Financial development and economic growth: Theory

2.1. What is financial development?

The costs of acquiring information, enforcing contracts, and making transactions cre­ate incentives for the emergence of particular types of financial contracts, markets and intermediaries.

In arising to ameliorate market frictions, financial systems naturally influence the allocation of resources across space and time [Merton and Bodie (1995, p. 12)]. For instance, the emergence of banks that improve the acquisition of information about firms and managers will undoubtedly alter the allocation of credit. Similarly, financial contracts that make investors more confident that firms will pay them back will likely in­fluence how people allocate their savings. As a final example, the development of liquid stock and bond markets means that people who are reluctant to relinquish control over their savings for extended periods can trade claims to multiyear projects on an hourly basis. This may profoundly change how much and where people save. This section’s goal is to describe models where market frictions motivate the emergence of distinct financial arrangements and how the resultant financial contracts, markets, and interme­diaries alter incentives and constraints in ways that may influence economic growth.

To organize a review of how financial systems influence savings and investment deci­sions and hence growth, I focus on five broad functions provided by the financial system in emerging to ease information, enforcement, and transactions costs. While there are other ways to classify the functions provided by the financial system [Merton (1992), Merton and Bodie (1995, 2004)], I believe that the following five categories are helpful in organizing a review of the theoretical literature and tying this literature to the history of economic thought on finance and growth.

• Produce information ex ante about possible investments and allocate capital.

• Monitor investments and exert corporate governance after providing finance.

• Facilitate the trading, diversification, and management of risk.

• Mobilize and pool savings.

• Ease the exchange of goods and services.

While all financial systems provide these financial functions, there are large differences in how well financial systems provide these functions.

Financial development occurs when financial instruments, markets, and intermedi­aries ameliorate - though do not necessarily eliminate - the effects of information, enforcement, and transactions costs and therefore do a correspondingly better job at pro­viding the five financial functions. Thus, financial development involves improvements in the (i) production of ex ante information about possible investments, (ii) monitoring of investments and implementation of corporate governance, (iii) trading, diversifica­tion, and management of risk, (iv) mobilization and pooling of savings, and (v) ex­change of goods and services. Each of these financial functions may influence savings and investment decisions and hence economic growth. Since many market frictions ex­ist and since laws, regulations, and policies differ markedly across economies and over time, improvements along any single dimension may have different implications for resource allocation and welfare depending on the other frictions at play in the economy.

In terms of integrating the links between finance and growth theory, two general points are worth stressing from the onset. First, a large growth accounting literature suggests that physical capital accumulation per se does not account for much of long- run economic growth [Jorgenson (1995,2005)].^[519] Thus, if finance is to explain economic growth, we need theories that describe how financial development influences resource allocation decisions in ways that foster productivity growth and not aim the analytical spotlight too narrowly on aggregate savings.

Second, there are two general ambiguities between economic growth and the emer­gence of financial arrangements that improve resource allocation and reduce risk. Specifically, higher returns ambiguously affect saving rates due to well-known income and substitutions effects. Similarly, lower risk also ambiguously affects savings rates [Levhari and Srinivasan (1969)]. Thus, financial arrangements that improve resource allocation and lower risk may lower saving rates. In a growth model with physical cap­ital externalities, therefore, financial development could retard economic growth and lower welfare if the drop in savings and the externality combine to produce a suffi­ciently large effect. These ambiguities are general features of virtually all the models discussed below so I do not discuss them when describing each model.

The remainder of this section describes how market frictions motivate the emergence of financial systems that provide five broad categories of financial functions and also describes how the provision of these functions may influence resource allocation and economic growth.

2.2. Producing information and allocating capital

There are large costs associated with evaluating firms, managers, and market condi­tions before making investment decisions. Individual savers may not have the ability to collect, process, and produce information on possible investments. Since savers will be reluctant to invest in activities about which there is little reliable information, high infor­mation costs may keep capital from flowing to its highest value use. Thus, while many models assume that capital flows toward the most profitable firms, this presupposes that investors have good information about firms, managers, and market conditions [Bagehot (1873, p. 53)].

Financial intermediaries may reduce the costs of acquiring and processing infor­mation and thereby improve resource allocation [Boyd and Prescott (1986)]. Without intermediaries, each investor would face the large fixed cost associated with evaluating firms, managers, and economic conditions.

By improving information on firms, managers, and economic conditions, financial in­termediaries can accelerate economic growth. Assuming that many entrepreneurs solicit capital and that capital is scarce, financial intermediaries that produce better information on firms will thereby fund more promising firms and induce a more efficient allocation of capital [Greenwood and Jovanovic (1990)].

The Greenwood and Jovanovic (1990) paper is particularly novel because it formally models the dynamic interactions between finance and growth. Financial intermediaries produce better information, improve resource allocation, and foster growth. There is a cost to joining financial intermediaries, however. Growth means that more individuals can afford to join financial intermediaries, which improves the ability of financial in­termediaries to produce better information with positive ramifications on growth. Thus, this research emphasizes (i) the two-way interactions between finance and growth and (ii) the relationship between income distribution and financial development during the process of economic development.

Besides identifying the best production technologies, financial intermediaries may also boost the rate of technological innovation by identifying those entrepreneurs with the best chances of successfully initiating new goods and production processes [King and Levine (1993b), Galetovic (1996), Blackburn and Hung (1998), Morales (2003), Acemoglu, Aghion and Zilibotti (2003)].^[520] This lies at the core of Joseph Schumpeter’s (1912, p.

