THE RELATIONSHIPS BETWEEN INSTITUTIONS, FINANCIAL

DEVELOPMENT, BANKING PERFORMANCE,

PRIVATIZATION, AND GROWTH

By

Isaac Marcelin

A Dissertation
Submitted in Partial Fulfillment of the Requirements for the
Doctor of Philosophy Degree

Department of Business Administration

in the Graduate School
Southern Illinois University Carbondale
December, 2010
 UMI Number: 3440316

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 DISSERTATION APPROVAL

THE RELATIONSHIPS BETWEEN INSTITUTIONS, FINANCIAL DEVELOPMENT,

BANKING PERFORMANCE, PRIVATIZATION, AND GROWTH

by

Isaac Marcelin

A Dissertation Submitted in Partial

fulfillment of the Requirements
for the degree of
Doctor of Philosophy
in the field of Business Administration

Approved by:

Dr. Ike Mathur, Co-Chair

Dr. Jim Musumeci, Co-Chair
Dr Dave Davidson
Dr. David Rakowski
Dr. Kevin Sylwester

Department of Business Administration

in the Graduate School
Southern Illinois University Carbondale
August 12, 2010
 ABSTRACT

AN ABSTRACT OF THE DISSERTATION OF

Isaac Marcelin, for the Doctor of Philosophy degree in Business Administration,

presented on August 12, 2010 at Southern Illinois University Carbondale.

TITLE: THE RELATIONSHIPS BETWEEN INSTITUTIONS, FINANCIAL

DEVELOPMENT, BANKING PERFORMANCE, PRIVATIZATION,

AND GROWTH

MAJOR PROFESSORS: DR. IKE MATHUR, DR. JIM MUSUMECI, AND DR. DAVE

DAVIDSON

The problem of the present study is twofold (1) analyze the impacts of institutions

and private property rights on the banking industry, and (2) the effects of property rights,

contracting rights and intellectual property rights concurrent to privatization of state

owned enterprises on a wide range of industries. First, it uses a sample of 37 countries to

assess the effects privatization on industry growth of output, value added and

establishments with regards to property rights institutions, using 3SLS technique.

Consistent with the law and finance view, our results show that privatization works better

in settings with better contracting, patents, and IPRs laws to foster industry growth. The

results suggest that least developed countries can accelerate the growth of their industrial

sector by structurally bettering their legal institutions to benefit from their privatization

programs. There is strong evidence of structural unemployment in sectors that are more

capital intensive; privatization has a crowding out effect channeled through financial

development. The results have broad implications vis--vis policy choices for

i
institutional reforms specifically in terms of control of corruption, enhancing property

rights, contracting rights, and IRPs protection for privatization to bear fruits.

Second, this study assumes that banks in countries with infective institutions

operate in a highly risky environment, which is reflected in the interest rates spread, loan

quality, and net interest margin. It investigates the relationships between banks and

institutions using seemingly unrelated regressions and data from 79 countries. It shows

that institutional improvements abate inefficiencies in the banking sector, reduce

obstacles to external finance, and improve the quality of bank loan portfolios.

Specifically, had a country in the 25th percentile of the institutional quality index, depth

of credit information, and the spread improved its value to the mean sample of these

variables, banks in that country would have had an annual decrease of 2.24% in net

interest margin, 1.57% in unpaid loans, and 0.822 basis points in the spread. Other

institutions including private and public registries are effective in improving access to

external finance. Importantly, information on borrowers past loan repayment patterns

significantly decreases the spreads only when controlled for predated institutional quality.

This finding highlights the significance of institution-building especially in countries

where sudden power shifts result into pendular swings in public policies.

Third, using three independent samples to investigate the institutional factors affecting

the performance of the banking sector around the world, this study finds that financial

effects of three sets of institutions including private creditors right, property rights, and

institutional quality on bank performance are strong. It uses SEM technique to show that

better quality of institutions is negatively related to bank profitability while private

creditors right and property rights institutions are positively related to bank profitability.

ii
 DEDICATION

I dedicate this dissertation to Professors Jacques Saint-Surin and Rony Bony at the

University Notre Dame of Haiti, and Dr Michael Masoner, Professor Emeritus at

Southern Illinois University Carbondale.

iii
 ACKNOWLEDGEMENTS

I hereby formally express my gratitude to Dr Ike Mathur and Dr Jim Musumeci for co-

chairing my doctoral dissertation committee. I am thankful to Dr. Mathurs family for

allowing him to invest his time to accompany me in this endeavor. I am especially

thankful to Mrs. Judith Masoner to have endured me for long hours and allowed Dr

Michael Masoner to work with me even when he was struggling with eyes problems.

Furthermore, I would like to thank Dr Dave Davidson, Dr David Rakowski, and Dr

Kevin Sylwester to have accepted to serve on my doctoral committee, and their

invaluable time and advice; all the faculty members at the Business School who have

contributed to my formation from my MBA to my Doctoral Degree in Business

Administration. I would especially thank Dr Arlyn Melcher and Dr Dave Davidson for

their supports and endorsements from my MBA.

Moreover, I would like to thank the Fulbright commission in Haiti, especially

Mme Dorothe Latortue and the Fulbright representatives and the U.S. such as Amy

Whittish and Rene Anne Burke; my professors at the University Notre Dame of Haiti

and those at the Institut Universitaire des Sciences Juridiques et du Development

Regional INUJED.

Last, but not the least, I would like to thank my parents and friends in Haiti, in the

United States, and around the world for their supports and encouragements as I pursued

this valuable academic goal. I would like to thank Vincent Hill, Zakiya Hill, Safiya

McNeese, Haseeb Abdul, Sibert Cyrus, Dr Jean Garcia COQ, Joelle M. Nanivazo, and

John E. Junarsin for their supports and contributions.

iv
 TABLE OF CONTENTS

CHAPTER ...................................................................................................... PAGE

ABSTRACT ........................................................................................................... i

DEDICATION ....................................................................................................... iii

ACKNOWLEDGEMENTS ..................................................................................... iv

LIST OF TABLES .................................................................................................. vii

LIST OF FIGURES ................................................................................................. ix

CHAPTER 1 .......................................................................................................... 1

FINANCIAL DEVELOPMENT, RESOURCE INTENSITY, PRIVATIZATION,

PROPERTY RIGHTS AND GROWTH .................................................................... 1

1.1 INTRODUCTION ................................................................................ 1

1.2 LITERATURE REVIEW ...................................................................... 7

1.3 THE MODEL .................................................................................... 31

1.4 DATA ANALYSIS ............................................................................ 39

1.5 RESULTS ......................................................................................... 49

1.6 CONCLUSION .................................................................................. 73

CHAPTER 2 INSTITUTIONALLY DETERMINED BANK

PROFITABILITY, SPREADS AND LOAN QUALITY ........................ 76
2.1 INTRODUCTION .............................................................................. 76

2.2 LITERATURE REVIEW ................................................................... 82

2.3 THE MODEL ................................................................................... 95

2.4. DATA ANALYSIS ........................................................................... 96

2.5 PRELIMINARY EVIDENCE ........................................................... 103

2.6. RESULTS ...................................................................................... 108

2.7. CONCLUSION ............................................................................... 132

2.8. FIGURES ....................................................................................... 136

vi
 CHAPTER 3 INSTITUTIONS, PROPERTY RIGHTS, POWER OF
CREDITORS AND BANK PERFORMANCE .................................... 138
3.1 INTRODUCTION ............................................................................ 138

3. LITERATURE REVIEW ................................................................................. 142

3.2 THE THEORETICAL MODEL......................................................... 150

3.3 DATA ANALYSIS .......................................................................... 157

3.4 PRELIMINARY RESULTS .............................................................. 164

3.5 MODEL EVALUATION .................................................................. 165

3.6 RESULTS ....................................................................................... 170

3.8 CONCLUSION ................................................................................ 180

BIBLIOGRAPHY ............................................................................................... 183

VITA ................................................................................................................. 195

vi
 LIST OF TABLES

Table 1 .............................................................................................................................. 41

Table 2 .............................................................................................................................. 42

Table 3 .............................................................................................................................. 45

Table 4 .............................................................................................................................. 51

Table 5 .............................................................................................................................. 54

Table 6 .............................................................................................................................. 57

Table 7 .............................................................................................................................. 60

Table 8 .............................................................................................................................. 64

Table 9 .............................................................................................................................. 66

Table 10 .......................................................................................................................... 104

Table 11 .......................................................................................................................... 104

Table 12 .......................................................................................................................... 106

Table 13 .......................................................................................................................... 109

Table 14 .......................................................................................................................... 117

Table 15 .......................................................................................................................... 119

Table 16 .......................................................................................................................... 121

Table 17 .......................................................................................................................... 124

Table 18 .......................................................................................................................... 126

Table 19 .......................................................................................................................... 128

Table 20 .......................................................................................................................... 160

Table 21 .......................................................................................................................... 165

vii
Table 22 .......................................................................................................................... 166

Table 23 .......................................................................................................................... 172

Table 24 .......................................................................................................................... 173

Table 25 .......................................................................................................................... 175

viii
 LIST OF FIGURES

Figure 1.0-1: Trend in Privatization in billion of USD ..................................................... 40

Figure 2.0-1: Institutional Quality, Bank Spread, and Loan Quality across Countries .. 136

Figure 2.0-2: Loan Quality and Bank Spread across Countries...................................... 136

Figure 2.0-3: Institutional Quality and Loan Quality across Countries .......................... 137

ix
 CHAPTER 1

FINANCIAL DEVELOPMENT, RESOURCE INTENSITY, PRIVATIZATION,

PROPERTY RIGHTS AND GROWTH

1.1 INTRODUCTION

Over the last two decades an interesting debate over state owned enterprises

(SOEs) has taken shape; most SOEs have grown uneconomic; whereas the future of the

public firm has faced with overwhelming odds. Centuries ago, however, several theorists

have addressed the issue of state ownership of firms and/or means of production from

different perspectives. Amongst others, Adam Smith argues that: "In every great

monarchy of Europe the sale of the crown lands would produce a very large sum of

money. When these lands had become private property, they would, in the course of a

few years, become well improved and well cultivated to increase revenue."1 This said,

privatization, a policy reclaimed by the neoliberal movement promoting the transfer of

resources, ownership, and management from state owned enterprises to the private sector,

is an aged-long policy debate. The question of its merits elicits pointed political reactions.

Its implementation has always faced with strong ideological and socio-political

resistances. Nevertheless, it has emerged as the most credible policy alternative to

countering the size and the growth of the public sector deemed uneconomic, self-

destructive, and inefficient.

1
The Wealth of Nations, Book V, chap.2, p. 1041

1
 Despite the prevalence of privatization, a plethora of developing countries have

not yet been successful in privatizing most of their SOEs. Those that have reaped the

benefits of privatization are likely to continue on that path. In 2007, $US 132 billion has

been raised in 51 developing countries. Total proceeds from privatization in 2007

increased by 173 percent from their 2002 level as illustrated in fig. 1. The years of 1997

and 2007 were two dominant years in terms of trends in privatization. China, India and

Nigeria aggressively privatized their SOEs in recent years. Besides being an important

source of revenue for privatizing governments, privatization is credited to have

structurally transformed incumbent SOEs. The privatization literature evidences that poor

financial performance, mismanagement and political problems have plagued SOEs,

deemed to have reached the crossroads. As rocky the road to privatization appears to be,

especially in the developing world, it appears that the SOEs' crisis has culminated to a

point where privatization of some form is inevitable. There are numerous studies with

overwhelming evidence of the transformative power of privatization. However, most

available studies are firm, industry or country specific. Broad conclusions derived from

current studies suffer from inter-industry comparability. Therefore, it is important to

relate industry share of privatization to growth in industry sectors in a systematic way to

assess whether privatized firms across the industry spectrum allocate resources and

redeploy their assets more efficiently. That is, a comprehensive approach is needed to

assess the merit of privatization as a policy. However, considering the institutional

infrastructure in the developing world, privatizing and restructuring SOEs is a

multidimensional and such a complex endeavor, any complete analysis on privatization

ought to heed all the relevant dimensions. These dimensions include, inter alia, the extent

2
to which private property rights, contracting rights, and intellectual property rights (IPRs)

are protected in the privatizing country. They also encompass the degree to which firms

in a given industry sector rely on those rights to grow. Additionally, it is important to

investigate how firms in the various industry sectors handle the issue of employment in

the incumbent firms. It is also crucial to analyze the joint influence of privatization and

financial development on firms across the industry continuum. An analysis encompassing

these various dimensions should lead to a more comprehensive view of the effects of

privatization and restructuring of incumbent SOEs. Despite abundant theoretical and

empirical evidence supporting the superior efficiency of the privatized firms, the

available evidence is either too confined or too generic. It does not allow us to draw a

clear picture of the relationship between privatization and the various economic sectors.

This paper intends to initiate the debate over the effects of privatization and restructuring

policies on an industry by industry and expects to provide new insights for further

research.

Importantly, despite strong empirical evidence on the superior management,

better governance, enhanced liquidity, and cost efficiency of the privatized firm, empirics

are yet to consider several key factors relevant to analyzing privatization. For instance,

what are the impacts of a country's institutions on its privatized firms' performance? In

other words, have privatized firms grown independently of their property rights

environment? Does ownership matter more than property rights? Are all firms across the

various industries equally responsive to property rights? Could SOEs match the

performance of the privately held firms under any market structure had government

interference in the firms' operations not been detrimental to their performance? Do firms

3
in industries that are more capital intensive and/or intangible intensive more sensitive to

property rights grow faster? Do firms in industries that are more capital intensive

significantly layoff their employees subsequent to privatization or restructuring to acquire

machinery and technology to grow? It is thus against this backdrop this study seeks to

investigate the effects of privatization and expects to emerge with a fuller conclusion of

the effectiveness of privatization across industries.

We proceed by looking at the interactions between property rights with

privatization, the interactions between industry capital intensity, industry intangible

intensity and private property rights and/or privatization. We argue that if private

property rights protection does not guarantee firms' progress and efficiency, at least it

ensures to a certain degree the efficient use and control of existing resources while

attracting additional ones. Further, if the transfer of means of production is motivated by

potential efficiency gains, financial resources will be transformed into investments only

when entrepreneurs see potential for profits and a propitious investment climate.

Therefore, in markets with weak property rights laws, efficient asset allocation may be

thwarted as returns on assets are not protected against competitor's unlawful behavior as

well as against authoritarian state apparatus. To this end, we study the extent to which

better property rights concurrent with privatization and resource intensities such capital

and intangible intensities ensure firms' growth on an industry by industry basis. It is very

important for policy makers to know whether post-privatization firms' growth is

attributable to ownership change or institutional reforms as pertained to property rights

and better corporate governance. The financial development literature establishes that in

4
more capital and intangible intensive sectors firms grow faster due to property rights

protection and to better redeployment of assets.

Consistent with the law and finance view, our results show that privatization

works better in settings with better legal institutions. Better contracting, patents, IPRs

laws coalesce to foster industry growth in the context of privatizing SOEs. This has

strong implications for policymakers especially in the debate over whether developing

countries should enforce these laws to the levels of their developed countries counterparts

when considering that developed countries have systematically violated these rights

before attaining their development stage (see Chan and Grabel, 2004) for a complete

discussion. However, even with the limitations of our results -- estimated over a five year

period -- our results support overall view of the finance and law and the financial

development literatures that the least developed countries can accelerate the growth of

their industrial sector by structurally bettering their legal institutions for their

privatization programs to work. Differences across countries in their legal and financial

infrastructures prevent general recommendations on the issue of legal and financial

reforms to be undertaken to accompany privatization programs. Nonetheless, the

convincing fact is that least developed countries will benefit from strengthening

contracting, property rights, and IPRs laws to support innovation and move beyond

medieval stage of development. The outcome of such policies ensures that privatized

firm's assets are protected against unlawful competition and they can be put to work to

generate growth, and improve contracting laws will reassure investors that their

investments are protected against the state apparatus and the legality of the state actions

can be challenged before the courts without fear of political reprisals.

5
 We specifically find that the inter-quartile difference in industry growth of output

is a healthy 9.22% over the 5 year period of our study and a 9.94% higher sectoral value

added attributable to industry share of privatization. Similarly, the regression estimates

predict an accumulated decrease 2.33% in industry growth and a decrease of 5.36% in

industry value added over the 5 year period of our study due to the prevalence of

corruption. Strikingly, we find that the effect of privatization on the differential real

growth rate of industry employment is a net loss of 12.31% in employment in industry

sectors that are highly capital intensive over five years. Furthermore, we find that there

would have been a growth in of 1.72% in establishments or firms per industry sector had

a country successfully enhanced and enforced its IPRs laws moving from the 25th

percentile to the 75th percentile of IPRs protection of our sampled countries from 2003

through 2007. We also find that better contracting rights would generate 1.03% and

0.97% higher growth in industry output and industry value added respectively.

Clearly, these results have several policy implications as they highlight the role of

private property rights, contracting rights, control of corruption, and enforcement of IPRs

laws in catapulting firms' growth in countries privatizing their SOEs. The study

underscores the import of policies promoting pro-market environments and commitment

to the security of persons and properties ensuring firms' growth. It also shows that policy

choices emphasizing on secure property rights laws and greater constraints on leaders

have the potential of broad financial impacts. Asset pricing theory suggests that private

investors' participation in privatization is not a natural occurrence in highly volatile

countries. It is important for private investors to examine government's goals and policies

to understand its motivations prior to engaging resources. These include an appraisal of

6
transaction and asset risk for firms. Our results have great import for labor policies since

employment is a crucial matter given the political unrest that massive and structural

unemployment might trigger. Many countries seek to mitigate the drawbacks from such

immense layoffs by enrolling the laid off workers into programs where they can acquire

new skills to enter other industries. Nonetheless, any successful outcome of such strategy

is yet to manifest itself. Lastly, our results have broad implications on credit allocation

since we observe a crowding out effect associated with privatization through our

measures of financial development. This suggests that policymakers might consider

partial privatization in some instances for other projects, in the private sector, with

positive NPVs to get financed and produce their stabilizing effects on growth,

employment and other macroeconomic indicators.

The remainder of this chapter is organized as follows. The next section reviews

the different stand of literatures relevant to our study. Section 3 presents the

methodological framework and the measurement procedures. Section 4 discusses the data

aggregation. Section 5 will present the empirical findings. Section 6 will summarize and

conclude.

1.2 LITERATURE REVIEW

Two competing views on state ownership have thrived over the years: The

neoliberal and the anti-neoliberal. The neoliberal view is that SOEs are owned by the

general public acting as shareholders who elect government officials, serving as board of

directors who choose SOEs' management. As a result, SOEs suffer from direct

supervision since they are not subject to stringent oversight like are their privately owned

7
counterparts where shareholders actively exert pressure on management to improve the

bottom line. Shleifer and Vishny (1994) argue that SOEs are more susceptible to pressure

exerted by interest groups to the detriment of profit maximization. Hua Sheng and Du

Haiyan argue that Chinese SOEs were suited to early stage of mass production. With the

development of the economy, the problem of SOEs' low efficiency became apparent. As

these firms met with no competition from outside, they offered no rewards inside. As a

result, they were characterized by poor management and sub-optimal resource allocation.

However, following their privatization, privatized Chinese firms were granted natural

rights to retain earnings and employees' compensations. Employees' interest became

aligned to those of the firms, reaching thus their profit targets (see Ramanadham, 2002).

Whereas the anti-neoliberals argue that, it behooves to the state to turn around large firms

to produce at low costs for its constituents.

The two types of corporations operate in starkly different environments.

Managements of privately owned companies have more incentive to take on risk and

create value lest they be removed from their position. Other market mechanisms such as

hostile takeovers, analyst coverage, rating agencies, short selling, and proxy fights, inter

alia, are effective tools to sanctioning poor performing privately owned enterprises. Even

remotely, SOEs do not feel such pressures and thus are free from market stresses.

Nonetheless, in many instances, dismantling the state ownership may not lead to the

expected results. For instance, in many developing countries where the institutions are

fragile, powerful groups may get upper hand on the privatization process and embark in

assets stripping and other activities detrimental to the incumbent SEOs without fear of

legal consequences. Indeed, anti-neoliberals point to the fact that the massive transfers of

8
ownership from the state to the private sector have been marred with important corporate

governance failures such as new empire building, and insider trading in Russia, the

voucher program in the Czech Republic, religious considerations in Bosnia, and the

various obstacles in utility and infrastructure privatization in developing countries. Here

is the necessity of investigating whether former SOEs redeploy their assets and allocate

their resources efficiently following their privatization.

Several sets of theories compete to explain the merits of privatization in the

context of property rights and market mechanisms. A first set of theories is that of market

mix arguing that competition is more relevant than property rights. The core of this

theory is that if SOEs can bring the right product to the customers at a competitive price,

they would match privately owned companies performance. Stiglitz (1994) argues that

the difference between public and private production is overblown. He stresses that the

real differences from the two types of firms arise from commitments and incentives; for

there are managerial incentives problems in market economies just as there are in planned

economies. Nevertheless, this argument overlooks the experience of many countries

where competitive forces have forced SOEs out of business. Therefore, the view that

ownership does not matter more than market structures, might be both empirically and

theoretically challenged. A second set of theories contends that SOEs are inherently

inefficient and that the ailment to failing SOEs rests in dismantling the state ownership.

The premise here is that no matter how strong a country's institutions are, or how well

intentioned is the government, privately held firms will always have superior

management and thereby better performance. Surely, both empirical and theoretical

evidence on the sub-par SOEs' performance is unsettled. Here, comes the need to

9
investigate property rights environment ensuring firms' success in the context of

privatization.

1.2.1 State Ownership vs. Private Ownership: New Perspectives

SOEs have come as a necessity in many countries, and to some extent, the most

effective way to holding together everyone in countries emerging from the former

colonial power is to nationalize and/or confiscate what have been left behind. This can be

viewed as an affirmation of sovereignty and nationalism and the highest expression of

economic, financial and political freedoms. However, in the early 70s with the advent of

Premier Margaret Thatcher, there has been an ideological shift. The disengagement of the

state in managing businesses has emerged as a restructuring policy; a policy that was

forcefully pursued by President Ronald Reagan and touted as smaller and leaner

government being more efficient. The IMF has been successful and convincing

developing countries that they are falling behind due in part to their financing of failing

SOEs. Hence, most developing countries, especially the relatively politically stable ones,

have extensively privatized their SOEs. Western institutions have convinced the former

Soviet Union members that privatization was the way to proceed toward economic

prosperity and financial stability.

However, opponents of the policy argue that public production is the delivery of

goods or services in lieu of generating profits. The essence of this argument is that public

ownership was a response to market failures in times where the private sector was either

unwilling or unable to take on crucial financial and economic endeavors necessary to

industrialization. The countervailing argument is supported by the fact that academics

diverge on the superior performance of the privatized firms.

10
 Friedman (1993) argues that governments usually undertake economic activities

desirable and crucial for improving quality of life when the need arises. When these

activities become unprofitable or when market forces, and needs for capital and

technology threaten an SOE's existence, then the government is left with few options:

Pass the baton to the private sector or find another justification for a continued existence.

Neoliberals argue that the market solution is more viable and sustainable, for changing

the mission of a state firm is political, ideological and might be motivated by nationalistic

and populist feelings.

Eventually, SOEs have grown inefficient and unprofitable. Their inefficiency is

traced to lower incentive for profit and inferior management. Opponents of dismantling

public ownerships argue that privatization is not a credible alternative but restructuring

SOEs would be a better policy. They point to corporate scandals in the 1990s and early

2000s evidencing that managements were involved in window dressings by publishing

deceptive financial statements in effort to boost stock prices. Enron and Worldcom

represent the face of companies that have morphed into huge trading deceptive schemes

and corporate frauds. The investing public became perplex about financial markets and

anti-neoliberals seize on the market failure to support their claim that privatization is far

from being the solution to failing SOEs.

Another point of contention in the argument between SOEs and private ownership

is the agency problem created by incentives for profit. Neoliberals argue that

shareholders are better off when talented managers are highly compensated or given

incentives to add value to the firm. Incentive is lacking in SOEs since most SOEs are

vocationally for non profit. Nevertheless, incentives for profits are not materially

11
different in nature in the public and in the private venues so long as those who run the

companies SOEs or private understand that their interests do not supplant those of the

other stakeholders. The anti-neoliberal argument is that the agency problem is far more

acute in the private sector by pointing to a variety of ineffective corporate practices.

These include loans to executives at zero or near-zero interest rates which oftentimes are

not reimbursed; executives responsible for taking their companies to slippery slopes

continue to receive significant bonuses, cash in their holding in a timely fashion and

small stakeholders might lose their whole investment. Oftentimes, managements push

firm's pension fund to invest in the companies' own stock in efforts to keep stock prices

high. When executives misstate financial statements, time the market, and exercise their

stock options, the value represented by the company simply disappears when news of

wrongdoing brakes except that those executives make unscrupulous gains from their

unethical activities.

Financing the two types of firms is a matter of contention. To keep a failing

private company afloat, investors have to draw from their own personal wealth while for

a failing SOE the wealth base is much larger since it is originating from taxpayers. In the

latter case, the costs are shared by every citizen whereas the benefits are at best shared by

a few if not a clique --conditional on the firm's activities. In this instance, even in the case

of failure by SOEs the costs are viewed as minimal. There is one rule of thumb: A failing

private enterprise fails because it signals mismanagement of the firm, which has to file

for bankruptcy and/or liquidate its assets unless it is bailed-out by the government. On the

other hand, a failing SOE devoid of financial slack has the government as its lender of

last resort for fear of political consequences.

12
 Furthermore, advocates of privately owned enterprises question whether people

really have voice in the SOEs? Theoretically, the general public is the shareholder of the

SOEs since it elects the government - the board of directors - which chooses the

management of the state firm. However, if government is not democratically elected, or if

institutions are not smooth then the shareholders' interest will not have the primacy in the

management of the SOEs. Therefore, sub-par performing SOEs can cause important

change in government and trigger political instability or administrative corrections.

Nonetheless, without democratic institutions such distant threats are ineffective and may

not be a credible alternative to market corrections. Indeed, in countries with efficient

markets such as the United States, Canada and Europe, market disciplines might be

severe. Management feels them from different fronts. First, if a privatized firm is publicly

traded, then shareholders are expected to short sell the shares of a poor performing

company to readjust their portfolio. Second, hostile takeovers are credible threats that

managements are aware of, they heed them or face the consequences. Third, shareholders

may enter a proxy fight to remove management. Fourth, other corporate mechanisms

such as stock options and pay performance can align management of the former SOEs'

interests with those of the shareholders. Management of SOEs faces only remote threats

since they are rarely publicly traded. In cases where there is embryonic checks and

balances system, many SOEs are considered as cash cow whose powerful management

can bribe vulnerable congressmen facing reelection while politicians at all level have a

proclivity to use the firm' funds to cementing their political base. In many cases,

monopolies emerge and protected by laws. Therefore, SOEs are foreordained to

functioning in ways unparalleled to market principles.

13
 Shirley and Walsh (2000) document that even well intentioned governments may

not be able to assure that SOE managers do their bidding despite of what corporate

governance theories suggest. They argue that the empirical literature favors those

skeptical of SOEs as a tool to address market failures. They further note that studies of

industrialized countries, where they might expect more developed political markets to

motivate greater government concern with welfare maximization or better information

and incentives to overcome corporate governance problems, private firms still have an

advantage. They conclude that private advantage is more pronounced in developing

countries, where market failures are more likely.

A prevailing argument is that SOEs are susceptible to political manipulation, and

restructuring them comes with political costs. A government facing reelection may either

subsidize or freeze prices, temporarily move services to specific constituencies in

business areas under its influence as a subterfuge to red herring the electorate. Hence,

politically weak government thriving through volatile political and economic

environments should be less prone to privatize. Indeed, Boehmer et al. (2005), and Clarke

and Cull (2002) contend that politicians choose to privatize only when the political

benefits of privatization outweigh the political costs. They find that in the developing

economies, political factors significantly affect SOB privatization decisions. Otchere

(2005) points out that economic restructuring generates high degree of political instability

because of the uncertainties associated with the transition from state apparatus to market-

based economies. More recently, Swee-sum, Seow-Kuan Tan, and Tsao-Min Wee (2007)

note that if the issue of employment is mismanaged, the restructuring of the economy

comes with political unrest. The authors noted that while there are uncertainties

14
associated with changes this does not suggest that opponents of privatization have a

natural proclivity toward the status quo. Rather, they might just be reluctant because they

are afraid of the upshots of the unknown. Consequently, if privatization does not lead to

visible and significant improvements in the living standard of the population, this will

favor the resurgence of hard liners and renationalization is likely. Indeed, Boubakri,

Cosset, Fischer, and Guedhami (2005) find that private investors are more inclined to

hold larger stakes of firms in more stable political and social environments. They find

that investor protection and social and political stability explain the cross-firm differences

in ownership concentration, which might serve as a force to concurrently defend their

rights in face of political and legal uncertainties.

Boubakri et al. (2004) argues that a lower level of political risk and a friendly

institutional environment are significantly related to performance improvements after

privatization. Perotti and Oijen (2001) assert that firms in countries where political risk is

lower should also exhibit a better performance since the government refrains from

reversing the privatization policy and interfering in the activities of the firm. In fact, if the

privatized firm is well managed and is noticeably economically transforming by

increasing its share of GDP, it may be a step towards stabilizing a country given that

economic progress has the potential to ensure democracy, political stability and social

cohesion by averting social decay and political chaos.

1.2.2 State Ownership vs. Private Ownership and Firm s' Performance

Proponents of privatization of SOEs point to the estimated increase in efficiency

resulting from private ownership. The increased efficiency is attributed to the greater

import that private owners tend to place in profit maximization as compared to

15
governments, less inclined toward profits but the welfare of society at large. Further, they

advocate that SOEs are entrenched and protected from market forces in ways that lessen

their need to efficiently use their assets and optimally allocate their resources. They point

to weaknesses in both financial and economic performance of the SOEs especially in

developing countries where SOEs are more likely to add to the fiscal burdens (see

Cleassens and Djankov, 1998). Furthermore, Ramesh Adhikari and Colin Kirkpatrick

(see Ramanadham, 2002) argue that public enterprises have been significant borrowers in

domestic and foreign credit markets. Where, as commonly happens, the government

guarantees the public enterprise debt, a deterioration in its financial performance can

have serious repercussions for the governments' budget. Indeed, many studies in the

financial literature have estimated the impacts of privatization at different dimensions.

Although the overall results on SOEs and privatized firms are mixed, by and large the

literature reports enhanced financial results associated with privatization.

Government borrowing that was necessary to sustain SOEs in many countries

contributed to the debt crisis of the 1980s (Chang and Grabel, 2004). A key report on

SOEs by the World Bank opens with several striking facts. The report states that in

Tanzania, central government subsidies to SOEs respectively account for 72 and 150 per

cent of central government spending on education and health. In Egypt, Peru, Senegal

and Turkey, a mere 5 per cent reduction in SOE operating costs would reduce the fiscal

deficit by about one-third (World Bank 1995: 1-2, in Chang and Grabel, 2004).

Several researchers, including Berglof and Roland (1998), Boehmer, Nash, and

Netter (2005), Clarke and Cull (2002), Harper (2002), La Porta et al. (2002), Megginson

et al. (2004), and Shleifer and Vishny (1994) argue that SOEs are effective channel of

16
redistribution for political dividends. According to the prevailing viewpoint, state firms

answer to political masters rather to market forces and mechanisms. As a result, wide

divergences from profit-maximizing behavior are not only possible, but also sometimes

tactical since governments have more freelance to exert pressure upon SOEs to

implement their agenda oftentimes deemed populist, and inimical to corporate growth.

Clearly, SOEs underperform partly because they are foreordained to fulfill some specific

socio-political objectives especially when governments, based upon their ideology, tend

to utilize them accordingly.

In the absence of well established and stable institutions such as a politically free

and well functioning court system and a politically balanced parliament, it is difficult to

assume potentates to wisely utilize the assets of a nation. In this regard, socio-political

choice might supersede corporate objectives thereby welfare and profit maximization,

and corporate growth. In fact, Shleifer and Vishny (1994) point out that government

ownership is a tool to achieve political objectives through the provision of employment

and subsidies to supporters in return for political contributions and votes. However, the

assessment of this issue requires that one bear in mind the original goal and the intention

upon which SOEs have been created for: Produce a level of output to meet a broad

demand. If this broad demand is reasonably sufficiently met, this might avert social and

political upheavals. This may create a dilemma between SOEs, their raison d'tre, and

market mechanisms.

Boubakri et al. (2005) evaluate the performance of 230 privatized firms from 32

developing countries. They document a significant increase in profitability, efficiency,

investment and output. Their analysis shows that the changes in performance vary with

17
the extent of macro-economic reforms and environment. In particular, economic growth

is associated with higher profitability and efficiency gains; trade liberalization is

associated with higher levels of investment and output, while financial liberalization is

associated with higher output changes. Further, control relinquishment by the government

is a key determinant of profitability, efficiency gains and output increases. Finally, they

find higher improvements in efficiency for firms in countries in which stock markets are

more developed and where property rights are better protected and enforced.

Another study by Boubakri and Cosset (2005) looks at the relation between

ownership structure, investor protection, and firm performance. They seek to answer the

following questions: (1) what is the ownership structure that results from privatization

and how does it evolve thereafter? (2) Does the level of investor protection influence the

post privatization ownership structure? (3) Does the post privatization ownership

structure depend on other factors? (4) How do ownership structure and investor

protection relate to firm performance, and what explains this relation? They find that the

effect of ownership concentration on firm performance is stronger in those countries in

which investor protection is weaker. These results suggest that ownership concentration

is a key mechanism of corporate governance in such countries. Taken together, their

results, obtained in the context of privatization, shed light on the functioning of corporate

governance, particularly the role of ownership concentration and investor protection.

Further, in their cross-country study, La Porta et al., (2002) find that the financial

performance of publicly owned banks is inferior to that of private banks. Cornett et al.,

(2003) find that state owned banks are significantly less profitable than privately owned

banks.

18
 Alexandre and Charreaux (2004) look at the efficiency of French privatization

and analyze privatization in light of corporate governance theory. The authors fail to

confirm the positive effect on overall static and dynamic efficiency of the firm

traditionally attributed to privatization for French privatizations. In addition, they argue

that whatever positive value accrues from privatization is affected by the contextual,

organizational, governance, and strategic variables that influence the privatization

process. They point to the methodology used by Boubakri et al. (2005), Megginson et al.

(1994) comparing performance before and after privatization (over 3-year periods). They

argue that this method supposes implicitly that the influence of privatization occurs

instantaneously, and that there is a rupture or a shock leading to a relatively fast recovery

of the firm's performance, and that privatization is that rupture. They argue that, on the

one hand, in certain firms, there is a restructuring prior to privatization, such as an equity

issue or a downsizing. While, on the other hand, the effects of privatization might take a

long time to occur. The improvement in performance reflects the changes in the corporate

governance system, the reconfiguration of the organizational architecture, and the

implementation of a new strategy. Developing these systems or implementing these

strategies can take time, often more than 3 years, because of the organization's inertia.

