Does Structural Matching between Finance and Law Promote Economic Development?

• Published date: 01 September 2024
• Author: Baifang Wang
• Date: 01 September 2024
• DOI: http://doi.org/10.1111/cwe.12551

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 140–165, Vol. 32, No. 5, 2024

140

Does Structural Matching between Finance and

Law Promote Economic Development?

Baifang Wang*

Abstract

Financial systems generally operate under two different models: one where capital

markets play a primary role in financial transactions and resource allocation (market-

oriented model), and another where banks are the central institutions for these activities

(bank-oriented model). The degree of investor protection afforded by the legal system

varies across these systems. What is the most efficient alignment between financial

structure and investor protection? This paper attempts to quantify the structural

matching relationship between the financial structure and investor protection in

various countries, and examines empirically the impact of this relationship on economic

development. Using a sample of cross-country panel data, it finds that the degree

of structural matching was positively related to economic development. Both the

combination of a securities market and strong investor protection and the combination

of a banking system and weak investor protection can contribute to promoting economic

development. It extends the law and finance theory framework, enhances the analysis

of scenarios with weak alignment between financial structure and investor protection,

explains the growth path of developing countries, and highlights the diversity and the

dynamic nature of the optimal financial structure.

Keywords: economic development, financial structure, investor protection, structural

matching

JEL codes: G2, K4, O1, P5

I. Introduction

How does finance support the real economy? What kind of financial structure is

optimal? The bank-oriented view holds that banks mobilize savings, supervise

enterprises, and protect the interests of savers through mortgages and liquidations (Shen

and Lee, 2006; Baum et al., 2011; Nassios et al., 2020; Azolibe, 2022). The market-

oriented view holds that the securities market promotes price discovery of financial

*Baifang Wang (corresponding author), PhD candidate, School of Economics, Jinan University, China. Email:

3475236375@qq.com.

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Structural Matching between Finance and Law 141

assets through competition and diversification of investments to share risks, thereby

stimulating technological innovation and economic development (Kim et al., 2016;

Qin and Zhou, 2019; Bats and Houben, 2020). Simply comparing these two types of

systems to decide which is generally better does not address the more complex question

of what the optimal financial structure is for countries at different stages of economic

development. In other words, the best financial system might vary depending on

how developed a country’s economy is. This issue may be particularly important for

developing countries.

The law and finance theory represented by La-Porta, Lopez-de-silanes, Shleifer,

and Vishny (La Porta et al., 1998), henceforth referred to as LLSV, proposes that

stronger legal protection for investors leads to more developed financial markets and

fosters economic development. This theory provides a new perspective on determining

the optimal financial structure by emphasizing the importance of law. However, it

only applies to developed countries in Europe and the US with complete securities

markets and legal systems. Developed securities markets and legal systems for investor

protection are very expensive to build and cannot be achieved overnight. As the

most representative developing country and emerging economy, China has sustained

robust annual economic growth despite weak investor protection, an underdeveloped

securities market, and a dominant banking system. This is known as the “Chinese

miracle.” Whether developing countries need to follow the model of the developed

countries is therefore an important issue.

In practice, the relative importance of a country’s banking system and its securities

market varies according to the specific needs of the real economy, resulting in a

differentiated financial structure. Similarly, the effective allocation of financial resources

requires a country’s legal system to have differing levels of enforcement for investor

protection, resulting in a heterogeneous legal framework. In terms of the coordination

between financial structure and legal system structure, a complete legal system and

strong investor protection enable the securities market to provide efficient financial

services. However, in the absence of a deep securities market, the banking system must

undertake most financial functions, and a legal system with weak investor protection

becomes a compromise choice. Thus, an extension of the analytical framework to

the existing law and finance theory is needed if the economic development of both

developed and developing countries under different financial and legal environments is

to be explained logically and consistently.

This paper examines the optimal financial structure at various stages of development

through a new perspective on structural matching, employing both theoretical and

empirical analysis. Specifically, it investigates how different financial institutional