Master thesis
Financial Structure and Economic Growth:
An Empirical Research from 1994 to 2009
January 2012
University of Groningen
Author Supervisor
ABSTRACT
Based on the theoretical debate, the previous research mainly have five theories about the relationship between economic growth and financial structure, which are (1) bank-based theory, (2) market-based theory, (3) financial service theory, (4) law and finance theory, and (5) hybrid theory. In this thesis, we investigate how financial structure affects economic growth. We employ both panel and cross-section data on 32 countries over a time period from 1994 to 2009, and shows a significant relationship between financial development and economic growth, which support for the financial service theory. However, the rest hypotheses are rejected.
Contents
ABSTRACT ... 1
1. INTRODUCTION ... 3
2. LITERATURE REVIEW ... 4
2.1 Theoretical consideration ... 5
2.1.1 Bank-based theory ... 5
2.1.2 Market-based theory ... 7
2.1.3 Financial service theory ... 9
2.1.4 Law and finance theory ... 10
2.1.5 Hybrid views ... 10
2.2 Empirical evidence ... 11
3. DATA AND MEASURES ... 19
3.1 Data measurement ... 19
3.2 Methodology description ... 22
3.3 Sample... 26
4. EMPIRICAL RESULTS ... 31
5. CONCLUTION AND LIMITATION... 36
ACKNOWLEGEMENTS ... 38
1. INTRODUCTION
Lots of previous studies have shown the relationship between financial structure and economic growth, which is becoming a crucial policy issue. If one form of financial structure is more conductive to economic growth than another, the economic policy must take this into account (Arestis, Luintel & Luitel, 2005).
Based on the theoretical debate, the previous research mainly have five theories, which are (1) bank-based theory, (2) market-based theory, (3) financial service theory, (4) law and finance theory, and (5) hybrid theory. Advocates of the bank-based and market-based theories argue that banks and markets are substitutes in promoting economic growth(Pinno & Serletis, 2007), whereas financial service theory (Merton and Bodie, 1995; Levine, 1997) embraces both bank-based and market-based theories and illustrate that it is financial services themselves that are by far more important than the form of their delivery (World bank, 2001). The law and finance theory stress that the legal system is the primary determinant of the effectiveness of the financial system in facilitating innovation and growth (La Porta, Lopes-de-Silanes, Shleifer and Vishny, 1997, 1998, 1999, 2000). Finally, the hybrid theory means that bank-systems have more benefits in some situations whereas market-systems are better in other situations.
The rest of this thesis is organized as follows. In Section 2, it discusses the literature reviews regarding to the relationship between financial structure and economic growth (both theoretical consideration and empirical evidence). The data and measures are described in Section 3. Section 4 presents the results regarding to the relationship between financial structure and economic growth. Finally, Section 5 summaries the thesis and indicates the limitation and implication of our study.
2. LITERATURE REVIEW
The debate on the relative merits of bank-based versus market-based financial systems has a long history of over a century (Gerschenkron, 1962; Allen and Gale, 2000; Levine, 2002). 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 (Levine, 2000). Some theories focus on the competing roles of banks and markets in funding corporate expansion, while others stress that banks and markets may arise, coexist, and prosper by providing different financial functions to the economy, and still other theories stress complementarities between banks and markets.
Figure 1. A Theoretical Approach to Finance and Growth (Source: Levine, 1997)
2.1 Theoretical consideration
The comparison of bank-based system and market-based system is focus on the first and second of financial functions (i.e. gathering information and corporate governance).
2.1.1 Bank-based theory1
The bank-based theory emphasizes the positive role of banks in development and
1
The bank-based theory and market-based theory are collected from Levine (2005), Finance and Growth: theory
Market frictions - information costs - transaction costs Financial markets and intermediaries Financial functions - mobilize savings - allocate resources - exert corporate control - facilitate risk management - ease trading of goods,
services, contracts
Channels to growth
- capital accumulation - technological innovation
growth, and, also, stresses the shortcomings of market-based financial systems.
Historically, economists have focused on banks. Bagehot (1973) and Schumpeter (1912) emphasize the critical importance of the banking system in economic growth and highlight circumstances when banks can actively spur innovation and future growth by identifying and funding productive investments.
For gathering and processing information, bank-based financial systems are in a much better position than market-based systems to address agency problems and short-termism (Stiglitz, 1985; Singh, 1997). Banks have a privileged access to information (Grosfeld, 1994). Banks can mitigate the potential disincentives from efficient markets by privatizing the information they acquire and by forming long-run relationships with firms (Gerschenkron, 1962; Boot, Greenbaum andThakor, 1993). Banks can make investments without revealing their decisions immediately in public markets and this creates incentives for them to research firms, managers, and market conditions with positive ramifications on resource allocation and growth. However, the well-developed markets reveal information publicly, which leads to the free-rider problem, thereby reducing incentives for investors to devote resources toward researching firms. Therefore, information asymmetries are accentuated, more so in market-based rather than in bank-based financial systems (Boyd and Prescott, 1986).
2004). The specialists who support for bank-based theory also illustrate the shortcomings of market-based theory. The channels through which the stock market performs its tasks are (1) the pricing process and (2) the takeover mechanism. These two mechanisms in practice operate imperfectly so that even well-functioning stock markets (such as those in the United States and the United Kingdom) do not perform the monitoring, screening and disciplinary function at all well (Singh, 1997). Shleifer and Vishny (1997) argue that markets do not effectively monitor managers. In liquid markets, investor can inexpensively sell their shares, so that they have fewer incentives to undertake careful - and expensive - corporate governance (Bhide, 1993). Thus, greater stock market development may hinder corporate governance and induce an inefficient allocation of resources according to the bank-based view. Although large, concentrated ownership may overcome some shortcomings, it will bring new problems in stock markets. Besides the fact that concentrated ownership implies that wealthy investors are not diversified (Acemoglu and Zilibotti, 1997), concentrated owners may benefit themselves at the expense of minority shareholders, debt holders, and other stakeholders in the firm, with adverse effects on corporate finance and resource allocation. Furthermore, large equity owners may seek to shift the assets of the firm to higher-risk activities since shareholders benefit on the upside, while debt holders share the costs of failure. In addition, concentrated control of corporate assets produces market power that may corrupt the political system and distort public policies.
