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Market-Based versus Bank-Based Financial Systems Coursework

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Updated: May 17th, 2019

Introduction

Debate between policy makers and economists has been witnessed over the century. The relative issue being debated appertains to the ensuing pros of market-based as opposed to the bank based financial systems.

By the end of nineteenth century, most German economists persistently asserted that their financial system which was entirely bank-centered evidently assisted in propelling Germany past the industrial power (UK) market centered system (Goldsmith, 1969, p.41).

In the twentieth century, the debated issue stretched to incorporate Japan which is perceived as a key bank-centered economy alongside the US which is widely regarded as a classic market centered system. In fact, in not more than a decade, various economic observers alleged that the bank centered financial system of Japan could propel its economy beyond the US which was deemed the chief global economic power.

Embedded in the debate that engrosses market centered vs. bank-centered pecuniary systems is the tradeoff acuity.

Most economists have incessantly affirmed that the embraced bank based systems apparently helps in the mobilization of savings, viable investment identification and the exertion of corporate control especially in the initial economic development phases as well in the weak organizational environments (Goldsmith, 1969, p.56).

Nevertheless, other economists lay much emphasis on the market merits namely capital allocation, the provision of risk managing instruments alongside the mitigation of problems related to extremely influential banks. Despite the unending debate, economists have utilized various theories to highlight the financial systems comparative advantages.

Theoretical framework

Most researchers’ works have ideally produced informative insights pertaining to the operation of these two financial systems. It is however very intricate to draw any meaningful conclusions with respect to the long-standing and escalating effects of the market-centered and bank-centered financial systems merely on the basis of these four nations.

This follows the eminent facts that the quoted countries tend to have somewhat comparable long run development rates.

Even though the named countries in total comprise of nearly fifty percent of the global output and occasionally experienced substantial divergence in growth rates over the past decades, a broad analysis materialize to offer greater essential information on the debate that involve bank-centered versus the market-centered financial systems (Levine, 1997, p.689).

To better analyze and compare these financial systems, scores of secondary datasets might offer an investigative correlation that exists amid economic growth as well as the extent at which nations tend to either be market-centered or bank-centered.

The competing theories which tender empirical evidence mainly anchor on the financial structure. As regards bank-centered highlighted views, it appears that banks play a positive task in capital mobilization, risk management, supervision of managers and viable projects identification (Levine, 1997, p.691).

Bank-centered view similarly underlines the ensuing comparative weaknesses associated with the market-centered systems. It is noted that properly developed markets swiftly disclose market information to the public and this in turn reduces individual savvy investors’ motives to obtain such vital information (Stiglitz, 1985, p.134).

Therefore, massive market developments might encumber the inducement to identify pioneering projects which could spearhead growth. Such problems are effectively mitigated by the banks due to the formulated enduring correlations with firms and they do not immediately disclose decisive information within the public markets.

According to Bhide (1993, p.36), bank centered proponents lay much emphasis on the fact that liquid markets construct narrow-minded investors climate. Investors within the liquid markets may economically trade their shares in order to have inducements that would enhance the exertion of painstaking corporate control. As such, an immensely developed market might thwart economic growth as well as corporate control.

In the developing economies, banks seem to efficiently finance the industrial growth as opposed to the stock markets. Rajan and Zinagales (1999, p.87) noted that influential banks that have intimate correlations with firms stand better chances of efficiently obtaining information on firms and consequently encourage to settle up their debts when compared to atomistic markets.

Based on this observation, bank-centered systems which are unimpeded by the accruing dogmatic restrictions appertaining to their insurance market and securities actions may take advantage of the economically processed information, boost industrial growth and develop enduring associations with firms.

Market-centered do not merely underline the positive responsibility played by markets as regards to corporate control, the enhancement of risk management, allocation of capital and the dissemination of information but similarly evaluates the banks problems (Levine & Zervos, 1998, p.56).

This implies that there are possibilities that influential banks can protect established firms and extract information rents to baffle advancement when competitions emanate. Advocates of market-centered views emphasize that markets might reduce any inbuilt ineptitudes that are related to banks so as to boost economic growth (Weinstein & Yasef, 1998, p.637).

Econometric description

The suitability of bank-based system and the market-based systems can be analyzed based on the units of typical growth equations.

The growth representations and their econometric equivalents are representative of the actual per capita Gross Domestic Product, p, a function dependent on variables, Y. These standard growth equations can be modified as below in order to establish the rivalry between the two systems (Bhide, 1993, p.36).

Take into consideration these regression equations:

  1. P = k’Y + mS + U(1)
  2. P = n’Y + qF + U(2)
  3. P = r’Y + tS + wF + U(3)

P stands for the actual per capita Gross Domestic Product while Y stands for the typical growth factors. S evaluates the financial organization in which the huge values of S denote a market based system while the negligible values denote the bank-based system (De-Haan et al., 2009, p.67).

