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Project on Indian Financial Market - Module: 1
Financial Development and Economic Growth in India
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]
Bank-based versus Market-based Finance in India
Banks have traditionally been the dominant entities of financial intermediation in India. This is reflected in the predominance in the share of banks in the aggregate financial assets of banks and financial institutions, taken together. The relative share of banks, which stood at nearly three-fourths in the early 'eighties, came down gradually over a period of time, and has hovered around the two-thirds mark since the 'nineties. While this meant that financial institutions have gained in terms of shares in financial assets, it also implies that there is considerable potential for market financing to grow.
Given the predominance of bank-based finance in India, questions arise about the advantages and disadvantages of bank-based financial systems vis-à-vis (stock) market-based financial systems. The banking system avoids some of the information-deficiencies associated with the securities markets. Put differently, banks perform screening and monitoring functions on behalf of investors, which, left to themselves, can be undertaken only at a high cost. As a consequence, resource allocation and credit availability are considered to be superior under a bank-based as opposed to a market-based financial system. On the contrary, lower transaction costs in the absence of intermediation, may favour market-based sources of finance.
Experiences of the two most successful industrialised countries - Germany and Japan -reveal that the dominance of bank-based system has been the most successful financial vehicle for late industrialisation. While the institutional arrangements underlying bank-based systems vary, the basic contours are that banks establish long-term relationships with industrial companies, often reinforced by cross-holdings. For example, in Japan, banks had preferential access to transaction deposits of the firms, while the firms had secured access to loans from the banks, especially in situations of cyclical downturns. This ensured a steady supply of long-term finance to the firm, irrespective of the phase of cyclical fluctuation and built up a synergy between investment and growth. On the other hand, in countries, such as, the US and the UK, financial markets have played an important role in the development of these economies. A cross-country comparison reveals that both bank-based and market-based systems are in vogue (Box III.3).
Box III.3
Bank-based and Market-based Financial Systems
Financial systems differ not only with respect to their degree of sophistication, but also with respect to the type of the system. An important aspect of the growth process that has been widely discussed in recent time is the type of the financial system that is most conducive to growth. At one extreme, there is Germany, where a few large banks play a dominant role and stock market is not very important. At the other extreme is the US, where financial markets play an important role and the banking industry is much less concentrated [Allen and Gale (1995)].
Recent work in this area, using company balance sheet data, have demonstrated that internal sources of finance constituted the major portion of corporate (physical) investment in major OECD countries and that the role of the stock market (net of redemption) was limited in the majority of these countries. This can be traced to the fact that in the early stages of development, adequate incentives exist to bring borrowers' and lenders' interests into line. An efficient banking system may act as an important conduit for channelling scarce resources from the surplus to the deficit sectors. The role of disintermediation in such circumstances is likely to be limited. In the longer term, as markets develop and the financial infrastructure is in place, intermediaries may be less central to the development of firms.
Traditional explanations of differences in financing patterns (such as tax treatment) attracted little empirical support. Recent advances have attempted to endogenously determine the emergence of bank-based or market-based financial system [e.g., Arnold and Walz (2000)]. In the presence of informational problems, if banks are initially competent monitors of firms, then a bank-based financial system emerges, and banks become more productive due to learning-by-doing and the financial sector continues to be dominated by banks. If, on the other hand, the productivity of the banking sector is initially low, then a market-dominated regime emerges: banks become even more unproductive because there are no learning effects in banking, and market-based sources of finance gain in prominence.
This leads to two important and inter-related questions: (i) how do these marked differences in ownership emerge, and (ii) how are they related to the structure of financial systems? It has been argued that, there are two classes of economies: (a) banking economies, which have a small proportion of quoted companies, high concentration of ownership and long-term relations between banks and industry, and (b) market economies which have a high proportion of quoted companies, low concentration of ownership and short-term relations between banks and industry. In case of the former, firms have long-standing relationship with banks. This is ascribed to closer involvement of banks in corporate activities, for example, bank representation on corporate boards, bank holdings of corporate equity, etc. In case of the latter, the banking industry is much less important. In these countries, securities market share centre-stage with banks in terms of channelling society's savings to firms, exerting corporate control and easing risk management.
A major shortcoming with existing comparisons of market-based versus bank-based financial systems is that they focus on a very narrow set of countries with similar levels of GDP per capita, so that the countries have very similar long-run growth rates. In order to statistically test this proposition, Demirgic-Kunt and Levine (1999), using a database of 150 countries, have attempted to illustrate the relationships between financial structure and economic development.
Thus, a comparison of financial systems across different income groups reveals several clear patterns. First, banks, other financial intermediaries and stock markets become larger, more active and more efficient as countries become richer. Thus, financial sector development tends to be greater at higher income levels. Secondly, an analysis of differences in financial structure across different income groups demonstrates that size measures of financial structure do not follow a clear pattern, as countries become richer. |
A tentative measure of the significance of stock markets relative to the banking system is the ratio of market capitalisation to assets of scheduled commercial banks. During the 'seventies and the 'eighties, this ratio remained significantly low, with a high of 21.3 per cent in 1970.
With the establishment of the SEBI as an autonomous body for regulation and promotion of capital markets (with focus on simplification of issue procedures, enhancement in disclosure standards and greater investor protection), the role of stock markets has gained prominence. As a result, the relative importance of stock markets vis-à-vis banks has increased significantly in the 'nineties. The ratio of market capitalisation to assets of scheduled commercial banks which was 28.4 per cent in March 1991 increased sharply to 85.2 per cent in March 1996. It came down to 55.3 per cent in March 1999, only to increase to 79.3 per cent in March 2000.14.
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