Legal institutions and financial markets: the impact of institutions on corporate governance and capital allocation

Abstract

Institutions shape people’s behavior and exert fundamental influence on financial markets. In this thesis I examine how financial markets and firms are affected by institutions, paying particular attention to investor protection law and marketization. In the first paper, I examine the impacts of checks on government power on stock market and firm value. Specifically, I propose that better government power check system reduces the risk of firms and investors being expropriated by public officials therefore boost firm value. Based on the revised internal discipline of the Communist Party of China, I find that the promulgation of the internal discipline led to a significant increase in firm value. Furthermore, the increase in market value depends on the vulnerability of firms to expropriation by public officials. Private firms, firms located in provinces with poor institutions, firms that are less influential to local economies and firms without political connections experience the highest increase in value. Taken together, this paper confirm the importance of checks on government power to firm value. The second essay looks at corruption of state-owned enterprises(SOEs) in China. I propose that bribery of SOE managers will be less prevalent in listed SOEs with more state ownership due to the monitoring effect of large shareholders and the monitoring effect is more important for listed SOEs located in provinces with poor institutions. Based on the sample of listed SOEs in China, I find that the number of bribe-taking managers of an SOE is negatively correlated with the proportion of state ownership and the relation is more prominent in provinces with poor institutions. These results still hold after adjusting for partial observability and imbalance of sample. The second essay confirm the monitoring effect of large shareholders on firm managers. The third essay proposes that better investor protection not only contributes to larger financial markets but also provides firms with more freedom in choosing their capital structure. Based on a sample of listed firms in 64 countries, I find that size of financial markets are positively correlated with the extent to which investors’ rights are protected, which is consistent with existing literature. More importantly, I find that the dispersion of capital structure among firms is positively correlated with how well shareholders rights are protected. This finding support my hypothesize that better investor protection enlarges financial markets and therefore allow firms to have more freedom to choose capital structure that meet their needs. However, the relation between creditor protection and dispersion of capital structure among firms is non- linear. The dispersion tend to be lower when creditor protection is too weak or too strong and it peaks when creditor protection is at medium level. This finding support both supply side and demand side view of debt financing. Overall, this thesis presents original evidence on the important role of institutions on financial markets and firm.