Stock markets may also stimulate the production of information about firms. As mar­kets become larger and more liquid, agents may have greater incentives to expend resources in researching firms because it is easier to profit from this information by trading in big and liquid markets [Grossman and Stiglitz (1980)] and more liquid [Kyle (1984) and Holmstrom and Tirole (1993)]. Intuitively, with larger and more liquid mar­kets, it is easier for an agent who has acquired information to disguise this private information and make money by trading in the market. Thus, larger more liquid markets will boost incentives to produce this valuable information with positive implications for capital allocation [Merton (1987)]. Morck, Yeung and Yu (2000) provide tests of the information content of stock markets. While some models hint at the links between efficient markets, information, and steady-state growth [Aghion and Howitt (1998)], existing theories do not draw the connection between market liquidity, information pro­duction, and economic growth very tightly.

Finally, capital market imperfections can also influence growth by impeding invest­ment in human capital [Galor and Zeira (1993)]. In the presence of indivisibilities in human capital investment and imperfect capital markets, the initial distribution of wealth will influence who can gains the resources to undertake human capital aug­menting investments. This implies a suboptimal allocation of resources with potential implications on aggregate output both in the short and the long run.

2.3. Monitoringfirms and exerting corporate governance

Corporate governance is central to understanding economic growth in general and the role of financial factors in particular. The degree to which the providers of capital to a firm can effectively monitor and influence how firms use that capital has ramifications on both savings and allocation decisions.^[521] To the extent that shareholders and creditors effectively monitor firms and induce managers to maximize firm value, this will improve the efficiency with which firms allocate resources and make savers more willing to finance production and innovation.

Diffuse shareholders may exert effective corporate governance directly by voting on crucial issues, such as mergers, liquidations, and fundamental changes in business strategies, and indirectly by electing boards of directors to represent the interest of the owners and oversee the myriad of managerial decisions. With low information costs, shareholders can make informed decisions and vote accordingly. In the absence of large market frictions and distorted incentives, boards of directors will represent the inter­est of all shareholders, oversee managers effectively, and improve the allocation of resources. Starting from at least Berle and Means (1932), however, many researchers have argued that small, diffuse equity may encounter a range of barriers to exerting sound control over corporations.^[522]

An assortment of market frictions, however, may keep diffuse shareholders from ef­fectively exerting corporate governance, which allows managers to pursue projects that benefit themselves rather than the firm and society at large.^[523] In particular, large in­formation asymmetries typically exist between managers and small shareholders and managers have enormous discretion over the flow of information. Furthermore, small shareholders frequently lack the expertise and incentives to monitor managers because of the large costs and complexity associated with overseeing mangers and exerting cor­porate control. This may induce a “free-rider” problem because each stockowner’s stake is so small: Each investor relies on others to undertake the costly process of monitoring managers, so there is too little monitoring. The resultant gap in information between corporate insiders and diffuse shareholders implies that the voting rights mechanism will not work effectively. Also, the board of directors may not represent the interests of minority shareholders. Management frequently “captures” the board and manipulates directors into acting in the best interests of the managers, not the shareholders. Finally, in many countries legal codes do not adequately protect the rights of small sharehold­ers and legal systems frequently do not enforce the legal codes that actually are on the books concerning diffuse shareholder rights. Thus, large information and contracting costs may keep diffuse shareholders from effectively exerting corporate governance, with adverse effects on resource allocation and economic growth.

One response to the frictions that prevent dispersed shareholders from effectively governing firms is for firms to have a large, concentrated owner, but this ownership structure has its own problems. Large owners have greater incentives to acquire in­formation and monitor managers and greater power to thwart managerial discretion [Grossman and Hart (1980, 1986); Shleifer and Vishny (1996); and Stulz (1988)]. The existence of large shareholders, however, creates a different agency problem: Conflicts arise between the controlling shareholder and other shareholders [Jensen and Meckling (1976)]. The controlling owner may expropriate resources from the firm, or provide jobs, perquisites, and generous business deals to related parties in a manner that hurts the firm and society, but benefits the controlling owner. Indeed, Morck, Wolfenzon and Yeung (2005) show that concentrated ownership appears to have enduring political and macroeconomic implications. Around the world, controlling owners are frequently pow­erful families that use pyramidal structures, cross-holdings, and super voting rights to magnify their control over many corporations and banks [La Porta et al. (1999), Morck, Stangeland and Yeung (2000), Claessens et al. (2002), Caprio, Laeven and Levine (2003)]. Morck, Wolfenzon and Yeung (2005) marshal an abundance of evidence in arguing that (i) these controlling families frequently translate their corporate power into political influence and (ii) the elite then use their influence to shape public policies in ways that protect them from competition and subsidize their ventures. Thus, highly con­centrated ownership can distort corporate decisions and national policies in ways that curtail innovation, encourage rent-seeking, and stymie economic growth.

To the extent that diffuse or concentrated shareholders do not ameliorate the cor­porate governance problem, theory suggests that other types of financial arrangements may arise to ease market frictions and improve the governance of corporations. In what follows, I discuss how various financial arrangements - liquid equity markets, debt con­tracts, and banks - may arise to enhance corporate governance and accelerate growth. There are countervailing arguments, however, that each of these financial arrangements actually exerts a deleterious influence on corporate governance. I provide a more com­plete pro and con assessment of these different mechanisms below when I discuss the bank-based versus market-based debate.

Besides the mechanisms discussed thus far, a large and influential literature trumpets the importance of well functioning stock markets in fostering corporate governance [Jensen and Meckling (1976)]. For example, public trading of shares in stock markets that efficiently reflect information about firms allows owners to link managerial com­pensation to stock prices. Linking stock performance to manager compensation helps align the interests of managers with those of owners [Diamond and Verrecchia (1982) and Jensen and Murphy (1990)]. Similarly, if takeovers are easier in well-developed stock markets and if managers of under-performing firms are fired following a takeover, then better stock markets can promote better corporate control by easing takeovers of poorly managed firms. The threat of a takeover will help align managerial incentives with those of the owners [Scharfstein (1988) and Stein (1988)]. Many, however, argue that well functioning stock markets actually hurt corporate governance. I discuss this below when reviewing the bank-based versus market-based debate. Finally, I am not aware of models that assess the role of markets in boosting steady-state growth through its impact on corporate governance.

