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p. 6 of 58 BACK | NEXT Purpose and Structure of the Toolkit Part One: Introduction and Overview I. The Financial Sector: An Overview A. The Role of the Financial Sector B. Financial Sector Development C. Law, the Financial Sector, and Economic Growth II. International Financial Standards and Standard-Setting Organizations III. Implementation and Monitoring Part Two: Preconditions and Infrastructure for Financial Sector Development Part Three: Financial Regulation and Supervision Part Four: Regional Financial Integration Part Five: ADB's Intervention in the Financial Sector Bibliography Glossary and List of Abbreviations Acknowledgements

Financial Sector Legal and Regulatory Toolkit : Part One: Introduction and Overview : I. The Financial Sector: An Overview

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C. Law, the Financial Sector, and Economic Growth

1. Rule of Law
2. Financial Sector and Economic Development
3. Law and Finance
4. Role of Law in Financial Development
5. Law and Finance and Legal Systems
6. Law, Finance, and Economic Development Today

Rule of Law

Law plays a variety of roles in societal organization and in governance, with governance systems relying on legal systems to structure institutional governance and economic organization.

The rule of law is a mix of technical or procedural components, as well as substantive moral content that encompass

• a system of government where institutions and officials are guided and constrained by the law, i.e., government that is accountable to, not above, the law;
• a body of laws that are transparent, reasonably predictable, validly derived, and fairly and equitably applied;
• laws, principles and procedures that protect those civil, political, and economic rights that have become enshrined as universal human rights; and
• a fair and effective legal system led by an independent and professionally competent judiciary that acts as the final arbiter of the law.

The term "rule of law" largely relates to process rather than substance and refers to a law that is

• created by a legitimate authority, certain, clear, publicly accessible, consistent, prospective, and commanding obedience;
• applied through transparent processes and principled reasoning, and subject to organized appeal;
• interpreted and monitored by an independent judiciary free of political control; and
• congruent with the behavior of administering officials.

Without a predictable, enforceable set of rules, uncertainty reigns in an economy. Without transparent legal rules enforced by a competent judiciary, the cost of business rises: raising capital becomes more expensive, entrepreneurs require higher risk premiums, and debtors do not repay debts because they know that laws and contracts are not consistently enforced. Societies that lack the rule of law suffer. Lack of confidence in law enforcement and fair, effective dispute resolution supervised by the courts leads to the creation of alternative institutions, opens the door to the criminalization of the economy and creates a fertile breeding ground for corruption. Therefore, the rule of law provides an essential framework for economic activity.

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Financial Sector and Economic Development

The financial sector plays a key role in supporting economic development. A sound financial system facilitates financial intermediation and resource allocation, which in turn support economic growth and development. It also reduces the risks of financial crises. A sound financial system is therefore essential for both financial stability and financial sector development.

Following the financial sector crises of the 1990s around the world and the current global crisis, international efforts have focused on the causes of the crises, their solutions, and prevention of future crises. Attention has also increasingly turned to the role of institutions in economic development, with recent research suggesting that institutions may in fact be the most significant factor.

Following are some key lessons to emerge from that experience:

• A reliable framework is essential to determine the rules of the game for financial transactions and to support financial sector development. Without an appropriate legal and institutional context based on law, financial markets cannot function.
• Weak financial sectors have been a significant cause of many financial crises. An adequate regulatory and supervisory framework is necessary to strengthen financial institutions and to help prevent the occurrence of crises. The current global financial crisis further highlights the dangers inherent in lax or improperly designed financial regulatory systems, even in the context of sophisticated financial sectors in developed economies.
• In the context of distress or crisis, an adequate framework supports the resolution of difficulties. In the absence of such a framework, crisis resolution becomes much more difficult, time-consuming, and expensive. In the context of the current global financial crisis, it is now widely agreed that one of the most significant problems has been the lack of effective frameworks to resolve large complex global financial conglomerates.
• Law, legal institutions, and regulatory and supervisory structures are fundamental to a sound financial system. There is emerging consensus with respect to the supporting institutions necessary for a sound financial sector, both domestically and internationally. As a result of the current global financial crisis, the content and operation of this framework is currently subject to major discussion at international, regional and domestic levels.

Part Three of this toolkit discusses the consensus that is emerging on these supporting institutions.

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Law and Finance

Today, the interaction between law and financial market development is characterized by the ongoing development of "law and finance" theory, which in many ways is a development of institutional economics and finance and growth research.

A 2003 World Bank Policy Research Working Paper [ PDF ] provides a concise summary on this interaction:

"The first part of the law and finance theory holds that in countries where legal systems enforce property rights, support private contractual arrangements, and protect the legal right of investors, savers are more willing to finance firms and financial markets flourish. In contrast, legal institutions that neither support property rights nor facilitate private contracting inhibit corporate finance and stunt financial development. The second part of the law and finance theory emphasizes that different legal traditions that emerged in Europe over previous centuries and were spread internationally through conquest, colonization, and imitation help explain cross-country differences in investor protection, the contracting environment, and financial development today. (Beck & Levine, 2003).

