Financial Systems

This chapter elucidates the key debates surrounding the optimal design of financial systems and institutions: bank-based versus market-based; universal versus specialized banking; relationship versus arms-length banking. The chapter also examines the historical pattern of financial system development – explaining the economic, legal, and political factors that influenced the shape of these systems as well as the long-run growth outcomes observed among the group of economies that underwent industrialization prior to World War I. The extensive evidence and analyses available indicate that financial systems historically took on a wide and complex range of forms that are difficult to categorize narrowly, yet provided similar functions; thus arguing for a functional, rather than institutional, approach to financial system design and regulation. Moreover, the research to date strongly supports the idea of persistence and path dependency in financial system design, that economic conditions at the time of industrialization help set the initial conditions that shape financial system and banking institution design, and historical political conditions, such as centralization of power, plays an ancillary role via the extent of regulation on banks and the development of free capital markets. In other words, history matters.

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Financial Systems

Financial Systems

Financial Structure

Notes

Fohlin (2012) and Allen et al. (2010) provide detailed historical comparisons of the corporate finance systems of the United Kingdom, the United States, Germany, Japan, and (in Fohlin 2012) Italy. Fohlin (2012) also compares more schematically the financial systems of a larger set of industrialized economies of the prewar period. Morck’s (2005) edited volume contains historical studies of the corporate governance systems of several different countries.

Regulatory restrictions prevented the natural progression of banking in the United States. Even there, a few banks grew very large, and banks developed a correspondent system to replicate national branching.

1990 data taken from a survey of 144 large German firms’ general meeting minutes, quoted in Elsas and Krahnen 2003.

For historical country studies of corporate governance practices, see the volume edited by Morck (2005). A recent volume edited by David and Westerhuis (2014) provides long-run country studies more specifically on corporate networks. The Oxford Handbook of Banking edited by Berger et al. (2014) contains several relevant chapters on banking generally. In more recent times, the proxy voting system has come to incorporate a range of financial institutions, such as mutual funds and investment advisors. See Ferreira and Matos (2012) on the impact that proxy voting by banks has on corporate lending globally.

Many studies of young firms focus on venture capital financing and the role of venture capitalists, as in Hochberg et al. (2007). Most young firms do not find financing from venture capital organizations but rather from banks. See Hellmann et al. (2007) on venture capital activities of banks. Ivashina and Kovner (2011) use proportion of lending to measure relationship strength in their study of the impact on lending costs of relationships between LBO firms and banks. Santikian (2014) emphasizes the role of noninterest revenue generation and added connections with new borrowers as measures of relationship strength. The Kauffman Foundation (2013) sponsored a large longitudinal survey of US firms founded in 2004, and they report results on their website: http://www.kauffman.org/~/media/kauffman_org/research%20reports%20and%20covers/2013/06/kauffmanfirmsurvey2013.pdf.

Gerschenkron’s seminal work is his 1962 Economic Backwardness in Historical Perspective. He had also written on Italy in 1955 and later on Russia (1970). See also Gerschenkron (1968). Sylla and Toniolo’s (1991) edited volume contains several essays relating to and analyzing Gerschenkron’s work. See, in particular, Sylla’s chapter on banking.

For most of the countries listed, the determination of banking characteristics stemmed from exhaustive searches of secondary literature as well as discussions with several scholars who have studied these systems. Gaps remain where information is too sparse to support a certain categorization. Further studies have appeared since, including Musacchio’s (2009) extensive study of Brazil and Colvin et al.’s (2014) analysis of a large sample of Dutch banks in the 1920s crisis there.

One may also consider national laws and regulations regarding banking scope, corporate governance relationships, bank branching, and operations of securities markets. Because regulations constraining banking operations vary in their intensity and enforcement, as well, systems have historically differed even in the absence of regulatory restraints; the “de facto” approach may better capture actual rather than hypothetical differences among systems.

The merger between Travelers Insurance Group and Citibank in early 1998 was a direct challenge to the early twentieth century banking acts.

Gerschenkron (1962) provided the seminal postwar exposition of the German system; however, Riesser (1910 German original; translated by the US National Monetary Commission in 1911) and Jeidels (1905) offered detailed contemporary accounts of the German banking system, and Whale (1930) added further analysis – all of which seem to have influenced Gerschenkron’s thinking on the German banking system. See the discussion in Fohlin (2007a).

See American Bar Association (1984) on the Clayton Act provisions regarding interlocking directorates.

