Professional Documents
Culture Documents
Gong 2018
Gong 2018
by
QIANG GONG
Zhongnan University of Economics and Law
JUSTIN YIFU LIN
Peking University
and
YILIN ZHANG †
Southwestern University of Finance and Economics
1 Introduction
Financial structure varies greatly across countries, with a common rule that
the more developed the economy, the higher the chance that its financial
structure is market based1 (Fig. 1). Is a financial market more efficient than
the bank as the core of financial system? Should developing countries imi-
tate the financial structure of developed countries to catch up with or even
1
2 The Manchester School
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 3
as the role of government and market in this process (Lin, 2009; 2012; Lin
et al., 2013). A key point of NSE is that an optimal industrial structure exists
at each developmental stage, matching the factor endowment structure; and
as the economy develops and the factor endowment structure changes, the
optimal industrial structure evolves correspondingly. The NSE can explain
why countries vary enormously in industrial structures, and can provide
a reference for a country’s financial and industrial policies. The theory of
Optimal Financial Structure derived from the NSE, further indicates that
because industries vary in scale and risk characteristics and each financial
institution, such as banks and stock market, has its own advantages and dis-
advantages in mobilizing savings, allocating capital, and diversifying risks,
each industry has its own suited financial channels and tools, and each
country has an optimal financial structure, in a sense that fully meeting the
financial needs of firms, in line with its industrial structure. Furthermore,
the appropriate financial structure may vary among countries depending
on their stage of development, which is usually associated with particular
industrial structures.
Our research shows that whether banks or financial markets are suit-
able for a certain industry is determined by the industry’s risk character-
istics. When evaluating the efficiency of a country’s financial system we
should examine whether the financial structure matches the overall indus-
trial structure instead of unilaterally emphasizing the degree of financial
deepening. A country’s financial structure and level of economic devel-
opment are positively correlated, and the fundamental reason is that eco-
nomic development brings about changes in industrial structure, hence
leading to the evolution of the financial structure. The leading industries
in high-income countries are usually at the technology frontier (Acemoglu
et al., 2006). Industrial development relies on a great deal of technolog-
ical R&D and product innovation, which involve considerable risks and
huge demand for diversifying risks (Acemoglu and Zilibotti, 1997). Thus
financial markets usually play a more important role in developed coun-
tries. Financial structure is generally bank based in developing countries,
where the mature labor-intensive sectors dominate in the industrial struc-
ture and economic development mainly relies on the latecomer advantage.
In developing countries, banks can overcome information asymmetry
more effectively and achieve higher financial allocation efficiency owing
to mature industry with lower risk. If developing countries blindly pursue
a high development level of financial markets without considering their
stage of development, they will incur efficiency losses. Worse, this choice
may hinder their economic growth or even lead to instability in the finan-
cial system.
The existing research mainly focuses on the effects of financial struc-
tures on economic development, namely, whether a bank-based or
© 2018 The University of Manchester and John Wiley & Sons Ltd.
4 The Manchester School
2
Yet some studies have suggested that financial structure has no significant effects on eco-
nomic growth, and it is only the overall development level of the financial system that
matters (Merton, 1995; Merton and Bodie, 1995; Demirgüç-Kunt and Levine, 2004).
However, if the financial structure is not the key factor, then why does the financial
structure seem to be growing in importance with economic development? Demirgüç-
Kunt and Levine (2004) also found that financial markets were much more active and
efficient than banks in high-income countries, and the financial structure tended to be
market-based in countries with a sound legal system.
