Financial Structure – stock markets vs. banks

The financial system serves as an intermediary between the population that has savings and the firms and households that need financing. The transfer of funds can happen through two main channels. Savings can accumulate in the banking system in the form of bank deposits and then the banks give credits. The second channel is the stock market. In that case, people invest their money directly by acquiring ownership in firms. Each share represents part ownership in a company.

Financial systems differ in terms of their reliance on stock markets vs. banks. For example, the U.S. has a very well developed stock market whose capitalization (i.e. the traded shares times their prices) as percent of GDP is greater than the credit provided by banks to the private sector. In other words, most of the financing used by firms in the U.S. comes from the stock market and not from banks.

In contrast, in Germany most of the financing is provided by banks and less by stock markets.
The difference between the two systems is mostly historic. Since the Great Depression, the U.S. has implemented restrictions on its banking system in terms of what banks can do and whether they can operate in all states. In Germany banks are allowed to have a greater scope of operation and to have closer ties to industry.

In general, most financial systems are bank-based, i.e. bank lending is much more developed than the stock markets. As countries develop economically and politically, their stock markets develop as well since they require very well functioning institutions. Investors have to be able to rely on solid financial information and to rely on the legal protection of their property rights (recall than owning shares means ownership in a company). If these conditions are not in place, stock markets cannot develop. In contrast, banks can function even in countries where information is less reliable and legal rights are less solid. Banks manage to gain information about borrowers and to motivate them to pay their debts by developing close ties with them.

Is it better for economic development to have more developed stock markets than banks as in the U.S. or the other way around as in Germany? There is quite a bit of research on that question but the bottom line seems to be the following: as long as there is strong rule of law in the country fostering the overall development of the financial system, there isn’t much difference between bank-based and stock market-based systems in terms of economic growth.

If one is interested in these issues, the best book on financial structure is by H. Franklin Allen and Douglas Gale, called Comparing Financial Systems.

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