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ECONOMICS OF FINANCIAL INSTITUTIONS (ECON 3011) UNIT 1 PRESENTATION

I hope by now you would have at least taken a look at the reading material and class notes which are not fully completed, by the way. You may have noticed that the lecture notes end at some point at Unit 3 Monetary Policy and the Economy. I shall complete this note In this presentation we shall take a look at each of the following sub-units: Types and Roles of Financial Institutions The financial development/economic growth nexus Bank-based vs. Market-based Financial Systems The structure of Caribbean Financial Systems

By the end of this presentation, you should be able to: identify and categorise the various type of financial institutions explain the roles played by the financial system/financial institutions critically assess the literature/evidence on the relationship between financial development and economic growth critically assess the literature/evidence on the superiority of bank-based financial systems vis--vis market-based financial systems understand the structure of financial systems in the Caribbean and assess the implications thereof Types and Roles of Financial Systems The diagram at the beginning of the notes clearly illustrates the various types of financial institutions (FIs) e.g. financial intermediaries (Institutions that bridge the gap between borrowers/deficit agents and lenders/surplus agents) and markets for securities i.e. financial instruments, which are negotiable and have some financial worth. You should note the further classification of financial intermediaries into depository institutions (those that accept deposits e.g. commercial banks and credit unions); and non-depository institutions (those that do not accept deposits e.g. insurance companies and stock exchanges).

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2 You should be able to identify and explain the traditional roles played by FIs as service providers including: Risk transformation (risk trading, pooling, hedging and diversification strategies) Maturity transformation (matching investors with varying investment time horizons) Providing a payments mechanism (facilitating cash and non-cash transactions) Liquidity provision (bringing together pools of buyers and sellers) Cost reduction (possess resources to reduce transaction and search costs etc) Pricing of financial assets (options pricing etc) Monitors managers and exerts corporate control (stock price acts as a signalling device to potential investors; eliminates managerial myopia) Efficient resource allocation

Final Points Please note how the above leads us nicely into the debate on the rationale for the existence of financial intermediaries in Unit 2. Any comments/questions?

2. Financial Development/Economic Growth Nexus The literature on this sub-unit is vast; ranging from investigations into the relation between the financial system and the economy in general to more specific studies analyzing the relationship between particular FIs e.g. banks and/or stocks markets and economic growth/development. In this sub-unit, you should focus on two aspects of the debate; namely, correlation and causation. Let me explain: Correlation studies simple establish whether or not there is a relationship between financial development and economic growth (most of the papers relate to this type of enquiry). Causation studies actually seek to determine the direction of the relationship i.e. does the stock market grow because the economy expands Or does the economy grow because of increased stock market activity? In the theory these two questions relate to Patrick (1966) concepts of the demand following hypothesis and the supply leading hypothesis. Anyway, I do not expect you to read Patricks seminal paper; simply being familiar with the two concepts is enough at this level. You should read most of the papers I posted on the economic growth or economic development/financial development nexus. If nothing else, you should take a look at the paper by Levine (1997) entitled Financial Development and Economic

3 Growth: Views and Agenda. This paper surveys all the relevant literature on the debate up to that point. This section is mainly reading and critical analysis, which means that it is mainly up to you to do the reading and ask any questions you may have. You do not have to recall the econometric models used in some of the papers of an investigative nature. Remember the findings and intuition is what I am interested in. Final Points Levines paper is a must read but you generally survey the other papers e.g. Stock Markets, Banks and Economic Growth and Stock Markets: A Spur to Economic Growth to mention a couple. Let me know if I sent you these. Note the various views of researchers including those who believe there is no important nexus between financial development and economic growth e.g. Lucas (1988) and Stern (1989); and those that believe there is a important nexus between financial development and economic growth e.g. Levine himself. A good response to a question on this debate should present all the views. Note the policy implications of the findings e.g. the argument that stock markets spur growth suggest that countries should consider developing their capital markets in an attempt to increase GDP etc. Remember that the expansion and integration of capital markets in the Caribbean is a topical issue at present! What are your views on stock market development in the region? Have you read the short paper by Justin Lin walk, dont run in which the world bank chief economist seems to favour the development of indigenous banks as economic growth engines in small, developing countries? Any comments/questions?

