Testing Greenspan’s ‘Spare Tire’ Hypothesis: Benefits of Shareholder Protection Laws during Banking Crises

Shareholder protection laws have been praised for their positive impacts on stock market development, liquidity, efficiency of corporate investments, and overall economic growth. These laws help ensure that majority shareholders and management do not expropriate resources from minority shareholders, thus encouraging investment from minority investors and allowing companies to use equity issuance as an alternative source of financing when bank loans are unavailable. Former Federal Reserve Chairman Alan Greenspan also suggested that these laws could have acted as a “spare tire,” for Japan and East Asia during the 1997 banking crisis, and could have helped mitigate the severity of its economic and financial consequences. In, “Spare Tire? Stock Markets, Banking Crises, and Economic Recoveries,” authors Ross Levine, Chen Lin, and Wensi Xie analyze firm-level data from approximately 3,600 companies in 36 countries between 1990 and 2011 to test the validity of this “spare tire” hypothesis.

The authors evaluate several interrelated implications of this hypothesis. First, they review the premise that firms in countries without strong shareholder protection laws will have more limited ability to issue equity at low cost and will therefore suffer more during a banking crisis than firms that can access this alternative source of financing.

Levine, et al. use the Anti self-dealing index, a measure that evaluates the degree to which nation-level legal systems protect minority shareholders from self-dealing transactions between management and controlling shareholders, as a proxy for the strength of shareholder protection laws in a particular country. A higher index value indicates that outside investors will feel more confident about investing in these companies. Highly rated firms can more easily substitute bank financing with equity issuance during banking crises. Consistent with the spare tire hypothesis, the authors find that decreases in firm profitability and employment during a crisis are 36 percent and 15 percent smaller, respectively, in economies with above average index values.

The second implication of this hypothesis is that firms which rely less on external financing (e.g. bank loans or equity issuance) will benefit less from these laws. Indeed, the authors find that shareholder protection laws more significantly impact firms with high external financial dependence than firms with low financial dependence. For example, in the analysis of one measure of firm profitability (the ratio of EBIT to assets), the impact of shareholder protection laws was nearly six percent larger for firms that depended heavily on external financing.

Finally, the authors test the implication that shareholder protection laws do not impact the size or liquidity of the market prior to the banking crisis, but instead their benefits occur during a crisis when bank loans are not readily available. Levine, et al. evaluate whether firms in countries with stronger shareholder protection laws issue more equity during bank crises. Again, the results are consistent with the spare tire hypothesis, showing that firms in these countries issue additional equity during crises that is equivalent to 0.8 percent of their total assets, which is seven times larger than the median equity percentage in the sample. In addition, all additional equity issuance in these countries is attributable to firms with high financial dependence on external sources, reinforcing the validity of the second implication of the spare tire hypothesis.

Despite the prominence of Greenspan’s “spare tire” hypothesis, a formal analysis of this theory had not been conducted prior to this evaluation. Data from multiple firms, countries, and years do indeed support this hypothesis. Analysis provides additional support for the economic and financial benefits of developing the legal infrastructure to protect minority shareholders. Instead of satisfying the personal interests of management or controlling shareholders, these laws help ensure the longevity and success of the company as a whole, in addition to the economy more broadly.

Article Source: “Spare Tire? Stock Markets, Banking Crises, and Economic Recoveries,” Ross Levine, Chen Lin, and Wensi Xie, National Bureau of Economic Research, Working Paper, January 2015

Feature Photo: cc/(David Blaikie)