Endowment, industrial structure, and appropriate financial structure: a new structural economics perspective

Abstract

This paper proposes a demand-side theory on the appropriate financial structure for an economy. As argued in the new structural economics, the factor endowment structure in an economy determines its optimal industrial structure. Firms operating in different industries and applying different technologies have different characteristics in firm size and risk. Since various financial institutions have their own strengths and weaknesses in providing financial services, there is an appropriate financial structure for the economy at its particular development level. As the economy develops, the appropriate financial structure for the economy evolves correspondingly. The basic patterns of actual financial structure in the real world are consistent with these predictions.

Keywords:

• endowment structure
• industrial structure
• financial structure

JEL Classifications:

• G10
• G21
• O16
• O43

Notes

1. While the concepts of “bank-based” and “market-based” financial structure are widely used in the literature, to our knowledge, there is no precise definition of these two types of financial structure. The generally accepted approach is to illustrate the distinction between them by comparing the financial systems in the USA and the UK (as examples of market-based structure) with those in Germany and Japan (as examples of bank-based structure).

2. Empirical studies show that the costs of raising capital through an IPO or SEO are very high and the ratio of direct and indirect costs to proceeds in an IPO or SEO is much higher for smaller issues (Lee et al. 1996; Chen and Ritter, 2000).

3. Since capital is usually accumulated at a faster rate than the growth of labor force and natural resources, the endowment structure of an economy tends to be more capital abundant as the economy develops. This process is referred to as “upgrading of endowment structure” in Lin (2003, 2009).

4. For a detailed discussion of the path of Japan’s industrial upgrading, see Ozawa (2005).

5. The analysis here also applies to developing economies with abundant natural resources. Due to lack of capital, these economies usually adopt labor-intensive technologies in most industries. Even in the sector of extraction of mineral resources, relatively labor-intensive technologies are often adopted, except by multinational corporations from rich countries.

6. Japan’s economic development after WWII followed the “industrial flight map” provided by the USA, the UK, and other advanced economies. And the US market provided stable, mature, and large demand for Japanese products, which contributed greatly to Japan’ s rapid economic growth in this period (Ozawa 2005, 2006).

7. There is evidence that large banks make lending decisions in a way systemically different from small banks, with large banks relying on standard financial information while small banks depend more on qualitative information about borrowers (Berger et al. 2005; Cole, Goldberg, and White 2004).

8. We may investigate this notion from another perspective: the behavior of foreign banks in developing countries. In the case of foreign banks operating in developing countries, the difficulty in communicating soft information can be compounded because the distance (cultural, geographic, and organizational) between headquarters and local subsidiaries is likely to be especially large. Thus, if the above arguments about large banks hold, foreign banks in developing countries should lend less to small businesses. There is evidence showing that, compared with domestic banks, foreign banks in developing countries on average lend less to informationally difficult firms and focus more on high-quality borrowers (Berger, Klapper, and Udell 2001; Detragiache, Tressel, and Gupta 2008; Mian 2006). Although some studies, such as Clarke, Cull, and María (2006), find evidence suggesting that access to credit is easier for all firms, including small and medium-size ones, in countries with higher presence of foreign banks, this result may not invalidate our arguments. The positive effect found in those papers may be because increased competition for large clients by foreign banks forces domestic banks to seek new market niches, which could benefit small borrowers.

9. At first glance, our results may seem inconsistent with the literature on firms’ financing choices (such as Diamond 1991; Rajan 1992; Holmstrom and Tirole 1997; Boot and Thakor 1997; Song and Thakor 2010), in which a common result is that good firms (those with high reputation, high quality projects, more own capital, or high creditworthy entrepreneurs) opt for market financing, those borrowers of lower quality approach banks, and those extremely bad borrowers get no credit. Most of those studies only compare arm’s-length debt with bank loans while leaving out equity financing. When equity is introduced along with bond and bank loans, such as in Bolton and Freixas (2000), it is shown that under certain conditions, the safer firms tap the bond markets, the riskier firms prefer bank loans, very risky firms issue equity, and the riskiest firms get no funding. Our paper discusses mainly the roles of equity markets and banks. In fact, bond financing is not a significant financing source for nonfinancial firms except in a few developed countries, such as the USA and Canada (Mayer 1990).

10. For instance, firms providing retailing, restaurant, repairing, and other services are usually small even in developed countries.

11. Some studies following the “law and finance” literature emphasize the importance of the legal system in determining financial structure. They argue that legal protection of minority investors and effectiveness in implementing the law are more critical for the operation of financial markets than for banks. Thus, a bank-based financial system will have advantages in countries with a weak legal system (LLSV 1997, 1998). Rajan and Zingales (2003) show that political struggles may affect the evolution of the financial system. Financial regulations may also be captured by vested interest groups (Rajan 2010; Calomiris and Haber, 2012).

12. The median of stru_activity has similar trends across income groups and over time. Moreover, if we use a narrower indicator of banking development and thus measure financial structure as stock market value traded divided by private credit by banks, the patterns are very similar.

13. Of course, during that period, the institutional and technical development of the financial system was still at a very early stage. The primitive communication technology in the nineteenth century was an obstacle for a bank to develop a national branching network. But the fact that industrial firms were basically small and local was also a major reason for that. Furthermore, capital markets, which were relatively developed in both countries at that time, did not play a significant role in financing industrial firms.

14. Song and Thakor (2010) show that banks and financial markets exhibit three forms of interaction: competition, complementarity, and co-evolution.