As a result, those banks that are unhampered by regulatory restrictions, can exploit economies of scale and scope in information gathering and processing, ameliorate moral hazard through effective monitoring, form long-run relationships with firms to ease asymmetric information distortions, and thereby boost economic growth (for more details on these aspects of bank-based systems, see Levine, 2002, and Beck and Levine, 2002),
Hypothesis 1: All else being equal, the level of stock-bank ratio, as a measure of the financial structure, is negatively related to economic growth
2.1.2 Market-based theory
markets, and stresses the problems of bank-based financial systems. Market-based financial systems mitigate the inherent inefficiencies associated with banks and then better in enhancing economic development and growth. Big, liquid and well-functioning markets foster growth and profit incentives, enhance corporate governance and facilitate risk management (Levine, 2002, and Beck and Levine, 2002).
Larger more liquid markets will boost incentives to produce this valuable information with positive implications for capital allocation (Merton, 1987). Well-functioning markets are very liquid which creates incentives for information analysts to permanently estimate the firms’ value and to discover potential synergies. The information about investment prospects is rapidly incorporated into stock prices (Grosfeld, 1994). However, with powerful banks, they “can stymie innovation by extracting informational rents and protecting firms with close bank-firm ties from competition ….. may collude with firm managers against other creditors and impede efficient corporate governance” (Levine, 2002). This ability to extract part of the expected payoff to potentially profitable investments may reduce the effort extended by firms to undertake innovative, profitable ventures.
As a result, market-based institutions can produce better improvement in resource allocation and corporate governance than bank-based agreements
Hypothesis 2: All else being equal, the level of stock-bank ratio, as a measure of the financial structure, is positively related to economic growth
2.1.3 Financial service theory
Financial service theory argues that neither market-based nor bank-based categorizations are particularly important for identifying growth enhancing financial systems (Merton and Bodie, 1995; Levine, 1997). The issue is creating an environment in which intermediaries and markets provide sound financial services. Quite simply, this theory suggests that it is neither banks nor markets that matter; it is both banks and markets. They are different components of the financial system; they do not compete, and as such ameliorate different costs, transaction and information, in the system (Boyd and Smith, 1998; Levine, 1997; Demirguc-Kunt and Levine, 2001). These components of the financial system provide financial functions: they evaluate project, exert corporate control, facilitate risk management, ease the mobilization of savings, and facilitate exchange. By providing these financial services more or less effectively, different financial systems promote economic growth to a greater or lesser degree. Thus, this “financial service view” rejects the primacy of distinguishing financial systems as bank-based or market-based (Merton, 1992, 1995; Merton and Bodie, 1995, 2004; Levine, 1997). Levine (2002) doesn’t distinguish bank-based and market-based system; instead, he argues that international financial liberalization, by improving the functioning of domestic financial markets and banks, accelerates economic growth. Consequently, as Levine (2002) argues, “the financial services view places the analytical spotlight on how to create better functioning banks and markets, and relegates the bank-based versus market-based debate to the shadows”.
2.1.4 Law and finance theory
Relationship-based systems are superior to market-based systems in environments where laws are poorly drafted and enforced (Rajan and Zingales, 1998; Egli etal., 2001). Greater financial development, as defined by the legal environment, is positively related to economic growth (Levine, 2002). For this perspective, a well-functioning legal system facilitates the operation of both markets and intermediaries. It is the overall level and quality of the financial functions that are provided to the economy that influences resource allocation and economic growth. The law and finance view holds that distinguishing countries by the efficiency of national legal. While focusing on the law is not inconsistent with banks or markets playing a particularly important role, La Porta et al. (2000) clearly argue that legal institutions are a more useful way to distinguish financial systems than concentrating on whether countries are bank-based or market-based. LaPorta et al. (1997, 1998) and Levine (1998, 1999) find that markets develop better in countries where the rights of the minority shareholders are well protected.
Hypothesis 4: All else being equal, the level of Legal enforcement is positively related to the overall financial development, which has significantly positive effects on economic growth.
2.1.5 Hybrid views
The hybrid views point out varied relationship between financial structure and economic growth in different situations. In another words, banks are important for growth under some conditions while markets are more important under alternative conditions.
economic and business activity has greatly increased the variety of ways in which insiders can try to conceal firm performance. Although progress in technology, accounting, and legal practice has also improved the tools of detection, on balance the asymmetry of information between users and providers of funds has not been reduced as much in developing countries as it has in advanced economies – and indeed may have deteriorated” (p. 7).
Hypothesis 5a: All else being equal, the level of market-bank ratio is positively related to the economic growth in developed countries.
Hypothesis 5b: All else being equal, the level of market-bank ratio is negatively related to the economic growth in developing countries.
The other hybrid view demonstrates that market-based systems are particularly good for economic growth in common law countries, while bank-based systems are more suitable for civil law countries. Johnson, LaPorta, Lopez-de-Silanes, and Shleifer (2000) observe that civil-law courts allow substantial expropriation of minority shareholders in situations in which controlling shareholders transfer the assets and profits out of the firm. These countries do not emphasize the rights of minority shareholders with adverse effects on the functioning of equity markets (Levine, 1999). In contrast, common law countries tend to stress the rights of minority shareholders with beneficial implications for securities market development.
Hypothesis 5c: All else being equal, the level of market-bank ratio is positively related to the economic growth in common law countries.
Hypothesis 5d: All else being equal, the level of market-bank ratio is negatively related to the economic growth in civil law countries.
