July 2011, Robert Cull and Colin Xu, DECFP
A recurrent debate in the finance and development literature is on financial structures: does the mix of institutions and markets that make up the financial system have an impact on the development process? In mid June this year we hosted a conference on the topic at the World Bank (click here for the agenda and papers) to take a fresh look at the issue focused on a few key issues: What do financial structures look like? How do they evolve with economic development? And what are the determinants and impact of financial structures?
Past findings, also confirmed in the papers at the conference, show that financial systems become more complex as countries become richer with both banks and markets getting larger, more active, and more efficient. Comparatively speaking, financial structure tends to become more market-based in higher-income countries, but there is also wide variation in structure indicators across countries at similar income levels. At our conference on the same topic ten years ago, the emerging empirical view was that what mattered for economic development was the level of financial development, and that the relative mix of banks and stock markets did not matter much. Admittedly, this view was challenged by financial theorists who argued that a country’s financial structure must be important because of its impact on the types of industries that get financed, with equity finance through stock exchanges supporting innovative industries and debt finance through banks being better suited to existing industries. (Allen and Gale, 2000; Boyd and Smith, 1998).
Fast forward ten years to World Bank Chief Economist Justin Lin’s opening address at our conference, where he articulated a theoretical framework for optimal financial structure that varies with a country’s stage of development. Since the industrial structure and the firms within it tend to differ in terms of size, risk, and financing needs at each stage of development, the demand for financial services will also vary, resulting in different financial structures that are better able to perform these functions as economies develop. Small, labor-intensive firms are likely to characterize the early stages of development, and thus a key prediction of Lin’s framework is that banks, especially small local ones, are a better fit for those firms than stock markets, due to their superior abilities to harness local information, assess “soft” information regarding creditworthiness, and engage in long-term relationships with borrowers.
Several papers at the conference offered support for the notion that financial structure matters for economic development, and that some structures are better than others depending on the stage of development. Asli Demirguc-Kunt, Erik Feyen and Ross Levine use cross-country quantile regressions to assess how the sensitivities of economic activity to banks and securities market development evolve as countries grow. The quantile regressions provide information on how the associations between economic development and both bank and securities market development change as countries grow richer. They find that as economies develop, (1) both banks and markets become larger relative to the size of the overall economy; (2) the sensitivity of economic development to changes in bank development decreases; and (3) the sensitivity of economic development to changes in securities market development increases.
Robert Cull and Colin Xu use firm-level data across many countries, looking at how labor growth rates of firms vary with their country’s financial structure. Combining firm-level data from 89 countries with updated country-level data on financial structure, the authors find that labor growth is swifter in low-income countries that have a higher level of private credit/GDP, consistent with predictions regarding optimal financial structure. In high-income countries, labor growth rates are increasing in the level of stock market capitalization. However, the authors find no evidence that small-scale firms in low-income countries benefit most from private credit market development. Rather, the labor growth rates of larger, capital-intensive firms increase more with the level of private credit market development in those countries.
A third piece of evidence suggests that financial structure matters for poverty alleviation as well. Kangni Kpodar and Raju Singh, using data from 47 developing countries from 1984 to 2008, show that financial deepening through banks is associated with reduced poverty levels, while market-based measures of financial development are associated with higher incidence of poverty. In addition, the interaction between institutional quality and the size-based measures of the importance of stock markets relative to banks is negative and significant in their regressions, indicating that as institutions improve, the positive link between market-based financial development and poverty incidence phases out, and even reverses after some threshold of institutional development is reached. Conversely, the results suggest that in weak institutional environments bank-based financial systems tend to reduce poverty more than market-based ones.