3
Adequate information collection can help overcome information asymmetry and is critical
to the efficiency of financing. The returns and costs of information collection determine
the funding providers’ investment. Studies have indicated that banks can obtain infor-
mation and use it as reference privately to provide financing to an enterprise, which al-
lows banks to equalize the payoff and return on information collection; thus, they have
sufficient incentives to collect information related to enterprises, managers, and the
business environment (Gerschenkron, 1962; Boot et al., 1993). In contrast, investors in
financial markets are faced with problems of ‘free riding’ of information collection
(Stiglitz, 1985). Sharpe (1990) pointed out further that the external financing constraints
of enterprises could be eased through establishing a long-term relationship with banks,
which can reduce the cost of information collection.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 5
4
Industrial risks include technological innovation and market risks (i.e., risks of product in-
novation). The former refers to the risks associated with the technological innovation
activities of an enterprise, and the latter refers to the uncertainty of whether the prod-
ucts will be accepted by the market. Industrial risk depends on the technical character-
istics of the industry (Lin, 2009; Lin et al., 2013).
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 7
Further, we find that financial markets have greater demand for the
institutional environment compared to banks, which means that the evolu-
tion of the financial structure should be supported by improvement in the
institutional environment, whose qualities are related to the relevant laws,
credit system, property rights protection, and information disclosure sys-
tem and other soft infrastructures(La Porta et al., 1998; Tadesse, 2002).5 In
financial markets, mortgage and liquidation have little effect on moral re-
straints, because investors adopt equity financing, thus a sound institu-
tional environment is needed to protect their interests. The imperfections in
laws, credit, and other related systems result in investors’ lack of incentives
to supply capital, thus enterprises have to surrender lots of equity to obtain
financing. Compared to financial markets, banks can protect their own in-
terests more effectively and impose moral restraint on enterprises by requir-
ing them to provide mortgage loans and reserving the right of default
settlement. This paper shows that when the effectiveness of financial mar-
kets is inhibited by the institutional environment, bank financing is more
effective in promoting the development of mature industries with lower
risks; however, the efficiency of bank financing decreases significantly in
cases of innovative industries with higher risks, where the financial market
can only support the industries well by improving the institutional
environment.
Our conclusions are consistent with recent empirical studies that find
that the effects of banks and financial markets differ significantly at differ-
ent economic development levels. To be specific, financial systems in less
developed countries are bank based, which is more conducive to promot-
ing economic growth; as the economy reaches a higher level of develop-
ment, the importance of financial markets continues to rise (Harris, 1997;
Tadesse, 2002; Demirgüç-Kunt and Levine, 2004; Demirgüç-Kunt et al.,
2012; Kpodar and Singh, 2011; Rioja and Valev, 2012; Cull and Xu, 2013;
Lin et al., 2013). For example, Demirgüç-Kunt et al. (2012) investigate the
development performance of 72 developed and developing countries over
the previous 30 years and find that as the economy grows, the correlation
between total output and bank development decreases, while the correla-
tion between total output and the financial market increases. Cull and Xu
(2013) find that in low-income countries, the more active the loan trans-
actions, the faster the labor force grows; while in high-income countries,
faster labor growth originates from larger financial markets. The empirical
studies of La Porta et al. (1998) find that how well investors’ interests are
protected is determined by the legal system and its executive power, and
when the quality of a country’s legal system is poor, the shareholding ratio
of investors in financial markets is higher and the ownership structure of
5
The institutional environment is a kind of ‘soft’ infrastructure (Lin, 2009, 2012 , 2013).
© 2018 The University of Manchester and John Wiley & Sons Ltd.
8 The Manchester School
2 Model
We consider an economy that consists of homogeneous risk-neutral enter-
prises, banks, and investors. The enterprise, owned by its operator, needs
to finance a project by choosing bank loans (bank financing) or issuing
shares in the financial markets (market financing).6 For the sake of sim-
plicity, we consider the case of an enterprise that can only choose one type
of financing. The banks and financial markets are perfectly competitive.
We first describe the financing process, then define the industry’s risk and
institutional environment, and finally describe the information structure
6
Following the literature on financial structure, the financial markets in the theoretical
framework refer to the stock market (Allen and Gale, 2000; Levine, 2005).
