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CHAPTER 4
Financial Systems
The availability and access to finance can be a crucial The historical experience of industrial nations and
influence on the economic entitlements that economic the experience of developing countries today point to
agents are practically able to secure. This applies all the another important lesson. Sound public finances and a
way from large enterprises (in which hundreds of stable currency are key to the development of private fi-
thousands of people may work) to tiny establishments nancial institutions.5 For example, the Dutch “financial
that rely on microcredit. revolution” started with the development of public debt
—Amartya Sen, 1999 in the form of negotiable securities, and England solved
the liquidity and public debt problems by introducing
6
long-term and perpetual annuities. More recently, gov-
conomic history provides ample support for the ernments that have suppressed their financial systems
idea that financial development makes funda- in order to finance public spending have ended up with
Emental contributions to economic growth. Fi- troubled and underdeveloped financial systems.
nancial development played a critical role in promot- One of the important functions of financial systems
ing industrialization in countries such as England by is to shift risk to those who are willing to bear it. Fi-
facilitating the mobilization of capital for large invest- nancial contracts can help pool and diversify risk. Re-
ments (box 4.1). Scholars have also argued that well- cent studies find that financial development also tends
functioning banks spur technological innovation by 7
identifying and funding those entrepreneurs with the to reduce aggregate economic volatility. This is an im-
best chances of successfully developing new products portant insurance mechanism for the poor or near-
1 poor, since negative economic shocks increase the
and implementing innovative production processes. numbers of the poor. However, although financial sys-
A large body of evidence suggests that financial de- tems have risk-reduction capabilities, in the absence
velopment contributes significantly to growth, even after of supporting institutions that provide prudent risk-
2
accounting for other growth determinants. Through its taking incentives, financial development can lead to
strong effect on overall economic growth, financial de- 8
velopment is central to poverty reduction. Recent re- the magnification of risk rather than its mitigation.
search also shows that financial development directly Financial markets arise to reduce the information
benefits the poorer segments of society and that it is as- costs of borrowing and lending and of making trans-
sociated with improvements in income distribution.3 actions. In so doing, financial systems serve a number
Preliminary evidence suggests that measures of finan- of functions that are essential in a modern economy.9
cial development are positively and significantly corre- They provide payment services that facilitate the ex-
lated with the share of income of the bottom quintile change of goods and services, mobilize savings, allocate
4 credit, and monitor borrowers. By evaluating alterna-
of the income distribution. Thus, arguments that the
development of the formal financial system only bene- tive investments and monitoring the activities of bor-
fits the rich do not appear to be supported by the em- rowers, financial intermediaries overcome information
pirical evidence. problems and increase the efficiency of resource use.
Box 4.1 ticular financial structure. What is important is to have
The financial revolution versus the industrial secure rights for outside investors and efficient contract
revolution enforcement mechanisms—central themes of this Re-
port. Openness to trade and greater competition con-
It is commonly believed that technological development tribute to the development of financial institutions, re-
in England during the late 18th century was the driving gardless of the country’s legal origin, colonial history,
force behind the industrial revolution and modern eco-
nomic growth. An alternative perspective gives more em- or political system.
phasis to the significance of institutional change and par- Financial regulation becomes a far easier task when it
ticularly to the role of financial institutions in the process. makes use of the monitoring and disciplining ability of
For example, some argue that capital market improve- market participants. An essential element of improving
ments, which mitigated liquidity risk, were the primary
cause of the industrial revolution. Many of the inventions the quality and effectiveness of market discipline for fi-
already existed but required large injections and long-term nancial institutions is ensuring the accuracy and availabil-
commitment of capital, which was not possible without ity of information on the operations of these institutions.
further development of financial markets. The industrial Developing countries with poor information and human
revolution had to wait for the financial revolution. resources and lacking the complementary institutions
As in England, a sophisticated financial system devel-
oped in the United States before its industrial revolution that would facilitate the monitoring and enforcement of
in the 19th century. The Dutch Republic, long before its capital standards may still benefit from additional buffers
remarkable growth in the 17th century, had a financial rev- that are easier to observe and enforce. Examples are liq-
olution that involved institutional innovations such as the uidity requirements and rules that require action by reg-
adoption of negotiable international bills of exchange to fi-
nance the economy’s external trade, negotiable securities ulators under well-specified conditions.
