Effects of Financial Structure on Economic Growth
Financial Structure and Economic Growth.
Chapter1. Introduction
One of the biggest and most heated debates in recent financial times especially with the prevailing effects of globalization and market instability has been the impact of financial structures on economic growth.
However, varying conclusions have been made on a theoretical point of view. It is quite evident that it is very difficult to hold other factors affecting economic growth constant and assess only financial structure. This is one evident challenge that is quite clear that the indirect effect of financial structures can be identified through the various economic growth measures.
This paper is geared at assessing three different issues as regards the topic of economic growth and financial structures namely the overall change of financial structures as economies grow, assessment of presence of financial sources and financial structure changes.
In the global world having businesses have extensively invested in portfolio analysis of the most economical yet sustainable financial structures. In this regard, they have used methods such as the Gordons model of cost of capital analysis and other measures to determine the most cost effective capital combination in making investment decisions. The impact created by these investments on economic growth is the major focus in this paper while taking direct focus on their overall sustainability.
A proposition by Mansfield (2003) and Benton (2005) is that provision of finance creates an environment that businesses are able to thrive in. A detailed analysis of this has shown that most businesses especially in the developing countries fail due to lack of access of enough capital resources, Mansfield (2003) puts it across that capital availability is the one of the most important factor of production. This just makes it clear that the essence of the presence of enough capital justifies that businesses are able to gain the rewards of capital as a factor of production.
The reward of capital as a factor of production is profit. This profit that is generated by businesses contributes to the gross domestic products when this businesses pay tax. In this analysis a detailed analysis of gross domestic product from different countries of the world extracted from word bank and International Monetary Fund will be included in this survey.
The perspective adopted by Hermann (2000) is that of a heuristic approach to the underlying concept of different forms of financial structure. Different organizations have different financial structures or capital mix. The major question in this topic is what is the influence of these different financial structures on economic growth
To demystify the different financial structures we look at the different abilities of organizations to be able to meet their capital requirements under both the financial system and the market system. To do this a detailed analysis of the characteristics, merits and demerits of these two systems is necessary.
Economic Growth
The term economic growth is used to refer to an increase in the measure of aggregate income or gross domestic product with relevance to the quantity of goods and services produced only and is usually measured as the rate of change in GDP. For the sake of comparing the per capita income for different countries, the statistics are given or quoted in a single currency depending on the prevailing purchasing power parity or exchange rates. Economic growth is either positive or negative.
Financial structures contribute to this disparity. Economic recession and depression is normally associated with negative economic growth. To compensate for inflation or deflation, the gross domestic product is given in terms of the nominal or current figure, which is usually inflation adjusted as opposed to the actual money figure.
Measuring of economic growth is done using the real gross domestic product, real in that the effects of inflation have been adjusted. The three ways to measure growth of real GDP are the annual average growth rate, the year-over-year growth rate and the quarterly growth at an annual rate.
Financial structures define the frameworks of the various ways a firm uses to get and maintain or support resources necessary for its operations. These entails the elements listed on the right-hand of the firms balance sheet and may include loan capital, equity capital, overdrafts and trade credit among others. It is how these resources are utilized that leads to the assessment of economic growth.
In this analysis we try to assess how much the financial structures adopted in different countries is able to affect the gross domestic product in one way or another. The quarterly growth at an annual rate gives the change in real GDP from one quarter to the next compounded to an annual rate.
The year-over-year growth rate compares the level of GDP in one quarter to the level of GDP in the same quarter in the previous year. This method is less volatile as compared to the quarterly growth at an annual rate since it is not compounded. The average of year-over-year percent changes for a given year yields the annual average growth rate.
Financial Structure.
Capital projects undertaken by businesses in any given economy depend on the funds available to finance these investments. For example a decision by a firm to acquire a new plant that will aid in more efficient production implies specific way of financing that project. The major question in place is that of the best capital mix to apply in financing that project. Should a firm apply debt or equity or both What are the implications of the debt equity mix on the operations of the firm What are the implications of this capital structure on economic growth
Managerial economics has tried to elaborate on the various economic advantages that accrue when firms are economically and adequately financed. In this debate the system to be applied is what determines how well these firms are financed.
The various ways applied by businesses to finance their operations are known as the financial structure of the firm and this is represented on the left side of the balance sheet of a firm.
The management of a company seeks to answer many questions in regard to financial structure and some of them include how should the investment project be financed economically Of what economic use is the project to the firm Can the optimum capital mix be determined in practice for a company and what implications will the project have on economic growth and development of a given country.
Despite the quest of achievement of economic growth by the firm there are two underlying issues that the firm tries to address which include risk and return of the investment. The return is the expected growth in cash flows of a firm as result of investing in a given project where as the risk is the uncertainty created as result of undertaking the investment. The two concepts (risk and return) affect the cost of capital and the market value of a firm.
The market value of a firm is what leads us to the debate if a firm is able to generate economic growth as a result of good financial structure. The creation of a high market value means that the firm is able to contribute to the economy in terms of taxes and other government deductions which are used in assessing the gross domestic product of a country. A high gross domestic product means that there is economic growth and this creates an integration of how financial structure relates to economic growth.
Financial Structure and Financial Development.
Raymond W. Goldsmiths (1969) in his book, Financial Structure and Development insists that for economies to grow financial systems must also grow. He defines a financial structure as the overall composition of financial instruments markets and other financial institutions operating in a given economy.
Financial development on the other hand entails the growth in efficiency, effectiveness and sustainability of financial systems in a given economy. In his book Goldsmith explores the evolution of financial systems and the success and failures they have experienced in various countries.
The reason why the debate of how different financial structures affect economic growth is that financial development in the different markets is the variable behind economic growth and development. Therefore assessment of the correlation between financial development and economic growth is very important for the advancement of this debate.
Goldsmith however faced challenges in establishing this relationship between financial development and economic growth. In fact the inter firm and inter industries analysis of this had very limited success. Goldsmith however was successive enough to document a clear positive correlation between financial development and economic development across different countries.
