Bank-Based Versus Market-Based Financial Systems: A Growth-Theoretic Analysis

Abstract

We study bank-based and market-based financial systems in an endogenous growth model. Lending to firms is fraught with moral hazard as owner-managers may reduce investment profitability to enjoy private benefits. Bank monitoring partially resolves the agency problem, while market-finance is more 'hands-off'. A bank-based or market-based system emerges from firm-financing choices. It is not possible to say unequivocally which of the two systems is better for growth. The growth rate depends, crucially, on the efficiency of financial and legal institutions. But a bank-based system outperforms a market-based one along other dimensions. Investment and per capita income are higher, and income inequality lower, under a bank-based system. Bank-based systems are more conducive for broad-based industrialization. A temporary income redistribution, under both financial systems, results in permanent improvement in per capita income as well as income distribution.

The impact of the financial system’s structure on firms’ financial constraints

“…The evidence in Tables 4-6 indicate the existence of tighter financial constraints for firms operating in market-based financial systems and, in accord with Khurana et al (2006), a negative relationship between financial development and the severity of financial constraints. In a theoretical study, Chakraborty and Ray (2006) suggest that a bank-based financial system encourages participation in production activities and provides funding to a larger number of entrepreneurs. Taking into account that monitoring is able to resolve some of the agency problems associated with raising funds, firms may enjoy better access to funds when monitored by banks rather than by the market.…”

A theory of bank versus bond finance and intra-industry reallocation

“…Their model actually allows this financing choice to affect the efficiency of firm managers, who become more efficient under the scrutiny of equity investors. We also apply a stylized form of the agency problem in Holmstrom and Tirole (1997) and Chakraborty and Ray (2006). However, in terms of the manufacturing sector, the general equilibrium model by Champonnois (2010) is most similar to ours.…”

“…Our key assumptions therefore are generally complementary with the underlying mechanisms in the Diamond (1991) model, even though we do not involve dynamic reputation effects and do not presume different default rates across borrowers. Holmstrom and Tirole (1997) and Suarez (1998, 2000), and Chakraborty and Ray (2006) assume that firms are heterogeneous in their initial endowment of assets when deciding between monitored and unmonitored sources of finance. Holmstrom and Tirole (1997) focus on the macroeconomic effects of exogenous shocks to entrepreneurial or bank capital, similar to Carlstrom and Fuerst (1997), while Repullo and Suarez (2000) analyze the impact of exogenous shocks to the market interest rate due to changes in monetary policy.…”

“…Chakraborty and Ray (2006) embeds an agency problem similar to that in 7 We cannot use the plentiful data on nonperforming loan ratios, as these are akin to stock variables, while the default rate is a flow variable. Estimates of the default rate tend to be much lower than the gross firm exit rate, which is measured precisely for the United States, so the exit rate is not an appropriate proxy, either.…”

“…There are two types of contracts available to the firms, intermediated bank loans and public bonds. Bond issuance is not possible for firms below a certain threshold size due to an agency problem in the spirit of Holmstrom and Tirole (1997) (HR) and Chakraborty and Ray (2006) (CR) and involves a higher fixed cost than bank loans. Therefore, for the distribution of firm size and economic welfare.…”