2.2 Empirical evidence
Table 1: Some Empirical results:
Authors Theory Countries and period
Measure of economic growth
Measure of independent variables
Bank Stock market Law Control variables Atje & Jovanovic
(1993)
market-based theory 119 countries 1960-1985
The GDP per Adult
Bank credit ratio Value traded ratio N/A Investment rate, Secondary school Black market premium, Government expenditure, Trade, Inflation, Demirguc-Kunt and Levine (1996) Financial service theory 44 countries 1986-1993 GDP per Capita
Liquid liability ratio, Quasi-liquid liability ratio, Bank credit ratio
Market capitalization ratio, Value traded ratio, Turnover, Concentration, Volatility,
Asset pricing efficiency, Institutional development
N/A N/A
Levine & Zervos (1996)
Market-based theory 41 countries 1976-1993
The real per capita growth rate
N/A Market Capitalization ratio, Value traded ratio, International integration
Means-removed market capitalization ratio,
Liquid liability ratio
N/A N/A
Levine and Zervos (1998) Financial service theory 47 countries 1976-1993 Output growth, Capital stock
Bank credit Market capitalization ratio, Turnover,
growth Productivity growth Savings
Value traded ratio, International integration
Revolutions and coups, Government, Inflation,
Black market premium,
Beck,
Demirguc-Kunt, Levine and Vojislav (2000)
Financial service theory,
Law and finance theory
48 countries 1980-1995
GDP per capita growth
Bank credit ratio, Overhead costs, Interest rate margin
Value traded ratio, Market capitalization ratio, Turnover ratio
Credit, Anti-director, Rule of law, Legal origin
Initial GDP per capita, Schooling,
Inflation,
Black market premium, Government size
Demirguc-Kunt and Levine (2001)
Hybrid view 150 countries 1960s-1990s
GDP per capita Bank credit ratio, Overhead costs, Interest rate margin
Value traded ratio, Market capitalization ratio, Turnover ratio
Legal origin,
Legal codes, Contract enforcement Accounting standards, Bank regulation, Deposit, Insurance Tax Inflation rate Arestis, Demetriades, Luintel (2002)
Bank-based theory 5 countries (Germany, United states, Japan, United Kingdom and France) 1968-1998 The logarithm of real GDP
Bank credit ratio, Market capitalization ratio, Stock market efficiency
N/A N/A
Levine (2002) Financial service theory,
Law and finance theory
48 countries 1980-1995
Real per Capita GDP Growth
Bank credit ratio, Overhead costs, Interest rate margin
Value traded ratio, Market capitalization ratio, Turnover ratio
Legal codes,
Law enforcement, Legal origin
Crights, Government, Inflation rate, Initial income, Schooling, Srights, Trade
Ergungor (2004) Hybrid view 46 countries (28-civil-law, 18-comon law) 1960-1995
GDP per capita Bank credit ratio Value traded ratio Antidirector rights, Rule-of-law tradition, Laws protection, Law tradition
Schooling, Inflation rate, Black market Premium, Bureaucratic efficiency, Revolutions,
Government,
Arestis, Luintel and Luintel (2005)
Hybrid theory 6 countries 1962-2000
Growth of real per capita income
Bank lending ratio Market Capitalization/Bank lending
N/A N/A
Pinno and Serletis (2007)
Financial service theory,
Law and finance theory,
Hybrid view
48 countries 1980-1995
Real per capita GDP
Bank credit ratio, Overhead costs, Interest rate margin
Value traded ratio, Market capitalization ratio, Turnover ratio
Shareholder rights, Rule of law
Ergungor (2008) Hybrid view 46 countries 1980-1995
Real per capital GDP growth, Per capita capital stock growth, Productivity growth
Bank credit ratio, Overhead costs, Interest rate margin
Value traded ratio, Market capitalization ratio, Turnover ratio Inflexibility, Legal Origin, Judicial efficiency Initial GDP, Inflation, Manufacturing, Trade, Corrupt, Ethnic, School, Shareholder Luintel, Khan, Arestis, Theodorids (2008)
Hybrid view 14 countries 1979-2005
Per capita GDP
Per capita real physical capital stock
Private credit ratio Market capitalization ratio, Value traded ratio
Turnover ratio
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Some studies have employed rigorous country-specific measures of financial structure, concentrating on comparisons that view Germany and Japan as bank-based systems, while the US and UK as market-based systems. Some results support “financial service view”, showing that given the similarity of their long-run growth rates, many observers may conclude that differences in financial structure obviously did not matter much (Allen and Gale, 2000; Demirgüç-Kunt and Levine, 2001; and Stulz, 2001). Some results support “bank-based theory” Corbett and Mayer (1992) argue that a German-type financial system (i.e. bank-based system) has an absolute advantage over an Anglo-Saxon one (i.e. market-based system), and that CEEC should move towards to former and not towards the latter. Some support for “market-based theory”. For instance, the strength of the German or Japanese economies, and notably the strong ties between banks and industry, is now often viewed as an obstacle to rapid adjustment in a changing economic environment. Weinstein and Yafed (1994) demonstrate that in the case of Japan firms with close ties to a bank did not grow faster or perform better than other firms. However, there are some shortcomings of “four-country comparison”. Firstly, these four industrialized countries have resembling real per capita income levels and they historically share similar growth rates. Consequently, it is hard to attribute their analogous growth rates to alternative forms of either the bank-based or the market-based financial system (Goldsmith, 1969). Secondly, it is difficult to draw broad conclusions; especially these four countries have very similar long-run growth rates (Levine, 2005).
Some studies address these problems by using abroad cross-country approach that allows treatment of financial system structure across many countries with different growth rates. They analyze multi-country dataset at firm-, industry- and aggregate-levels, employing different econometric methods under the panel and/or pure cross-country setup (Luintel, Khan, Arestis, and Theodoridis, 2007).