Financial development as one of the factors influencing financial structure is a key consideration in the adoption of financing schemes. This is because the level of accessibility and cost effectiveness of capital is determined by how financial systems are effective and efficient.
A country like England has very efficient and well developed financial structures. In fact very many scholars are of the view that one of the factors that led to high industrialization in England is the level of financial development. Walter (1873) argues that efficient financial structures ignited by the high level of financial development facilitated the mobilization of the various capital resources for very big investments.
Robinson (1952) says that finance follows enterprise in developed financial systems. According to this proposition, economic development through efficient financial structures spurs the need for different financial arrangements among different entrepreneurs.
This is to show that financial systems are able to respond automatically to the demand for capital. This demand and efficient utilization of capital leads to economic growth. However, some economists still oppose this proposition of the relationship between financial development and economic growth.
Lucas (1988 p.6) asserts that economics badly over stress the role of financial structures in economic growth. In fact Chandavakar (1992) explains that no role is played by financial systems in economic growth of any given country. Other scholars such as Seers (1984) and Nicholas (1989) in fact ignore this topic in their discussion of the level of economic growth in different countries yet they are Nobel Prize winners in the field of economics.
Beck, Demirg-Kunt, and Levine (2000), conclude that although definite conclusions must be made and with very distinctive and clear qualifications, the overall actual response from a theoretical point of view and corresponding empirical evidence suggest a very high relationship between financial development and overall economic growth.
In general it is quite evident that economies grow out of the availability of funds. Efficient and sufficient circulation of funds in the economy creates favorable conditions for businesses to thrive. In this regard the development of financial systems is very vital for economic growth to be achieved. The next chapter aims at explaining the various types of financial structures and how they have contributed to economic growth in different countries such as Japan and Germany.
Chapter 2 Financial Structures
Market system
A system can be defined as a unit that contains severally subparts that are unilaterally integrated and are interrelated. In economics, the operation of various economic processes does not occur single handedly but depends on the integration of various processes so as to form a working system. The study of micro economics develops some of the key concepts involved in the operation of the economic process in a market system.
According to Heilbroner (1970) every macroeconomic process has its microeconomic base. It is quite evident that a market system involves large scale economic processes and yet these large scale economic processes derive their necessity from the behavior patterns from individuals and firms.
The market is a system based on macroeconomic processes and is obvious not a bazaar. The adoption of the market system to finance operations of a given economy depends on how well the market is adapted to meet the various needs of the economy as a whole. The major issue of concern in this topic is how the market exerts its controlling as well as impelling force on shoppers, job seekers, prices and firms.
According to Heilbroner (1970) the buying and selling that we see each and every day are not just merely casual activities that repeat themselves each and every day but are part of the system as a whole.
The market system is geared towards solving some of the basic economic problems such as what to produce How to produce What goods to give to whom These are the problems that mobilize men to give an effort so as to produce some output. This output contributes to economic growth as a whole.
According to Levin (2003) the market system is not politically feasible and that it has a high potential for adverse externalities. In the development of this argument Levin that the externalities and transaction costs involved in this system are as a result of the high interdependence of the individuals or households and firms. In this the assumption that the economy operates in a two sector economy as exemplified by the circular flow of income which forms as a major basis for the development of the market system is not valid.
There are many more other external factors involved in this and therefore in this regard a market system fails to provide a reasonable basis for the development of the concept of the relationship of market system and economic growth.
Levin (2003) insists that for a market system to be eligible it must be complete in its general form of application. A market system will only be complete if the prevailing externalities are completely eliminated and when subsequent transaction costs are reduced to the bare minimum.
However according to Heilbroner (1970) the market system is very efficient as it acts a self correcting mechanism. In this debate Heilbroner (1970) continues to argue that the market for goods operates as a dynamic constantly altering and yet self-adjusting mechanism. This can be elicited in the interaction of the demand and supply curves in normal markets.
Many developing countries such as countries in Africa and Asia have a high prevalence and dependence on the market system. The main task involved in these countries has been that of how to allocate production efficiently in the economy to achieve economic growth.
The Bank Based system
The theory of the bank system is base lined upon the sole utilization of banks and other financial institutions to support economic growth and development. Though it is not the most efficient system of finance according to Mansfield (2003) it tries to exhibit most of its strong points in relation to the shortcomings envisaged in the market based system.
This debate tries to explain which of the two systems can efficiently finance firms in developing countries and the same time is in the best position to spur economic growth as much as possible.
This argument is based upon the principles of market efficiency and optimization. Fully utilized or efficient markets are markets that are able to exploit all resources or factors of production and are able to gain optimum rewards from these factors of production.
Are banks so necessary for the survival of firms Are the stock markets on the other hand just necessary for the firms Gerschenkron (1962) argues that economically backward or undeveloped countries cannot trust capital markets as the only source of finance. The argument in this is that banks can finance development of the economy as a whole more effectively than decentralized stock market.
The extent to which this theory according to Alexander Gerschenkron, in his analysis of Japan in the early 1950s is true has been upheld by many scholars. In the analysis of Japan Gerschenkron, noted that there were different market failures which could be overcome by the fact that banks were in a position to utilize deposits and savings to avert this kind of failure.
Despite the strong argument that bank based system are more suitable for economically backward countries there are still many scholars especially in the finance sector who do not believe so and argue that the whole issue is misguided because of the existence of the agency theory and the existence of perfect information in these financial markets.
One evident transition that has even supported this conclusion is that of Europe whereby finance ministers have insisted on financial markets more than banks as a source of capital for firms and there has been so much economic growth that has been experienced. This transition has changed various economies to an extent that scholars have come to believe that existence of perfect information and presence of agency theory with minimal conflict is just enough to create perfect market systems.
In this analysis a closer look at two different countries which are not in the same level of development is very vital. In this regard a good analysis is one that analyses an economy that grew out of the market system and one that has achieved economic growth out of the normal bank system.
