 years since the publication of “Law and Finance,” the paper Robert W. Vishny, Myron S. Scholes Distinguished Service Professor of Finance, wrote alongside three collaborators who were all at Harvard at the time: Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer. In that relatively short space of time, Vishny and his coauthors have helped to transform the study of finance and comparative economics. “Law and Finance” became not only one of the most important papers in finance, but one of the most cited papers in social science overall.

Indeed, the paper has had such influence on subsequent scholarship that its innovation and ambition are not always immediately apparent to researchers who were not immersed in the relevant research in the 1980s and 1990s.

At the time, academic research in finance generally examined securities in terms of what they paid off under different circumstances. Theorists had thought about the various “control rights”—the ability of shareholders to vote on directors’ tenure, and of debt-holders to repossess collateral—that come with securities, but there was little empirical work on the subject. Vishny and his coauthors were among the first researchers to look empirically at the rights that accompany securities, in addition to the cash flows.

That would have been innovative in itself, but “Law and Finance” approached the subject with tremendous breadth, with the team collecting data from no fewer than 49 countries. This breathed new life into comparative economic analysis, which, until the fall of the Berlin Wall, had been dominated by an old literature that compared the functioning of socialist and nonsocialist countries. That had died with the end of the Cold War, but it had not yet been replaced by a new framework for international comparisons that was rigorous and could be tested. As Vishny and his coauthors note in 1998, “Comparative statistical analysis of the legal underpinnings of corporate finance—and commerce more generally—remains uncharted territory.”

Consequently, the contemporary literature was highly focused on the world’s leading industrialized economies. It would not be much of an exaggeration to say that scholars at the time seemed to think that the only economies worthy of being studied were those of Germany, Japan, and the United States.

There was a practical barrier to more comprehensive analyses: it took a lot of resources to undertake a rigorous comparative study. Vishny and his coauthors had the resources to hire and manage the armies of research assistants needed to collect the necessary data.

The paper meticulously documents legal rights in each jurisdiction for holders of both equity and debt. It also looks at how legal rights are actually enforced in each country. However, Vishny and his collaborators do not just examine the law itself, but also look back to the origin of each jurisdiction’s legal system. “Our starting point is the recognition that laws in different countries are typically not written from scratch, but rather transplanted—voluntarily or otherwise—from a few legal families or traditions,” they write. They distinguish between two broad traditions of commercial laws: common law, which has its roots in English law, and civil law, which derives from Roman law and has particular French, German, and Scandinavian forms.

Both common and civil law traditions have spread widely around the world, the paper notes, “through a combination of conquest, imperialism, outright borrowing, and more subtle imitation.” Although law subsequently evolved differently in each country, “legal families” are identifiable, establishing a framework for international comparisons. It was novel at the time to use legal history and culture in this way.

Scrutinizing legal families enabled Vishny and his coauthors to make an audacious claim: that common-law systems better protect creditor rights and stockholder rights, and thus there is more financial development in common-law countries. Although many saw this as controversial, it was empirically testable. The paper showed a remarkable regularity of positive outcomes for investors in common-law systems. To this day, that regularity remains powerful and robust.

The paper was an instant hit upon publication, in part because it had implications for a wide swath of adjacent academic fields, among them finance, corporate governance, economics, development economics, law, and political science, as well as for scholarship dealing with international comparisons. This reach helps explain why the paper remains widely cited.

Another reason for the paper’s immediate impact was historical circumstance. With the end of the Cold War and the abject failure of what had been postulated as an alternative to free-market capitalism, policymakers around the world wanted to make their countries more US-like. Vishny and his coauthors provided a useful benchmark.

In the years since, “Law and Finance” has continued to influence economic policymakers and regulators. It has also helped shape investor behavior. Financial practitioners were clearly aware of the importance of control rights before 1998, but the paper gave them a rigorous framework with which to assess them.

Within academia, the research helped to transform several fields. It spawned a rebirth of comparative international analysis based on institutions, and that rebirth had an enormous impact on economics and economic-policy literature. This went well beyond institutions of higher education. One obvious example is the World Bank’s Doing Business reports that measure business regulations in 189 economies and selected cities, the development of which was prompted by the work of Vishny and his collaborators.

In finance, writing papers based on international comparisons is now widely accepted and firmly in the mainstream, and virtually any paper that deals with international comparisons has to refer to the thesis proposed in “Law and Finance.” Indeed, many non-US academics only started to specialize in finance after the paper’s publication, because they saw an opportunity to bring data from their home countries and compare it to the US data.

It may be too bold to claim that “Law and Finance” alone had this impact. At the time of its publication, there was a detectable trend toward more international comparisons. However, Vishny and his coauthors were certainly at the forefront, and conducted their study in a much broader, more comprehensive way than had been done before.

The impact on the study of corporate governance was no less significant. In August 1995, Shleifer and Vishny presented “A Survey of Corporate Governance” at a Nobel symposium on law and finance in Stockholm. (That paper was published in the Journal of Finance two years later.) The survey article, coupled with “Law and Finance,” changed the debate on corporate governance. Up to that point, the dominant view of corporate governance came from the free-cash-flow theory put forward by Michael Jensen, the Harvard economist (who earned his MBA and PhD from Chicago Booth), which posited that managers who have too much free cash flow tend to waste it on pet projects. However, in many countries outside the US, the main problem was less about profligacy than about majority shareholders stealing from minority shareholders. That issue, which had been marginal in academic circles, became mainstream after Vishny and Shleifer’s contributions.

Both in spite of and due to its influence, “Law and Finance” is not universally acclaimed. Some scholars questioned the legal mechanism, asking why this was unique to common law. Others asked whether the paper had not assumed from the start that US-style institutions were superior. Some noted that the claim that common law better protects investors appeared to be paradoxical. The paper measures the superiority of common law by looking at statutory protections, yet civil law is more statute-based, so showing more statutes protecting investors in common law countries seemed contradictory.

Yet although the hypothesis of the distinction between common-law systems and civil-law systems spawned a huge literature testing the framework, the basic thesis in “Law and Finance” has been confirmed time and again, and remains a key reference point for supporters and detractors alike.

It is testament to Vishny and Shleifer’s contribution to scholarship that not only did they write a string of papers around the same theme as “Law and Finance,” placing it at the heart of a body of work, but that they have coauthored a number of widely cited papers

What’s perhaps most remarkable is that “Law and Finance” does not depend on fancy econometrics or complex equations. It uses averages, tests for differences in averages, and runs some simple regressions. This massively influential paper is not very technical and is clear, straightforward, and comprehensible to any MBA student. That in itself contains an important lesson for other researchers.

Works cited

Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, “Law and Finance,” Journal of Political Economy, December 1998.

Andrei Shleifer and Robert W. Vishny, “A Survey of Corporate Governance,” Journal of Finance, June 1997.