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Bank-Based Financial Intermediation and The Economic Growth: A Further Interpretation of Tsuru's Model With An Application To Saudi Arabian Economy
Bank-Based Financial Intermediation and The Economic Growth: A Further Interpretation of Tsuru's Model With An Application To Saudi Arabian Economy
Bank-Based Financial Intermediation and The Economic Growth: A Further Interpretation of Tsuru's Model With An Application To Saudi Arabian Economy
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Bukhari M S Sillah
Islamic Development Bank
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Bukhari M. S. Sillah
Department of Economics, College of Business Administration
King Saud University, Riyadh
e-mail:bsillah73@yahoo.com
The researcher would like to thank the Deanship of Scientific Research at King Saud
University represented by the Research Center at CBA for supporting this research
Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
Abstract
The paper attempts to remodel the financial intermediation hypothesis of Tsurus in the framework
of steady state capital growth. In this framework, higher savings lead to higher steady state
capital, and hence higher economic growth. The financial intermediation plays a crucial role in
savings mobilization and channeling into the economy, and this activity can be done through
market or banks. By investigating the role of banks in this activity, the paper formulates a
hypothetical relationship between banks and the savings, and it is found that the development and
expansion of banking system rapidly increases savings as the banks approach their full capacity
utilization point. The relationship is found to reflect a semi S-shaped curve between the bank-
based financial intermediation and savings. The application of the model to Saudi banking data
does confirm the presence of this semi S-shaped curve of relationship. The savings decline as the
banks pass their full capacity utilization point. This finding implies that development of bank
based financial system is a key to rapid economic development and expansion, with a caution that
banks should not be allowed to exceed their full capacity utilization by creating a level of loans
that cannot be sustained by their money creation capacity. The paper suggests applications of the
formulation to other countries to derive more evidence on this semi S-shaped relationship
between bank-based financial intermediation and the savings.
Introduction
In modern economies, banks have a big role to play in influencing both the savings and
investment practices. They mobilize savings through various modes of deposits from
surplus agents and then channel these deposits as both consumption and investment
financings to deficit agents. This intermediation role of the banks has to be carried out
efficiently to avoid both overleveraging and under-financing in the economies. This
current paper is an attempt to investigate this question of middleman efficiency of the
banks by re-interpreting and estimating the proposed concepts of bank efficiency by
Tsuru (2001). The concepts are first qualitatively analysed, a model is constructed and
then quantitatively estimated to study the behaviour of bank middlemanship with an
application to Saudi Arabian economy. The paper is organized as follows. Section two
discusses some literature, analyzes the theoretical framework and formulates the models
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of estimation, section three discusses the results, and section four derives the conclusions
and some policy implications.
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thereby retarding growth, everything else being equal. In addition, proponents of this
view argue that the higher returns debt-intermediation derives from better resource
allocation depress savings rates such that overall growth rates slow down with enhanced
debt-intermediation development, (Levine et al. 2000). For Galetovic (1994) debt
intermediation increases the rate of physical capital accumulation, which in turn causes
the diminishing returns to quickly set in thereby retarding the long run growth and
reducing the economic welfare. Allen (1993) finds that debt intermediation activities
follow growth arguing that the evolution of intermediation is part and parcel of the
evolution of the markets they serve. This implies that debt intermediation is endogenous
to the nature of growth process making the level of the intermediation development
dependent on the level of economic development. According to Leahy et al. (2001)
banks are important at the early stages of the development but with their importance
diminishing with further development as income levels rise and the economy become
efficient and better arrangements of financial intermediation emerge. Bencivenga and
Smith (1991) argue that the introduction of intermediation in an economy shifts the
composition of savings towards capital, causing intermediation to be growth promoting.
