In some countries, banks are firms’ key source of financing. In others, firms look mainly to credit markets to meet their financial needs. Why should this be so? New research suggests that a country’s legal tradition strongly influences which financial system becomes dominant there.Banking law ; Finance

O. Emre Ergungor

English

Research Papers in Economics

W hat promotes economic develop-
ment? The question has puzzled econo-
mists for years. Recent research suggests
that a country’s financial system plays a
key role in its growth (see King and
Levine 1998 and Levine 1999). In some
countries—France and Germany, for
example—most firms borrow the money
they need from banks. In others—like the
United States and the United Kingdom—
firms most often turn to credit markets to
raise capital. Some anecdotal evidence
suggests that in the latter half of the
1990s, economies with market-based
financial systems grew more rapidly than
bank-based systems. But research shows
that over long periods, countries with
large banking industries do as well as
those with large financial markets. The
important factor is how well developed a
financial system is, not its type (see
Demirguc-Kunt and Maksimovic 1998
and Levine and Zervos 1998).
If that is so, why do some countries have
market-oriented financial systems while
others are oriented toward banks? One
strand of research suggests that a coun-
try’s financial system is influenced by
the path its industries took during the
industrial revolution. Another strand
traces countries’differences in financial
structure to differences in their regula-
tory environments. But neither approach
satisfactorily explains why banks pre-
dominate in some countries and markets
predominate in others. The missing
piece of the puzzle seems to be a coun-
try’s legal traditions, which determine
the structure of its financial system.
Countries that follow common law
(based on the law of England) are 
market-oriented, while those that follow
civil law (based on the law of France)
have a marked preference for banks.
This Commentary examines the role of
legal systems in determining the type of
financial system a country develops. It
describes the differences in how judges
interpret and enforce contracts under
civil law versus common law and how
those differences affect a country’s
financial system. Where civil law pre-
vails, the courts’literal interpretation of
contract language makes writing one-
time, bilateral contracts problematic and
requires involving a financial intermedi-
ary such a bank in the contracting
process. The wider discretion enjoyed by
common law judges in interpreting con-
tract language reduces the cost of writ-
ing contracts and favors market-oriented
financial systems. On the whole, differ-
ences in how countries make and apply
laws (that is, their legal traditions) may
be the most important factor shaping
their financial systems.
■ Civil Law versus
Common Law
Judges’power to issue opinions that go
beyond the literal interpretation of
statutes is an important difference
between civil and common law. Civil
law’s tradition of strict interpretation of
statutes and contracts dates to the French
Revolution. Accusations that corrupt
judges were betraying the people by sys-
tematically ruling in favor of the aristoc-
racy led to the enactment of Article 5 of
the French Civil Code of 1804, which
forbade judges to lay down general rules
in deciding cases. Continued mistrust of
judges strongly influenced the organiza-
tion of the courts, which were eager to
show their submissiveness to the new
order. The result—complete obedience
to the word of the law—became an inte-
gral part of the civil law tradition.
Under civil law, the judge’s duty is strict
application of the law as laid down in
codes and enactments. But no legislation
can be applied in a purely mechanical
way, so civil codes contain explicit
directions for interpreting texts. The
most famous of these interpretive direc-
tives is Article 1 of the Swiss Civil Code
of 1907, which instructs the judge that if
he can find no rule in enacted law, he
must decide in accordance with custom-
ary law and, failing that, in accordance
with the rule that he as a legislator would
adopt, consistent with approved legal
doctrine and judicial tradition. But dur-
ing the years the Swiss Civil Code has
been in force, Article 1 has rarely been
invoked. Swiss judges almost always
prefer to follow more traditional meth-
ods of interpretation, which involve logi-
cal and grammatical torture of the code
in search of a section that applies to the
issue at hand.
February 1, 2002*
Federal Reserve Bank of Cleveland
Legal Systems and Bank Development
by O. Emre Ergungor
ISSN 0428-1276
*Printed March 2002
In some countries, banks are firms’
key source of financing. In others,
firms look mainly to credit markets to
meet their financial needs. Why
should this be so? New research sug-
gests that a country’s legal tradition
strongly influences which financial
system becomes dominant there.In the common law tradition, however,
judges sometimes are required not only
to apply the law but also to interpret and,
to a degree, even create it. This creation
process has been described as “the dis-
covery of the old unwritten custom of