Some theoretical models indicate that debt contracts may emerge to improve cor­porate governance, with beneficial ramifications on economic growth. An extensive literature demonstrates how debt contracts may arise to lower the costs of monitor­ing firm insiders [e.g., Townsend (1979), Gale and Hellwig (1985), Boyd and Smith (1994)]. In terms of growth, Aghion, Dewatripont and Rey (1999) link the use of debt contracts to growth. Using Jensen’s “free cash flow argument”, Aghion, Dewatripont and Rey (1999) show that debt instruments reduce the amount of free cash available to firms. This in turn reduces managerial slack and accelerates the rate at which managers adopt new technologies.

In terms of intermediaries, Diamond (1984) develops a model in which a financial intermediary improves corporate governance. The intermediary mobilizes the savings of many individuals and lends these resources to firms. This “delegated monitor” econ­omizes on aggregate monitoring costs and eliminates the free-rider problem since the intermediary does the monitoring for all the investors. Furthermore, as financial inter­mediaries and firms develop long-run relationships, this can further lower information acquisition costs.

In terms of economic growth, a number of models show that well-functioning fi­nancial intermediaries influence growth by boosting corporate governance. Bencivenga and Smith (1993) show that financial intermediaries that improve corporate gover­nance by economizing on monitoring costs will reduce credit rationing and thereby boost productivity, capital accumulation, and growth. Sussman (1993) and Harrison, Sussman and Zeira (1999) develop models where financial intermediaries facilitate the flow of resources from savers to investors in the presence of informational asymmetries with positive growth effects. Focusing on innovative activity, De la Fuente and Marin (1996) develop a model in which intermediaries arise to undertake the particularly costly process of monitoring innovative activities. This improves credit allocation among com­peting technology producers with positive ramifications on economic growth.

From a different perspective, Boyd and Smith (1992) show that differences in the quality of financial intermediation across countries can have huge implications for in­ternational capital flows and hence economic growth rates. They show that capital may flow from capital scarce countries to capital abundant countries if the capital abundant countries have financial intermediaries that are sufficiently more effective at exerting corporate control than the capital scarce regions. Thus, even though the physical prod­uct of capital is higher in the capital scarce countries, investors recognize that their actual returns depend crucially on the monitoring performed by intermediaries. Thus, poor financial intermediation will lead to sub-optimal allocation of capital.

2.4. Risk amelioration

With information and transactions costs, financial contracts, markets and intermediaries may arise to ease the trading, hedging, and pooling of risk with implications for resource allocation and growth. I divide the discussion into three categories: cross-sectional risk diversification, intertemporal risk sharing, and liquidity risk.

Traditional finance theory focuses on cross-sectional diversification of risk. Financial systems may mitigate the risks associated with individual projects, firms, industries, re­gions, countries, etc. Banks, mutual funds, and securities markets all provide vehicles for trading, pooling, and diversifying risk. The financial system’s ability to provide risk diversification services can affect long-run economic growth by altering resource alloca­tion and savings rates. The basic intuition is straightforward. While savers generally do not like risk, high-return projects tend to be riskier than low-return projects. Thus, finan­cial markets that make it easier for people to diversify risk tend to induce a portfolio shift toward projects with higher expected returns [Gurley and Shaw (1955), Patrick (1966), Greenwood and Jovanovic (1990), Saint-Paul (1992), Devereux and Smith (1994) and Obstfeld (1994)].^[524]

Acemoglu and Zilibotti (1997) carefully model the links between cross-sectional risk, diversification, and growth. They assume that (i) high-return, risky projects are frequently indivisible and require a large initial investment, (ii) people dislike risk, (iii) there are lower-return, safe projects, and (iv) capital is scare. In the absence of financial arrangements that allow agents to hold diversified portfolios, agents will avoid the high-return, risky projects because they require agents to invest disproportionately in risky endeavors. They show that financial systems that allow agents to hold a diversified portfolio of risky projects foster a reallocation of savings toward high-return ventures with positive repercussions on growth.

In terms of technological change, King and Levine (1993b) show that cross-sectional risk diversification can stimulate innovative activity. Agents are continuously trying to make technological advances to gain a profitable market niche. Engaging in innova­tion is risky, however. The ability to hold a diversified portfolio of innovative projects reduces risk and promotes investment in growth-enhancing innovative activities (with sufficiently risk averse agents). Thus, financial systems that ease risk diversification can accelerate technological change and economic growth.

Besides cross-sectional risk diversification, financial systems may improve intertem­poral risk sharing. In examining the connection between cross-sectional risk sharing and growth, theory has tended to focus on the role of markets, rather than intermediaries. However, in examining intertemporal risk sharing, theory has focused on the advan­tageous role of intermediaries in easing intertemporal risk smoothing [Allen and Gale (1997)]. Risks that cannot be diversified at a particular point in time, such as macro­economic shocks, can be diversified across generations. Long-lived intermediaries can facilitate intergenerational risk sharing by investing with a long-run perspective and of­fering returns that are relatively low in boom times and relatively high in slack times. While this type of risk sharing is theoretically possible with markets, intermediaries may increase the feasibility of intertemporal risk sharing by lowering contracting costs.

A third type of risk is liquidity risk. Liquidity reflects the cost and speed with which agents can convert financial instruments into purchasing power at agreed prices. Liquid­ity risk arises due to the uncertainties associated with converting assets into a medium of exchange. Informational asymmetries and transaction costs may inhibit liquidity and intensify liquidity risk. These frictions create incentives for the emergence of financial markets and institutions that augment liquidity.