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 9
between the enterprise and the funding providers, bank, and financial
market investors.7
2.1 Timing
Financing is divided into three stages (Fig. 2). In stage t = 0, the enterprise
finances the project with investment amount I. The enterprise agrees the
interest with a bank or the equity ratio with investors, and then the bank or
the investors decide whether to provide the funds. If the enterprise chooses
to finance from the bank, the bank can choose to liquidate the project in
t = 1. At the end of stage 2, the enterprise pays the bank interest or issues
dividends to investors.
Following Bolton and Freixas (2000), the enterprise owner invests his
or her own funds w≤I in stage t = 0. The remaining I−w, which is standard-
ized to 1, is obtained from banks or financial markets. In stage t = 2, the
project may succeed or fail. The project profit 𝜋 is a random variable, the
distribution of which is shown below. If the project succeeds, the enterprise
pays interest or dividends, whereas if the project fails, there is no surplus.
If the project continuously operates in stage t = 2, the enterprise owner,
regardless of success or failure, earns private income b, which is very small
but can cover w (w < b≤1). In addition, b cannot be transferred to the outside.
If the enterprise chooses bank financing in stage t = 1, banks may liq-
uidate the project and get the liquidation residual A < 1. In this case, no
surplus is produced in the enterprise and the project is over. If the{bank}
does not liquidate the project in stage t = 2, the enterprise repays min R,𝜋
to the bank, { where} R is the summation of principal and interest, and re-
tains 𝜋 − min R,𝜋 . The project’s liquidation value in stage t = 2 is 0. If
7
Instead of using a macro general equilibrium model, we chose to use a simple partial equilib-
rium model as the micro foundation for the Optimal Financial Structure theory. This
partial equilibrium framework is in line with the Optimal Capital Structure theory, but
has a distinguished feature from existing corporate finance model. Specifically, we de-
liberately distinguish between two types of risk of a firm: the innovation risk and entre-
preneurial risk. We study the different effects of these two risks on the optimal financing
channel of firms and derive a demand-side micro foundation for the Optimal Financial
Structure theory.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
10 The Manchester School
the enterprise chooses market financing, the project is not liquidated. The
enterprise pays dividends s𝜋 to investors and retains (1 − s) 𝜋 in stage t = 2.
Let 𝜃 denote the industry risk, which is the likelihood that the project is
H. Higher 𝜃 means that the success of the project depends more on original
R&D and product innovation, and the technical risk and market risk are
higher. The success probability is low, and the profit in success is high.
8
Similar assumptions can be found in studies such as Jovanovic and Rousseau (2001) and
Pástor and Veronesi (2005).
© 2018 The University of Manchester and John Wiley & Sons Ltd.
12 The Manchester School
in the market, are more likely to benefit in the short term, and are also eas-
ier to identify and monitor. In contrast, in the high-risk industries where
R&D and product innovation are more intensive, companies usually have
more difficulty generating profit in the short term. Fund providers are more
difficult to effectively monitor and identify (Allen and Gale, 1999; Lin et al.,
2013). Therefore, we examine the situation where fund providers can iden-
tify L but cannot distinguish between H and bad projects in t = 1. In stage
t = 2, the success of the project and the benefits of success are common
knowledge.
9
Under the more general assumption, the basic conclusion of this article still holds. Due to
limited space, this article considers the most typical case, which is helpful in simplifying
the model and exploring related issues.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 13
s.t. (1) 𝜃A + (1 − 𝜃) pL R ≥ 1
(2) pH R ≤ A
accessible.
Lemma 2 shows that bank financing is accessible for enterprises
when the industry’s risk is low. When the industry’s risk is low, 𝜕R∕𝜕𝜃 > 0,
10
According to the MM theorem (Modigliani and Miller, 1958), it can be shown that if a bank
does not liquidate non-L projects, the profits from market financing are always not less
than those of bank financing. In other words, market financing is always better than
nonliquidity bank financing. Therefore, the bank liquidates non-L projects.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
14 The Manchester School
indicating that enterprises need to pay higher interest rates to cover the
bank’s loan risk as the risk increases. Because bank liquidation can pre-
vent bad enterprises from entering, good enterprises can reduce the inter-
est expense caused by the imperfect institutional environment (𝜕R∕𝜕v = 0)
through bank financing. When the industry risk is high, the interest is so
large that it is beyond the enterprise’s reach (R), greater than 𝜋L, in contra-
diction with Assumption 3, or causes the incentive compatibility Condition
2 to no longer hold.