the land” (in the declaratory theory of
common law). Some legal scholars com-
pare common law to Newton’s laws of
nature, which had always existed; New-
ton, they say, did no more than discover
and label them (see Greenberg 1986).
Judges’rulings often rely on precedents
that were established by past decisions;
that is, judges can base their decision on
more than the specific terms of existing
laws, they can apply other judges’argu-
ments and interpretations, and they can
extend the general principles underlying
previous decisions to situations they
view as similar. In Law and Society,
Steven Vago claims the practice has sev-
eral strengths. Vago says it is often much
easier and less time-consuming to follow
precedents than to search all over again
for solutions that have already been
found by applying pre-existing laws.
Precedents also enable the judge to draw
on wisdom accumulated by earlier gen-
erations outside of legal statutes. Apply-
ing precedents is argued to minimize
arbitrariness and make it easier for less
experienced judges to issue fair deci-
sions. More important, it enables indi-
viduals to plan their conduct, secure in
the expectation that past decisions will
be honored in the future.
All this could lead us to suppose that
common law courts are more effective
in resolving conflicts than civil law
courts because they are freer to create
and interpret the law when the statues
are incomplete and do not address a 
particular situation. However, this 
argument may seem too strong because
Western European and North American
countries are known to have very effi-
cient judicial systems. But the most
commonly used measures of judicial
efficiency include factors like the speed-
iness with which a case is resolved in
court or judges’susceptibility to bribes.
In our context, “efficiency” is not 
measured by the number of cases 
heard or the amount of time and money
expended per case. Nor does it concern
judges’integrity. It refers to the interpre-
tive power of judges to go beyond the
letter of the law and the fact that codes
in civil law countries constrain judges
far more powerfully than those in com-
mon law countries (see Glaeser and
Shleifer 2001). 
■ Legal Systems and Financial 
System Development
One way to characterize a country’s
financial system is to look at the ratio
between loans by deposit-taking banks
and market capitalization. As this ratio
goes up, so does the importance of 
banks in the economy. By this standard,
figure 1 shows that in 1994, markets
were more important than banks in
economies like those of the United
States (with a ratio of 1.33), the United
Kingdom (1.22), Nigeria (0.85), 
Zimbabwe (0.78), Malaysia (0.68), and
South Africa (0.43). Banks were the 
key players in France (ratio of 6.57),
Austria (22.67), Egypt (5.50), the 
Philippines (4.50), Indonesia (3.20), 
and Argentina (4.14). 
The crucial point in figure 1 is that
countries whose legal systems are based
on common law have market-oriented
economies (with a low bank/market
ratio), and countries with legal systems
based on civil law are bank-oriented
(with a high bank/market ratio). Why 
is there a relationship between legal 
systems and financial systems when nei-
ther factor in itself seems to affect a
country’s per capita GDP (horizontal
axis of figure 1)? The answer may lie 
in differences in the way contracts are
written and enforced.
We know that it is practically impossible
for any contract to include a clause that
covers every contingency. Then how do
you settle disputes that arise when an
uncovered contingency becomes a real-
ity? You can go to court. This is a viable
alternative in common law countries
because judges are not strictly bound by
the clauses of the contract but feel free to
interpret them (or the laws for that mat-
ter) to determine whether the parties
acted in accord with the spirit of the con-
tract. One good example is contracts’
penalty clauses, which specify sanctions
for a party’s failure to abide by the terms
of the agreement. In the U.S. (common
law) legal system, penalty clauses are
generally inapplicable because the judge
determines whether a contractual
promise has been broken and, even if it
has, can alter the contractual penalty. 
But in civil law countries, contracts,
including penalty clauses, are strictly
enforced. Another good example is the
code that governs the distance between
buildings and trees in a community. In
civil law countries, a slight violation,
although reasonable and harmless to a
neighbor, compels destruction of the
building or eradication of the offending
tree. In common law countries, a stan-
dard of reasonableness guides the
judge’s decision (the second example is
from Mattei 2000).
Recent research shows that, in the civil
law tradition, restraints on judges’inter-
pretive powers affect the way contracts
are written and enforced. When a coun-
try’s civil law courts are not effective in
settling disputes between credit market
participants, banks emerge as institutions
that can resolve conflicts and enforce
contracts without a court’s intervention
(see Ergungor 2001 for a full discussion).
To see how banks mitigate contractual
problems, imagine that a borrower has
devised a fraudulent way to transfer
assets or profits. The lender has been
