Financial Architecture and Economic Performance: International Evidence

Abstract

The paper examines the relations between the architecture of an economy's financial system - its degree of market orientation - and economic performance in the real sector. We argue that the relative effectiveness of bank-based versus market-based financial systems depends on the strength of the contractual environment and the extent of agency problems in the economy. We find that while market-based systems outperform bank-based systems among countries with developed financial sectors, bank-based systems fare better among countries with underdeveloped financial sectors. Countries dominated by small firms grow faster in bank-based systems and those dominated by larger firms in market-based systems. The findings suggest that recent trends in financial development policies that indiscriminately prescribe market-oriented financial-system-architecture to emerging and transition economies might be misguided because suitable financial architecture, in and of itself, could be a source of value.