Working Paper: CEPR ID: DP2276
Authors: Davide Lombardo; Marco Pagano
Abstract: We analyze how the law and its enforcement affect equity market equilibrium. Improvements in the legal system, while invariably associated with broader equity markets, have different effects on equity returns depending on the institutional change considered and on the degree of international stock market segmentation. The model is useful to interpret the results of recent empirical work, such as La Porta et al. (1997) and Lombardo and Pagano (1999). In particular, it can rationalize the observed cross-country pattern, whereby better institutions are associated both with broader equity markets and higher risk-adjusted returns on equity
Keywords: law; enforcement; shareholder protection; corporate governance; return on equity
JEL Codes: G12; K22; K42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Improvements in legal rules and their enforcement (K40) | Reduction in the private benefits that managers can extract (G34) |
| Reduction in the private benefits that managers can extract (G34) | Increase in the return paid to shareholders (G35) |
| Better legal and auditing standards (G38) | Lower costs incurred by shareholders to monitor managerial actions (G34) |
| Lower costs incurred by shareholders to monitor managerial actions (G34) | Higher returns on equity (G12) |
| Improvements in legal institutions (O17) | Unchanged or lower expected rates of return in perfectly integrated markets (G19) |
| Improvements in legal institutions (O17) | Increased expected returns in segmented markets (G19) |