damaged, but a civil law court cannot
remedy the situation because the bor-
rower’s technique is not specifically cov-
ered in the statutes. In other words, the
borrower’s actions are immoral but not
necessarily illegal. Civil law courts do
not function this way because they are
negligent or incompetent but because,
unlike their common law counterparts,
they put more emphasis on the word of
the law than on fairness. This allows
insiders in civil law countries to struc-
ture unfair transactions that conform to
the letter of the law. Johnson et al.
(2000) confirm this behavior of civil law
courts in conflicts between minority and 
controlling shareholders when control-
ling shareholders transfer the assets and
profits out of the firm.
The economic effect of civil courts’limi-
tations is that would-be borrowers can-
not convince lenders that they will not
exploit them, so they cannot borrow
from capital markets. What advantage
does a bank have in these circum-
stances? It can make a credible commit-
ment to provide borrowers with a service
in the future that individual investors
cannot offer. For example, a bank can
promise to lend a customer money in the
future at a predetermined rate (a contract
known as a loan commitment). For rea-
sons similar to those that weaken
promises made by individual borrowers,
promises by individual lenders would
lack credibility: Individual lenders are
more inclined to opportunistic behavior
because even though they put their 
reputation and future business opportu-
nities at risk, they collect all the benefits
of their action. In contrast, shareholders■ Conclusion
The orientation of a country’s financial
system seems to be influenced by that
country’s legal system: Firms in com-
mon law countries are more likely to
use credit markets, and firms in civil
law countries prefer banks. This Com-
mentary examines the reasons for this
difference and argues that banks can
mitigate a legal system’s ill effects on
financing. Banks can use both carrot
and stick to restrain opportunistic bor-
rowers from exploiting legal loopholes;
in doing so, banks allow credit markets
to function properly. This ability gives
banks a crucial role in the economy in
addition to their traditional role as liq-
uidity providers.
Malaysia
Hong KongSingapore
United States
Chile
South Africa
Zimbabwe
Thailand
India
United Kingdom
Australia New Zealand
Canada Pakistan
Israel
Brazil
Mexico
Peru
Sweden Colombia
Korea
Turkey
Netherlands
Belgium Japan
Indonesia
Denmark
Argentina Norway Switzerland
Philippines
Finland
Egypt
France
Greece
Spain
Italy
Portugal Germany
Austria
Nigeria
5
10
15
20
25
05 1 0 15 20 25 30 35 40
Per capita GDP (thousand of dollars)
Bank / market ratio
0
Common law legal tradition
Civil law legal tradition
FIGURE 1 RATIO OF BANK LOANS TO STOCK MARKET
CAPITALIZATION VERSUS PER CAPITA GDP, 1994
■ Recommended Reading
Allen, Franklin, and Douglas Gale.
1999. “Diversity of Opinion and
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Allen, Franklin, and Douglas Gale.
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Financial Systems, Cambridge: The
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Boot, W. A. Arnoud, Anjan V. Thakor,
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Bank-Based Financial Systems: Do
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Reserve Bank of Cleveland, Working
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of an institution would have to share
those benefits with all the other share-
holders, while each individual share-
holder has his entire reputation at risk
(see Boot, Thakor, and Udell 1991).
The ability to offer services that mar-
kets cannot offer gives banks superior
bargaining power. Banks can restrain
borrowers’opportunistic behavior with
a credible threat to withhold unique,
valuable services. All market partici-
pants anticipate that a borrower who
has a relationship with a bank will
honor his obligations in order to pre-
serve that relationship. Thus, banks
prevent credit market failure.
SOURCES:  Levine (1998); and La Porta et al. (1997).Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Material may be reprinted if the source is
credited. Please send copies of reprinted
material to the editor.
O. Emre Ergungor is an economist at the
Federal Reserve Bank of Cleveland. 
The views expressed here are those of the
author and not necessarily those of the 
Federal Reserve Bank of Cleveland, the
Board of Governors of the Federal Reserve
System, or its staff. 
Economic Commentary is published by the
Research Department of the Federal Reserve
Bank of Cleveland. To receive copies or to be
placed on the mailing list, e-mail your
request to 4d.subscriptions@clev.frb.org or
fax it to 216-579-3050. Economic Commen-
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of terms are provided.
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LaPorta, Rafael, Florencia Lopez de
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Mattei, Ugo. 2000. Comparative Law
and Economics. Ann Arbor: The Uni-
versity of Michigan Press.
Vago, Steven. 2001. Law and Society.
Upper Saddle River, N.J.: Prentice Hall.

Legal systems and bank development

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