Funding growth in bank-based and market-based financial systems: evidence from firm-level data

Abstract

We investigate whether firms’ access to external financing to fund growth differs in market-based and bank-based financial systems. Using firm-level data for 40 countries, we compute the proportion of firms in each country relying on external finance and examine how that proportion differs across financial systems. We find that the development of a country's legal system predicts access to external finance, and stock markets and the banking system affect access to external finance differently. However, we find no evidence that firms’ access to external financing is predicted by several proxies for relative development of stock markets to the development of the banking system.

Introduction

A key question in development economics is the relation between a country's financial system and its economic development. Historians such as Gerschenkron (1962) have sought to explain a perceived relation between the differences in the pattern of economic development between Britain and the Continental European economies and the differences between bank-based and market-based financial systems. More recently, the differences in the relative performance of the Japanese and the US economies have led observers to conclude that bank-based and market-based financial systems may produce different growth patterns.¹ La Porta et al. (1997), La Porta et al. (1998)) challenge this view, and argue that a country's legal system is a primary determinant of the effectiveness of its financial system. This hypothesis implies that the distinction between market-based and bank-based financial systems is not primarily important for policy.

In this paper we use firm-level data from a panel of 40 countries to analyze how a country's legal and financial systems affect firms’ access to external finance to fund growth. For each country we predict a financial system based on the country's legal environment. We use our estimates to ask: Does the financial system have an effect independent of the legal system? Is the use of external financing different in market-based and bank-based systems? Do the market-based and bank-based systems differ in the provision of long-term and short-term funds?

We find that the use of external financing by firms is positively related to the development of both the predicted banking system and the securities markets in each country. However, in our sample we do not find evidence that variations in the development of the financial system that are unrelated to the legal system affect access to external finance. In particular, we find no evidence that firms use external financing differently if they are in countries classified as bank-based or market-based, on the basis of the development of their banking sector relative to their securities markets.

These results are consistent with the LLSV (1998) approach that stresses the primacy of the legal system. The policy implication that flows from the results is that the way to improve access to external finance is to aid in the development of a country's legal system, and then to let firms and investors contract either directly (as in a market-based system) or through the intermediation of banks.

We also find that securities markets and bank development have a different effect on the type of external finance firms obtain, particularly at relatively low levels of financial development. In those countries where the legal contracting environment predicts a high level of development for securities markets, more firms grow at rates requiring long-term external finance. We do not find the same effect for predicted bank development. Thus, especially for countries with lower levels of financial development, differences in contracting environments that affect the relative development of the stock market and the banking system can have implications for which firms and projects obtain financing.

There exists a growing literature on the effect of financial sector development on economic development. King and Levine (1993a), King and Levine (1993b) highlight the importance of financial development for macroeconomic growth. Recently Levine and Zervos (1998), Rajan and Zingales (1998), and Demirgüç-Kunt and Maksimovic (1998) explore the relation between financial development and growth of countries, industries and firms, respectively. Wurgler (2000) provides an analysis of capital allocation efficiency in a sample of countries.

The importance of the legal system for corporate finance was first explored by LLSV (1998). Modigliani and Perotti (1999) argue that in the absence of a strong legal system that can protect the rights of external investors, financial transactions are intermediated through institutions or concentrated among agents who have sufficient bargaining power to enforce their rights privately. Demirgüç-Kunt and Maksimovic (1996) and Booth et al. (2001) examine whether theories advanced to explain firms’ capital structures in developed countries can explain financing choices in countries with less developed financial markets. Empirical evidence on the effect of legal effectiveness on firm growth and financing is provided by Demirgüç-Kunt and Maksimovic (1998), Demirgüç-Kunt and Maksimovic (1999), Demirgüç-Kunt and Maksimovic (2001), and on growth at more aggregated levels by Beck et al. (2000) and Levine (2000). This paper extends the methodology of Demirgüç-Kunt and Maksimovic (1998) to address differences in bank-based and market-based systems in firm growth.

The rest of the paper is organized as follows. Section 2 briefly discusses reasons that bank-based and market-based systems perform differently and our approach to testing those differences empirically. Section 3 introduces the data and summary statistics. Our principal results are reported in Section 4 and Section 5 concludes.