According to Boyd and Prescott (1986), one shortcoming of the market system is lack of perfect information as compared to the banking system whereby information symmetry is one of the characteristics. In fact in Germany the continued interaction between banks and investors and investors spurred much more economic growth than the general market system.
The existence of perfect information means that the interaction between firms, individuals or households and the financial institutions which in this case are banks is based on past, present and future information. This means that this information is readily available through the different communication facilities available such as the media.
This information helps firms and individuals make sound financial decisions such as the amount of capital to invest in different projects, selection of the most viable projects to invest in and in selection of the optimum capital structure to operate with.
The combination of the above decisions spurs economic growth since firms will be in a position to contribute to the gross domestic of the country through the returns generated from these investments. The subsequent lack of this perfect information leads to subsequent inefficiencies.
Another major advantage of the bank system is that monitoring of finances is highly enhanced. Through this elimination of moral hazard is efficiently met. The reason why there is monitoring is that most financial institutions issue finances with collaterals in place. This forms a basis for providing reasonable assurance that the firm will do everything to make sure it is able to meet its obligations.
The whole system of banking is set up in manner that there is adequate controlled that integrate business policies and strategies in such a manner that the whole financial process is properly managed. This is through the enhancement of corporate governance. Corporate governance is concerned with the whole issue of the policies, laws, rules and processes adopted by organization in their day to day to day organization.
In this regard firms which are able to apply good corporate governance practices are in a better position to spur economic growth more than those which are not concerned with it. Firms in the market system as evidenced by Japan lack this due to lack of market efficiency.
There is much more cross cutting evidence that developing countries are in a higher position to adopt the bank based system rather than the market system because of the presence of very high market inefficiencies in these countries.
On the other hand it is vice verse for developed countries such as the likes of United States and United Kingdom whereby the market competition and stock exchanges could finance firms and thereby economic growth was highly experienced. This was especially due to the high rates of industrial revolution experienced in these countries. Since industrial revolution was slow in developing countries market systems could not be relied upon as the only source of finance necessary and enough to spur economic growth.
Macroeconomic Policies in bank based systems
A major player in determining the structure, behavior, performance and activity of an economy is banking and finance. Depositing and lending of funds from banks is subject to the management of these funds (finance) in a particular economy.
Government relays on the success of macroeconomic policies to achieve its objectives of establishing a stable and growing economy. The success of these policies, reliant on banking which is in turn subject to finance determines the level of economic growth.
On the international front therefore, macroeconomic policies dictate international banking and finance. This means that macroeconomic policies (fiscal policy and monetary policy), being independent of individual governments regulations on banking, are used to determine the structure, decision making, performance and behavior of the global economy. Macroeconomic policies therefore surpass regional and national boundaries without conflicting specific government regulations to influence the global economy.
According to Cawley, John Tomas Philipson. (1999), macroeconomic policies also affect the activity of the economy through control of government spending in addition to setting interest rates which has a direct implication on international banking. This means that these policies have implications on other financial issues relating to financial institutions other than banks.
Since macroeconomic policies, specifically the fiscal policy, determines the activity of the entire economy, operations of companies and corporations involved in financial activities will also be subject to alterations in these policies.
The expansionary stance implies governments monetary authority increasing the supply of money by reducing the interest rates in an attempt to curb unemployment in the event of a recession. The monetary policy is based on the relationship between the total supply of money and price of borrowing and lending money, that is, the rates of interest.
It uses a variety of tools in order to administer control on the two in an attempt to influence outcomes of exchange rates with foreign currencies, economic growth rate, inflation and unemployment.
If issuance of currency is under a monopoly or in the case of a regulated system of issuing currency where all the banks are tied to a central bank, the monetary authority is able to alter money supply thus able to influence interest rates and thus the goals of the monetary policy is achieved.
The monetary policy can also be termed expressed in various ways accommodative if the interest rates set by the monetary authority are aimed at creating growth in the economy, neutral if the interest rates are neither aimed at controlling inflation nor creating growth in the economy and tight if the set interest rates are aimed at reducing inflation in the economy.
Financial Structure and Bank Profitability
Financial structures also have an independent impact on the performance of banks. The overall impact on banks of these financial structures also has an effect on economic growth because banks also contribute to the gross domestic product of a country just like any other business.
The distinction that is necessary at this juncture is just to determine how financial structure affects the profitability of banks in less developed countries and in developed countries. In less developed countries there are no well developed financial systems. One of the effects of the quest to try and improve efficient bank systems is a decrease in the bank margins and profits.
Different countries differ in the extent to which their financial systems are either bank based or market based. The extent to which a financial system is said to be bank based is dependent on the overall reliance in mobilizing savings and allocation of capital by the banks in existence.
In developing countries it is quite evident that financial systems are also not developed. In this regard bank profits and margins are also in these countries. However one cross cutting feature is that most of these countries adopt the bank based system as the market based system cannot be efficient enough to handle economic growth.
Developed countries have efficient systems and their banking systems are well developed and therefore banks contribute significantly to the economic growth of these countries. However if these financially developed countries have efficiently working stock markets, the overall effect is a reduction in bank profits and bank margins.
One of the points to note is that apart from financial structure there are other factors that affect the overall profitability of banks and therefore it should not be taken as the only factor that affects the profitability and bank margins.
As developing countries develop, banks also develop. The development and growth of these banks leads to increased competition and thereby creating a long run effect of reduced bank profits and margins. However the consumers of the services provided by banks stand a chance to benefit as they are able to access capital at very low rates due to this competition.
A detailed analysis of the topic of financial structure and banks profits can be approached in two ways. The first way is to consider the effect of financial development on bank profits. From this is it easy to develop an assessment on the impact of these profits on economic growth. The second way to approach this topic is considering the effect of financial structure on the performance of banks when financial development is controlled.
There are two measures of banks performance. One of these measures is bank profitability which can be assessed as the profits generated by the bank divided by the assets. The other most important measure of the performance of banks is the bank interest margins which is calculated as the net interest generated divided by the assets of the bank.