They conclude that privatization has a favorable effect on the performance for only a very

small minority of the privatized firms. Most often, the effect is not significant. Of those

results that are significant, about as many involve a loss of efficiency as the contrary. The

results they obtain for the various explanatory models of the dynamic efficiency confirm,

at least in part, the assumptions put forth to explain the process of privatization.

Moreover, Otchere (2005) finds that privatized banks subpar performed the benchmark

19
index in the long-run. Kole and Mulherin (1997), study a sample of U.S. corporations in

which the federal government held 35 percent to 100 percent of outstanding common

stock for between 1 and 23 years during and following World War II. They find that the

performance of the state owned companies was not significantly different from that of

private sector firms in the same industry.

1.2.3 Privatization, Property Rights and Contracting Rights

A void hitherto to be filled in the literature consists of the link between

privatization and the investing environments as it pertains to property rights and

contracting rights, and intellectual property rights protections. Here, this study

emphasizes on the impacts of privatization and property rights on firms' growth on an

industry basis. Specifically, it asks whether firms whose ownership has shifted from the

state to the private sector have allocated their resources productively and how does their

resource allocation relate to changes in property rights institutions. Assessing the impact

of privatization elicits several interrogations including whether the prevailing results in

the extant literature enlighten our understanding of the relationship between privatization,

private property rights, intellectual property rights protection and firm's productivity and

financial performance? Did the developing countries that have embarked in dismantling

the state ownership have improved their property rights protection? Have the institutions

vital to market economy preceded privatization or implemented afterwards? Do

governments privatize industries that are more capital intensive than others? Is there any

relationship between intangible intensity, private property right, privatization and firm's

performance?

20
 Property rights are set of legal rights relating individuals and/or institutions with

their possession of tangible assets and/or intangible assets (Cleassens and Leaven, 2003).

They are integral component of any social system as they are associated with rights of

ownership of goods as the community and the state recognize one's prerogatives to

benefit from her properties and exclude others from exercising those rights without fear

of retaliations. Demsetz (1967) suggests that the role of property rights in social systems

is to help people form expectations in dealing with others. Given that interactions

between transacting parties need to be regulated within a legal setting, Demsetz' view

implies that property rights are first recognized and then enforced within a judicial

system to influence asset allocation. Such legal system should serve as safeguard for

private property rights owners such as investors taking part in privatization process to be

able to challenge their government if their private property rights are taken away without

fear reprisal. This also includes strong contracting rights where firms can challenge the

legality of the stage actions in case of expropriation, repatriation and reneging from

previously established contracts by the state. Thus, in countries with strong institutions,

property rights recipients can exert their rights by seeking judicial enforcement of the

rights they possess or compensation for damages caused by third parties including the

state. Indeed, the law and finance theory argues that judicial principles inherited from

colonial traditions explain to a great extent the ability of the court to make such

determinations with efficacy. It contends that the common law legal heritage is friendlier

to private property rights as it recognizes that certain kind of contracts between

transacting parties are enforceable through the judicial system regardless of their degree

21
of formalism, and their non-observance bears costs to infringing parties. The theory infers

that contracting with the state incurs much risk in the French civil law legal heritage.

Zuobao, Feixue, and Shaorong (2005) analyze a sample of Chinese firms and

conclude that in the absence of a competitive property rights and a well-functioning legal

framework, partial privatization may be damaging to firm value due to expropriation of

public assets by insiders. Like political rights, economic rights are a bundle of freedoms

and protections governing ownership and exchanges. Economic rights have received less

attention compared with democracy in the empirical literature, forcing analysts interested

in cross-national examination of these institutions usually to look for proxy measures

(Che and Qian, 1998; and Goldsmith, 1995). Theoretically, Che and Qian show that in an

environment without secure property rights against state encroachment, private

ownership leads to excessive revenue hiding. Sun and Tong (2003) document that in the

absence of a well-functioning property-rights market privatization can result in the

transfer of public assets to private agents who do not use them efficiently than under the

state ownership.

Surely, property rights environments are shaped by political institutions. Political

environments are crucial to successful privatization. A key to a successful privatization is

stability in both institutional and legal systems of the privatizing country. A privatization

environment that suffers from such characteristics might result into complete failure in

several aspects. First, the process itself might be biased so that government takes away

public assets and dispense them to people close to power circles. Privatization in this

sense might be a total social injustice. Second, there is convincing evidence of majority

shareholders expropriating wealth from minority shareholders because of poor minority

22
protection rights. Atanasov (2005) finds that in the absence of legal constraints, majority

owners extract more than 85% of firm value as private benefits of control. He finds that

institutional investors form portfolios of predominantly controlling positions or

participate in majority coalitions. Majority-owned firms cannot persist as publicly traded

corporations if the expropriating activities of controlling block-holders are not legally

restricted. La Porta et al. (2002) argue that a legal environment that does not protect

minority shareholders facilitates concentrated ownership. Atanasov (2005) argues that a

stock market with dispersed ownership and high minority shareholder valuations will not

emerge if there is no legal control over controlling blockholders.

Alexandre and Charreaux (2004) argue that the method2 chosen to privatize SOEs

impacts future performance. However, in countries with weak legal infrastructures, where

accountability of political leaders is uncertain or at best weak, the transparency and the

credibility of privatization programs, regardless the method chosen may be doubtful.

Those with strong political acquaintance might unfairly gain from the process, and as a

result subsequent privatizations might face fierce public resistance. Therefore, the method

and level of privatization in a country might be a good proxy to assess its degree of

transparency both in government and in market. Megginson et al.( 2004) examine the

political, institutional, economic factors on the choice between selling an SOE through

share issue privatization (SIP) and asset sale using a sample of 2,457 privatization events

from 108 countries with a total value of $US 1,186,284 million. They find SOE is more

2
Methods of privatization include share issue privatization (ISP), voucher privatization, which was more
predominant and Eastern Europe, and assets sales.

23
likely to be sold in an asset sale the less there is state control of the economy, and

investors are more willing to invest in asset sale.

The present study presumes that privatization has been adopted long enough for

its impacts to be assessed on a sectoral basis to inform policymakers which economic

sectors to prioritize when formulating policies on privatizing and restructuring SOEs.

There is sufficient data on privatization across countries, time and industries warranting a

sectoral decomposition of the relationship with firm's productivity and firms' growth. The

association between privatization and property rights, intellectual property rights

encompassing financial assets has not received due attention in the literature. The extent

to which financial assets, private property rights and intellectual property are protected by

law are crucial for privatization to take place and bare fruits.

The current study conjectures that circumstantial changes such as ownership

changes should positively influence property rights laws and thereby contracting rights.

The change in ownership should exert pressures on the property rights environment, for

concerned groups or investors engaging resources in sectors responsive to property rights

protection ought to formulate policy changes and endeavor to influence policymakers in

several ways. These interest groups are assumed to be very influential even if it might

take a long time for structural change to occur. The result of their proposals should lead

to new policy implementation that will in turn impact the circumstances leading to their

implementation: An environment where investors were hardly protected against unlawful

actions of competitors as well as authoritarian actions of the state. Therefore, as Reynolds

(1985) puts it, property rights are inseparable from the right of property. That is, there is a

24
great of causation between private property rights and privatization since the latter gives

rise to new properties and new rights to private investors.

In many developing countries there are a variety of organizational and

institutional arrangements in business practices that are harmful to firms' growth. Good

institutions guarantee property rights and minimize transaction costs. When investors

have to pay premiums to contract with each other or to receive public services this

discourages investments and by and large deviates legitimate funds to unlawful and

unproductive activities. Reynolds (1985) argues that every society must have a system of

property rights. The nature of this system of property rights influences relationships

between economic agents. When property rights are not clearly defined or incorrectly

specified externalities create allocation problems for a market system. Thus, weak

property rights infrastructures discourage long term commitments to investments and

repel foreign investors. Cleassens and Leaven (2003) argue that in countries with more

secure property rights, firms might allocate resources better and consequentially grow

faster as the returns on different types of assets are more protected against competitors'

actions. Putting the pieces of the property strand of literature together, this study is

investigating the joint effect of property rights, contracting rights, IPRs, and privatization

on firm's growth and value added. It hypothesizes that privatization has a positive effect

on corporate growth and the interaction between privatization and property rights is more

positive for countries with better property rights indicators.

The study uses two of measures for property rights (1) property rights, and (2)

control of corruption as measured by the Heritage Foundation. It follows the strategies

implemented in studies such as (Rajan and Zigales, 1998; and Cleassens and Leaven,

25
2003) in using U.S. industry level data to proxy for industries that rely heavily on

property rights laws and thereby intangible intensity to grow. Furthermore, social

planners are often conflicted between distributional policies, nationalization and

confiscation and renationalization of assets; our study seeks to subtly address the impacts

of such policies as it relates property rights, contracting rights, and privatization to

industry growth by striking a balance between political risks to politicians with incentives

to propose regulations appeasing to political supporters but ineffective at bettering

property rights in ways that embolden the use of a society's pool of resources. To simply

put it, the attempt is to measure in a codified approach whether property rights and

financial assets are protected by law and their effect on industry growth; whether

intellectual properties are also protected and how this percolates to industries relying on

intangible assets; whether the judiciary is independent, and whether the legal framework

allows private business to settle disputes in ways where the legality of governments'

actions can be challenged without fear of retribution. The risks involved include political

instability, political risk, along with ownership political risk as well as operating and

transfer risks. It is expected that there is a relationship between privatization and these

battery of risks channeled through property rights institutions. The present study seeks to

capture these multidimensional relationships and assess how successful shifting of

governments' operations from the public sector to the private sector has been in reducing

costs and ensuring greater corporate efficiencies.

1.2.4 Intellectual Property Rights (IPRs) and Firms' Growth

Intellectual Property Rights (IPRs) are just like other types of property rights;

absent protection of IPRs, there will be no incentives for investors to risk their resources

26
in the generation of new ideas or new products (Chang and Grabel, 2004). Here, we

examine whether changes in ownership have a heterogeneous effect on industry growth

depending on IPRs protection. Numerous industries may depend on the strength of patent

rights, trademarks, goodwill, rights over ideas, and various intangible assets to grow. We

assume that industries depending on certain class of assets grow disproportionately

slower if IPRs are weak. We also conjecture that stronger IPRs enforcements stimulate

more R&D activities in industries that are more intangible intensive. Therefore,

controlling for the joint effect of privatization and IPRs and the joint effect between

privatization and R&D, allowing IPRs to vary by R&D activities should have a positive

impact on industry growth.

Chang and Grabel (2004) review the arguments related to intellectual property

rights protections. One side of the debate claims that individual corporations as legal

persons should be granted property rights over ideas. In effect, until recently, developing

countries routinely ignored patents and other IPRs, despite national laws governing these

matters. Today, countries must protect IPRs to the degree that they are protected in

industrialized nations. Protection of IPRs encourages innovation and foreign direct

investment; enforcement of trade-related intellectual property rights (TRIPS) makes it

easier for developing countries to gain access to advanced technologies and products; for

inventors and investors will no longer fear that they will be denied their rightful profits

because of IPR violations; and firms in industrialized nations will be more willing to

create products and technologies specifically for developing countries. On the other hand,

opponents of the protection of private IPRs argue that IPRs are not a prerequisite for

generation of new knowledge in all circumstances. They argue in favor of public property

27
rights in the open software program where one can enjoy the product and improve upon it

and share the improved product with no rights of selling the new version for profits. They

claim that private property rights like patent rights create monopolies and sometimes

patents are granted for products are just improvements on previous versions not invented

by the new patentee.

Schumpeter argues that capitalist system provides incentives for innovation

because individuals can reap the rewards of innovation during a period of monopoly.

Neoliberals question the legitimacy of such monopolies and their social consequences

arguing that democratization of the process by which products are created might avoid

duplication of resources to create similar products in poor countries. They point to the

fact that patents were not important to the development of industrialized nations; plus,

evidence shows that developing countries that have signed on TRIPS regulations have yet

to benefit from such regulations that do nothing but slowing their development process.

They point out that there is no reason so far to believe in transfer of technologies

advocated by neo-liberals to developing countries that have enforced the IPR laws. It

appears that countries that have better legal systems and politically stable are recipients

of technological transfer not those that adhere to TRIPS (see Chang and Grabel, 2004).

1.2.5 Privatization, Employment and Wages

Oftentimes, privatizing SOEs elicits strong opposition from state employees

fearing massive layoffs. Recently, Lam et al., (2007) conjecture that the move toward

market-based economy often results in structural unemployment. This may explain why

governments, oftentimes, offer early retirement plans, compensations, and tax

exemptions as incentives to starting up new businesses to avert unemployment. In many

28
cases, in developing countries mostly, these initiatives do not prevent the shortcomings of

privatization. In fact, Harper (2002) studies Czech's privatization and finds a large decline

in employment following privatization. However, the author argues that the most

profitable firms were the less likely to cutback employment. His finding is rather

eccentric finding since most studies argue insignificant changes in employment following

privatization. One possible explanation maybe that his study covers firms from various

industries from a formerly planned economy while the other studies in the extant

literature focus mainly on the banking sector. Research covering wide range industries

focus mostly on market-based economies where more skillful resources might have

already been employed. It may be that to truly assess the impact of privatization on

employment one needs to address the issue in a country by country case along the

industry lines.

Indeed, Otchere (2005) finds that privatized banks did not lay off employees;

rather, they reduced the rate of growth in employment after privatization although the

privatized banks were significantly overstaffed than were their rivals. Megginson et al.,

(1994), Boubakri and Cosset (1998), and D'Souza et al., (2005), agree that employment

does not significantly decline after privatization. More surprisingly, their analysis

acknowledges that state ownership leads to lower post privatization employment.

Actually, D'Souza et al., (2005) find an insignificant increase in employment following

privatization while Sun and Tong (2003) show that SIP in China does not lead to massive

layoff and instead, it leads to increased employment. This triggers the question to wit

whether state owned firms were truly overstaffed?

29
 Here, we specifically examine whether privatizing sectors that are more capital

intensive are more responsive to growth in employment. We conjecture that capital

intensive industries are more dependent on external finance, heavy machinery and skilled

labor to grow. By the same token, intangible intensive industries should rely more on

R&D and skilled labor to grow. These industries should be more sensitive to property

rights and IPRs protection and are expected to significantly downsize following

privatization. To test these conjectures, the study follows the financial development

literature in identifying industries in the U.S. that rely on property rights to grow. It

assumes that industries that are more capital and intangible intensive are more sensitive

to property rights. Using the United States as proxy, the assumption carries over the

developing economies for which we examine how privatization interacts with capital and

intangible intensities as well as property right to spur firm's growth. The financial

development literature points out that one possible setback of using U.S. industry level

data as proxy is that it is less accurate than countries actual data. However, considering

that these proxies are predetermined, they are thus clean of endogeneity generally

plaguing firms' and industry's growth estimates. More importantly, in backward

economies where technology is modest, manpower is an important factor of production to

the point that actual industry data from many of these economies may be illusory in terms

of capital needs of these countries and their industrial sectors. Without a credible proxy

for industry capital intensities, inferences from country industry data might be unreliable.

Low capital intensities for some countries might be misleading in terms of industry

capital needs due to the fact that many governments in developing countries rely on

30
scavenging donor countries for salvageable machinery to support their SOEs to

producing some basic goods.

To test the different theories of property rights, contracting rights, IPRs and

privatization, we formally test the following hypotheses:

H1: There is no relationship between industry share of privatization and firms'

growth of output, value added and establishments at the industry level.

H2: Industry share of privatization has a positive and significant impact on firms'

growth and a more positive and significant effect for industries in need of property rights

protection.

H3 :If investors require property rights protection before SOEs' ownership

dismantlement in sector with important need of capital, then the effect of the interaction

between industry share of privatization and capital intensity is positive, and a stronger

effect of the interaction between industry need of capital and property rights protection

on industry growth.

H4: If industries with higher need for stringent property rights laws are more

intangible intensive, then the interaction between intangible intensity and property right

has a positive effect on firms' growth within these industries, and this effect is stronger

with the interaction of IPR.

1.3 THE MODEL

The relationships between firm's growth, privatization and property rights are

examined using a classical Cobb-Douglas production function as follows.

31
 where all factors are assumed constant returns to scale (CRS) and subscripts i and

t represent country i at time t. Y, is (a) growth in total output, (b) growth in industry value

added, and (c) growth in establishments within an industry or related industries in a given

country at a given time. Specifically, growth is measured in these three different ways as

the average by ISIC sector over the period 2003-2007. These measures of industry

growth will capture whether firms across industry lines are more efficient under private

ownership and whether the industries are becoming more competitive. L is the labor

force, K stands for physical capital and A is factor technology. The factor parameters

and are unconstrained and represent the marginal productivities of labor and capital.

For instance, the parameter states the percent change in total output for a one percent

change in factor labor. It is the marginal productivity of labor. Likewise, the parameter

states the percent change in total output for a one percent change in physical capital. It is

the marginal productivity of capital. In the neo-classical endogenous-growth model the

factors are constrained so that +=1.Here, we allow the parameter to be freely estimated

without calibrating them. After taking the natural logarithm of both sides of eq. (1), it can

be rewritten as

Equation (2) states that firms' growth within an industry is a function of

technology, human capital, physical capital, industry fixed effects and the error

component. Mankiw, Romer, and Weil (1992) argue that A reflects not just technology

but resource endowments, climate, institutions, and might be thus different across

32
countries. Park G. and Ginarte (1997) assert that A represents the level of labour-

augmenting technology and depends on institutional, cultural, environmental and related

factors. Moreover, if firms better allocate resources and grow faster in countries with

more secure property rights(Cleassens and Leaven (2003)), and technological progress

depends on these property right mechanisms, then A can reasonably be proxied by

property right indexes and intellectual property rights as is often the case in the financial

development literature.

As a mean to raise funds by the state, privatization is an incredible channel of

financing for the newly privatized firms. Capital structure theory suggests that the value

of the firm is the sum of the value of its debts and that of its equities. Therefore,

privatization simultaneously accomplishes two fiduciary acts. First, the privatizing

government takes the proceeds from privatization to either apply them to its budget or

invest them in other infrastructures and or social projects. Second, the newly privatized

firm is then held by private investors to the degree of privatization proceeds, the size or

value of the incumbent SOE. Assuming that the newly privatized firm is unlevered, the

value of the firm is then determined by the amount of the new equity base i.e., the

proceeds from privatization. In addition to increasing the equity base of the privatized

firm, privatization brings about long term financing and commitment of capital markets

via new equity offerings, cross-listings, and foreign ownership. Therefore, as a proxy for

physical capital stock K can be substituted by proceeds from privatization or the newly

privatized firms' value of equity. Using time averages and augmenting the baseline

regression, the empirical strategy in (Rajan and Zingales, 1998; Cleassens and Leaven,

2003) can be thus implemented.

33
 The Rajan and Zingales (1998)'s study triggers a series of empirical investigations

with different sort of extensions. In line with this strand of literature we look at how firms

in a given industry rely on property rights laws to grow and how property rights

themselves interact with privatization on the premise that industries that are more

sensitive to property rights are difficult to privatize and grow at a slower pace. Certainly,

some sectors are more vulnerable to illegal activities, thus it is expected that some class

of assets such as intangibles be more sensitive to property rights as well as types of

ownership. Generally, intangibles are assets with no physical existence in themselves but

represent rights to enjoy some privilege (Cleassens and Leaven, 2003). Therefore, highly

intangible instensive industries can be expected to be more dependent on property rights

to growth. Hence, a joint positive influence of intangible intensity and privatization on

firms' growth is expected. Similarly, assuming no factor intensity reversal, capital

intensive industries are more efficient and contribute more to improving living standards.

Capital intensive industries are very dependent on both external finance and property

rights to grow. They are dependent on external finance to renew their machinery and

technology. They rely on property rights to protect their assets especially in politically

volatile countries; so we expect firms in capital intensive industries to be privatized more

and grow faster when property rights protection is strong. The relationship between

privatization, firm's growth and property rights can be examined using classical aggregate

production function as follows.

34
 where the subscripts j and k respectively represent industrial sector j and country

k. represent a vector of coefficients either by industry j or by country k. Equation (1)

states that the various privatized industries in the many countries around the world

positively contribute to the countries' firms' growth. It explicitly indicates that there is not

only a relation between firm's growth on an industry basis but also the interaction of the

countries property rights laws or the countries legal structures with their industry need of

both capital and protection and firm's productivity. In other words, the basic hypothesis

here is that privatization has a positive and significant impact on firm's growth (i.e. 3>0)

and more significant for industries in need of property rights protection especially in

countries with better property rights laws. Furthermore, the coefficients on the interactive

terms between capital intensity and intangible intensity and property rights will be more

significant for developing countries than for developed and upper middle income

countries.

Additionally, were capital and intangible assets critical to firm's growth, then

highly capital intensive firms in cash strapped countries should be privatized intensively,

and the privatized firms should be more productive and financially stronger. Nonetheless,

financing sources for these firms across the industry spectrum depend on the market or

the investing environment architecture. In other words, if the sources associated with

financing the privatizing firms stem from private investors, then we expect funds

35
providers to require an environment propitious to investing especially for sectors where

activities can be easily counterfeited or more exposed to competitors' behavior. Thus, the

interaction between privatization, capital intensity and intangible intensity will be

positive and significant and more so in countries with better property rights laws. Hence,

another specification follows.

where the variables are as defined in the previous equations except that eq. (4)

states that the relationship between growth and privatization is positive and significant

while the significance is magnified by the by the interaction between privation and

industry need for capital and property protection. Proceeding this way allows us to

decouple the link between firms' growth and privatization while assuming that industry

needs for capital and property rights protection is not only different across the industry

spectrum but relate differently to growth. This should have significant policy implications

as policymakers and social planners will be advised on which economic sectors to

emphasize when formulating reform proposals.

That property rights protection is critical to resource allocation is well

documented on the extant literature. Indeed, there is overwhelming cross-country

36
evidence of a strong positive relationship between private property rights and growth

(Knack and Keefer, 1995; Hall and Jones, 1999; and Cleassens and Leaven, 2003).

Moreover, legal environment is positively and robustly associated with per capita growth,

physical capital accumulation, and productivity growth (Levine, 1998). The current study

expects to obtain newer meaningful estimates due to extensive and more comprehensive

data available on privatization as well as the new approach of dissecting privatization

based upon its industrial architecture. The financial development view is that industry

sectors using relatively more intangible assets grow faster. Nonetheless, a country ability

to privatize or to convince private investors to participate in the privatization process

might be function of its quality of property rights environment. Therefore, sectors that are

more sensitive to property rights might press the government for restructuring before

committing funds to the process. All these channels and other sources suggest that

privatized firms' performance and property rights might be joint determined outcomes

related to a country's overall set of institutions and wellness. Such endogeneity might

prejudice the consistency of the estimates.

1.3.1 Instruments

To address the endogeneity concerns, we follow the literature by instrumenting

property rights with exogenous factors such as county legal origin. Acemoglu, Johnson,

and Robinson (2001); Acemoglu, Johnson, Robinson, and Thaicharoen (2003);

Acemoglu, Johnson, and Robinson (2004)) extensively study the causes of the

differences in policies and economic outcomes. They argue that ineffective enforcement

of property rights for investors, widespread corruption, and high degree of political

instability, inter alia, are the root causes of the observed differences. They document that

37
colonial heritage shapes to a large extent the contemporaneous institutions. Namely, in

countries where Europeans where faced with high mortality rates, they established

extractive institutions while in friendlier climates they put in place institutions that are

more favorable to investor's protection. Undoubtedly, their analysis of economic

outcomes can be extended to financial outcomes. Corroborating the colonial origin

theory, La Porta et al. (1998) examine legal rules protecting corporate investors and

creditors and the quality of enforcement of these rules. They find that common-law

countries provide stronger investors' protection. Therefore, this study uses country legal

origin as instruments for property rights.

With regards to the use of instrumental variables, Blundell and Bond (1998) argue

that if the instruments are only weakly correlated with the endogenous variables, then the

use of instrumental variables is a vain endeavor since estimation may be invalid (see

Carlin and Mayer, 2003). That is, invalid instruments may produce meaningless

coefficient estimates. Thus, we will run first stage regressions to check for the strength of

the instruments. Carlin and Mayer suggest the regression of each endogenous variable on

the instrument set and assess their correlation with the variables that their instrument.

Therefore, our estimation strategy constitutes of 3SLS estimation technique using legal

origin as instrument for property rights, contracting rights and IPRs protection in all

regressions.

It is not practical to use panel data because privatization might not occur

seamlessly across countries across time. This poses a challenge in choosing the

instruments and lagged privatization would not be available. In fact, Barro and Lee

(1994) use 5-year lagged explanatory variables as instruments and report that the use of

38
such instrumental variables has modest effects on the coefficient estimates. Therefore,

our strategy is the use of cross-sectional regressions relating to averages over 2003

through 2007. We also use different sub-periods as well as different sources of property

rights indexes to ascertain the stability and robustness of the results. The cross-country

regressions are widely used in the literature. This approach has important advantages

from both economic and statistical perspectives. Economically, it provides evidence of

lasting relationships between regressands and regressors. Statistically, it avoids some

time effects or economic events relevant to specific time periods since the averaging

smoothens out these those effects.

Overall, the present study looks at privatization across the industry spectrum; the

legal environment in which privatization occurs and their impact on resulting property

rights and intellectual property rights; the financial underpinnings of the privatizing

industries, and the institutional transformations that accompany the privatization

programs. The World Development Report of 1996 stresses out that the changes in

ownership structure in transition economies were mainly classified as the cornerstone of

institutional transformations.

1.4 DATA ANALYSIS

Our privatization data are from two main sources including (1) a broad database

on privatization maintained by the World Bank, and (2) the privatization barometer. The

World Bank database covers privatization deals around the world while the privatization

barometer database covers mostly privatization deals in European countries. We use 807

firms privatized during the years of 2003 through 2007 over 37 countries across 17

39
different industries where over 86% of the firms operate in the manufacturing sector. The

classification of the firms into their industry sector is based upon the firms' four-digit

North American Industry Classification System (NAICS) and two-digit Standard

Industrial Classification (SIC) codes. The data show that privatization is more extensive

in the manufacturing sector where the firms are regrouped based on their two-digit SIC

code. In non-manufacturing sectors, however, the firms are classified both on their two-

digit SIC code and their related four-digit NAICS codes. Industries where privatization

deals are seemingly irrelevant are discarded from the analysis.

Proceeds from privatization in 2007 topped $US 132 billion along with 202

transactions from 51 countries of which 43 emerging economies. In 2007, total proceeds

from privatization increased by 173 percent from their 2002 level. The years of 1997 and

2007 were two dominant years in terms of trends in privatization. Fig. 1 illustrates the

trend in privatization over the years.

140000
120000
100000
80000
60000
40000
20000
0
1985 1990 1995 2000 2005 2010

Figure 1.0-1: Trend in Privatization in billion of USD

China, India, and Nigeria aggressively privatized their public owned companies

over the years of 2000s. It is evident that privatization is an important source of revenue

40
for privatizing governments; and it occurs in the various economic sectors. Table 1

presents some descriptive statistics on privatization on a yearly basis.

Table 1

Privatization: Descriptive Statistics

Table 1 presents descriptive statistics for privatization over from 1988 through 2007
Year N. of Obs. Mean Median Std. Dev Total
1995 809 40.76 3.00 108.04 32,973.77
1996 877 37.71 2.51 108.00 33,071.28
1997 634 46.57 2.90 125.89 29,523.26
1998 458 45.70 3.00 119.58 20,931.95
1999 273 39.67 2.57 108.48 10,829.84
2000 170 41.54 4.22 112.25 7,062.62
2001 155 36.98 2.45 104.28 5,732.27
2002 134 34.99 2.68 94.78 4,688.08
2003 148 35.24 2.11 94.67 5,216.08
2004 208 33.04 4.03 83.65 6,872.66
2005 267 44.99 3.25 121.38 12,011.71
2006 225 37.47 2.57 100.26 8,431.24
2007 202 40.54 1.97 113.71 8,189.03

For a better assessment of the impact of privatization and other institutional and

property rights indicators on firms' growth, the privatization dataset has been sliced to

reflect the industry share the privatization pie. This allows a closer look at privatization

and the sources of firms' growth on an industry basis. Capital intensive industries are

assumed to be gauged against labor intensive industry, which is not part of our analysis.

To determine the level of capital intensity and intangible intensity we pursue the extant

literature on financial development. Following Rajan and Zingales (1998) who use data

for each industry in the United State as benchmarks for external finance dependence;

Cleassens and Leaven (2003), and Fisman and Love (2007) apply the same procedure to

construct benchmarks for their respective studies.

41
 Table 2

Sectoral Measure of Capital Intensity and Intangible Intensity

The following table presents measures of capital and intangible intensities per sector based upon U.S.
firm level data. We measure capital intensity as the inverse of the total asset turnover ratio and
intangible intensity by the ratio of intangible assets to net fixed assets. We collect data for all of the
U.S. firms operating in the same four-digit SIC code in the COMPUSTAT database for the period of
1988 through 2007 following (Rajan & Zingales, 1998) and (Cleassens & Leaven, 2003), and obtain
the industry averages for each sector. We use the U.S. industry averages as benchmarks for each
industrial sector. We focus on the sectors that have at least twenty privatization deals over the period
of our study. The total number of firms used to construct the benchmarks is 5768. While the number
privatized firms, in our study, over the same time period is 3262 in 92 countries across 20 industrial
sectors
SIC Code Industrial Sectors Capital Intangible # of
Intensity Intensity firms
01 Agricultural Production 5.29 0.0817 27
10 Metal Mining 12.68 0.0287 512
15 Bldg Contr.-Genl. Contr., and Hvy Contr. 3.17 0.0680 73
20 Food and Kindred Products 1.18 0.1352 152
21 Tobacco Manufactures 1.80 0.2400 9
22 Textile Mill Products 0.82 0.0933 21
26 Paper and Allied Products 1.82 0.0782 63
27 Printing, Publishing and Allied Products 1.76 0.2782 78
28 Chemicals and Allied Products 18.94 0.0880 724
29 Petroleum Refining and Related 2.83 0.0612 57
Industries
30 Rubber and Miscellaneous Plastics 3.08 0.1257 67
Products
32 Stone, Clay, Glass and Concrete Products 1.18 0.0884 32
33 Primary Metal Industries 2.62 0.0637 95
35 Ind., Coml., Mchry., Computer 3.08 0.0959 310
Equipments
36 Electrical, Other Electrical Equipment 3.22 0.0838 595
37 Transportation Equipments 1.84 0.1075 161
39 Miscellaneous Manufacturing Industries 6.90 0.1358 66
44 Water Transportation 3.31 0.0343 67
45 Transportation by Air 1.21 0.0634 58
47 Transportation Services 2.72 0.1489 36
48 Communications 4.28 0.1712 298
49 Electric, Gas, Sanitary Services 3.48 0.0328 375
50 Wholesale 1.18 0.0872 133
60 Financial Institutions 12.93 0.0179 743
73 Business Services 4.18 0.1345 888
87 Eng., Research, Mgmt. & Related 9.01 0.1000 128
Services
Mean 4.40 0.1017
Median 3.08 0.0882
Standard Deviation 4.38 0.0602

42
 Therefore, this study uses data on U.S. firms as benchmarks for intangible

intensity and capital intensity ratios assuming that these ratios form good benchmarks for

developing markets. Intangible intensity is used to measure the extent of innovation.

Their interaction with property rights should assess the strength of property rights laws in

a given country and their impact on firms' productivity and performance. Intangibles

represent firms' rights to enjoy some privileges rather than physical assets per se

(Cleassens and Leaven, 2003). The type of assets encompassing intangibles are given by

COMPUSTAT item 33 including blueprints or building designs, copyrights, covenants

not to compete, design costs, distribution rights and agreements, easements, engineering

drawings, trademarks, franchises, organizational costs, client bases, computer software

patent costs, licenses, and goodwill, operating rights, patents, etc. In COMPUSTAT,

tangible assets are found in item 8 to include net property, plants and equipments whose

gross values are found in COMPUSTAT item 7 while depreciation depletion and

amortization are found in COMPUSTAT item 196. Table 2 presents some descriptive

statistics on the sector measures of capital and intangible intensities.

Capital intensity is measured as the inverse of the total asset turnover ratio using

data on U.S. firms at the industry levels as proxy; where total asset turnover is net sales

divided by the average of the current year's total assets and prior year's total assets. In

COMPUSTAT, sales is found in item 12 to include any revenue source that is expected to

continue for the life of the company, other operating revenue, installment sales, franchise

sales (when corresponding expenses are available). Under item 6 are found total assets

which include current plus net property, plant, and equipment plus other noncurrent

assets including intangibles assets, deferred items and investments and advances. In

43
theory, mainly in countries where governments are cash strapped, capital intensive

industries are expected to be more likely subject to privatization. The higher is the value

of capital intensity ratio, the more capital intensive is the industry. However, low capital

intensity might reflect the life cycle of the industry in that long lived assets within the

industry are depreciated resulting in low book value of assets and high assets turnover.

By the same token, low capital intensity might indicate that important capital outlays will

be needed in the near term. In the context of our study, we assume that industries for

which capital intensity is low use more labor and politically difficult to privatize. Capital

intensive industries are expected to be more efficient and their efficiency will improve

with privatization as new capital is generated, new assets equipments will contribute in

improving productivity.

Our property rights data come from the Heritage Foundation dataset from which

we use their measure of property along with their measure of control of corruption as a

proxy for property rights. Using control of corruption as a proxy for property rights is

suggested by Fernandes and Kraay (2006) who test the two types of property rights

institutions subtantiated by Acemoglu et al. (2005). The Heritage Foundation assigns a

rating based upon the extent to which individuals are free to work, produce, consume,

and freely invest. The extent to which freedom and rights are both protected and

unrestrained by the state apparatus is appraised. Details on the variables from the

Heritage Foundation are given in table 3. The index by the Heritage Foundation has been

used by numerous researchers such as (Cleassens and Leaven (2003), Goldsmith (1995),

Kaufmann, Kraay, and Mastruzzi (2008), La Porta et al. (1999), and La Porta et al.

(2002).