The standard link between liquidity and economic development arises because some high-return projects require a long-run commitment of capital, but savers do not like to relinquish control of their savings for long-periods. Thus, if the financial system does not augment the liquidity of long-term investments, less investment is likely to occur in the high-return projects. Indeed, Hicks (1969, pp. 143-145) argues that the products manufactured during the first decades of the Industrial Revolution had been invented much earlier. Rather, the critical innovation that ignited growth in 18th century England was capital market liquidity. With liquid capital markets, savers can hold liquid assets - like equity, bonds, or demand deposits - that they can quickly and easily sell if they seek access to their savings. Simultaneously, capital markets transform these liquid financial instruments into long-term capital investments. Thus, the industrial revolution required a financial revolution so that large commitments of capital could be made for long periods [Bencivenga, Smithand Starr (1995)].

In Diamond and Dybvig’s (1983) seminal model of liquidity, a fraction of savers re­ceive shocks after choosing between two investments: an illiquid, high-return project and a liquid, low-return project. Those receiving shocks want access to their savings be­fore the illiquid project produces. This risk creates incentives for investing in the liquid, low-return projects. The model assumes that it is prohibitively costly to verify whether another individual has received a shock or not. This information cost assumption rules out state-contingent insurance contracts and creates an incentive for financial markets - markets where individuals issue and trade securities - to emerge.

Levine (1991) takes the Diamond and Dybvig (1983) set-up, models the endoge­nous formation of equity markets, and links this to a growth model. Specifically, savers receiving shocks can sell their equity claims to the future profits of the illiquid pro­duction technology to others. Market participants do not verify whether other agents received shocks or not. Participants simply trade in impersonal stock exchanges. Thus, with liquid stock markets, equity holders can readily sell their shares, while firms have permanent access to the capital invested by the initial shareholders. By facilitating trade, stock markets reduce liquidity risk. Frictionless stock markets, however, do not elim­inate liquidity risk. That is, stock markets do not replicate the equilibrium that exists when insurance contracts can be written contingent on observing whether an agent receives a shock or not. Nevertheless, as stock market transaction costs fall, more investment occurs in the illiquid, high-return project. If illiquid projects enjoy suffi­ciently large externalities, then greater stock market liquidity induces faster steady-state growth.

Thus far, information costs - the costs of verifying whether savers have received a shock - have motivated the existence of stock markets, but trading costs can also has­ten the emergence and highlight the importance of liquid stock markets. In Bencivenga, Smith and Starr (1995), high-return, long-gestation production technologies require that ownership be transferred throughout the life of the production process in secondary se­curities markets. If exchanging ownership claims is costly, then longer-run production technologies will be less attractive. Thus, liquidity - as measured by secondary mar­ket trading costs - affects production decisions. Greater liquidity will induce a shift to longer-gestation, higher-return technologies.

Besides stock markets, financial intermediaries may also enhance liquidity, reduce liquidity risk and influence economic growth. As discussed above, Diamond and Dyb­vig’s (1983) model assumes it is prohibitively costly to observe shocks to individuals, so it is impossible to write incentive compatible state-contingent insurance contracts. Un­der these conditions, banks can offer liquid deposits to savers and undertake a mixture of liquid, low-return investments to satisfy demands on deposits and illiquid, high-return investments. By providing demand deposits and choosing an appropriate mixture of liq­uid and illiquid investments, banks provide complete insurance to savers against liquid­ity risk while simultaneously facilitating long-run investments in high return projects. Banks replicate the equilibrium allocation of capital that exists with observable shocks. As noted by Jacklin (1987), however, the banking equilibrium is not incentive compat­ible if agents can trade in liquid equity markets. If equity markets exist, all agents will use equities; none will use banks. Thus, in this context, banks will only emerge to pro­vide liquidity if there are sufficiently large impediments to trading in securities markets [Diamond (1991)].^[525] Turning back to growth, Bencivenga and Smith (1991) examine a growth model in which pre-existing impediments to the emergence of liquid equity markets highlight the liquidity-enhancing role of banks. They show that, by eliminat­ing liquidity risk, banks can increase investment in the high-return, illiquid asset and therefore accelerate growth.

Financial systems can also promote the accumulation of human capital [Jacoby (1994)]. In particular, financial arrangements may facilitate borrowing for the accumu­lation of skills. If human capital accumulation is not subject to diminishing returns on a social level, financial arrangements that ease human capital creation help accelerate economic growth [De Gregorio (1996), Galor and Zeira (1993)].

Another form of liquidity involves firm access to credit during the production process, which may reduce premature liquidity of projects and thereby foster investment in longer gestation, higher-return projects. Holmstrom and Tirole (1998) note that firm production processes are long-term, uncertain, and subject to shocks. Thus, some firms may receive shocks after receiving outside financing and need additional injections of capital to complete the project. In the presence of informational asymmetries, interme­diaries can sell an option to a line of credit during the initial financing of the firm that entitles the firm to access additional credit at an intermediate stage in certain states of na­ture.^[526] This improves the efficiency of the capital allocation process, but the model does

not formally link the provision of liquidity with economic growth. Aghion et al. (2004), instead, focus on how the ability of firms to access credit during the production process influences innovation and long-run growth when firms face macroeconomic shocks (e.g., recessions). They develop a model where firms can either invest in short-term, low-return investments or in more risky, growth-enhancing research and development (R&D). They also assume that there are adjustment costs to R&D. In this context, under­developed financial systems that are less able to provide firms with funds to ease these adjustment costs will hinder innovation. Moreover, macroeconomic volatility exerts a particularly negative impact on innovation and growth in under-developed financial sys­tems because firms’ willingness to undertake R&D depends on their ability to borrow in the future to meet adjustment costs, which is influenced negatively by the likelihood of experiencing a recession and positively by the level of financial development. Aghion et al. (2004) also provide empirical evidence consistent with the prediction that financial development reduces the adverse growth effects of macroeconomic volatility.

