Theory: Difference between market-based financing (MBF) and bank-based financing

(BBF). What are the relative advantages and disadvantages of bank-based financial
systems (Japan) and market-based financial systems (US). Does financial structure matter?
Markets or bank-based intermediaries, which is more effective at providing financial
services?
Introduction
Economies have long debated the advantages and disadvantages of bank-based financial systems
v market-based financial systems. In BBF such as Germany and Japan, banks play a leading role
in mobilizing savings, allocating capital, overseeing the investment decisions of corporate
managers and providing risk management vehicles. In MBF such as UK and US, securities
markets share center stage with banks in terms of getting societys savings to firms, exerting
corporate control and ease risk management. Availability of bank or market finance enables
firms to make larger investment and raise external financing than is possible otherwise. What are
the pros and cons of both financial systems? Which one is more effective in providing financial
services during good and bad times? Does the financial structure matter?
Banks and markets channel savings into investment in quite different ways. Banks perform
intermediation mostly on their balance sheets. They take in savings typically as deposits and
provide funding primarily in the form of loans, often through close relationships with borrowers.
Banks can overcome problems arising from asymmetric information and contract enforcement
(moral hazard, adverse selection and agency problems) using the knowledge they accumulate
through relationships. Markets, by contrast, keep savers and investors at arms length, by serving
as a forum where debt and equity securities are issued and traded. Markets overcome problems
arising from asymmetric information and contract enforcement by means of contract covenants
and the courts.
Analysis
BBF Differences MBF
+ With long run relationships, BBF
reduce the costs of acquiring and
processing info and thus improve
resource allocation

+ produce info on firms and sell this to
savers

Producing
information
and allocating
capital

+ Larger liquid markets incentivize
agents to expend resources in
researching firms because it is easier
to profit from this info by trading

+ easier for agent who has acquired
info to disguise this private info and
make money by trading
+ economizes on aggregate monitoring
costs and eliminates the free-rider
problem since the intermediary does
the monitoring for all investors

Monitoring
firms and
exerting
corporate
governance
+ Links managerial compensation to
stock prices aligns their interests with
shareholders

+ Better stock markets can promote
+ Bank monitoring resolves moral
hazard problems: firms that obtain
external financing may deliberately
reduce the success probability of their
investment in order to enjoy private
benefits, market investors are too
disparate to effectively control
borrowers activities.

+ exert pressure on firms to repay
debts esp in countries with weak
contract enforcement capabilities.
Without enforcer, external investors
may be reluntant to finance industrial
expansion in countries with
underdeveloped institutions.

- Banks act in their own best interest,
not necessarily with the best interest at
large

- Due to longer term relationship, may
impede efficient adjustment to
structural change (reluctant to
bankrupt inefficient companies or
prevent outsiders from removing
inefficient managers)

- Monitoring cost is costly, BBF is
more expensive than MBF

after
providing
finance
Investors lack
expertise and
incentives
because of
large costs and
complexity.
Providers of
finance aims to
effectively
monitor firms
and induce
manager to
maximize firm
value
better corporate control by easing
takeovers of underperforming firms

+ market based system effectively
identify, isolate and bankrupt truly
distressed firms and prevent them
from hurting the overall economy

+ Capital allocation, risk management
tools and mitigating problems
associated with excessively powerful
banks

- Insiders have better info than
outsiders, info asymmetry mitigates
takeover threat, outsiders outbid
insiders for control only when they
pay too much

- encourage myopic investor climate
as investors can inexpensively sell
their shares so that they have fewer
incentives to undertake expensive
corporate governance

- Conflict of interest between
controlling and other shareholders
(concentrated owners benefit
themselves at the expense of minority
shareholder, debt holders and other
stakeholders, share cost of failures),
concentrated power corrupts political
system
+ provide basic risk management
services for standardized situations
Facilitate
trading,
diversification
and risk
management

+ financial instruments provide
opportunities for households to hold
diversified portfolios (smaller
denomination)

+provide greater flexibility to tailor
make products with richer set of risk
management tools and vehicles for
raising capital

+ contributes to efficient funding and
transfer of credit risk, provide
competition to banking, diversifies
credit sources available in the
economy

+ pool savings from investors and
convince savers of the soundness of
investments (reduce transaction & info
cost)

+ enables small denominator
investments
Mobilize and
pool savings

+ permits price signals: guides firms
into making worthwhile investment
whilst relationship BBF could lead
firms facing weak CF to undertake
misguided investments

+Remove counter party risk

+ Outperforms MBF from a
development perspective: financial
intermediation creates an environment
more conducive for transforming a
traditional to a modern economy by
overcoming large-scale investment
requirements, requiring minimum
entrepreneurial wealth to obtain
finance.