44
 Table 3
Variable Description and Data Sources
Table I describes the variables used in the study and gives information about the data sources. The first column
names the variables as they are used in the regressions. The second column provides their full description and the
sources where they are collected from.
Variable Description
Log of proceeds from privatization in USD. Privatized firms are classified into
Sectoral share of privatization their SIC codes based on the NAICS classification. Source: Privatization
database, World Bank Group.
The logarithm of the average output in a particular industry from 2003-2007.
The sectors are classified on the basis of their ISIC and re-matched with their
Growth in industry output
SIC based on their NAICS. Source: United Nations Database on Industrial
Statistics.
The logarithm of the average real growth in value added in a particular
industry from 2003-2007. The sectors are classified on the basis of their ISIC
Growth in industry value added
and re-matched with their SIC based on their NAICS. Source: United Nations
Database on Industrial Statistics.
The logarithm of the average growth in the number of establishments in a
particular industry from 2003-2007. The sectors are classified on the basis of
Growth in establishments
their ISIC and re-matched with their SIC based on their NAICS. Source:
United Nations Database on Industrial Statistics.
The logarithm of the average growth in employment in a particular industry
from 2003-2007. The sectors are classified on the basis of their ISIC and re-
Growth in employment
matched with their SIC based on their NAICS. Source: United Nations
Database on Industrial Statistics
The logarithm of the average growth wages and salaries in a particular industry
from 2003-2007. The sectors are classified on the basis of their ISIC and re-
Growth in wages
matched with their SIC based on their NAICS. Source: United Nations
Database on Industrial Statistics
Capital intensity is the inverse of the total asset turnover ratio using data on
U.S. firms at the industry levels as proxy where total asset turnover is net sales
divided by the average of the current year's total assets and prior year's total
assets. In COMPUSTAT, sales is in item 12 and include revenue sources that
Sectoral measure of capital are expected to continue for the life of the company, other operating revenue,
intensity installment sales, franchise sales, and some special cases that encompass
several items. Under item 6 are found total assets which include current plus
net property, plant, and equipment plus other noncurrent assets including
intangibles assets, deferred items and investments and advances. Source:
COMPUSTAT.
Intangibles include intangible assets in COMPUSTATs item 33 including
blueprints or building designs, copyrights, covenants not to compete, design
costs, distribution rights and agreements, easements, engineering drawings,
trademarks, franchises, organizational costs, client bases, computer software
Sectoral measure of intangible patent costs, licenses, and goodwill, operating rights, patents, etc. In
intensity COMPUSTAT, tangible assets are found in item 8 to include net property,
plants and equipments whose gross values are found in COMPUSTAT item 7
while depreciation depletion and amortization are found in COMPUSTAT item
196. Intangible intensity is the ratio of intangible asset- to-net fixed assets of
U.S. firms over our study period. Source: COMPUSTAT.

45
 Table 3 (Continued)
Variable Description and Data Sources

The property rights component gauges the ability of individuals to accumulate

private property, secured by clear laws fully enforced by the state. It measures
the degree to which a countrys laws protect private property rights and
enforces those laws. It also assesses the likelihood that private property will be
Property rights expropriated and analyzes the independence of the judiciary, the existence of
corruption within the judiciary, and the ability of individuals and businesses to
enforce contracts. 100 points scale (100 means private property rights
absolutely warranted and 0 means government sole owner of properties).
Source: Index of Economic Freedom by the Heritage Foundation.
This index measures the extent to which corruption is prevalent within a
county. Corruption erodes economic freedom by introducing insecurity and
uncertainty into economic relationships. It is measured on a scale from 0 to10
Control of corruption
where a value of 10 means very little of corruption and 0 means absolutely
corrupt government. Source: Index of Economic Freedom by the Heritage
Foundation.
Contract is the average between contract viability and repatriation risk.
Contract viability assesses the likelihood of government backtracks from
contracts and renationalize formerly privatized SOEs. Repatriation or
expropriation risk assesses the factors not covered by other political, economic
Contract
and financial risk components. Both components are measured on a scale from
0 to 4, where a score of 4 represents very low risk of contract viability and 0
represents very high risk related to contracting with the state. Source:
International Country Risk Guide.
An index measuring to what extent the judiciary in a country is independent
from influences of members of government, citizens or firms. The index is
Judicial independence measured on a scale of 1 to 7 where a value of 7 represent entirely independent
and 1 represents heavily influenced. Source: Global Competitiveness Report
by World Economic Forum.
An index of the efficiency of the legal framework in which private businesses
can challenge the legality of government actions and/or regulations. The index
Judicial efficiency is measured on a scale of 1 to 7 where a value of 7 represents highly efficient
and 1 represents extremely inefficient. Source: Global Competitiveness Report
by World Economic Forum.
An index to what extent the interests of minority shareholders are protected by
Protection of minority the legal system. The index is measured on a scale of 1 to 7 where a value of 7
shareholders represents fully protected and 1 represents not protected at all. Source: Global
Competitiveness Report by World Economic Forum.
An index measuring the extent companies in a country spend on R&D. The
index is measured on a scale of 1 to 7 where a value of 7 represents spend
Research and development
heavily on R&D and 1 represents do not spend on R&D. Source: Global
Competitiveness Report by World Economic Forum.
A rating by firms on how well intellectual property rights are protected. The
rating varies from 1 to 7 where a value of 7 represents very strong and 1
Intellectual property rights
represents very weak. Source: Global Competitiveness Report by World
Economic Forum.
An evaluation of law and order tradition within a country. The index takes a
Rule of law value ranging from 0 to 10 where lower scores display the absence of law in
the countrys tradition. Source: International Country Risk Guide.

46
 Table 3 (Continued)
Variable Description and Data Sources

The Regulatory Quality Index measures the incidence of market unfriendly

policies including price controls or inadequate bank supervision, as well as
perceptions of the burdens imposed by excessive regulation in areas such as
Regulatory quality
foreign trade and business development. It attempts to describe the degree to
which governments create an atmosphere that encourages trade and foreign
investment. Source: World Governance Indexes.
A measure of the speed with which investors and firms in a given country
Stock market turnover
turning over stocks. Source: Global development finance -The World Bank.
The logarithm of the number of listed companies on a countrys stock
Number of listed companies
exchanges. Source: The Global development finance The World Bank.
Domestic credit provided by the banking sector to GDP. Source: The Global
Private credit to GDP
development finance The World Bank.
The logarithm of average GDP per capita from 2003-2007. Source: World
GDP per capita
development index The World Bank.
The percentage of firms using bank to finance investment within a country.
Firms using bank to finance
Survey based on more than 100000 firms. Enterprise survey The World
investment (percent)
Bank.
The percentage of firms using cash flows to finance investment within a
Firms using internal finance for
country. Survey based on more than 100000 firms. Enterprise survey The
expenses (percent)
World Bank.
The percentage of firms using bank to finance expenses within a country.
Bank financing investment
Survey based on more than 100000 firms. Enterprise survey The World
(percent)
Bank.
A dummy variable identifying the legal heritage of a country including (1)
English common law, (2) Socialist legal origin, (3) French civil law, (4)
Legal origin
German legal origin, and (5) Scandinavian legal origin. Source: La Porta et al.
(1999).

For contracting rights we use two series by the International Country Risk Guide

(ICRG), which include contract viability and expropriation and/or repatriation risk. The

ICRG is a private investor risk rating agency and is commonly utilized in the literature to

model property rights database (see e.g. Acemoglu and Johnson, 2005; Beck, Demirg-

Kunt, and Levine, 2003; Cleassens and Leaven, 2003; and Knack and Keefer, 1995). The

dataset includes measure of political risk, economic risk and financial risk. Traditionally,

the measures of property rights from this dataset constitute five different indicators: The

quality of bureaucracy, corruption in government, rule of law, expropriation risk and

repudiation of contracts by governments. It is assumed that if governments are not

47
accountable to the people, then abuse of power is likely and that the right to own

properties and benefit from them should be weak. This should negatively impact

privatization along with firms' growth. North and Weingast (1989) argue that the security

of property rights is not a natural occurrence; rather, it is an outcome of policy choices

and social institutions. Any government strong enough to define and enforce property

rights is also strong enough to abrogate those rights (see, Levine, 2005). Further, we

include the index of internal conflict by assuming that these conflicts are source of

tensions weakening governance and the enforceability of the laws. When the laws are

hardly enforceable, it impacts the ability of governments to protect the rights of private

investors; which in turn should have important implications for financial markets and

transactions.

We also obtain data on intellectual property protection, judicial independence and

efficiency of legal framework indexes, and protection of minority shareholders form the

Global Competitive Report by the World Economic Forum. The attempt is to measure in

a codified fashion to what extent property rights, including financial assets, are protected

by law; whether intellectual properties are also protected; whether the judiciary is

independent, and whether the legal framework allows private business to settle disputes

in ways where the legality of governments' actions can be challenged without fear of

reprisals. It is expected that there is a relationship between privatization and these

indexes. A positive correlation between the interaction of intangible intensity and

intellectual property rights and growth is anticipated. Interactions between judicial

independence, the legal framework and privatization are anticipated to be positive.

Finally, our data for financial development indicators are obtained from the Global

48
Development Finance by the World Bank as well as Enterprise Survey by the World

Bank. All the variables are fully described in table 1 whereas tables 2 and 3 present some

descriptive statistics.

1.5 RESULTS

This section presents the empirical results of our study. Table IV presents the

results for the first wave of regressions where industry growth is the dependent variable.

Here, industry growth is measured as (1) growth in output per industry based on the

production of the set of firms regrouped in the same SIC code, (2) the value added of all

firms in the same SIC code per country, and (3) the growth in the number of new

establishments per industry. The estimation period ranges from 2003 through 2007 with,

data limitations, one observation per industry per country. Each of the regressions

includes industry dummies to control for industry specific effects. The control variables

consist of private credit to GDP ratio, the natural logarithm of the number of listed

companies, the strength of minority shareholder protection, financial disclosure, and rule

of law, judicial independence, judicial efficiency and regulatory quality. The included

control variables seek to capture financing related factors or the level of financial

development in each country, and institutional and legal related factors that are assumed

to affect firms' operations, privatization contracts, with industrywide effects. In addition,

following Rajan and Zingales (1998) and Cleassens and Leaven (2003) we use U.S. firm

level data to derive industry capital intensity ratio and intangible intensity ratio. The

inclusing of the interactions between capital intensity, intangible intensity interact and

49
privatization are capturing the impacts of privatization on firm's growth through these

indicators.

One of the factors that receive the most extensive analysis in the literature is

performance change after privatization. Following Megginson et al., (1994), the

subsequent studies include Boubakri and Cosset (1998), D'Souza and Megginson (1999),

and (D'Souza et al. 2000; see Alexandre and Charreaux 2004) compare performance

changes three years before and three years after privatization; and do not concur that

privatization per se can improve performance of formerly SOEs. To be sure, the papers of

Harper (2002), Megginson (2005), Boubakri et al., (2005b), Bonin et al. (2005b), Otchere

(2005), D'Souza et al., (2005), Megginson and Netter (2001), Djankov and Murrell

(2002) find mitigated improvements in performance following privatization. In fact,

Harper (2002) studies subsequent privatizations in the Czech Republic, and puts that the

most important factor in determining a firm's performance following privatization is in

which wave the firm was privatized. Our study does not look at individual privatized

firms per se, rather seeks to capture the impact of privatization on overall firms within the

same industry.

The first set of regressions is estimated using 3SLS technique. The results show

that industry share of privatization has a positive sign in all regressions, supplying

primary evidence of a positive effect of privatization on aggregate firms when the public

sector disengages itself in operations which can be performed by the private sector.

However, while privatization fosters industry growth, privatizing industry sectors that

rely much heavily on external finance grows significantly slower as the coefficient of

50
privatization and private credit to GDP is negative and statistically significant at the 1%

level.

Table 4

Average effects of Privatization on Industrial Growth

This table presents the average effects of sectoral share of privatization on industrial growth. The dependent
variables for specifications (I), (II) and (III) are respectively the average real growth rate per economic sector,
the average real growth rate of sectoral value added, and the average growth rate of new firms per industrial
sector per country. All of the specifications include industry dummies, which are not reported. 3SLS
estimation technique is used to estimate the equations. Fraction of sectoral measure of capital intensity and
sectoral measure of intangible intensity are calculated using U.S. firms level data from the Compustat.
Following Cleassens and Leaven (2003), Rajan and Zingales (1998), the United States is removed from the
observations as it is used as benchmark. Significance levels ***, ** and * correspond to 1%, 5% and 10%,
respectively.

(I) (II) (III)

0.015 -0.007 0.162
Constant
(0.217) (0.202) (0.190)
0.676*** 0.726*** 0.350**
Industry share of privatization
(0.175) (0.163) (0.153)
Sectoral measure of capital intensity* -0.178 -0.134 -0.259**
Industry share of privatization (0.135) (0.125) (0.118)
Sectoral measure of intangible intensity * -0.039 -0.020 -0.089
Industry share of privatization (0.100) (0.094) (0.088)
0.103 0.058 -0.360*
Financial disclosure
(0.253) (0.236) (0.221)
-0.284 -0.209 0.440***
Rule of Law
(0.186) (0.173) (0.163)
0.558** 0.481** 0.013
Private credit to GDP
(0.260) (0.242) (0.228)
0.230 0.243 0.097
Protection of minority shareholders
(0.181) (0.169) (0.159)
0.153 0.194** 0.379***
Log of number of listed companies
(0.108) (0.101) (0.095)
Private credit to GDP * Industry share of -1.016*** -0.957*** -0.380
privatization (0.315) (0.293) (0.276)
-0.023 -0.062 0.016
Stock market turnover ratio
(0.133) (0.124) (0.117)
R-squared 0.2824 0.3787 0.4499
Number of countries 37 37 37
Industry effects Yes Yes Yes
# of obs. 119 119 119

51
This result illustrates the difficulties with which governments are faced to mobilize

financial resources through their domestic market when privatizing large firms. It also

suggests that privatization has a "crowding out effect" on private firms seeking finance.

Also, we observe a growth imbalance in privatizing industries that more capital intensive.

The interaction between sectoral measure of capital intensity and industry share of

privatization had a negative relationship with industry growth. The latter result confirms

that firms in industries relying more on external finance to growth evolve negatively with

privatization through time.

In terms of policy implications, the results in table 4 suggest that privatization is

an effective tool for overall industrial development and they also highlight the import of

external finance in financing growth. The coefficients of industry share of privatization

on the various measures of industry growth are quite large. Specifically, the coefficients

on real growth, industry value added and growth in establishments per industry were

respectively3 (=.676, t=3.86), (=.726, t=4.45) and (=.35, t=2.29), using the estimates

from columns (4) through (6) of table 4. In addition, the main effect of our main measure

of financial development, private credit to GDP, was positive and significant (=.558,

t=2.15) and (=0.481, t=1.99) for industry growth and industry value added, positive and

insignificant (=0.013, t=0.06) using the estimates from columns (1) through (3) of table

4. The results corroborate those of Cleassens and Leaven (2003); nonetheless, the

interaction effect between privatization and private credit to GDP that was negative and

significant suggesting a muted effect of privatization on growth in sectors with significant

3
Although the model specification involves only as parameter to be estimated, we refer
to as estimator of growth in industry output; as the estimator of growth in industry
value added, and as the estimator of growth in establishments per industrial sector.

52
needs for external finance. This suggests that when governments privatize large firms it

dries out liquidity from the economy, and financial resources to financing private firms

for the industry to grow deplete.

The positive relationship between the rate of growth in establishments per

industry and the rule of law index (=.44, t=2.71) confirms the law and finance view that

better legal and regulatory framework is more conducive and supportive of firms' growth

as substantiated by LLSV (1998, 1999) and supported by Beck et al. (2000), Cleassens

and Leaven (2003) and Levine (2005).

Overall, table 4 highlights that privatization boosts industry growth, industry

value added and the rate of new establishments per industrial sector. Importantly, the

positive relationship between privatization and growth in establishments points to the

inefficiency of the public sector. It suggests the existence of significant barriers to entry

industries where firms have to compete with the public sector. Nonetheless, when the

government refrains itself from market operations, the competitive forces congregate to

spur growth. The results also show that there is a lower share in capital intensive sectors

associated with privatization as financial resources rarefy.

Table 5 presents the results of the average effects of industry share of

privatization, private property rights protection, and control of corruption on industry

growth. As in table 4, growth is measured as the real rate of growth in firms' output

within the same economic sector, the real growth rate in firms' value added within the

same economic sector, and the growth rate in establishments per economic sector.

Property rights protection and control of corruption are constructed by the Index of

Economic Freedom provided by the Heritage Foundation.

53
 Table 5

Average effects of Privatization, Property Rights Protection on Industrial Growth

This table presents the average effects of industry share of privatization, private property rights and control of
corruption on industrial growth. The dependent variables for specifications (I) and (III) is the average of real
growth rate in industrial production per economic sector; and (II) and (IV) is real growth rate in industry value
added per economic sector; and (V) is the growth rate of new establishments per economic sector. All of the
specifications include industry dummies, which are not reported. All of the regressions are estimated using 3SLS
estimation technique. Countrys legal origin, from La Porta et al. (1999), is used as instrumental variable.
Fraction of sectoral measure of capital intensity and sectoral measure of intangible intensity are calculated using
U.S. firms level data from the Compustat. Following Cleassens and Leaven (2003), Rajan and Zingales (1998),
the United States is removed from the observations as it is used as benchmark. Significance levels ***, ** and *
correspond to 1%, 5% and 10%, respectively.
(I) (II) (III) (IV) (V)
0.040 -0.019 0.255 0.275 0.414*
Constant
(0.191) (0.208) (0.246) (0.256) (0.231)
0.127* 0.212*** 0.146** 0.219*** -0.064
Industry share of privatization
(0.071) (0.077) (0.065) (0.068) (0.061)
Sectoral measure of capital intensity* -0.015 0.005
Industry share of privatization (0.073) (0.079)
Sectoral measure of intangible intensity * -0.035 -0.009
Industry share of privatization (0.053) (0.058)
Sectoral measure of capital intensity* -0.104 -0.079 0.247 0.364 0.149
Property Rights (0.183) (0.20) (0.344) (0.358) (0.322)
Sectoral measure of intangible intensity * 0.169 0.178 0.198 -0.014 -0.200
Property Rights (0.156) (0.170) (0.301) (0.313) (0.282)
Industry share of privatization * Property -0.126** -0.118* -0.074 -0.017 0.101*
Rights (0.060) (0.066) (0.062) (0.065) (0.058)
0.240* 0.217
Judicial independence
(0.137) (0.150)
0.056 0.194 0.150 0.225* -0.042
Log of per capita GDP
(0.124) (0.136) (0.138) (0.144) (0.129)
-0.212** -0.259** -0.156* -0.180* 0.307***
Human capital
(0.095) (0.103) (0.091) (0.095) (0.085)
-0.111* -0.044 -0.096* -0.031 0.099*
Log of number of listed companies
(0.062) (0.068) (0.059) (0.061) (0.055)
0.710*** 0.596*** 0.593*** 0.455*** 0.697***
Log of industry share of employment
(0.057) (0.062) (0.064) (0.067) (0.060)
-0.244** -0.211*
Financial disclosure
(0.124) (0.136)
-0.042 -0.141 -0.017 -0.134* 0.120*
Private credit to GDP
(0.086) (0.094) (0.077) (0.081) (0.073)
0.137 0.074 0.268 0.363 0.184
Private property rights
(0.171) (0.186) (0.268) (0.279) (0.251)
-0.001 -0.186 0.365**
Rule of law
(0.195) (0.203) (0.183)
0.081 0.115 0.028
Protection of minority shareholders
(0.087) (0.090) (0.081)
0.068 0.430 -0.426
Control of corruption
(0.394) (0.411) (0.370)
-
Control of corruption * Industry share of -0.359** -0.123
0.705***
privatization (0.174) (0.163)
(0.181)
Control of corruption * Sectoral measure of -0.143 -0.184 -0.111
capital intensity (0.121) (0.126) (0.113)
Control of corruption * Sectoral measure of -0.119 0.028 0.121
intangible intensity (0.219) (0.229) (0.206)
R-squared 0.7486 0.7255 0.77 0.7715 0.8421
Number of countries 37 37 37 37 37
Industry Effects Yes Yes Yes Yes Yes

54
 Consistently with the results in table 4, the results show that industry share of

privatization had a positive and significant association with growth. The results exhibited

in table 5 from column (1) through column (4) show that a positive and significant

relationship existed between the interaction of sectoral measure of intangible intensity,

property rights protection and our various measures of growth. The results are similar to

those of Cleassens and Leaven who argue that such results are evidence of asset

allocation effect whereby in industrial sectors using relatively more intangible assets

develop faster in countries with better property rights protection.

However, we also find that privatization in industries that are more responsive to

property rights protection holds back industry growth. The estimated coefficients for the

interaction between property rights and industry share of privatization are (=-.126, t=-

2.1) and (=-.118, t=-1.79) repectively. Similarly, our results show that the prevalence of

corruption is detrimental to industry growth both in terms of output and value added. The

estimated effects of corruption are (=-.359, t=-2.06) and (=-.705, t=-3.89) . This result

corroborates those of Fernandes and Kraay (2006) who use control of corruption as proxy

for property rights and find that corruption is negative related with growth; they argue

that the prevalence of corruption is a good proxy for the absence of well-functioning

institutions because corruption can be thought of as the expropriation of private property

rights. Nonetheless, there is a positive relation between our measures of growth, control

of corruption and industry share of privatization. This result suggests that privatizing

industrial sectors that are more responsive to corruption grow faster with stronger and

effective control of corruption. Finally, we observe a negative relationship between

control of corruption, sectoral measure of capital intensity and the rate of growth in

55
establishments per economic sector. This suggests that industrial sectors using relative

higher capital intensity grow significantly slowly in terms of new establishments when

corruption is prevalent in the investing environment. Therefore, effective control of

corruption is more conducive for firms' growth and firms allocate assets more effectively

in business environments with lower lever of corruption. The results also suggest that

firms have more capital to invest and grow when corruption is low.

Overall, table 5 indicates that firms grow significantly across industry lines due to

privatization. Likewise, more intangible intensive industries grow faster due to property

rights protection, and privatization is sectors which are more responsive to property rights

protection leads to reduced industrial growth, suggesting muted effects of privatization in

countries with poor property rights protection. The regressions show that the underlying

legal and institutional frameworks are crucial for firms' development across the industry

spectrum. Importantly, privatization without institutional reforms has a significantly

adverse effect on firms' growth as the interaction between rule of law and privatization

had a negatively significant effect on growth, which evidences muted effects of

privatization in countries with ineffective enforcements mechanisms as the main effect of

rule of law on industry growth is positive and significant.

In table 6 we present the effects of contracting rights and privatization on industry

growth. It is assumed that if contracts are not viable and if governments can repossess or

confiscate privatized firms, then privatization will not be an effective public policy and

that the joint effect on industry growth should be negative.

56
 Table 6
Average Effects of Privatization and Contract Viability on Industrial Growth
This table presents the average effects of industry share of privatization and contract viability on
industrial growth. The dependent variables for specifications (I) and (II) is the average real growth
rate or growth in industrial production per economic sector, and (III) and (IV) is real growth rate in
industry value added based on the industry SIC codes. All of the specifications include industry
dummies, which are not reported. All of the regressions are estimated using 3SLS estimation
technique. Countrys legal origin, from La Porta et al. (1999), is used as instrumental variable.
Fraction of sectoral measure of capital intensity and sectoral measure of intangible intensity are
calculated using U.S. firms level data from the Compustat. Following Cleassens and Leaven (2003),
Rajan and Zingales (1998), the United States is removed from the observations as it is used as
benchmark. Significance levels ***, ** and * correspond to 1%, 5% and 10%, respectively.
(I) (II) (III) (IV)
0.158 0.202 0.253 0.264
Constant
(0.207) (0.211) (0.199) (0.210)
0.395*** 0.744*** 0.313** 0.656***
Industry share of privatization
(0.151) (0.154) (0.159) (0.168)
Sectoral measure of capital intensity* -0.042 -0.021 -0.044 -0.025
Industry share of privatization (0.072) (0.074) (0.070) (0.074)
Sectoral measure of intangible intensity * -0.012 0.002 -0.034 -0.003
Industry share of privatization (0.053) (0.054) (0.053) (0.056)
0.206** 0.231*** 0.172** 0.220**
Contract viability
(0.085) (0.087) (0.083) (0.087)
Contract viability * Industry share of -0.482*** -0.828*** -0.361* -0.731***
privatization (0.186) (0.189) (0.192) (0.202)
Contract viability * Sectoral measure of -0.238 -0.099 -0.176 -0.050
capital intensity (0.276) (0.282) (0.269) (0.284)
Contract viability * Sectoral measure of -0.126 -0.063 -0.085 -0.024
intangible intensity (0.232) (0.237) (0.225) (0.237)
-0.030 0.094 -0.062 0.110
Log per capita GDP
(0.114) (0.117) (0.146) (0.154)
-0.148* -0.176* -0.171* -0.185**
Human capital
(0.094) (0.096) (0.091) (0.096)
-0.191*** -0.134** -0.180*** -0.132**
Log of listed companies
(0.058) (0.059) (0.057) (0.060)
0.663*** 0.549*** 0.726*** 0.572***
Log industry share of employment
(0.058) (0.059) (0.068) (0.071)
-0.030 -0.121 -0.072 -0.152
Private credit to GDP
(0.083) (0.085) (0.084) (0.089)
0.160** 0.157**
Judicial independence
(0.074) (0.076)
-0.30** -0.169
Financial disclosure
(0.148) (0.157)
0.471*** 0.314**
Judicial efficiency
(0.142) (0.149)
0.116 -0.012
Regulatory quality
(0.174) (0.184)
-0.056 0.002
Private property rights
(0.171) (0.181)
Industry share of privatization * Private -0.067 -0.024
property rights (0.061) (0.065)
R-square 0.7541 0.7655 0.7762 0.7721
Number of countries 37 37 37 37
Industry effects Yes Yes Yes Yes

57
 Indeed, following Acemoglu and Johnson (2005) who seek to disentangle

property rights institutions from contracting institutions, Fernandes and Kraay (2006) test

the extent to which private property is secure from predation by the state and contracting

institution, which measure how well institutions such as the courts allow private parties to

contract with one another. The results in table 4 concern private property protection by

the state, which is a vertical relationship between firms, investors and the state given the

power of the state to justify its action by taking over firms. Here, "contracting rights" is

important for successful privatization programs. We measure contract viability using the

average of two variables (1) contract viability or expropriation risk, and (2) repatriation

of profits risk. Together, these measures assess the factors affecting the risk to investment

not affected by other political, economic and financial risk in a given country as defined

and constructed by the various risks factors in the International Country Risk Guide

(ICRG). The key to a successful privatization is stability in both institutional and legal

systems of the privatizing country. Harper (2002) argues that stable environments both

political and economic help privatized firms restructure and improve operating

performance as well as attract foreign investors and capital even in less developed

countries. Privatization in an environment that suffers such characteristics might result

into complete failure in several aspects.

The results are consistent with those presented in tables 4 and 5 in that sectoral

share of privatization is positively associated with industry growth. The relationship

between contractual rights and industry growth of output and value added were

respectively positive and significant (=.231, t=2.67) and (=.220, t=2.52), using the

estimates from columns (2) and (4) of table 6. However, the interaction between

58
contractual rights and industry share of privatization were respectively negative and

significant, (=-.828, t=-4.37) and (=-.731, t=-3.61), using the estimates from columns

(2) and (4) of table 6. The results indicate muted effect of privatization in countries with

poor contracting rights. The results also suggest that firms in industrial sectors that are

more susceptible to the state predation, seemingly for strategic reasons, require stronger

contracting rights in that privatization with poor contracting rights is detrimental for

growth. The common use of control of corruption as a proxy for contracting rights might

have some limitations since corruption practices go beyond the state apparatus and are a

set of informal institutions and practical ways of doing business in both private and

public sectors and countries with ineffective institutional infrastructure. Therefore, using

contract viability and or expropriation risk, and repatriation risk as a measure of

contracting institution more captures the strength of contracting rights more accurately.

Other institutional variables such as judicial efficiency and judicial independence have a

positive and significant relationship with industry growth.

Overall, table 6 shows that contracting rights matter for industrial growth. Our

results support the law and finance view that the quality of the legal and contracting

frameworks influences financial sector development as they supply evidence of stronger

ties with development that go beyond the financial sector. However, contract viability in

the context of privatization hinges on improvements in the living standards of the

population subsequent to privatization especially when the state apparatus is significantly

strong. Should employment decline sharply and privatized enjoy monopolistic power and

that they set prices above efficient market prices, then public sentiments will echo those

59
of hard liners' and government reneging on the sale of the formerly SOE might certainly

lead to renationalization.

Table 7

Average effects of Privatization on Industry Employment and Wages

This table presents the average effects of industry share of privatization on growth of employment
and wages per industry. Seemingly unrelated regressions technique is used to estimate the equations.
All of the specifications include industry dummies, which are not reported. Privatization is the
average of the number of privatization deals per country by industry.Fraction of sectoral measure of
capital intensity and sectoral measure of intangible intensity are calculated using U.S. firms level data
from the Compustat. Following Cleassens and Leaven (2003), Rajan and Zingales (1998), the United
States is removed from the observations as it is used as benchmark. Significance levels ***, ** and *
correspond to 1%, 5% and 10%, respectively.
Dependent variable Employment Wages
-1.208*** -0.337
Constant
(0.424) (0.472)
0.094 0.10
Industry share of privatization
(0.089) (0.097)
Industry share of privatization * Sectoral measure of capital -0.229** -0.259**
intensity (0.107) (0.119)
Industry share of privatization * Sectoral measure of 0.094 0.037
intangible (0.081) (0.090)
0.017 0.309*
Protection of minority shareholders
(0.149) (0.165)
-1.024*** 0.212
Rule of law
(0.347) (0.385)
1.335*** 1.014***
Log of per capita GDP
(0.195) (0.217)
0.996*** 0.338
Financial disclosure
(0.208) (0.231)
-0.410*** -0.242*
Human capital
(0.138) (0.154)
-0.698 -1.115**
Control of corruption
(0.484) (0.538)
-0.050 -0.414
Control of corruption * Industry share of privatization
(0.249) (0.277)
0.207*** 0.009
Firms using bank to finance investment (%)
(0.062) (0.069)
0.305** 0.019
Firms using internal finance for investment (%)
(0.133) (0.148)
-0.417*** -0.094
Bank financing investment (%)
(0.137) (0.152)
R-squared 0.5562 0.4537
Number of countries 37 37
Industry Effects Yes Yes
# of obs. 119 119

60
 Lam et al., (2007) note that if the issue of employment is mismanaged, the

restructuring of the economy comes with political unrests. The authors imply that these

unrests are associated uncertainties created by structural changes such as change in

ownership of SOEs. Indeed, Otchere (2005) argues that economic restructuring generates

high degree of political instability because of the uncertainties associated with the

transition from state apparatus to market-based economies. However, such uncertainties

are not evidence that skeptics of privatization have a natural proclivity toward the status

quo; rather, they are more likely to be reluctant because they are afraid of the upshots of

the unknown. Nonetheless, privatization has been implemented long enough around the

world so that its effects on employment can be econometrically measured, yet the issue of

the effects of privatization on employment is empirically a puzzle. With Harper (2002)

who finds a large decline in employment following privatization; Otchere (2005) finds

that privatized banks did not lay off employees; Megginson et al., (1994), Boubakri and

Cosset (1998), and D'Souza et al., (2005), agree that employment does not significantly

decline after privatization; Sun and Tong (2003) find that SIP in China does not lead to

massive layoff and instead, it leads to increased employment, the empirical finding of the

effects of privatization on employment is quite puzzling.

Our results on table 7 show mixed evidence of the effect of privatization on

employment. On the one hand, they suggest that employment does not significantly slip

following privatization, and the wage bill has mostly remained intact in industry sectors

where privatization is prevalent. On the other hand, the interaction term between capital

intensity and sector share of privatization depicts a grim employment landscape since

both employment and wages significantly decrease (=-.229, t=-2.15) and (=-.259, t=-

61
2.18) respectively4, in privatizing industry sectors that are heavily capital intensive,

suggesting that highly capital intensive sectors were significantly overstaffed, and that to

comprehend the effect of privatization on employment inter-industry study might depict a

better reality than industry or firm specific studies. However, the observed decline in

employment might be caused by several factors including, inter alia, enhanced

management, increased technological factors requiring more skilled labor, industry

consolidation. Our results supply counterevidence of a negative effect of privatization on

industrial employment and wages. Our findings, based on a broad range of industrial

sectors, paint a clearer picture of the relationships between privatization employment and

wages.5 This is a vital issue since mismanaging employment subsequent to privatization

programs can have expansive political and institutional costs. The additional dissecting

evidences that the effects of privatization on employment is more industry-specific. Our

observation may be due to the fact that highly capital intensive industries ought to release

excess labor to acquire necessary machinery and technology to grow.

We next assess the joint effect of privatization and Intellectual Property Rights

(IPRs) on industrial growth. IPRs are just like other types of property rights; absent

protection of IPRs, there will be no incentives for investors to risk their resources in the

generation of new ideas or new products (Chang and Grabel, 2004). In table 8 we

examine whether changes in ownership have a heterogeneous effect on industry growth

4
Where captures the interaction effect between industry share of privatization and sectoral measure of
capital intensity on employment; whereas captures the interaction effect between industry share of
privatization and sectoral measure of capital intensity on wages.

5
The results have not changed qualitatively with the exclusion of the service sector, which arguably might
be laden with more idle employees than would be expected in the manufacturing sector. This may be due to
the fact that our sample comprises only one service sector along with 16 manufacturing sectors. Such
results are not reported but available upon request.

62
depending on IPRs protection. Numerous industries may depend on the strength of patent

rights, trademarks, goodwill, rights over ideas, and various intangible assets to grow.

Columns (1) through (6) of table 8 show clear evidence of a positive and significant

relationship between IPRs and industry growth as measured by growth in output or

efficiency, growth in value added and growth of new firms within a given industrial

sector. The coefficient estimates of IPRs on our three measures of growth were

respectively positive and significant, (=2.47, t=3.39), (=2.269, t=3.33) and (=2.984,

t=5.45) using the estimates from columns (4) through (6) of table 8. We added two

interaction terms between (a) IPRs and sectoral measure of capital intensity (b) IPRs and

sectoral measure of intangible intensity. Both of the interaction terms were insignificant

while the estimated effects of IPRs on industry growth remained unaffected. Importantly,

we control for the interaction between industry share of privatization and IPRs. There is

strong negative relationship between the interaction of IPRs and industry share of

privatization on growth measured by growth in output and growth in value added per

industry, (=-1.045, t=-1.8), (=-1.321, t=-2.44) using the estimates from columns (4)

and (5) of table 8 respectively. This implies that the effects of privatization and IPRs

protection are felt more strongly in industries that are more responsive to IPRs to grow.

