Legal Institutions, Corporate Governance and Aggregate Activity: Theory and Evidence

This paper investigates the interaction between legal institutions and financial arrangements and the effects that these have on corporate decisions and aggregate activity, both theoretically and empirically. In the theoretical part, we develop a two country general equilibrium model with overlapping generations and asymmetric information in the credit market. We show that, at the steady state equilibrium, the country providing tighter legal enforcement has a larger aggregate output level and a bigger capital stock. Moreover, on the level of the individual firm, credit financing, capital stock and firm size are also higher where the judicial system is working better, while the leverage ratio is the same in the two countries. The driving force behind these results is that improvements in the legal protection of the creditor rights to repossess a collateral asset, increase the investment rate of return, by tempering the inefficiencies due to asymmetric information. In the empirical part, we provide evidence that confirms our theoretical predictions: firms located in Spanish or Italian judicial districts where courts are more efficient (the number of backlogs is lower, the number of concluded trials is larger or the average length of a trial is shorter) have access to a larger amount of external finance and have a larger size. We also document that Italian regions with more effective courts are endowed with a higher stock of private capital and enjoy a higher welfare level, if measured by the added value or the gross domestic product