An important question related to both growth and finance theory is whether the financial system influences growth in the long run. We build a model in which financial markets reduce the amount of risk-sharing that financial intermediaries can provide but promote investment in a productive technology. Hence, in our model, market oriented financial systems yield more growth, but provide less risk-sharing than bank oriented systems. Which system provides the highest welfare is ambiguous.
We build on a model by Fecht (2004) in which banks play two different roles: First, as in Diamond and Dybvig (1983), they provide insurance to consumers against preference shocks. Second, as in Diamond and Rajan (2000, 2001), the refinancing from numerous small depositors enables banks - in contrast to other financial institutions to credibly commit to not renegotiate the repayment obligations on deposits, as this could trigger a run. While banks can invest freely in financial markets, households have to pay a cost to do so. We call households who pay that cost “sophisticated”.
As shown in Fecht (2004), a trade-off arises between the amount of risk-sharing provided by banks and the number of sophisticated depositors. Indeed, access to a financial market allows patient sophisticated depositors to renege ex-post on the risk-sharing arrangement offered by banks. We embed the static model into a dynamic overlapping-generations structure, as in Ennis and Keister (2003). In this dynamic model, there is a trade-off between risk-sharing provided by banks and growth. An increase in risk-sharing implies less investment in productive assets and less growth, because a higher degree of risk-sharing goes along with larger liquidity holdings at any point in time. Because competitive banks must maximize the expected utility of depositors alive at each date, they do not take into account the benefits to future generations of an increase in the capital stock. By constraining the amount of risk-sharing banks can offer, markets promote investment in capital and thus promote growth. However, since this increase in growth comes at the cost of risk-sharing, the effect of markets on welfare can be positive or negative, depending on parameter values.
While we believe that this trade-off is important, it should be noted that our model focuses on the liability side of banks. Thus, because some activities on the asset side of banks may promote growth, our results could overstate the growth reducing impact of bank-oriented systems. Empirical evidence provided by Beck and Levine (2002) and Levine (2002) suggests that a more developed financial system promotes growth. However, they fail to find any evidence that the composition of the financial system, whether it is bank or market-based, under a given level of financial development influences growth.
More recent work by Ergungor (forthcoming) can reconcile our results with the data. Ergungor (forthcoming) shows that market-based financial systems promote growth compared with bank-based systems, in countries with flexible legal systems. The reason is that activities on the asset side of banks have less of a growth-enhancing role in countries with flexible legal systems than in countries with inflexible legal systems. In countries with less flexible legal systems, the asset side of banks probably has a bigger growth-enhancing role, which offsets the effect we describe. In summary, while we believe that the effect we describe is always present, it might be difficult to tease it out of the available data when the asset side of the bank plays an important role in promoting growth. The prediction of our model should be easiest to see in data coming from countries where the asset side of banks plays less of a role in promoting growth, which is what Ergungor’s study suggests.
The remainder of the paper proceeds as follows: Section 2 discusses the related literature. Section 3 describes a static model. Section 4 embeds the static model into an OLG framework and reports our main results. Section 5 concludes.
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