Explaining the effect of financial development on the quality of property rights

• Author: Niloy Bose,Chandramouli Banerjee,Chitralekha Rath
• Published date: 01 May 2019
• Date: 01 May 2019
• DOI: http://doi.org/10.1111/rode.12580

REGULAR ARTICLE

Explaining the effect of financial development on

the quality of property rights

Chandramouli Banerjee

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Niloy Bose

2

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Chitralekha Rath

1

1

University of Wisconsin-Milwaukee,

Milwaukee, Wisconsin

2

Virginia Tech., Blacksburg, Virginia

Correspondence

Niloy Bose, Department of Economics,

Virginia Tech., Blacksburg, Virginia, VA

24061.

Email: nbose@vt.edu

Abstract

Empirical evidence suggests that financial development

can catalyze property rights reforms. This paper offers a

theory of financial markets to explain these facts defining

the relationship. The explanation is based on a simple

trade-off between the costs and the benefits of securing

property. Securing the right to property at a cost allows

agents to post collateral against loans. However, the bene-

fits of collateral vary according to the existing credit mar-

ket conditions, which we take into account in the tradeoff

between the costs and the benefits of securing property

rights along the path of financial development to explain

the conditions under which financial development can

create incentives for better property rights institutions.

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INTRODUCTION

There is a consensus that property rights encourage investment (Besley, 1995; Knack & Keefer,

1995; Johnson, McMillan, & Woodruff, 2002), entrepreneurship (Murphy et al., 1991) and innova-

tion (Furman, Shleifer, & Vishny, 2002). Researchers have also recognized that a system of stro ng

property rights can enhance efficiency in financial sectors. This is intuitive since legislation pro-

tecting property often encompasses financial contracts (PortaLopez-de-Silanes, Shleifer, & Vishny,

2002; Claessens & Laeven, 2003; BeckDemirgüç-Kunt, & Maksimovic, 2005), and even when it

does not, it can improve contracting efficiency by allowing borrowers to pledge collateral (Djan-

kovMcLiesh, & Shleifer, 2007; De Soto, 2000; Besley & Ghatak, 2009). In this paper, we argue

that the extent to which properties can be effectively collateralized depends not only on the exist-

ing laws but also on the private initiatives to uphold such laws. Significantly, such initiatives are

closely tied to the existing credit conditions and beyond a certain level of financial development, a

more mature financial market can generate additional incentives to secure rights to property.

At the heart of this paper lies an important distinction between the property rights law s that

exist on the book and the effective property rights. We view the later as being jointly determined

DOI: 10.1111/rode.12580

Rev Dev Econ. 2019;23:957–974. wileyonlinelibrary.com/journal/rode © 2019 John Wiley & Sons Ltd

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by the laws that exist on books and by the costly initiatives undertaken by individuals who uphold

such laws. For example, there may exist a law that makes encroachment upon privately held land

illegal. Yet, an individual must undertake a variety of costly procedures such as surveying the

land, drawing up a legal deed, notarizing the deed in court, etc. to uphold such a law . Similarly,

putting a fence up around the property or undertaking other costly legal measures to prevent tres-

passing is a common and an effective private initiative among land owners to pre-emptively pro-

tect against encroachment and to uphold the laws that exist on the book. Thus, private initiatives

do shape the effectiveness and the quality of property rights institutions and whatever the de jure

condition of property right protection may be, it is the de facto outcome that we focus on this

paper.

1

With this in mind, our theoretical construct appeals to a broad belief that the quality of institu-

tions, including property rights, is not impervious to the changes in prevailing economic and social

conditions.

2

For example, the models of institutional change advocated by Demsetz (1967) and

North (1981) suggest that institutions evolve once the economic and/or social gains from institu-

tional change exceed the costs of not doing so. Both argue that technological innovation and the

development of new economic markets lead to the introduction of new institutional arrangements

or the reform of existing arrangements. We build on these ideas and argue that a changing eco-

nomic environment induced by financial developments can shape the evolution of property rights

by altering the tradeoff between the costs and the benefits of protecting property.

To fix the idea, consider a simple model of financial intermediation where individuals must

access external funds to operationalize investments and where asymmetric information between

borrowers and lenders opens up the possibility of some borrowers being denied loans. Faced with

this possibility, individuals can post assets as collateral to improve the terms and conditions of the

loans they receive.

3

However, before they do, these individuals must safeguard their assets and

must establish legal rights over these assets at a cost. The extent to which the individuals are will-

ing to establish their rights then determines the effective quality of the property rights in a society.

Clearly, an individual's decision depends on the tradeoff between the cost of securing the right to

ownership and the expected benefit from posting collateral, which in this case is measured by an

improved access to credit. We argue that in a situation where the credit market condition is poor,

posting collateral does not significantly improve an access to credit. There is a large body of evi-

dence to support such a claim. For instance, Feder, Onchan, and Raparla (1988) and Feder and

Nishio (1998) report that the impact of titling on credit access is relatively unimportan t in areas

where the depth of the formal credit market is shallow and where informal lending is predominant.

Carter, Wiebe, and Blarel (1994) and Mushinski (1999) identify a credit impact only for medium

and large farm owners who presumably have existing connections to the formal credit market. Dei-

ninger and Goyal (2012) show that computerizing the land registry has had an effect on borrowing

in the urban area but not in rural areas that typically have relatively poor access to credit. The pat-

tern is also evident in cross-country studies. Djankov et al. (2007) finds that improvements in

rights that affect the ability of borrowers to use collateral are strongly and positively correlated

with credit market development in a cross-section of countries. In a poorly functioning credit mar-

ket, the ineffectiveness of collateral offers little incentives for individuals to establish effective

rights over property. However, as the credit market improves, so does the benefits from posting

collateral leading to higher incentives to safeguard and establish legal rights over assets. In this

paper we seek to model this endogenous evolution of property rights along the path of financial

development.

In theory, the changing tradeoff between the costs and the benefits of protecting property along

the path of financial development can give rise to various relationships between the financial

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