to finance the public debt, a convenient payment system, Bank privatization affects the efficiency of financial
a stable currency, a strong private banking system, and se- services. Individual country experiences show that ef-
curities markets. fective regulation and a clean balance sheet are critical
Source: Hicks 1969; Rousseau and Sylla 1999; Sylla 2000. for successful privatization. Competition improves effi-
ciency, increases incentives for innovation, and pro-
motes wider access. Recent evidence indicates that ac-
cess to finance by smaller firms does not decrease with
Financial systems limit, pool, and trade risks resulting foreign entry. Country experiences demonstrate that
from these activities. an efficient banking system requires a contestable sys-
Financial assets, with attractive yield, liquidity, and tem—one that is open to entry and exit—but not nec-
risk characteristics, encourage saving in financial form. essarily one with many competing institutions.
A financial system’s contribution to growth and poverty Even in the most developed financial systems, in-
reduction depends upon the quantity and quality of its formation problems and the relatively high fixed costs
services, its efficiency, and its outreach. of small-scale lending limit the access of small firms
Financial institutions include banks, insurance com- and microenterprises. A system of complementary in-
panies, provident and pension funds, investment and stitutions can help. Improving collateral laws and es-
pooled investment schemes (mutual funds), compul- tablishing collateral registries, improving information
sory saving schemes, savings banks, credit unions, and about small borrowers through credit registries, and re-
securities markets. In developing countries, particularly ducing costs through the use of computerized credit-
in poorer areas, highly personalized types of lending scoring models are ways of improving access for small
with enforcement mechanisms based on local reputa- borrowers.
tion and group norms also play a very important role. This chapter discusses how financial structure varies
The challenge facing policymakers is to build robust across countries and the effect of financial structure on
financial systems that assist in risk mitigation in the economic outcomes. It then considers regulation of
event of shocks. This chapter provides lessons for pol- banks, ownership, and competition in the banking sec-
icymakers to help them reach this goal, based on re- tor and institutions to increase access to banking for
search and on country experiences, most of which have those who are currently left out. Issues related to stock
become available in recent years. market development are also covered in chapter 3.
Policymakers should consider improving the legal Nonbank financial intermediaries are covered in a re-
10
and regulatory environment rather than building a par- cent World Bank report and are not addressed here.
Should policymakers promote bank-based Should policymakers concerned with promoting
or market-based financial systems? growth and poverty reduction focus on developing
As economies develop, the needs of the users and the banks or developing stock markets? Some argue that
providers of financial services change. Informal finance banks have advantages over markets when complemen-
15
becomes less important, and self-financed capital in- tary institutions are weak. Even in countries with
vestment gives way first to bank-intermediated debt fi- weak legal and accounting systems and poor contract
nance and later to the emergence of capital markets, as enforcement, powerful banks can force firms to reveal
additional instruments for raising external funds (fig- information and pay their debts, thus facilitating in-
dustrial expansion.16 Conversely, well-developed stock
ure 4.1).11 Although banks dominate most formal fi-
nancial systems, the relative importance of the stock markets quickly reveal information, which reduces the
market tends to increase with the level of development incentives for individual investors to acquire informa-
(box 4.2).12 Far more finance is raised from bank loans, tion. This can reduce incentives for identifying innova-
tive projects, hindering efficient resource allocation.17
however, than from selling equity, even in industrial Furthermore, since investors can sell their shares inex-
countries.13 pensively, their incentives to monitor managers rigor-
Economists have debated the role of financial struc- ously are diminshed, which hinders corporate control
ture—the advantages and disadvantages of bank-based and national productivity.18 But stock markets provide
financial systems relative to market-based systems—for the ability to diversify risk and customize risk manage-
more than a century. At the end of the 19th century ment devices.
German economists argued that the German bank- The importance of financial structure for economic
based financial system had helped Germany overtake development has been extensively examined in recent
the United Kingdom as an industrial power. During the research. Country-, industry-, and firm-level investiga-
20th century the debate expanded to the United States tions all show that for a given level of development, dis-
and Japan.14 More recently, the question of the overall tinguishing countries by financial structure does not
design of a financial system has demanded the atten- help explain cross-country differences in long-run
tion of policymakers, with the urgent need to design fi- GDP growth, industrial performance, new firm forma-
nancial systems in many transition economies. 19
tion, firm use of external funds, or firm growth.