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Levine and Zevros (1998), using cross-country regressions for a number of countries covering the period 1976 to 1993, emphasis that market-based systems enhance growth through the provision of liquidity, which enables investment to be less risky, so that companies can have access to capital through liquid equity issues (see, also, Atje and Jovanovic, 1993, and Harris, 1997). Demirgüç-Kunt and Levine (2001b) classify countries according to the degree to which they are bank-based or market-based. They also examine the evolution of financial structure across time and countries. They find that banks, nonbank financial intermediaries (insurance companies, pension funds, finance companies, mutual funds, etc.) and stock markets are larger, more active, and more efficient in richer countries and these components of the financial system grow as countries become richer over time. Also, as countries become richer, stock markets become more active and efficient relative to banks. Furthermore, Tadesse (2002) confirms that while market-based systems outperform bank-based systems among countries with developed financial sectors, bank-based systems are far better among countries with underdeveloped financial sectors. Pinno and Serletis (2007) find evidence that growth in developing countries benefits from bank-based financial systems and in developed countries from market-based financial systems.
Some studies arguer that bank-based or market-based system doesn’t matter. Their broad conclusions are that the overall level of financial development (the financial services view) and legal system efficiency (the law and finance view) are important; however, financial structure (either the bank-based or the market-based view) is irrelevant.
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for 48 countries over the 1980–1995 periods, and demonstrates that the cross-country evidence is consistent with the financial services view. Better developed financial systems positively influence economic growth. More particularly, the data are consistent with the view that the legal system plays a leading role in determining the level of growth-promoting financial services. Levine and Zervos (1998) show that stock market liquidity and banking development both positively predict growth, capital accumulation, and productivity improvements when entered together in regressions, even after controlling for economic and political factors. The results are also consistent with the “financial service theory” that financial markets provide important services for growth, and that stock markets provide different services from banks. Beck, Demirguc-Kunt, Levine and Vojislav (2000) employ data from 48 countries over 1980-1995, and show that financial structure is not an analytically useful way to distinguish among financial systems. The World Bank (2001) provides a comprehensive summary of the available evidence, which argues strongly that the evidence should be interpreted as clearly suggesting that “both developments of banking and of market finance help economic growth: each can complement the other”. This finding supports the view that markets and banks may provide complementary growth-enhancing financial services to the economy.
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3. DATA AND MEASURES
3.1 Data measurement Growth (dependent variable)
The rate of per capita GDP growth is used to measure the growth. Larger value of Growth means that the country grows faster.
Bank development (independent variable)
In this thesis, we use three variables (i.e. bank-activity, bank-size, and bank-efficiency) to measure the Bank development. Firstly, we use bank credit ratio to measure the activity of the bank. Bank credit ratio equals to the value of private credit by deposit money in banks and other financial institutions divided by GDP. This measure excludes credits to the public sector (central and local government as well as public enterprises). Secondly, we use bank credit ratio to measure the size of the bank. Thirdly, we use overhead costs, which is equal to the accounting value of a bank's overhead costs as a share of its total assets, to demonstrate the inefficiency of banks. We also use interest rate margin in place of overhead costs. Therefore, the bank-efficiency is defined as the reciprocal of the inefficiency of banks.
Stock market development (independent variable)
Again, three variables (i.e. market-activity, market-size, and market-efficiency) are used to measure the stock market development. Firstly, we use value traded ratio to measure the activity of the stock market, which equals the value of the trades of domestic shares on domestic exchanges divided by GDP. This ratio is the liquidity indicator of stock market, because it measures trading volume as a hare of national output and should therefore positively reflect liquidity on an economy-wide basis. (Levine & Zervos, 1998). Secondly, market capitalization ratio, which is equal to the ratio of the value of listed shares to GDP, is used to measure the size of the stock market. Thirdly, we again use the
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Financial structure (independent variable)
In this thesis, we use four measures to illustrate the Financial Structure. (1) Structure-activity
We construct the structure-activity to measure the activity of stock markets relative to that of banks. We use total value traded ratio to measure the activity of the stock market, and
bank credit ratio to measure the activity of the bank. Therefore, the indicator of Structure-Activity is defined as the logarithm of the total value traded ratio divided by the bank credit ratio. When the value of Structure-Activity is large, it means that the financial system is more market-based.
(2) Structure-Size
We construct the Structure-Size to measure the size of stock markets relative to that of banks. On one hand, we use the market capitalization ratio to measure the size of the stock market. On other hand, the bank credit ratio is adapted to measure the size of the bank. Therefore, the indicator of Structure-Size is defined as the logarithm of the market
capitalization ratio divided by the bank credit ratio. When the value of Structure-Size is
larger, it means that the financial system is more market-based.
(3) Structure-Efficiency
We use the Structure-Efficiency to measure the efficiency of stock markets relative to that of banks. As Levine (2002), we use the total value traded ratio and turnover ratio to measure the efficiency of stock markets. Then, we use overhead costs to demonstrate the inefficiency of banks. Because the overhead costs measure the inefficiency (not the efficiency) of banks, the indicator of Structure-Efficiency is defined as logarithm of the
total value traded ratio times overhead costs. When the value of Structure-Efficiency is
larger, it means that the financial system is more market-based.
Financial development (independent variable)
As the indicators of financial structure, we use four variables to measure financial development
(1) Finance-Activity
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use total value traded ratio to measure the activity of the stock market, and again bank
credit ratio is used to measure the activity of banks. Therefore, the indicator of Finance-Activity is defined as the logarithm of the total value traded ratio times the bank
credit ratio. When the value of Finance-Activity is large, it means that the level of financial development is high.
(2) Finance-Size
We construct the Finance-Size to measure the size of stock markets and banks. We still use the market capitalization ratio to measure the size of the stock market. Then, again I use the bank credit ratio to measure the size of the bank. Therefore, the indicator of Finance-Size is defined as the logarithm of the market capitalization ratio times the bank
credit ratio. When the value of Finance-Size is large, it means that the level of financial
development is high.
(3) Finance-Efficiency
We use the Finance-Efficiency to measure the efficiency of stock markets and banks. The total value traded ratio is used to measure the efficiency of stock markets. Then, we use
overhead costs to demonstrate the inefficiency of banks. Because the overhead costs
measure the inefficiency (not the efficiency) of banks, the indicator of Finance-Efficiency is defined as logarithm of the total value traded ratio divided by the overhead costs. When the value of Finance-Efficiency is large, it means that the level of financial development is high.