2.5. Pooling of savings

Mobilization - pooling - is the costly process of agglomerating capital from disparate savers for investment. Mobilizing savings involves (a) overcoming the transaction costs associated with collecting savings from different individuals and (b) overcoming the in­formational asymmetries associated with making savers feel comfortable in relinquish­ing control of their savings. Indeed, much of Carosso’s (1970) history of Investment Banking in America is a description of the diverse costs associated with raising capital in the United States during the 19th and 20th centuries.

In light of the transaction and information costs associated with mobilizing savings from many agents, numerous financial arrangements may arise to mitigate these fric­tions and facilitate pooling. Specifically, mobilization may involve multiple bilateral contracts between productive units raising capital and agents with surplus resources. The joint stock company in which many individuals invest in a new legal entity, the firm, represents a prime example of multiple bilateral mobilizations.

To economize on the costs associated with multiple bilateral contracts, pooling may also occur through intermediaries, where thousands of investors entrust their wealth to intermediaries that invest in hundreds of firms [Sirri and Tufano (1995, p. 83)]. For this to occur, “mobilizers” have to convince savers of the soundness of the investments [Boyd and Smith (1992)]. Toward this end, intermediaries worry about establishing stellar reputations, so that savers feel comfortable about entrusting their savings to the intermediary [DeLong (1991) and Lamoreaux (1994)].

Financial systems that are more effective at pooling the savings of individuals can profoundly affect economic development by increasing savings, exploiting economies of the balance sheet. This view of intermediation has not, to my knowledge, been incorporated into a model of economic growth.

of scale, and overcoming investment indivisibilities. Besides the direct effect of better savings mobilization on capital accumulation, better savings mobilization can improve resource allocation and boost technological innovation. Without access to multiple in­vestors, many production processes would be constrained to economically inefficient scales [Sirri and Tufano (1995)]. Furthermore, many endeavors require an enormous in­jection of capital that is beyond the means or inclination of any single investor. Bagehot (1873, pp. 3-4) argued that a major difference between England and poorer countries was that in England the financial system could mobilize resources for “immense works”. Thus, good projects would not fail for lack of capital. Bagehot was very explicit in not­ing that it was not the national savings rate per se, it was the ability to pool society’s resources and allocate those savings toward the most productive ends. Furthermore, mobilization frequently involves the creation of small denomination instruments. These instruments provide opportunities for households to hold diversified portfolios [Sirri and Tufano (1995)]. Acemoglu and Zilibotti (1997) show that with large, indivisible projects, financial arrangements that mobilize savings from many diverse individuals and invest in a diversified portfolio of risky projects facilitate a reallocation of invest­ment toward higher return activities with positive ramifications on economic growth.

2.6. Easing exchange

Financial arrangements that lower transaction costs can promote specialization, tech­nological innovation and growth. The links between facilitating transactions, special­ization, innovation, and economic growth were core elements of Adam Smith’s (1776) Wealth of Nations. He argued that division of labor - specialization - is the principal factor underlying productivity improvements. With greater specialization, workers are more likely to invent better machines or production processes [Smith (1776, p. 3)].

Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object, than when it is dissipated among a great variety of things.

Smith (1776) focused on the role of money in lowering transaction costs, permit­ting greater specialization, and fostering technological innovation.^[527] Information costs, however, may also motivate the emergence of money. Since it is costly to evaluate the attributes of goods, barter exchange is very costly. Thus, an easily recognizable medium of exchange may arise to facilitate exchange [King and Plosser (1986) and Williamson and Wright (1994)]. The drop in transaction and information costs is not necessarily a one-time fall when economies move to money, however. Transaction and information costs may continue to fall through financial innovation.

Greenwood and Smith (1996) have modeled the connections between exchange, spe­cialization, and innovation. More specialization requires more transactions. Since each transaction is costly, financial arrangements that lower transaction costs will facilitate greater specialization. In this way, markets that promote exchange encourage productiv­ity gains. There may also be feedback from these productivity gains to financial market development. If there are fixed costs associated with establishing markets, then higher income per capita implies that these fixed costs are less burdensome as a share of per capita income. Thus, economic development can spur the development of financial mar­kets.

In the Greenwood and Smith (1996) model, however, the reduction in transaction costs does not stimulate the invention of new and better production technologies. In­stead, lower transaction costs expands the set of “on the shelf” production processes that are economically attractive. Also, the model defines better “market” as a system for supporting more specialized production processes. This does not explain the emergence of financial instruments or institutions that lower transactions costs and thereby produce an environment that naturally promotes specialized production technologies. This is im­portant because we want to understand the two links of the chain: what features of the economic environment create incentives for the emergence of financial arrangements, and how do these emerging financial arrangements influence economic activity.

2.7. The theoretical case for a bank-based system

Besides debates concerning the role of financial development in economic growth, financial economists have debated the comparative importance of bank-based and market-based financial systems for over a century [Goldsmith (1969), Boot and Thakor (1997), Allen and Gale (2000), DemirguQ-Kunt and Levine (2001c)]. As discussed, financial intermediaries can improve the (i) acquisition of information on firms, (ii) in­tensity with which creditors exert corporate control, (iii) provision of risk-reducing arrangements, (iv) pooling of capital, and (v) ease of making transactions. These are arguments in favor of well-developed banks. They are not reasons for favoring a bank­based financial system.

Rather than simply noting the growth-enhancing role of banks, the case for a bank­based system derives from a critique of the role of markets in providing financial functions.