[ ( ) ( )]
s. t.vs 𝜃E 𝜋̃H + (1−𝜃) E 𝜋̃L ≥ 1
[ Constraints
( ) are( )] investors’ participation constraints, where
vs 𝜃E 𝜋̃H + (1−𝜃) E 𝜋̃L is investors’ expected return in t = 0. No liqui-
dation risk exists in market financing. Lemma 3 gives feasibility conditions
for market financing.
Lemma 3: There exists v̂ that (1) when v < v̂ market financing is not
accessible; (2) when v ≥ v̂ market financing is accessible, s = vp 1𝜋 , and enter-
prise’s expected profit is 𝜋 E =pL 𝜋L − 1v at t = 0.
L L
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 15
Thus, the efficiency of bank financing and market financing vary de-
pending on the industries they serve. Depending on their stage of develop-
ment, countries correspond to optimal financial structures. In developing
countries, due to their latecomer advantages, the technology and prod-
ucts of the leading industries are relatively mature. The real economy has
a higher demand for bank financing services, and therefore, the bank-led
financial structure is more conducive to supporting the rapid development
of the real economy. Unlike in developing countries, most industries in de-
veloped countries have reached the technological frontiers. They need to
expand their technological frontiers through original R&D of technologies
and open up new markets through new products. The industry risk is high
and banks’ effectiveness is limited. At this moment, market financing is
needed to diversify the high risk. The financial system in developed coun-
tries is dominated by market financing, which can further promote sus-
tained economic growth.
According to Proposition 2 we can explain the empirical findings re-
lated to the financial structure. The financial structure best suited to the
stage of economic development can fully meet the financial needs of the real
economy, promote the allocation of financial resources to the most compet-
itive production sectors, and maximize economic development. Due to the
different industrial structures in developing and developed countries, their
optimal financial structures vary (Lin et al., 2013). For example, if a country
has more firms that prefer bank financing, the country’s banking system
is likely to be relatively larger than the countries where more firms prefer
equity financing, under the condition of controlling other factors like num-
bers of firms, culture, geographical characteristics, etc. Moreover, since the
characteristics of firms’ financial demand are determined by the firms’ risk
characteristics and the latter depends on the development stage of the coun-
try, we may see from Fig. 1 that there is a positive correlation between a
country’s financial structure and its development stage.
Naturally, the aggregate output of developing countries is associated
with a higher level of development of the banking system, while developed
countries depend more on financial markets (Demirgüç-Kunt et al., 2012).
In addition, the most competitive enterprises in the economy have better
absorbed the labor force. The optimization of the financial structure can
promote the allocation of resources to these enterprises, resulting in an
increase of total labor demand, the effective mobilization of an idle labor
force, and an effective increase of labor income (Kpodar and Singh, 2011;
Cull and Xu, 2013).
A question worth discussing is what we see from Fig. 1 is positive
correlation or causal effect between economic development and financial
structure? This question has important policy implication because if it is
causal effect, then it means that a market-based financial structure is bet-
ter than bank-based financial structure, not only for developed countries
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 17
but also for developing countries. In this situation, government should pro-
mote the development of equity market regardless of the country’s develop-
ment stage. Instead, if it is just positive correlation, then government need
to carefully decide what kind of financial structure is appropriate for the
country. It is easy to see that the analysis above supports the causality view.
The policy implication here is that government should take a look at the
country’s development stage and firms’ risk characteristics and financial
demand characteristics, and then think about what kind of financial struc-
ture is more in line with the industrial structure.
