Why the Rule of Law Matters for Financial Stability: Insights from International Comparison

This study examines how the rule of law shapes credit market stability, focusing on volatility as a vital dimension of the financial cycle. Moving beyond the scale of credit, the analysis highlights credit volatility as an institutional outcome reflecting the collective risk perceptions, expectations, and discretionary behaviors inherent in the legal environment. To this end, it empirically tests the substantive link between the rule of law and credit dynamics, which has often been dismissed as merely rhetorical or symbolic. Using panel data from 70 countries from 1980 to 2023, this study finds that a stricter rule of law, measured by internationally recognized indices, is significantly associated with lower bank credit volatility. By distinguishing between short-term fluctuations and long-term structures, the empirical analysis demonstrates that the influence of the rule of law on credit fluctuations is a long-term phenomenon rather than a short-term effect. The analysis employs panel methods with robustness checks to assess the relationship between institutional quality and credit volatility. Consistent with prior literature, the rule of law is also positively associated with credit depth. The results suggest that well-functioning legal institutions are linked to credit market stability. By demonstrating the tangible effects of the rule of law on financial outcomes, this study contributes to the ongoing debates on its practical relevance and provides policy implications for enhancing macro-financial resilience.