This might also imply that industries depending on certain class of assets grow

disproportionately slower if IPRs are weak as competitors can reap the benefit of others'

intellectual properties without fear of legal and financial consequences. Therefore, this

should be reflected on the level of R&D activities in these industries. Hence, we also

allow the effect of IPRs to vary by R&D activities and assess their joint impact on

industry growth. The estimate of the coefficient of IPRs on growth was unaffected, while

63
 Table 8

Average effects of Privatization, Intellectual Property Rights Protection on Industrial Growth

This table presents the average effects of industry share of privatization and intellectual property rights protection
on industrial growth. The dependent variables for specifications (I) and (IV) is the average real growth rate or
growth in industrial production per economic sector, (II) and (V) is the real growth rate in sectoral value added,
and (III) and (VI) is the growth in new establishments per industry based on SIC classification.. All of the
specifications include industry dummies, which are not reported. All of the regressions are estimated using 3SLS
estimation technique. Countrys legal origin, from La Porta et al. (1999), is used as instrumental variable. Fraction
of sectoral measure of capital intensity and sectoral measure of intangible intensity are calculated using U.S. firms
level data from the CompuStat. Following Cleassens and Leaven (2003), Rajan and Zingales (1998), the United
States is removed from the observations as it is used as benchmark. Significance levels ***, ** and * correspond
to 1%, 5% and 10%, respectively.
(I) (II) (III) (IV) (V) (VI)
-0.368 -0.300 -0.432 -0.436 -0.349 -0.365
Constant
(0.403) (0.377) (0.346) (0.40) (0.374) (0.287)
0.772* 1.061*** -0.080 0.797* 1.088*** -0.215
Industry share of privatization
(0.446) (0.417) (0.382) (0.458) (0.428) (0.333)
1.227** 1.252** 2.232*** 1.667** 1.532** 2.517***
Intellectual property rights
(0.629) (0.588) (0.540) (0.774) (0.724) (0.563)
Sectoral measure of capital intensity * -0.275 -0.269 -0.514 -0.321 -0.269 -0.312
Intellectual property rights (0.445) (0.416) (0.382) (0.450) (0.420) (0.327)
Sectoral measure of intangible intensity 0.581 0.381 0.446 0.536 0.360 0.530
* Intellectual property rights (0.486) (0.455) (0.417) (0.495) (0.463) (0.360)
1.122*** 0.807** 1.025*** 1.321*** 0.951** 1.497***
Research and development
(0.442) (0.413) (0.379) (0.477) (0.446) (0.347)
Intellectual property rights * Industry -1.074* -1.348** 0.080 -1.086* -1.364** 0.297
share of privatization (0.604) (0.565) (0.518) (0.615) (0.575) (0.447)
Intellectual property rights * Research -1.595** -1.133* -2.167*** -2.314*** -1.701** -3.675***
and development (0.777) (0.727) (0.667) (0.891) (0.833) (0.648)
Property rights (World Economic -0.252 -0.240 -1.023*** -0.759* -0.673* -1.521***
Forum) (0.275) (0.258) (0.236) (0.407) (0.381) (0.296)
0.153 0.198** 0.346*** 0.126 0.188* 0.454***
Log of number of listed companies
(0.108) (0.101) (0.093) (0.130) (0.122) (0.095)
-0.047 -0.099 -0.088 0.019 -0.036 0.018
Stock market turnover ratio
(0.137) (0.128) (0.118) (0.157) (0.147) (0.114)
-0.062 0.007 0.121
Log of per capita GDP
(0.257) (0.242) (0.188)
0.078 0.065 0.341***
Tertiary school enrollment
(0.174) (0.163) (0.127)
0.541** 0.509** 0.652***
Financial disclosure
(0.251) (0.234) (0.182)
0.065 0.040 0.181
Judicial efficiency
(0.443) (0.414) (0.322)
R-squared 0.3024 0.3908 0.4863 0.3347 0.4202 0.6434
Number of countries 37 37 37 37 37 37
Industry effects Yes Yes Yes Yes Yes Yes

64
there was a strong negative relationship between the interaction of IPRs and R&D in all

regressions. Given the positive effect of both IPRs and R&D on industry growth, a

negative joint effect implies a muted effect of IPRs in countries with high level of R&D

or vice versa on industry growth. This finding is puzzling inasmuch as a positive joint

effect of IPRs and R&D was expected.

In recent years, a passionate discussion on IPRs has taken place: The neoliberal

argument is that developing countries need to enforce IPRs to the level of developed

nations to ensure growth and attract foreign direct investments while anti-neoliberals

argue that IPRs are irrelevant for developing countries to grow, and that they should be

treated as international public goods (see Chan and Grabel, 2004) for a detailed

discussion on the opposing views. Nonetheless, our results highlight that as the digital

economy grows, no matter which side of the debate prevails, both IPRs and R&D are the

pivots and drivers of industry growth and that public policies need to heed these factors

to create wealth.

Overall, table 8 shows that IPRs and R&D are important factors in the context of

privatization. Violation, nullification or impairment of IPRs might have nefarious

consequences on firms in industries depending on them to grow. Statutory reinforcement

of IPRs might not be enough to ensure industry growth, and that policymakers should

weigh the impact of the absence of IPRs on overall economic and financial development

and be strike a balance between the potential rewards to patentees and the public interest.

65
 Table 9

Average effects of Privatization, Financial Development on Industrial Growth

This table presents the average effects of industry share of privatization and financial development on
industrial growth. The dependent variables are the average real growth rate or growth in industrial
production per economic sector for specification (I), the real growth rate in sectoral value added for
specification and (II), the growth in new establishments per industry based on SIC classification for
specification (III). All of the regressions include industry dummies, which are not reported. All of the
regressions are estimated using 3SLS estimation technique. Countrys legal origin, from La Porta et al.
(1999), is used as instrumental variable. Fraction of sectoral measure of capital intensity and sectoral
measure of intangible intensity are calculated using U.S. firms level data from the Compustat. Following
Cleassens and Leaven (2003), Rajan and Zingales (1998), the United States is removed from the
observations as it is used as benchmark. Significance levels ***, ** and * correspond to 1%, 5% and
10%, respectively.
(I) (II) (III)

Constant 0.102 -0.319 -5.194*

(3.534) (3.326) (2.970)
Industry share of privatization 0.314 0.268 1.346*
(1.022) (0.962) (0.859)
Sectoral measure of capital intensity * Intellectual -0.259** -0.223* -0.325***
property rights (0.124) (0.117) (0.104)
Sectoral measure of intangible intensity * Intellectual -0.021 -0.003 -0.045
property rights (0.093) (0.088) (0.078)
Stock market turnover ratio -0.439 -0.514 -0.777*
(0.495) (0.466) (0.416)
Private credit to GDP 0.576 0.266 0.572*
(0.434) (0.409) (0.365)
Log of number of listed companies 0.087 0.250 0.152
(0.209) (0.197) (0.176)
Firms using bank to finance investment (%) -0.106 0.053 1.347*
(0.871) (0.820) (0.732)
Firms using internal finance for investment (%) 0.383* 0.162 0.375**
(0.229) (0.215) (0.192)
Bank financing investment (%) -0.505 -0.403 -2.012**
(0.999) (0.940) (0.840)
Private credit to GDP * Industry share of privatization -1.135** -0.711 -0.848**
(0.522) (0.491) (0.439)
Stock market turnover ratio * Industry share of 0.589 0.707 0.888**
privatization (0.547) (0.515) (0.460)
Log of number of listed companies * Industry share of -0.014 -0.474 0.475
privatization (0.504) (0.474) (0.423)
Firms using bank to finance investment (%) * Industry 0.464 0.216 -1.880*
share of privatization (1.392) (1.310) (1.170)
Firms using internal finance for investment (%) * -0.789** -0.402 -0.299
Industry share of privatization (0.401) (0.377) (0.337)
Bank financing investment (%) * Industry share of 0.088 0.058 0.457**
privatization (0.281) (0.265) (0.236)
Rule of law 0.639 0.924** -0.002
(0.453) (0.426) (0.381)
Rule of law * Industry share of privatization -1.208*** -1.469*** 0.049
(0.438) (0.413) (0.368)
Protection of minority shareholders 0.131 0.018 0.678**
(0.413) (0.388) (0.347)
Protection of minority shareholders * Industry share of 0.367 0.677 -1.547*
privatization (1.075) (1.012) (0.903)
Financial disclosure 0.250 0.190 -0.079
(0.237) (0.223) (0.199)
R-squared 0.4425 0.507 0.6063
Number of countries 37 37 37
Industry effects Yes Yes Yes

66
 In table 9 we examine the effects of privatization on industry growth by allowing

sectoral share of privatization to vary by financial development factors. As measures of

financial development we use stock market turnover ratio, private credit to GDP, number

of listed companies, the percentage of firms using bank to finance investments, the

percentage of firms using internal finance to finance investment, the extent to which

banks financing investment, protection of minority shareholders, and financial disclosure.

We allow most of these variables to vary by privatization and assess their impact on

industry growth. Levine (1992), King and Levine (1993), Levine (1997), Levine and

Zervos (1998), Cleassens and Leaven (2003) and others use most of these financial

development indicators and concur that there is a strong relationship between the various

sources of finance and growth. The point of convergence is that financial services can

accelerate growth by improving the allocation of capital and by enhancing the

productivity of firms (see Mavrotas and Son, 2008).

The coefficients of the financial development variables indicate a stronger

relationship between finance and growth through privatization via the different

interaction terms compared to the main effects of such financial development indicators

on industry growth. As in previous estimation, the interaction between private credit to

GDP and sectoral share of privatization was negative and significant. The interaction

between stock market turnover ratio and sectoral share of privatize had a positive

relationship with industry growth in terms of new firms. A striking result is the negative

relationship between the interaction of percentage of firms using banks to finance

investment and privatization on the industry growth in terms of growth in establishments.

This result is in line with the negative effect observed between the interaction of private

67
credit to GDP and sectoral share of privatization on industry growth, suggesting that

credit become scarce as governments privatize large firms, and this evidences the

crowding out effect of privatization. Meanwhile, the interaction between banks financing

investment and sectoral share of privatization had a positive effect on industry growth in

terms of new establishments.

Overall, the financial development indicators spur industry growth but the

relationships appear to be stronger when industry growth is measured by the number of

firms within the same SIC code across countries. The general picture is that financial

development enhances industry growth through privatization. Should higher financial

development stimulate faster growth as suggested by the financial development literature,

our results show that some financial development indicators are more relevant for

industry growth than others, however. Our results have important implications in terms of

capital allocation from the perspectives of growth. Our study does not take into account

the endogeneity between financial development and growth since this issue has been

dealt with in the literature which posits that finance follows growth (see Levine, 1997)

and others for a complete discussion. We simply assess whether finance stimulates

growth through privatization.

1.5.1 Policy Implications

The regressions indicate that sectoral share of privatization is related to each of

the industry growth indicators in our study. Our main finding is that privatization triggers

greater economic efficiency - in terms of increased output; greater industry value added,

and brings about more competition as more firms enter the various privatizing industries.

They also show that privatization is strongly related to employment, private property

68
protection, IPRs and financial development. The findings have numerous policy

implications. For instance, using the estimates from table 4 we can infer how much

higher the growth of an industry at the 75th percentile of industry share of privatization

would have been compared to an industry at the 25th percentile of privatization. in fact,

the industry located at the 75th percentile of privatization had a value of 5.36 while the

one located at the 25th percentile of privatization had a value of 2.75. The estimated

coefficients of industry share of privatization for industry growth of output and value

added are respectively 0.676 and 0.726. The regression estimates predict that the

difference in growth rate due to privatization is about 1.76% per year. Ceteris paribus,

there would have been an accumulated growth in industry output of 9.22% over the 5

year period of our study. Similarly, the regression estimates from column (2) of table 4

predict a higher growth in sectoral valued added of 1.9% per year due to privatization.

Ceteris paribus, there would have been an increase in industry value added of 9.94% due

to privatization.

Furthermore, the effect of privatization on differential real firm growth can be

calculated in a similar fashion using the estimates for privatization and the interaction

effect between privatization and property rights protection or control of corruption using

the estimates from table 5. Indeed, using the estimates from table 4 we can infer how

much higher (lower) the growth of an industry at the 75th percentile of industry share of

privatization would have been compared to an industry at the 25th percentile of

privatization. With the industry located at the 75th percentile of privatization had a value

of 5.36 while the one located at the 25th percentile of privatization had a value of 2.75,

the inter-quartile difference in industry share of privatization is 2.61. Likewise, the inter-

69
quartile difference in control of corruption is 0.91. In addition, the estimated coefficients

of industry share of privatization for industry growth of output and value added are

respectively 0.146 and 0.219. The regression estimates then predict that the difference in

privatizing industrial growth rate due to prevalence of corruption is 0.4716 basis points

per annum. Ceteris paribus, there would have been an accumulated decrease in industry

growth of 2.33% over the 5 year period of our study. Similarly, the regression estimates

from column (4) of table 5 predict a fall in growth in sectoral valued added of 1.1% per

annum due to lax in control of corruption in the privatizing industry. Ceteris paribus,

there would have been an increase in industry value added of 5.36% over the 5 year

period of our study due to the prevalence of corruption.

Regarding contracting rights, the regression estimates from columns (2) and (4) of

table 6 predict a 8.42 basis points higher in industry growth of output and 0.1931 basis

points per annum in growth of industry value added should a country successfully

improve its contracting rights from the 25th percentile of contracting rights index to the

75th percentile. This would have generated an accumulated industrial growth of 1.03%

and 0.97% in firms' productivity and value added, respectively. Importantly, the

regression estimates of table 7, the inter-quartile difference in employment is a net loss of

12.31% in the industry located at the 75th percentile of our sampled countries. This is a

crucial matter given the political unrest that such massive unemployment might trigger.

Many countries seek to mitigate the drawbacks from such immense layoffs by enrolling

the layoff workers into programs where they can acquire new skills to enter other

industries. Nonetheless, any successful outcome of such strategy is yet to manifest itself.

70
 Our estimates in table 7 show an insignificant relationship between privatization

and industry level of employment and wages. Nevertheless, there is evidence of

significant negative effect between the interaction of industry share of privatization and

sectoral measure of capital intensity on employment and wages. This implies that

industry sectors that are more capital intensive significantly lay off excess labor

following privatization. Considering that the inter-quartile value of privatization is 2.61

and that of capital intensity is 2.99, we can use the coefficient estimate of the interaction

between privatization and sectoral share of capital intensity of predict by how much

lower employment would have been for a country which privatizes heavily and located in

the 75th percentile of privatization and its privatized sectors are also located in the 75th

percentile of sectoral measure of capital intensity compared to a country located in the

25th percentile of both measures. The effect of privatization on the differential real

growth rate of industry employment is predicted to be a drop in employment by 1.79 per

annum, which when accumulated over the 5 year period of our estimation period results

in a loss of 8.55% in industrial jobs. Our estimates corroborate the findings by (Cleassens

and Djankov, 1998) that SOEs are generally found to be less efficient, have excess labor

and higher wages, tend to accumulate losses, and do not necessarily take into account

externalities.

Finally, we can use the estimates from column (6) of table 8 to infer how much

higher an industry in a country located at the 75th percentile of IPRs would grow in terms

of new firms as compared to an industry in a country located at the 25th percentile of

IPRs when these two countries and industries are located on the same range for both

privatization and R&D. Indeed, the regression coefficients predict a growth of 0.34 basis

71
points per annum in new firms should a country in our sample move from the 25th

percentile to the 75th of IPRs and R&D. Accumulated over the 5 year period of our

study, resulting into a 1.72% of new firms within the same industrial sector.

Clearly, privatization matters for firms' growth across the industry spectrum, and

assessing the impact of privatization surpasses analyses of method of transfer of

ownership. Our overall result suggests that privatization can take a country to the path of

industrial development and thereby economic and financial developments. The results

have broad implications vis--vis policy choices for institutional reforms specifically in

terms of control of corruption, enhancing property rights protection, contracting rights,

and IRPs protection for privatization to bear fruits. This suggests that for a successful

privatization program, policymakers need to heed not only require the evolution of the

statutory laws but also their applicability while sticking a balancing act in terms of

drawbacks from slippage of employment that might undermine the instability of political

institutions while harming investment and growth.

Our financial development indicators suggest that implementing privatization as a

public policy tool requires that policymakers take into consideration the size of the

financial sector and other country-specific constraints to avert crowding out the private

sector so that other productive activities by the private sector get financed. This suggests

that partial privatization may be one approach to privatization while the public sector

does not suck up liquidity and render financing expensive but there will be a safeguard to

ensure a plurality of views within privatized firm's new managerial team.

Consistent with the law and finance view, there is a clear pattern that privatization

works better in setting with better legal institutions. That is, better contracting, patent,

72
IPRs laws coalesce to foster industry growth in the context of privatization of SOEs. This

has strong implications for policymakers especially in the debate over whether

developing countries should enforce these laws to the levels of their developed countries

counterparts when considering that developed countries have systematically violated

these rights before their development stage (see Chan and Grabel, 2004) for a complete

discussion. However, our results have limitations given that they are observed only over a

five year period. Nevertheless, without data extended over longer time period our results

support overall view of the finance and law and the financial development literatures that

the least developed countries can accelerate the growth of their industrial sector by

structurally bettering their legal institutions for their privatization programs to work.

Many differences exist across countries both and their legal and financial infrastructures

preventing a general recommendation on the issue of legal and financial reforms to be

undertaken to accompany privatization programs. Nonetheless, the convincing fact is that

there every country will benefit in strengthening IPRs laws to support innovation and

move beyond medieval stage of development, enhance property rights protection to

ensure privatized firm's assets are protected against unlawful competition and they can be

put to work to generate growth, and improve contracting laws to reassure investors that

their investments are protected against the state apparatus and the legality of the state

actions can be challenged before the courts without fear of political reprisals.

1.6 CONCLUSION

This study investigates the effects of privatization, property rights and financial

development on industrial growth. We confirm some previous findings in the law and

73
finance and the financial development literature. For instance, we find a positive

relationship between sectoral measure of intangible intensity and private property rights

protection on industry growth. We extend both the law and finance and the financial

development literatures with our finding that industry share of privatization spurs

industrial growth; and privatization without private property rights, contracting rights,

and IPRs protection does not promote industrial growth as measured by industry growth

of output, growth of value added, and growth in the rate of establishments in the industry.

Even if the debate around the overall impact of privatization is unsettled, looking

at the issue industry by industry supplies fresh perspectives of the effects of privatization

across the industry spectrum. In fact, there is abundant academic evidence on the superior

efficiency and performance of the privately owned businesses compared to their SOEs

counterparts. This conclusion is still puzzling in that risk taking behavior has worsened,

and privatization devoid of strong legal environment and political stability yields to

substandard results. Again, our overall result is that firms in industries where SOEs have

been privatized fare better when the legal machinery works reasonably well. With all its

deficiencies, privatization has its merits. It appears to be the most viable alternative to

state ownership. In many instances, it contributes to promoting industry firms' growth.

Nevertheless, we also notice that employment significantly slips after privatization in

sectors that are highly capital intensive. This is an issue policymakers need to heed when

implementing privatization programs to avoid structural long term unemployment. The

improved firms' growth is assumed to stem with the greater emphasis private owners put

on wealth maximization as opposed to governments that place more importance on the

74
societal and the political coupled with protection of their rights against unlawful

competitions and predatory behavior of the state.

However, there are many issues still have to be addressed for a successful

privatization and for other private sectors activities to get financed. For instance, in

developing countries where the financial sector is underdeveloped and inefficient,

governments may not fully privatize for two principle reasons. First, privatization large

firms at once may dry out liquidity and crowds out the private sector. Second,

government partial ownership might decrease concerns about renationalization and serve

as a substitute to monitor managers of the newly privatized firms as well especially where

market corrections such as takeovers, short selling, proxy fights and the like are absent.

Finally, our overall result signifies that if the privatized firm is well managed and is

noticeably economically transforming by increasing its industry growth, this may be a

step towards stabilizing a country given that economic progress has the potential to

ensure democracy, political stability and social cohesion by averting social decay and

political chaos.

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 CHAPTER 2

INSTITUTIONALLY DETERMINED BANK PROFITABILITY, SPREADS AND

LOAN QUALITY

2.1 INTRODUCTION

Several currents of institutional and financial thoughts thrive through the last two

decades of the twentieth century. The institution literature differentiates between property

rights institutions protecting the rights of citizens against government expropriations and

contracting institutions or set of rules and practices governing private contracts between

citizens (Acemoglu and Johnson, 2005). The law and finance literature substantiated by

La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997 and 1998, LLSV hereinafter)

establishes that legal institutions based on common law legal heritage provide better

protection to corporate shareholders and creditors. The two strands of literatures are

significantly intertwined inasmuch as the institution literature forms the backbone of the

law and finance theory. Hart (1995) and others concur that institutions matter for

financial contracting (see LLSV, 1998). There is abundant empirical and theoretical

evidence of the relationship between institutions and financing strategies (see e.g., Beck,

Demirg-Kunt and Levine, 2003; La Porta et al., 1997, 1998; and Levine, 2005 amongst

others). However, the relationship between institutions and banks net interest margin,

interest rates spread and loan quality is yet to be considered in financial research. This

constitutes an important research gap since the banking sector constitutes the spine of the

financial sector in most countries and thereby the driver of financial development;

meanwhile; developing countries banks are more profitable than their developed

76
countries counterparts (Demirg-Kunt and Huizinga, 1998). Financing costs are

significantly higher in countries with ineffective judicial system (Demirg-Kunt and

Huizinga, 1998; Laeven and Majnoni, 2003); and loan quality appears to be very poor in

countries with ineffective institutions. In addition, numerous countries have implemented

credit information bureaus to keep track on consumers and firms credit histories.

Although the banking literature has shown the importance of information in banking

(Diamond, 1984), the effect of such new institutions on bank net interest margin, interest

rates spread and loan quality is less understood due to another significant research gap. It

is therefore against this backdrop the present study is investigating the effects of two

types of institutions on banks: (1) market related institutions (private contracting

institutions and/or nonmarket institutions encompassing the relation between the legal

system and the financial environment), and (2) credit information institutions.

In effect, institutional practices determine whether financial contracting is

substantial. LLSV (1998) argue that in the traditional finance of Modigliani and Miller,

securities are recognized by their cash flows. Debt has fixed promised stream of interest

payments, whereas equity entitles its holder to dividends, but Hart (1995) argues that this

is far from the whole story and that the defining feature of various securities is the rights

that they bring to their owners. Building upon the LLSV and Harts argument, the present

study moves the debate one step ahead by looking at the effects of a broad set of

institutions on banks, or how these nontraditional financial attributes affect banks

operations inasmuch as the substance of financial contracts generates strong and/or

perverse investment incentives, influence cost of funds, moral hazard and adverse

selection problems due to institutional deficiencies and/or efficiencies.

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 Another apparent institutional failure is that in several countries the identification

of first-time borrowers is uncertain. Information on commercial, industrial and individual

borrowers is at best limited and its reliability often doubtful. Miller (2000) surveys Latin

American, Eastern Europe and African banks on their use of credit reporting to grant

credit to borrowers. A surprising 28 % of banks in the survey were not familiar with such

product known as credit reporting. Only 40% of the surveyed banks indicated that they

are using scores reported by those registries. Amongst those familiar with credit reporting

systems, 76% indicated that they would deny credit altogether if a negative information

was reported about a clients credit history. Therefore, there is a need to study the

relations between this set of institutions and banks and their role in alleviating risks, and

address their shortcomings.

The closest research related to our study in terms of the relationship between

institutions and banks are those of Demirg-Kunt and Huizinga (1998) and Laeven and

Majnoni (2003). However, their studies are limited to judicial efficiency and law and

order to quantify the quality of institutions. Francesca and Di Giorgio (2004), Crowley

(2007), Laeven and Majnoni (2003), find a negative association between the spread and

institutions. However, Magda, Tullio and Marco (2001) argue that there is no conclusive

relationship between institutions and banks spread. They argue that the relationship

depends on banking competition and the type of judicial reform undertaken. The present

study not only encompasses the institutional aspects already investigated by these studies

but also includes other market and nonmarket institutions which are assumed to affect

banks operations. Of particular importance is the role of credit information institutions in

banking, a relation for which Miller (2000) gives a descriptive picture.

78
 Notwithstanding the extensiveness of institutional study, the research gap in terms

of the effects of institutions and information institutions on bank net interest margin,

interest rates spread or lending risk premium, and loan quality is still significant given

numerous other institutional proxies overlooked in the literature. Moreover, the research

gap appears to be even wider as for the relationship between institutions loan quality.

Therefore, this study expects to emerge with a clearer picture of the outcomes generated

by such relationships and their implications for financial contracting. Indeed, the legal

infrastructure guarantees the stability of the successive generations of financial

transactions over a long period of time, which defines and constitutes a financial system.

Here, we quantify institutions using two set of data from the Heritage Foundation (HF)

and from the World Governance Indexes (WGI). Institutions as measured by the HF data

are more market related while the institutional measures derived from the WGI are more

related to a countrys overall legal infrastructure, which are used to check the robustness

of our results. We finally use depth of credit information; an index measuring the

availability of information about debtors from public or private sources known as credit

bureaus; as information institutions.

This study advances the literature in several directions. It shows the importance of

institutional reforms for finance, specifically for the strengthening of the banking sector.

It shows how such a policy agenda would reduce lending risk premia6, which are the

most noteworthy impediments to commercial, industrial and consumer financing. Our

results clearly show that high lending risk premia and dubious loan quality are the

6
Throughout our discussion, we use indiscriminately bank spread, interest rate spread and lending risk
premia. Also, we indiscriminately refer to loan quality as bad loans and to bank net interest margin as bank
profitability.

79
consequences of institutional failures. They show that secure contracting environments

are sine qua non conditions for banks to properly work as the engine of any economy.

They highlight that weaker banks have more bad loans in their portfolios and that lending

risk premia are one of the most important drivers of bad loans, suggesting that higher

financing costs to individuals and firms with low net worth result from imprudent lending

practices. Of great import is the finding that effective and reliable information on

borrowers past loan repayment patterns significantly decreases interest rates spread only

when controlled for predated institutional quality. This finding highlights the import of

institution-building especially in countries where sudden power shifts usually lead to

pendular swings in public policies. In essence, the results show that the effects of credit

information institutions on our trilogy depends well on the institutional quality, which

reflects the effectiveness of the organisms dedicated to enforce private financial

contracts.

The point estimates suggest that improving the quality of institutions will lower

bank net interest margin and at the same time lowers lending risk premium and bad loans.

They also suggest that bettering credit information system is likely to have similar effect

on banks. Finally, the point estimates of the differential impact of institutions suggest

even a stronger cumulative positive effect for the banking sector should institutions work

effectively. The estimates are not only statistically significant but also economically

important. We find that had a country in the 25th percentile of the institutional quality

index increased its value to the sample mean of 57. 27 for institutions, 4.06 for depth of

credit information, and assuming the country had the mean interest rate spread of 6.2%,

banks in that country would have had 2.24% lower net interest margin per annum, and if

80
accumulated over the estimation period of 5 years, there would have been a reduction in

bank net interest margin of 10.58%; these banks would have seen a reduction in unpaid

loans of 1.57% per annum in their loan portfolio, with a cumulative effect of 7.55% fewer

unpaid loans over the 5 years of our estimation period; and, there would have been a

lower interest rate spread of .822 basis points per annum, or a 4.03% lower interest rate

spread if accumulated over 5 years of our estimation period.

In terms of policy agenda, it is recommended that governments provide a strong

institutional framework, establishing trust and confidence between lenders and

borrowers. In countries where credit information bureaus are operating, for instance, they

need to fulfill their promises by collecting and supplying low costs and reliable

information. In such circumstances, the institutional framework should be oriented in the

direction of reducing information asymmetries to provide market-enhancing tools to cope

with problems of incomplete financial markets especially when banks are dealing with

informationally challenged firms and other first-time borrowers. In fact, no country can

survive without a viable and vibrant financial sector. Therefore, it is an existential matter

to deepen and improve the viability of the financial/banking sector. Then again, this

viability is threatened by weak institutions and high risk contingencies. In other words, it

is impossible to have sound financial sector without building up all sorts of institutions.

The remainder of the paper is organized as follows. The next section discusses the

related literature. Section 3 shortly describes the data, presents summary statistics and

preliminary evidence of the relationships amongst the variables. Section 4 addresses the

empirical strategy and the prevalence of the estimates. Section 5 presents some

81
preliminary evidences and descriptive statistics. Section 6 presents the results and section

7 concludes.

2.2 LITERATURE REVIEW

North (1994) defines institutions as humanely devised constraints structuring

human interactions, and classifies them between formal and informal. Chavance (2009)

argues that it is possible to change formal institutions overnight, but the modification of

informal institutions takes place over a very long period of time. This is why

revolutionary transformations are never as far-reaching as their advocates would like, and

why the transfer or imitation of formal institutions between countries does not achieve

the hoped-for results. North further argues that countries that adopt the rules of other

countries will have very different (economic and financial) performances because of

differences informal norms and enforcement mechanisms. Transferring the formal

political and economic rules of successful Western market economies to Third World

economies is not a sufficient condition for (financial and economic) performance (see

Chavance, 2009). The implication is that governments can make new laws and create

new institutions aiming at supporting financial development in ways that would reduce

risk in the contracting environment to lessen financial burdens for firms and individual

borrowers along with stronger banks balance-sheets since the likelihood of default would

decrease as well as transaction costs; however, these laws would be meaningless if their

enforcement is not supported by informal institutions or mores and customs to allow the

judiciary to serve as effective and fair arbiter between private contractors. That is, in any

circumstances, if public officials and private citizens are circumventing the laws, then the

formal institutions will not support financial contracting and therefore there will be

82
substantial barriers to finance, and as a consequence, the banking sector will have high

net interest margin and spreads but with subpar quality of loan portfolio. Indeed,

Masahiko Aoki (2000) argues that institutions may be codified and represented in an

explicit approach, but the codified institutions will have institutional characteristics only

if agents collectively believe in them. For instance, statutory laws and regulations are not

institutions if they are not followed (see Chavance, 2009).

2.2.1 Institutional Reform

Borrowing from Masahiko Aoki (2000, 2001) and Chavance (2009) the study

argues that in the absence of enforcement mechanisms supporting the written laws, the

policy objectives in relational banking will not come about, and the good intentions of the

laws will not be fulfilled. Thus, our analysis is based upon the premise that the written

laws represent the formal institutions, while their applicability is totally different from

their enforcement, the mores and customs in societies. In fact, institutions can be

theoretically and conceptually strong but empirically weak. The study identifies several

sets of institutions, which surpass mere written laws but embody court efficiency in their

interaction with banks while affecting bank lending decisions. These institutions might

well be characterized as typical of relational financing. Indeed, if the law is enforced,

then this fact will reverberate in the quality of these institutions to impact the banking

sector, investment patterns, and lending/borrowing relationships. A practical way of

measuring such effects is to assess the impact of institutions on firms cost of funds and

level bad loans in banks portfolios. These tandems (institutions/banks,

institutions/spreads, and institutions/bad loans) offer a unique platform to analyze

whether financial contracts are viable when the institutions preordained to reinforce them

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work effectively. Here, institutional strength is measured using the extent to which

private contracting is supported by the legal system. This measurement is multifaceted in

that it encompasses (1) the legal right of creditors, (2) the financial freedom enjoyed by

banking and non-banking firms in free banking and investing regimes, (3) a public sector

free of corruption where political potentates restraint themselves from collecting undue

rents from private companies, and (4) an effective court system where creditors rights

are protected and disputes between borrowers and lenders are impartially resolved.

There is a significant research gap in terms of the effects of this broad set of

institutions on banks. The closest research related to our study in terms of the relationship

between institutions and banks are those of Demirg-Kunt and Huizinga (1998) and

Leaven and Majnoni (2003). However, their studies are limited to judicial efficiency and

law and order to quantify the quality of institutions. Moreover, the role of credit

information institutions in banking, a relation for which Miller (2000) gives a descriptive

picture is less understood due to lack of research in the area. Indeed, Jappelli and Pagano

(2000) look at the relationship of information sharing and lending and defaults; other

studies look at the issue of institutions and banking from the perspectives of, institutions

and interest rates Francesca and Di Giorgio (2004), loan characteristics, duration and

creditors rights and interest rates (Qian and Strahan, 2005), prevalence of creditors

rights (Safavian and Sharma, 2007), private credit and creditors rights and information

(Djankov, McLiesh and Shleifer, 2007; DMS hereinafter). Most of these studies share

one common weakness that of narrowly defining institutions as either the effectiveness of

the judicial system or the prevalence of the rule of law as defined by the World

Governance Indexes (WGI) by the World Bank. In addition to DMS (2007) who find that

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the WGI indexes are highly subjective and have significantly high standard errors,

judicial efficiency and law and order do not suffice to assess the quality of a countrys

institutions especially in developing countries where the banking sector and powerful

elites are likely to have upper hand on the judiciary. That is, even when the judiciary does

not work for society at large, but it will likely be more vigilant at preserving banks and

other potentates interests if the investment environment is highly corrupted. Another

shortcoming of the extant law and finance literature in its use judicial efficiency as the

best proxy for institutions is that the quality of the judiciary as it stands in many

developing countries depends not only on the ability of the courts to enforce contracts but

also in the complexity of the financial products and contracts that the judiciary is coping

with, which are assumed to be relatively unchallenging and straightforward in bank-based

economies where banks involve more in traditional operations consisting mostly of

taking savings and making loans. Here, rests the necessity to studying institutions and

banks on a broader scale for a better understanding of the willingness of creditors to

finance legitimate projects especially in countries with backward financial infrastructures.

The law and finance literature as well as the institution theory provide ample

theoretical justification of a lasting role of the colonial traits in todays institutional

infrastructure. Verblin (1921, see Chavance, 2009) argues that the situation of today

shapes the institutions of tomorrow through a selective, coercive process, by acting upon

mens habitual view of things, and so altering or fortifying a point of view or a mental

attitude handed down from the past. Acemoglu, Johnson, and Robinson (2001) argue that

the colonial institutions propagated during the colonization era persisted well beyond

independence. Levine (2005) corroborates the point view adding that the Napoleonic

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institutions built upon the French civil law system are more rigid and formalistic than the

British institutions whose bedrock is the common law system; and this rigidity has

various consequences on these countries financial system. Merryman (1996) notes that

the exportation of the French civil law to its colonies had more pernicious effects on

property rights and private contracting than the Codes effect on France and other

European countries that adopted the Napoleonic Code; and further argues that while

colonies imported the inflexibility associated with antagonism toward jurisprudence and

reliance on judicial formalism, most did not learn how the French circumvented the

adverse attributes of the Code (see Levine, 2005). In addition, the theory conceives that

the propagation of legal traditions had enduring influences on national approaches to

private property rights and financial development British colonizers advanced a legal

tradition that stresses private property rights and fosters financial development, whereas

in contrast colonizers that spread the French civil law implemented a legal tradition that

is less conducive to financial development (Beck et al., 2003).

The present study seeks to disentangle the apparent persistent effects of

institutions on lending/borrowing relationships and expects to emerge with a clearer

picture of the persistence of bad loans in bank loan portfolios, bank net interest margin,

and the direction of bank spreads by testing several hypotheses.

H1: If institutional quality and risk are highly correlated, then institutional changes

influence banks exposure.

H2: Assuming that bankers relax credit standards during economic expansion and

tighten them during economic downturns, and if, as monitors, they are informed of the

credit repayment patterns of their borrowers, then institutional quality might be a unique

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systemic factor explaining the persistence of unprofitable loans in banks balance-sheets

and simultaneously the main driver of banks spreads, and bank net interest margin.

H3: The joint effect of poor institutional quality and the spread is a significantly

higher level of bad loans on banks portfolios.

H4: If more information is available about borrowers credit history, then ex-ante

lender/borrower relationship is less adventurous. Therefore, the possibility of adverse

selection is significantly mitigated, so banks should charge lower lending risk premia,

and as a result, loan quality should improve.

