A new appraisal of the Structure of European Banking

Systems
Very preliminary version
Cristina Ruzaa
Rebeca de Juanb
UNEDc

Abstract
This paper aimed at the analysis of the main determinants of banking system
structure for European Union countries (EU-25 countries) for the period 19992007. For this purpose we firstly propose to perform a cluster analysis in terms
of financial structure of EU countries, and separately estimate the model for
each of the cluster groups obtained. Those estimated coefficients are applied to
a number of transition economies (new EU member states), in order to
determine the most appropriate benchmark for the efficient structure of their
banking systems. These benchmarks are compared to the actual data for
assessing the state of their banking system development and to appraise the
degree of banking system convergence.

Keywords: banking system, financial structure, new EU members, integration.

JEL Classification: G21, O16, P34.

Departamento de Economa Aplicada e Historia Econmica, Phone number: 0034-913986354. Fax:

0034-913987822. Email address: cruza@cee.uned.es.
b
Departamento de Anlisis Econmico II, Phone number: 0034-913987816. Email address:
rdejuan@cee.uned.es
c
Facultad de CC. Econmicas y Empresariales, UNED, Paseo Senda del Rey, n 11, 28040 Madrid,
Spain.

1. INTRODUCTION
The accession of the ten Central and Eastern European countries to the
European Union (EU) has posed an additional difficulty for the convergence
process towards the single European financial system. The official accession
candidates, most of them with underdeveloped financial systems, have made
some reforms in order to become more market-orientated, which in turn will
foster their economic growth and inter alia they will also encourage their
convergence towards a more developed financial system.

There is a longstanding debate in the economic literature about the existing

relationship between financial development and economic growth. The pioneer
study who devoted attention to this issue was The Theory of Economic
Development by Schumpeter in 1911 arguing that financial intermediaries play
a pivotal role in economic development because they choose which firms get to
use societys savings and hence they increase the efficiency of the allocation of
capital.

Since then, a vast number of studies have been focused on deepening into this
relationship and determine which the direction of causality between these two
components is. Even though those studies applied different methodologies,
countries of study, time scope for analysis and variables definition, we can
conclude that there is an overwhelming consensus about the positive interaction
between the financial and the real sector of an economy.

The traditional theoretical reasoning for that link is based on the role played by
financial intermediaries in mobilizing funds among surplus and deficit sectors,
their capability for evaluating financing projects and monitoring their
performance and, lastly but not least important, in facilitating any financial
transaction through a well structured payment system. Therefore, the financial
intermediary sector alters the path of economic progress by affecting the

allocation of savings under investment efficiency conditions, but not necessarily

altering the nations saving rate.

More recent studies had widened their scope of analysis focusing their attention
not only on the financial intermediaries but on the financial system on the whole,
which means taking into consideration the role played by capital markets. By
distinguishing a bank-based structure (German system) vis--vis a marketdominated approach (American system), some academics have tried to
determine which structure is more efficient in channelling funds among sectors.
However, those studies had not reached a consensus, because other factors
like the regulatory framework or the degree of development of the country
should also be considered for identifying the optimal financial structure for each
case of study.
At this point it appears clear that no general conclusion can be stated about an
optimal financial structure, because in the end it depends upon the country
analysed and its own characteristics. However, once it had been identified the
structure towards which a financial system tends to approximate over time, we
will be better capable of understanding the path of economic development and
growth.