In terms of acquiring information about firms, Stiglitz (1985) emphasizes the free­rider problem inherent in atomistic markets. Since well-developed markets quickly reveal information to investors at large, this dissuades individual investors from devoting resources toward researching firms. Thus, greater market development, in lieu of bank development, may actually impede incentives for identifying innovative projects that foster growth.^[528] Banks can mitigate the potential disincentives from efficient markets by privatizing the information they acquire and by forming long-run relationships with firms [Gerschenkron (1962), Boot, Greenbaum and Thakor (1993)]. Banks can make investments without revealing their decisions immediately in public markets and this creates incentives for them to research firms, managers, and market conditions with pos­itive ramifications on resource allocation and growth. Furthermore, Rajan and Zingales (1999) emphasize that powerful banks with close ties to firms may be more effective at exerting pressure on firms to re-pay their debts than atomistic markets.

On corporate governance, a large literature stresses that markets do not effectively monitor managers [Shleifer and Vishny (1997)]. First, takeovers may not be an effec­tive corporate control device because insiders have better information than outsiders. This informational asymmetry mitigates the takeover threat as a corporate governance mechanism since ill-informed outsiders will outbid relatively well-informed insiders for control of firms only when they pay too much [Stiglitz (1985)]. Second, some argue that the takeover threat as a corporate control device also suffers from the free-rider problem. If an outsider expends lots of resources obtaining information, other market participants will observe the results of this research when the outsider bids for shares of the firm. This will induce others to bid for shares, so that the price rises. Thus, the orig­inal outsider who expended resources obtaining information must pay a higher price for the firm than it would have paid if “free-riding” firms could not bid for shares in a liquid equity market. The rapid public dissemination of costly information reduces incentives for obtaining information, making effective takeover bids, and wielding cor­porate control [Grossman and Hart (1980)]. Third, existing managers often take actions - poison pills - that deter takeovers and thereby weaken the market as an effective disci­plining device [DeAngelo and Rice (1983)]. There is some evidence that, in the United States, the legal system hinders takeovers and grants considerable power to manage­ment. Fourth, although in theory shareholder control management through boards of directors, an incestuous relationship may blossom between boards of directors and man­agement [Jensen (1993)]. Members of a board enjoy their lucrative fees and owe those fees to nomination by management. Thus, boards are more likely to approve golden parachutes to managers and poison pills that reduce the attractiveness of takeover. This incestuous link may further reduce the effectiveness of the market as a vehicle for ex­erting corporate control [Allen and Gale (2000)]. Chakraborty and Ray (2004) examine bank-based and market-based financial systems in an endogenous growth model, con­cluding that banks can partially resolve the tendency for insiders to exploit the private benefits of control.

The liquidity of stock markets can also adversely influence resource allocation. Liq­uid equity markets may facilitate takeovers that while profiting the raiders may actually be socially harmful [Shleifer and Summers (1988)]. Moreover, liquidity may encour­age a myopic investor climate. In liquid markets, investor can inexpensively sell their shares, so that they have fewer incentives to undertake careful - and expensive - cor­porate governance [Bhide (1993)]. Thus, greater stock market development may hinder corporate governance and induce an inefficient allocation of resources according to the bank-based view. As noted above, Allen and Gale (1997, 2000) argue that bank-based systems offer better intertemporal risk sharing services than markets with beneficial effects on resource allocation.

In response to the problems associated with relying on diffuse shareholders, large, concentrated ownership may arise to prevent managers from deviating too far from the interests of owners, but as stressed above, this brings its own complications. Large in­vestors have the incentives and ability to acquire information, monitor managers and exert corporate control. Concentrated ownership, however, raises other problems. Be­sides the fact that concentrated ownership implies that wealthy investors are not diver­sified [Acemoglu and Zilibotti (1997)], concentrated owners may benefit themselves at the expense of minority shareholders, debt holders, and other stakeholders in the firm, with adverse effects on corporate finance and resource allocation. Large investors may pay themselves special dividends, exploit business relationships with other firms they own that profit themselves at the expense of the corporation, and in general maximize the private benefits of control at the expense of minority shareholders [Zingales (1994)]. Furthermore, large equity owners may seek to shift the assets of the firm to higher-risk activities since shareholders benefit on the upside, while debt holders share the costs of failure. Finally, as stressed by Morck, Wolfenzon and Yeung (2005), concentrated con­trol of corporate assets produces market power that may corrupt the political system and distort public policies. Thus, from this perspective, concentrated ownership is unlikely to resolve fully the shortcomings associated with market-based systems.

In sum, proponents of bank-based systems argue that there are fundamental reasons for believing that market-based systems will not do a good job of acquiring information about firms and overseeing managers. This will hurt resource allocation and economic performance. Banks do not suffer from the same fundamental shortcomings as mar­kets. Thus, they will do a correspondingly better job at researching firms, overseeing managers, and financing industrial expansion.

2.8. The theoretical case for a market-based system

The case for a market-based system is essentially a counterattack that focuses on the problems created by powerful banks.

Bank-based systems may involve intermediaries with a huge influence over firms and this influence may manifest itself in negative ways. For instance, once banks acquire substantial, inside information about firms, banks can extract rents from firms; firms must pay for their greater access to capital. In terms of new investments or debt rene­gotiations, banks with power can extract more of the expected future profits from the firm (than in a market-based system) [Hellwig (1991)]. This ability to extract part of the expected payoff to potentially profitable investments may reduce the effort extended by firms to undertake innovative, profitable ventures [Rajan (1992)]. Furthermore, Boot and Thakor (2000) model the potential tensions between bank-based systems charac­terized by close ties between banks and firms and the development of well-functioning securities markets.