The inefficiency or the efficiency of banks can be measured by these two measures (bank profitability and bank interest margins). This is because these two measures act as a connector or a link between savers and borrowers.
The adoption of bank finance by the various stakeholders for investment leads to business for banks. The variables mentioned above affect the cost of bank finance and thereby firms engage in investment profits which are profitable so as to meet these costs and hence economic growth.
In general the overall performance of banks is different in both the market system and the bank system. Therefore to bridge this gap financial development should be enhanced in the economy. If financial development is achieved there is a very high possibility that bank profits and interest margins will be achieved significantly.
The use of mathematical techniques to assess how financial development is significant in assessment of the profitability of banks has shown that there exists high correlation between the two. When financial development is achieved at the highest level regression analysis has shown that both the bank system and the market system lead to high profitability in banks. This profitability in turn leads to economic growth.
Commercial indicators of high competition in the banking industry are the reduced profitability and low interest rates in banks. The stock market on the other hand complements banks in areas of low level of financial development since there is not much competition in them. The only factor to consider in stock markets is their level of development.
Development of stock markets is very vital in that it provides perfect information for banks in which they are able to base their decisions on. Sound financial decisions by these banks lead to improved bank performance which on the other hand impacts greatly on economic growth.
Another reason why the development of stock markets is important is that through the existence of an efficient legal framework it is easy to improve the overall banking environment in terms of business processes and contract enforcement.
FIRMS FINANCING CHOICES IN MARKET BASED AND BANK BASED SYSTEM
The difference between market based and bank based systems is that in market based systems, firms obtain finances from the capital markets in the form of equity and bonds while in the case of bank based systems, banks, by offering credit, are the main financiers of the economy according to Schmukler and Vesperoni (2004).
Lenders in both market based and bank based system are however faced by the expenses of evaluating the performance of firms and their management. Schmukler and Vesperoni continue to argue that commanding control over the debtors and financial instruments liquidity are the major two factors that lenders have to weigh between.
Corporate bonds can be traded in markets which are liquid considering that they do not provide for inside monitoring and thus save on expenses to administer control over management since (Bhide, 1993). As opposed to these, banks, in offering unsecured loans for businesses, have to undergo the expense of acquiring inside information from borrowers in order to exercise control over them.
The two systems therefore are well suited to finance different kinds of firms. Banks are a better fit in financing organizations at their infancy while public markets would do better in funding already established firms with assets that are tangible. Inside monitoring which apparently applies more to banks holds a potential advantage in that it creates an extended relationship between the firm as the borrower and the bank as the lender (Schmukler and Vesperoni, 2004).
In order to obtain financing, a firm may opt for stage financing, which is offered in banks based systems and market based systems. This for example implies that a bank may offer short term contracts in place of long term loans. This therefore means that the bank will be able to access a firms credibility through its various stages in projects investment. Stage financing may be more effective in that, if a borrower pays their debts in time, there would be no need of trying to determine the true value of their assets and thus saving on the resources allocated to inside monitoring of the firm (Stulz, 1998).
The results of global financial crises affect firms from the different financing sectors in different magnitudes. For example, in the event of a crisis, bank based systems may tend to be more immune to global financial crisis since the long-term relationship between the bank and its borrowers enables the bank to collect enough information regarding the firms performance.
This means that the bank, from its inside information, will continue to lend to financially sound firms and therefore, firms in the bank based system end up being less affected by the events of a financial crisis. Contrary to this, global financial crisis effects on the economy causes public markets to become illiquid leading to a reduction in prices for all firms.
This is bound to make it difficult for investors to distinguish between potentially profitable firms and those that are not potentially profitable. However this still implies that if the banking sector was to be subject to financial crisis then firms in the bank based systems would be hard hit while those in the market based economies would remain unaffected.
In order to describe firms financing choices in market based and bank based economies, Schmukler and Vesperoni use data on firms from Argentina and Indonesia as bank based economies and Brazil, Mexico, Malaysia, South Korea and Thailand as market based economies (Schmukler and Vesperoni, 2000). The choice of these countries is based on the fact that they have been through financial liberalization, repression and crisis. Schmukler and Vesperoni test for the difference between financial choices for firms in bank based and market based economies by classifying countries depending on the attributes of their financial sector (Demirgut-Kunt and Levine, 1999).
They also study three attributes of the financial structure of a firm which are the firms choices between financing of equity and debt, external and internal financing and debts maturity structure. These attributes are built upon estimate models of dependent variables.
These variables are debt-equity, short term debt over equity, long-term debt over equity, short-term debt over total debt and retained earnings over total debt. Explanatory variables are grouped into effects of the country, macroeconomic factors, firms international capital market access, and attributes specific to a firm (Schmukler and Vesperoni, 2000).
According to Schmukler and Vesperoni (2000), there are factors or ratios that determine financing choices of firms. One of these ratios gives the fraction of short-term debt over total debt and the average debt-equity ratios for market based and bank based systems separately. From this ratio, two deductions can be identified.
One is that, for market based systems, debt-equity ratios are always higher contrasting the general expectation that as compared to debt, equity values in market based economies are higher. Second, though market based systems are best suited to funding firms with typically tangible assets, that is, liquid financial instruments and bank based systems are a better fit for long-term lending relationship, this does not always imply that greater liquidity results to short-term financial instruments.
Market based economies may also avail long-term financial assets liquidity. In essence, the second deduction from this ratio is that debt maturity structure is the same for both market and bank based economies as described in the foregoing explanation. These may also be explained by stage financing whereby short-term liabilities are not a preserve of market based economies and long-term liabilities a preserve of bank based economies.
Firms are affected differently by the effects of international capital markets access and financial liberalization depending on the firms financial structure, that is, bank or market based economy. This therefore means that there are two types of regression, regression for market based economies and regression for bank based economies.
A difference in market based and bank based systems implies a difference in the effects of integration with international financial markets, more significantly in market based systems. This will be so because variables that show international markets access are particularly expected to change significantly with changes in international financial markets integration. Resultant changes in variable that measure participation of firms in global equity and bond markets obtained in this case depicts the difference in effects across the two systems.
