1. Triphon Phumiwasana Milken Institute ephumiwasana@milkeninstitute.org Conference on Political Economic Indicators and International Economic Analysis: Measuring Quality and the Quality of Measures October 12-13, 2007 Diversified Financial Structure: Implications for Economic Growth and Stability

2. Why Study Financial Structure? “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

3. Motivation   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)

4. Growing Number of Articles (Results from a Google Scholar Search) Year Phrase Used in Search Both “Bank-Based Financial System” “Market-Based Financial System” 1997462 1998780 19999172 200016257 2001222710 2002314011 2003414816 2004444915 2005554210 2006484114 2007YTD21249

5. Selected Papers Reviewed 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. (2005) “ 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. Relationship Lending within a Bank-Based System: Evidence from European Small Business Data,” 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.

6. Measuring Financial Structure “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

7. How to Define Financial Structure? 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?

8. Financial Intermediation and Disintermediation Source: Laurent Jacque, 2001 Households Firms Debt, equity and private placement Mostly debt

9. Composition of Financial Assets Held By Households June 2007 United States $44.3 Trillion Japan $13.5 Trillion Source: Bank of Japan

10. Data Sources  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)

11. Simplified Version of “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?

12. Why Do Bank-Based Systems Develop First?   High initial cost to develop financial infrastructure for broader market development.   Banks lobby to keep out competitor.

13. Role of Market-Based Systems   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.

14. Factors Effecting Financial Structure 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)

15. Common Measurements of Financial Structure  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:  Efficiency: Reciprocal of Bank Overhead Cost to Total Asset Multiplied by Stock Market Traded Value / GDP

16. Time and Regional Differences in Financial Structure: Activity Time and Regional Differences in Financial Structure: Activity Bank Credit to Private Sector relative to Stock Market Traded Value 80 - 8485 - 8990 - 9495 - 9900 - 042005 High Income42.813.843.481.741.301.06 South Asia11.9115.594.682.050.950.49 Sub-Saharan Africa 23.1323.0218.005.363.212.52 Europe & Central Asia NA42.226.963.313.172.72 Latin America & Caribbean 40.9014.315.718.9810.835.79 East Asia & Pacific 10.32 6.84 1.24 1.89 2.61 2.71 Middle East & North Africa 9.49 12.83 8.97 8.15 7.76 1.16

17. Time and Regional Differences in Financial Structure: Size Time and Regional Differences in Financial Structure: Size Bank Credit to Private Sector relative to Stock Market Capitalization 80 - 8485 - 8990 - 9495 - 9900 - 042005 High Income14.751.561.491.081.020.92 South Asia6.493.791.071.581.740.82 Sub-Saharan Africa2.091.31.030.650.790.65 Europe & Central Asia NA4.673.881.921.461.38 Latin America & Caribbean 3.22.811.091.310.90.53 East Asia & Pacific1.791.780.720.860.910.8 Middle East & North Africa 0.951.481.791.391.510.72

18. Time and Regional Differences in Financial Structure: Efficiency Time and Regional Differences in Financial Structure: Efficiency Reciprocal of Bank Overhead Cost to Total Asset Multiplied by Stock Market Traded Value / GDP 90 - 9495 - 9900 - 04 2005 High Income184.5778.8847.5038.34 South Asia851.77313.49131.9356.8 Sub-Saharan Africa1,450.84408.18219.6149.70 Europe & Central Asia689.90236.81276.88253.65 Latin America & Caribbean 330.73499.09466.95375.13 East Asia & Pacific86.08117.36192.68214.31 Middle East & North Africa1,173.26846.36692.94103.52

19. Differences Among Emerging Markets Financial Structures 2004ActivitySizeEfficiency Venezuela58.622.6014092.81 Philippines3.740.75247.61 Chile3.630.54143.06 Malaysia2.690.72184.20 Poland2.620.95398.54 Hungary2.191.70150.06 Mexico2.130.54276.74 Israel1.811.0087.69 Egypt1.570.68168.66 Indonesia1.490.81239.37

20. Differences Among Emerging Markets Financial Structures 2004ActivitySizeEfficiency Brazil1.490.5766.94 Thailand1.451.08112.36 Argentina1.130.34141.2 Czech Republic0.991.17108.99 South Africa0.960.3822.62 Korea0.951.5941.56 Singapore0.940.59117.32 India0.650.6184.76 Hong Kong0.550.2718.13 Turkey0.380.5929.82 Pakistan0.210.7935.84

21. Hypotheses H 1 : A market-based financial system has a positive and significant impact on economic growth H 2 : A market-based financial system has a negative and significant impact on the stability of growth

22.   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 Data

23. Estimation Y it = Five-year average GDP Growth X it = Control variables (Initial income, Government Expenditure, Trade and Schooling) B it = Natural log of bank credit to private sector as a share of GDP F it = Financial structure (higher value indicates more bank-based system) I i = Lack of Property rights, Corruption, Costly of Contract Enforcement Z it = Instrumental variables B it (hat) = estimated B it Time-Fixed Effects with Instrumental Variables:

24. Dependent Variable: Growth of Real GDP Per Capita All Countries Developed Countries Developing Countries

25. Dependent Variable: Standard Deviation of Growth in Real GDP Per Capita All Countries Developed Countries Developing Countries

26. Conclusions  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.

27. Conclusions  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.

28. Suggestions for Future Research  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