The authors conduct the first assessment of the role of shareholder protection laws in shaping firms’ responses to a banking crisis. When economies experience a systemic banking crisis, pre-crisis shareholder protection laws shape how firms respond to the crisis in terms of equity financing, profitability, employment, and investment efficiency. The authors find that firms in countries with stronger shareholder protection laws tend to experience a smaller drop in equity issuances, profits, employment, and investment efficiency. The results are particularly strong for firms that depend heavily on external financing.

Shareholder protection laws shape the functioning of stock markets and the efficiency of corporate investments, but previous researchers have not assessed whether shareholder protection laws influence how firms respond to a banking crisis. When banking systems fail, the flow of bank credit to firms is disrupted, with harmful effects on investment, employment, and economic growth. The authors build on a 20-year-old conjecture by Alan Greenspan, former chairman of the Federal Reserve Board, suggesting that stock markets could mitigate these negative effects by providing an alternative corporate financing channel to corporations when their banking system goes “flat.”

Even when controlling for the reduction in bank lending during crises, the authors find that among firms in countries that rely more heavily on external financing, equity financing falls by less following the onset of a systemic banking crisis in economies with higher values of the anti-self-dealing index. After the start of a banking crisis, 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.

These results reflect shareholder protection laws and not levels of financial or legal institutional development. Shareholder protection laws do not account for cross-country differences in the severity of banking crises (i.e., they do not influence the severity of crises). Regardless of the size of the crisis, firms tend to increase equity issuances more when stronger shareholder protection laws allow firms to issue equity to keep capital moving so they can remain solvent and avert further damage to the economy.

The authors use firm-level data from 3,600 manufacturing firms in 36 countries over 1990–2011. US firms are excluded from testing and serve as the benchmark. The test covers three core predictions that emerge from the authors’ “spare-tire” view. The first prediction is that if firms can issue equity at low cost when a banking crisis limits the flow of bank loans to firms, doing so will ameliorate the impact of the banking crisis on firm profits and employment. Second, when a systemic banking crisis reduces lending to firms, the benefits of a sound stock market will accrue primarily to firms that depend heavily on bank loans. Third, the spare-tire view stresses that the ability of the stock market to provide financing during a banking crisis—not the size of the market before the crisis—is what matters for how well stock markets reduce the harmful effects of banking crises on corporate performance. Bank loans might be the preferred source of financing in normal times, but the spare-tire view holds that when that source goes flat, equity issuances can substitute.

By examining what happened to many firms over two decades and across an assortment of time-varying country and firm characteristics, the authors can rule out many other potential explanations for why firms in different countries respond differently to crises—for example, differences in the size of the crisis, the level of economic development, the sophistication of financial markets, the potential role of other laws, and accounting protocols. The authors assess these predictions by combining several datasets and using a difference-in-differences methodology to examine what happens to firm equity issuances, profitability, and employment.

The authors study the effects of regulation on the finance industry, focusing on banking crises that make it harder for firms to obtain loans, which threatens their profitability and survival. No matter how the authors cut the data, the effects are large. In countries with comparatively sound shareholder protection laws, the adverse impact of a systemic banking crisis on firm profitability and employment is one-third less severe than in countries with weaker protections for small shareholders. When a country has stronger shareholder protection laws, investors are more enthusiastic about buying shares in firms because corporate insiders are less able to take advantage of small investors; this enthusiasm translates into more money for firms, allowing them to weather banking crises more effectively.