The evolving importance of banks and markets Asli Demirguc-Kunt, Erik Feyen, and Ross Levine

Question:  Does financial structure—the mixture of intermediaries and markets—matter for economic development?

One answer is “no.”  Banks provide services that promote development  Markets provide services that promote development  The mixture per se does not matter  Demirguc-Kunt and Levine (2001)  La Porta et al (1997, 1998, 1999)

Another answer is “yes.”  Banks & markets provide different services  Economies at different stages of development  require different mixtures of these services  require different financial structures  Thus, economic growth alters  the optimal mixture of financial services  And hence the optimal financial structure  Deviations from the optimum hurt the appropriate mixture of financial services, curtailing economic activity  Lin, et al. (2011)  Allen and Gale (1995, 2000), Boyd and Smith (1998), Morck and Nakamura (1999), Weinstein and Yafeh (1998)  Sort of like electrolytes in the body

This paper reassesses ① the evolving importance of banks and markets during the process of economic development. ② the association between financial structure and economic development.  Rather than focus on financial structure per se, as in Demirguc-Kunt and Levine (2001)  We focus on deviations from an estimated optimum that evolves during the process of development.

What’s different from past X-country studies?  New: 1. Quantile regressions 2. Examine deviations from optimal financial structure and the association with development  But:  We do not nail down a causal mechanism  We do not derive sharp policy recommendations, though the work is policy relevant

Quantile regressions

Specification quantile regressions  Y c,t =  X c,t +  1 P c,t +  2 S c,t +  c,t  Y c,t = log real per capita GDP  P c,t = private credit  S c,t = securities capitalization  X c,t = Y c,0, G c,t, Trade c,t,  c,t, School c,t, T-FEs.  72 countries (including all available OECD)  Five-year periods, , max 6 obs per country  Estimation  OLS … yields “  ” for the average country  Quantiles …  obtain “  ” for each percentile (quantile) of Y  How does “  ” evolve with economic development?

Quantile coefficients for Private credit & Securities Market Cap.

Quantile coefficients for Private credit & Securities Market Cap. (standard controls)

Evolving importance of banks & markets  Evidence consistent with Allen/Gale & Boyd/Smith  Development increases demand for services provided by securities markets more those provided by banks  Specifically:  “Quantities” of both increase  Sensitivity of Y to banks falls  Sensitivity of Y to markets increases  Evidence is inconsistent with …  Only supply of finance rising with development  Roles of banks & markets following similar paths

Economic magnitude of banks and markets at different levels of development %

Financial structure gap

Computing the financial structure gap Financial structure gap c,t  Ln(  Actual structure c,t – Optimal structure c(y)  )  Actual structure c,t = Bank credit / Securities market capitalization

Computing the financial structure gap Financial structure gap c,t  Ln(  Actual structure c,t – Optimal structure c(y)  )  To compute Optimal structure c(y) 1. Select benchmark countries (high income OECD) with few impediments to achieving the optimal financial structure 2. For benchmark countries, estimate:  Actual structure c,t = a*Y c,t + B*X c,t + u c,t  X c,t includes: LO, Equator, PopSize, PopDen, & Natural Res. 3. For ALL countries, use these estimated parameters to construct “Optimal structure c(y) ”

Financial structure gap (FSG) and economic development  Y c,t =  X c,t +  b B c,t +  s S c,t +  FSG c,t +  c,t  Sample excludes high income OECD countries

Financial structure gap (FSG) and economic development

Structure matters …  The financial structure gap is negatively associated with economic activity, controlling for  Bank development  Market development  Financial structure  Time FEs  Country FEs  & Time-varying country characteristics

Economic magnitude  With only country FEs as controls:  1  in FSG  6%  in Y  With all controls:  1  in FSG  3%  in Y

FSG is NOT less important at lower levels of development

Empirical findings:  Financial structure matters  Deviations from the optimal structure are associated with less economic activity  The sign of deviation does not matter  Earlier studies did not deviation from optimum  As Y , countries require relatively more market services  Countries become more bank and market based  But  The sensitivity of output to bank development falls  The sensitivity of output to market development increases