This paper offers the first comprehensive analysis of legal change in the protection of shareholder and creditor rights in transition economies and its impact on the propensity of firms to raise external finance. Following La Porta et al. (1998), the paper constructs an expanded set of legal indices to capture a range of potential conflicts between different stakeholders of the firm. It supplements the analysis of the law on the books with an analysis of the effectiveness of legal institutions. Our main finding is that the effectiveness of legal institutions has a much stronger impact on external finance than does the law on the books, despite legal change that has substantially improved shareholder and creditor rights. This finding supports the proposition that legal transplants and extensive legal reforms are not sufficient for the evolution of effective legal and market institutions.

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This paper offers the first comprehensive analysis of legal change in the protection of shareholder and creditor rights in transition economies and its impact on the propensity of firms to raise external finance. Following La Porta et al. (1998), the paper constructs an expanded set of legal indices to capture a range of potential conflicts between different stakeholders of the firm. It supplements the analysis of the law on the books with an analysis of the effectiveness of legal institutions. Our main finding is that the effectiveness of legal institutions has a much stronger impact on external finance than does the law on the books, despite legal change that has substantially improved shareholder and creditor rights. This finding supports the proposition that legal transplants and extensive legal reforms are not sufficient for the evolution of effective legal and market institutions.JEL classification: G15, K22, K42, O16, P51.

In this article we examine the determinants of institutional change using a panel dataset comprising 25 transition economies. A defining characteristic of our approach is that we treat institutional change as a multidimensional unobserved variable, accounting for the fact that each of our indicators represents a noisy signal. Our results suggest that institutional change is significantly path dependent. However, policy can to some extent break this dependence through economic and political liberalisation at the start of the transition and with the help of an external anchor such as EU accession. Copyright 2007 The Author(s). Journal compilation Royal Economic Society 2007.