The above hypotheses are tested using bank level data and country level data for

seventy-nine countries in effort to complement the prevailing literature which provides

strong evidence of a more profitable banking system in developing economies,

suggesting that banks in most developing countries are coping with a riskier investment

and contracting environments in that they are compensated for taking on greater risk than

banks doing business in developed countries. There is also evidence that the institutional

framework in developing countries is also weaker than that of developed countries.

Therefore, if the quality of a countrys institutions is poor and there is significant

interaction between banks and the various institutions, the case for the institutional

reform leading to a sounder banking system in these countries appears to be strong.

However, such institutional reforms may be hopeless if the capability and the incentives

to carry them out are either absent or trumped by special interest groups and powerful

elites in case where the status quo generates profits. The empirical evidence suggests that

the status quo is favorable to bank profitability (see e.g., Demirg-Kunt and Huizinga,

2001; Flamini, McDonald, and Schumacher, 2009). Indeed, Demirg-Kunt and

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Huizinga (1998) argue that the absolute quality of the banks and securities markets in a

country depends on the legal system's ability to enforce contracts. Ultimately, this begs

the question of what kind of institutional reforms or regulations are to be instituted in

these countries to promote stronger banking sector, lower lending risk premia, fewer bad

loans, and finally, a healthier investing environment.

2.2.2 Information Related Reforms

Institutional reforms go in tandem with technological advances. Backward

legal/institutional settings create a system in which technology can hardly be used to

establish financial contracts authenticity. With lack of viable information gathering and

processing mechanisms, transaction, information costs and information asymmetries are

expected to be high. Mechanisms through innovations - that would leapfrog outdated

social and economic infrastructures, which create enormous geographical distances

between those seeking funding and potential creditors are lacking in most countries.

Despite its relative technological advantage, it appears that the financial sector, in

emerging economies, is unable to deepen financing and direct financial resources in an

efficient way due to informational challenges, lack of bank information sharing or

increased bank secrecy laws. Without necessary informational and institutional reforms,

in spite of the capability of banks to perform ex-post monitoring and verify the stated

financial strength of borrowers to minimize the risk of default, it might be difficult for

bankers to efficiently apply their expertise for start-ups, small firms, and first time

borrowers if credit information institutions are deficient. In this instance, institutional

build-up improving ex-ante monitoring play a viable role in, financing new projects, and

88
potentially lessening risk of adverse selection, reducing the spread, and creating wealth

through duly financed projects.

In many countries, however, credit information agencies are mostly nonexistent

and when they exist they are ineffective. Miller (2000) surveys Latin American, Eastern

Europe and African banks on their use of credit reporting to grant credit to borrowers. A

surprising 28 % of banks in the survey were not familiar with such product known as

credit reporting. Only 40% of the surveyed banks indicated they are using scores reported

by those registries. Amongst those familiar with credit reporting systems, 76% indicated

that they would deny credit altogether if a negative information was reported about a

clients credit history. However, more recently, Brown and Zehnder (2005) analyze the

impact of the introduction of credit registries on loan repayments, and find that the

introduction of a registry significantly raises repayment as well as the credit volume

extended by lenders but not in markets with repeated transactions. Love and Mylenko

(2003), and DMS (2007), find that bank credit to the private sector increases where

information sharing institutions are more developed. Pagano and Jappelli (1993), and

Kallberg and Udell (2003) document that information sharing reduces selection costs for

lenders by allowing them to predict loan defaults. Padilla and Marco (1999) argue that

creditors often share information about their customers credit records to help them to

spot bad risks. They argue that if creditors are known to inform one another of defaults,

borrowers must consider that default on one lender would disrupt their credit rating with

all other lenders. Their argument, however, applies to a limited fraction of the world

where records about firms and individual borrowers are kept and efficiently used in credit

allocation. This disciplinary function through information sharing is at best minimal in

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many developing countries where information about firms is sensitive and does not flow

from one lender to another in a formal way that would incentivize the borrower to

perform to keep her record intact. Furthermore, it can be argued that only borrowers who

anticipate future financial needs will not mull over defaulting if they are heavily indebted

and their financial charges excessive. On the other hand, in many settings such as French

legal heritage where the cultures revolve around a strong state apparatus, the central bank

might play a very important role in facilitating information sharing across lenders while

private credit bureaus are gaining esteem and credibility. This study seeks to add to the

growing evidence that information through private or public credit registries have an

impact on bank net interest margin, interest rates spread and loan quality, and that impact

is anticipated to affect long term lending/borrowing relationships. It conjectures that in

backward economies, the role played by the banking sector in monitoring and sanctioning

firms management reflects the overall quality of these countries institutions. Therefore,

banks role in disciplining firms and other funds seekers have not reached the level of

significance of developed countries where institutional forces converge toward risk

minimization.

In terms of policy agenda, we argue that governments must provide a strong

institutional framework, establishing confidence between lenders and borrowers. In

countries where credit information bureaus are operating, they need to fulfill their

promises by collecting and supplying low costs and reliable information. In such

circumstances, the institutional framework should be oriented in the direction of reducing

information asymmetries to provide market-enhancing tools to cope with problems of

incomplete financial markets especially when banks are dealing with informationally

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challenged firms and first-time borrowers. In fact, no country can thrive without a viable

and vibrant financial sector. Therefore, it is an existential matter to deepen and improve

the viability of the financial/banking sector. Then again, this viability is threatened by

weak institutions and high risk contingencies. In other words, it is impossible to have

sound financial sector without building up all sort of institutions supporting market

operations.

2.2.3 Interest Rate Spread

The main medium through which banks benefit from their activities is through the

spread, the difference between their cost of borrowing (deposit rates) and the cost of

lending (lending rates). Financing costs have numerous implications for firms and other

fund borrowers. They might prevent projects with positive NPVs from financing by

making bank credit difficult to obtain, and worsening financial position of high risk

borrowers with low net worth. It is conjectured that a highly risky environment increases

borrowing costs. Likewise, when weak banks dealing with a riskier clientele they are

expected to charge higher spreads as their expectation of bankruptcy is higher for

themselves and for their borrowers. In such circumstances, banks in ineffective

institutional settings are expected to have high discount rates and short investment

horizons, especially when they have capital constraints. Ineffective institutions may be

characterized as weak enforcement mechanisms and poor information about borrowers.

In fact, Boot and Thakor (2000) document that banks impose higher interests on their

borrowers because of information asymmetry problems.

Several studies analyze the determinants of bank interest spreads including

Leaven and Majnoni (2003) and Crowley (2007) in the context of cost of credit and

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judicial reforms. The debate over the effect of institutions on bank spread is not settled,

however. Francesca and Di Giorgio (2004), Leaven and Majnoni (2003), and Crowley

(2007) find a negative association between the spread and institutions. However, Magda

et al. (2001) argue that there is no conclusive relationship between institutions and bank

spread. They argue that the relationship depends on banking competition and the type of

judicial reform undertaken. However, the cross-country evidence provided by Demirguc-

Kunt and Huizinga (1998) points to large benefits of judicial efficiency on the reduction

of banks net interest income, independently from any notion of market power. This may

hide different levels of judicial effectiveness across developed and developing countries

where typically banking markets are more concentrated and judges could more likely be

captive of the economic power (see Leaven and Majnoni, 2003). Clearly, the effect of

institutions on the spreads is an ongoing debate. From this point of view, our study is

closer to that of Leaven and Majnoni (2003) who use law and order as proxy for

institutional effect on the spread, that of that of Demirg-Kunt and Huizinga (1998) and

Francesca and Di Giorgio (2004) who use judicial effectiveness as measure of

institutional effect on the spread, and that of Qian and Strahan who use creditors rights

as proxy for institutional effect on the spread. However, the current study has panoply of

differences in its way of quantifying institutions to disentangle the effect of the judiciary

which might be held captive of the economic power as argued by Leaven and Majnoni.

Therefore, additional evidence of a relationship between the spread and institutions

would guide policies on what type of institutional reforms are needed to protect the

interests of lenders while channeling finance at better costs to firms and low net

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worth/high risk individuals: A balanced policy that is so much needed in many

developing countries.

2.2.4 Loan Quality

Loan quality is referred to as bad loans, which are a function of how much lenders

know about borrowers credibility, industriousness and repayment capabilities. With

Brown and Zehnder (2005) finding a positive impact of credit registries and repayment

rates and Padilla and Marco (1999), and Jappelli and Pagano (2002) amongst others who

argue a positive effect of information sharing between lenders to spot bad risk, it is clear

that coping with information on borrowers to improve loan quality is a major hurdle to

overcome in many financial settings. More recently, (Fehr and Zehnder, 2009) analyze

the interaction between relational incentives and legal contract enforcement. They find

that in the absence of legal enforcement and reputation formation opportunities the credit

market breaks down almost completely while if reputation formation is possible a stable

credit market emerges even in the absence of legal enforcement of debt repayment.

However, they find that legal enforcement of repayments causes a further significant

increase in credit market trading with only small impact on overall efficiency.

Clearly, despite numerous studies on loan repayments, financial research is yet to

consider the issue of loan quality and institutional quality. The present study addresses

the issue of loan quality within an institutional view point, and intends to fill this gap by

analyzing the effects of the quality of the institutions on borrowers repaying patterns.

Indeed, formal institutions as expressed by the written laws are expected to have limited

effects if the enforcement mechanisms inflict only innocuous sanctions and impose

insufficient constraints on would-be defaulters. Therefore, effective institutions are

93
expected to have a positive impact on loan repayments via a negative relationship with

bank bad loans. Evidence of such a relationship would suggest that improving

institutional quality makes banks balance-sheet stronger and policies aiming at

institution building maybe a better instrument for improving access to credit in lieu of

letting banks inflating the spread to auto-compensate for certain risks, which could be

mitigated through institutional mechanisms.

2.2.5 Bank Net Interest Margin

Profitability is the net result of a number of not only managerial decisions and

corporate policies, but also broad institutional effects affecting operations of the banking

system. Finance charges might vary significantly amongst countries, but are expected to

be fairly homogenous within countries assuming competitive markets. Interests charged

by banks will move in tandem with a countrys risk environment. The literature on

institutions stresses the role of internal and external governance in firms performance.

The relationship between institutions and banks has not been fully addressed in the

literature, however. In effect, bank net interest margin has been considered as a proxy for

banks inefficiency (Demirg-Kunt and Huizinga, 1998). Other academics suggest the

margin to be a function of a countrys laws and institutions (see Demirg-Kunt, Laeven,

and Levine 2004; Leaven and Majnoni, 2003). Indeed, Demirg-Kunt et al. (2004)

argue that amongst the obstacles to finance is interest margin. When the banking sector

enjoys a high net interest margin, this is an indicator of the inadequate availability of

credit, and market distortions in term of lack of competition and market power of banks.

In fact, Demirg-Kunt et al. (2004) find that net interest margins are narrower in

countries with better institutions. In their earlier study of commercial bank interest

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margins and profitability Demirg-Kunt and Huizinga (1998) find that indicators of

better contract enforcement, efficiency in the legal system, and lack of corruption are

associated with lower interest margins and lower profitability. The current study

complements the prevailing literature by arguing that high net interest margin is not only

an impediment to external finance but also a factor in increased vulnerability and

insolvency of struggling firms and an impediment to start-ups and small firms growth.

Without institutional reforms, bank net interest margin and the spread will keep many

borrowers away from financing. Finally, large bank net interest margins as well as

increased spreads are indicators of backwardness of a countrys financial markets.

2.3 THE MODEL

To test how institutions affect bank profitability, the spread and loan quality, we

set a system of equations while assuming a multi-directional relationship amongst the

dependent variables. Since we are interested in how institutions simultaneously affect the

dependent variables, we also allow the coefficients of these variables to vary by

institutions when they are used as control variables in the system. The model takes the

following form:

95
 where net interest margin is the computed bank net interest margin in country at

time ; bank spread is the difference between bank cost of borrowing and bank cost of

lending in country at time ; and loan quality represents the percentage of

nonperforming loans in banks balance-sheet in country at time , and are

the primary coefficients of interest since they capture the effects of institutions on bank

profitability, bank spreads and loan quality respectively. , and are vectors of

slopes of other explanatory and control variables; and, , and are the residual terms,

which allowed to be correlated. The system is estimated using seemingly unrelated

regressions technique. Estimating multiple models simultaneously while accounting for

correlated errors yields efficient estimates of the coefficients and standard errors. The X

matrices comprise the control variables along with several interaction terms where the

variables of interest are allowed to vary by institutional quality.

2.4. DATA ANALYSIS

The system of equations is estimated using bank and country levels data for

seventy-nine countries. Bank data are drawn from the BankScope as provided by the

World Bank. Amongst the bank related variables are net interest margins, returns on

assets, returns on equity, bank credit, and bank z-scores. The different waves of

estimation seek to capture the effects of institutions on bank net interest margin, the

spread, and loan quality. This study adds to current research by expanding the concept of

institutional measures and assessing the import of such an institutional expansion on

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access to finance, bank inefficiency (as expressed by net interest margin) and the quality

of bank loan portfolio.

2.4.1 Dependent Variables

Our system of equations involves three dependent variables: Bank net interest

margin, bank spreads and loan quality. Looking at these variables simultaneously within

an institutional context improves current research in the direction of institutional and

banking reforms to improve the efficiency of the banking sector, access to finance, and

strengthening banks balance-sheet.

2.4.2 Bank Net Interest Margin

Bank net interest margin is a proxy of overall profitability. In countries with

ineffective institutions, if lenders perception of risk is correct, and they give appropriate

response to their anticipation in their lending decisions, then overall lending and financial

investment will be both low and costly.

2.4.3 Interest Rate Spreads

The spread is the difference between bank cost of funds in terms of interests on

demand deposits and the rate that banks charge borrowers. It is anticipated that bank will

charge higher interest to their debtors in countries where institutional quality is poor.

Ineffective institutions increase the risk that debtors go bankrupt and default on their

promises. The spread may also serve as a proxy for lenders financial strength since

riskier and smaller borrowers are likely to flock to these banks for financing. That is,

precarious banks with low capital may seek to replenish their capital using high spreads

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and short loan duration. Indeed, Hubbard, Kuttner and Palia (2002) find that low-capital

banks tend to charge higher loan rates than well-capitalized banks. They argue that this

effect is primarily associated with firms for which information costs are likely to be

important, and, when borrowing from weak banks, these firms tend to hold more cash, for

many firms face significant costs of switching lenders and thus provide support for the

bank lending channel of money transmission.

In our data, it is observed that bank spread varies to a large extent. The lowest

recorded average spread over 2004 through 2008 is 3% for Belarus while the highest

spread is 457% for Zimbabwe, which has been dropped from the analysis since it is

practically an outlier. This leaves Brazil as the country with the highest spread in our

sampled countries, 39.1 %. Similarly to banks stakeholders, banks debtors stakeholders

face a certain amount of risk unrelated to the risk inherent to their operations. Therefore,

ineffective institutions add to the risk faced by firms, which get magnified when those

firms use leverage to finance their operations. The data for bank spreads are from the

Global Development Finance by the World Bank and cross-validated with data from the

International Financial Statistics by the International Monetary Fund, and with data by

the Global Competitiveness Report by the World Economic Forum.

2.4.4 Loan Quality

Loan quality refers to the percentage of bank nonperforming loans to total gross

loans. They are funds owed to creditors with virtually no chance to be collected. In

banks balance sheets these loans are classified as worthless assets and are written off

after all legal attempts to collect them have been exhausted. Banks in countries with poor

institutions are expected to have higher level of expenses in terms of loan loss provisions.

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 2.4.5 Independent and Control Variables

In testing the theory of institutions, we use two sets of institutions (1) market

institutions and (2) information institutions; and control for bank credit to the private

sector, bank cost income ratio bank liquid liabilities, bank z-score, bank returns on asset

and bank returns on equity in the net interest margin specification. Other control variables

include the sophistication of the financial system, soundness of banks, judicial

independence, depth of credit information, and percentage of adults covered by private

credit bureaus and public registries. Most of these variables are controlled for in the

spread and loan quality specifications.

2.4.6 Institutional Quality

Safavian and Sharma (2007) note that scholars now generally concede that legal

institutions matter to financial markets, and attention has turned toward identifying and

quantifying the specific mechanisms which link law and finance. Building on this

perspective, this study measures institutional quality using four indexes from the Heritage

Foundation (HF), and other indexes from the World Governance Index (WGI) for

robustness check. Together, the indexes from the HF measure to what extent firms can

enjoy their legal rights within the legal framework, and the extent to which contracts are

enforceable through the judiciary and through other external governance vehicles. This

has strong implications in lending/borrowing activities when contracts abiding lenders

and borrowers can be upheld in courts in the events of financial distresses by a defaulting

firm, and the court decisions take effect and not hindered by the inertia of other

institutional branches. We average four different indexes to measure institutional quality:

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Business freedom, freedom from corruption, investment freedom and financial freedom.

Together, this set of freedoms captures the extent to which individual and corporations

are allowed to use their physical and financial assets without restrictions from the state.

Specifically, the business freedom assesses the ability to open and operate firms without

barriers such as kickbacks, and red tapes. The investment freedom assesses whether local

institutions are supportive of free flow of capital. The financial freedom is a measurement

of the extent to which banks can operate freely and independently from government

interferences. The freedom from corruptions assesses the perception of corruption in the

business and contracting environments. It also captures the extent of corruption at

governmental, legal and judicial, and administrative levels. Fernandes and Kraay (2007)

put that corruption is the use of public office for private gain, and the taking of bribes by

public officials can be thought of as the expropriation of private property by the state.

Clearly, a composite of these four indexes represents a catch-all and reliable proxy of

institutional quality with the potential of capturing enormous information about

institutions that any single series such as law and order or the efficiency of the judicial

system could ever capture.

All of the four indexes are measured on a scale from zero to 100 where zero

represents the absolute absence of the underlying freedom in a given country and a value

of 100 suggests negligible interference of the state. The HF data has been used in several

studies including (Beck et al., 2003; Laeven and Majnoni, 2003; and Levine, 2005). The

WGI data is widely utilized in the institution literature especially for political institutions

and external governance measures. From that dataset, we average four governance

indicators to measure institutional quality including Government Effectiveness,

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Regulatory Quality, Rule of Law, and Control of Corruption. These governance

indicators are constructed on a scale from 2.5 to 2.5 so that higher values correspond to

better outcomes (see DMS, 2007 for more details on these indices).

2.4.7 Depth of Credit Information

The credit information index measures the availability of information about

debtors from public or private sources known as credit bureaus. Specifically, the index

measures rules affecting the scope, accessibility, and quality of credit information

available through public or private credit registries. The index takes values from 0 to 6,

where a higher value suggests the availability of more credit information to facilitate

lending decisions. Its main characteristics include credit history both on firms and

individuals who can legally access their own data and challenge any inaccurate

information. The index is provided by the International Finance Corporation from the

World Bank. Two other information variables are also utilized: the percentage of adults

covered by private credit bureaus and the percentage of adults covered by public

registries.

2.4.8 Creditor Rights

The creditor rights index, ranging from 0 to 10, is a variable constructed to

capture change and regulations and business procedures affecting the rights of creditors

within a country. The index is an assessment of the role played by collateral in the event

of bankruptcy, and is provided by the International Finance Corporation from the World

Bank. The index measures the extent to which secure creditors are able to takeover

collateral when debtors file for bankruptcy or enter reorganization without stay or asset

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freeze imposed by the court (see DMS, 2007). In such events, secure creditors are paid

first from the proceeds resulted from liquidating the bankrupt firm. Ceteris paribus, if

banks constitute the major creditor in most countries around the world, strong creditor

rights should be negatively related to bank net interest margin, interest rates spread as

well as loan quality. The negative association is expected since when banks legal rights

are stronger, risks, the driver of the spread and bad loans dwindle. In countries where

financial markets are underdeveloped, there are very few mechanisms to vetting firms

seeking credits, however; strong creditor rights might be a vehicle that protect the rights

of lenders and facilitate lending activities. Indeed, Safavian and Sharma (2007) study two

aspects of the law and finance theory: The laws on creditor rights and the quality of

contract enforcement by courts. They find that the effectiveness of creditor rights is

strongly linked to the efficiency of contract enforcement. They find that firms have more

access to bank credit in countries with better creditor rights, but the association is weak in

countries with inefficient courts. In addition, they find that the effect of a change in

creditor rights on change in bank credit increases with court enforcement.

2.4.9 Other Control Variables

We control for numerous other factors related to banks and/or institutions. For

instance, agency costs may motivate banks that are coping with low capital level and

weak balance-sheet to attempt applying a disproportionate spread to what a borrowers

riskiness suggests. Then, we include bank z-score amongst the control variables.

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Additionally, the banking sector might be highly concentrated or consolidated, then we

control for bank overhead, bank concentration ratio and bank cost income ratio7.

2.5 PRELIMINARY EVIDENCE

Table 1 presents the correlations between the four components of our institutional

quality variable along with private property rights. The variable is constructed using the

simple average of business freedom, investment freedom, financial freedom and freedom

from corruption. All of the components are positively highly significantly correlated.

This indicates that an improvement in one component likely to positively affects the other

components.

7
Notwithstanding the set of control variables varies with the hypothesis being tested, the initial set of
control variables is as follows. X1it =[depth of credit information, bank credit to private sector, bank
concentration ratio, bank cost income ratio, bank liquid liability, bank z-score, bank returns on assets, bank
returns on equity, soundness of bank, financial market sophistication] it; X2it =[inflation, depth of credit
information, bank concentration ratio, bank cost income ratio, bank overheads, bank returns on assets,
bank returns on equity, soundness of bank, private creditors rights] it; X3it =[depth of credit information,
bank credit to private sector, bank concentration ratio, bank cost income ratio, bank liquid liability, bank z-
score, bank returns on assets, bank returns on equity, soundness of bank, private creditors rights, financial
disclosure]it. However, when testing for the effects of information on bank profitability, bank spread and
loan quality, almost the entire set of control variables is replaced. The most prominent control variables in
such instances are legal origin and proxies for information. All specifications have some interaction terms.
The interaction between (depth of credit information, bank spreads, loan quality, and legal origin) and
institutional quality allows us to address possible endogneity between level variables and other unobserved
bank determinants unaccounted, for even if such concerns are largely abated using seemingly unrelated
regressions that lead efficient estimates. Some additional tests comprise a control variable called judicial
independence, a variable collected from the Global Competitiveness Report published by the World
Economic Forum. This variable is akin to the traditional legal effectiveness usually used as proxy for
effective courts and institutions in the literature.

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 Table 10

Correlations between the Institutional Quality Components

This table presents the correlations between the four components of institutional quality (IQ), which is constructed as the
average value between business freedom, investment freedom, financial freedom, and freedom from corruption, where each
component has the same weight.
[1] [2] [3] [4] [5]
Business Freedom [1] 1.0
Investment Freedom [2] 0.6410*** 1.0
Financial Freedom [3] 0.5975*** 0.6984*** 1.0
Property Rights [4] 0.7665*** 0.7004*** 0.6255*** 1.0
Freedom from [5]
0.7417*** 0.6396*** 0.5698*** 0.8804*** 1.0
Corruption

The general positive correlations between these institutional indicators suggests

that it is difficult to identify and separate a single institutional factor, which is more

important for financial contracting and enforcement in general, and for investment in

particular. Therefore, such a general strong and unidirectional relationship suggests that

more information regarding institutional quality is captured using a composite index.

Table 11
Correlations between Institutional Quality and Banks Related Variables
Table II presents the correlations between institutional quality and banks related variables, and some control variables. ***, **
and * represent significance levels of less 1%, 5% and 10%.
[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12
]
Institutional [1]
1.0
Quality
Loan Quality [2] -0.49*** 1.0
Interest Rate [3]
-0.33*** 0.06 1.0
Spreads
Depth of Credit [4]
0.41*** -0.41*** -0.04 1.0
information
Creditors Rights [5] 0.27*** 0.11* -0.30*** -0.20*** 1.0
Financial Market [6]
0.45*** -0.20*** -0.21*** 0.35*** 0.15** 1.0
Sophistication
Ease Access to [7]
0.67*** -0.28*** -0.39*** 0.23*** 0.33*** 0.59*** 1.0
Loan
Financial [8]
0.72*** -0.31*** -0.38*** 0.34*** 0.34*** 0.65*** 0. 80*** 1.0
Disclosure
Soundness of [9]
0.72*** -0.44*** -0.18*** 0.35*** 0.30*** 0.53*** 0.74*** 0.79*** 1.0
Banks
Bank Credit to [10]
0.49*** -0.20*** -0.29*** 0.33*** 0.22*** 0.56*** 0.54*** 0.69*** 0.42*** 1.0
Private Sector
Bank Net Interest [11]
-0.37*** -0.015 0.61*** -0.04 -0.31*** -0.24*** -0.45*** -0.43*** -0.24*** -0.42*** 1.0
Margin
Bank [12]
0.31*** -0.23*** -0.11* 0.16** 0.06 0.05 0.21*** 0.25*** 0.30*** -0.04 0.024 1.0
Concentration
Table 2 presents the correlations between institutional quality and the main

variables in our study. As a general pattern, institutional quality was highly statistically

104
correlated with all of the variables. Importantly, increases in institutional quality were

negatively significantly related to bank net interest margin, bank spread and loan quality.

Although depth of credit information was insignificantly related to the spread, this

variable had a significant negative correlation with both loan quality and bank net interest

margin, implying that information about borrowers past payment history is more relevant

in reducing adverse selection than in improving access to finance. More specifically, the

correlation between lending risk premia and bank profitability was .

The negative correlation between bank profitability and institutional quality was

, and importantly, a statistically significant negative correlation of

existed between institutional quality and bad loans. Additionally,

the negative association between institutional quality, loan quality and the spread is

illustrated in figure 1. Generally, there seems to be strong evidence of a linear

relationship between almost all the hypothesized variables for the sampled countries.

Interestingly, the negative association between institutional quality, bank spread and loan

quality suggests that, even if the correlations are not perfect, an improvement in

institutional quality will benefit the banking sector by decreasing bank net interest

margin, removing barriers to external finance, and improving loan quality.

Furthermore, governance mechanisms such as financial disclosures had a negative

and significant relationship with bank net interest margin, the spread, and loan quality. It

seems that governance practices, which reverberating a countrys institutional quality

play an important role in improving access to finance and the stability of the banking

system. For instance, soundness of banks was negatively significantly correlated with

bank net interest margin, the spread, loan quality. This relationship suggests that weaker

105
banks might charge higher lending risk premia and as a result, they have more bad loans

in their loan portfolio. Specifically, enhanced institutional quality was highly related to

the soundness of the banking system , the sophistication of financial

market and ease access to loan.

Table 12
Descriptive Statistics of Institutional Quality Measures and other Indicators
This table presents summary statistics of the variables used in our study. We perform a median split based on
institutional quality. We form two groups with observations bellow and above the median of institutional
quality. We compute the means for the countries falling below the median and the means for those countries
that fall above the median of institutional quality. The t-statistics of tests of differences in the means to assess
how these two groups of countries compared across indicators. The variables are described in detail in
Appendix I.***, **, and* represent significant levels of 1%, 5% and 10% respectively. Group1 refers to
below median observations, while group2 refers to above median observations. The null hypothesis is the
equality of the means across the two groups assuming unequal variances.
t-Tests of
Means across Groups and
Difference in
Countries
Means
Group Group All Group 1 vs. Group
1 2 Countries 2
Institutional quality 44.49 71.02 57.72 -25.12***
Loan Quality 6.98 2.34 4.63 9.15***
Interest rate spreads 7.98 4.41 6.20 6.40***
Creditor rights 4.89 6.49 5.69 -6.79***
Depth of credit information 3.31 4.82 4.06 -8.32***
Bank concentration 0.59 0.69 0.64 -5.16***
Returns on assets 0.001 0.01 0.005 -0.76
Returns on equity 0.125 0.128 0.126 -0.23
Bank cost income ratio 0.68 0.67 0.67 0.27
Private creditors rights 4.89 6.49 5.69 -6.79***
Private credit bureau (percentage of
8.84 14.50 11.66 -2.45***
adults covered)
Public registry (percentage of adults
15.60 33.59 24.57 -11.72***
covered)
Private credit 55.80 106.43 81.04 -8.77***
Financial market sophistication 3.79 4.94 4.36 -9.77***
Ease access to loan 3.06 4.00 3.52 -11.25***
Judicial independence 3.31 4.74 4.02 -11.04***
Financial disclosure 4.36 5.38 4.87 -13.17***
Soundness of banks 5.01 6.07 5.54 -14.62***
Inflation 7.54 3.72 5.64 8.77***
Overhead 0.047 0.037 0.042 3.53**
Bank net interest margin 0.058 0.035 0.046 8.40***

106
 Although these correlations were not perfect, they suggest that there might be

countries with good institutional quality and basic or traditional lending and savings

activities by the bank sector, unreliable banks, and lack of transparency in both banks

financial statements and financial transactions. Since correlation does not always imply

causation, the differential effects of these variables and their association with institutional

quality along with their joint effect on bank profitability might be better captured in

regression settings. Table 3 presents additional stylized facts of the variation of the

variables with institutional quality across the sampled countries. The descriptive statistics

are computed for the period covering 2004 through 2008. A median split was performed

based on institutional quality (IQ) to illustrate the differences across countries along the

main variables. Two groups were then constituted around the median of institutional

quality and then the difference in the means of the groups for each variable was tested. In

most cases, the results indicate that the scale of banking related factors evolves with

institutional quality. The mean tests analysis gives further insights on the relationships.

The results show that banks in countries whose value of institutional quality falls below

the median had significantly higher spread, poorer loan quality or higher level of bad

loans, and higher overheads. Furthermore, banks in countries with substandard

institutional quality have higher net interest margin, which is a primary indication of their

inefficiency and also the riskier environment in which they operate. Furthermore,

governance related variables such as financial disclosure, and judicial independence were

significantly weaker in countries with poor institutional quality. Likewise, in countries

with poor IQ private creditors had weaker rights, and both information institutions such

as private credit bureaus and public registries cover fewer adults. The pattern was also

107
observed for all of the other variables related to the banking sector and/or a countrys

financial system. In their quasi-totality, the variables show significant differences

between the two groups.

2.6. RESULTS

The regression results are presented in this section. The method of estimation

consists of seemingly unrelated regressions (SUR), which allows us to exploit the

interrelationships amongst the equations. The results of the first wave of estimations are

presented in table 4, where each column displays the results for each of the equations in

the system. For comparison purposes, the first three regressions are estimated using OLS,

while the last three specifications are the SUR estimates. Bank net interest margin is the

dependent variable in the fourth equation, while interest rates spread, and loan quality are

the dependent variables for the fifth and the sixth equations respectively. Since

institutional quality is broadly defined and measured in both the institutions and the law

and finance literatures, replicated results based on other measures of institutional quality

with data from sources different from the Heritage Foundation shall be reported only in

Appendix. In the first column of table 4, it can be observed that bank profitability had a

significant negative association with institutional quality the

average of four measures of economic freedom including business freedom, financial

freedom, freedom of investment and freedom from corruption. These indexes are

constructed such that a country with a higher value has better institutional quality. The

negative association between institutional quality and bank profitability suggests that

poor institutional quality requires banks to increase their interest margin to compensate

for risk contingencies.

108
 Institutional quality entered both the regressions of the spread and that of loan

quality negatively and significantly, indicating that improvements in institutional quality

would increase access to external finance while decreasing the incidence of bad loans on

banks balance sheet.

Table 13
The Effect of Institutions on Bank Profitability, Spreads and Loan Quality
This table presents the regression results capturing the relationships between institutional quality and banks related
measures. The first three columns present the OLS results. The last three columns are the SUR estimates. The
variables are describes in detail in Appendix I. The values into parentheses are the standard errors of the estimates.
Robust standard errors are reported for the OLS. ***, **, and * represent significant levels of less than 1%, 5% and
10%. a represent F-statistics for the OLS estimation technique. Bank net interest margin is the dependent variable
for specifications (I) and (IV); Bank spread is the dependent variable for specifications (II) and (V), and bad loan is
the dependent variable for specifications (III) and (VI).
Seemingly Unrelated
Ordinary Least Squares
Regressions
(I) (II) (III) (IV) (V) (VI)
0.003 0.002 0.002 0.003 0.002 0.002
Constant (0.038) (0.050) (0.043) (0.037) (0.050) (0.043)
-0.29* -0.217*** -0.313* -0.328** -0.214*** -0.362**
Institutional quality (0.170) (0.085) (0.184) (0.166) (0.084) (0.182)
-0.269* 0.031 -0.524*** -0.357** 0.035 -0.558***
Depth of credit information (0.169) (0.058) (0.184) (0.166) (0.057) (0.181)
1.032*** 0.516* 1.102*** 0.754***
Bank spreads (0.269) (0.299) (0.264) (0.295)
-0.352 -0.221 -0.523** -0.226
Loan quality (0.235) (0.283) (0.224) (0.279)
-0.522** -0.362 -0.562** -0.468*
Institutional quality * Bank spreads (0.260) (0.285) (0.255) (0.281)
0.131 0.217 0.112 0.231
Institutional quality * Loan quality (0.221) (0.267) (0.210) (0.264)
Institutional quality * depth of credit 0.340 0.358 0.388* 0.417*
information (0.243) (0.267) (0.238) (0.263)
-0.027 -0.126** 0.046 -0.013 -0.126** 0.036
Private creditors rights (0.044) (0.057) (0.050) (0.044) (0.057) (0.049)
-0.180*** 0.015 -0.301*** -0.230*** 0.020 -0.331***
Soundness of bank (0.058) (0.077) (0.065) (0.057) (0.076) (0.064)
0.130*** 0.110** 0.078* 0.135*** 0.110** 0.107**
Bank cost income ratio (0.039) (0.051) (0.045) (0.039) (0.051) (0.045)
0.113** 0.127**
Inflation (0.058) (0.057)
-0.280*** -0.528***
Bank net interest margin (0.059) (0.057)
R-squared 0.4985 0.1202 0.3476 0.4726 0.12 0.3147
F/Chi-square 34.59a 5.98a 20.66a 438.71 50.1 255.19
# Obs. 359 359 359 359 359 359

109
The relationship between institutions and the spread is further illustrated in fig. 4, while

that of institution and loan quality is illustrated in fig.3. Several studies including

Demirg-Kunt and Huizinga (1998), and Leaven and Majnoni (2003) report a negative

relationship between institutions and the spread and net interest margin. Their definition

of institutions is limited to only judicial efficiency or law and order.With our broader

definition of institutions, however, the results in table 4 indicate that bank requires lower

risk premium and thereby lower interest margin when they enjoy greater financial

freedom, cleaner investment environments in terms of freedom from corruption and

effective court systems, and lower financial constraint from the state apparatus. The

results also suggest that institutions are a very important factor in explaining cross-

country differences on bank profitability, access to external finance, and improvements in

loan quality. The results corroborate those of Demirg-Kunt and Huizinga (1998) on the

impacts of institutions on bank profitability. Indeed, the data suggest that improvements

in institutions work in the direction of enhancing the banking sector. Importantly, our

data show that little change in institutional quality has big effect on bank net interest

margin, bank spreads, and loan quality. It appears that institutions as represented by the

laws regulating financial contracting and the enjoyment of various financial freedoms are

the channels through which the development of the banking sector can be achieved over

the long run. Clearly, the results in table 4 feed the necessity to identify and analyze

financial and economic reforms with potentiality to affect the banking sector.

