European Economic Perspectives 28

Protection Rackets

Why does the degree of legal protection enjoyed by shareholders vary so much across countries? New CEPR research suggests that the explanation lies in the differences between national political systems.

There are considerable cross-national differences in the degree to which shareholders are protected against the opportunistic behaviour of managers. But there is also growing evidence that better protection encourages more abundant external equity for companies, which translates into broader stock markets and more dispersed share ownership.

So why don’t all countries design their legal systems to maximize shareholder protection and financial market development? That is the question addressed by Marco Pagano and Paolo Volpin in a recent CEPR Discussion Paper. ‘Politics’ is the obvious answer: legal rules are established via the political process. But how exactly do politics affect the design of legal systems?

Pagano and Volpin take the view that political decisions about legal rules are based on economic interests. Can this view offer a theoretical explanation for the observed international differences in investor protection, as well as their persistence? The issue of legal reform cannot be faced without such a theory. To know if and how investor protection can be improved in a given country, it is first important to understand how it arrived at its current degree of protection.

The researchers develop a stylized model of a country with three classes or social groups: entrepreneurs, rentiers and workers. Entrepreneurs hold a controlling stake in their companies, while rentiers – and possibly workers – are minority shareholders. Once entrepreneurs have set up their firms, a political decision can change the regime of investor and employee protection. So when signing financial and labour contracts, people must take account of the expected outcome of such a decision. In particular, the amount of external equity finance and its price are affected by the legal regime expected to prevail.

In the model, the political preferences of each group are shaped by economic motives. Rentiers – and workers insofar as they hold shares – want high investor protection so as to reduce the private benefits extracted by managers. Entrepreneurs, in contrast, prefer low investor protection. As initial owners of their companies, they ultimately bear the cost of low protection, namely reduced availability of equity capital. But this is a sunk cost at the time of the political decision: once the company has raised external equity, entrepreneurs want to lower protection to increase their private benefits.

If the political debate is only about investor protection, the outcome will be high investor protection since entrepreneurs are a political minority. But the debate may involve other issues such as employment protection, notably employers’ freedom to fire workers. And only one group – employed workers – wants high employment protection.

With two issues on the political agenda, political alliances are possible. In particular, entrepreneurs may strike a deal with workers in which high employment protection is exchanged for low investor protection. Such a ‘corporatist’ arrangement would be mainly at the expense of rentiers, who would prefer low employment protection and high shareholder protection.

According to the model, the structure of the political system determines whether there is a corporatist outcome. If each social group is represented by a political party (none of which holds the majority of votes), this outcome will emerge if parties can vote jointly on the issues of shareholder and employee protection. Such a joint vote requires a coalition submitting a multidimensional political platform to a vote.

This implies that a combination of low investor protection and high employment protection will be associated with institutional settings where coalition governments are prevalent and the government is subject to a confidence vote. If instead parties vote on the two issues separately, high shareholder protection will get the votes of rentiers and workers, and low employee protection those of rentiers and entrepreneurs. In this case, there is a ‘non-corporatist’ outcome of high investor protection and low employee protection – the rentiers’ favourite regime.

These predictions from the model are consistent with the empirical evidence for OECD countries. Continental European countries and Japan, whose governments are generally formed by coalitions and subject to a vote of confidence, have low investor protection and high employment protection. In contrast, Anglo-Saxon countries, whose political systems have the opposite features, have high investor protection and low employee protection.

The researchers also analyse a model of political competition where parties do not coincide with specific social groups. Instead, two ‘non-ideological’ parties design their platforms to compete for the support of all voters. In this model, the diffusion of equity ownership among voters is the key influence on the political outcome. If equity ownership is widely dispersed, parties will converge on a platform that favours shareholder rights and low employment security. But if equity ownership is concentrated, parties converge on the same regime as in the corporatist outcome. Although internationally comparable data about the diffusion of equity ownership are sparse, the existing evidence is broadly consistent with this prediction.

This article discusses research reported in ‘The Political Economy of Corporate Governance’, CEPR Discussion Paper No. 2682 (January 2001) by Marco Pagano and Paolo Volpin. Pagano is at the Università di Salerno and Co-Director of CEPR’s Financial Economics programme; Volpin is at the London Business School.

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