Ease the
exchange of
goods and
services
- traditional sector worse-off unless
they specifically reduce the costs of
bank intermediation

Conclusion
BBF can exploit economies of scale in information processing, ameliorate moral hazard through
effective monitoring, form long run relationships with firms to ease asymmetric information
distortions and thereby boost economic growth.

Competitive capital markets play positive roles in aggregating diffuse information signals and
effectively transmitting this information to investors with beneficial implications for firm
financing and economic performance.

Both systems may be better at providing funds for different firms. Firms with lower marketable
collateral and higher incentive problems borrow from banks while wealthier firms rely on
unintermediated MBF. Banks may be well prepared to fund start up firms while public markets
can be better prepared to finance established firms, typically with more tangible assets. Larger
firms have better access to capital market.

Financing during normal times
Banks and markets also behave differently when it comes to moderating business cycle
fluctuations. In normal downturns, relationship banks, especially well capitalized ones, find it
easier to keep lending than markets do (Bolton et al (2013)). Drawing on their long-term
relationships with clients, banks are more inclined to offer credit during a downturn. By contrast,
transaction lenders, who do not invest in information about the borrower, typically pull back
during a recession. When there is no financial crisis, economies with bank-based systems appear
more resilient. When banks are not themselves under strain, they help their clients absorb
economic shocks.
Financing during recession/financial crisis
However, a financial crisis can impair banks shock-absorbing capacity. When banks are under
strain, they are less able to help their clients through difficult times. Banks may put off necessary
balance sheet restructuring (Caballero et al (2008)). Exp: Large Japanese banks often engaged in
sham loan restructurings that kept credit flowing to otherwise insolvent borrowers (which we call
zombies). This is something that capital market investors cannot afford to do. Countries that rely
relatively more on bank financing tend to be more severely hit. In fact, recessions in countries
with bank-oriented systems are three times as severe (12.5% of GDP) as in those with a market-
oriented financial structure (4.2% of GDP). When the banking sector is itself handicapped by the
effects of a crisis, recessions tend to be more severe and countries with bank-oriented systems
suffer more than others. In a financial crisis, therefore, systems that is more market-oriented may
speed up the necessary deleveraging, thereby paving the way for a sustainable recovery (Bech et
al (2012)).
In conclusion, when it comes to moderating business cycle fluctuations, banks and markets differ
considerably in their effects. In normal downturns, healthy banks help to cushion the shock but,
when recessions have coincided with financial crises, we find that the impact on GDP has been
three times as severe for bank-oriented economies as it has for market-oriented ones.
Cross sector analysis: By their nature, different lines of business are more suited to different
types of intermediation.
BBF
Sectors with tangible and transferable capital (such as agriculture), as well as those where
output is easier to pledge as collateral
Firm size also has a bearing on the funding mix. Small firms typically depend on bank finance
because of the fixed costs involved in tapping capital markets, not least those associated with the
corresponding governance mechanisms. (such as construction), are more amenable to bank debt
finance.
MBF
By contrast, sectors that rely heavily on human capital (eg professional services), or those
where output is hard to collateralize, will tend to rely more on equity or bonds.
Cross country analysis
The financial service view (Levine 1997)
Minimizes the importance of the BBF and MBF debate. Financial arrangements
(contracts, markets, intermediaries) arise to ameliorate market imperfections and provide
financial services (assess potential investment opportunities, exert corporate control,
facilitate risk management, enhance liquidity and ease savings mobilization. The issues
are creating an environment in which intermediaries and markets provide sound financial
services.
The law and finance view (La Porta, Lopez-de-Silanes, Shleifer and Vishny (LLSV) (1998))
Emphasize whereby a well-functioning legal system facilitates the operation of both
markets and intermediaries. Finance is a set of contracts and are made more or less
effective by legal rights and mechanisms. Hence, law and enforcement mechanisms are a
more useful way to distinguish financial systems than focusing whether countries are
BBF or MBF.
Empirical evidence Cross country research of 150 countries by Levine (2012)
Consistent with the financial services view => supporting neither MBF or BBF.
Better developed financial systems positively influence economic growth.
Consistent with law and finance view => the legal system plays a leading role in
determining the level of growth-promoting financial services.
The conclusions are not altered when looking at extremes: countries with very well
developed banks but poorly developed markets do not perform notably different from
those with very well developed markets but poorly developed banks or than those with
more balanced financial systems.
Hence
The component of financial development defined by the legal rights of investors and the
efficiency of contract enforcement is very strongly associated with growth.
Thus, the data tend to support the LLSV (1999) view that (i) the legal system crucially
determines financial development and (ii) financial structure is not a particularly useful
way to distinguish financial systems.
Financial contracts depend critically on the legal framework and the enforcement of
contracts and property rights. Investors are more likely to part with their money if they
feel sure of being able to claim it back.
Findings:
Banks, nonbanks, and stock markets are larger, more active, and more efficient in richer
countries. Financial systems, on average, are more developed in richer countries.
In higher income countries, stock markets become more active and efficient relative to banks.
There is some tendency for national financial systems to become more market oriented, as they
become richer.
Countries with a Common Law tradition, strong protection of shareholder rights, good

