Bank-Based and Market-Based Financial Systems: A Comparative Analysis of Financial Structure and Capital Market Development in Emerging Economies

Abstract

Financial systems differ widely in how they channel savings into investment. In bank-based systems, of which Germany and Japan are the usual examples, banks gather savings, allocate credit and monitor the firms they lend to. In market-based systems, typified by the United States and the United Kingdom, securities markets play a larger role in raising capital, pricing risk and exercising corporate control (1,2). Supporters of bank-based finance point to the information that banks acquire through long-term lending relationships and to their capacity to mobilize capital in the early stages of industrialization (3,4). Supporters of market-based finance stress the information that prices convey, the wider range of risk-sharing instruments available and the discipline that markets impose on managers, while noting that powerful banks may extract rents from the firms that depend on them (2,3). This article compares the two systems on information production, risk sharing, corporate governance and their contribution to economic growth. Cross-country evidence indicates that the overall level of financial development and the quality of legal protection for investors explain growth better than the mix of banks and markets (1,5,6). The article argues that emerging economies should give priority to legal and institutional foundations and a sound banking sector, and should expect the role of securities markets to grow as incomes rise (7).