Phelps et al (1977), and King and Levine (1993) are of the view that the power to allocate
capital is one of the most significant powers in any economic system, because it
determines which enterprises will prosper and which will not. King and Levine(1993),
using various measures of financial development find all the indicators of intermediation
development to be strongly associated with real per capita GDP growth, the rate of
physical capital accumulation, and improvements in the efficiency with which economies
employ physical capital. These relationships remains economically important and
statistically significant even after controlling for trade, and variations in fiscal and
monetary policies and that some of the indicators of intermediation used in the study are
good predictors of subsequent growth. However, the findings that financial indicators
can predict economic growth, does not necessary mean that finance causes growth. It is
possible that finance is only a leading indicator. In explaining the relationship between
finance and growth, Jayaratne and Strahan (1996) observe that rates of real per capita
growth in income and output increased significantly following interstate branch reform in
USA. More importantly, they also note that improvements in the quality of bank lending
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rather than increased volume of bank lending are responsible for growth changes. Using
Vector Error Correction Method, Rousseau et al. (1998) examine the relationship
between financial intermediation and economic performance in USA, UK, Canada,
Norway, and Sweden using data spanning from 1870 to 1929, established a quantitative
importance of long–run relationship between intermediation measures and per capita
level of output. However, they were not able to establish a causal relationship. Levine et
al (2000), using a dynamic panel data econometrics suggest that exogenous components,
such as liquid liabilities and total assets of financial intermediation are positively
associated with economic growth, and this result tends to support the findings of King et
al. (1993). ). From this review, it emerges that the financial intermediation can have a
supply leading relationship leading and pulling the economic growth often at the early
stages of economic development, as the power of credit creation boosts the enterprises
and start-ups in the economy. This relationship will be augmented further in the presence
of increasing human capital in the country, as financial development and human capital
are found to be complementary for the economic growth, Mobolaji (2010). The supply
leading roles of the financial intermediation then change to demand following roles as the
economic development goes to advanced levels, where high income levels in turn create
higher demands for financial services, Liang and Reichert (2006). This financial
intermediation can be conducted by the market, direct financial intermediation, or by the
banks, an indirect financial intermediation. In investigating which intermediation better
perform the financial intermediation for the economy, Levine (2002) find though the
financial intermediation is strongly related to the economic growth, but there is ”no
support for either the bank-based or market-based view”. The implication from these
varying conclusions of the literature is that countries should conduct base line studies on
the finance growth relationships in general, and the role of banks in this relationship in
particular, to provide evidence for policy making. The current paper attempts to provide
such particular evidence on the role of banks in the financial intermediation-growth
relation for the policy makers in the Kingdom of Saudi Arabia. The argument is
developed around the hypothesized link of the financial intermediation to the economic
growth.
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
Where
r \ Growth rate of capital per worker
A Productivity of capital
s Saving rate
Depreciation rate
Portion of savings used for investments, 0 1
The model argues that banks influence the portion of savings used for investments. That
is, savings are filtered through the banks to become investments. The quality and
efficiency of banks determine how much savings can be processed into investments
output. Before discussing the model, let us construct the model using both AK model and
neoclassical Cobb-Douglas model taking into account the labor growth which is left out
in the Tsuru’s construction by following the step by step derivation of steady state capital
growth by Barro and Martin (1995):
AK model
Y AK f ( K , L) (3)
K \ I sf ( K , L) K (4)
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
K \ I sf ( K , L) K (5)
Let r be capital labor ratio. Then we have the following to complete the dynamics of the
AK model:
K
r (6)
L
Y K
y f ( ,1) f (r ) Ar (7) Intensive production function
L L
L\
Let L e nt with L0 0, then n (8)
L
LK \ KL\ K \ K\
r\ 2 nr , or r \ nr (9)
L2 L L L
From equations (9) and (10): left-sides are equal, then the right-sides are equal; thus,
r \ nr sf (r ) r, or r \ sf (r ) (n )r (11)
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
Then,
r\
r \ sAr (n )r , or sA (n ) (12)
r
This is graphically presented as below:
sA
r\
r
(n )
That is, as long as sA (n ) the growth rate of capital will be positive. In fact, banks
can increase the magnitude of this growth rate by filtering more savings into investments
than any time before. They also hinder and reduce this growth rate by withholding high
portion of savings and spending them on the operations and maintenance of the banks.