According to that, the aim of this paper is to provide some empirical evidence
on the main determinants of the two aforementioned financial system structures
for a set of European Union countries (EU countries). The data covers the EU25 countries to the period 1999-2007.
Therefore, this paper contributes to existing empirical evidence by carrying out
a two step procedure: i) classifying EU-15 countries according to their financial
system structure and ii) applying panel data techniques to each of the cluster
groups obtained.
To do this, we focus attention on analysing the main determinants of financial
structure for two groups of European Union countries: on the one hand, those
based on a bank-dominated financial structure and, on the other hand, those
more close to a market-based structure. To group the countries according to

one of the two financial structure considered, we proceed to identified them

using cluster analyses. Subsequently, we estimated the main determinants of
financial structure for each of the cluster groups obtained using panel data
techniques. Afterwards, we apply those estimated coefficients to the new EU-10
members states in order to determine the benchmark for the efficient structure
of their banking system. Finally, we compare these benchmarks to the actual
data in each new EU member to measure their relative inefficiency and
appraise their banking system converge across time.
Therefore, this paper will produce empirical evidence that (1) identify the
benchmark towards which new EU members are evolving and (2) help policy
makers in designing appropriate financial sector reform strategies.

The rest of the paper is organised as follows. Section 2 reviews the main
literature contributions to the link between financial system and economic
growth, and the main determinants of different financial structures. Section 3
introduces the specification of the model and the data we used. Section 4
presents the empirical results and in Section 5 some concluding remarks and
lines for further research are outlined.

2. LITERATURE REVIEW
Whether financial structure influences economic growth is a crucial policy issue,
and its relative importance has been the focus of a theoretical academic debate
for over a century. There is a bulk of economic literature dealing with this issue
and many theories note that financial intermediaries and financial markets arise
to ameliorate particular information asymmetry problems, however models do
not find consensus about the fundamental channel through which financial
intermediaries are connected to growth.

The pioneer study in this field was The Theory of Economic Development by
Schumpeter in 1911, who stated that the wide variety of services provided by
financial intermediaries are contributing to foster technical innovation and, thus,
economic growth. Later, Hicks (1969) and Levine (1997) refined the argument

by arguing that the key factor behind the rate of Englands economic growth
was financial innovation, rather than technical innovation itself.

Other group of studies (i.e. McKinnon, 1973; Shaw, 1973; Kapur, 1976; Galbis,
1977, among others) focused the attention on the importance of liberalising the
financial system as means of promoting economic growth by allowing financial
intermediaries to allocate the scarce capital resources to the more productive
uses, and hence, increase the volume and productivity of physical capital.
Even the endogenous growth paradigm had reinforced the importance of
financial intermediaries to economic growth, focusing the attention on the
virtuous circle of changes in the saving rate, investment decisions and technical
innovations (Pagano, 1993).

In a different vein, we found sceptical academics denying such a major role of

the financial system arguing that the direction of effects flows actually on the
opposite direction. Therefore, the economic growth the key element that
promotes the financial system to develop once the economy has reached
maturity. The most significant papers on the subject, among others, are
Robinson (1952) and Kuznets (1955).

Lewis (1955) goes beyond by arguing a two-way relationship. He found that

financial system develop as a consequence of economic growth, which in turn
feed back as an incentive for real growth. Likewise, a number of studies
applying endogeneous growth models arrive to the same conclusions
(Greenwood and Jovanovic, 1990 and Bethelemy and Varoudakis, 1997), and
the work of Luintel and Khan (1999) and Rother (1999) found a bi-directional
causality whose explanation is relatively plain: financial intermediation facilitates
growth through their investment efficiency capability, while at the same time the
increased demand for financial services in growing economy induces
subsequent growth in the financial sector.

A different piece of work had focused on modelling the possible simultaneity

bias of the finance-growth relationship by using instrumental variables that
explain cross-country differences in financial development but are uncorrelated
with economic growth (i.e. Levine, 1998 and 1999, and Levine et al, 2000).

All this competing hypothesis previously outlined had set the origin of a
longstanding controversy surrounding the finance- growth nexus. There is a
wide number of review articles like Thakor (1996), or more recently DemirgcKunt and Levine (2008) which surveyed the main research on the financegrowth link from different literature perspectives: cross-country studies, models
using instrumental variables, panel data studies, microeconomic studies and
country case analysis. In general terms they concluded that theory provides
ambiguous predictions regarding whether financial development exerts a
positive, causative impact on long-run economic growth, while on the other
hand the consistency of existing empirical results motivates vigorous inquiry into
the policy determinants of financial development as a mechanism for promoting
growth in countries around the world.

