This paper is a theoretical analysis of bank-based and market-based financial systems in economic growth and development. We are motivated to study this issue because of a long-standing debate on the relative importance of the two systems. The success of market-based systems in the US and UK have led some observers to tout their virtues, while others have advocated bank-based systems because of their vital role in German and Japanese industrialization. Eastern Europe and Latin America’s financial liberalization of the 1990s has revived this debate market-based systems are being seen as more dependable for growth and development.
We examine this debate in an endogenous growth model where a financial system emerges endogenously from firm-financing choices. We show that two countries with different financial regimes may enjoy similar rates of economic progress; what matters for growth is the efficiency of the country’s financial and legal institutions, rather than the type of its financial system. But from the perspective of developing a traditional economy into a modern, industrialized one, a bank-based system outperforms a market-based one.
With the availability of systematic evidence during the past decade, the relevance of finance for development is now widely accepted (Levine, 1997). Concurrently, an extensive theoretical literature on financial institutions has developed. While research in corporate finance has examined firm financing choices, growth theorists have studied the role of finance in capital and knowledge accumulation.
In corporate finance, the organization of financial activities is seen to affect growth through corporate governance and a firm’s ability to raise external funds. Financial intermediaries reduce costs of acquiring and processing information about firms and their managers and thereby reduce agency costs by assuming the role of ‘delegated monitors’ (Boyd and Prescott, 1986; Diamond, 1984). For instance, Holmstrom and Tirole (1997), distinguish between bank and market-finance according to their information content: bank monitoring resolves moral-hazard problems at the level of the firm. Firms with lower marketable collateral and higher incentive problems borrow from banks, while wealthier firms rely on unintermediated market-finance. Hence, as Boot and Thakor (1997) point out, bank lending is likely to be important when investors face ex post moral hazard problems, with firms of higher observable qualities borrowing from the capital market.
Some authors have also highlighted how market finance creates appropriate incentives for a firm. In Scharfstein (1988), equity markets encourage corporate governance through hostile takeovers of under-performing firms. Rajan and Zingales (1998b, 1999) argue that market-finance transmits price signals which guides firms into making worthwhile investments. Relationship-based bank finance, in contrast, could lead firms facing weak cash flows to undertake misguided investments.
Among contributions on finance and growth, Greenwood and Jovanovic (1990), Bencivenga and Smith (1991) and de la Fuente and Marin (1996) show how financial intermediaries promote growth by pooling risks, providing liquidity and monitoring risky innovations. Greenwood and Smith (1997), on the other hand, analyze how financial markets assist growth through increased special ization. But growth theory has been largely silent on the ‘bank versus market’ debate, stressing the importance of either banks or financial markets. In recent years, policymakers have been advocating a shift toward financial markets, especially in Latin America and Eastern Europe where financial systems similar to those in the US have been proposed (Allen and Gale, 2000). It is unclear, though, why market-based systems necessarily dominate bank-based ones. As Levine (1997, pp. 702-703) points out, “we do not have adequate theories of why different financial structures emerge or why financial structures change...we need models that elucidate the conditions, if any, under which different financial structures are better at mitigating information and transaction costs.” It is precisely here that the contribution of our paper lies.
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