There is a large body of theoretical and empirical literature to support the proposition that an efficient, well functioning financial system is a necessary condition for long-term economic growth. Almost a century ago, Schumpeter [1911] argued that financial intermediation through the banking system played a pivotal role in economic development by affection the allocation of saving and thereby improving productivity, technical change and economic growth. Modern financial theory emphasize the intermediation role between borrowers and savers, thereby performing the function of saving mobilization, capital fund allocation, monitoring of the use of funds, and managing risk, which together support the economic growth process [Levine 1997].
The empirical investigation of the financial development and economic growth relationship had relied heavily on econometric analysis [King and Levine 1993]. The findings of King and Levine [1993a] are representative of this body of literature higher level of financial need development are significantly and robustly correlated with faster current and future rates of economic growth, Physical capital Accumulation and economic efficiency improvements, and finance does not follow; growth finance seems importantly to lead to economic growth.
The debate on the relative merits of bank-based versus market-based financial systems has a long history of over a century. Nonetheless, there is hardly any consensus at the theoretical level. Competing theoretical models posit the superiority of one type of financial system over the other or they simply relegate financial structure as irrelevant. On the one hand, Stiglitz (1985), to name but a few, argue that the bank-based system is superior to the market-based one. On the other hand, Levine (1997), Boyd and Smith (1998), among others, suggest the opposite. Still, Levine (1997) maintain that it is neither the banks nor the markets; instead, it is the provision of overall financial services that is crucial in promoting growth. Similarly, Huybens and Smith (1999) underline the complementarities between banks and markets in the provision of financial services. The theoretical debate on financial structure culminates into four distinct views: the bank-based, the market-based, the financial services and the law and finance.
Highlighting their shortcomings, argues that these four industrialized countries have resembling real per capita income levels and they historically share similar growth rates. Consequently, it is hard to attribute their analogous growth rates to alternative forms of either the bank-based or the market-based financial system. Similarly, Beck and Levine (2002) and Levine (2002) assert that although UK, US, Germany and Japan did experience periods of divergent growth rates, nonetheless, “it is very difficult to draw broad conclusions about bank-based and market-based financial systems from only four countries” (Beck and Levine, 2002, p. 148). They argue that the empirical assessment of the role of financial structure should be based on broad dataset that encompasses wide-ranging national experiences.
If the problems of information asymmetries, moral hazards and adverse selection were not acute in financial markets and financial institutions were operationally efficient (a feasible scenario if financial institutions are of sufficiently high quality) then either form of financial system (market-based or bank-based) should, in principal, provide just about the same financial services for augmenting growth. Financial structure, in this scenario, would be irrelevant. However, the reality is far from it. Countries exhibit different ‘states of the world’, they have different production structures, levels of banking, financial and capital market development. These structural make ups tend to be rigid requiring significant amount of time and effort for any change. Thus, different ‘states of the world’ may require different financial arrangements to cater for the diverse financial needs.
This paper complements the existing empirical literature by way of new results based on time-series analyses, and compare our results with the existing empirical literature. Our basic specification augments the Cobb–Douglas production function by measures of financial structure and financial development. The long-run relationship between real per capita GDP, per capita physical capital stock, and measures of financial development and financial structure is estimated through co-integration tests. We check stationary of the time series using Augmented Dickey Fuller (ADF) unit root test, Johansson Co-Integration technique and error correction method (ECM) for short run dynamics and apply the Fully Modified Ordinary Least square(FMOLS).
The rest of the paper is organized as follows. In the section that follows we briefly discuss the theoretical arguments; this is followed by a discussion of the existing empirical evidence in Section 3. Section 4 outlines our model specifications and the econometric methods employed. Section 5 discusses the dataset; Section 6 discusses the main empirical results, and Section 7 summarizes and concludes.