Banks - as debt issuers - also have an inherent bias toward prudence, so that bank­based systems may stymie corporate innovation and growth [Morck and Nakamura (1999)]. Weinstein and Yafeh (1998) find evidence of this in Japan. While firms with close to ties to a “main bank” have greater access to capital and are less cash constrained than firms without a main bank, the main bank firms tend to (i) employ conserva­tive, slow growth strategies and do not grow faster than firms without a “main bank”, (ii) use more capital intensive processes than non-main bank firms holding other fea­tures constant, and (iii) produce lower profits, which is consistent with the powerful banks extracting rents from the relationship.

Allen and Gale (2000) further note that although banks may be effective at eliminat­ing duplication of information gathering and processing, which is likely to be helpful when people agree about what information needs to be gathered and how it should be processed, banks may be ineffective in non-standard environments. Thus, banks may not be effective gatherers and processors of information in new, uncertain situations in­volving innovative products and processes [Allen and Gale (1999)]. Similarly, but in a model of loan renegotiations, Dewatripont and Maskin (1995) demonstrate that in a bank-based system characterized by long-run links between banks and firms, banks will have a difficult time credibly committing to not renegotiate contracts. In contrast, more fragmented banking systems can more easily commit to imposing tighter budget con­straints. The credible imposition of tight budget constraints may be necessary for the funding of newer, higher-risk firms. Thus, concentrated banks may be more conducive to the funding of mature, less risky firms, while more market-based systems, according to these theories, more easily support the growth of newer, riskier industries.

Another line of attack on the efficacy of bank-based systems involves their role in ex­erting corporate control over firms and the corporate governance of banks themselves. Bankers act in their own best interests, not necessarily in the best interests of all credi­tors or society at large. Thus, bankers may collude with firms against other creditors. For instance, influential banks may prevent outsiders from removing inefficient managers if these managers are particularly generous to the bankers [Black and Moersch (1998)].^[529] For the case of Germany, Wenger and Kaserer (1998) show that bank managers are enor­mously powerful. They not only have the corporate control power over firms that derives from being large creditors to those firms, banks also vote the shares of a larger number of small stockholders. For instance, in 1992, bank managers exercised on average 61 percent of the voting rights of the 24 largest companies and in 11 companies this share was higher than 75%. This control of corporations by bank management extends to the banks themselves! In the shareholder meetings of the three largest German banks, the percentage of proxy votes was higher than 80 percent, much of this voted by the banks themselves. For example, Deutsche Bank held voting rights for 47 percent of its own shares, while Dresdnervotes 59 percent of its own shares [Charkham (1994)]. Thus, the bank management has rested control of the banks from the owners of the banks and also exerts a huge influence on the country’s major corporations. Wenger and Kaserer (1998) also provide examples in which banks misrepresent the accounts of firms to the public and systematically fail to discipline management. Also, Rajan and Zingales (2003) ar­gue that in response to adverse shocks that affect the economy unevenly, market-based systems will more effectively identify, isolate, and bankrupt truly distressed firms and prevent them from hurting the overall economy than a bank-based system. In a bank­based - relationship-based - system, bank managers may be more reluctant to bankrupt firms with whom they have had long-term, and perhaps multidimensional, ties. While this may smooth temporary aggregate shocks, it may also impede the efficient adjust­ment to structural changes. Thus, to the extent that banks actually weaken the corporate governance of firms, bank-based systems represent sub-optimal mechanisms for over­seeing firms and improving resource allocation.

Furthermore, relying on a bank-based financial system may be problematic because of the difficulties in governing banks themselves [Caprio and Levine (2002)]. While subject to debate, many argue that information asymmetries between bank insiders and outsiders are larger than with nonfinancial corporations [Furfine (2001), Morgan (2002)]. Under these conditions, it will be very difficult for diffuse equity and debt holder to monitor and control bank insiders [Laeven and Levine (2005)]. The gover­nance problem facing depositors is of course exacerbated in the presence of deposit insurance. Furthermore, greater opacity implies even greater complexities in writing incentive contracts to align managerial incentives with bank equity holders and credi­tors. Perhaps because of the particularly severe informational impediments to governing banks, banks are even more likely than nonfinancial corporations to have a large, con­trolling owner [Caprio, Laeven and Levine (2003)]. This concentration of ownership in conjunction with greater opaqueness may make it easier for bank insiders to exploit both other investors in the bank and the government if it is providing deposit insurance. The history of Mexico, for example, is replete with incidents of powerful families using their control over banks to exploit other creditors and taxpayers [Haber (2004,2005), Maurer and Haber (2004)]. For instance, La Porta, Lopez-de-Silanes and Zamarripa (2003) find high rates of connected lending in Mexico. They find that 20% of total loans go to re­lated parties. These loans benefited from interest rates that were about 415-420 basis points below those to unrelated parties. Related borrowers also benefited from longer maturities, were significantly less likely to have to post collateral, were 33% less likely to pay back, and the recovery rates on these loans were massively less (78 percent lower) than on loans to unrelated parties. Similarly, Laeven (2001) presents evidence that in­siders in Russian banks diverted the flow of loans to themselves and then defaulted 71% of the time.

Finally, proponents of market-based financial systems claim that markets provide a richer set of risk management tools that permit greater customization of risk ame­liorating instruments. While bank-based systems may provide inexpensive, basic risk management services for standardized situations, market-based systems provide greater flexibility to tailor make products. Thus, as economies mature and need a richer set of risk management tools and vehicles for raising capital, they may concomitantly benefit from a legal and regulatory environment that supports the evolution of market-based activities, or overall growth may be retarded.