Since this behavior of the banks are directly linked to the growth rate of capital, which in
turn is equal to the growth rate of per capita output of the economy, then their behavior is
important to the economy, and any fluctuation in their behavior of filtering the savings
will cause fluctuations in the entire economy.
We can also present Tsuru’s model in a Solow Model of production dynamics starting
from equation (11), Barro and Martin (1995), above as
r \ sf (r ) (n g )r (13)
While f (r ) is the intensive form of a Cobb-Douglas production function.
Then growth rate of capital per worker is
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
r\ f (r )
s (n g ) (14)
r r
sf (r )
r* r
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sf (r )
figure(a)
r
re r0
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f (r )
sf (r )
sf (r )
figure(b)
r
r* re r0
Comparing two graphs (a) and (b), we can see that the equilibrium capital per worker is
lower in the presence of financial intermediation than that without financial
intermediation given that f (r ) and s do not change as the intermediation is introduced.
Since cannot be greater one, the presence of intermediation makes the economy worse
off; the absorption of savings by the intermediation reduces the investments. The
intermediation can achieve the equilibrium point of the graph (a) only by channeling all
the savings into investments, ( 1) . The other way to achieve the graph (a) equilibrium
point is to consider any absorption by the intermediation to be productive investments; so
I
that, sf (r ) (1 ) sf (r ) sf (r ) , which is exactly the same like that prevailing in
L
the absence of intermediation. The model has posited interesting questions, and the
importance of the model lies in elaborating those questions. This is possible through
small modification of it.
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
from savers to the entrepreneurs. This saving will be relatively small in the presence of
banks; it will be high in the absence of banks, because in that case all surplus agents must
invest their funds directly or do no investments. Thus in the presence of banks the
I
investments per worker in the economy becomes s1 f (r ) s 2 ( ) f (r ) , with s1 f (r ) as
L
the investments through non-bank intermediation and s 2 ( ) f (r ) as the investments
through bank intermediation. The rate savings channeled via banks to investments is
dependent on the efficiency of banks; s 2 (0) 0 means the banks are completely
inefficient, and all that is saved through banks never makes to productive investments;
while s 2 (1) 1 means the banks are perfectly efficient, all that is saved through banks is
being channeled to productive investments.
S
In the case of financial autarky, total saving per worker is sf (r ) . We assume that this
L
saving is greater than s1 f (r ) , the saving or investment by the non-bank sector in a bank-
based economy. Meanwhile, the total saving per worker in a bank-based economy,
I
s1 f (r ) s 2 ( ) f (r ) can be less than, equal or greater than the total saving per worker
L
S
in a non-bank-based economy, sf (r ) , depending on how efficient are the banks in
L
financing the productive investments. The graphs below illustrate these cases.
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Figure5: Steady state in an economy with bank and non-bank financial intermediation
f (r ) (n g )r
f (r )
(s1 s2 ( )) f (r )
sf (r )
r1 r2 r0 r
Case 1: (s1 s2 ( )) s
The graph above shows a case where banks are efficient at both mobilizing and directing
savings to productive investments. This has resulted in a higher equilibrium capital per
worker, r2 , than that prevailing in the non-bank-based economy. The production
technology, f (r ) , in both economies is the same; but banks’ intermediation has raised
savings rate, and the mobilized savings by banks are not wasted on the absorption.
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f (r ) (n g )r
f (r )
sf (r )
(s1 s2 ( )) f (r )
r2 r1 r0 r
Case 2: (s1 s2 ( )) s
We have already assumed from the outset that s1 s when the production technology is
the same in both economies. Therefore, the possibility for the total saving rate in a bank-
based economy to be higher than that of the non-bank-based economy is determined by
the level of banks’ mobilization and efficiency. The case above illustrates a situation
where banks release only small amount of liabilities into investments; that is, the is
low, or their mobilization of liabilities, s 2 , is low. In both situations, the equilibrium
capital per worker in the bank-based economy will be lower than that of the non-bank-
based economy.