Legal frameworks originating in the common law tradition tend to offer higher protection to
holders of equity and debt securities. Minority shareholders have more tools, such as the exercise
of their voting rights, to protect their interests from actions by management or large shareholders.
Creditors find it easier to avoid an automatic stay on assets and enjoy greater priority when their
claims are secured and they face managements that have less freedom to seek court protection.
As a result, common law systems foster the development of market-based finance, which
depends on the efficiency of arms length relationships between issuers of securities and
investors.
By contrast banks, through their repeated interaction with clients and through their closer
screening and monitoring of borrowers, can compensate for the more limited protection
offered by French civil law frameworks.
Conclusion
The data provide no evidence for the bank-based or market based views. Distinguishing
countries by financial structure does not help in explaining cross-country differences in long-run
economic performance. Rather, the cross-country data strongly support the financial services
view. Distinguishing countries by their overall level of financial development helps to explain
cross-country difference in economic growth. Countries with greater degrees of financial
development as measured by aggregate measures of bank development and market
development enjoy substantially greater economic growth rates. Moreover, the component of
financial development explained by the legal rights of outside investors and the efficiency of the
legal system in enforcing those rights is strongly and positively linked with long-run growth. The
data are consistent with the view that the legal system importantly influences financial sector
development and this in turn influences long-run growth. The results highlight the importance of
strengthening the rights of investors and improving the efficiency of contact enforcement.
According to this view, the crucial issue for growth is whether the economy has access to a well-
functioning financial system. The exact composition of the financial system is of secondary
importance. Both systems provide complementary growth-enhancing financial services to the
economy. Finally, our evidence suggests that banks and markets differ considerably in their
moderating effects on business cycle fluctuations. Banks are more likely to supply loans during a
normal downturn, thus smoothing the impact of the recession. But their shock-absorbing
capacity is impaired when the downturn is associated with a financial crisis. In this case,
accounting regulations, low levels of corruption, and no explicit deposit insurance tend to be
more market-based.
Countries with a French Civil Law tradition, poor protection of shareholder and creditor rights,
poor contract enforcement, high levels of corruption, poor accounting standards, restrictive
banking regulations, and high inflation tend to have underdeveloped financial systems.
recessions in countries with bank oriented systems are three times more severe than in those with
a market-oriented financial structure.
But BBF have some advantages over MBF for less developed countries:
1) Levels of investment and per capita GDP are higher
Bank monitoring resolves some of the agency problem and enable firms to borrow more
Arms-length MBF plays no such role and results in a lower amount of external finance
available to all firms
2) BBF allows greater participation in manufacturing activities by providing external
finance to a larger number of entrepreneurs. Traditional sector is smaller and wealth
distribution better under such a system
Outlook: Tougher requirements under Basel III of tighter capital, liquidity and leverage rules for
the regulated banking sector could encourage risk taking and increase incentive for financial
activities to move to the unregulated MBF sector, creating potential regulatory arbitrage.