Additionally, the depth of credit information index, ranging from 1 to 6, captures

the scope of information available on banks borrowers. A higher value of that index

suggests that more information is known about the borrowers past debt repayment

110
patterns. The results in the fourth column of table IV indicate that the index was

significantly negatively related to bank net interest margin

suggesting that banks in countries with effective institutions do not make abnormal

profits due to institutional deficiencies, translated into a highly risky investment setting as

well as high banks overhead costs. However, the interaction between depth of

information and institutional quality enters the regression of bank net interest margin

significantly positively suggesting muted effects of institutional

differences between countries with better institutional quality coupled with better credit

information agencies and poor institutional quality coupled with limited information

about borrowers. This is also primary indication that banks charge lower lending risk

premia when borrowers credibility and creditworthiness can be gauged, but contracts

between lenders and borrowers should be reinforced and upheld by effective institutions

including the courts in the event of default; thence, the joint effect between institutions

and credit information on bank profitability is significantly positive, which means that

banks seek higher compensation when institutions are of poor quality even when credit

information is available.

Ideally, effective credit information institutions should produce low costs

information, and give rise to productive activities making lending /borrowing

relationships healthier. North (1994) argues that if institutional framework rewards

productive activities, then organizations such as firms will come about to engage in

productive activities. In banking e.g., financing these productive activities will make

lending/borrowing relationships healthier since firms will generate adequate cash flows to

grow and service their debt. Indeed, the depth of credit information had a negative

111
association with bad loans, suggesting that, on average, credit

information agencies have great impact on banks balance sheets as they reduce the

incidence of default, and the interaction between institutional quality and depth of credit

information was positive and significant , suggesting a muted

effect of depth of credit information in countries with standard institutions. These results

indicate that improving institutions will have positive impact on banks portfolios. In

addition, institutions had negative and significant relationship with bank spread

, but depth of credit information was not significantly related with the

spread8. Overall, the results indicate that improvements in institutions in general and in

information institutions in particular play a significant role in removing obstacle to

external finance.

8
As expected, it was the interaction between depth of credit information and institutions which
was negatively statistically related to the spread. This expectation was based on the fact that the first-order
correlation between the spread and depth of credit information was statistically indistinguishable. Adding
both depth of credit information and the interaction of thereof with institutional quality would reduce the
weight of institutional quality in explaining change in the spread or even cause this variable to change sign
since both the main effects of depth of credit information and the interaction effect between the latter
variable and institutional quality would be dueling to explain the same variable. This means that
information institutions serve no especial purposes if other institutions are weak. In fact, when the
interaction between institutional quality and depth of credit information was added to the bank spread
equation, the main effect of institutions on the spread which was negative became positive and significant
but the interaction was strongly negatively significant. The interaction coefficient was significantly larger
than that of the main effect in absolute terms. The differential effect would then neutralize the main effect
had the interaction term been kept in the regression. This implies that effective institutions play a
significant role in reducing bank spreads when lenders know more about borrower s credit history, and that
institutions alone are less relevant if borrowers own risk cannot be estimated and their probability of
default cannot be predicted. Also, the negative and significant effect of the interactive term between the
institutions and depth of credit information would suggest a muted effect for depth of credit information for
countries with enhanced institutional quality on banks spreads. However, because the characteristics of
information institutions are assumed to be heterogeneous across countries as well as enforcement
mechanisms and because there might also be a leading effect of institutions on information, suggesting that
the state of current institutional quality will shape future lending/borrowing relationships, thus adding the
interaction term between institutions and depth of credit information could bias our estimates. Therefore,
the interaction term has been excluded from the estimation of the spread in table IV as well as from
subsequent ones so that we do not allow changes in credit information vary by contemporaneous
institutional quality.

112
 The estimated effect of the spread on bank net interest margin was positive and

significant . This relationship was anticipated given that interest

rates are the driver of bank profitability. Importantly, the regression for loan quality

showed a positively significant association between bank spread and bad loans

. This result suggests that conventional practices of widening interest

rates on borrowers who are either informationally or economically challenged fail to

remedy the problem of default on loans. It appears that even if poor credit and lower

repayment capabilities serve as a leitmotif for banks to raise lending risk premia,

charging significantly steep interest rates on borrowers with certain credit features might

contribute to the growth of bad loans on banks balance-sheets, and such conventions

might be imprudent banking practices. Nonetheless, the negative association between bad

loans and institutional quality implies that that there exists a more effective alternative to

addressing the problem of loan repayment, which is to improve the quality of the

institutions in lieu of increasing lending risk premia for economically and financially

vulnerable borrowers. It appears also that notwithstanding some borrowers specific

characteristics, the institutional settings keep those that are financially and economically

vulnerable away from external finance. Indeed, the findings seem to suggest that higher

lending risk premium contributes to weakening repayment capability, aggravates

financial vulnerabilities and failures, and thereby increases the probability of default. Our

results corroborate those of Brock and Rojas-Suarez (2000) who find that higher levels of

nonperforming loans are related to higher spreads (see Crowley, 2007). This relationship

is also illustrated in fig. 2. Indeed, if past credit history is the best predictor of a

customers probability of repaying her debts, charging a significantly high interest risk

113
premium will either justify her choice of defaulting or sink her into a long period of

financial trauma. Similarly, increased borrowing costs for financially distressed firms

might accelerate their financial troubles and speed up the bankruptcy process. Our results

support those of Barajas, Steiner, and Salazar (1999) who find that when the spread is too

large, it is regarded as considerable impediment to the expansion of financial

intermediation.

It seems that a better financial outcome for both lenders and borrowers would

have been to institutionally address the issue of risk or to limit access to finance to

borrowers with certain risk characteristics instead of financing them with predatory rates.

A short term institutional solution might include civic education related to borrowers

behavior toward debts since it is not far-fetched to assume that self-regulating markets

might be a hindrance to the development of the financial and the banking sector as well

as impediment to external finance. Then, the assumption that institutional improvements

through regulations might alleviate the effect of risk begs the question of whether banks

should be banned from making certain types of loans, or whether banks lending

standards are too stringent when it comes to borrowers default risk. In fact, when debt

services are high, a financially strained borrower may choose to subdue herself from her

contract and file for bankruptcy. In such scenario, lenders lose the promises of their funds

and the adverse effect will show in their balance-sheet as bad loans. It can be assumed

that, from an individual borrowers point of view, only those who anticipate future

financing needs will not mull over defaulting as their primary option if they are

financially strapped while servicing debts at high costs. Either way the debt circle does

not seem to end. As a result, borrowers with reasonable risk features will be charged

114
higher lending risk premia than what is suggested by their riskiness to compensate

lenders for losses suffered from the defaulters. To avoid both sinking the borrower into

further financial distress, and/or her retraction from her financial obligations, and

weakening the banking sector, it appears that socially efficient institutional policies need

to be implemented so that risk level is assuaged and both borrower and lender benefit

from their relationship.

Additionally, there was a the negative relationship between soundness of banks

and loan quality implying that poorly managed banks and

undercapitalized banks engage in imprudent lending practices to highly risky customers

by charging higher lending risk premia while anticipating to recover their loan through

higher discount rates and shorter investment horizon. The data suggest that such lending

practices have negative impact on banks balance-sheets. The results support those of

Caprio and Summers (1993), and Stiglitz (1996) who find that banks with high franchise

value reflecting costly bank entry have incentives to remain well-capitalized and to

engage in prudent lending behavior (see Demirg-Kunt and Huizinga, 1998).

Specifically, the negative relationships between soundness of bank and bad loans and net

interest margin suggest that unsound banks have higher expected bankruptcy cost for

themselves and their customers. To replenish their capital, since these banks deal with a

riskier pool of customers, they intend to have shorter investment horizon, shorter loan

duration, and lower money at risk. In fact, Hubbard et al. (2002) find that low-capital

banks tend to charge higher loan rates than well-capitalized banks. Overall, the negative

relation between soundness of banks and the spread evidences that when banks capitals

115
deplete, they toughen lending standards as they have higher expectations of their own

bankruptcy.

Notwithstanding our estimate confirms the finding of (Bae and Goyal, 2009) who

find that banks respond to poor enforceability of contracts by reducing loan amount,

shortening loan maturities, and increasing loan spreads, we find that the main effect of

creditors rights on the spread had indeed the correct sign, negative significant,

while creditors rights had insignificant effects on both the spread

and loan quality. This suggests that when creditors enjoy more rights they are less

reluctant in financing projects with positive NPVs. Thus, in building institutions, to

further deepen access to finance, policymakers should consider those institutional

features guaranteeing creditors rights in ways that ease out their fear and concerns.

To sum up, although there is considerable support in the literature that a profit

maximizing bank should make a loan exhibiting positive NPV value, but the institutional

effects on banks is largely understudied. Institutional quality is indeed negatively related

to bank net interest margin, interest rates spreads, and loan quality. Our results suggest

institution building is a viable channel through which access to finance can be improved

and the banking sector strengthened. The overall result implies that banks may be

applying high discount rates and rejecting projects which would have had positive NPVs

were institutional quality enhanced. This means that policymakers have to address the

quality of a country overall institutions to lower risk so that more projects get financed

catapulting economic growth.

116
 Table 14

Additional Evidence of the Effect of Institutions on Bank Profitability, Spreads and Loan
Quality
This table presents the regression results capturing the relationships between contemporaneous
institutional quality and banks related measures. All of the variables are measured from 2004 through
2008. Data on country legal origin are from La Porta et al. (1999). Seemingly Unrelated Regressions
technique is used to derive the estimates. The variables are describes in detail in Appendix I. The
values into parentheses are the standard errors of the estimates. ***, **, and * represent significant
levels of less than 1%, 5% and 10%. Bank net interest margin, bank spread and bad loans are the
dependent variables for specifications (I), (II) and (III) respectively.
(I) (II) (III)
-0.004 -0.007 0.008
Constant
(0.038) (0.049) (0.046)
-0.316*** -0.089 -0.408***
Institutional quality
(0.050) (0.068) (0.060)
-0.094** -0.303***
Depth of credit information
(0.044) (0.051)
0.489*** 0.234***
Bank spread
(0.041) (0.058)
-0.354*** -0.032
Loan quality
(0.042) (0.054)
0.249 0.385* 0.151
French legal heritage
(0.214) (0.246) (0.223)
0.078 -0.029
Depth of credit information* French legal system
(0.105) (0.118)
-0.079 -0.072
French legal system * Loan quality
(0.056) (0.069)
-0.042 -0.060
French legal system * Bank spread
(0.053) (0.064)
-0.141*** -0.166*** -0.142**
Financial market sophistication
(0.047) (0.060) (0.058)
-0.050 0.013 0.017
Institutional quality * Financial markets sophistication
(0.045) (0.058) (0.054)
French legal heritage * Financial markets 0.102 -0.439** 0.136
sophistication (0.150) (0.195) (0.180)
-0.318* 0.147 -0.195
Institutional quality * French legal heritage
(0.188) (0.240) (0.230)
-0.028 -0.11* 0.012
Private creditors rights
(0.042) (0.055) (0.051)
-0.019 -0.058 -0.054
French legal heritage * Private creditors rights
(0.119) (0.157) (0.144)
0.162*** 0.10* 0.161
Bank cost income ratio
(0.040) (0.050) (0.049)
0.11**
Inflation
(0.055)
-0.521***
Bank net interest margin
(0.063)
R-squared 0.4851 0.1449 0.2838
Chi-square 413.77 58.40 205.94
# Obs. 339 339 339

117
In table 5 we test whether institutions based on legal heritage influence bank profitability,

interest rates spread and loan quality differently. Consistently with the results in table 4,

the results in table 5 show that institutions were effective in reducing interest rates

spread, and enhancing loan quality. LLSV (1997 and 1998) and Beck et al (2002, and

2005) argue that in countries with legal traditions that support contractual arrangements

firms get financed much easily. Beck and Levine (2002) find that legal traditions that

differ in the priority they give to the rights of individual investors vis--vis the state, and

this has repercussions for the development of property rights and financial markets.

The authors argue that legal systems that (a) reject jurisprudence: The law created

by judges in the process of solving disputes; and (b) rely instead on changes in statutory

law will tend to evolve more inefficiently with negative implications for finance. The law

and finance literature emphasizes that the French civil law regime is less supportive of

private contracting. Djankov, La Porta, Lopez-De-Silanes, and Shleifer (2003) look at the

incidences of legal formalism, often attributed to the French Napoleonic legal system, by

measuring the number of formal legal procedures necessary to resolve a simple case of

collecting on an unpaid check or evicting a non-paying tenant; they find that countries

with greater legal formalism have higher costs of enforcing simple contracts, longer

delays in courts, and lower perceived fairness and efficiency of the judiciary system.

They argue that greater legal formalism is a proxy for worse contracting institutions.

Indeed, column (I) of table 5 shows that banks are more profitable in countries with

French legal origin and improvements in French legal institutions would significantly

increase bank efficiency. In column (II) of table 5, the results show that there were

significant barriers to external finance in countries with French legal heritage.

118
 Table 15

The Effect of Institutions on Bank Profitability, Spreads and Loan Quality

This table presents the regression results capturing the relationships between institutional quality, depth of
credit information and banks related measures. The first three columns present the OLS estimates. The last
three columns are the SUR estimates. The dependent variable for the different specifications are as follows:
Bank net interest margin for (I) and (IV), bank spreads for (II) and (V), and bad loans for (III) and (VI). The
variables are describes in detail in Appendix I. The values into parentheses are the standard errors of the
estimates. Robust standard errors are reported for the OLS. ***, **, and * represent significant levels of less
than 1%, 5% and 10%. a refers to chi-square statistics for the SUR estimations.
Ordinary Least Squares Seemingly Unrelated Regressions
(I) (II) (III) (IV) (V) (VI)
0.013 0.001 -0.006 0.013 0.001 -0.006
Constant
(0.040) (0.051) (0.047) (0.039) (0.049) (0.046)
-0.527* -0.448*** -0.939*** -0.513* -0.448*** -0.948***
Institutional quality
(0.291) (0.134) (0.322) (0.283) (0.131) (0.314)
1.062*** -0.142 1.088*** -0.161
Bank spread
(0.299) (0.348) (0.291) (0.340)
-0.440* -0.179 -0.437* -0.200
Loan quality
(0.254) (0.297) (0.247) (0.290)
-0.342 -1.153*** -0.340 -1.153***
Private creditors rights
(0.239) (0.260) (0.232) (0.254)
Institutional quality *Loan 0.229 0.160 0.227 0.162
quality (0.240) (0.286) (0.234) (0.279)
Institutional quality *Bank -0.505* 0.078 -0.504* 0.078
spread (0.285) (0.331) (0.277) (0.323)
Institutional quality * Depth 0.499 1.029*** 0.496* 1.030***
of credit information (0.321) (0.357) (0.312) (0.349)
-0.168 -0.654*** -0.743*** -0.150 -0.655*** -0.755***
Private credit bureau
(0.216) (0.208) (0.246) (0.210) (0.204) (0.240)
-0.143 -0.477** -0.614** -0.132 -0.481** -0.622***
Public registry
(0.210) (0.214) (0.245) (0.204) (0.209) (0.239)
Institutional quality * Private 0.292 0.516** 0.609** 0.278 0.516** 0.618**
credit bureau (0.234) (0.236) (0.266) (0.228) (0.230) (0.259)
Institutional quality * Public 0.116 0.414* 0.421* 0.106 0.418* 0.427*
registry (0.207) (0.221) (0.243) (0.202) (0.217) (0.238)
-
-0.010 -0.200*** -0.203*** -0.014 -0.201***
Soundness of banks 0.204***
(0.077) (0.070) (0.059) (0.075) (0.069)
(0.060)
Private credit bureau 0.060 -0.096 -0.096* 0.062 -0.100* -0.098*
coverage of adults (%) (0.052) (0.063) (0.061) (0.051) (0.061) (0.059)
Public registry coverage of -0.023 0.014 -0.128** -0.022 0.012 -0.129**
adults (%) (0.056) (0.068) (0.065) (0.054) (0.067) (0.064)
Institutional quality * Private
-0.043 -0.076 -0.011 -0.041 -0.075 -0.012
credit bureau coverage of
(0.041) (0.052) (0.048) (0.040) (0.050) (0.047)
adults (%)
Institutional quality * Public
0.019 -0.110** -0.024 0.022 -0.109** -0.026
registry coverage of adults
(0.043) (0.053) (0.050) (0.041) (0.051) (0.049)
(%)
0.141** 0.154**
Inflation
(0.070) (0.068)
R-squared 0.5106 0.1655 0.3502 0.5100 0.1651 0.3499
a a a
F/Chi-square 19.69 4.65 11.70 348.18 64.39 172.28a
# Obs. 319 319 319 319 319 319

119
The table also shows that when financial markets are more sophisticated (developed),

bank net profit margin was lower, access to finance - as measured by interest rate spread-

increased, and loan quality improved. Meanwhile, the results in column (II) of table 5

indicate that improvements in institutions based on French legal heritage would

significantly improve access to finance, and that access to external finance is more

difficult in backward financial markets.

Another way of gauging the effects of institutions on bank net interest margin,

interest rates spread and loan quality is to control for information institutions as

represented by private credit bureaus and public registries, commonly known as credit

bureaus or credit information registries. Miller (2000) reports that credit information

registries refer to a database of information on borrowers in a financial system.

Information in these registries is available for individual consumers and/or firms. The

core of the data is a borrowers past payment history. The information contains, inter alia,

late payments, defaults, debt outstanding, and regularity of payments. The present study

argues that these registries serve limited purpose if they are implemented in an ineffective

institutional setting. In table 6, we present some evidences of the impacts of information

institutions on bank profitability, interest rates spread and loan quality. In this table we

control for information institutions as represented by private credit bureaus and public

registries. In fact, the results of the effects of institutional quality are highly consistent

with those presented in tables 4 and 5. Private credit bureaus are represented by a dummy

variable which take a value of one if a private credit bureau exists in a country and zero

otherwise; and similarly, public registries are a dummy variable which takes the value of

one if a public registry exists in a country and zero otherwise.

120
 Table 16

The Effect of Predated Institutions on Bank Profitability, Spreads and Loan Quality
This table presents the regression results capturing the relationships between predated institutional quality and banks
related measures. Institutional quality is measured over 1999 through 2003. All of the other variables are
contemporaneously measured i.e., from 2004 through 2008. Private credit bureau is a dummy that takes of 1 if a private
credit bureau exists in a country and 0 otherwise. Public registry is a dummy that takes a value of 1 if a public registry
exists in a country and 0 otherwise. Seemingly Unrelated Regressions technique is applied. The variables are describes in
detail in Appendix I. The values into parentheses are the standard errors of the estimates. ***, **, and * represent
significant levels of less than 1%, 5% and 10%. Bank net interest margin is the dependent variable for specification (I);
bank spread is the dependent variable for specification (II), and loan quality is the dependent variable for specifications
(III).
(I) (II) (III)
Constant 0.003 -0.017 -0.005
(0.039) (0.048) (0.045)
Institutional quality -0.211*** -0.233*** -0.149**
(0.059) (0.074) (0.070)
Bank spread 0.526*** 0.154**
(0.045) (0.062)
Loan quality -0.330*** -0.085
(0.046) (0.058)
Depth of credit information -0.034 -0.20** -0.393***
(0.070) (0.086) (0.079)
Institutional quality * Loan quality -0.031 0.096* -0.046
(0.044) (0.055) (0.052)
Institutional quality * Bank spread -0.025 0.002
(0.040) (0.047)
Institutional quality * Depth of credit -0.045 -0.145*** -0.103**
information (0.044) (0.054) (0.051)
Soundness of bank -0.225*** 0.066 -0.343***
(0.060) (0.075) (0.069)
Private creditors rights -0.035 -0.068 0.02
(0.045) (0.056) (0.053)
Private credit bureau coverage of adults (%) 0.076 -0.01 -0.039
(0.049) (0.061) (0.058)
Public registry coverage of adults (%) 0.001 0.108 -0.104*
(0.056) (0.069) (0.065)
Private credit bureau dummy 0.108** -0.261*** -0.123**
(0.054) (0.066) (0.064)
Public registry dummy -0.048 -0.194*** -0.213***
(0.060) (0.074) (0.070)
Financial market sophistication -0.085* -0.126** -0.013
(0.052) (0.064) (0.062)
Inflation 0.095
(0.064)
Bank net interest margin -0.453***
(0.063)
R-squared 0.4872 0.2142 0.3353
Chi-square 374.13 89.43 219.05
# Obs. 319 319 319

Additionally, we control for the percentage of adults covered by the two types of

credit bureaus. The results in table 6 from columns four to six show that both private

121
credit bureaus and public registries are significantly effective tools in improving access to

finance in bettering loan quality given the significant negative relationship between these

variables and interest rates spread and loan quality. Furthermore, the interaction between

institutional quality and both types of information institutions was negative and

significant suggesting that these institutions are more effective when other institutions

within a country function properly. Likewise, the results suggest improvements in

institutional quality along with percentage of adults covered by public registries would

significantly improve access to external finance.

In table 2, it has been shown that the correlation between depth of credit

information and interest rates spread is insignificant. When this variable entered

subsequent regressions it was insignificant and the interaction between it and institutional

quality made other estimates unstable due to multicollinearity, so that it was dropped

from the estimation of the spread. In table 7, we use predated values of institutions back

five years from our estimation period to measure institutional quality. Using predated

data, institutional quality had the same effects on bank profitability, the spread, and loan

quality. Nevertheless, controlling for past institutional quality, depth of credit information

was negatively significantly related to the spread and the

interaction between past institution and depth of credit information was also negatively

significant . These results suggest that there is a lag in

institutional quality before they effectively affect information on borrowers to improve

access to external finance. This conveys a form of reticence by lenders to remove

financing hurdles based on current state of institutions and current information on

borrowers. It takes sometimes for lenders to build their confidence in the institutions and

122
act on information. Although there have been some institutional build-up in the last two

decades in several parts of the developing world, this finding is crucial for policymakers

in many Latin American countries, Sub-Saharan Africa, Eastern Europe, Mid-Western

and Western Asia where there have been a need for continuity of political institutions,

which is a sine qua non condition to remove barriers to finance. The results imply that

institution build-up is pivotal to financial markets and pendular swings in public policies

damage external finance in ways that may prevent firms from pursuing positive NPV

projects. Importantly, in a competitive and efficient market, it is expected that banks earn

zero profit. Our results in table 7 show that past institutional quality and depth of credit

information coalesce to remove inefficiencies in the banking sector even though the

relationship between bank profitability and depth of credit information was insignificant

for both the main effect of information and the interaction between information and past

institutions while both the main effect and the interaction significantly reduced the spread

and improved loan quality. Therefore, our results imply that finance follows institutional

build-up, that certainty and stability matter for finance, and that policymakers from

different political tenets have to commit to the health of the institutions and their

longevity for economic and financial progresses.

In tables 8 and 9 we present additional results of the impacts of historical

institutional quality on the banking sector. The tables are similar to tables 5 and 6 where

all of the variables except institutional quality are contemporaneous.

123
 Table 17

The Effect of Predated Institutions on Bank Profitability, Spreads and Loan Quality
This table presents the regression results capturing the relationships between predated institutional quality and
banks related measures. Institutional quality is measured from 1999 through 2003. All other variables are
contemporaneously measured i.e., from 2004 through 2008. Seemingly Unrelated Regressions technique is
used to derive the estimates. The variables are describes in detail in Appendix I. The values into parentheses
are the standard errors of the estimates. ***, **, and * represent significant levels of less than 1%, 5% and
10%. a represent F-statistics for the OLS estimation technique.
(I) (II) (III)
0.001 -0.018 -0.004
Constant
(0.038) (0.048) (0.045)
-0.219*** -0.232*** -0.146**
Institutional quality
(0.059) (0.074) (0.070)
0.521*** 0.147**
Bank spread
(0.045) (0.062)
-0.313*** -0.074
Loan quality
(0.046) (0.058)
-0.034 -0.202** -0.40***
Depth of credit information
(0.069) (0.086) (0.078)
0.326* 0.053 0.18
French legal heritage
(0.184) (0.229) (0.218)
-0.022 0.10*
Institutional quality * Loan quality
(0.043) (0.055)
-0.021 0.003
Institutional quality * bank spread
(0.040) (0.047)
Institutional quality* depth of credit -0.036 -0.136** -0.097**
information (0.044) (0.055) (0.048)
-0.428** -0.102 -0.058
Institutional quality * French legal system
(0.190) (0.237) (0.226)
Depth of credit information* French legal 0.104 0.095 -0.167
system (0.095) (0.119) (0.112)
-0.206*** 0.080 -0.357***
Soundness of banks
(0.060) (0.075) (0.069)
-0.048 -0.073 0.021
Private creditors rights
(0.045) (0.056) (0.053)
0.069 -0.009 -0.046
Private credit bureau coverage of adults (%)
(0.049) (0.061) (0.058)
0.002 0.110* -0.101*
Public registry coverage of adults (%)
(0.055) (0.069) (0.065)
0.107** -0.259*** -0.135**
Private credit bureau dummy
(0.054) (0.066) (0.063)
-0.048 -0.193*** -0.213***
Public registry dummy
(0.060) (0.074) (0.069)
-0.078 -0.130** 0.001
Financial market sophistication
(0.052) (0.065) (0.062)
0.089
Inflation
(0.064)
-0.432***
Bank net interest margin
(0.064)
R-square 0.499 0.2181 0.3445
Chi-square 382.17 91.09 219.77
# Obs. 319 319 319

124
 The results are consistent with those presented from the previous tables and they

also confirm the import of institutional build-up in improving access to finance and

reducing bank profitability and enhancing loan quality. The results provide additional

evidences and further insights of the persisting impacts of institutions on the banking

sector. We implement this strategy for two reasons: (1) the historical dimension of the

institutionalization process, and (2) contemporaneous effect of past institutions on banks.

This allows us to reassert that there is a strong impact of historical institutions on finance

and that finance follows institutions.

Similarly to the results presented in table 5, we follow the methodology

implemented in table 8 where institutional data for the five years (1999-2003) preceding

our estimation period of 2004-2008 to estimate the effects of legal heritage are utilized.

The results show that there was a significant relationship between historical institutional

quality and contemporaneous banking activities based on a countrys legal heritage.

Interestingly, the results are consistent with those using current institutional quality both

in sign and in significance. Here, we seek to test the hypothesis improvements in

institutional quality precede reduction in bank spreads and bad loans and that finance

follows institutions and the long run effect is beneficial for lending/borrowing

relationships. It is crucial to investigate whether past institutional quality affects current

banking operations to support institution building agenda. The overall results are in line

with the main findings of the paper that improvements in banking follow improvements

in institutions as risk in the banking environment is mitigated, the lower will be the

spread and better is the quality of the loans in banks balance-sheets, and the sounder is

the banking sector.

125
 Table 18

Additional Evidence of the Effect of predated Institutions on Bank Profitability, Spreads and
Loan Quality
This table presents the regression results capturing the relationships between contemporaneous institutional
quality and banks related measures. All of the variables are measured from 2004 through 2008. Data on country
legal origin are from La Porta et al. (1999). French legal heritage is a dummy variable that takes a value of one if
a country has the French Civil Law in effect and 0 otherwise. All of the variables are describes in detail in
Appendix I. Seemingly Unrelated Regressions technique is used to derive the estimates. The values into
parentheses are the standard errors of the estimates. ***, **, and * represent significant levels of less than 1%,
5% and 10%. a represent values from 1999 through 2003. Bank net interest margin, bank spread and bad loans
are the respective dependent variables for specifications (I), (II) and (III).
(I) (II) (III)
-0.01 -0.016 -0.001
Constant
(0.039) (0.050) (0.045)
-0.211*** -0.242*** -0.224***
Institutional quality a - Heritage Foundation
(0.051) (0.057) (0.060)
-0.056 0.088 -0.251***
Depth of credit information
(0.044) (0.058) (0.049)
0.518*** 0.250***
Bank spread
(0.042) (0.057)
-0.391*** 0.008
Bad loan
(0.044) (0.057)
0.425** -0.087 0.218
French legal heritage
(0.179) (0.157) (0.228)
a -0.039 -0.017
Institutional quality * bank spread
(0.039) (0.045)
Institutional quality a * depth of credit -0.032 -0.127** -0.062
information (0.039) (0.057) (0.046)
-0.423** -0.099
Institutional quality a * French legal system
(0.179) (0.232)
Depth of credit information* French legal 0.104 -0.164
system (0.137) (0.114)
-0.278*** -0.371***
Soundness of banks
(0.053) (0.061)
0.119**
Inflation
(0.054)
0.038
Institutional quality a * bad loan
(0.056)
0.001
French legal system * bad loan
(0.072)
-0.028
French legal system * bank spread
(0.060)
-0.522***
Bank net interest margin
(0.060)
R-square 0.4553 0.126 0.314
Chi-square 390.02 49.96 237.3
# Obs. 339 339 339

126
 To further increase our confidence in our findings, we substitute institutional

quality with financial disclosure. Institutional practices such as increasing information

disclosure and transparency through market institutions that include ratings and auditing,

analysts following, and board of directors are important supplements to government

regulations and supervision as suggested by corporate governance theories. Government

based supervision and regulations are complement to these market institutional factors. In

some instances, governmental institutions respond to biases on market institutions, which

oftentimes disenfranchise private investors.

Indeed, it is expected that market institutions will reflect public institutions are

they complement each other on the various fronts. It could be an overwhelming task to

reinforce disclosure rules if public institutions are ineffective. Too often firms executives

engage in unethical schemes to undermine supervision and circumvent the law. Hence,

market institutions may not represent the public goods that they are preordained to be if

they can bribe regulators and supervisors or hired them away to weaken supervision.

Therefore, financial disclosures are viewed here as very important gauge of the

effectiveness of public institutions since they reflect governance practices within a

country. Financial market and especially the banking sector cannot be part of a nations

financial and economic progress if corporate governance practices are weak because

those firms concerned by carrying out clean corporate governance are the borrowers of

banks. Therefore, if they continually misstate their financial situation, their lenders will

undoubtedly suffer financial setbacks. Policy choices in the direction of financial

enhancing disclosure should be undertaken around the world, especially in developing

countries where the institutional framework is at best weak.

127
 Table 19

The Effect of Institutions on Bank Profitability, Spreads and Loan Quality

This table presents the regression results capturing the relationships between institutional quality, depth of credit
information and banks related measures. Institutional quality is proxied by financial disclosure. Data on
financial disclosure and judicial independence are drawn from the Global Competitiveness Report published by
the World Economic Forum. The equations are estimated using seemingly unrelated regressions. The dependent
variable for the different specifications is as follows: Bank net interest margin for (I), bank spreads for (II) , and
loan quality for (III). The variables are describes in detail in Appendix I. The values into parentheses are the
standard errors of the estimates. Robust standard errors are reported for the OLS. ***, **, and * represent
significant levels of less than 1%, 5% and 10%.
(I) (II) (III)
-0.001 -0.012 0.015
Constant
(0.038) (0.047) (0.048)
-0.305*** -0.252*** -0.298***
Financial disclosure
(0.073) (0.093) (0.094)
-0.081* 0.073 -0.340***
Depth of credit information
(0.043) (0.055) (0.052)
0.11*** 0.002 0.098*
Bank cost income ratio
(0.040) (0.050) (0.052)
-0.304*** -0.007
Loan quality
(0.041) (0.053)
0.419*** 0.187***
Bank spread
(0.043) (0.061)
0.143 0.438* -0.157
French legal heritage
(0.186) (0.230) (0.234)
-0.033 -0.016
Financial disclosure * Loan quality
(0.042) (0.054)
-0.013 -0.054
Financial disclosure* Bank spread
(0.041) (0.051)
-0.014 0.036 -0.013
Financial disclosure * Depth of credit information
(0.043) (0.055) (0.050)
-0.139*** -0.178** -0.127
Judicial independence
(0.071) (0.089) (0.090)
-0.105 -0.445** 0.151
Financial disclosure * French legal heritage
(0.185) (0.230) (0.233)
0.016
Inflation
(0.054)
-0.106** -0.016
Bank Z-score
(0.051) (0.049)
-0.486***
Bank net interest margin
(0.066)
R-squared 0.4884 0.2177 0.2332
Chi-square 391.65 94.49 158.6
# Obs. 319 319 319

Controlling for judicial independence - a variable commonly used in the law and finance

literature - the results in table X show a negative relation between financial disclosure

and bank profitability , and negative and significant relationship

128
between interest rates spread and financial disclosure , and a

negative relationship between financial disclosure and loan quality

. It is also observed that the spread was larger in French civil law countries

. The results confirm that there is more obstacles in countries with

ineffective institutions and these obstacles are steeper in countries with French legal

heritage.

Overall, the results show that banks are more willing to make loans with more

transparency, suggesting that public policies promoting disclosure and transparency are

vital for a countrys capital markets and banking sector.

2.6.1 Policy Implications

The estimates from the different tables show a clear pattern of the institutional

effects on banks net interest margin, the spread, and loan quality. The estimated effects

were not only statistically significant but also economically important. Using the

estimates from the regressions in columns four to seven from table 4 we can infer

whether a country banking sector would be more efficient, whether external financing

had been eased and whether banks balance sheets have been strengthened in terms of

improvements in loan quality. In other words, the estimates can be used to show the

impact of institutions on banks for a country whose interest rates spread falls at the mean

of the countries which are below the median of institutional quality compared to a

country whose interest rate spread falls at the mean of the countries which are above the

median of institutional quality. Specifically, banks in the country which falls at the mean

of interest rate spread for the group of countries that are below the median of institutional

129
quality had a mean spread of 7.98% and an average bad loan of 6.98% whereas banks in

the country that falls at the mean of interest rate spread for the group of countries which

fall above the median of institutional quality had a mean spread of 4.41% and an average

bad loan of 2.34. Using estimates from column four of table 4, the regression coefficients

predict that bank net interest margin would fall by .209 basis points per year

accumulating of five years this would result into 1.04% reduction in bank net profitability

or bank inefficiency. The regression coefficients indicate also that interest rates spread

would have been reduced by .214 basis points per year for a one standard deviation

change in institutional quality, accumulation over five years, this would result into a

reduction of 106.43 basis points in interest rates spread. Furthermore, the regression

estimates from column 6 of table 13 predict that banks in the country at the mean of the

group of countries which fall below the median of institutional quality had 2.3% more

bad loans per year than banks in the country at the mean of the group of countries which

fall above the median of institutional quality. Accumulating over five years the banks in

that country had 12.19% more bad loans in their loan portfolio than banks operating at

the above median institutional quality. Finally, controlling for past institutional quality,

the regression coefficients in column two of table 7 predict that banks in the country at

the mean of the group of countries which fall below the median of institutional quality

had .22 basis points higher than banks in the country at the mean of the group of

countries which fall above the median of institutional quality. Accumulating over five

years the banks in that country had 109.4 basis points higher in the spread.

