Intorduction: classed as poorly developed financial systems Bank-Based vs

Intorduction:

 

The relationship between financial systems
and economic growth use to be an area of contention, however this relationship
is now generally believed due to empirical evidence (Levine, 1997). According
to Levine (1997, pg 689) there are five functions of financial systems, they
are “facilitating the trading of risk,
allocating capital, monitoring managers, mobilizing savings, and easing the
trading of goods, services, and financial contracts”. There are generally two
different types of financial systems that deliver these functions, bank-based
systems as seen in Germany and Japan, and market-based systems as typified by
the United Kingdom and the United States.

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Since
the link between financial systems and economic development has been
established, the question for developing countries is whether there is one
‘modern’ financial system that they can adopt? If this is not the case it is
pertinent to see what lessons developing countries can take from the
experiences of developed countries and countries that are still in the
development process.

 

 

History of financial systems:

 

According to Allen and Gale (2000),
throughout history there have been three stages to the development of financial
systems. Around the time of the first century A.D. the first, primitive,
financial systems began to emerge. These financial systems, such as the
financial systems of the Greeks and of the Roman Empire all displayed similar
characteristics. Metal coins and other precious metals were used as the only
financial instruments, while individuals were able to take out loans for
consumption, to finance trade or for agricultural production. There were a
small number of financial intermediaries, but these were restricted to money
changers and money lenders.

 

It was only after the thirteenth century
that these financial systems began to develop past this first stage. During the
second stage, early forms of financial institutions were developed, such as
banks and insurance companies. Financial instruments also developed to “include
trade credit, mortgages and government and corporate securities” (Allen and
Gale, 2000, pg 28). However the trading of these government and corporate
securities only took place in informal markets. Throughout the third stage of
the development of financial systems these markets became formalised and
governments increased their involvement through the use of financial institutions
like a central bank. During the development process two events occurred, the
South Sea Bubble in England and the Mississippi Bubble in France, ” that led to
the development of two distinctly different types of financial system: the
stock market-oriented Anglo-Saxon model and the bank-oriented continental
European model” (Allen and Gale, 2000, pg 29). While these may be the three
main stages of development of a financial system, much development occurs
during the third stage. This leads to the current situation where some
countries have well-developed financial systems, and other countries have what
would be classed as poorly developed financial systems

 

 

Bank-Based vs Market-Based Financial
Systems:

 

Banks evolved as financial intermediaries
that transformed deposits into loanable funds. Through the banking system idle
money can be directed towards productive investments. Consumers can benefit
from the economies of scales banks can take advantage of because it is easier
for banks to diversify their investments, reducing the liquidity risk faced by
individual depositors. Within Japan and Germany it is the banks that play the
main role in mobilising funds for investment purposes in their financial
systems. In Japan banks form intimate relationships with the firms they finance,
allowing for the long-term provision of funds and allowing the banks to support
struggling firms during times of ‘distress’ (Aybar and Lapavitsas, 2001). This
system in Japan is often referred to as the main bank system. Similar
relationships between German banks and firms led to the formation of the hausbank
system, allowing firms to finance their short and long-term needs (Allen and
Gale, 2000). Through forming these long-term relationships banks can reduces
the risks of moral hazard and asymmetric information by getting to know the
firms with which they lend (Levine, 2002).

 

Market-based systems in the developed world
can be characterised by countries such as the United Kingdom and the United
States. While both countries are more market-based systems, banks still play a
key role in both countries financial systems, including helping consumers
smooth intertemporal consumption. Within market-based systems stock markets are
assumed to provide supplementary products and services to banks. Stock markets also
allow firms to seek direct finance from savers rather than through
intermediaries. Allen and Gale (2000) explain that in the United Kingdom banks
would engage in short-term loan provision for industry but did not take part in
long-term lending. This forced firms to search elsewhere for long-term funding,
and in particular, after the Bubble act was repealed in 1824, it led to large
firms using formal stock exchanges to raise long-term finance. Stock markets
allowed the financing of investments that banks would not finance, due to
better risk pricing within the markets. Also increased liquidity of capital
markets in the UK allowed savers to obtain assets that gave them quick access
to their savings (Levine, 1997).