Legal enforcement (independent variable)
Strength of legal rights index is used to measure the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending. The index ranges from 0 to 10, with higher scores indicating that these laws are better designed to expand access to credit.
Dummy variables (1) Legal origin
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(2) Economic Development
We use dummy variable to measure the countries’ economic development. The value of Economic Development is 1 if it’s a developed country, while the value of Economic Development is 0 if it’s a developing country.
Control variables
There are lots of control variables which may have influence in the economic growth, such as black market premium, bureaucratic efficiency, schooling, etc. Because of data limitation, we only contain four control variables: (1) the logarithm of one plus the inflation rate, (2) the logarithm of unemployment rate, (3) the logarithm of international trade (exports plus imports) as a share of GDP, (4) the logarithm of government expenditure as a share of GDP. We control for these factors in order to assess the independent link between growth and both financial structure and overall financial development (Levine and Renelt, 1992).
3.2 Methodology description
As similar theory reported by Levine (2002), the bank-based theory, the market-based theory, financial service theory and law and finance theory can be represented as rival predictions on the parameters in a standard growth equation.
Firstly, we consider the econometric specification, from Levine (2002). He illustrates that standard growth models and their econometric representations typically model real per capita GDP growth, i.e., Growth, as a function of a number of growth determinants (defined as X). Then, the model is modified to analyze the competing theories of financial structure. 1 1 2 it it it it Market Growth a b b X Bank ε = + + + (1) 2 1 2 it it it it
23 3 1 2 3 it it it it it it Market
Growth a d d Market Bank d X
Bank
ε
= + + ∗ + + (3)
Where i is the country index, t is the time index; Growthit is real per capita GDP growth,
it
it Market
Bank is financial structure, Marketit Bankit
∗ measures overall financial sector
development (i.e. the level of development of banks, nonbanks, and securities markets), X
is a set of standard growth determinants (control variables). Larger values of it it Market Bank
indicate more market-based, while smaller values indicate more bank-based. Lager values of Marketit∗Bankit indicate a great level of financial development. εit is the error term,
and the small letters, a1, b1, b2, a2, c1, c2, a3, d1, d2, d3 are coefficients. Since we discuss the relationship of financial structure and economic growth, we are focus on b1, c1, d1, and d2 in this paper.
It may be confused that Equation (2) can suffer from omitted variable bias since we do not include Bank and Market independently. However, in this thesis, Market*Bank is an independent variable (which is the measurement of the overall financial development), instead of interaction term.Moreover, models of interaction typically produce conditional, rather than unconditional hypotheses (Brambor, Clark and Golder, 2006). Because our hypothesis (3) based on Equation (2) is unconditional hypothesis, Equation (2) is not an interaction model. Therefore, there is no omitted variable bias problem in our model.
As Levine (2002) demonstrates, different hypotheses for financial structure and growth imply different predictions on the values of the parameters in regressions (1)-(3).
Hypothesis 1 (Bank-based theory):
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Hypothesis 2 (Market-based theory):
The market-based theory emphasizes the positive role of markets in development and growth. The market-based theory predicts b1>0, c1>0, d1>0, and d2>0, since markets contribute to overall financial development, at the same time, market-based systems are particularly good for economic growth.
Hypothesis 3 (Financial service theory):
Financial service theory argues that neither market-based nor bank-based categorizations are particularly important for identifying growth enhancing financial systems. Instead, the overall financial development positively influence on economic growth. The financial service theory predicts that c1>0 and d2>0.
Hypothesis 4 (Law and finance theory):
(Marketit∗Bankit)=a5+gLegalit+εit (4)
6 1 2 ( ) 3
it
it it it it
it Market
Growth a h h E Market Bank h X
Bank
ε
= + + ∗ + + (5)
Where Legalit is Strength of legal rights index, and E Market( it∗Bankit) is the predicted
value of Finance by legal codes and enforcement efficiency. Higher scores of Legalit
indicate that these laws are better designed to expand access to credit. εit is the error terms, and the small letters, a5, g, a6, h1, h2, h3 are coefficients.
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with Finance) (Cater Hill, Griffiths, & Lim, 2007). In terms of Equation (4)-(5), the law and finance theory predicts that g>0 and h2>0.
Hypothesis 5 (Hybrid views):
7 1 2 3 it it it it it it Market Market Growth a k k Developed k X Bank Bank ε = + + ∗ + + (6)
Where Developed is dummy variable, Developed=1 if it is a developed country while Developed=0 if it is a developing country. εit is the error terms, and the small letters, a7, k1, k2, k3 are coefficients.
One hybrid view shows that growth in developing countries benefits from bank-based financial systems and in developed countries from market-based financial systems (Tadesse, 2002; Pinno and Serletis, 2007). In terms of Equation (6), the hybrid view predicts that (k1+k2)>0, k1<0. For Equation (6), GDP per capita can also be used instead of the dummy variable (Developed), which makes the effect of financial structure on economic growth change continually based on the different GDP per capital level. However, consistent with the “hybrid” theory, we still choose the dummy variable.
8 1 2 3 it it it it it it Market Market Growth a l l Common l X Bank Bank ε = + + ∗ + + (7)
Where Common is dummy variable, Common=1 if it is a common law country while Common=0 if it is a civil law country. ε8 is the error terms, and the small letters, a8, l1, l2, l3 are coefficients.
Another hybrid view says that market-based systems are particularly good for economic growth in common law countries, while bank-based systems are more suitable for civil law countries. In terms of Equation (7), the hybrid view predicts that (l1+l2)>0, l1<0.
In this paper, we use three steps to measure the relationship between financial structure and economic growth.
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hypotheses, assuming that (1) the regression parameter values are identical across individuals; (2) the variances of the error items are equal for all individuals. Especially, instrument variable (IV) is used when we test law and finance theory (Hypothesis 5), using strength of legal rights index as instruments for countries, because IV regressions allow us to control for simultaneity bias and reverse causality from economic development to financial development by extracting the exogenous component of financial development and structure (Beck, Levine & Maksimovic, 2000).
