3/11/2016

Management of
Financial Institutions
Which is best for India- a Market based
financial system or a Bank based financial
system
Presented to

PROF. PANKAJ BAAG, IIM KOZHIKODE

Present by

Vivekananda Suaro, EPGP-07-097

Which is best for India- a Market based financial system or a Bank based financial system

There is a rich literature on comparative benefits of bank-based versus market based financial
systems. The bank-based view highlights the positive role of banks in leveraging informational
advantage about the firms for capital allocation and ensuring better credit discipline, close
relationships with parties, provide tailor made contracts, efficient inter-temporal risk sharing, no
free rider problem but it has some drawbacks like retards innovation and growth, impedes
competition.
In contrast, the market-based view highlights the growth enhancing role of well-functioning
markets in fostering greater innovation; enhancing greater market discipline and corporate
governance, provides attractive terms to both investors and borrowers, facilitate diversification,
allows risk sharing, allows financing of new technologies but it too has some drawbacks like it is
prone to instability, exposure to market risk, free rider problem. Market based systems were
supposed to reduce the problem of moral hazard inherent in bank-based systems. However, it is
increasingly being recognized that any system is essentially an interplay of dynamic interaction
between banks and markets and right interpretation of this interplay would be critical for addressing
systemic stability.
There is a fundamental shift in the recent times banks have become intricately linked to financial
markets and hence more susceptible to strains in financial markets; at the same time, functioning of
markets has become intricately linked to banks which then emerge as the receptacle for most of
risks within the financial markets.
As per literature in financial field, a bank is a financial intermediary that offers loans and deposits,
and payment services. However, nowadays banks have diversified their services and operating
methods, to such an extent that this definition, although quite recent, does not offer a complete
perspective anymore of what a bank really is. Additional services that banks perform today include:
Brokerage services (arranging transactions of stocks and bonds between buyers and
sellers);
Asset securitization (pooling and repackaging of illiquid financial assets such as loans into
marketable and more liquid securities).
Therefore, banks often act as financial intermediaries between other financial intermediaries and
ultimate borrowers or lenders. The increased complexity of the banking system is particularly

VIVEKANANDA SUARO EPGP-07-097

MANAGEMENT OF FINANCIAL INSTITUTIONS

PAGE 1

Which is best for India- a Market based financial system or a Bank based financial system

important in the aftermath of the Financial Crisis when banks capacity of maintaining a safe level
of liquidity is being questioned more than ever.
Countries such as India, Japan, France and Germany, where banks provide around 20% of the
corporate financing, it is known that banks are making significant effort to develop a relationship
banking culture, with long-term loans and preferential interest rates for clients with a good
history. These economies can be called Bank-Based Economies.
There are also countries where the borrowing-lending activities take place through organized
markets, such as London Stock Exchange, in the UK, or New York Stock Exchange in USA. These
are known as Market-Based Economies. Although banks are present in these countries, but they are
highly competitive, the relationship with lenders and borrowers is purely limited to the transactions
of granting loans or taking deposits and loans are usually granted on short-term.
Market-based view highlights the growth enhancing role of well-functioning markets in fostering
greater innovation; enhancing greater market discipline and corporate governance, provides
attractive terms to both investors and borrowers, facilitate diversification, allows risk sharing,
allows financing of new technologies but it too has some drawbacks like it is prone to instability,
exposure to market risk, free rider problem. Market based systems were supposed to reduce the
problem of moral hazard inherent in bank-based systems.
My Verdict: I guess a mixture of both Market and Bank based financial system is a better choice
for India.

VIVEKANANDA SUARO EPGP-07-097

MANAGEMENT OF FINANCIAL INSTITUTIONS

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