Estonia and Kenya are used to illustrate the relative importance of institutions and

depth of credit information on bad loans and bank spreads. With a value of 5 (at the 75th

130
percentile of the depth of credit information index) and an average institutional quality of

80.45 (at the 75th percentile of the institutional quality index), Estonia is perceived as a

country with strong institutions where the average interest rates spread was 2.8% and the

average bad loans was 0.7% during our estimation period; whereas, in Kenya, with an

average institutional quality of 45.35 (at the 25th percentile of the institutional quality

index) banks had an average interest rates spread of 8.66% and an average bad loan of

19.22% . Using the estimates from column seventh of table 4, it can be inferred that had

Kenya had the sample mean of institutions of 57. 27 and depth of credit information of

4.06, and interest rates spread of 6.2%, Kenyan banks would have been more efficient by

2.24% per annum, and accumulating over the estimation period of 5 years, there would

have been a reduction in bank net interest margin of 10.58%. Similarly, had Kenya had

the sample average of 4.06 for the depth of credit information index, Kenyan banks

would have seen a reduction in unpaid loans of 1.57% per annum, and accumulating over

the 5 years of our estimation period, there would have been a reduction of 8.17% of

unpaid loans in banks loan portfolio. Additionally, using the regression estimates of

column 2 of table 4, it is predicted that, had Kenya had the sample mean of 4.06 in the

index of depth of credit information, interest rates spread would have been .822 basis

points lower per annum, and accumulating over 5 years of our estimation period, the

spread would have been 4.03% lower. These suggest significant reduction in obstacles to

external finance and significant enhancement of the banking sector due to institutional

improvements.

Certainly, the results have clear policy implications not just for banking firms but

also for all sorts of borrowers facing financial hurdles. Should profit maximizing banks

131
make loans that only have positive NPVs, i.e. positive discounted value of future

repayments, then setting an appropriate discounting rate is crucial in evaluating these

loans. Since through the interaction between institutions and the spread, our evidence

suggests that banks charge lower lending risk premia in settings with more effective

institutions, thus institutional quality plays an important role in funneling credit and

removing barriers to external finance. There is also strong evidence that institutional

quality reduces bad loans. Therefore, focusing on the quality of the institutions is a viable

way of promoting a productive investment environment.

2.7. CONCLUSION

The current paper looks at the impacts of institutions on bank net interest margin,

interest rates spread, and loan quality. The results show clear policy implications of

institutional build-up for the banking sector and for borrowers to access external finance.

They show that in the absence of strong and effective institutions there are significant

obstacles to financing. Our main finding is that with better institutions, bank net interest

margin, interest rates spread, and bad loans are lower. This suggests that in countries with

very poor institutions there are significant barriers to finance and banks loan portfolios

are significantly poor. The results underlie the necessity for institutional reforms. The

evidence shows that these reforms will have great impacts on bank efficiency and on

bank lending to firms. There is also strong evidence that unlike contemporaneous

institutional quality, historical institutional quality has strong relationship information

about borrowers past debt repayment patterns. However, the immediate impact of the

different interaction terms is that institutions matter for financial development. This is

132
confirmed with alternative measures of institutions such as financial disclosures and

judicial independence. Our findings feed the law and finance theory that financial sector

is more advanced in countries with common law legal heritage. We find significant

obstacles to external finance plague the French legal heritage countries.

The results have several policy implications. First, in countries where credit

information institutions are embryonic or at best weak, interbank information exchanges

can be increased to remove inefficiencies in the banking system. If such recommendation

is against statutory laws, these deficiencies in the laws need to be addressed so that

transactions cost are reduced and adverse selection problems mitigated in effort to reduce

interest rates spread. Second, in countries with weak institutions, embryonic and/or

inexistent stock markets, where corporate governance practices are poor and financial

disclosures substandard, financing large scale projects might require loan syndication

which will alleviate the incidence of information asymmetry, boost information sharing,

avoid retail banking, remove inefficiencies, duplications, and lower transaction costs.

Notwithstanding free rider and monitoring problems, lending group will improve firms

vetting, and mitigate the impact of moral hazard. The free rider problem might prove

minimal as firm management would feel the pressure of increased surveillance by several

professional teams of stakeholders. Such a strategy will be beneficial for both banks and

firms. Costs of borrowing would significantly decrease, and participating banks will

diversify their risk exposures. Third, the most single factor in reducing the spread as well

as the level of bad loans is improvements in institutional quality. That is, improving a

countrys institutional framework would translate the lower risk borne by the banking

sector leading into cheaper costs of financing. Such a result would have a broader effect

133
on a countrys various economic sectors with potentials of trickling down, for financial

and economic activities would simultaneously increase. Fourth, in countries where

private credit information bureaus are inexistent, public registries should be compulsory,

run and operated as central bank agencies - at least at their early stage. In countries where

such institutions exist, policymakers should enact laws guaranteeing the confidentiality of

gathered information and criminalize their improper use. Bank secrecy laws have to be

revamped so that they align with new idea of using information as a public good and do

not interfere with the good functioning of lawful registries. Fifth, civic education of

lenders and borrowers on the purpose and the role of credit registries might be part of

new a strategy and policy agenda to establish confidence of reluctant borrowers to gain

their supports for such institutional changes and their view on the use of information.

These educational campaigns need to show that information can be served to open up

opportunities for firms seeking financing and strengthening the financial system. In

countries where such institutions exist their deficiencies need to be redressed so that they

serve their preordained purposes.

The results suggest that the most viable financial reforms are those supported by

institutional reforms give banks assurance and incentive to engage in safer and sounder

banking activities in lieu of imprudent lending practices. The results also imply that in

addition to using secular tools such as reserves requirements, interest rates, and open

market operations, in unstable and unsophisticated financial environments, an important

tool to safeguarding the banking sector is for the public sector to engage in institution

building, which would reveal beneficial for banks with weak balance-sheets as their need

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to charge high interest rates on lending which impedes loan repayments would be

significantly mitigated.

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 2.8. FIGURES

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Loan Quality Spread Institutions

Figure 2.0-1: Institutional Quality, Bank Spread, and Loan Quality across Countries

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Loan Quality Spread

Figure 2.0-2: Loan Quality and Bank Spread across Countries

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 25

20

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Loan Quality Institutions

Figure 2.0-3: Institutional Quality and Loan Quality across Countries

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Spread Institutions

Figure 2.4: Institutional Quality and Bank Spread Across Countries

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 CHAPTER 3

INSTITUTIONS, PROPERTY RIGHTS, POWER OF CREDITORS AND BANK

PERFORMANCE

3.1 INTRODUCTION

La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997, 1998 and 1999, LLSV

hereinafter), bear out the law and finance theory supporting that legal traditions

developed and implemented during colonization ages perpetuate through times and

constitute the core of the differences in private property rights protection and the basis of

financial contracting. A theory built on the institutions theory, substantiated by

Acemoglu, Johnson, and Robinson (2001, AJR hereinafter) who show that in colonies

where Europeans faced higher mortality rates and could not settle they set up extractive

institutions; whereas in environments such as the United States, New Zealand and

Canada where the mortality rates were similar to those in Europe, the settlers successfully

replicated and implemented European-like institutions with strong emphasis on private

property rights protection. As a consequence, the colonial states and its institutions

persisted well beyond the independence of these countries resulting in contemporaneous

institutions reflecting by and large the colonization strategies. The law and finance theory

predicts that historically determined differences in legal institutions help explain

international differences in financial systems today (see e.g., Beck, Demirg-Kunt, and

Levine, 2003). It differentiates between institutions established based on the British

Common Law and the French Civil Law. Especially, Common Law institutions were

conceived to protect individual ownership rights against the Crown while Napoleonic

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institutions were envisioned to reinforce the rights of the state vis--vis the citizens. As a

result, current institutions whose bedrock is the French Civil Law were established to

lessen the power of the courts interfering with state policy (see e.g. Beck et al., 2003;

Levine, 2005; and LLSV, 1997, 1998, 1999).

The present study seeks to establish a linkage between institutions, property rights

and private creditors right to banks profitability, and hitherto, the first attempt to

investigate such relationships. The endeavor is to show the importance of institutions in

affecting banks profit since the institution literature highlights that institutions are crucial

in determining investment patterns within a country. It is crucial to assess the extent to

which, exogenous factors such as, legal traditions formed centuries ago through

colonization and conquests cast their shadow on countries current banking system

through its political and legal institutions which have deep impacts on asset and capital

allocation as suggested by several studies including (AJR, 2001; Allen et al., 2005; Beck

et al., 2003; Fernandes and Kraay, 2006; Ginarte and Park, 1997; and Levine, 2005). The

study seeks to advance the literature in several directions. First, it is the first of its kind to

address the issue of bank profitability within the framework of a countrys institutional

quality, property rights and power of creditors channeled through the lenses of its legal

system. Second, the examination of the relationship between bank performance and

power of creditors theory, as pioneered by LLSV (1997, and 1998) who constructed an

index of creditors right, is a relatively understudied. The index has been used in several

influential studies including Djankov, McLiesh and Shleifer (2007, DMS hereinafter).

The current study updates the index in an effort to capture the impact of such a measure

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on bank performance. The index has been interpreted as a measure of creditor power in

the law and finance literature.

3.1 Research Problem

Banks are amongst the most important institutions within a country; hitherto, at

least empirically, the research on the performance of the banking sector overlooks, of the

impact of other institutions on bank performance. Except the study by Dermirg-Kunt

and Huizinga (1998) who find that better institutions negatively affect bank profit

margins, we are not aware of any published work that investigates the relationships

between institutional quality, property rights protection and power of creditors with bank

performance. Understanding what factors, financial and nonfinancial factors, that affect

bank performance is crucial for bank management, bank shareholders, the government as

well as the entire investing community. Fairly though, the performance of banks is the

essence of most research in the banking literature. Still, institutional factors and property

rights effects on banks are less understood. Dermirg-Kunt and Levine (2005) document

that as the financial sector (banks and other financial intermediaries) becomes larger,

countries become richer. Institutional theory suggests that institutions such as the

judiciary, private property rights, law and order, and the regulatory framework should

have a positive impact on the performance of the banking sector. Indeed, an efficient

legal framework implies that creditors can grab pledged collaterals and convert them into

financial resources in the event of default by the borrower. Although an effective

regulatory quality conveys rights to private creditors since contracts are better

enforceable and litigations can be settled by independent courts, the legal framework is at

best ineffective in many countries, and by analogy the overall institutional framework.

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However, there are crucial questions that are unanswered at least empirically in the

literature. For instance, can banks perform better in weak institutional framework? What

are the impacts of a weak regulatory environment on bank profit? Controlling for private

property rights protection and power of creditors, does institutional quality affect the

performance of the banking sector?

This study models institutions through the various indexes in the International

Country Risk Guide (ICRG) database, the Indexes of Economic Freedom constructed by

the Heritage Foundation (HF), and the World Economic Forum (WEF). It gauges the

financial and economic outcomes of institutions on financial infrastructures. Using a

structural modeling (SEM) technique, the study tests these different theories of institution

on bank performance. It attempts to introduce a general framework within which profit

maximizing bank performance can be gauged and shows that the model is fitted and

cross-validated across multiple samples. It consistently finds that institutional quality has

an adverse effect on the performance of the banking sector while both property rights

protection and power of creditors have a strong positive impact on bank performance. It

finds that, had a country simultaneously increased by one standard deviation its value of

institutional quality, property rights and power of creditor, its banking sector would have

been 20.3 percent more profitable over 1995-2008.

Interestingly, the results have several policy implications. First, they imply that

bettering a countrys institutional framework would mitigate the effect of risk borne by

the banking sector leading to cheaper costs of financing. Such a result would have a

ripple effect on a countrys various economic sectors with potentials of trickling down,

for financial and economic activities would simultaneously increase. A policy that is

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especially important for countries where social programs are scanty and financial markets

underdeveloped. Second, the positive relationship between property rights protection and

power of creditors implies that public policies aiming at strengthening institutions should

lead to much more stable banking sector since these two policy variables have strong

positive relationships with institutional quality.

The remainder of the paper is structured as follows. Section 2 briefly reviews the

relevant literature related to institutions, property rights and power of creditor. Section 3

discusses the data aggregation and variable measurements. Section 4 presents the

empirical strategy. Section 5 presents the results, whereas section 6 summarizes the

findings and concludes.

3. LITERATURE REVIEW

The first strand of related literature is the Law and Finance literature dominated

by a series of studies by LLSV (1997, 1998 and 1999). This portion of the literature

relates country legal heritage and institutional infrastructure to investor protection and

minority rights; and is supported by the celebrated study by AJR (2001). Also a related

strand is the financial development literature substantiated by (LLSV, 1998; Levine;

1996; Levine et al., 1999; and Rajan and Zingales, 1998). This thread of literature

analyzes the differences in countries level of financial development as explained by their

legal systems. The current study encapsulates these strands of literature by relating the

theory of institutions, property rights protection, and power of creditors to the

performance of the banking sector. DMS (2007) argue that what matters for the viability

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of private credit is the power of creditors. This third theory posits that when lenders can

more easily force repayment, grab collateral, or even gain control of the firm, they are

more eager to extend credit.

Commercial banks in developing economies exhibit higher profit margins

compared to their counterparts in developed economies (Bennaceur and Goaied; 2008;

Demirg-Kunt and Huizinga, 2001), Panayiotis et al, 2006; and Valentina et al., 2009).

To be sure, standard theory suggests that banks shareholders are claimants for its profits,

and it is thereby in their interest to maximize profit while minimizing costs (Bikker, and

Bos, 2008). With ineffective institutions, however, such profits are at the expanse of high

risk and high costs of capital hindering firms growth. Assuming that bank management

chooses input/output mix consistent to profit maximization while diversifying risk,

interests on loans are expected to be large. The risk level will be such that bankers

mistrust the system and set forth short investing horizons as well as high discount rates.

Even without a proclivity for short term profits there could be less enchantment to plough

back their profits. This comes to the expanse of shareholders appetite for profits as their

own banking firm might not have an opportunity to broadly diversify. Consequently,

countries with subpar institutions should have inefficient financial sectors and low credit

markets. Thus, from a policy perspective, improving the efficiency of the credit markets

and the financial infrastructure requires improvements in institutional quality namely via

the legal machinery. Institutions characteristics reflect the level of risk borne by

investors; and, if risk can directly explain high financial gains by the banking sector in

emerging economies in a way suggested by lenders risk hypothesis, then the level of risk

is a reflect of institutional factors as explained by the law and finance theory.

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 3.1.1 Property Rights

Beck, et al. (2003) argue that in countries where legal systems are enforced,

private property rights support private contractual arrangements and protect the legal

right of investors, savers are more willing to finance firms, and financial markets flourish.

They present two mechanisms of the Law and Finance theory. First, a political

mechanism that works through the way that legal traditions differ in terms of the priority

they attach to private property vis--vis the rights of the State and the protection of

private contracting rights. Second, an adaptability mechanism, referring to the degree of

formalism in the legal system that, if overdone, may impair the legal systems capability

to minimize the gap between the contracting needs of the economy and the normative

status quo. The Law and Finance literature concurs that the Common Law system

provides a superior basis for financial development and a more favorable setting for

firms growth as well as economic growth (see Beck et al., 2003; LLSV, 1998; and

Levine, 2005). Governments in French Civil Law countries tend to enjoy greater latitude

in their abilities to conduit resources toward politically advantageous ends even if this

abrogates private property rights and pre-existing contracts; they have difficulty credibly

committing not to interfere in private contractual agreements (Levine, 2005). The present

study argues that if property rights are vulnerable and if the banking sector is not sparred,

then this should be reflected in the performance of a portfolio of banks. Thus, a positive

relationship is expected between private property protection and the performance of the

banking sector. That is, if banks assets are not protected, then banks should perform

poorly in weak property rights protection settings.

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 Merryman (1996) notes that the exportation of the French Civil Law to its

colonies had more pernicious effects on property rights and private contracting than the

Codes effect on France and other European countries that adopted the Napoleonic Code.

While colonies imported the inflexibility associated with antagonism toward

jurisprudence and reliance on judicial formalism, most did not learn how the French

circumvented the adverse attributes of the Code (see Levine, 2005). Indeed, the inimical

effect of the formalism of the French civil law institutions leads to a financial sector that

is lagging behind in terms of innovation, and adoption of new financial products, and the

prevalence of high costs of capital. Demirgc-Kunt and Maksimovic (2000) posit that the

absolute quality of the banks and securities markets in a country depends on the legal

system's ability to enforce contracts. They further argue that the legal systems in different

countries may have a comparative advantage in supporting a quality banking system or a

quality of financial securities.

Several other studies including Cleassens and Leaven (2003), Knack and Keefer

(1995), Levine, (2005), and Park G. and Ginarte (1997) strongly support the relationship

between better property rights and firms performance. In fact, Levine (2005) argues that

the security of property rights is not a natural occurrence. Rather, it is an outcome of

policy choices and social institutions. Protection of property rights requires a balance

between (1) an active government that enforces property rights, facilitates private

contracting and applies the law fairly to all; and (2) a government sufficiently constrained

that it cannot engage in coercion and expropriation.

Taken together, the present study seeks to quantify the relationship between

property rights and bank profitability. Here we test several hypotheses, to wit, whether

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banks in countries with better property rights law are more profitable than those in

countries with weaker property rights laws.

H1: Bank profitability is unrelated to private property right protection.

H2: If private property rights protection reflects the quality of a countrys

contracting institutions, then in countries with better property rights protection, banks are

more profitable.

3.1.2 Institutions

The Law and Finance literature posits that colonial institutions are deeply rooted.

AJR (2001) argue that the colonial institutions persisted well beyond the countries

independence. Levine (2005) puts that the Napoleonic institutions are more rigid and

formalistic. This rigidity in the inherited institutions has various consequences on these

countries banking financial systems in terms of operations, loan origination and overall

interaction with clientele. Indeed, banks are the spine of the financial systems, and in

some instances, the only formal financing channel in several developing countries.

Oftentimes, when a countrys overall institutional framework is weak, the development

of its financial sector suffers. This is especially true in the former French colonies. In

other words, the French Civil Law countries have overwhelmingly bank-based economies

as compared to their Common Law countries counterparts that are more successful at

developing and implementing market-based financial sector due in part to better

investors protection laws and enhanced private property rights and better institutions.

North (1990) argues interactions between human beings create uncertainties,

which in turn give birth to institutions, conceived as the constraints to these interactions.

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Differences in institutions explain differences on economic performance, for different

institutions affect economic progress differently. Some countries put in place institutions

promoting economic growth and development whereas others embrace institutions that

generating economic contraction and stagnation. This analysis can be extrapolated to the

banking sector dealing with daily uncertainties and managing risk. If the institutional

quality embodies risk, this implies that in countries with ineffective institutions banks are

coping with more uncertainty and higher risk and therefore set their discount rates high

and their investment horizon short. That is, if the financial sector is influenced by

nonfinancial factors the following hypotheses can be tested.

H3: Weak institutions have a positive impact on bank profitability.

H4: Even in weak institutional settings, bank management chooses input/output

consistent with profit maximization theorem.

In effect, a weak legal framework implies that the law is not properly enforced

against defaulting customers. Further, had institutional obstacles also hindered banks

ability to collect claims, and they would have been obliged to accept symbolic

arrangements which would affect their ability to generate profit and grow. The oxymoron

is that the literature on bank profitability reports superior returns for banks in developing

countries where it can be assumed that the institutional framework is fragile. The present

study seeks to delve into the factors that might contribute to high banks profits, inter alia,

high margins on lending encompassing the overall risk. Ultimately, if the banking sector

is highly concentrated and banks witnessing high returns as well as high interest margins,

this will imply a form of anomaly of anomaly that policymakers should address.

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 When banks operate in highly risky environments, bankers will be more risk

averse. As a result, countries with subpar institutions should have less developed

financial sectors and low credit markets. Thus, improving the efficiency of the credit

markets and the financial infrastructure, bettering the quality of the countrys institutions

via the legal machinery is crucial. Institutions characteristics reflect the level of risk

borne by investors. If risk can directly explain the exorbitant rates in emerging economies

in a way suggested by lenders risk hypothesis, then the level of risk is a reflect of

institutional factors as explained by the law and finance theory.

3.1.3 Power of creditors

The last thread of literature draws on is the private creditor rights by DMS (2007),

LLSV (1997), and Tullio and Marco (2000). This line of studies connects creditors

ability to collect claims against defaulting debtors and circumvent moral hazard due to

information asymmetries. This thread is divided into two main theories: The theory of

private power of creditor and the theory of information. Here, we study the import of the

former in explaining bank profitability in both developed and developing economies. A

variety of sources is used to update the index of creditor rights constructed by MDS

(2007) to quantify banks power. The index measures the legal rights of creditors against

defaulting debtors. Our empirical strategy consist of simultaneously testing the different

theories to assess which one matters most for the banking sector using an SEM technique.

In line with DMS, we ask how stable is bank profitability over time and how different is

it amongst countries? We look at changes in creditor rights and how these changes affect

bank profitability. More formally, we test the following additional hypothesis.

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 H5: Bank profitability is a positively significantly related with power of creditors.

To test the three different policies, the current study merges these strands of

literature and allows the policies effects on banks to directly compete. In line with AJR

(2001), North (1990), we are investigating whether institutions interact negatively with

the banking sector. In effect, several studies by Demirg-Kunt and Huizinga (2001),

Demirg-Kunt and Levine (2001), and more recently, Valentina et al. (2009) analyze

commercial bank profitability and support the notion of high profit margins for

developing countries banks. The closest study in terms of institutional effects is that of

Demirgc-Kunt and Huizinga (1998) who use bank data from 80 countries and show that

differences in interest margin and bank profitability reflect various determinants

including bank characteristics, macroeconomic conditions, taxes, regulations, financial

structure, legal and institutional indicators. Their results show that indicators of better

contract enforcement, efficiency of the legal system and lack of corruption are associated

with lower realized interest margins and lower profitability. However, they study fails to

address the causes of the negative effects of their limited set of institutional variables on

certain bank characteristics.

Another study by Demirgc-Kunt and Maksimovic (2000) investigates firms

access to external financing using firm-level data for 40 countries. They ask whether

financial system has an effect independent of the legal system. They find that

development of a countrys legal system predicts access to external finance. LLSV (1998

and 1999), argue that the legal system in a country is the primary factor of the

effectiveness of its financial system given the import of firms and investors being able to

transact effectively between themselves and through the financial system. Modigliani and

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Perotti (1999) argue that in the absence of a strong legal system that can protect the rights

of external investors, financial transactions are intermediated through institutions or

concentrated among agents who have sufficient bargaining power to enforce their rights

privately (see Demirgc-Kunt and Maksimovic (2000)). LLSV (1999) explicitly and

emphatically show the import of the legal system in determining the enforceable

contracts between firms and investors. Altogether, the Law and Finance literature concurs

that the most single factor to heed in assessing the differences the different countries

financial sectors performance resides in the extent to which private property rights are

protected and by ricochet the efficacy of the institutions.

3.2 THE THEORETICAL MODEL

The hypothesized model is investigating the relationship between bank

performance, institutions and private property protection channeled through property

rights enforcement. The institutions of interest are of two types. The first set of

institutions consists, inter alia, of a countrys legal framework, judicial system, law and

order, business freedom, investment freedom, financial freedom and freedom from

corruption. The second set of institutions consists of the extent to which lenders are able

to collect from borrowers and their ability to grab collateral in the event of default. It is

hypothesized that both types of institutions directly affect the performance of the banking

sector in every country. Against this backdrop, bank performance is hypothesized be

directly predicted by institution quality, power of creditor and property rights. Property

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rights serve as intervening factor between the two types of institutions and bank

performance.

Here, the object is to investigate the effects of three different theories on bank

performance, the exploration of the factors that directly and indirectly affect the

performance of the financial sector is considered. It is assumed that institutional, private

property rights and power of creditor factors coalesce to explain the performance of the

banking sector. The variables related to both institutions and property rights are measured

in different ways to comprehensively (a) assess the impacts of institutions and property

rights on bank; (b) compare the possible range of financial outcome due to those factors

and (c) assess any intermediate effects between these factors and bank performance.

3.2.1 Bank Performance Factor

The literature is laden with research on bank performance involving numerous

control variables. However, there has not any proposed model insofar where policies that

affect bank performance can be directly evaluated against one another. Here, the bank

performance factor points to profitability of banks as pertained to their assets and equity.

It is a way of gauging the efficiency of the banking industry in managing assets to

generate earnings. Higher returns on assets indicate that the banking sector is effectively

generating profit on its investments through finance charges; whereas returns on equity

serve an indication of how bank shareholders wealth has been impacted over the study

period. The performance factor is composed of these two indicators and is directly

influenced by institutional quality, property rights and power of creditor. In our model,

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property rights serves as intervening factors between institutional quality and bank

performance.

3.2.2 Institutional Factor

Risk-return tradeoffs analysis in the banking literature has not taken into

consideration the impacts of institutional quality on bank. Here, the institutional factor

addresses the cumulative effects of institutions on bank performance. These effects are

assessed over relatively long time spans 1984-2008, 1995-2008 and 1999-2008 using

three independent datasets. Here, the conventional view that institutional factors are

stable over time is challenged. That is, current institutions should have no effects on

contemporaneous bank performance. In other words, changing conditions in institutions

should be an irrelevant factor for the banking sector since stability in institutions implies

that institutional changes that matter are either historical or expectative rather than

contemporaneous changes. Institutional quality is hypothesized to have a direct impact on

bank performance and property rights.

3.2.3 Property Rights Factor

We are not aware of any public work related to property rights protection and

bank performance. There is no theoretical and/or empirical evidence pointing to the

association of these two factors. Bank performance should be positively related to the

extent to which property protection is strong. The property rights factor refers to the

extent the overall property rights protection environment affects contracting rights and

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business relationships between banks and customers. It is assumed that a weak property

rights environment should have a negative impact on bank profits as their physical and

financial assets are not protected, and the pledged collateral might hardly have financial

values since they might be difficult to grab and converted into financial resources.

Property rights are assumed to have a direct effect on both bank performance and power

of creditors. They are also influenced by the overall quality of a countrys institutional

infrastructure.

3.2.4 Power of Creditors Factor

The power of creditor factor is measuring private creditors rights and assessing

whether private creditors have substantial capability to reduce their losses in the event of

default. DMS (2007) posit that what matters to private credit is the power of creditors.

When lenders can more easily force repayment, grab collateral, or even gain control of

the firm, they are more willing to extend credit. Power of creditors is assumed to be

determined by property rights environments. They have a direct impact on bank

performance.

3.2.5 Causal Relationships between the Factors

The causal relationships between the factors can be established by drawing from

three threads of literature: Law and Finance, Property Rights and Institutions, which

concur that both property rights and institutions are previously determined factors or

causes inherited from historical factors. Outcomes can be at least partially managed with

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some degree of certainty when the causes are understood (Hair et al., 2006). Here, we are

interested in what causes variations in bank performance. The approach adopted in this

study involves estimating the causal relationships simultaneously; analyzing the

significance of the individual paths or relationships; investigating whether there exists

any direct or indirect effect amongst the constructs. Jaccard and Jacoby (2010) put that

causal models allows the identification of systematic relationships between variables that

can be manipulated to produce changes.

3.2.6 Structural Equation Models

Using structural equation modeling, we can thus analyze the causal relationships

amongst the constructs. Lomax (2004) argues that SEM techniques (a) are best suited to

test theoretical models and quantitative fashion; (b) explicitly take into account

measurement errors when statistically analyzing data; and (c) provide with increased

capability to analyze sophisticated theoretical models of complex phenomenon.

The first step involves the specification of the latent variables in function of their

indicators using a classical measurement model as follows.

where is a vector of observed variables associated with a

vector of dependent latent constructs ; is a vector of observed exogenous

constructs associated with , an latent exogenous constructs (with ); The

relationships between observed and latent constructs are captured by a

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matrix for the elements and by ,a( ) matrix for the elements; and

are mean vectors of measurement intercepts and latent dependent variables, and and

are vectors of variables representing the random measurement errors

unaccounted for. Subscript and represent country , and time . It is assumed

that and .

The measurement part of the model is akin to confirmatory factor analysis from

which an individual construct is related to its underlying theory. The measured variables

are in turn related to their measurement errors. Then the variables loadings are analyzed

judging from their significance. The next step consists of the analysis of the causal

relationships between the constructs through the following structural model:

where is an dimensional of endogenous constructs, is an slope

parameter matrix resulting from regressing latent endogenous constructs on latent

exogenous constructs, is an matrix of slopes from regressing the latent

constructs on other latent constructs, and is an -dimensional vector of the

disturbances in the hypothesized model. Furthermore, has zero diagonal elements, for

these elements indicate the extent to which a latent dependent variable influences itself;

and it is assumed that is non-singular, where is an identity matrix.

The method of analysis used in the SEM is the maximum likelihood estimation,

which assumes normality of our data. It optimally estimates the model parameters so that

the model there is little difference between the sample variance-covariance matrix and the

model implied reproduced variance-covariance. Amongst the numerous matrices

analyzed the matrices of interest are the matrix, an covariance matrix that

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contains the exogenous constructs; , an matrix of covariances of the

equations disturbances ; and a diagonal ( covariance matrix of , or a

matrix containing the variances and covariances amongst the disturbances of the

observed variables. In all, the different matrices of interest are and

leading to the covariance matrix for the observed variables and the exogenous

constructs respectively,

Finally, the covariance matrix between the Ys and Xs in our model is given by:

The covariance matrix given by eq. (6) includes most of the relevant matrices

except and .

Finally, the model overall fit is assessed through various goodness-of-fit measures

including the Bentler chi-square statistic: A measure of the closeness of the model

implied variance-covariance matrix and the observed variance-covariance matrix. This

chi-square statistic has degrees of freedom equal to the difference between number of

known and unknown parameters. When the chi-square value is small and non-significant,

residual values in the residual matrix are close to the sample data, hence there is little

difference between the sample variance-covariance matrix and the model implied

reproduced variance-covariance matrix (Schumacker and Lomax, 2004). Other goodness-

of-fit indices include the Normed fit index where a value close to .95 indicates a good fit;

and the Root-mean-square error of approximation where a value of .05 indicates a good

fit of the model to the data.

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 The proposed model is schematized in fig. 1 where the circles represent the latent

constructs while the rectangles represent the observed measured variables. The causal

relationships are represented by the direction of the arrows amongst the latent constructs.

The model involved four constructs including bank performance (BP), institutional

quality (IQ), power of creditors (PC), and property rights (PR). The model follows a

general framework of causal models where the constructs can be either exogenous

(determined outside of the model) or endogenous (determined within the model).

3.3 DATA ANALYSIS

The hypothesized model is tested using three different datasets. The data for bank

performance is from the World Bank and is compiled from the BankScope database by

Beck et al., (2001) for financial institutions around the world. Our main data for

institutional quality are from the Heritage Foundation (HF), the International Country

Risk Guide (ICRG), and the World Economic Forum (WEF) also known as Global

Competitiveness Report (GCR). The ICRG database is a private investor risk rating

agency, and commonly utilized in the literature to model institutions (see e.g. AJR, 2001;

Hall and Jones, 1999; Knack and Keefer, 1995; and Glaeser et al., 2004). The data covers

183 countries spanned from 1984 to 2008 it includes measures of political risk, economic

risk and financial risk. Glaeser et al. (2004) point out that the set of measures of

institutions are constructed in a way dictators that freely choose good policies receive

high scores. They provide ample discussion of the shortcomings of the measures.

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 3.3.1 Measurement

There are a variety of ways of measuring both institutions and property rights.

The only variables involved in the testing of the model whose measurements are the same

across samples are bank performance and power of creditors.

3.3.2 Institutions

Measures of institutional quality vary across our various samples. In the HF

sample, for instance, institutional quality involves four measured variables: Business

freedom, freedom from corruption, investment freedom and financial freedom. The

indices are constructed on a scale from 0 to 100 where zero represents the absolute

absence of the underlying freedom within a given country and a value of 100 suggests

negligible interference of the state. The financial freedom component of the construct

attempts to capture financial freedom of banking security as well as government

regulation of financial services; the obstacles met in opening and operating financial

firms and the interference of the state in credit allocation. The investment freedom

gauges the scope of constraints on flow of investment capital, and whether individual

firms are allowed to freely move capital across borders without restriction. The freedom

from corruption component captures the uncertainties created by the interactions between

investors. Lastly, the business freedom attempts to quantitatively measure the ability to

start, operate and close businesses while accounting for the burden of regulations and

government efficiency and carrying out the process.

From the ICRG, three variables are used to capture institutional quality including

the quality of bureaucracy, law and order and military involvement in politics; whereas

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from the WEF, two variables are used to measure the institutional construct: Judicial

independence and legal efficiency. The variables from the ICRG and WEF are described

in detail in table 1. A fourth set of institutional variables from the World Governance

Index was under consideration. The indexes are constructed by Kauffman et al. (2008)

and include measures of institutions quality such as Voice and Accountability, Political

Stability and Absence of Violence/Terrorism, Government Effectiveness, Regulatory

Quality, Rule of Law, and Control of Corruption. However, as noted by Glaeser et al.

(2004) these governance indicators are oriented so that higher values correspond to better

outcomes, on a scale from 2.5 to 2.5; and that the ratings are based on subjective

assessments from a variety of sources, are subject to substantial margins of error as

indicated. They find that the Kauffman dataset is highly related to level of economic

development in lieu of political constraints on leaders per se. In line with their findings,

we observed that the Kauffman dataset fits perfectly our model. However, the standard

errors are so large so that we discarded the results from that dataset altogether even if

they were consistent with our findings using other data sets.

