Triphon Phumiwasana Milken Institute ephumiwasana@milkeninstitute Conference on Political Economic Indicators and Inter

1. Diversified Financial Structure: Implications for Economic Growth and Stability 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

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)

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. • 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.

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 Mostly debt Debt, equity and private placement Households Firms Source: Laurent Jacque, 2001

9. Composition of Financial Assets Held By HouseholdsJune 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:Reciprocal of Bank Overhead Cost to Total Asset Multiplied by Stock Market Traded Value / GDP

16. Time and Regional Differences in Financial Structure: ActivityBank Credit to Private Sector relative to Stock Market Traded Value

17. Time and Regional Differences in Financial Structure: SizeBank Credit to Private Sector relative to Stock Market Capitalization

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

19. Differences Among Emerging Markets Financial Structures

20. Differences Among Emerging Markets Financial Structures

21. Hypotheses 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

22. Data • 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

23. Estimation 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

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