In the wake of such scandals as Bremer Vulkan and Metallgesellschaft in Germany, Banesto and Seat in Spain, and Ferruzzi in Italy, reform of corporate governance has become a priority for European policy-makers. What’s more, there is growing pressure from outside Europe, as many US-based institutional investors diversify their portfolios and begin to question incumbent management. Increasingly too, there is pressure from within, as European countries seek to restructure their pension systems.

But the corporate governance problem is not straightforward. In the UK, as in the US, it can be summarized as ‘weak owners, strong managers’; in continental Europe, it is better characterized as ‘strong blockholders, weak minority investors’. In the latter case, the notion of ‘shareholder value’, often presented as the guiding principle for corporate governance, is much less clear when large blockholders are able to exploit minority investors.

Solutions to these problems are currently being sought both by individual countries and by the EU itself. But recent research suggests that reformers should tread carefully. Corporate law and corporate finance are intimately related, often in ways that economists and other analysts do not yet fully understand. Reforms may thus have unexpected effects, as Erik Berglöf shows in a recent article in Economic Policy.

Recent research by La Porta et al clearly establishes the link: countries with strong legal protection of minority shareholders have less concentrated ownership of equity than countries where the rules leave more discretion to managers and controlling investors. What’s more, the patterns of finance and law are determined by history, in particular their legal origins: for example, on most accounts, investors in countries with laws of French origin fare worse than their counterparts in legal systems of German or Anglo-Saxon origins.

The connection between corporate law and corporate finance is vital for economic growth. A 1993 paper by King and Levine, for example, claims that financial development is the single most important explanation of differences in economic growth among countries. In a paper presented to CEPR’s Corporate Governance network, Rajan and Zingales suggest that financial development affects industrial development: industries with large external finance requirements are less developed in countries with weak securities markets. And another paper by La Porta et al links financial development to investor protection and hence to legal origins: countries with French-style corporate laws tend to have less developed securities markets.

But despite legal differences, corporate financing patterns in Europe are actually much more similar than is generally believed: in most countries, internal finance is the most important source of funding for firms; debt is the most important external source; and the net contribution of equity finance to the corporate sector is rather limited.

The real differences across countries lie in the patterns of ownership and control. In continental Europe, ownership is concentrated and investors are ‘control-oriented’, giving up opportunities for diversification to take on large stakes in individual companies. In contrast, the UK corporate landscape is dominated by dispersed owners with ‘arm’s-length’ relationships with the firms they own. As might be expected, these differences in ownership and control are matched by important variations in corporate legal structures.

The actual mechanisms for corporate governance also differ between control-oriented and arm’s-length systems. In control-oriented systems, any initiatives for change come from large investors or creditors with a close long-term relationship with the firm. This has implications for the role of corporate institutions: the board of a firm where one owner controls the majority of shares cannot be expected to act as an independent monitor of management.

In systems dominated by arm’s-length finance, corrective actions are often initiated by outsiders. Nevertheless, contrary to commonly held beliefs, hostile takeovers are rarely important in disciplining firms. In most countries, they are extremely unusual, and even in the UK, they do not normally target poorly performing firms. Work published in 1995 by Franks, Mayer and Rennebog suggests that corrective actions in such firms tend to be initiated by a single investor, often another company, with a large blockholding. This is much as in continental Europe.

Moreover, the turnover of controlling stakes is higher in control-oriented governance systems than is generally believed: the difference is that these transactions typically take place outside the official exchanges. It is also a misconception that control is never challenged in these countries. Research earlier this year on Germany by Jenkinson and Ljungqvist documents several cases where outsiders have been able to implement policies hostile to controlling investors and incumbent management, often with the help of the company’s house bank.

So what are the implications of this research for plans to reform European corporate governance? Certainly, any attempts at reform must take into account the links between corporate governance and corporate law. But perhaps more importantly, national differences must be recognised, especially between the UK and continental Europe. Different problems require different solutions and any EU-wide reform is likely to fail even if it were able to gain the necessary political support. A ‘voluntary code of conduct’ is also probably a non-starter: the European Commission is unlikely to give up its right to regulate in this area and in any case, such a code would tend to attract large firms that already meet the requirements.

Instead, Berglöf argues, reform should have a national focus and if a single guiding principle is needed, protection of minority investors is probably the best choice. At the same time, it is important to recognise that there are costs to protection: maximum protection is not desirable since managers and controlling owners need some degree of discretion as well as incentives to work effectively.

An important goal of any financial system reform should be to make securities markets more liquid. But liquidity should be pursued directly, not through restrictions on investors’ ability to exercise governance. Making institutional investors more active may be important in the UK, but it is not the most urgent issue elsewhere in Europe at the moment. US-based institutions are likely to take the lead, but as pension reform proceeds, the new European pension funds must also become active investors.

If there is to be a European corporate governance policy, the focus should probably be on transparency of ownership and control arrangements, Berglöf concludes. For example, an investor buying stocks in a firm that is part of an Italian pyramid, or in a Dutch firm with golden shares, will have difficulties in evaluating the investment.

The EU’s Transparency Directive is an important first step towards greater transparency. But as recent work by European researchers on corporate governance shows, a great deal remains to be done. Examples from Austria, Germany and the Netherlands demonstrate the weaknesses in the implementation of the directive so far.