Why did some countries develop larger capital markets than others?

The Evolution of Financial Markets Project uses new annual, macro-historical data on stock market capitalization, bank deposits and the output of the financial sector for eighteen advanced economies between 1870 and 2010 to shed light on this perennial question.

Legal origins theory claims that common law fosters investor protection and financial development. As countries' legal origins have been determined hundreds of years ago, this predicts that common law countries featured larger capital markets and larger financial systems than civil law countries throughout history. I show that these predictions hold in my data.

Stock Market Capitalization by Legal Origin

Stock Market Capitalization by Legal Origin

Common law countries had substantially larger capital markets than civil law countries since at least 1870. Stock markets in common law countries were twice as large in 1885, 50% larger in 1929, and two-to-three times as large as in civil law countries after World War II. Convergence between common and civil law countries prior to World War I, was followed by strong divergence immediately after World War I.

Output Share of Finance Industry by Legal Origin

Output Share of Finance Industry by Legal Origin

Common law countries featured substantially larger financial sectors than civil law countries since at least 1870. This results in a consistent and significant gap in the output share of financial industry between common and civil law countries. The relative size of the financial sector increased throughout the covered period in both groups.

Share of Bank Finance by Legal Origin

Share of Bank Finance by Legal Origin

Financial systems in civil law countries also heavily relied on banks, while capital markets have been dominant in common law countries. The relative share of bank finance in civil law countries has been significantly higher than in common law countries throughout the 19th and 20th century.

The gap between common law and civil law countries varies substantially over time. The size of capital markets converged prior to World War I. This was reversed once and for all immediately after World War I. The timing of this “Great Reversal” points towards a crucial role of World War I.

Great Reversal after World War I

Great Reversal after World War I

High levels of financial integration and free capital movement during the Gold Standard era, made substantial foreign listings at the London Stock Exchange possible. Listing at the LSE allows foreign firm to credibly commit to British corporate governance practices. Thus foreign listings act as a substitute for investor protection and thereby alleviate existing differences in investor protection across the world. As a result the size of capital markets in common and civil law countries converged prior to World War I.

Foreign Listings at the London Stock Exchange – 1870-1929

Foreign Listings at the London Stock Exchange – 1870-1929

Financial fragmentation, shocks to the capital stock and political uncertainty during and after World War I lead to the breakdown of international markets. Capital flows dwindled and European firms lost access to international capital markets. Financial markets were thrown back into the pre-gold standard era and reverted back to their pre-1900 long-run equilibrium. This led to divergence between common and civil law countries after World War I