The positive changes in the fiscal segment such as the securities are represented by F. the more significant the values of F, the more the fiscal services. U denotes the error term in the equation while the other letters are merely coefficients.

Both bank based and market based systems are especially good in initiation and propagation of growth. However, their entire contribution to financial advancement is dependent on the banks for bank -based and markets for market-based (Rajan & Zinagales, 1999, p.89).

Therefore, bank –based assessment predicts the coefficients q and w are above the zero mark while m and t are negative while the market-based assessment predicts the all coefficients will be above zero mark. The law and finance perception, argues that the eventual financial advance is vital more than whether the cause is market-based or bank-based. It thus does not single out which is the better of the two.

The hybrid view on the other hand, puts up the argument of banks being more vital in the growth of financial services under certain conditions while the market-based systems are more important under substitute conditions (Stiglitz, 1985, p.136).

Banks are seen to be crucial when the economic growth is low. This changes as the people’s incomes increase causing the countries to reap more benefits from the market-based systems. The regression equation can thus be specified as below.

(iv) P = k’X + mS + dS*Y + U (4). These view supposes that m>0 ang d>0.

A reason advanced to explain this occurrence is that banks possess a comparative advantage in the economies exhibiting less powerful legal frameworks. Powerful banks can retrieve information forcefully from weak organizations or even go to the extent of compelling them into paying their debts (Kidwell et al., 2008, p.52).

Gains to economies from market-based systems can only be realized with then strengthening of the legal frameworks. Figuratively, the regression equation suggested is as follows (v) P = k’X + mS + dS*L + U (5) which predicts b<0 and k>0.

Data

For any comparisons to be made on the financial structure of the two systems, the real definition of financial structure must be well comprehended. The definitions of bank-based system and that of market-based financial system are on the financial structure are varied. Therefore proper understanding can only be got from analysis of varied forty-eight countries for a period of 15 years.

The advantage of this broad cross-country method is that it allows a similar evaluation of fiscal systems across different nations thus improving the reliability of the resultant international comparisons (Fiordelisi et al., 2010, p.35). The financial structure can be analyzed on various arrays of substitute measures.

Activities in Structure

These compute the ratio of the performance of the stock markets in relation to that of the banks. The measurement of the stock market performance is by application of total value traded ratio while that of the bank is the bank credit ratio. When the ratio is obtained, a more market-based system is denoted by a large of the structure activity and the opposite implied

Structure size

This aims to measure the quantity of the sock markets in relation to that of the bank. The magnitude of the domestic stock-market is acquired via the utilization of the marketplace capitalization ratio as well as credit ratio for the banks. Eventual structure is equivalent to the logarithm of the market capitalization ratio by that of the bank (Stiglitz, 1985, p.135).

Structure efficiency

This appraises the efficacy of the stock market with regard to that of the financial institutions. The effectiveness is measured by use of the value-traded ration or other advanced method while the bank uses the overhead costs. When the logarithm of the total value added is computed and the result multiplied by the overhead costs we obtain the structure –efficiency (Wurgler, 2000, p.189).

Structure regulatory

This measure the regulatory restrictions imposed on commercial banks. These restriction will limit what the bank can do and in the process lower its effect in the development of the financial services.

Therefore, depending on the values of the above data the bank-based system can be preferred to the market-based system (Kettell, 1999, p.21). At certain units, the value could be favorable for the banks while in other it would be market-based system.

Financial Structure

The financial structure, especially the structure – activity indicator shows appealing classifications of both bank-centered and market-centered financial system. In fact, the total value of traded ratios serves as the basic index of classification. Low values indicate a bank-based system while a high ratio indicates a market-based system.

The size measure using structure- size index shows the anomalies between the market-based and bank-based systems. Many theories use market liquidity but this notion seems prone to problems (Wurgler, 2000, p.190). The structure-efficiency index uses the inefficiency stock market to describe bank-based financial systems for example, Kenya, Egypt and Ghana.

Structure-regulatory variable places few restrictions on banks turning the financial system to be bank-based as opposed to market-based systems that tightly regulate the activities of banks as is the case with the United States. The activity, size and efficiency financial structure measures can be used to determine whether an economy is bank-centered or market-centered.

Stiglitz (1985, p.134) argues that states with strong shareholder rights in relation to creditor rights, firm accounting systems and no deposit insurance lean on market-centered financial systems.

Thus, neither bank-centered nor market-centered grouping is critical in identifying growth enhancing financial systems. Indicators on financial services surrogate the extent to which state financial systems provide financial services via evaluating companies and screening managers, alleviating threat management and mobilizing resources.

