«THE CHARACTER OF THE STATE IN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH THESIS SUBMITTED FOR THE AWARD OF THE DEGREE OF DOCTOR OF PHILOSOPHY AT THE ...»
Levine (2004:29) analyzes the case for a market based system and posits that big and influential banks through their ‘vicious’ dealing with firms have indirectly created the incentive for firms to look elsewhere for capital. His position is that banks after having dealt with these firms for a long time know their entire cycle and therefore are able to institute higher rent seeking policies in their relationship with these firms. At a point in their relationship, these firms move to source funds from the capital market with a preference for the softer equity market (Brigham and Houston 2003). Allen and Gale (2000) observed that Japanese firms have a higher tendency to seek funds from their banks rather than from the financial market due to a long standing tradition of a bank based financial system. Weinstein and Yafeh (1998) take a closer look at the Japanese financial system and conclude that Japanese firms tend to maintain long run relationships with one main bank due to their restricted access to financial markets. In spite of their long run relationships with the firms, the banks maintain a conservative approach to lending, analysing viable projects for which they will advance financing to firms thereby stifling their investment initiatives (Weinstein and Yafeh 1998). The Japanese tradition of firms sticking to one main bank over a long run relationship is no doubt similar to the Nigerian situation elaborated earlier on.
They posit that a market based system provides better pricing of risk and assets which is consistent with the view of Fama (1970). Fama describes pricing mechanisms of the capital market as being effective such that capital resources are allocated in a timely manner to where they are most required.
This no doubt is a prerequisite for economic growth (McKinnon 1973).
Greenwood and Smith go further to show how the market based model embraces a wide range of professionals such as stockbrokers, underwriters, bankers, insurance brokers and a host of others making stock market transactions more open to scrutiny and discipline. This view of Greenwood and Smith is purely an ideological claim as can be seen when compared to the outcome stressed in Allen and Gale (2000) where it was argued that intermediaries and markets play complimentary roles in the financial system depending on the country in question.
2.3.3 Banking/Market Based Finance-Growth Models Allen and Gale (2000) compared the financial systems of a group of developed countries, The United States of America, The United Kingdom, Germany, France and Japan and observed that the USA and The UK rely predominantly on a market based financial system while Germany, France and Japan seem to have a preference for the bank based system. In their argument, they give credit to both systems emphasising that bank based systems have a greater propensity to monitor the activities of individual firms while market based systems may not have such close vigilance over corporate activities. Market based systems however are better dispersed with the effect that they have a wider outreach thereby improving liquidity. They conclude by saying that a well positioned financial system must not place its full reliance on either the bank based model or the market based model but must incorporate both models into its financial development agenda. This compliments the argument of Greenwood and Smith (1997) where they show that the market based system draws on varied professionals including a well functioning banking system for its success.
Demirguc-Kunt and Levine (1999) using cross country evidence from 150 countries highlight that financial structure is irrelevant to economic growth by analyzing the size, activity and efficiency of various financial systems. They argued that as a country grows richer, its financial system becomes more advanced irrespective of whether it is bank or market based. In their study, they also highlighted that a countries legal system had a significant role to play in the choice of the countries financial structure showing that countries with a common law system with shareholder right protection had a tendency to follow a market based structure while those with a French legal system with weaker shareholder protection rights had the tendency to follow bank based systems. Their overall argument reinforced the view that financial structure is irrelevant. Beck, Demirguc-Kunt, Levine and Maksimovic (2000) using firm, industry and country evidence further consolidate the view held in DemirgucKunt and Levine (1999) by showing that a countries legal system is more relevant to economic growth than its financial structure. Beck et al (2000) demonstrate that irrespective of which financial structure a countries financial system follows, firms using retained earnings and/or external finance in either bank or market based systems grew alike thereby attributing economic growth to other factors outside of financial structure. Ayadi, Adegbite and Ayadi (2008) in a study of Post-Structural Adjustment Programme Nigeria however argued that financial structure was relevant in advanced stages of economic development stating that market based systems were better positioned to allocate capital efficiently to productive ventures. The Nigerian Legal system is derived from the English common Law shown by Demirguc-Kunt and Levine (1999) to be more amenable to the market structure. While still on Nigeria, Nzotta and Okereke (2009) using time series data for the Nigerian economy for a 22 year period showed that financial structure is irrelevant to economic development rather policy makers should concentrate their efforts in making financial policy that would help deepen the financial system by creating appropriate channels for the allocation of credit to the real sector of the economy. In their view, the economy will grow if the appropriately channelled credit transforms effectively to increased investment in the real sector. Fitzgerald (2006) in an intensive study succinctly demonstrates that neither bank based or market based systems had an upper hand in driving economic growth as financial liberalization does not increase the rate of savings and investment but merely increases the efficiency and liquidity of the financial system. The implication of this argument is that economic growth will result from the proper channelling of the increased liquidity as argued by Nzotta and Okereke within a proper legal framework as previously argued by Demirguc-Kunt and Levine (1999) and Beck et al (2000).