In second step, we use the Breusch-Pagan test to test the presence of random effects. Because the null hypothesis (no random effects) is rejected, we conclude that pooled OLS model is not appropriate method to be applied. Then, we use the Hausman test, which leads us to reject the hypothesis that the coefficient estimates are equal to one another. In other words, the random effects estimator is inconsistent while the fixed effects estimator remains consistent. Therefore, we choose a fixed effects model based on the Hausman test, which may be explained by unobserved country heterogeneity. Our methods which allow for fixed effects, yield substantially different findings than previous researches (e.g. Levine, 2002) regarding the relationship between financial structure and economic growth.
In third step, we use the cross-section data by using average variables, because there are some problems with the annual growth rates, such as they are affected by business cycle fluctuations. We introduce the cross-method to make the results more convincible. In this step, after we checking, there is no heteroskadasticity and autocorrelation problems, therefore, we use the OLS model.
3.3 Sample
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28 Table 2: Variables and sources
Variable Definition sources
Growth The rate of real per capita GDP growth in the 1994-2009 period. World Development Indicators, World bank Bank credit ratio Private credit by deposit money banks and other financial institutions to
GDP, calculated using the following deflation method:
{(0.5)*[Ft/P_et + t-1/P_et-1]}/[GDPt/P_at] where F is credit to the private sector, P_e is end-of period CPI, and P_a is average annual CPI
Demirguc-Kunt and Levine (2001)
overhead costs Accounting value of a bank's overhead costs as a share of its total assets. Demirguc-Kunt and Levine (2001)
Interest margin Accounting value of bank's net interest revenue as a share of its interest-bearing (total earning) assets.
Demirguc-Kunt and Levine (2001)
total value traded ratio
Total shares traded on the stock market exchange to GDP World Development indicators, World Bank market capitalization
ratio
Value of listed shares to GDP, calculated using the following deflation method: {(0.5)*[Ft/P_et + Ft-1/P_et-1]}/[GDPt/P_at] where F is stock market capitalization, P_e is end-of period CPI, and P_a is average annual CPI
Demirguc-Kunt and Levine (2001)
turnover ratio Ratio of the value of total shares traded to average real market capitalization, the denominator is deflated using the following method: Tt/P_at/{(0.5)*[Mt/P_et + Mt-1/P_et-1]
where T is total value traded, M is stock market capitalization, P_e is end-of period CPI P_a is average annual CPI
Demirguc-Kunt and Levine (2001)
Strength of legal rights index
Strength of legal rights index measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending. The index ranges from 0 to 10, with higher scores indicating that these laws are better designed to expand access to credit.
Doing Business project, World Bank,
Legal origin The value of Legal Origin is 1 if it is a common law country, while the value of Legal Origin is 0 if it is a civil law country.
Demirguc-Kunt and Levine (2001)
Economic Development
The value of Economic Development is 1 if it’s a developed country, while the value of Economic Development is 0 if it’s a developing country.
International monetary fund
Inflation rate Ln (1+inflation rate) International Financial
Statistics
Unemployment rate Ln (unemployment) International monetary fund
international trade Ln ((exports+imports)/GDP) World development
indicators, World bank government
expenditure
Ln (government expenditure/GDP) World development
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Table 3 presents the summary statistics on one growth indicator, three stock market development indicators, and three bank development indicators of 32 countries over 1994-2009 period. It shows substantial variance among the countries in different years. For example, in 1994, Peru has the highest growth rate of 10.762 percent, while Russian Federation has the lowest growth rate of -12.46 percent; Switzerland had value traded ratio equal to 6.731 in 2009, while the value traded ratio of Cote d’Ivoire is only 0.001 in 2001.
Table 3: Summary statistics
Mean Maximum Minimum Standard
deviation
Observations
Growth 2.352 10.762 -12.461 3.258 512
Bank credit ratio 0.747 2.298 0.068 0.529 512
Overhead costs 0.041 0.259 0.007 0.026 511
Interest margin 0.041 0.220 0.009 0.026 512
value traded ratio 0.628 6.731 0.001 0.890 512
capitalization ratio 0.678 3.403 0.000 0.613 512 Turnover ratio 0.759 6.224 0.007 0.819 512 Structure-activity -1.103 1.589 -6.320 1.561 512 Structure-size -0.209 2.078 -5.766 0.763 512 Structure-efficiency -5.072 -1.400 -10.752 1.855 511 Finance-activity -2.298 2.497 -9.987 2.598 512 Finance-size -1.405 1.815 -11.148 1.697 512 Finance-efficiency 1.659 6.135 -4.646 2.227 511
Note. Structure-Activity=ln (total value traded ratio/bank credit ratio). Structure-Size=ln (market capitalization ratio/bank credit ratio). Structure-Efficiency=ln (total value traded ratio*overhead costs). Finance-Activity=ln (total value traded ratio*bank credit ratio). Finance-Size=ln (market capitalization ratio*bank credit ratio). Finance-Efficiency=ln (total value traded ratio/overhead costs).
Multicollinearity
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directly relevant to our regressions. We find that the financial development variables (i.e. Finance-Activity, Finance-Size, and Finance-Efficiency) are highly correlated with each other, with the highest value 0.96 (the correlation between Finance-Activity and Finance-Efficiency). The same problem can be detected in the correlation between financial structure variables. Therefore, to avoid the problem we mentioned before, we will test the hypotheses one by one according to activity, size and efficiency sequence, instead of including all of the variables (e.g. Finance-Activity, Finance-Size, Finance-Efficiency) in one regression.
