Financial system structure and economic growth: Structure matters

https://doi.org/10.1016/j.iref.2006.09.001Get rights and content

Abstract

This paper investigates how the structure of a financial system—whether it is bank or market-oriented—affects economic growth. In contrast to earlier research, which indicates that the financial system's structure is irrelevant for growth, I find that there is a nonlinear (contingent) relationship between growth and financial structure. Countries that have an inflexible judicial system grow faster when they have a more bank-oriented financial system.

Introduction

Are bank-based or market-based financial systems better for promoting long-run economic growth? A series of recent papers finds that the structure of the system is irrelevant. Neither type is more effective than the other at promoting growth; what matters is the financial system's overall level of development (see, for example, Rajan and Zingales, 1998a, LaPorta et al., 2000, Beck et al., 2000, Levine et al., 2000, Beck et al., 2001, Levine, 2002). The evidence I provide in this paper contradicts the first observation. I find that after controlling for the effect of overall financial development on growth, the structure of the financial system still matters; when countries have inflexible judicial systems, which are unable to adapt laws to changing economic conditions, the degree of bank-orientation is positively correlated with long-run economic growth. In flexible systems, the advantage of banks disappears.1

So, there is a discrepancy with the earlier studies because I factor in judicial flexibility. Beck, Demirguc-Kunt, and Levine (2003) show that legal origin matters in financial development because legal traditions differ in their ability to adapt. This appears to be the most important factor that sets them apart—compared to the differences in property rights protection. Ergungor (2004) shows that in civil-law countries where judges lack interpretive flexibility (i.e., the ability to adapt by interpreting the laws and creating new rules), financial systems are bank-oriented. The reason is that in inflexible judicial systems, the risk of an unfair verdict makes the writing of one-time arm's-length financing contracts problematic.2 Banks emerge in these inflexible judicial environments as a supplier of an alternative contracting mechanism: relationship lending. Through repetitive dealings, they allow borrowers to build a good reputation for repayment, which keeps borrowers honest without court intervention and reduces the cost of borrowing (Egli, Ongena, & Smith, 2002).

Based on these observations, I argue in this paper that in an inflexible judicial environment, banks’ vital role in the economy as relationship lenders makes them an important engine for economic growth (more on this in Section 2). In other words, banks assume additional roles to compensate for the inflexibility of the judicial system. As flexibility increases, this role becomes less critical and the advantage of a bank-based system disappears. Note that this approach is different from the one in earlier papers which argue that relationship-based systems are superior to market-based systems in environments where laws are poorly drafted and enforced (see, for example, Rajan & Zingales, 1998b). I find that a country's judicial flexibility affects its economic growth and the financial structure's impact on growth even after controlling for legal origin and how well the laws are drafted and enforced.

This paper also investigates the channels through which judicial inflexibility and financial structure influence output growth; namely the growth of the capital stock and productivity. I find that the main channel linking judicial inflexibility and output growth runs through the growth of the capital stock. A bank-oriented financial system induces more capital-intensive investment in an inflexible judicial system whereas a market-oriented financial system is more effective in promoting capital stock growth in a flexible legal environment. Although the connection between liquid markets and a high rate of capital stock growth is well-established (see, for example, Levine & Zervos, 1998), the observation that markets are better than banks only in flexible judicial environments is new.

The rest of the paper is organized as follows. Section 2 explains the theory behind my arguments. Section 3 describes the data. Section 4 presents the results from cross-country regressions. Section 5 concludes.

Section snippets

Background

Judicial flexibility pertains to the courts’ ability to expand the breadth of laws in order to identify and penalize fraudulent behavior in cases where laws do not explicitly prohibit that behavior. In inflexible judicial systems, codes are a potent restraint on courts’ ability to adapt laws to changing economic conditions. The source of judicial flexibility is deeply-rooted in countries’ history and the way their legal systems evolved in response to political forces over centuries.3

Data and method

My sample contains 46 countries.8 I estimate a model that expresses real per capita GDP growth (Growth), the growth rate of the per capita capital stock (Cap_Growth) and productivity growth (Prod_Growth) as a function of overall financial development measured by the activity of markets and banks (Fin_Dev) in the 1980–1995 period.9

Output growth

Table 5 presents the results from the instrumental-variables regression (3). Note that given the way the model is designed, the results show correlations not causations. In the discussion that follows, any remark that may unintentionally suggest causation should be interpreted as correlation.

Regressions [1]–[6] show that financial system development matters in promoting output growth but so does the financial structure. Keeping financial development constant, countries that have inflexible

Conclusion

This paper fine tunes the standard growth model commonly used in the literature. I use a conditioning variable set that accounts for various political, economic, and social factors, particularly the inflexibility of judicial decision making.

Theory suggests that in inflexible judicial environments, countries will attain higher growth rates if they have well-developed banking systems because relationships are essential for reputation building. In contrast, in flexible judicial environments,

References (37)

  • F. Allen et al.

    Financial systems in Europe, the USA and Asia

    Oxford Review of Economic Policy

    (2004)
  • R.J. Barro

    Determinants of economic growth: A cross-country economic study

  • R.J. Barro

    Inflation and growth

    Federal Reserve Bank of St. Louis Review

    (1996)
  • T. Beck et al.
  • P. Bolton et al.

    A theory of predation based on agency problems in financial contracting

    American Economic Review

    (1990)
  • A.W.A. Boot et al.

    Reputation and discretion in financial contracting

    American Economic Review

    (1993)
  • A. Demirguc-Kunt et al.

    Financial structure and economic growth: A cross-country comparison of banks, markets, and development.

    (2001)
  • S.D. Djankov et al.

    Courts

    Quarterly Journal of Economics

    (2003)
  • Cited by (79)

    View all citing articles on Scopus

    I would like to thank two anonymous referees for their helpful comments. All errors are mine. The views stated herein are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System.

    View full text