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
(s1 s2 ( )) f B (r )
sf NB (r )
r1 r2 rNB rB r
Case 3: the production technologies are different and bank-based economy has higher
production technology, f B (r ) , than non-bank-based economy f NB (r ) . Thus, even if
the saving channeled to investments is the same, (s1 s2 ( )) s , in both economies, the
total per capita saving in the bank-based economy will be higher than that in the non-
bank-based economy resulting in a higher equilibrium capital per worker in the former
than in the latter. This is possible according to Joseph Schumpeter if the banks finance
not only the existing lines of production but also create new lines of production by
selecting and sponsoring entrepreneurs.
But can this portion, s 2 ( ) , be allocated to another type of financial intermediation that
can do better than the banks, because it has lower absorption costs, (1 ) , than the
banks? The natural answer is yes, stock exchange has lower absorption, and it is an
intermediation where funds from investors are directly channeled to the users with
minimal absorption. But does stock exchange mobilize savings or sponsor entrepreneurs?
This is where the banks make difference. Banks create the liquidity in which the stock
exchange operates, by either underwriting stock issues of companies or by sponsoring the
stock dealers and stock buyers. Stock exchange is a complement to the banks. Stock
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
exchanges bring about fund managers and investment analysts, who monitor and evaluate
the industries including the banking industry. These by-products of stock exchange
provide networking of the economic sectors and create knowledge and information for
the efficient operations of the markets. The previous modeling shows that banking
efficiency relates to the saving rate in the economy. If we assume the banking efficiency,
denoted here to be e, measures the utilization rate of the banking capacity, then e is
total output
e , we can assume further that total output is the total bank loans and
total capacity
total capacity is the total potential money created by the banks. This potential money can
D
be measured to be , where D is the total deposits and rr is the required reserve
1 rr
SR
ratio. Since the required reserve ratio can be estimated as , where SR is the statutory
D
D2
reserve, we can calculate the potential bank money as , which is easier to
D SR
determine from the monetary data. We can write the relationship between saving and the
banking efficiency rate as,
S bt f et ; Where S bt the saving through the banking system and e is the measure of the
bank efforts. We assume that the functional relationship between saving and the bank
efforts exponential in the sense that savings through the banking system grows
exponentially as follows
S bt Ae X (et ) 15
Where,
A = the initial saving value, and for simplicity, we assume it is one.
X (et ) b1et b2 et2 , 16
So that X \ (et ) 0, X \ \ (et ) 0 . The function, X (et ) can be assumed to be the bank
utility from being efficient, which increases in e , but falls off at higher values of e. This
is because higher levels of efficiency are costly and difficult to obtain, and hence the
utility derived at higher levels of efficiency falls. By substituting the value for X (et ) in
saving function, we get,
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
b1et b2 e 2
S bt e
And by taking the log of both sides, we get,
ln S bt b1et b2 e 2 , we write this econometrically as
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
The estimated coefficients of the model in table 1 below confirm the hypothesis that
banking efforts of producing increasing loans out of the potential capacity leads to
increased saving in the initial stages of banking development and expansion, and it then
depresses savings as realizes its potential capacity.