 

In the United States it was inefficiencies
in the banking system during the 1800’s that led to an increased relevance of
financial markets. Afterwards it was financial innovation, such as the creation
of organised options and futures markets that helped keep the position of
financial markets within the United States financial system (Allen and Gale,
2000).

 

In both situations bank-based and
market-based financial systems have developed to deal with information and
transaction costs. However it is due to different economies facing different
types of these costs that has led to the development of different financial
structures (Levine, 1997). There is also still a lot of debate as to whether
bank-based or market-based systems are more conducive to economic development.

One of the main reasons for this debate is while the United Kingdom and Germany
have different financial structures they both have very similar growth rates
(Levine, 1997, 2002).  These findings
would suggest that a country specific approach might be needed when it comes to
looking at solutions for developing countries as to how they can develop their
financial systems.

 

Financial Systems and Development

 

One school of though as to how to achieve
economic development through financial development believe that government
repression of the financial system is key. While financial systems attempt to
deal with problems of information and transaction costs, the systems themselves
can suffer from market failures, giving way for potential government
intervention. Stiglitz (1985, 1994) is a particularly prominent proponent of
the view of financial repression.

 

One form of failure experienced by the
financial system is bankruptcy. The government has incentive to prevent the
failure of banks, as the collapse of just one can lead to significant effects
on the financial system. Now that the government is taking up the role of
insurer, intervention in the financial system would seem paramount for the
government to ensure a smoothly operating financial system and reduce the risks
faced by the government. By providing this insurance the government is reducing
the liquidity risk faced by depositors, which would be likely to increase
deposits, therefore increasing the quantity of loanable funds. The market
failure of missing and incomplete markets can also cause justification for
government intervention. Generally these markets are missing or incomplete due
to information costs or due to the fact that they suffer from problems of
adverse selection or moral hazard. In this situation the government could force
membership of insurance programs or indirectly encourage the disclosure of
information through taxation, regulation and subsidisation. For example
information regarding income tax could be used to lower default risk (Stiglitz,
1994).

 

Market failures also occur in the form of
imperfectly competitive markets, uninformed investors and failure in
identifying and monitoring investments. With regard to the latter, banks that
have close relationships with firms have incentives to make sure these firms
are functioning effectively. Banks themselves can achieve this by attaching
certain stipulations to their loan contracts. Alternatively one way in which
the government could help solve this problem would be to allow banks to hold
equity shares in a particular firm, giving the banks incentives to ensure the
firm is being managed correctly (Stiglitz, 1985). While this could reduce the
failure of monitoring, the vested interest the bank now has in the firm could
lead to unnecessary high-risk loans being granted, even when the bank knows the
firm is likely to collapse, in order to try and keep the firm afloat. Government
correction of these failures could lead to development of a countries financial
system, and therefore lead to increased economic growth.

 

On the other hand Demirguc-Kunt and Levine
(1999) show empirically that countries that display repression of banks,
overall have more underdeveloped financial systems. Their findings also show
that most of the underdeveloped financial systems are bank-based, as market-based
financial systems tend to develop as a country develops.  Also in wealthier countries stock markets
tend to be more efficient than banks. Clearly as a country develops, so does
its needs with regards to its financial system, hence most countries start out
with bank-based systems, but as a country gets wealthier there is a tendency of
transition towards market-based systems.

 

Bank-based systems may be better suited to promote
economic development and easier for the government to intervene in early on in
the development of a country, but for the best growth prospects a well
developed financial system is need, which includes a developed stock market
(Aybar and Lapavitsas, 2000). This is particularly important as development of
stock markets is found to have a significant impact on long-run economic
development (Atje and Jovanovic, 1993).