A different perspective of analysis consists of determining the main factors

behind the two alternative views of financial development: the bank-based and
the market-based financial structures. Theoretically, bank-based financial
systems such as Germany and Japan, are those where banks play a leading
role in mobilizing savings, allocating capital, overseeing the investment
decisions of corporate managers, and in providing risk management vehicles,
particularly during the early stages of economic development and in weak
institutional environments (Levine, 2002). In market-based financial systems like
the UK and the United States, securities markets share centre stage with banks
in terms of getting societys savings to firms, exerting corporate control, and
easing risk management.
One of the pioneer and seminal studies that measured the degree of financial
system development was Goldsmith (1969), which measured it as the value of
financial intermediary assets divided by the GNP, and found a strong

relationship between financial and economic development, but that does not
necesarily imply a causality effect.
While King and Levine (1992, 1993) noted that the level of financial
intermediary development precedes and can be interpreted as a good predictor
of economic growth, other studies like Rajan and Zingales (1998), Demirgc,
Kunt and Maksinovic (1998) demonstrated a causal impact of financial
intermediary development on real per capita GDP growth using firm-level data.
Levine (1997) argues that the size of financial intermediaries is not an adequate
proxy for financial development, and subsequent papers of King and Levine
have proposed different alternatives for measuring it. In all those studies they
found a positive and strong correlation between financial development and
economic growth rates.
The next step in appraising the financial- growth link consists of introducing the
role played by capital markets like in the study of Demirgc-Kunt and Levine
(1996) that introduced and defined indexes considering aspects like market
liquidity, market concentration and so forth. They found empirical evidence on a
positive correspondence between per capita income and stock market
development, and also between this and financial intermediary development,
which reveals that stock markets and financial intermediaries in fact are acting
as complementary incentives for economic growth. Also, Levine and Zervos
(1998) construct numerous measures of stock market development to assess
the relationship between stock market development and economic growth,
capital accumulation, and productivity within a panel context.
More recent studies like Levine (2002) found that neither bank-based nor
market-based financial systems are particularly effective at promoting growth,
consistent with the so-called financial services view. However, when applying
different estimation techniques (i.e. dynamic heterogeneous panels) Arestis et
al (2004) confirm the significance of financial structure, even in the long run.

A different approach of study had been adopted by Gurley and Shaw (1955,
1960), and Goldsmith (1969), who suggested an evolutionary path of financial
systems and they show that as the economies develop the process can be
summarised: the self- finance process leads to a structure of intermediate debt

financing, and later to the emergence of incipient capital markets. According to

that, the study of Boot and Thakor (1996) described that at an initial phase the
financial system tend to be bank-based, and as long as it evolves the capital
market weight is progressively increasing. For instance, Boyd and Smith (1998)
and Demirgc-Kunt and Levine (1999), found evidence of a trend of financial
systems to become more market oriented, as they become richer, while Rajan
and Zingales (1998) argue that bank-based systems are better at promoting
growth in countries with poor legal systems, while market-based systems have
advantages as legal systems improve. Indeed, they study the mechanisms
through financial development may influence economic growth and to deal
rigorously with causality issues, arguing that better-developed financial systems
ameliorate market frictions that make it difficult for firms to obtain external
finance.
If we analyse the main factors driving financial intermediation as the previous of
step in understanding the link between financial development and economic
growth, we need to refer to Rother (1999) that classify them into two main
groups: from the supply and the demand side. However, the empirical evidence
reveals that a limited number of variables possess a significant impact on
financial intermediation; nonperforming loans, structure of the market for
financial intermediation and the expected inflation. One of the more recent
studies on the topic by Demirgc-Kunt and Levine (2008) emphasised the role
of historical determinants (i.e. the legal system origin and religion among
others), the political and macroeconomic stability, the information structure, the
regulation and supervision framework, the degree of contestability and
effciciency, the proportion of government ownership of financial intermediaries,
and the degree of access to financials services

