wp442 bank based or market based financial system what is be.pdf


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William Davidson Institute Working Paper 442

I.

Introduction
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.1 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.2 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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