Table 4: Correlations of Financial structure and Financial Development growth Structure-Activity Structure-Size Structure-Efficiency Finance- Activity Finance- Size Finance- Efficiency growth 1.00 0.35 -0.12 0.50 0.57 0.50 0.50 Structure-Activity 1.00 0.48 0.91 0.78 0.49 0.85 Structure-Size 1.00 0.34 0.15 0.24 0.22 Structure-Efficiency 1.00 0.90 0.70 0.86 Finance-Activity 1.00 0.88 0.96 Finance-Size 1.00 0.78 Finance-Efficiency 1.00
Note. Structure-Activity=ln (total value traded ratio/bank credit ratio). Structure-Size=ln (market capitalization ratio/bank credit ratio). Structure-Efficiency=ln (total value traded ratio*overhead costs). Finance-Activity=ln (total value traded ratio*bank credit ratio). Finance-Size=ln (market capitalization ratio*bank credit ratio). Finance-Efficiency=ln (total value traded ratio/overhead costs).
Heteroskedasticity
31 Autocorrelation
Autocorrelation refers to the correlation of a time series with its own past and future values. When autocorrelation exist, the least squares estimator is still a linear unbiased estimator, but it is no longer best (Cater Hill, Griffiths, & Lim, 2007). The formulas for the standard errors usually computed for the least squares estimator are no longer correct, and hence confidence intervals and hypothesis tests that use these standard errors may be misleading (Cater Hill, Griffiths, & Lim, 2007). For the panel data, we use Serial correlation to detect autocorrelation problem with the command “xtserial”, which causes the standard errors of the coefficients to be smaller than they actually are and higher R-squared (Drukker, 2003). We find that all of the equations have autocorrelation problem because they are all significant at 0.1% level. To solve the problem, the GLS (Generalized least Squares) estimation can be used in the regression procedure (Cater Hill, Griffiths, & Lim, 2007).
4. EMPIRICAL RESULTS
Table 5 shows the financial results using fixed effects (FE) model, while the Ordinary Least Squares (OLS) estimation is shown in Table 6 considering the period-average situation. In this thesis, we ignore the pooled OLS results because they are inconsistent. To concisely summarize a large number of regressions, we only report the results on the variables of interest.
Table (5) and Table (6) illustrate the R-squares for all the regressions including fixed effects model and OLS model. We find that the values of R-square are higher when we use the average dataset, which means there the proportion of variability is higher in the average dataset that is accounted for by the statistical model.
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Finance-Development are significant, while all the coefficients of Financial-Structure are insignificant. Furthermore, all of the coefficients of Financial-development are positive, which is consistent with the financial service theory. Considering the cross section data, in the OLS model, it is found that all the coefficients of Financial-development variables are still positive and significant except for the coefficient of Structure-Efficiency in Equation (3). The results can support for neither bank-based theory nor market-based theory. The bank-based theory emphasizes the negative relationship between economic growth and financial structure. The market-based theory predicts a positive relationship. We find that the results are consistent with the “financial-service view” predicts, c1>0 and d2>0. Instead of emphasizing market-based versus bank-based differences is that markets, the results imply that markets and banks may provide complementary growth-enhancing financial services to the economy (Boyd and Smith, 1998; Levine and Zervos, 1998a; Huybens and Smith, 1999). We conclude that, as illustrated by Levine (1997), minimizes the importance of the bank-based vs. market-based debate and demonstrates that financial services (irrespective of whether they are provided by banks or markets) are good for economic growth.
Secondly, as we mentioned before, we use IV estimation to test Hypothesis 4 (law and finance theory). We test whether the strength of legal rights index is valid as instruments, and find that (1) the instrument variable does not have direct effect on growth, (2) the instrumental variable is not correlated with the regression error term, (3) the instrumental variable is strongly correlated with Finance-Development. Therefore, we conclude that the strength of legal rights index is valid as IV. When we use fixed effect regression, we find that the law and finance theory is not supported in all the cases. There is no relationship between the expected value of financial-development and economic growth. When we use the cross-section data, the results do not change. We conclude that the evidence can not support for the law and finance theory. Although we can certify that a well-functioning legal system facilitates the operation of the financial development, we can not conclude that it can influences resource allocation and economic growth through financial-development. (see table 6 equation 4, the coefficient of law is significant; in equation (5), E(financial-development) is not significant).
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financial structure and economic growth. We find that there are no significant
relationships between financial-structure and economic growth, and
financial-structure*developed and economic growth except for the
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Table 5: The effect of financial structure and financial development on economic development (FE )
Fixed Effects (panel dataset)
(1) (2) (3) (4) (5) (6) (7) Structure-Activity 0.03 (0.02) -0.04 (0.02) 0.08*** (0.02) -0.00 (0.02) 0.04 (0.02) Structure-Size 0.01 (0.03) -0.03 (0.03) 0.18*** (0.03) 0.01 (0.03) -0.03 (0.03) Structure-Efficiency 0.04* (0,02) 0.01 (0.02) 0.08*** (0.02) 0.02 (0.02) 0.05** (0.02) Finance-Activity 0,07*** (0.01) 0.09*** (0.02) Finance-Size 0.09*** (0.02) 0.10*** (0.02) Finance-Efficiency 0.05*** (0.01) 0.04** (0.023) Legal-activity 0.39*** (0.10) Legal-size 0.24*** (0.05) Legal-efficiency 0.41*** (0.11) E (Finance-Activity) 0.06 (0.08) E (Finance-Size) -0.00 (0.02) E (Finance-Efficiency) 0.04 (0.04) Structure*developed-activity 0.08** (0.03) Structure*developed-Size 0.00 (0.05) Structure*developed-efficiency 0.04 (0.03) Structure*common-activity -0.02 (0.04) Structure*common-size 0.16** (0.06) Structure*common-efficiency -0.06 (0.03) R-square (activity) 0.09 0.18 0.22 0.22 0.12 0.04 0.08 R-square (size) 0.07 0.13 0.17 0.28 0.00 0.07 0.12 R-square (efficiency) 0.11 0.13 0.13 0.17 0.25 0.01 0.02 Notes: the reported independent variables are included one-by-one in the OLS regression. Structure-Activity=ln (total value traded ratio/bank credit ratio). Structure-Size=ln (market capitalization ratio/bank credit ratio). Structure-Efficiency=ln (total value traded ratio*overhead costs). Finance-Activity=ln (total value traded ratio*bank credit ratio). Finance-Size=ln (market capitalization ratio*bank credit ratio). Finance-Efficiency=ln (total value traded ratio/overhead costs).Bank-Activity=ln (bank credit ratio). Bank-Size=ln (bank credit ratio). Bank-Efficiency=ln (1/overhead costs). Market-Activity=ln (total value traded ratio). Market-Size=ln (market capitalization ratio). Market-Efficiency=ln (total value traded ratio). Legal=strength of legal rights index (0-10). Developed is a dummy variable that takes 1 if it is a developed country and 0 if it is developing. Common is a dummy variable that takes 1 if the country uses common law and 0 if it is civil law.