3. DATA AND TESTING STRATEGIES

Studies like Demirgc-Kunt and Levine (1999), in order to analyse financial
structure, classified countries as either market-based or bank-based by
constructing a conglomerate index of financial structure based on measures of
size, activity and efficiency. Then, countries with larger ratios are classified as
bank-based while countries where the conglomerate ratio of banking sector

development to stock market development is below the mean are classified as

market-based. In addition, the study considered a third group of countries with
highly underdeveloped financial systems (if it has below median values of both
bank and market development). Therefore, this grouping system produces two
categories of countries: bank-based and market-based. However in this paper
we use cluster analysis technique. It allow us to specify different groups of
countries in terms of financial structure.

The two main data sources used in this paper are provided by European
Central Bank (report on EU Banking Structure) and by Eurostat. As a
complementary source, we have also used the Annual Reports of the EU New
Member States provided by the Central Banks of each of these countries. The
data cover EU-25 countries, consisting of EU-15 countries and EU-10 new
members states. The data refers to the period 1999-2007. The total number of
observations are 225.

The analysis will proceed as follow. First of all, we will identify the countries
according to one of the two financial structure (bank-based structure and
market-based structure). To do so, we propose a cluster analysis. In the second
place, we will estimate the main determinants for financial development for each
of the cluster groups obtained using panel data techniques. Consequently, in
the third place, we will apply the estimated coefficients to the new EU-10
members states in order to determine the benchmark for the efficient structure
of their banking system. Finally, we will compare these benchmark to the actual
data in each new EU member to measure their relative inefficiency and
appraise their banking system converge across time.

It is important to remark that we have balanced panel data. In comparison to

purely cross-country approaches, the panel approach has three important
advantages and one particular disadvantage. The first benefit from moving to a
panel is the ability to exploit the time-series and cross sectional variation in the
data. A second benefit is that panel data techniques does not include the

unobserved country-specific effect as part of the error term, and therefore

coefficient estimates are not biased1. The third benefit from using a panel is that
the panel estimator uses instruments based on previous realizations of the
explanatory variables to consider the potential endogeneity of the other
regressors.
An important disadvantage from to moving to panel data is that it employs data
averaged over nine-year periods. Therefore, the panel methods may be less
precise in assessing the finance growth relationship than methods based on
lower frequency data.
To estimated the main for financial development for each of the cluster groups,
an empirical form has to provide to the financial structure of each country. Thus,
we specify the financial structure per country in each year as a function of
observed and unobserved characteristics given by

y = X + C + v
where y=[y11y1T.yN1 yNT] is a vector NT*1 (N=115, T=19) and
represents the financial structure, X=[x11x1T.xN1 xNT] is a matrix NT*k (k
number of variables) and includes the set of variables that explain the financial
structure of the countries, C=IN ., is a vector of ones and is the
unobservable individual effect. is the parameters to be estimates and v is the
error term.
Once the parameters are estimated, we replace them with their estimates in
the last function considering to the new EU-10 members states in order to
determine the benchmark for the efficient structure of their banking system.
Then, we compare these benchmark to the actual data in each new EU member
to measure their relative inefficiency and appraise their banking system
converge across time.

1
To control for the presence of unobserved country-specific effects, Arellano and Bond (1991) propose to firstdifference the regression equation to eliminate the country-specific effect and then use instrumental variables to
control for endogeneity. This approach eliminates biases due to country-specific omitted variables.

In what follows, we specify the definitions of the alternative dependent variables

and the explanatory variables that constitute the vector X, of equation (**)
(Table A1 summarizes the variables and gives some statistics). The dependent
variables are the following:
Number of credit institutions (CIs) per country.
Number of branches of CIs per country.
Number of employees of CIs per country.
Total assets of CIs per country.
Vector Y consists of the following variables:
population: De jure population of each country.
density: population density, measured by the number of inhabitants per

square kilometre.
GDP: Gross Domestic Product at constant prices.

