Power of Haas Ideas

Stock Market as Spare Tire

In a banking crisis, stock markets can keep the economy churning

Banking crises make it harder for firms to obtain loans, threatening their profitability and survival. That’s when the stock market can act like a “spare tire”—by allowing firms to issue equity to keep capital moving so they can remain solvent and avert further damage to the economy. But strong shareholder protection laws that prevent fraudulent corporate behavior must already be in place, according to Prof. Ross Levine.

Levine and colleagues from the University of Hong Kong compiled data on over 3,600 firms across 36 countries that experienced at least one systemic banking crisis from 1990 through 2011. They factored in shareholder protections, firm profitability, and the duration of the banking crises.

During similarly sized banking crises, firms in countries with strong shareholder protection laws raised more money through stock sales, performed better in terms of profits and investment efficiency, and terminated fewer employees than similar firms in countries with weaker shareholder protection laws.

No matter how they cut the data, the evidence indicated that the ability to access stock markets when banks go flat has a big effect on businesses—and on the lives of ordinary workers. Their findings are forthcoming in the Journal of Financial Economics.

“The mechanisms are clear,” says Levine. “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.” —Pamela Tom

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Prof. Ross Levine Prof. Ross Levine