Next we examine the impact of industry risk and institutional environ-
ment on enterprises’ optimal financing pattern.
this time the financial market becomes the key to enterprise development.
However, the effective functioning of the market requires a good institu-
tional environment as a prerequisite (𝜃 (̂v) >𝜃̃).
5 Conclusions
This paper studies the relationship between financial structure and eco-
nomic development and finds that different financial structures are suit-
able for different economic development stages. Specifically, a bank-based
financial structure is more effective in developing countries. Because devel-
oping countries are rich in labor and scarce in capital, labor-intensive and
mature manufacturing are in line with the comparative advantages deter-
mined by the factor endowment structure. Banks have advantages in servic-
ing these low-risk mature industries. A bank-based financial structure more
closely matches the industrial structure of developing countries.
In the real world, however, establishing a financial system is not free
but rather expensive and resource-consuming. A worth-thinking question is
that, for those poor and less developed countries, say poor African countries
like Zimbabwe and Liberia, should the limited resources of these countries
be devoted to the establishment of banking system or to the establishment
of stock market? Given the limited resources and budget constraint for all
countries in the world face, countries in different development stages should
adopt different financial development strategies when making policies re-
lated to the financial structure. Any country should seriously consider its
own industrial structure, which determines the real economy’s (firms’) fi-
nancial demand structure, and based on this choose the most suitable fi-
nancial structure, ultimately helping firms to meet their financial needs, so
as to achieve the fastest industrial upgrading and economic development.
With economic development and the structural upgrading of factor en-
dowments in developing countries, the effect of financial markets in promot-
ing industrial upgrading is enhanced. In the economic transition of developing
countries, the industrial structure changes from labor-intensive industries to
capital- and technology-intensive industries. Original R&D of technology
and product replace the strategy of technical imitation. With rising risks, the
demands of the real economy for financial markets increase. When develop-
ing countries reach a certain development stage, efficient financial markets
are needed to achieve further economic development and industrial upgrad-
ing. Efficient financial markets can fulfill the financial needs of qualified in-
novative enterprises and make the real economy more innovative.
A good market investment environment is the key to giving full play
to the effect of the financial market on industrial upgrading. Compared
to the banking system, financial markets are inadequate to protect inves-
tors’ interests, especially small and medium-sized investors’ interests. Until
relevant laws and investor protection systems are fully improved, investors
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 19
© 2018 The University of Manchester and John Wiley & Sons Ltd.
20 The Manchester School
APPENDIX
Proof of Lemma 1: The bank is capable to identify L, and gets A from liquidating it.
Under Assumption 2, if the bank discovers one program is L and choose not to liqui-
date, it is due to obtain R > 1 > A for sure. Hence, the bank definitely not to liquidate
L. Q.E.D.
1−𝜃A
Proof of Lemma 2: Let 𝜃A + (1 − 𝜃)pL R = 1, I get R = (1−𝜃)p and
L
B
(1 − 𝜃) p}L 𝜋L +𝜃A−1. According to Assumption 2 and Condition 2, letting R≤
𝜋 ={
min pA ,𝜋L , I get:
H { }
pL min pA −1
𝜃̂ ≡ { H} , (A1).
pL min pA −A
H
Q.E.D.
( ) ( )
Proof of Lemma 3: As is shown above, I assume that pL 𝜋L = 𝜃E 𝜋̃H + (1−𝜃) E 𝜋̃L .
[ ( ) ( )]
Whenvs 𝜃E 𝜋̃H + (1−𝜃) E 𝜋̃L = vspL 𝜋L = 1, I get:
v̂ ≡ sp 1𝜋 , (A2),
L L
[ ( ) ( )] ( 1
)
besides, whenv ≥ v̂ , max0≤s≤1 (1 − s) 𝜃E 𝜋̃H + (1 − 𝜃) E 𝜋̃L = 1 − pL 𝜋L,
vp 𝜋 L L
I get:
𝜋 E =pL 𝜋L − 1v (A3)
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 21
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