Financial-activity is an assessment of stock markets and intermediaries which uses total value traded ratio. Bank-based systems have high private credit ratio (Howells, & Bain, 2007). Basically the financial activity index is the measure of the total financial sector activity. Finance-size could be regarded as the assessment of stock markets along with intermediaries that tend to utilize market capitalization quotient.

The private credit ratio is used to determine the size of intermediaries (Mishkin, 2009, p.121). Conversely, finance competence may be regarded as the evaluation of financial sector competence with respect to the use of total cost traded ratio. In bank-based sectors, overhead costs are used (Valdez, & Molyneux 2010).

Financial structure does not show any significant relationship to economic growth. Results from growth aggressions tabulations, show that there is inconsistency with both bank-centered and market-centered financial systems (Grabbe, 1995, p.71).

While the bank-centered analysis envisage negative correlation amid growth versus and the financial structure dealings, the market-centered systems confirm a positive correlation amid the two. This notion predicts that use of financial structure is not a sufficient way of distinguishing between financial systems.

It is notable that optimal degree level of financial structure changes with income per capita. Rajan and Zingales (1999, p.27) argues that nations with feeble investor fortification codes and inadequately obligatory property rights and bank-centered systems will better promote growth. Nevertheless, economies benefit from more market centered systems as the legal systems improved.

Though they posted this assertion, the outcome does not suggest that differentiating between bank-centered and market-centered is an important way of differentiating financial systems even after using systematic evolution of financial structure. Use of estimated equations also points out that financial structure changes with income per capita (Boyd and Smith, 1996, p.375).

Use of regression table also shows that neither the structure nor the interactive variables enter clicks to the required dimension. Inclusion of structure and investor rights as well as interaction with financial structure does not show any conclusive changes. This provides evidence that financial structure is not a useful way to distinguish financial systems.

Analysis on samples based on the level of economic development, indicate that financial structure does not enter any regressions. Though the theories do not refute the work of Boyd and Smith (1996, p.378), the outcome suggest the lack of link between growth and the level of bank-centered system and market-centered systems is not due to selection of optimal level of financial structure.

References

Bhide, A. 1993. “The hidden costs of stock market liquidty”. Journal of financial intermediation, 34(1), pp.1-51.

Boyd, J. H. & Smith, B. D. 1996. “The Co-Evolution of the Real and financial Sectors in the growth process”. World bank economic review, 10(2), pp.371-396.

De-Haan, J., Oosterloo, S., & Schoenmaker, D. 2009. European Financial Markets and Institutions. Cambridge, UK: Cambridge University Press.

Fiordelisi, F., Molyneux, P., & Previati, D. 2010. “New Issues in Financial Institutions Management”. Basingstoke, London: Palgrave Macmillan.

Goldsmith, R. W. 1969. “Financial structure and development”. New Haven, CT: Yale University Press.

Grabbe, J. O. 1995. “International Financial Markets”. Upper Saddle River, NJ: Prentice Hall.

Howells, P. & Bain, K. 2007. “Financial Markets and Institutions”. Upper Saddle River, NJ: FT Prentice Hall.

Kettell, B. 1999. “What Drives Financial Markets. Upper Saddle River, NJ: FT Prentice Hall.

Kidwell, D. S., Blackwell, D. W., Whidbee, D. A., & Peterson, R. L. 2008. “Financial Institutions, Markets and Money. Hoboken, NJ: John Wiley & Sons.

Levine, R. & Zervos, S. 1998. Stock markets, banks, and economic growth”. American economic review.

Levine, R. 1997. “Financial development and economic growth: Views and Agenda”. Journal of economic literature, 35(82), pp.688-726.

Mishkin, F. S. 2009. The Economics of Money, Banking and Financial Markets. Upper Saddle River, NJ: Prentice Hall.

Rajan, R. & Zingale, L. 1999. “Which Capitalism? Lessons from the East Asian Crisis”. Journal of Applied Corporate Finance.

Stiglitz, J. E. 1985. “Credit Markets and the Control of Capital”. Journal of Money, Credit and Banking, 17(2), pp.133-52.

Valdez, S., & Molyneux, P. 2010. An Introduction to Global Financial Markets. Basingstoke, London: Palgrave Macmillan.

Weinstein, D. E., & Yasef, Y. 1998. “On the Costs of a Bank-Centered Financial System: Evidence from the Changing Main Bank Relations in japan”. Journal of Finance, 53(2), pp.635-672.

Wurgler, J. 2000. “Financial Markets and the Allocation of Capital”. Journal of Financial Economics, 58(1-2), pp.187-214.

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