A broader view of financial structure, beyond just banks and securities markets, could also be useful in understanding the effects of financial structure at different stages of economic development. Thorsten Beck, Asli Demirguc-Kunt and Dorothe Singer therefore investigate whether bank size and banks’ relative importance among all other financial institutions affect financial access by firms. They find evidence that the share of total financial assets held by the low-end and specialized financial institutions is positively associated with usage of some types of financial services (accounts, overdrafts, loans), but that the results are significant only for countries with the lowest per capita incomes. The size of financial institutions also appears to matter for financial access. Larger low-end institutions are associated with less severe reported financing obstacles and greater use of loans and overdrafts, though the effects diminish as per capita GDP increases. Similarly, the average size of specialized lenders is positively associated with having a loan or overdraft in low- and middle-income countries.
Yet another paper examined the finance-structure-development relationship through a historical lens. Franklin Allen and a team of financial historians provided a comprehensive review of the evolution of financial structures in the US, UK, Germany and Japan and how they contributed to the development process. While banks played an important role in the financial development of all four countries, the overarching conclusion from the historical comparisons is that a variety of financial structures can lead to high rates of growth in real per capita GDP. Thus, the fact that their financial systems differed in a number of ways suggests that if there is an optimal financial structure for a country it does not lead to a significantly greater level of growth than other possible structures, at least not at more advanced stages of development.
Two papers argued that politics is a central and inextricable component of the evolution of financial structure. Charles Calomiris and Stephen Haber develop a descriptive theory of how government’s multiple roles in dealing with the financial sector – as regulator and supervisor, as a borrower and a taxing authority, and as enforcer of contracts – lead to inherent conflicts of interest that restrict the political coalitions that shape and support financial development. Those limitations, in turn, often lead to fragile banking systems that allocate credit narrowly. For example, based on their reading of the financial histories of multiple countries (this will eventually be a book-length project for them), the nature of the coalitions that generate barriers to entry in banking varies across types of political regimes. In autocracy, it is easier to create a stable coalition in favor of tight entry restrictions, in part because potential borrowers from banks cannot vote. Autocracies therefore tend to create banking systems that allocate credit narrowly to the government and to enterprises owned by an elite class of government-selected bankers. At the same time, the narrow allocation of credit under authoritarian regimes has not resulted in greater banking sector stability. In times of economic strife, bank insiders and the government expropriate actors that are either loosely or not at all affiliated with the coalition (i.e., minority shareholders and depositors). In times of extreme difficulty, the autocrat can (and has) expropriated bank insiders.
Mass suffrage makes it harder to sustain a banking system that allocates credit narrowly to an elite group. It does not, however, necessarily ensure a stable banking system. It is possible for bank borrowers to vote for representatives that expand the supply of credit, improve the terms on which the credit is offered, and then forgive those debts when they prove difficult to repay. The authors argue that this was a large part of the United States subprime crisis. Their general message is that under any type of political system, banking systems are fragile. Therefore, only a small share of countries has been able to create stable banking systems that allocate credit broadly, because this outcome requires political institutions that allow for mass suffrage, but also limit the authority and discretion of the parties in control of the government.
Finally, Fenghua Song and Anjan Thakor develop a formal theoretical model to show that, if a politician’s objective is to expand credit access by inducing the banks to lend to more low-quality borrowers, her optimal strategy will vary with the stage of development. In the early stages of development, when capital is relatively expensive, equity capital subsidies in exchange for government ownership (i.e. state-owned banks) is most effective. At advanced development stages, regulation that imposes directed lending requirements on banks is the only feasible option.
In summary, the conference findings point in important new directions. First, financial structure changes – becoming more market-oriented – as economies develop. Second, new evidence suggests that different financial structures may be better at promoting economic activity at different stages of a country’s economic development. These findings advertise financial structure as an independent financial policy consideration. And, if the optimal mixture changes as an economy develops then this suggests the desirability of appropriately adjusting financial policies and institutions as countries develop. Should we, therefore, actively intervene to “fix” financial structures? No, but if market or bank development is far from what we would expect given a country’s stage of development, these findings give us a reason to dig deeper to understand why. Third, and finally, politics are clearly important for understanding the evolution of banks and financial structure. Policy prescriptions that do not take into account the underlying political economy of a country’s particular financial structure are unlikely to work.