4. EMPIRICAL RESULTS
4.1. Cluster analysis

Now we apply cluster analysis2 to identify countries with similar financial

structure. We carry out this analysis for the EU-15 countries for the year 2004.
This is the year when the ten new member states joined the EU.
As we noted above, we are considering heterogeneous countries with different
financial structures (i.e., United Kingdom and Germany). The levels of banking
intermediation and levels of stock market capitalisation will be used to group the
countries that presents the highly similar financial structures.
The method we will use to form clusters is the agglomerative hierarchical
clustering3, using as criteria the average linkage between groups method4 and

See Chatfield and Collins (1980) and Aldenderfer and Blashfield (1984).
See the chapter on cluster analysis in STATA 10.0 manual.
4
The average linkage between groups method calculates the distance between two clusters as the
average of the distances between all the pairs of cases in which one member of the pair is from each of
the clusters.
3

the centroid method5. In both methods, the distance between cases is

measured by means of the squared Euclidean distance. We choose these
methods because they can be said to maintain the nature of the original
space6 and use more information than other criteria to form the clusters.
Therefore, two agglomerative hierarchical clustering methods will be applied to
the matrix of squared Euclidean distances among countries in a twodimensional space defined by the following variables: 1) the ratio of total assets
of credit institutions (henceforth CIs7) to GDP, 2) the ratio of stock market
capitalization to GDP. A way of visualizing the results of the clusters analysis is
the dendogram. More details on the cluster analysis are given in Appendix B.
Next, we apply this analysis to EU-15 countries. It is important to remark that we
have dropped Luxembourg from the sample due to the fact that its considerable
taxes advantages leads to a high size of banking sector jointly with a low GDP.
The rate obtained it can not be compared with the banking sector of the rest of
countries. We obtain the dendogram using the average linkage between groups
method. Figure 1 shows the dendogram. The dendogram obtained with the
centroid method is very similar, but it is not reported due to space limitations.
Both methods confirm that natural groupings exist.
FIGURE 1 ABOUT HERE
The nested tree structure of the dendogram suggests that there are many
different possible groupings, and the issue is where to cut the tree so the most
reasonable number of groups is found. Unfortunately this question is still
unsolved for cluster analysis, although there are some tests8. From the point of
view of the present discussion, we have used the Duda & Hart index, which
were singled out as one of the best rule in determining the number of clusters.9
Table 1 reports the results of the Duda & Hart index.
TABLE 1 ABOUT HERE

The centroid method calculates the distance between two clusters as the distance between the means of
the variables.
6
See Aldenderfer and Blashfield (1984).
7
8

CIs are banks, savings banks and loan undertakings (cooperative banks).

See Aldenderfer and Blashfield (1984), Everitt, Landau and Leese (2001), Gordon (2000) and Milligan
and Cooper (1985)
9

See the chapter on cluster analysis in STATA 10 manual and Duda and Hart (1973).

The index indicates that the third-group solution is the most distinct from this
hierarchical cluster analysis. Therefore, the number of cluster is set as 3. One of
them are formed by 11 countries (Belgium, Denmark, Germany, Greece, Spain,
France, Italy, Austria, Portugal, Finland, Sweden), the second cluster is formed
by 2 countries (United Kingdom and Netherlands) and the third by 1 country
(Ireland). From this analysis we can argue that there are different financial
structure among countries: 11 countries present a bank-based structure, while 3
countries presents a market-based structure with different level of banking and
stock exchange capitalisation. Within this last group, United Kingdom and
Netherlands have similar financial structure.

