Law and Finance
The recent history of Luxembourg gives a relevant example of the deep interactions between the origin and design
of law, economic growth, and the development of financial markets. The current research program aims at: studying the
causality links between financial development and law; developing a theoretical background in order to support any
empirical investigations in this field.
Participating researchers:
Paul BEAULIEU
Links between institutions and financial development
The recent history of Luxembourg gives a relevant example of the deep interactions between the origin and design of institutions, the economic growth, and the development of financial markets. In their seminal papers, La Porta, Lopez, Schleifer, and Vishny (1997, 1998, 2000) build indexes on a limited number of countries and show that the nature of legal institutions significantly affects the path of their financial growth: in particular, their work support the idea that “Common Law” countries are more able to generate relevant financial information and to protect more small financial investors. By reducing their financial constraints, such institutions can facilitate the financing of small and medium firms.
Nevertheless, such studies do need to be improved upon in order to resolve three key issues:
1.Causality between financial development and institutions: Since the LLSV studies, it has become a widely accepted view that the legal institutions of countries should design their own financial structure, markets and performance. In other words, these institutions are viewed as exogenous variables. However, research needs to be undertaken in order to model and test this assertion. It is more likely that interactions between the areas of institutional environment and finance follow a dynamic of adjustments.
2.The LLSV approach is purely empirical: Such a paradigm needs a solid theoretical background in order to support any empirical investigation in this field. From that perspective, standard theory needs to be re-designed incorporating the institutional environment of decision makers. Nevertheless, according to the Coase theorem, taking the law into account may not affect efficient decision-making, because agents can always privately internalize legal costs and choose an “out-of-court” solution. Of course, such a view does not hold under asymmetric information and/or when transaction costs are significantly high. Moreover, the institutional environment can be viewed as the rules of a game: game theory is a commonly used tool in order to model decisions made in a specific legal context. Here again, we may wonder to what extent agents are sufficiently rational in order to incorporate all legal rules in their computations. Turning to limited rationality may be a more realistic approach.
3.The need for new institutional indexes: Usually, approaches referring to the LLSV approach use the same indexes as the original ones. A deep empirical investigation needs to be undertaken in order to assess the reliability of such indexes and to propose alternatives to them. This supposes the building of a long term network involving experts at a transnational level.
Relative Performance of Financial Centers
An extensive research program has been developed on the comparative performance analysis of the complex network of international financial centers.
This two-year research program will be the first multifactor evaluation of the main financial clusters around the world and will lead to the publication of a recurrent biennial report on the performance and competitiveness of international financial centers. The sampling includes the 24 main international financial places of the global financial system. The research program uses the functionalist framework of analysis developed by Nobel Prize winner Robert Merton. Negotiations are being conducted with stakeholders for data collection.
LSF working papers related to this research axis
LSF Annual Report 2007:
