Diversified Financial Structure: Implications for Economic Growth and Stability
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Diversified Financial Structure: Implications for Economic Growth and Stability. Triphon Phumiwasana Milken Institute [email protected] Conference on Political Economic Indicators and International Economic Analysis: Measuring Quality and the Quality of Measures

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Diversified Financial Structure: Implications for Economic Growth and Stability

Triphon Phumiwasana

Milken Institute

[email protected]

Conference on Political Economic Indicators and

International Economic Analysis:

Measuring Quality and the Quality of Measures

October 12-13, 2007


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Why Study Financial Structure? Growth and Stability

“Diversity within the financial sector provides insurance against a financial problem turning into economy-wide distress”

Alan Greenspan, 1999

“It is the financial services themselves that matter more than the form of their delivery. … It is better to focus policies on development of a solid infrastructure, rather than specific structures.”

World Bank, 2001


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Motivation Growth and Stability

  • Increasing number of financial market reforms in Latin America and Asia, encompassing the stock, bond and derivative markets

  • Long economic downturns in major bank-based systems—Japan and Germany

  • Empirical Evidence: Mixed

    • No cross-country relationship between financial structure and growth (Levine, 2002).

    • Market-based systems outperform bank-based systems among developed countries, while bank-based systems outperform market-based systems among developing countries (Tadesse, 2002).

    • Bank-based systems promote long-run growth better than market-based systems (Arestis et al, 2001)

    • Bank-based systems can reduce the impact of interest rate shocks. (Scharler, 2006)


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Growing Number of Articles Growth and Stability(Results from a Google Scholar Search)


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Selected Papers Reviewed Growth and Stability

  • Pinno, Karl and Apostolos Serletis (2007) “Financial structure and economic growth: the role of heterogeneity,” Applied Financial Economics

  • Chakraborty, Shankha and Tridip Ray (2006) “Bank-based versus Market-based Financial Systems: A Growth-theoretic Analysis,” Journal of Monetary Economics.

  • Scharler, Johann (2006) “Do Bank-Based Financial Systems Reduce Macroeconomic Volatility by Smoothing Interest Rates?,” Austrian Central Bank Working Paper.

  • Vitols, Sigurt (2005) “Changes in Germany's Bank-Based Financial System: implications for corporate governance,” Journal of Corporate Governance.

  • O. Emre Ergungor (2004) “Market- vs. Bank-Based Financial Systems: Do Rights and Regulations Really Matter?,” Journal of Banking and Finance.

  • Levine, Ross (2002) “Bank-based Or Market-based Financial Systems: Which Is Better?,” Journal of Financial Intermediation.

  • Degryse, Hans and Patrick Van Cayseele(2000) “Relationship Lending within a Bank-Based System: Evidence from European Small Business Data,” Journal of Financial Intermediation.

  • Weinstein, David E, Yishay Yafeh (1998) “On the Costs of a Bank-Centered Financial System: Evidence from the Changing Main Bank Relations in Japan,” Journal of Finance.

  • Gertler, Mark (1998) “Financial Structure and Aggregate Economic Activity: An Overview,” Journal of Money, Credit and Banking.


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Measuring Financial Structure Growth and Stability

“Because financial structure is determined by a combination of financial instruments and financial institutions, several aspect must be taken into account and given quantitative expression when ever possible. They are:

  • the relation of total financial assets to total tangible assets;

  • the distribution of total financial assets and liabilities among various types of financial instruments;

  • and the position of financial assets and liabilities in the accounts of the various economic sectors.

    Each of these stock relations has a corresponding flow aspect, doubling the number of relation relevant for the study of financial structure”

    Raymond Goldsmith

    Financial Structure and Development, 1969


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How to Define Financial Structure? Growth and Stability

  • Financial institutions vs. financial markets?

  • Banks vs. stock market?

  • Insurance companies? Bonds? Derivatives? Private equity? Hedge funds? Personal funding? Cooperative banks? Microfinance?

  • Domestic vs. cross-border funding?

  • Financial sector: Depth? Activity? Size? Efficiency?

  • The composition of the source of funding of firms in a country?