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Table 6: The effect of financial structure and financial development on economic development (period-Average)
period-Average (cross-section dataset)
(1) (2) (3) (4) (5) (6) (7) Structure-Activity 0.28 (0.24) -0.24 (0.33) 0.25 (0.25) 0.33 (0.27) 0.26 (0.24) Structure-Size 0.21 (0.49) -0.11 (0.46) 0.15 (0.50) 1.02*** (0.26) 0.13 (0.50) Structure-Efficiency 0.35 (0.19) 0.15 (0.32) 0.34 (0.22) 0.25 (0.19) 0.36 (0.19) Finance-Activity 0.34* (0.14) 0.46* (0.21) Finance-Size 0.50* (0.21) 0.52* (0.22) Finance-Efficiency 0.34* (0.13) 0.23 (0.29) Legal-activity 0.57** (0.19) Legal-size 0.35*** (0.11) Legal-efficiency 0.43* (0.16) E (Finance-Activity) 0.11 (0.24) E (Finance-Size) 0.27 (0.39) E (Finance-Efficiency) 0.01 (0.33) Structure*developed-activity -0.33 (0.79) Structure*developed-Size -0.58*** (0.17) Structure*developed-efficiency -0.38 (0.20) Structure*common-activity 0.25 (0.48) Structure*common-size 1.13 (1.59) Structure*common-efficiency 0.15 (0.11) R-square (activity) 0.58 0.64 0.65 0.23 0.49 0.58 0.58 R-square (size) 0.55 0.65 0.65 0.24 0.33 0.65 0.56 R-square (efficiency) 0.61 0.61 0.62 0.19 0.54 0.66 0.64 Notes: the reported independent variables are included one-by-one in the OLS regression. Structure-Activity=ln (total value traded ratio/bank credit ratio). Structure-Size=ln (market capitalization ratio/bank credit ratio). Structure-Efficiency=ln (total value traded ratio*overhead costs). Finance-Activity=ln (total value traded ratio*bank credit ratio). Finance-Size=ln (market capitalization ratio*bank credit ratio). Finance-Efficiency=ln (total value traded ratio/overhead costs).Bank-Activity=ln (bank credit ratio). Bank-Size=ln (bank credit ratio). Bank-Efficiency=ln (1/overhead costs). Market-Activity=ln (total value traded ratio). Market-Size=ln (market capitalization ratio). Market-Efficiency=ln (total value traded ratio). Legal=strength of legal rights index (0-10). Developed is a dummy variable that takes 1 if it is a developed country and 0 if it is developing. Common is a dummy variable that takes 1 if the country uses common law and 0 if it is civil law.
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5. CONCLUTION AND LIMITATION
In this thesis, we have studied the relationship between financial structure and economic growth. It is a controversial and complex subject that countries attract the attention of the policymakers and academics. We investigated the impact of the activity, size and efficiency of financial structure on the economic growth. A panel dataset containing 32 countries covering period from 1994 to 2009 is taken into account for analysis. It shows that there is no support for either the bank-based or the market-based view of financial structure, but overall financial development is robustly linked with economic growth (Levine, 2002).
The hypotheses based on built on five competent theories, including (1) bank-based theory, (2) market-based theory, (3) financial service theory, (4) law and finance theory, and (5) hybrid theory.
Both fixed effects model (panel data) and OLS model (cross-section data) were used to estimate the hypotheses, and our results are consistent with those in the relevant literature (e.g. Levine, 2002; Beck and Levine, 2002). Neither market-based nor bank-based categorizations are particularly important for identifying growth enhancing financial systems (Merton and Bodie, 1995; Levine, 1997), which support “financial service theory”. Distinguishing countries as bank-based or market-based is not an analytically useful way of improving economic growth even after allowing for the systematic evolution of financial structure (Levine, 2002). It is focused that the result doesn’t change when we includes the index of the strength of legal rights and interacted with financial structure (Arestis, Luintel, & Luintel, 2005), which can’t support law and finance theory. Finally, it is shown that financial structure does not enter significantly in the regressions even if the dummy variables (i.e. country development and legal origin) are included in the hybrid theory.
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& market based) are not significant, even if considering the strength of legal rights, country development and legal origin are considered.
Limitation and implication
Firstly, we measured the financial structure as the ratio of market to bank, and observed some countries have relatively active markets, which is due to very low level of bank development. Therefore, we can define that a financial system can be identified as market-based either because markets are very well developed or banks are underdeveloped (Beck, Levine & Maksimovic, 2000). It may lead bias to the relationship between financial structure and economic growth.
Secondly, we only focus on 32 countries, although containing both developed and developing countries. Further research is needed, concentrating on more countries for statistic study and seeking validity for a generatic results.
Thirdly, only four control variables (i.e. inflation rate, unemployment rate, openness and government expenditure) are used in this paper. Further study can include more control variables, such as black market premium, indicators of civil liberties, revolutions and coups, political assassinations, bureaucratic efficiency, and corruption.
Fourthly, in this thesis, we only consider the relationship between financial structure and economic growth. if we want to confirm the causal relationship (i.e. whether higher financial structure leads to higher economic growth), we need to do more efforts in the future research.
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ACKNOWLEGEMENTS
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