Figure 4.1
Financial system development across income groups
Percentage of GDP
60
Low income
50 Lower-middle income
Upper-middle income
40 High income
30
20
10
0
Central bank Deposit money Other financial Stock market Private bond market Public bond market
assets bank assets institution assets capitalization capitalization capitalization
Box 4.2 formation and accounting systems, and low levels of
Financial structure varies across countries: corruption to develop.
better information and legal systems that Financial structures generally do not change rapidly,
protect property rights play a role but there are exceptions. For example, Indonesia and
Turkey experienced changes in their financial structures,
A recent World Bank study built a database starting in the owing to rapid growth of their stock markets in the
1960s on financial markets and intermediaries for more 1980s following financial liberalization. The Republic of
than 100 countries. The study developed a number of in-
dicators that measure the relative size, activity, and effi- Korea is another notable exception because of the rapid
ciency of financial intermediaries and markets. The indica- development of its nonbank financial sector, where strict
tors, on the whole, show a tendency for financial systems government banking regulations did not apply. In Chile
to become more market based as countries become nonbank financial intermediaries and the stock market
richer. The table presents the relative activity measure of also experienced rapid development in the early 1980s,
financial structure and shows that countries can be classi-
fied as market based either because they have very liquid largely as a result of the privatization of the pension sys-
markets (as is the case for the United States) or because tem.20 Efforts to change financial structure overnight
they have poorly developed banking sectors (Mexico and usually do not succeed. Attempts to build stock markets
Turkey). To the extent that a country’s laws help potential in several transition economies and African countries in
shareholders feel confident about their property and vot-
ing rights without fear of corruption, and to the extent that recent times have not been very successful because the
comprehensive, high-quality information about firms is underlying legal, information, and enforcement mecha-
available to outside investors, financial systems tend to be nisms were underdeveloped (box 4.3).
more market based. Policies to promote financial development are likely
Financial structure across countries to be more effective if efforts are directed at developing
Value traded/ Bank credit/ the legal and regulatory environment to support the nat-
GDP GDP Structure- ural evolution of financial structure. Financial system
Country (percent) (percent) activity development depends critically on the protection of pri-
Germany 18.7 85.7 0.661 vate property. Recent studies have shown that legal pro-
India 4.8 24.1 0.701 tection of minority shareholders and creditors is a sig-
Japan 38.3 103.9 0.433
Mexico 6.3 14.8 0.371
Nigeria 0.03 12.5 2.619
Thailand 20.3 51.1 0.401 Box 4.3
Turkey 6.2 12.9 0.318 Promoting stock markets in developing
United States 34.4 65.2 0.277 countries
Note: Value traded/GDP = value of all shares traded on the ex-
change as share of GDP. Bank credit/GDP = claims by commer-
cial banks on the private sector as share of GDP. Structure- As countries become richer, wealthier households and
activity = logarithm (bank credit/value traded). corporations have more complicated financial needs, and
Source: Beck, Demirgüç-Kunt, and Levine 2000a; Demirgüç-Kunt financial markets emerge to meet this demand. But this is
and Levine forthcoming. not the whole story. Why, for example, does India have a
stock market while other low-income countries find it so
difficult to develop one?
There are many examples of failed efforts to develop
Financial structure tends to change during the de- stock markets. In the early- to mid-1990s, attempts to de-
velopment process, however, because banks and mar- velop stock markets in The Gambia and Zambia did not
prove successful. These countries built stock exchanges
kets have different requirements concerning informa- and provided people to staff them. There were, however,
tion and contract enforcement in order to function so few listed companies and so little market exchange that
effectively. For example, the information that a bank these stock exchanges could not generate the fees to be
collects is private and is gathered from its relationship self-sustaining.
Besides differences in income, some of the differ-
with individual clients. It does not necessarily depend ences in experience can be explained by differences in
on other complementary institutions, such as account- legal systems, the availability and quality of information,
ing standards. Once banks have invested in a firm, they and corruption. Low income, inadequate laws and regu-
use the threat of cutting off future credit for enforce- lations, information problems, corruption, and lack of
enforcement all play a role in deterring stock market
ment. By contrast, equity markets require strong pro- development.
tection of minority shareholder rights, good public in-
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