Finance, Investment and Growth

As economies grow and develop, financial structures have to change

A poor country needs banks, a richer one shareholders. This changing relationship between debt and equity finance is the subject of a paper just published by the Centre for Economic Policy Research by Wendy Carlin of University College London, and Colin Mayer of the Said Business School at Oxford University. They find that there is a strong relationship of financial systems with type of economic activity which differs by characteristics of industries and stages of economic development. In richer countries more information is disclosed because of the growth of equity finance and skill-intensive industries.

Many recent studies of the role of banks in economic development have overturned a number of widely held preconceptions. German banks, with their high level of ownership of private industry, do not use their power to encourage better management. And they provide less finance for industry than the supposedly cautious British banks. 

Carlin and Mayer examine the view that in fact ‘the structure of financial systems and ownership may be related to types of economic activity rather than overall levels’. This implies that stock markets are appropriate for high-risk investments while bank finance is appropriate for lower risk and traditional investments where the provision of long-term finance is needed. But types of economic activity change with the level of development.

The authors look at four sets of relations: bank-firm, the securities market, concentration of ownership and legal systems. These structures are found to bear on the nature of growth fixed investment and research and development in 14 OECD countries between 1970 and 1995. Care is taken to ensure that the effect is not mistaken for the cause.

A vital conclusion is that ‘In high GDP per capita countries, growth of equity and high skill-dependent industries is promoted through information disclosure encouraging expenditure on R&D rather than fixed capital formation and through concentrations of ownership providing commitments to their stakeholders. In contrast, in lower GDP per capita countries, banking systems are important in promoting bank finance-dependent industries and dispersed ownership is required to control agency problems in skill-intensive and equity-financed industries.’ 

There are important policy implications in these findings. Governments should attune national corporate and financial systems to the structure of the nation’s industry and its stage of economic development. ‘In the early stages of economic development, policy may be best focused on the creation of efficient banking systems and the control of ownership concentrations. At later stages, some activities may benefit from greater information disclosure and the commitments that concentrated owners can provide.’ 

Notes for Editors:

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The Authors:

Wendy Carlin, University College London; Research Associate, CEPR’s Transition Economics research programme. Colin Mayer, Said Business School, Oxford University; Research Fellow, CEPR’s Financial Economics research programme.