Financial Structure

Reference

Chapter V - Financial Structure & Economic Development

Summary

 

Assumptions

Theory/Model

Bank-based: better at reducing the market frictions related to short-run lower risk well collateralized projects

Security markets are better at financing more innovative, longer-run and higher risk projects that rely on more intangible inputs like human capital.

Four views on banks vs. markets

  1. Financial-structure-irrelevancy view: what matters is the interest rate and which projects have positive net return. Only financial depth, not structure, matters. A variation of this determines that financial depth is a function of the legal system. However, assumptions about perfect information between investors and managers ('hidden action' and 'hidden information') don't hold.
  2. Bank-base view says in early stages of development, banks are better than markets because powerful banks can make up for weak legal and accounting systems and frail institutions. 
  3. Markets-based view argues that diversification and risk management are only possible in stock markets. Also they promote competition whereas banks extract large rents for information-gathering costs which reduces the incentives to undertake risky projects (particularly as debt doesn't benefit from the upside).
  4. Structural view argues that banks and markets offer distinctly differ services that are, at different stages of development better suited or worst suited to a country. At early stages of development small regional banks work best, at later stages large established capital markets.

Application

Evidence

Financial systems are more developed in developed countries. And stock markets in higher-income countries are more active and efficient than banks which tend to  be more common when the country lacks good accounting, low levels of corruption, strong legal system.

Although previous efforts found no relationship between financial structure and economic development for the average country, when the level of development is taken into account a difference emerges (Demirguc-Kunt, Feyan and Levine 2011). Crucially as countries become richer their sensitivity to bank development decreases but their sensitivity to securities markets increases (note only use OECD countries). Furthermore, the financial structure gap, the difference between the ideal financial structure for a given level of development and the actual financial structure, has a negative relationship with economic activity.

 

Evaluation