Kroszner and Strahan (1999). G. William Domhoff, a sociologist at UC Santa Cruz, maintains a website that provides extensive information on interlocking directorates in the United States: http://www2.ucsc.edu/whorulesamerica/power/corporate_community.html.

On Brazil, see Mussachio (2009). For a general examination of stock market development, see Michie (2006). See Battilossi and Morys (2011) for a brief survey of markets in Madrid, Vienna, Belgrade, Bucharest, Sofia, Athens, and Istanbul.

Dietl (1998) and Hoshi and Kashyap (2004). See Morck and Nakamura (2005) for an exhaustive treatment; they explain the (substantial) differences between the modern (post-WWII) keiretsu and the prewar zaibatsu.

Apparently, Brazil imposed restrictions on interstate branching by domestic banks but permitted branching within states. Foreign banks could branch as they pleased.

See Calomiris (2000) for a collection of his previous articles dealing largely with branching and relevant political and regulatory debates. See Kroszner and Strahan (2014) for a study of US banking regulation mostly since the 1930s.

See Benston (1994) for a survey of some literature on banking economies of scale and scope in postwar times and Fohlin (2006) for a historical comparison of banking scale in the United States, the United Kingdom, and Germany. It is important to keep in mind the times in which authors analyze banking scale and scope, because they are influenced by the contemporary macro-financial context (post-WWII boom versus later stagnation) and policy debates (e.g., regulatory tightening since the Great Recession versus deregulation in the 1990s and early 2000s).

Fohlin (2005) surveys long-run patterns of corporate governance in Germany, and Fohlin (2007a, b) proposes the hypothesis that proxy voting by banks related closely to the listing of corporate equity on stock exchanges and the depositing of these shares by shareholders. For an early analysis, see Passow (1922). Franks et al. (2006) attempted to measure proxy voting based on shareholder lists from new issue offerings that were required to publish a register of all shareholders present at the preceding general meeting. By this measure, proxy votes cast by banks increased from 13.3% to 41.8%.

See Levine and Zervos (1998) and the recent update in Beck et al. (2010) for the World Bank’s effort in categorizing financial systems based on legal restraints on financial services. See also Rajan and Zingales (2003) and further discussion later in this chapter.

Gerschenkron (1962, 1968, 1970). Sylla (1991) reviews Gerschenkron’s theories and related work. Knick Harley (1991) addresses Gerschenkron’s idea of “substitution for prerequisites” of industrialization.

The historical literature (such as that spearheaded by Gerschenkron 1962) had always paid due attention to political and regulatory factors. The contemporary study by La Porta (1998), spawned an enormous literature, much of which attempts to reject their fairly simplistic framework, notably Rajan and Zingales (2003).

On Germany, see the edited volume by Horn and Kocka (1979) especially those by Horn, Friedrich, and Reich.

See the series of papers, La Porta et al. (1997, 1998, 1999). In Besley and Persson’s (2009) model, if the cost of protecting property rights is lower under common law than under civil law, then common law would allow for more credit as a share of GDP. Pagano and Volpin (2005) make related arguments, discussed subsequently under “Political Factors.” Of course, by now, many others have used a similar legal tradition indicator to help explain a number of financial and economic phenomena.

On the advanced level of financial development in Britain, Schultz and Weingast (2003) argue that the emergence of liberal democratic political institutions in the seventeenth century prompted a financial revolution that expanded credit availability (government debt at that stage).

These propositions surely seem almost preposterous in light of the crisis of 1907–1909 (and the financial crisis of 2007–2009). The severe drop in economic growth following the loss of liquidity and the general malfunctioning in the financial sector actually underscores the key part that a properly functioning financial system plays in permitting economic growth. Gaytan and Ranciere (2006) develop an overlapping generations model that incorporates liquidity crises and demonstrates a variable relationship between financial development and growth.

King and Levine (1993) and Levine and Zervos (1998), for example. The cross-country growth literature does struggle with identification and other econometric problems. See Manning (2003) for some discussion.

Rousseau and Sylla (2003) do a similar exercise as King and Levine for 17 countries from 1850 to 1997.

Beck (2013) also surveys the literature on financial development and growth, with a focus on government policy.

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Authors and Affiliations

1. Johns Hopkins University, Baltimore, MD, USA Caroline Fohlin
2. Emory University, Atlanta, GA, USA Caroline Fohlin

1. Caroline Fohlin