Financial structure and capital investment

Abstract

This article studies the effects of financial structure on the growth of physical capital accumulation. Several theoretical works have proposed that banks are better than stock markets in funding capital investment. We test these theories with panel data for 62 industrial and developing countries using Generalized Method of Moments dynamic panel techniques. Results show that bank based financial systems are indeed associated with faster capital growth. This effect is especially strong in countries where banks can have close links to nonfinancial firms.

Keywords:

• financial development
• financial structure
• capital accumulation

JEL Classification::

• G10
• O11

Notes

¹ Recent work by Luintel et al. (2008) adopts an alternative approach. The paper points out that pooling data from a wide range of countries masks significant heterogeneity across the sample countries. Financial structure could be important depending on countries’ economic and institutional structure. The analysis uses time series methods with data from 14 countries to show that financial structure can explain economic growth.

² For example, Hoshi et al. (1991) study the Japanese Keiretsu where industrial groups have an affiliated bank financing investments. Similarly, Kong (1998) studies the financing of Korean Jaebol versus non-Jaebol firms. He finds that the share of funds raised by borrowing for Jaebol firms is more than twice that of non-Jaebol firms.

³ A principal component is a linear combination of variables that captures as much of the variation in those variables as it is possible to capture via a linear combination of those variables (Kennedy, 1992).

⁴ According to Baffes and Shah (1998), the depreciation rate is derived from the expected lifetime of overall capital being about 15 years. This is an average as machines and equipment have a shorter lifetime and buildings and infrastructure have a longer lifetime.

⁵ These data are compiled from the World Development Indicators published by the World Bank and the data set made available by Beck and Levine (2004).

⁶ Note that the estimated coefficient that is reported is always the two-step GMM system coefficient. The one-step coefficient is not reported for conciseness since it is typically almost identical to its two-step counterpart.

⁷ The exact calculation is: coefficient × change in FINANCIAL STRUCTURE: −0.014 × (0.34 − 1.04) = 0.98%.

⁸ We also tried alternatively to define OWN = 1 for codes ‘1’ and ‘2’ and OWN = 0 for codes ‘3’ and ‘4’. The results were very similar since this change only affected a couple of countries.

⁹ Levine (2002) constructs a variable called Structure-Regulation that combines the information on whether banks can own equity with information on whether banks can engage in securities, real estate and insurance activities. He uses the Structure-Regulation variable as a measure of regulatory restrictions on banks to examine its influence on economic growth and its sources. Similar to the other measures of financial structure, Levine (2002) does not find statistically significant results on this variable. Here, we test a different hypothesis. We investigate whether the possibility for commercial banks to own equity in nonfinancial firms influences the effect of financial structure on capital investment. This hypothesis is based on work discussed earlier including Hoshi et al. (1991).