As Schmukler and Vesperoni (2000) continue to argue, a small difference between market based and bank based systems compared to the difference between developed and emerging economies implies that the effects of international capital markets access is also small.
Financial liberalization among other factors denotes deregulation in the local financial sector a period in which economies are in financial intermediation depending on the incentives of the market.
Financial liberalization does not necessarily imply effects on market based systems but can lead to a competent banking sector thus it is not certain that the variable depicting financial liberalization will change specifically in either of the systems according to Demirguc-Kunt and Levine (1999). Effects of the variable denoting financial liberalization are dependent on the aftermath of financial liberalization.
Specific attributes of a firm are bound to affect the financial structure in either bank based or market based economies. For both, market based and bank based economies, the extent of the debt maturity structure increases with increase in size of the firm.
For bank based systems, increase in size of the firm will result to increase in ratios of debt-equity and long-term debt. Long-term debt and short-term debt changes depending on the size of the firm in market based systems but short-term debt effects are not very pronounced.
In market based systems, larger firms result to a reduction in risk security assuming that large firms refer to firms that are more established. These larger firms are able to reduce their short term debt and increase their long term debt by moving their maturity structure from short to long term.
For bank based systems, in the case of stage financing, banks will not necessarily have to monitor the activities of a firm as it grows and gets sufficiently established in the market. From the foregoing, increase in size of a firm can be related to ratios of long-term debt and debt-equity.
On the choice of firms financing with regard to tangible assets, there exists insignificant difference in the case of bank based and market based systems with reference to the leverage ratios. Firms with more tangible assets achieve a greater level of internal financing and their debt maturity structure is long in the case of market based systems.
For both financial systems, there is no difference in profits over assets effects. With reference to firms attributes, the only difference between market based and bank based economies is that tradable producers are able to achieve more internal financing in market based economies. This is because tradable producers shift their maturity structure more to the short term.
Financial Services.
Bruce (2005) argues that the overall provision of a full range of financial services is necessary for economic growth achievement in developing countries. In this regard insurance companies, banks consumer finance organizations, government sponsored enterprises, stock brokerage firms and banks are all involved at the same time as sources of finance.
In this regard the financial structure consists of different capital providers at the same time. A detailed analysis of this shows that, the capital mix will be out of different sources. This is very advantageous as even the cost of capital is likely to go down due to the increased supply of capital. In this regard businesses and other firms are able to access capital needed to run their operations.
When businesses are able to access capital to run their operations they are able to contribute to the gross domestic product of the country in a very significant way. This in return spurs economic growth to a greater extent.
A country like the United States relies on financial services to finance 20 of its business operations. Major economic debates about this kind of system reveal that it is efficient in developed countries whereby financial services providers are well advanced.
Though not much criticism has been advanced about the use of financial services it has one major drawback in the rates of default. In this regard it is important to note that with very much default these financial institutions are likely to collapse and thereby will not be in a position to provide capital any further.
In any capital market the presence of financial services depicts a trend that allows for capital consumption in the most efficient way. However, the provision of financial services in developing countries has not been all that effective due to lack of awareness and information about the various sources of finance. In this regard due to the fact that these services are not fully utilized and thereby full blast economic growth is not achieved as would be expected.
In the provision of financial services on fact to behold is that the main emphasis is not the where the finance will be sourced but the emphasis is on the enactment of a conducive environment that provides efficient interaction of capital providers and capital consumers.
The provision of financial services primarily aims at the overall creation of market systems and financial institutions are able to efficiently and effectively finance operations in an economy.
The theory of financial systems aims at driving out the point that both the bank systems and market systems are both necessary for economic growth to be achieved in the best way possible. This is because the bank based system is not sufficient while the market based system is not efficient and thus a mixture of the two is very vital.
According to Levine (2001) different components of the financial system incur different costs depending on the area of coverage. The essence of their operations is just how to meet these costs such as transaction and information costs.
Risk management is also another pertinent issue relating to the financial services sector. This is because the risk associated with default is very high and in this regard a detailed analysis shows that most of these financial services providers try as much as possible to insure their interests so as to avert this risk.
Consequently the need to meet global market needs in terms of imperfections in demand and supply interactions of the market and bank systems contribute to the adoption of both systems so as to bridge this gap between the supply and demand of capital. Different structures adopted by different companies rely on the savings mobilization that financial services provide.
The essence that arises out of the need to tie capital is just enough for government economies to predict the level of change in terms of Gross domestic product and other economic growth measures.
Supply of wages is also dependent on the availability of capital and therefore the level of labor that will be provided to a firm just depends on the financial resources necessary to reward labor as a factor of production.
Any financial arrangement in this setting should therefore engage expert financial and corporate control so as to enhance and meet the desired level of liquidity. In real sense the factor that counts most in either the bank based system or the market system is how much the capital requirements of firms will be meet and what are the opportunity costs involved if these sources of capital are adopted.
The opportunity cost of not adopting a given set of system may be too high such that instead of promoting economic growth it degrades the level of the economy. In this regard careful and thorough market analysis is vital in creation of a financial system that is not only going to spur economic growth and development but one that is also able to sustain this growth.
Levin (2002) argues that The financial services view places the analytical spotlight on how to create better functioning markets and banks, and relegates the bank based versus the market based system debate to the shadows(p. 401).
Despite the fact that emphasis is laid on the bank based system and market based system, there is much need to identify other systems that function in to integration with these systems. One of the systems involved here is the legal system.
There is no business setting without conflict as put across by James (2000). Provision of financial services is very sensitive and therefore different legal measures and procedures must be put in place in order to make sure that these systems run smoothly.
There exists legal rights relating to finance which must be safeguarded at the same time and the reasonable assurance that they can be safeguarded is only provided by the legal system in place.
The reason for the emphasis of legal procedures in this topic is that unfair competition and engaging in illegal financial activities could have a negative impact on economies. In this regard it is vital that the procedures followed in both the bank based system and the financial system should be legal.
