Strict laws can save banking crises blues

In countries with strong legislation to prevent fraudulent corporate behaviour, banking crises have a less severe impact on firms and the economy in general, says a new study.

Banking crises make it harder for firms to obtain loans, threatening their profitability and survival.

That is when the stock market can act like a "spare tyre" -- by allowing firms to issue equity to keep capital moving so firms can remain solvent and avert further damage to the economy.

But strong shareholder protection laws must already be in place, according to study co-author Ross Levine, a professor from University of California-Berkeley.

"A spare tyre is an alternative source of external financing during a crisis. If everything is okay, we would not put the spare tyre on. But if you get a flat, you are glad that you have a spare," Levine said.

The study builds upon a conjecture by Alan Greenspan, former chairman of the Federal Reserve.

In 1999, Greenspan argued that the banking crisis in Japan and East Asia would have been less severe had those countries built a legal infrastructure to allow stock markets to provide corporate financing when the banks could not.

The researchers compiled data on over 3,600 firms across 36 countries that experienced at least one systemic banking crisis from 1990 through 2011.

They also factored in shareholder protections in the sample countries, firm profitability, and the duration of the banking crises.

"The mechanisms are clear. When a country has stronger shareholder protection laws, people are more enthusiastic about buying shares in firms because corporate insiders are less able to take advantage of small investors and this enthusiasm translates into more money for firms, allowing them to weather banking crises more effectively," Levine said.

The paper is scheduled to appear in the Journal of Financial Economics.