2.9. Countervailing views to bank-based vs. market-based debate

Some reject the importance of the bank-based versus market-based debate and instead argue that the issue is overall financial development, not the particular institutional arrangements that provide financial services to the economy. As noted above, informa­tion, transaction, and enforcement costs create incentives for the emergence of financial markets and intermediaries. In turn, these components of the financial system provide financial functions: they evaluate project, exert corporate control, facilitate risk man­agement, ease the mobilization of savings, and facilitate exchange. Thus, this “financial functions view” rejects the primacy of distinguishing financial systems as bank-based or market-based [Merton (1992, 1995), Merton and Bodie (1995, 2004), Levine (1997)]. According to this view, the crucial issue for growth is whether the economy has access to a well-functioning financial system; the exact composition of the financial system is of secondary importance.

Another criticism for emphasizing market-based versus bank-based differences is that markets and banks may provide complementary growth-enhancing financial services to the economy [Boyd and Smith (1998), Levine and Zervos (1998a), Huybens and Smith (1999)]. For instance, stock markets may positively affect economic development even though not much capital is raised through them. Specifically, stock markets may play a prominent role in facilitating custom-made risk management services and boosting liquidity. In addition, stock markets may complement banks. For instance, by spurring competition for corporate control and by offering alternative means of financing in­vestment, securities markets may reduce the potentially harmful effects of excessive bank power. The theoretical literature is making progress in modeling the co-evolution of banks and markets [Boyd and Smith (1996), Allen and Gale (2000)]. Furthermore, microeconomic evidence also emphasizes potential complementarities between inter­mediaries and markets. Using firm-level data, DemirguQ-Kunt and Maksimovic (1996) show that increases in stock market development actually tend to increase the use of bank finance in developing countries. Moreover, Sylla (1998) describes the interde­pendence of banks and securities markets in providing financial services to the U.S. economy in the late 18th and early 19th centuries. Thus, these two components of the financial system may act as complements during the development process. In many circumstances, we may not want to view bank-based and market-based systems as rep­resenting a tradeoff. Rather, there may be policy and analytical advantages to focusing on the legal, regulatory, and policy that allow both banks and markets to flourish without tipping the playing field in favor of either banks or markets.

One additional argument for not focusing on distinguishing financial systems by whether they are bank-based or market-based is the view that legal system differences are the fundamental source of international differences in financial development [La Porta et al. (2000)]. The law and finance view holds that finance is a set of contracts. These contracts are defined and made more or less effective by legal rights and enforce­ment mechanisms. From this perspective, a well-functioning legal system facilitates the operation of both markets and intermediaries. It is the overall level and quality of the financial functions that are provided to the economy that influences resource allocation and economic growth. The law and finance view holds that distinguishing countries by the efficiency of national legal systems in supporting financial transactions is more useful than distinguishing countries by whether they have bank-based or market-based financial systems. While focusing on the law is not inconsistent with banks or markets playing a particularly important role, La Porta et al. (2000) clearly argue that legal in­stitutions are a more useful way to distinguish financial systems than concentrating on whether countries are bank-based or market-based.

2.10. Finance, income distribution, and poverty

Thus far, I have focused on models of aggregate growth. I have not discussed the po­tential impact of finance on income distribution in general or poverty in particular. Although the focus of this article is on aggregate growth, the relationship between fi­nance and income distribution is independently relevant for understanding the process of economic development and is indirectly related to growth because income distribu­tion can influence savings decisions, the allocation of resources, incentives to innovate, and public policies. Thus, this subsection very briefly reviews a few recent theoretical inquiries into the relationship between the operation of the financial sector and income distribution.

Theory provides conflicting predictions concerning the relationship between finan­cial development and both income distribution and poverty alleviation. Some theories claim that financial intermediary development will have a disproportionately beneficial impact on the poor. Banerjee and Newman (1993), Galor and Zeira (1993) and Aghion and Bolton (1997) show that informational asymmetries produce credit constraints that are particularly binding on the poor because the poor do not have the resources to fund their own projects, nor the collateral (nor the political connections) to access bank credit. These credit constraints, therefore, restrict the poor from exploiting investment oppor­tunities. While these credit constraints may slow aggregate growth by keeping capital from flowing to its highest value use, a poorly functioning financial system will also produce higher income inequality by disproportionately keeping capital from flowing to “wealth-deficient” entrepreneurs. By ameliorating information and transactions costs and therefore by allowing more entrepreneurs to obtain external finance, financial de­velopment improves the allocation of capital, exerting a particularly large impact on the poor. On a more general level, some political economy theories suggest that better func­tioning financial systems make financial services available to a larger proportion of the population, rather than restricting capital to entrenched incumbents [Haber, Maurer and Razo (2003), Rajan and Zingales (2003), Morck, Wolfenzon and Yeung (2005)]. Thus, by ameliorating credit constraints, financial development may foster entrepreneurship, new firm formation, and economic growth. On the other hand, some argue that it is primarily the rich and politically connected who benefit from improvements in the fi­nancial system. Especially at early stages of economic development, access to financial services, especially credit, is limited to the wealthy and connected [Lamoreaux (1994), Haber (1991, 2004, 2005)]. Underthese conditions, greater financial development may only succeed in channeling more capital to a select few. Thus, it is an open question whether financial development will narrow or widen income disparities even if it boosts aggregate growth.

Other models posit a non-linear relationship between finance and income distribution. Greenwood and Jovanovic (1990) show how the interaction of financial and economic development can give rise to an inverted U-shaped curve of income inequality and fi­nancial intermediary development. At early stages of financial development, only a few relatively wealthy individuals have access to financial markets and hence higher-return projects. With aggregate economic growth, more people can afford to joint the formal financial system, with positive ramifications on economic growth. With sufficient eco­nomic success, everyone participates in the financial system, enjoying the full range of benefits. The distributional effect of financial deepening is thus adverse for the poor at early stages, but positive after a turning point.

3.