Better protection of the financial rights of market players such as financial institutions maintains higher levels of economic growth. Market laws and regulation provide favorable conditions for businesses to be conducted.
However in a contrasting view of the two systems there is a disparity in terms of legal systems. According to Rajan and Zingales (1998) it is quite clear those economies which uphold low levels of legal institutions and with very poor legal systems experience more benefit in terms of economic growth as compared to those that use the market system.
In this theory Rajan and Zingales (1998) also suggests that for the market system to produce high levels of economic growth, very efficient and strict legal systems should be put in place. This is because the market system deals with very many industrial players and lack of their regulation will lead to collapse of business.
Economic development and growth will only be achieved if there crosscutting analysis of the different financial systems and their inherent systems and comparing them with the level of development of the economy at hand and the corresponding legal system adopted.
Measures of Activities of Financial Intermediaries.
This debate would be incomplete if total disregard of financial intermediaries was upheld. Financial intermediaries are found both on the private sector and public sector and are a key determining factor of financial structures adopted by firms.
The size of these financial intermediaries in any given economy is very important as it determines the extent to which they are able to finance investments. There are two key size indicators of financial indicators according to Goldsmith (2009) which include private credit by deposit money banks to GDP and private credit by deposit money banks and other financial institutions to GDP.
The definition of the first measure of financial is based on two variables which are claims on the private sector by deposit money banks and the gross domestic product of a country. To get the real measure the claims on the private sector by deposit money banks is divided by the gross domestic product.
The definition of the other measure is given by the valuation of claims by both deposit money banks and other financial institutions .the general method applied in both measures is the complete isolation of the private and public sectors.
In conclusion it is quite evident that the market system involves large scale economic processes whereas the bank based system is based on the provision of financial services. The market based system is mostly adopted by developed nations like the United States whereas the bank based system is adopted by developing countries such as countries in Africa and Asia. The next chapter aims at analyzing the existing empirical evidence and formulation of economic models that will further this discussion.
Chapter 3 Existing Empirical Evidence
The discussion of the bank based and the market system would be incomplete without empirical examples of countries that have adopted such kind of systems. There would be even no reasonable basis of justifying the success of any of this system in the quest for economic growth and development.
In this analysis, the countries to look at as empirical evidences of how the discussion of these systems holds are the United States and United Kingdom and Germany and Japan for the market and bank system respectively.
One of the major characteristics of any market system of finance is that there exists a lot of freedom in the market as regards factors of production and their regards. The United States and the United Kingdom are some of the countries that have been able to adopt this kind of financial structure.
The major characteristic of the market economy in the United States is that government intervention is very minimal and in this regard the forces of demand and supply determine the level of production and consumption.
A detailed analysis of the United States economy reveals that the factors of production are fully and efficiently utilized by elimination of agency problems and risk control. The economy is founded on the basis of a legal system with sound legal policies which are a further evidence of the existence of a market based system that is so successful.
In this kind of system it is quite evident that labor mobility and efficiency is very high. A detailed view of this system of finance shows that for it to hold the labor market must be very efficient for maximum production or output to be achieved.
Market demand in this type of this system revolves around the interaction of the firms and households. The circular flow of income is what determines what is right for the economy to grow. The circular flow of income is a model that shows the interactions of firms and households in an open economy.
The operation of the circular flow in real sense acts as equilibrium in which both firms and households depend on each other. Equilibrium in the circular flow of income will only occur if the injections created are equal to the corresponding leakages as depicted in the following equation
Savings Taxes Imports Investment Government Spending Exports
The reason for the selection of Japan as a good example of the bank based is because Japan experienced a very fast economic growth due to its bank centered economy. In the 20th century banks were major financiers of operations in Japanese industries and thereby the reliance placed on them by theses industries was on the higher side. It was quite clear that those industries which had preferential access to financial services such as loans were able to grow at higher rate than those that did not rely on these services.
Though this debate remains strong in the minds of many scholars still some of them believe that the height of growth of the Japanese economy was as a result of strict government control and regulation of corporate finance.
Gerschenkron and modern theorists believe that argument which proposes Japanese growth was as a result of the presence of banks is flawed and lacks some sense of truth in it. They believed that the existence of banking institutions that gave firms access to loans and other kinds of debt did not really give these firms and advantage over others in terms of better investment and financial well being.
Perhaps a force to reckon with in this debate was the existence of the Zaibatsu group. This was one of the most powerful financial cliques of the late 1990s and early 2000s. It was believed that banks at the time which financed industrial and financial operations were under the direct control of Zaibatsu in a very significant way. This forms one of the reasons why Gerschenkron and modern theorists believed that banking systems were not involved in the economic growth of Japan.
Gerschenkron believed that the banks provided the necessary finance but it was the government that was responsible for the guidance and direction of these financial resources in order to spur economic growth.
Most of the affiliate banks under Zaibatsu were also involved but it was through the direction and focus provided by the government that sustainable economic growth was achieved. In this regard inefficiencies in financial markets were eliminated through government regulations according to Gerschenkron and his fans.
Though Gerschenkron viewed the Japanese system as one that was not contributed to by banks he reached to a point of controversy with William Lock wood one of the scholars who proposed that the Japanese system was purely run by the zaibatsu financial conglomerate.
In this regard Gerschenkron explained the economic growth of Japan as one that grew reasonably fast not because of Zaibatsu but because of the avoidance it insisted on the decentralized market system.
The German system on the other hand is one that grew out of the presence of decentralized intermediaries like Japan. Germany developed at the height of the world wars and the economy had even at one time dampened as a result of a recession.
Through the existence of market systems that were quick to generate revenues from economic facilities such as banks, Germany had no option apart from empowering them. The reason for the fast economic growth was because Germany had experienced very successful industrialization.
The intermediaries system was highly heightened during the Hitler era (1933-1945) whereby financial institutions were given high government support through the use of subsidies to the sectors that were likely to spur economic growth. Though this was a move by Hitler in order to give Germany military as well as economic power, it enabled the creation of efficient sources of finance.