 

 

The East Asian Miracle

 

The rapid growth of East and South East
Asian countries has become known as the ‘East Asian Miracle’. Development of
their financial systems, with the intentions to mobilise savings and increase
investment, played a critical part in countries rapid growth. According to
Stiglitz and Uy (1996) strengthening of the soundness of financial institutions,
which came through strengthening prudential regulation, played a key part in
financial development. While this was important for the domestic financial
systems it also helped to forge better connections with international financial
markets. Capital adequacy standards were used to improve the solvency of financial
intermediaries, and were arguably one of the most important controls at the
governments disposal. Appropriate capital adequacy standards reduced the risk
that size of liabilities surpassed the size of assets. Other government
intervention that helped improve the soundness of financial institutions
included imposing substantial collateral requirements in order to reduce
default risk, discouraging speculative lending and increasing regulation of
non-bank financial institutions.

 

Intervention was also undertaken to create
institutions and markets to develop the financial system by filling in gaps in
the private financial system. East Asian governments created development banks
to offer long-term credit for investment. The East Asian government chose to create
this long-term credit through banks rather than through securities markets due
to the supervision bank could impose over firms. This allowed banks to be able
to assess if it was necessary to withdraw or extend credit to the firms.

Governments initially had close relationships with the development banks they
created, especially through helping to establish initial sources of funds. Development
banks in East Asia have generally been successful, with a few failures, while
they have not been successful in other developing countries. Part of the
success of development banks in East Asia can be attributed to their
transformation from government institutions to financial institutions that were
market-oriented. This meant that funds would be directed to productive
investments, rather than going to bad investments for political reasons.

Specialised development banks also played an important, such as in Thailand
where agricultural development banks allowed farmers to use their land as
collateral to secure loans (Stiglitz and Uy, 1996).

 

Some invaluable lessons can be taken away
from the ‘East Asian Miracle’. Firstly for countries in the early stages of the
development process government intervention is important for the correction of
failures and to help establish new financial institutions. Secondly it is
pertinent that new institutions need to be constructed so that they do not
suffer from abuse of political power and corruption, this might be achieved
through greater legal enforcement. Also to reduce political pressures on
financial institutions and in order to allow them to properly develop,
governments need to remove themselves once the institutions have become well established.

Thirdly any institutions and lending programs introduced by the government need
to complement the institutions and services that are already in the private
sector rather than crowd them out (Stiglitz and Uy, 1996).

 

Conclusion

 

From review of the literature it is clear
that there is not a financial system that could be thought of as a ‘modern’
financial system. Financial systems are unique to each country, as the
financial systems have developed to deal with specific need of that country.

Therefore a one financial system fixes all approach would not work. This can be
seen by looking at the former colonies. When countries gained their
independence, they still had in place the financial institutions that were
brought in by the colonising countries. Hence their financial systems were
controlled by foreign banks, which were not interested in helping the country
develop (Long, 1991).

 

While there may not be one particular
financial system model that will solve the problems of developing countries,
certain patterns in the development of a financial system can be seen by
looking at the experiences of developed countries and from the ‘East Asia
Miracle’. Early on in the development process bank-based systems can produce
better growth prospects. There is much room for government intervention to
correct any failures of the banks, and fill in gaps in the market that the
banks have left. It is also important to have the proper legal structures in
place to prevent rent seeking behaviour. While the governments intervention is
important early on, from the experience of East Asia it is also equally important
that once the financial system starts to develop the government needs to start
to remove themselves from the control of the financial system. Financial
systems need to develop somewhat ‘naturally’, and not be influenced by
political pressures leading to financial development in the wrong areas. Finally
another pattern that emerges is that as a financial system develops, the
financial markets starts to play a larger role. Again this is important because
a developed stock market is linked with increased long-run growth. So while a
bank-based system is important to promote growth early on for developing
countries, they should not forget to develop their financial markets during the
process to achieve the best growth outcomes.

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