Levine (1997) further argues that both the banking system and the financial markets constitute financial development pointing out that any well developed financial system must not only have a highly liquid financial market but must also have a strong banking system. Boyd and Smith (1998) complement this argument by emphasising that the banking system and the financial markets compliment each other in their various functions. They posit that in the early growth stages of an economy, the banking system is the main provider of investment funds because the financial markets are either in their budding stage or possibly non existent. As the economy grows, and the banking system grows with it, the increased relevance of a rapidly growing financial market is apparent as it effectively competes with the banking system as the main provider of funds. This apparent takeover does not render the banking system useless as they still fund other types of investment including consumer items. This argument of the superiority of a bank based system over a market based system is a classical argument put forward by Schumpeter (1911). Boyd and Smith also clarify that the bond and equity markets are not substitute markets but play different roles in their provision of capital.
Using firm level data, Demirguc-Kunt and Makismovic (2002) discover that in developing countries, as growth is experienced in the financial markets, there is a correspondingly high demand for bank funds. This finding is strongly consistent with trends in the Nigerian market since 2007 whereby growth in the Nigerian All Share Index has seen investors taking out bank loans to purchase equity on the stock exchange (personal discussion with an officer of UBA Capital Markets, the investment arm of the United Bank for Africa Plc).
Scharler (2006) give further evidence in support of bank based financial systems by showing that the operations of banks in limiting the passing through of interest rate changes help reduce macroeconomic volatility.
2.4 EVIDENCE OF THE RELATIONSHIP BETWEEN FINANCIAL
DEVELOPMENT AND ECONOMIC GROWTH
Raymond Goldsmith Goldsmith (1969) presents a hypothesis whereby he posits that over time, financial activities have been separated into savings and investment due to the increased complexity of financial markets, institutions and trading processes resulting in increased economic growth. He supports his argument by stressing that members of the society exhibit two general attitudes towards risk; some people save more than they are willing to invest (due to uncertainty about the future) while others invest much more than they save. Ironically, the intermediaries that gather these savings from the risk averse savers mentioned above (at a low interest rate) pass them on to investors at a higher rate for investment. Goldsmiths concern however was to establish empirically that financial development leads to economic growth. To establish this, he carried out a study of 35 countries from 1860-1963. In spite of the wealth of his study which gave good indications about the causal relationship from finance to economic growth, Goldsmith was reluctant to draw direct conclusions about which of markets or intermediaries give the stronger causal effect on economic growth due to the small sample size he employed in his empirical studies (35 countries). Further evidence for Goldsmiths work can be found in King and Levine (1993), Demirguc-Kunt and Levine (2001) and Levine (2004). Demirguc-Kunt and Levine (2001) show that even though a vast body of literature has been amassed giving evidence that financial development does lead to economic growth, no concrete work has been carried out after Goldsmith (1969) to provide unwavering empirical evidence in support of the supremacy of financial intermediaries or markets in the causal effect of economic growth save for Allen and Gale (2000) who conclude that the choice between intermediary and market varies from one country to another and a mix of the two systems with the right balance is often beneficial. Levine, Loayza and Beck (2000) also add that causality from intermediaries or market is inconclusive and dependent on other factors such as the accounting and legal environment of the country under review. In another article specifically examining which of intermediary or market is better, Levine (2002) posits that the view of financial development has gone beyond market or intermediary preference as evidence amassed provided an inconclusive view of superiority each having its merits over the other. Choe and Moosa (1999) in addition to showing that financial development has a causal effect on economic growth in the Korean economy also provide a contrary view to Goldsmiths inconclusive view of the importance of markets or intermediaries by positing that intermediaries play a stronger role than markets in the causal relationship. Saint-Paul (2002) on the other hand show that markets provide the vehicle for diversification of risk which invariable improves the quality of investments therefore markets ultimately give a stronger causal effect on economic growth than intermediaries do. Ndikumana (2005) argues that financial systems play the role of channelling capital to investors so whichever system (market or intermediary) is in place, to the extent that investors receive investable capital at a cost effective rate, he concludes that causality from market or intermediary is irrelevant to economic growth.
2.4.2 Empirical Evidence (King and Levine 1993) King and Levine (1993) set up two hypotheses to test the relationship between financial development and economic growth;
H0: Financial development leads to economic growth.
H1: Economic growth facilitates financial development.
The study empirically established a relationship between the two variables by accepting the null hypotheses. A sample size of 80 countries was employed using data between 1960 and 1989. In conclusion they outline evidence that the increase in size, efficiency and activity of financial intermediaries and market has a causal impact on economic growth. They also conclude that financial development as in Schumpeter’s view has a causal effect on economic development.
Evidence from this study was used to augment the findings from an earlier study by Goldsmith (1969).
Liang and Teng (2006) in a study of the Chinese economy however finding contradictory evidence relating to the relationship; they find that there exist a uni-directional causality in the case of China from economic growth to financial development.