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 Table 20
Variables Description
This table presents the variables used in this chapter. Column (1) presents the name of the variables while column
(2) presents the description of the variables as provided by their respective sources.
Variables Description
Creditor Rights Variables
Index assesses four components of powers of secured lenders in bankruptcy (1) restrictions: creditor
consent, when a debtor files for reorganization (2) ability of secured creditors to seize collateral after
petition for reorganization is approved (3) whether secured creditors are paid first out of the
Creditor proceeds of liquidating a bankrupt firm, and (4) whether an administrator, and not management, is
Rights Index responsible for running the business during the reorganization. A value of one is added to the index
when a countrys laws and regulations provide each of these powers to secured lenders. The creditor
rights index aggregates the scores and varies between 0 (poor creditor rights) and 4 (strong creditor
rights). Taken directly from DMS (2005). Source: Djankov, S., McLiesh, C., and Shleifer, A (2005)
Institutions and Property Rights Variables
Assesses the institutional strength and quality of the bureaucracy such as continuity in
public policies when governments change. High points are given to countries where the bureaucracy
Quality of has the strength and expertise to govern without drastic changes in policy or interruptions in
bureaucracy government services. Low risk countries, the bureaucracy tends to be somewhat autonomous from
political pressure and to have an established mechanism for recruitment and training. The index
varies from 0 to 4. Source: International Country Risk Guide.
An evaluation of Law and order tradition within a country. The index takes a value ranging from 0
Rule of Law to 10 where lower scores display the absence of law in the countrys tradition. Source: International
Country Risk Guide.
An assessment of corruption within the political system. The most common form of corruption met
directly by business is financial corruption in the form of demands for special payments and bribes
Corruption In connected with import and export licenses, tax assessments, police protection, or loans. Such
Government corruption can make it difficult to conduct business effectively, and in some cases may force the
withdrawal or withholding of an investment. The index ranges from 0 to 6 where a lower value
means higher level of corruption. Source: International Country Risk Guide.
Tracks each countrys policies toward the free flow of investment capital (foreign
investment as well as internal capital flows) in order to determine its overall investment climate. 100
Investment point scale (100 means Foreign investment (FI) is encouraged and treated the same as domestic
Freedom investment, with a simple and transparent FI code and a professional, efficient bureaucracy. There
are no restrictions in sectors related to national security or real estate. No expropriation is allowed).
Source: Index of Economic Freedom by the Heritage Foundation.
Financial freedom is a measure of banking security as well as a measure of independence
from government control. State ownership of banks and other financial institutions such as insurers
and capital markets is an inefficient burden that reduces competition and generally lowers the level
Financial Risk
of available services. 100 points scale (100 means central bank independent regulation of financial
institutions limited to enforcing contractual obligations and preventing fraud. Credit is allocated on
market terms). Source: Index of Economic Freedom by the Heritage Foundation.
The property rights component is an assessment of the ability of individuals to accumulate
private property, secured by clear laws that are fully enforced by the state. It measures the degree to
which a countrys laws protect private property rights and the degree to which its government
Property
enforces those laws. It also assesses the likelihood that private property will be expropriated and
Rights
analyzes the independence of the judiciary, the existence of corruption within the judiciary, and the
Freedom
ability of individuals and businesses to enforce contracts. 100 points scale (100 means private
property rights absolutely warranted and 0 means government sole owner of properties. Source:
Index of Economic Freedom by the Heritage Foundation.
Corruption erodes economic freedom by introducing insecurity and uncertainty into
Freedom from
economic relationships. 10 points scale (10 means very little of corruption and 0 means absolutely
Corruption
corrupt government). Source: Index of Economic Freedom by the Heritage Foundation.
Bank Profitability
Average Return on Assets (Net Income/Total Assets). Source: Thorsten Beck, Asli Demirg-Kunt
Bank ROA
and Ross Levine, (2000); updated 2007.
Average Return on Assets (Net Income/Total Equity). Source: Thorsten Beck, Asli Demirg-Kunt
Bank ROE
and Ross Levine, (2000); updated 2007

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 3.3.3 Property rights

Several studies attempt to assess the impact of property rights on various financial

and economic outcomes. For instance, Ginarte and Park (1997) construct an index

involving five categories capturing the level of property rights protection. A major

challenge of their index is membership in international agreements. Theoretically, most

countries enshrine the rights to the ownership and stewardship of, and profits from, land,

capital, and other goods in their constitution, the basic elements of the capitalist system.

Oftentimes, they make and ratify most of the international treaties and conventions

regarding property and patent rights whereas the laws are barely enforced. Several

influential studies overlook this virtual of property rights protection. Indeed, Haiti has a

score of 3.19 for each of the 5 categories involved in the Ginarte and Parks study

whereas the highest score of India is 1.85. Haiti, Nigeria, and Zambias scores are better

than those of Argentina and Brazil, and comparable to those of the OECDs countries for

each of the categories. The evidence is that these countries were unable to translate these

high scores into real policies that ensure optimal financial resource allocation for better

economic outcome. Therefore, the main advantage offered by our study includes the

cross-validation of the results across samples in an effort to avoid any potential bias in

our measurement of property rights protection so that any inference of the effects of

thereof on bank performance can be generalized with more confidence.

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 3.3.4 Property rights (Heritage Foundation: HF)

The property rights index as constructed by the HF is referred to as property

freedom, an index originally built by the Transparency International. The index attempts

to capture the extent to which private property rights are protected and the likelihood that

private properties will be expropriated. It also measures the extent to which the court

system enforces contracts efficiently and quickly; and whether the justice system

punishes those who unlawfully confiscate private property. In addition to the property

rights index, the Heritage Foundation constructs several indexes including investment

freedom and financial freedom indexes. The index has been used by several authors

including (Cleassens and Leaven, 2003; Levine, 2005; and LLSV, 1998, and 1999). It is

scaled from zero to 100 with 10 points increment where a value of zero means private

property rights is outlawed and all property belongs to the state, and a value of 100 means

private property rights is guaranteed by the government.

3.3.5 Property rights (World Economic Forum: WEF)

The third set of data on property rights is from the World Economic Forum

(WEF) from 1999 through 2008. The index constructed by the WEF models property

rights by directly surveying firms around the world on the security of private property

protection in their country including financial assets. The index ranges from 1 to 7 where

a value of 1 indicates that protection of assets is very weak and a value of 7 indicates a

very strong protection as judged by international standards.

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 3.3.6 Property rights (International Country Risk Guide: ICRG)

The third dataset used for property rights is from the ICRG, a private investor risk

rating agency, and commonly utilized in the literature to model property rights (see e.g.

Cleassens and Leaven , 2003; Goldsmith, 1995; and Knack and Keefer, 1995). We follow

Fernandes and Kraay (2006) by using control of corruption as a proxy for property rights

protection. Indeed, Fernandes and Kraay measure private property rights using the

Kauffman measure of corruption arguing that this measure captures the extent to which

businesses are secure from predation by the State. It is also a measure of contracting

institutions reflecting how well institutions such as the courts allow private parties to

contract with each other. The sample that involves ICRG spans over 1984 to 2008 and the

data cover 183 countries.

3.3.7 Power of Creditor and Information

The power of creditor is from DMS (2007) and updated using various sources

such as the CIA factbook, the Lexis Nexis, the library of the International Bar

Association as well as the Doing Business by the World Bank to update the index of

power of creditors used in DMS study. The update concerns the last four years of our

study for any change in bankruptcy laws affecting power of creditors. Extensive details of

the index are provided in DMS (2007). The index measures four powers of secured

lenders in bankruptcy (1) whether there exists restrictions, such as creditor consent when

a debtor files for reorganization (2) whether secured creditors are able to seize their

collateral after the petition for reorganization is approved (3) whether secured creditors

are paid first out of the proceeds of liquidating a bankrupt firm, and (4) whether the

163
administrator, and not management is responsible for running the business during the

reorganization. Borrowing from DMS (2007), a value of one is added to the index when a

countrys laws and regulations provide each of these powers to secured lenders. Thus, the

creditor rights index aggregates the scores between 0 (poor creditor rights) and 4 (strong

creditor right.

3.3.8 Bank Performance

Bank performance data are provided by the World Bank and compiled by Beck et

al., (2001). The original data is drawn from BankScope and cover financial institutions

around the world. The data is periodically updated and spread over 1960 through 2008.

We use returns assets (ROA), and return on equity (ROE) to form the composite variable

called bank profitability. ROA is the average return on assets (Net Income/Total Assets),

and ROE is computed as the average return on equity (Net Income/Total Equity).

3.4 PRELIMINARY RESULTS

Some descriptive statistics are provided as preliminary empirical evidence of the

relationship between bank performance, institutions and property rights in this section.

The data has been divided into quartiles based on the countries institutional qualitys

values and the mean values have been analyzed. Means of institutions, bank ROA, bank

ROE and property rights form the basis of the primary assessment of the relationships

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between bank performance and institutional quality. The reference sample for this

analysis is the Heritage Foundation sample.

Table 21
Intergroup Mean Differences Tests
This table presents Inter-group test of mean differences. Results based on the Heritage Foundation sample.
Groups Mean S.D.
difference
Groups ROA ROE INST PR
Mean S.D Mean S.D Mean S.D Mean S.D 1 v. 2 Bank 0.01*** 0.004
1 0.022 0.03 0.19 0.21 30.88 4.5 24.91 10.53 1 v. 3 return 0.016*** 0.0025
2 0.012 0.08 0.15 0.21 46.76 5.1 41.49 12.29 1 v. 4 s on 0.0103*** 0.0024
3 0.006 0.04 0.10 0.16 63.46 4.8 64.24 17.82 2 v. 3 assets 0.006* 0.004
4 0.012 0.02 0.12 0.12 82.37 4.8 88.44 5.28 2 v. 4 0.0003 0.003
3 v. 4 -0.006** 0.0028
1 v. 2 Bank 0.040** 0.0169
1 v. 3 return 0.091*** 0.0165
1 v. 4 s on 0.069*** 0.0173
2 v. 3 equity 0.050*** 0.0108
2 v. 4 0.012** 0.0048
# obs. 213 692 496 179 3 v. 4 -0.023* 0.0114
Table 2 shows that the most obvious pattern is that countries with lower

institutional quality outperform those with better institutional quality with regard to the

performance of their banking sector. Furthermore, performing inter-quartile mean

difference tests, the results suggest that the greater performance of the banking sector in

countries with ineffective institutions is statistically significant for both ROA and ROE.

Similarly to institutional quality, these countries display weaker property rights

protection.

3.5 MODEL EVALUATION

We begin by providing the correlations between the institutional variables and the

banking variables. The correlations are provided in table 3. We next analyze the proposed

model. The models assumptions were assessed using three broad datasets. After

applying casewise deletion to the samples, there were no missing data. The three final

165
samples were (a) ICRG, 1726 cases from 1984 through 2008 (b) HF, 1580 cases from

1995 through 2008, and (c) WEF, 777 cases from 1999 through 2008.

Table 22

Correlations between Institutions Determinants and Bank Profitability

Table 22 Presents the. Correlation Matrices of Indicator Variables

Panel (A) presents the correlations of the measured variables using data from the World Economic Forum (WEF)
from 1999-2008
1 2 3 4 5 6 7 8
1. Judicial independence 1
2. Property right .491 1
3. Legal efficiency .939 .495 1
4. Private creditors rights .120 .029 .128 1
5. Bank returns on assets .086 .034 .084 .131 1
6. Bank returns on equity -.090 -.060 -.088 .212 .205 1
Mean 4.06 4.76 4.03 1.96 .009 .129
S.D 1.41 2.24 1.27 1.09 .077 .172
N 777 777 777 777 777 777
Panel (B) presents the correlations of the measured variables using data from International Country Risk Guide
(ICRG) from 1984-2008
1. Bureaucratic quality 1
2. Law and Order .540 1
3. Property rights .586 .652 1
4. Military in politics .565 .655 .566 1
5. Bank returns on assets -.0335 .011 -.034 .049 1
6. Bank returns on equity -.125 -.057 -.076 -.048 .183 1
7. Private creditors rights .141 .163 .035 .085 .080 .104 1
Mean 2.35 3.96 3.06 4.07 .011 .128 1.88
S.D 1.13 1.38 1.34 1.66 .054 .207 1.15
N 1726 1726 1726 1726 1726 1726 1726
Panel (C) presents the correlations of the measured variables using data from World Governance Indices (WGI)
from 1996-2008
1. Bank returns on assets 1
2. Bank return on equity .163 1
3. Private creditors rights .119 .102 1
4. Property rights .008 -.086 .210 1
5. Government effectiveness .007 -.112 .240 .958 1
6. Political stability and .006 -.065 .156 .782 .792 1
absence of violence
7. Rule of Law .019 -.106 .227 .965 .961 .818 1
8. Regulatory quality .012 -.110 .233 .904 .934 .782 .919 1
Mean .010 .131 1.79 .075 .162 -.125 .039 .202
S.D .063 .173 1.13 1.04 1.001 .9412 .991 .878
N 1036 1036 1036 1036 1036 1036 1036 1036
Panel (D) presents the correlations of the measured variables using data the Heritage Foundation (HF) from 1995-
2008
1. Business freedom 1
2. Investment freedom .555 1
3. Freedom from corruption .706 .489 1
4. Financial freedom .538 .633 .523 1
5. Property rights .753 .600 .830 .572 1
6. Bank returns on assets -.013 -.079 -.004 -.075 -.029 1
7. Bank returns on equity -.107 -.137 -.092 -.109 -.156 .207 1
8. Private creditors rights .172 .066 .153 .176 .149 .099 .095 1
Mean 65.12 55.28 42.11 53.08 51.72 .012 .132 1.87
S.D 13.85 17.81 24.25 18.97 22.99 .057 .192 1.14
N 1580 1580 1580 1580 1580 1580 1580 1580

166
 The data were normalized to have a mean of zero and a variance of 1 to lessen

measurement errors. Nonetheless, univariate analyses suggest that assumption of

normality was violated for ROA and property rights. The normalized Mardias alpha was

significantly high for all of the three sub-periods as well as their Z statistics for ROA.

Consequently, robust maximum likelihood estimation technique was used to estimate the

models parameters along with the Satorra-Scaled chi square that corrects for skewness.

The identification of the model as applied to the different datasets was then

assessed. In the ICGR data, the sample correlation matrix contains 28 distinct variances

and covariances, . The measurement model indicates

that 20 parameters to be estimated to wit, 7 factor loadings, 7 corresponding

measurement errors and 6 correlations between the constructs. The order condition is

therefore met as there are more distinct values in the sample correlation matrix than free

parameters in the hypothesized model, d .

Likewise, applying the model to the HF data, the sample correlation matrix

contains 36 different variances and covariances, ,

whereas the measurement model indicates 22 parameters to be estimated: 8 factor

loadings, 8 associated measurement errors, and 6 correlations between the constructs.

Thus, the order condition is met, for there are amply more distinct values in the sample

correlation matrix than are free parameters in the hypothesized model,

. Lastly, fitting the model to our WEF data, the

sample correlation matrix contains 21 different variances and covariances,

, while the measurement model indicates 18 different parameters to be

estimated: 6 factor loadings, 6 related measurement errors and 6 correlations between the

167
constructs. The order condition is met since there are more distinct values in the sample

correlation matrix than there are free parameters in the measurement model,

. As a result, the rank condition is satisfied, the

determinants of the different matrices across the samples are therefore nonzero.

The means and covariance matrices are estimated when the model is fitted to the

data. Several questions are of great import. For instance, (1) to what extent the model fits

the data or how does the model reasonably estimate the population covariance matrix? (2)

Does a measurement model fit better than a reduced form model? Is there any significant

covariance between Institutions, power of creditor, property rights and bank performance

or is there an indirect relationship between bank performance, institutions, and power of

creditor and property rights? In effect, there is strong support for the model as

hypothesized across our three different samples. The Satorra-Bentler scaled chi-square

test of the robust ML estimation is significant in the ICRG sample,

, indicating a significant difference between the estimated and observed

covariance matrices for this sample, the test is also significant for the HF but insignificant

for the WEF samples with respective test statistics

. An insignificant chi-square suggests no

significant difference between the estimated and the observed covariance matrices for

these samples. The significant difference observed between the estimated and observed

covariance matrices in the ICRG and the HF samples is largely due to the scope of these

samples. In such large samples, any slight differences in the subjects might result into

significant Therefore, the fit indices are a better measure to gauge the models

goodness-of-fit when sample size is large (see Tabachnik, Fidell, and Linda, 2001;

168
Schumacker, and Lomex, 2004; Bollen, and Curran, 2006; Raykov, and Marcoulides,

2006). In fact, all of the fit indices suggest a good fitting model across all of the samples.

The model robust comparative fit indices (CFI) are .98, .97 and 1, for the ICRG, WGI

and WEF respectively, where a value of 1 indicates that the model perfectly fits the data.

Additionally, the model RMSEA is .06 for the ICRG sample and .068 for the HF and .00

for the WEF samples. Models with RMSEA .1 are said to be correctly specified (Curran

and Bollen (2009)). Likewise, the Bentler-Bonett Index also known as the Normed Fit

Index (NFI) are respectively .98 for using the ICRG for institutional measured variables,

.97 and 1 using data from WGI and WEF respectively. All of the measurement models

goodness-of-fit information suggests the model fits the data.

Nevertheless, given a fitting model, it is important to investigate whether the

model can be improved by adding or deleting some paths. Model modification is guided

by the Maximum Likelihood (ML) and the Wald tests. The ML test indicates that adding

military involvement in politics to the property rights construct would significantly

improve the fit of the model using the ICRG sample. However, without theoretical

justification, it is advised not to free the models parameters just for improving the fit.

Therefore, there was no path modification in the model across samples. Overall, the

measurement model displays reasonable fit and the results are robust. Post-hoc model

modifications were also considered before assessing the model structurally.

Bank performance was first used as the dependent variable and the other

constructs as IVs. In fact, this alteration did not change the parameters of the model in

any significant way across the three samples. A nested model where bank performance as

a function of the two institutional constructs and property rights was considered

169
simultaneously with power of creditor as a function of property rights while property

rights are determined by institutions. Across all of the samples, a better fitting model is

achieved through the causal model. The final model fits the data very well, Satorra-

Bentler

using the ICRG sample; the WEF yields similar fit indices, and the HF sample has a

3.6 RESULTS

An SEM analysis was conducted on three different datasets to address the

question of what factors affect the performance of the banking sector. Only coefficient

estimates for the HF sample are interpreted in the analysis. The various question of

interest consist of whether a countrys institutions influence its financial sector? Does

property right protection matter for a well functioning banking sector? Do countries

where lenders have more power to recollect have more profitable banking sector? Are

direct effects of institutions more important to bank performance than are indirect

effects? To address these issues, a basic model has been proposed and empirically

assessed. The basis for the analysis is the covariance between the measured variables.

The initial evaluation of the proposed model is performed through a measurement model

in which all the paths were significant. There were no constraints imposed on the paths.

When the model is tested using the other datasets, the fit indices are even

stronger. There were no significant departures from normality except for ROA and

property rightsthat has shown significant skewness. Therefore, robust statistics (CFI and

170
NFI) were reported to correct for such departures. All the other indicators of a good fit

were analyzed including the normalized residuals and the plot of the normalized

residuals. The general observation is that the model is a good fit. Nevertheless, a

specification search has been performed to improve the fit of the model by first using

bank performance as dependent latent construct. Indeed, some paths could have been

freed to improve the fit of the model, but there is no theoretical reason to free any of the

proposed paths with their significantly strong loadings on their respective construct.

Using bank performance as dependent construct, however, the fit indices remained

virtually unchanged and the chi-square statistics remained highly significant. Additional

model search considerations included the Maximum Likelihood (ML) test of adding

parameters and the Wald test for dropping parameters. The ML test suggests that, using

the Heritage Foundation sample, business freedom index could be freed be added to the

property rights index and investment freedom could also be added to the creditors right

index. However, these suggestions are not substantial when additional tests are

performed. Indeed, Jreskog and Srbom (1984) argue that freeing fixed parameters

might improve models fit but the modifications may not be theoretically justified (see

Lavee and Patterson, 1985). A fuller nested model was then considered in which bank

performance is predicted by institutional quality, power of creditor and property rights

whereas property rights are predicted by institutional quality, and power of creditors

predicted by property rights.

Table 4 displays the results of the measurement model relating the measured

variables with their latent construct and their residuals. The third column of the table

shows the estimated coefficients or path loadings. All of the variables were

171
significantly loaded on their respective latent construct. As a usual practice, one of the

measured observed variables was chosen to be fixed to a value of 1.0. This fixation

requires no theoretical justification on which variable to fix except that it allows the other

variables loaded on a given construct to be freely estimated. In the sixth column in table

III are presented the residuals of the observed measured variables, . Indeed, the

measures and the constructs were significantly different given both the loadings and the

residuals were significant.

Table 23
The measurement models parameters
Measurement Models Estimates (Relations between measured variables and latent constructs
Construct Indicator
Panel A. ICRG sample, N=1726 (1984-2008) Path Unstandardized Standardized Residual Variance
Coefficient Coefficient
Bank Performance ROA (1.00) 0.31 0.903***
ROE 2.009** 0.59 0.650**
Institutional Quality Bureaucratic quality (1.00) 0.71 0.496***
Law and Order 1.161*** 0.82 0.320***
Military in politics 1.087*** 0.77 0.414***
Creditors Right Power of Creditor (1.00) (1.00) _
Property Right (ICRG) Property Rights (1.00) (1.00) _

Panel B. The Heritage Foundation sample, N=1580 (1995-2008)

Bank Performance ROA (1.00) 0.33 .342***
ROE 1.90*** 0.63 .607***
Institutional Quality (HF) Business Freedom (1.00) 0.81 .342***
Investment Freedom 0.841*** 0.68 .535***
Freedom from Corruption 0.951*** 0.77 .405***
Financial Freedom .831*** 0.67 .545***
Creditors Right Power of Creditor (1.00) (.90) .190**
Property Right (HF) Property Rights (1.00) (.26) .930***

Panel C. WEF sample, N=777 (1999-2008)

Bank Performance ROA (1.00) 0.28 .920***
ROE 2.553** 0.73 .474**
Institutional Quality (WEF) Judicial Independence (1.00) 0.96 .071***
Legal Efficiency 1.011*** 0.97 .050***
Creditors Right Power of Creditor (1.00) (1.00) _
Property Right (WGI) Property Rights (1.00) (1.00) _

Table 5 presents the results of the structural model where in panel A the variance

of our exogenous construct (institutional quality) from the ) matrix is presented.

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 Table 24

Maximum Likelihoods Estimates of SEM

This table presents the Maximum Likelihood estimates for the Structural Model Equations Estimates
(relationships amongst latent constructs). Robust standard errors are reported into parentheses.
Variance-Covariance of Heritage World Global International
Exogenous Latent Variables Foundation Economic Governance Index Country Risk
(Phi Matrix)a Forum Guide

.658*** .929*** .959*** .503***

(1.00) (1.00) (1.00) (1.00)

Path coefficients between latent variables

Heritage Foundation Path Unstandardized Standardized Residual Variance
coefficient coefficient
Institutional Quality Bank -.883*** -2.201 (Bank .09
Performance (.038) Performance)
Institutional Quality 1.156*** 1.00 (Creditors Right) .051
Property Right (.033)
Creditors Right Bank .676*** 1.947 (Property Right) .000
Performance (.076)
Property Right Bank .07** .217
Performance (.019)
Property Right Creditors .184*** .173
Right (.033)

World Economic Forum

Institutional Quality Bank -.309** -1.05 (Bank .004
Performance (.089) Performance)
Institutional Quality Property .527*** 1.00 (Creditors Right) .106
Right (.052)
Creditors Right Bank .845 1.04 (Property Right) .000
Performance (6.86)
Property Right Bank .320 .574
Performance (1.76)
Property Right Creditors .253** .931
Right (.086)

International Country Risk Guide

Institutional Quality Bank -.812 -1.90 (Bank .024
Performance (1.13) Performance)
Institutional Quality Property 1.098*** 1.00 (Creditors Right) .056
Right (.036)
Creditors Right Bank 1.084 .984 (Property Right) .000
Performance (5.97)
Property Right Bank .496*** 1.28
Performance (.029)
Property Right Creditors .178*** .504
Right (.035)
Again, the results have been replicated using the three sets of independently

constructed measured variables for both institutions and property rights. The variances

were significantly high across all of the samples. Additionally, the path coefficient

between the latent endogenous constructs and latent exogenous constructs represented by

173
 , represent the causal relationships or regression coefficient between

constructs where the former is a construct associated with the

measured variables (Institutional Quality) and latter represent two of our endogenous

constructs (Bank Performance and Property Rights). The other sets of parameters

estimated are the and the where the former are causal relationships

or regression coefficients from one endogenous construct - Bank performance,

Creditors Rights and Property Rights - to another, and the latter expresses the residuals

of the .

The results indicate that bank performance is significantly directly positively

influenced by greater power of creditor ( , and property rights

protection ( . Nevertheless, bank performance is significantly

negatively related to enhanced institutional quality ( .

Replications of the results across our different datasets confirm that consistent pattern

both in the long run and in the medium run. The causal model fit indices are excellent

across our samples. Using the Heritage Foundation sample e.g., the fit statistics are

. Ceteris paribus, banks perform better in countries with poorer

institutional quality and stronger power. The RMSEA for the model using the other

datasets indicates a perfect fit.

A closer look at the results suggests that institutions appear to have both

statistically significant directly and indirectly effects on bank performance. A pattern also

observed for property rights and private creditors rights. The combined effect of these

institutions on the performance of the banking sector is also significant. The indirect

174
effect of institutions on bank performance is positive and significant (

. Both the indirect and indirect effects of institutions on property rights are positive

and statistically significant. It appears that a positive effect of enhanced institutional

quality on bank performance can be channeled through improved stronger power of

creditors. For instance, the indirect effect of property rights on bank performance is

( ; whereas, power of creditors is indirectly positively significantly

influenced by institutional ( .

Table 25

Maximum Likelihood Estimates of Direct, Indirect and Total Effects

Table 25 presents Maximum Likelihood parameter estimates of the direct, indirect and total effects for three Structural
Equations Models explaining the performance of the banking sector around the world. The parameter estimates are
unstandardized estimates. ***, ** and * refer to p-value<.01, 0.05 and 0.1 respectively.
Heritage Foundation World Economic Forum ICRG
Direct Indirect Total Direct Indirect Total Direct Indirect Total
effect effect Effect effect effect Effect effect effect Effect
Institutional -.087*** .796*** -.883** -.309** .281** -.028 -.812 .756 -.055
Quality (.044) (.102) (.038) (.089) (.102) (.065) (1.13) (1.19) (2.31)
Creditors .676** .676** .845 .845 1.08 1.08
_ _ _
Rights (.076) (.076) (6.86) (6.86) (5.97) (5.97)
Property .143*** .213** .07*** .320 .214 .533** .496*** .193 .689
Rights (.029) (.040) (.019) (1.76) (.122) (.165) (.029) (1.07) (1.08)

Most importantly, the estimated coefficients are not only statistically large, but

also of great economic implications. For instance, the coefficient for property rights

implies that had a country increased by one standard deviation the value of its property

right index as measured by the Heritage Foundation, the performance of its banking

sector would have increased by 7 basis points per year, over 1995 through 2008, from its

initial level of 1995. This would have a cumulative effect over thirteen years of .91

percent higher in bank profitability. The estimated coefficient of power of creditor

suggests that for a one standard deviation increase in creditors right bank performance

would have increased by .676 basis points per year from 1995 to 2008 from its initial

value of 1995. Accumulating over thirteen years, this would have led to a 9.19 percent

175
increase in profitability of its banking sector. Conversely, a one standard deviation

change in institutional quality results in a decrease of .883 basis points per year in the

profitability of banking sector of any given country from 1995 through 2008 with a

cumulative decrease of 10.84 percent in bank profitability over thirteen years. The results

show that the impacts ineffective institutions on the banking sector are economically

more important than the impacts of private property protection. It appears that banks have

significant power in taking over borrowers assets and in grabbing collaterals of

defaulting customers. The mild impact of property rights protection might be an

indication of banks power in the event that their assets have always been secure and that

change in property rights laws does not affect them to the same extent does a change in

power of creditors.

Summing up, had a country simultaneously increased by one standard deviation

its value of institutional quality, property rights and power of creditor, its banking sector

would have been 10.10 percent more profitable over 1995-2008. In other words, the

economic significance of the various types of institutions holds strong over the years.

3.7 Policy Implications

The present study endows a growing literature related to the law and finance

theory. Its overall result suggests that banks are more profitable, as measured by ROA

and ROE, in countries with poor institutional quality. This confirms the finding of

Demirg-Kunt and Huizinga (2005) who find that banks have higher profit margins in

underdeveloped financial systems. Property rights have independent effects on bank

performance. Parallel to better performance of the banking sector in countries with

176
subpar institutions is the positive effect of better property rights protection on bank

performance, which is in turn positively influenced by institutional quality. It is also

observed that power of creditors is positively significantly associated with bank

performance. It appears that there are complementarities between power of creditors and

property rights institutions leading to a better performing banking sector.

The negative association between bank performance and institutional quality

suggests that in countries with sub-standard institutions banks face higher lenders risk.

The probability of default, moral hazard and adverse selection are high and that banks

require higher discount rates as they have shorter investment horizon. In other words, to

compensate for the ineffectiveness of the institutional framework, banks charge

significantly higher rates on lending and pay significantly lower rates on demand

deposits. This explains to a large extent why banks perform better in settings with poor

institutional quality. Ceteris paribus, it seems that there is a lesser need for banks in well

functioning institutional frameworks to charge exorbitant rates and generate abnormal

profits. The results signify that poor institutional quality makes financing more

expensive. Also, ineffective institutional structure implies that litigations amongst private

contractors do not settle with efficacy within an efficient legal framework. Further, this

indicates that the legality of the state actions vis--vis firms might not be successfully

challenged in the courts. The compounding resulting effect is a highly risky business

environment with higher bankruptcy costs for banks and their customers and increased

costs of borrowing (from banks to customers) and decreased costs of deposits for banks.

Therefore, countries with poor institutions might lag in the development of their

financial sector, and as a result, some projects with positive NPVs might not be financed.

177
In terms of policy formulation, a highly profitable banking sector should serve as a good

proxy for gauging a countrys overall institutional quality. Thus, policies focusing on

bettering the quality of the institutions will lead to cheaper financing and consequently

better developed financial sector. Demirg-Kunt and Huizinga (2005) find that banks

are less profitable as financial markets become more developed. Indeed, a more

developed financial sector brings about competition and thereby reduces financing costs

for firms and individuals. Fernandes and Kraay (2006) note that good institutional

performance led to the growth of public debt markets as private parties came to trust the

states promises to service public debt, which in turn catalyzed the development of

private financial markets in England.

All of our independent samples consistently show that a reasonable mix to

gauging the factors influencing the performance of the banking sector appears to be

institutional quality, power of creditor and property rights institutions. The evidence

bears out through a variety of datasets with numerous ways of measuring institutional

quality. For instance, using our WEF, we define institution following Acemoglu and

Johnson (2005) and Fernandes and Kraay (2006) as efficiency of the legal framework and

judicial independence as a proxy of contracting institutions. It seems that banks benefit

from weak institutions and that they are able to offset their risk, control their costs and

losses while generating profits. Further, a significant and positive relationship between

power of creditor and bank performance indicates that banks can not only fully pass on

their interest expenses to their bad customers but they are also in a position to grab

pledged collateral and convert them into financial resources. Similarly, the positive

association between property rights and bank performance highlights the power of the

178
banking industry even in poor institutional settings. This said, even in cases where

property rights laws are poor, banks assets are unlikely to be expropriated by the state

apparatus, and the more enhanced are private property protection laws the more

profitable is the banking sector.

The striking feature of our study is the negative association between bank

performance and institutional quality suggesting that poorer institutional quality is better

for the banking sector. The pattern is inconsistent with our expectation that better

institutional quality should lead to more profitable banking sector. The causal model

allows us to decompose the effects of institutions, property rights and creditors rights on

bank performance, however. It appears that most impact of power of creditor on banking

performance occurs through better institutional quality. Both property rights and

creditors rights emerge as intervening factors between institutions and bank

performance. It looks that if countries with weak institutional framework have more

profitable banking sector and underdeveloped financial markets, and therefore to lower

costs of financing, policymakers should seek to better the quality of their institutions. The

benefits of such policies are multifold. First, this would mitigate the effect of risk borne

by the banking sector leading to cheaper costs of financing. Such a result would have a

ripple effect on a countrys various economic sectors with potentials of trickling down as

financial and economic activities would simultaneously increase. A policy that is

especially important for countries where direct welfare from the public sector is scanty

and financial markets underdeveloped. Second, since the results show that both property

rights protection and power of creditors are significantly positively related to institutional

quality, then public policies aiming at strengthening institutions should lead to much

179
more stable banking sector since institutional enhancement bolters property rights

protection and empowers creditors.

3.8 CONCLUSION

This study inspects the relationships between bank performance, institutional

quality, property rights protection and creditors rights. It applies a structural equation

modeling technique to simultaneously test these different policy variables and assess their

impact on the banking sector. It tests the proposed model by carefully replicating the

results on different samples. Institutional quality is the most complex variable in our

different datasets. It is modeled differently in the literature and constructed in a variety of

ways. The most striking observation is that consistently, across our samples, institutional

quality has a negative relationship with bank performance. There is a strong tie between

bank performance and both better property rights protection and stronger power of

creditors. Though the task may not have been completed, the current study feeds the Law

and Finance literature and assesses the broader effects of these policies variables on the

most single economic sector, the banking sector, for most countries where financial

markets are embryonic or sometime inexistent.

In terms of policy implications, bettering a countrys institutions will lead to

sounder banking sector and it is this relationship that matters the most financially (with

regard to banks) and policy-wise (with regards to lowering cost of financing). Better

institutions reduce risk and improve capital allocation. This relationship evidences that

institutions affect the banking sector in a way that has not previously modeled. The

180
conundrum is that institutions have a negative impact on banks, which are more

profitable settings with ineffective institutions as they are compensated for risk.

However, the financial sector and the banking sector in these settings are rudimentary and

consist most of the time of a commercial banking sector and a central bank leaving the

business sector and finance seekers with measly choices related to costs of borrowing.

Furthermore, the relevance of the negative effect of institutions on banks lays in the fact

that riskier business environments hinder feeds the poverty trap, which has a tendency of

perpetuating itself in a structural way as more financial resources are extracted away

from any financed projects in ways that firms are unable to generate excess cash flows

while struggling to service their debts and coping with wider nefarious effects of

ineffective institutions affecting their operation and balance sheet at different levels. It

appears that the relationship between the banking sector and institutions suggests an

institutional failure in lieu of a market failure.

The study has some limitations that are worth pointing out. The negative impact

of institutions on bank performance represents a controversial issue more for legal and

institutional theorists than for financial theorists since asset pricing theories explain the

relationship between risks and expected returns. What is more opaque from a merely

theoretical point of view, however, why should improvement in institutional quality work

against bank profitability? Another point of hesitancy is that our study analyzes the

banking sector as a whole without distinguishing between types of banks in terms of

privately owned, state owned and specialized banks (commercial, investment, savings,

credit unions or cooperatives, savings and loan associations, etc.). Whereas the positive

relationship between bank performance, property rights and creditors rights is less

181
controversial, further research shall improve our understanding of the negative

relationship between bank performance and institutions especially from an institutional

point of view.

182
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 VITA

Graduate School
Southern Illinois University

Isaac Marcelin Date of Birth: May 26, 1973

335 Warren Rd, Carbondale, Illinois 62901

27, Rue lUnion, Rte Nle #1, Cap-Haitien, Haiti, HTT1110

isaacmarcelin@gmail.com

University Notre Dame of Haiti

Bachelor of Business Administration, June 2001

Southern Illinois University Carbondale

Masters of Business Administration, August 2007

Dissertation Title:
THE RELATIONSHIPS BETWEEN INSTITUTIONS, FINANCIAL DEVELOPMENT,
BANKING PERFORMANCE, PRIVATIZATION, AND GROWTH

Major Professor: Dr Ike Mathur

195