While certain aspects of this research are now being revised as a result of the global financial crisis, the crisis has at the same time strengthened the view of the important linkages between law, regulation and finance and the fundamental need to make sure that systems and incentives embedded in such institutional structures are appropriate for both financial stability and economic growth."

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Role of Law in Financial Development

There are two mechanisms through which law plays a role in financial development: the "political" mechanism and the "adaptability" mechanism.

• The political mechanism suggests that different legal systems embed differing relationships between the state and private property. (Glasser & Shleifer, 2002)
• The adaptability mechanism suggests that different legal systems have differing levels of flexibility and reactive ability to changes in economic circumstances and needs.

It is generally agreed that law and legal institutions have an important role in economic growth and financial development although there are ongoing discussions as to the state of play.

Nonetheless, the following important elements have been identified:

• Financial markets are better developed in countries with strong legal frameworks and effective enforcement mechanisms.
• National differences in financial development may be explained by a range of factors, including the origins of governing law, exemplified in the treatment of investor or property rights, or how legal systems adapt to commercial circumstances.
• The spread of legal traditions had enduring influences on national approaches to private property rights and financial development.

At the same time, the global financial crisis is causing a fundamental reevaluation of much research addressing the financial sector and definitive conclusions in the current environment are not presently possible.

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Law and Finance and Legal Systems

The legal environment and jurisdictional or regulatory differences in investor protection are strong determinants of the effectiveness of financial systems and can influence economic performance.

It is also argued that legal traditions significantly influence investor protection and market sophistication, including the view that common law traditions better support creditor rights and effective markets than civil law jurisdictions. This latter view however is subject to significant disagreement: Civil law states can sustain flourishing capital markets; some common law jurisdictions do the converse. European experiences since 1986 suggest that regional harmonization and mutual recognition of minimum standards can be effective despite varying legal and institutional settings.

Generally speaking, prior to the onset of the global financial crisis, there was general agreement that a permissive legal and regulatory approach to finance (most typically embodied in common law legal systems) was more conducive to financial sector development and economic growth than restrictive legal and regulatory approaches to finance (most typically embodied in civil law legal systems). However, as a result of the global financial crisis, which has emanated from the most permissive common law legal systems, the relative merits of restrictive versus permissive legal and regulatory approaches are being reevaluated.

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Law, Finance, and Economic Development Today

Generally speaking, the model of economic organization appears to be tending towards a regulated market and society.

Read more about the development of the regulatory state [ PDF ] (Glaeser & Shleifer, 2003).

The model of a regulatory society suggests that the government should step back from the economy and instead focus on the provision of "public goods." Classic public goods include defense, political stability, and economic policy. A wide range of other services have also been called public goods, including public utilities, education, justice/dispute settlement, social welfare, and environmental protection. As a result of the global financial crisis, it is now generally agreed that financial stability is a public good and one that requires attention at the domestic, regional and international levels. From the standpoint of economic development, clear and effectively protected property rights also constitute a public good.

In a regulatory society, there are a number of overriding issues of concern, such as:

• Role of the government in the society and the economy. How much control, influence, or participation is proper or culturally preferable? Is there a tendency or need for government to change in response to the shift in societal expectations?
• Regulatory societies' tendency towards complexity. How much complexity can exist before regulatory societies become ineffective?
• Forms of regulatory societies. There are competing models of a market economy, and each economy has various public and private institutions that differ among countries. The differences and their consequences for economic performance are the focus of "new comparative economics." (Djankov, et al, 2003)
• Fiscal policy and taxation. How are services to be paid, and by whom?

Today, law and regulation address all aspects of the economy and business, including enterprise establishment, management and operation, finance, and closure. Partnerships and companies require action of law in order to be effective. A wide range of regulations govern enterprise management and operation, particularly in relation to competition, consumer and employee protection, corporate governance, and accounting and auditing.

In finance, law also plays a key role in establishing fundamental property rights, general economic conditions, necessary infrastructure for the functioning of complex financial markets, basic rules of the game, and prudential regulation. There is increasing agreement on internationally acceptable minimum financial standards and underlying principles to address these issues. Part Three of this toolkit discusses these standards and underlying principles.

As a result of the global financial crisis, the role of the government in the financial sector has increased generally, especially in economies in which the government formerly played the role primarily of regulator only. It is certain that in the aftermath of the global financial crisis, the role of the government in the financial sector will change, with the general direction towards greater involvement than in the years prior to the financial crisis.

Back B. Financial Sector Development	Next II. International Financial Standards and Standard-Setting Organizations