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APPENDIX A: DATA DESCRIPTION

The two main data sources used in this paper are provided by European
Central Bank (report on EU Banking Structure) and by Eurostat. As a
complementary source, we have also used the Annual Reports of the EU New
Member States provided by the Central Banks of each of these countries. The
data cover EU-25 countries, consisting of EU-15 countries as Belgium,
Denmark, Germany, Ireland, Greece, Spain, France, Italy, Luxembourg,
Netherlands, Austria, Portugal, Finland, Sweden, United Kingdom, and EU-10
new members states as Czech Republic, Estonia, Cyprus, Latvia, Lithuania,
Hungary, Malta, Poland, Slovenia, Slovakia. The data covers to the period
1999-2007. The total number of observations are 225.
In what follows, we specify the definitions of the alternative dependent variables
and the explanatory variables that constitute the vector X, of equation (**)
(Table A1 summarizes the variables and gives some statistics).
The dependent variables are the following:
Number of credit institutions (CIs) per country.
Number of branches of CIs per country.
Number of employees of CIs per country.
Total assets of CIs per country.
Vector Y consists of the following variables:
population: De jure population of each country.
density: population density, measured by the number of inhabitants per

square kilometre.
GDP: Gross Domestic Product at constant prices.

TABLE A1 ABOUT HERE

APPENDIX B. CLUSTER ANALYSIS

Cluster Analysis is the generic name for a wide variety of procedures that can
be used to create a classification. The aim of these procedures is to form
clusters or groups of highly similar cases or countries. More formally, a
clustering method is a multivariate statistical procedure that allows us to
reorganize the sample of countries into homogeneous groups in terms of some
characteristics10. For example, cluster analysis is used to classify animals or
plants in biology, and to identify diseases and their stages in medicine.
In cluster analysis, distance is a generic measure of how far apart two objects
fall. There are many different definitions of distance. The choice between the
measures depends on which characteristics of the data are important for the
particular application. The widely used distance measure between two countries
is the squared Euclidean distance, computed from the vectors of values of their
characteristics.
In cluster analysis, the selection of variables determines the characteristics that
will be used to identify subgroups. In this paper, we apply this analysis for the
identification of countries with similar financial structure defined in terms of the
ratio of total assets of CIs to GDP and the ratio of stock market capitalization to
GDP. Therefore, distance measures the relative closeness of groups of
countries.
There are many methods for forming clusters. The most applied are the
agglomerative hierarchical clustering, and the divisive hierarchical clustering11.

In agglomerative hierarchical clustering, the clusters are formed by grouping

cases, starting with groups of just one country and ending up with all countries
gathered into a single group. In divisive hierarchical clustering, the clusters are
formed by splitting clusters, starting with all countries gathered into a single
group and ending up with as many groups as there are countries.

10
11

See Aldenderfer and Blashfield (1984).

See, for example, the chapter on cluster analysis in STATA 10 manual.

Under agglomerative hierarchical clustering, there are many criteria for deciding
which clusters should be combined at each step, but these criteria are invariably
based on a matrix of distances. They differ in how the distances between
clusters at successive stages are estimated. In general, clustering methods are
the following: linkage methods (e.g., the average linkage between groups
method that we employ in this study), error sums of squares or variance
methods, and centroid methods (we have also employed this method to check

robustness).
As long as there are many methods for calculating distances and for combining
objects into clusters, there are many ways of visualizing the results of cluster
analysis (e.g., icicle plot, agglomeration schedule, dendogram). In this study, we
employ the dendogram that shows the clusters being combined, and the actual
distances rescaled to numbers between 0 and 25.

FIGURE 1. Dendogram using average linkage

TABLE 1. Duda & Hart Index

Number of
clusters

1
2
3
4
5
6
7
8
9
10

Duda/Hart
pseudo
Je(2)/Je(1)
T-squared

0.0316
0.5077
0.5529
0.3147
0.0000
0.1993
0.4110
0.4706
0.1982
0.1505

398.07
11.64
8.89
19.60
.
12.05
5.73
2.25
4.05
5.64