The advantages stipulated under the bank based system existed also in Germany. In fact the Germans proudly label their economy as a social market economy or soziale Marktwirtschaft, In this regard control of financial structures was independent unlike in earlier times whereby it was dominated by government intervention and control.
The major privilege that this intermediaries system enjoyed then was the fact that the existing markets at the time of industrial revolution in Germany was able to diversify and manage risks very efficiently. In fact the car industry then was able to survive through effective risk management practices.
Germany also experienced very high technological advances and the best source of finance at this time was the bank system as compared on to the market system which required the presence of superior information and high government regulation.
The issue at hand during the time of Nazi power was the fact that there existed so much diversity in opinion among the stakeholders. Also there was no much perfect information present during that time. According to (Allen and Gale 1999, 2000) where there is scarcity of information and very diverse opinions, the bank oriented system comes in handy than the market based system in promoting long run economic growth.
The major concern in the Germany economy which also turned out to work very well with the bank system was the legal system that existed in the country at that time. This in turn ensured that business processes such as contracts were run smoothly and whenever there was conflict the legal system in place was able to handle them in the best way possible.
Long run economic growth is just not easy especially when financial structures come in place. The general economic situation should be one that fosters an economic condition which is suitable for adoption of any of the above system. The analysis of the countries, Japan and Germany just shows how the conditions present at the moment were able to spur economic growth and development in the long run in these two countries.
The fact that finance is a necessary condition for economic growth and development is necessitated by the investment opportunities present. (Allen and Gale 1999, 2000) stipulates that countries do not grow fast if there is an inadequate finance to finance business operation.
However this debate has been criticized over time by most literatures and they try to explain that financial structure is not important for economic growth. Therefore the general effect of financial structures on economic growth must be taken cautiously.
Conclusions from technical surveys suggest that there is just sufficient evidence that financial structures cannot be relied upon as the only measure of explaining why different countries have different growth rates.
The explanation advanced in light of this disparity is that the access of finance in either of the two systems is not something that is just so easy and therefore the existence of different countries with similar growth rates but with different financial systems.
In light of this the most important factor according to (Allen and Gale 1999, 2000), is the existence of a very strong legal system that is able to ensure that the rights of investors are properly safeguarded and that contracts are enforced in the best way possible.
The advantage of this is that financial markets are developed efficiently and that fair play is enhanced. Intermediaries in the market sector also get a chance to develop efficient systems which in turn improve their operations.
Chapter 4 Specification and Econometric Methods
The general analysis of the production function can be done on the basis of determination of the level of output of a given economy. In this regard we assume that the economy upholds two main factors of production which are labor and capital.
The optimum combination of the two factors of production is what yields the level of production in a given economy. This optimum combination where by the producer is indifferent is depicted by the use of a contour line called the isoquant. This is where the production process is based.
The production function specifies the output of a given economy or industry. Though seen as a subject based or derived from micro economics, it is quite evident that most of the macroeconomic principles are based on the production function.
This is to show that there exists a mathematical relationship between the output derived in a given economy and the input of the two factors of production mentioned earlier. The main issue of concern in the components of the production function is determination of the most optimal combination of these factors of production.
It is also quite evident that sometimes one of the factors of production is fixed while the other one is variable in the short run. However, the production function is not influenced by this and in real sense it remains constant.
Production theory basics are not interested in monetary factors such as costs and price but are rather interested in physical units of output in an economy. This kind of function completely ignores the business processes and therefore fixed and variable costs determination is not necessary for the advancement of this debate.
The main issue of concern in this debate is how the financial structure can be incorporated in the production function and has an impact on the economic growth of a given country. This will be in the determination of the most efficient input allocation to derive maximum input.
This specific analysis involves the application of a generalized production function of the following form
Q f(X1, X2, X3...Xn)
Where
Q represents the quantity of physical units produced,
X1, X2, X3...Xn represents the various factors of production such as capital, land, labor and entrepreneurship
However, in our debate due the fact that we are not interested in joint production as would be yielded by the above equation we take a general form of the Coub- Douglass production function. Being a multiplicative production function it is represented as follows
QF (K, L)
Where
Q quantity of physical units produced
K capital
L labor
To advance this debate let X1 represent labor and X2 represent capital. Since the Coub-Douglass function is a multiplicative model it will take the form
Where a, b, and c are parameters which have been empirically determined.
To simplify the equation we simply add logs and the function will be as follows
Log (QX2) a b c log(X1X2) a
To relate this equation to the financial structure we introduce a variable that is the percentage of the overall market capitalization over bank lending. The coefficient of this function is represented by W as follows
Log (QX2) a b c log(X1X2) a d log (W) a
A high value of W means that the economy is more of a market based economy rather than a bank based economy since bank lending is low. On the other hand a low value of W means that bank lending is high and so the market is more of a bank based system.
With this econometric relation in place it is quite clear that it is easy to establish a relationship between the level of production and the financial structure involved in the course of the production.
The various data available only accounts for per capita output rather than data on labor because time series on labor force does not exists and if it does it is not sufficient. The parameter in place especially d determines the level of impact financial structure creates on economic growth. In this regard the more significant it is, the bigger the effect it creates on economic growth and the less the significance the lower the effect it creates on economic growth.
CHAPTER 5 DATA ANALYSIS
The data provide in the table shows very important information on economic growth in terms of the share of gross domestic product and the corresponding market exchange rates. One very clear observation in the table is that United States has one of the highest shares of gross domestic product in the world as compared to other countries such as Germany and Japan.
Major evidence available is that United States has one of the highest market exchange rate indexes. This supports the adoption of the market based system as a source of finance for the different firms and industries in the United States. This shows that the market system is efficient enough to generate a market index that is very high.
Comparison with other developing countries shows that their share of gross domestic product is quite low as compared to the United States. Their market index is also very low as compared to that of the United States. One of the contributing factors to this is the adoption of a bank based system.