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Financial Intermediation and Disintermediation Growth and Stability

Mostly debt

Debt, equity and private placement

Households

Firms

Source: Laurent Jacque, 2001


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Composition of Financial Assets Held By Households Growth and StabilityJune 2007

United States

$44.3 Trillion

Japan

$13.5 Trillion

Source: Bank of Japan


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Data Sources Growth and Stability

  • Flow of funds: U.S., U.K., Japan, Germany, Malaysia, China

  • International Financial Statistics (bank)

  • BankScope (bank data)

  • Bank for International Settlements (bond and derivative)

  • Global Stock Market Fact Book--S&P (stock by country)

  • World Federation of Exchanges (stock by exchange)

  • SwissRe (insurance)

  • Bloomberg (stock by exchange, bond, derivative)

  • Thomson Financial (stock, bond and derivative)

  • World Bank financial structure database 2007 (bank, stock, bond, insurance)


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Simplified Version of Growth and Stability“Financial Structure”

  • Examine the two widely used channels which connect saving to investment

  • Classification of channels: market-based vs. bank-based systems

  • Most evidence shows that finance promotes growth, but do channels of finance matter?


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Why Do Bank-Based Systems Growth and Stability Develop First?

  • High initial cost to develop financial infrastructure for broader market development.

  • Banks lobby to keep out competitor.


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Role of Market-Based Systems Growth and Stability

  • Allow portfolio diversification for investors and widening the choice of finance for firms.

  • “Spare Tire”: At macro level, so long as both systems are not perfectly correlated, having two system may produce a more stable economy.


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Factors Effecting Financial Structure Growth and Stability

Level of Development (Boyd and Smith,1996; Gurley and Shaw, 1955)

Legal Origin(La Porta et al,1998)

Laws and Regulations (Levine, 2002; World Bank, 2001))

Demographics and Human Capital (Black, 2002)


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Common Measurements of Financial Structure Growth and Stability

  • Activities: Bank Credit to Private Sector relative to Stock Market Traded Value

  • Size: Bank Credit to Private Sector (some authors use Bank Assets) relative to Stock Market Capitalization

  • Efficiency:Reciprocal of Bank Overhead Cost to Total Asset Multiplied by Stock Market Traded Value / GDP


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Time and Regional Differences in Growth and StabilityFinancial Structure: ActivityBank Credit to Private Sector relative to Stock Market Traded Value


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Time and Regional Differences in Growth and StabilityFinancial Structure: SizeBank Credit to Private Sector relative to Stock Market Capitalization


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Time and Regional Differences in Growth and StabilityFinancial Structure: EfficiencyReciprocal of Bank Overhead Cost to Total Asset Multiplied by Stock Market Traded Value / GDP




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Hypotheses Growth and Stability

H1: A market-based financial system has a positive and significant impact on economic growth

H2: A market-based financial system has a negative and significant impact on the stability of growth


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Data Growth and Stability

  • WDI (209), IFS (168), S&P (114)

  • Annual data: 1985-1999

  • 5-year panel data

    • Financial structure changes over time

    • More degree of freedom

    • Average business cycle is about 4-5 years

  • 114 countries in bivariate, 68 countries in multivariate, regressions

  • Separate developing and developed countries

    • Robustness check

    • Institutional differences


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Estimation Growth and Stability

Time-Fixed Effects with Instrumental Variables:

Yit = Five-year average GDP Growth

Xit = Control variables (Initial income, Government Expenditure, Trade and Schooling)

Bit = Natural log of bank credit to private sector as a share of GDP

Fit = Financial structure (higher value indicates more bank-based system)

Ii = Lack of Property rights, Corruption, Costly of Contract Enforcement

Zit = Instrumental variables

Bit(hat) = estimated Bit


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Dependent Variable: Growth and StabilityGrowth of Real GDP Per Capita

All Countries

Developed

Countries

Developing

Countries


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Dependent Variable: Growth and StabilityStandard Deviation of Growth in Real GDP Per Capita

All Countries

Developed

Countries

Developing

Countries


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Conclusions Growth and Stability

  • Bank-based financial structures in general have a negative impact on growth. The results are stronger for developed countries.

  • Evidence is inconclusive as to whether a bank-based or market-based system is better for growth for developing countries.


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Conclusions Growth and Stability

  • On average, evidence does not indicate that a bank-based system either lowers or increases volatility of growth

  • Among developed countries, however, a bank-based system is positively associated with higher volatility of growth.

  • Some evidence exists, however, that for developing countries a bank-based system is negatively associated with volatility of growth.


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Suggestions for Future Research Growth and Stability

  • Improve financial structure measurements

  • Examine whether government ownership of banks affects the relationship between a bank-based financial structure and growth.

  • Examine the degree to which cross-border financing impacts the domestic structure, and whether the inflow through each channel impacts economic growth differently.

  • Examine bond market development and growth


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