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Bank-based vs. Market-based Financial Systems

This sub-unit is also the topic of rich debates. The main focus is on whether or not bank-based systems (traditionally Germany and Japan) are more potent that market-based systems (traditionally US and UK). The literature identifies few, if any, studies that conclude that one type of system is superior to the other. That is, the general view is that the debate on the relative superiority

4 of either system is inconclusive. This argument is well captured and presented in the papers I posted. In addition to those papers, you should consider the following findings from various researchers (You many or may not have these papers, let me know!):

An overview some of the research done include: Bank-based and Market-based Financial Systems by Demirg-Kunt and Levine (1999) The authors examined the financial structure of a cross-section of up to 150 countries by developing as grouping system based on a conglomerate index of financial structure defined by size, activity and efficiency. They find: Banks, non-banks and stock markets are larger, more active and efficient the richer the countries i.e. financial systems are more developed in richer countries Stock markets tend to be more developed in high income countries. Countries tend to become more market oriented the richer they become (How does this fit in with Justin Lins paper Walk, dont Run) Countries with a common law tradition, strong protection and share holder rights, good accounting regulations, low levels of corruption and no explicit deposit insurance tend to be market oriented Countries with a French law tradition, poor governance and enforcement regulations, restrictive banking practice etc have under-developed financial systems. Bank-based or market-based Financial Systems: Which is better? By Levine (2000) Levine assesses the four views that dominate the literature; namely (i) the bankbased view (ii) the market-based view (iii) the law and finance view (iv) the financial services view. He finds: No evidence in favour of the bank-based or market-based views found. Evidence in favour of the financial services and the law and finance views Financial structure is irrelevant to long-term economic growth, however, the overall level of financial development is relevant

Bank-based vs. Market-based Financial Systems: A Growth-theoretic Analysis by Chakraborty and Ray (2004) The authors studied both systems in the context of an endogenous growth model i.e. these systems evolve within the model based on a firms financing choice. They find that: Either system evolves from a firm financing choice and that none is unequivocally better for growth than the other Growth is more dependent on the efficiency of financial and legal institutions Bank-based systems out-perform market-based systems from the point of view that investment and per-capita income is higher and income inequality is lower under the former Bank-based systems are more conducive for broad-based industrialisation

New Firm formation and Industry Growth: Does Having a Market or Bank-based System Matter? by Beck and Levine (2004) Authors tried to determine which type of financial structure is better at financing industry expansion, which is dependent on external financing. They find: No evidence in favour of either type of financial structure Overwhelming evidence that industries, which depend heavily on external finance grow faster in economies with a higher level of overall financial development and with better legal systems that protect investors Overall financial development stimulates the development of new firms Caribbean Financial System Structures

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As usual, information on Caribbean countries is limited. Read Financial System Structures in the Caribbean by Worrell et al (2001). I have posted a couple other readings. However, the following general points could be noted: Caribbean financial systems are predominantly bank-based They generally provide a relatively small portion of investment capital compared with other sources of funding e.g. retained earnings and international finance Recent financial products are dominated by ATMs

6 Systems have been relative free of international financial contagion. Only Jamaica experienced a financial crisis in 1996-1997 Stock markets are thin with lower market capitalisation and few shares traded. Banks are under increased competition from other FIs including credit unions and insurance companies Final Points Critically analyse the debates on the four views in the literature Ask yourself the questions; based is the evidence, which is better? Do the systems compete against or complement each other? Again Justin Lins paper is relevant! In countries with bank-based system e.g. the Caribbean; what is the structure like in terms of the ratio of foreign owned to domestically owned banks? What are the likely implications of this ratio i.e. advantages and disadvantages for say, borrowing, or in the advent of an international banking crisis? What about the concept too big to fail? is it relevant to the Caribbean?

Please post comments on this Unit and look out for the Unit 2 Theory of Financial Intermediation.

Terry Bascombe