+----------------------------------------------------+
| Ordinary least squares regression |
| Model was estimated Jan 28, 2013 at 10:27:29PM |
| LHS=LS Mean = 4.683252 |
| Standard deviation = 1.490893 |
| WTS=none Number of observs. = 32 |
| Model size Parameters = 3 |
| Degrees of freedom = 29 |
| Residuals Sum of squares = 27.90252 |
| Standard error of e = .9808954 |
| Fit R-squared = .5950619 |
| Adjusted R-squared = .5671351 |
| Model test F[ 2, 29] (prob) = 21.31 (.0000) |
| Diagnostic Log likelihood = -43.21373 |
| Restricted(b=0) = -57.67807 |
| Chi-sq [ 2] (prob) = 28.93 (.0000) |
| Info criter. LogAmemiya Prd. Crt. = .5103324E-01 |
| Akaike Info. Criter. = .5048102E-01 |
| Autocorrel Durbin-Watson Stat. = 1.2248558 |
| Rho = cor[e,e(-1)] = .3875721 |
| Not using OLS or no constant. Rsqd & F may be < 0. |
+----------------------------------------------------+
+--------+--------------+----------------+--------+--------+----------+
|Variable| Coefficient | Standard Error |t-ratio |P[|T|>t]| Mean of X|
+--------+--------------+----------------+--------+--------+----------+
E | 6.50302416 1.10756196 5.871 .0000 .82372861
E2 | -2.90136918 1.08855453 -2.665 .0124 .73593923
GDP | .00188910 .00043773 4.316 .0002 763.222719
The savings grow exponentially as banking sector modernises and develops its means of
deposit mobilization and channelling them back to the economy as loans and other
financial facilities. However, as our model hypothetically predicts, this banking
development and expansion decreases the savings during high level of banking
development. During high levels of banking development and expansion, the banking
utility from increasing its efforts diminishes and the deposits mobilized become
inefficiently channelled into loans. At these stages, banks’ deposits mobilized become
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
increasingly absorbed by the banking sector itself rather than by the economic
investments. Plugging the banking data of Saudi Arabia from 1980-2011 in the estimated
model to explain the relationship between savings and the bank the potential capacity
utilization, we get the figure below:
In this figure, the banking development and efforts of generating high volume loans were
low in the 1980s resulting in low savings through the banking sector as well. As the
banking development picked up in 1990s to 2000s, the savings through banking system
grew and increased. The savings through the banking system then flatten and fall off as
the banking efforts, or capacity utilization exceeds one. From the Saudi data, the optimal
banking capacity utilization rate is 1.138, which is associated with the highest savings
through the banking sector. Utilization rates different from this optional rate are
associated with lower savings.
Using the estimated model and sorting the capacity utilization rates of the banking system
is Saudi Arabia asendingly, the nature of relationship between savings and the bank
capacity utilization rate becomes evidently clearer. When the capacity utilization is
stretched beyond the optimal rate of 1.138, the savings curve falls off, as illustrated in
figure. The estimated model also shows that average value of the marginal propensity to
save is 0.44, which is very high. But in oil producing economy, where a lot of the oil
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
receipts often result in trade surpluses, government budget surpluses, and hence high
savings for economy, the marginal propensity to save could be arguably very high. These
surpluses are highly affected by the oil prices; and thus can be dwindled substantially or
sometimes wiped out and changed to deficits as oil prices plummet. These high
fluctuations in the savings can be the other factor responsible for the high average value
of the marginal propensity to save in Saudi Arabia.
Figure9: calibrated relationship between savings and bank capacity utilization rate
The hypothetical model that banking capacity utilization has an exponential relationship
with the savings is evidently proven by the Saudi Banking data. As banking development,
measured in the terms of increasing capacity utilization grows and expand, the savings
banks can generate grow rapidly as long as the capacity utilization rate (the banking
development) is low; the savings then approach its steady value as the banks approach the
full utilization of their capacity. The savings grow and increase rapidly as the bank
utilization rate approaches one; and when the rate passes one the savings diminish and
fall. Thus, banks should operate towards reaching the utilization rate of one in order to
have high level of savings in the economy. These findings prove that the bank-based
economy can have higher savings, higher investments (assuming savings = investments),
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Global Journal of Quantitative Science Vol. 2. No.4. December 2015 Issue. Pp.1-13
high capital accumulation, and higher economic growth than a non-bank based economy,
with other things remaining constant. But the bank-based economy contains a factor of its
own gradual diminution as banks credit expansion can cause banks to operate beyond the
optimal rate of their capacity utilization, a situation that cause the savings to fall. This
produces a semi S-shaped relationship between the bank-based financial intermediation and
savings. The application of the model to Saudi banking data does confirm the presence of this
semi S-shaped curve of relationship. In this respect, it is suggested that the capacity
utilization rate should be considered as one of the tools of banking supervision in an
attempt to maintain high steady value of savings in the economy.
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