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Bank-Based or Market-Based Financial Systems: Which is Better?

This paper empirically assesses competing theoretical views on a century old policy debate: Are bank based or market-based financial systems better for promoting long-run economic growth? Since the 19th century, many economists have argued that bank-based systems are better at mobilizing savings, identifying good investments, and exerting sound corporate control, particularly during the early stages of economic development and in weak institutional environments. Others, however, emphasize the advantages of markets in allocating capital, providing risk management tools, and mitigating the problems associated with excessively powerful banks.

Economists have constructed a vast number of theoretical insights into the comparative advantages of different financial systems. Reflecting these schisms, policymakers continue to struggle with the relative merits of bank-based versus market-based financial systems in making policy decisions. Thus, the objective of this paper is to produce empirical evidence that (1) distinguishes among competing theories and (2) helps policy makers design appropriate financial sector reform strategies.

Empirical research on the comparative merits of bank-based and market-based financial systems has centered on Germany and Japan as bank-based systems and the United States and the United Kingdom as market-based systems. This work has produced illuminating insights into the functioning of these financial systems. Nonetheless, it is difficult to draw broad conclusions about the long-run growth effects of bank-based and market-based financial systems based on only four countries, especially four countries that have very similar long-run growth rates.

Although these countries together account for over 50 percent of world output and although there are decades during which their growth rates diverged substantially, broadening the analysis to a wider array of national experiences will provide greater information on the bank-based versus market-based debate. Consequently, this paper constructs a new dataset to investigate the relationship between economic growth and the degree to which countries are bank-based or market-based.

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Bank-Based or Market-Based Financial Systems: Which is Better?