The data in this table takes into analysis various parameters in the United States. In the first instance it is quite clear that the United States operates a market based financial system. The data ranges from the year 1960 to the year 1980 when industrial revolution n in the United States was still a factor to reckon with. It is quite clear that the FINANCIAL SYSTEM DEPOSITS GDP ratio has been on the rise since 1960 signifying significant level of economic growth. Market capitalization is also on the rise according to the data given.
A careful analysis of this data shows that more and more economic growth is achieved as years go by and there is increase in bank credits in the US. This suggests that however the debate of the adoption of a pure market based system in the US may hold. There is a significant adoption of finance from banking institutions.
The data provided also gives a clear relation that economies grow as a result of market efficiencies. In this regard as market growth is enhanced by the presence of adequate finance for the corresponding industries. This is evidence by the growth of liquid liabilities by industries from 1582626.00 in 1960 to 3650927.00 in 1980 in the United States.
The graph of growth in liquid liabilities sin the united states clearly shows this. In this regard it is quite evident that growth in the gross domestic product has also been contributed by the growth in liabilities over the years. This means that the different sectors are able to access funds.
This is an analysis of Japan and Germany which adopted the bank based system in their economic growth measures. BANK CREDIT BANK DEPOSITS show a rising trend. A high correlation exists between the level of deposits and borrowings as years go by. In this regard these countries exhibit a high reliance on the bank system.
One of the features evidencing this is the rise in gross domestic levels as evidenced in the increase of the BANK DEPOSITS GDP ratio over the years. For example the table shows that Germany had a BANK DEPOSITS GDP ratio of 0.32 in the year 1960 while in the year 1980 there was a significant increase of this ratio to 0.53 meaning that there was significant increase in the gross domestic product thereby economic growth.
The overall growth in money deposits in the banks created over the years just shows by how much Japan relied on finance from banks. BANK DEPOSITS GDP are a measure of by how much the bank deposits contribute to the economic growth in terms of the growth in domestic product.
The graph of the growth in BANK DEPOSITS GDP over the years shows this.
Attached too are excel file which show different aspects of financial structures and their relevance to economic growth in different countries. This analysis draws its data form low income countries, medium income countries and high income countries of the world.
Some of the aspects contained in the excel files are world bank income group of the country which shows whether a country is in which group of income according to world bank statistics and deposit money bank assets (deposit money central) bank assets . The three countries involved in this analysis are Gabon which happens to be an upper middle income country, Indonesia which is a lower middle income country and France which is a high income country.
The three countries analyzed show different parameters as regards deposit money bank assets (deposit money central) bank assets, liquid liabilities GDP, central bank assets GDP, deposit money bank assets GDP, other financial institutions assets GDP, private credit by deposit money banks GDP, bank deposits GDP, bank credit bank deposits, financial system deposits GDP, and private bond market capitalization GDP over different years.
Chapter 6 Conclusion
This paper was geared to focus on the effects of financial structure and economic growth and a brief literature on the same has been put across. The link that exists between the financial structures put in place by different countries and the growth rate they experience has also been explained.
A detailed analysis on how different financial structures are deficient or efficient has also been put forward. In this it is prudent to conclude that there is diversity of opinion and views that the suitability of any financial structure on any country cannot just be measured in real terms but is affected by many other factors.
The various theoretical and technical approaches advanced against the market based system derive their negativity from the advantages of the bank based system. On the other hand the disadvantages of the bank based system are derived from the various advantages of the market based system.
The disparity in the views advanced by various scholars implies that economic growth is not only dependent fully on the financial structures adopted by the various countries. This debate is contributed by the fact that different economies have different financial structures but experience nearly the same growth rate.
It is has also been evident that legal institutions and the general concept are key issues to consider in the adoption of any of these systems. This is because legal institutions determine the protection of investors rights and the also determine the extent to which contracts are enforceable. Finance is also vital especially in the bank based system since it helps in evaluation of financial decisions.
Another major area of concern has been how different financial structures impact on economic growth of different countries. It has been quite clear that most of the developing countries prefer the bank based system rather than the market system.
Developed countries like the United States have adopted the market based system and are therefore able to support their economies as a result of stable financial markets. They also have a definite well balanced circular flow of income whereby there is efficient interaction of both demand and supply.
It is also quite clear that through the different literature that is available from various scholars, that the bank based system, financial services and the law and finance views have more theoretical support than the market based system. This is due to the prevailing strict conditions that are available under the market based system.
One feature to note in modern economies is that both the market system and bank based systems complement each other. The issue at hand in the market system is how far the government should regulate the different aspects of the economy so as to maintain market demand and availability of funds at the optimum. Through this regulation, it is inevitable to employ the services of intermediaries. The whole process ends up being a mixed financial structure since it has aspects of both the bank based system and the market system.
As advanced throughout the development of this paper it is quite evident that the two different financial structures have their corresponding advantages and disadvantages depending on the different economic scenarios. The choice of what system to adopt depends on the suitability it poses on the countrys economic growth and development.
The bank based system or the use of intermediaries is better suited for financing firms that engage in economically viable projects where by the possibility of existence of a moral hazard such as default is highly mitigated. For example financial institutions such as banks will finance capital investment with the likely hood of yielding higher returns as opposed to those that do not yield return
On the other hand the market system is well suited for financing developed economies whereby there is existence of a continuous advancement in technologies. It is also very efficient in countries where by firms are able to function with minimum government intervention in the provision of financial aid.
Different countries differ in the extent to which their financial systems are either bank based or market based. The extent to which a financial system is said to be bank based is dependent on the overall reliance in mobilizing savings and allocation of capital by the banks in existence.
The most ideal economy that would be in existence would be the economy that upholds the two financial structures at par. This is because adoption of any of the systems has its shortcomings that are derived from the strong points of the other. For example one of the shortcomings of the use of intermediaries such as banks is the risk of default. However if there was existence of a well developed financial market this risk could be minimized as there exists financial markets which can be used as an alternative source of finance.