Publication Date

11-9-2006

Description

Historical and empirical studies carried out during the last several decades have amply demonstrated that an effectively functioning financial system is linked to economic growth, macroeconomic stability and poverty reduction. What are the mechanisms through which financial system plays such an important role? First the financial system is the main conduit through which funds are transferred in exchange of goods, services or promises of future return. Second, it mobilizes savings from those who have surplus disposable funds and allocates these funds among the efficient and productive investors for expansion of the economy. Third, it transforms risk through aggregation from a large number of economic actors and then distributing it among who are more willing to bear it. Fourth, the financial institutions monitor performance of the users of the funds. The financial system in any country consists of a spectrum of institutions – organized securities markets at one end to microfinance at the other with banks and non-banking financial institutions appearing somewhere in between. The securities markets and banks are the major components of the system and the relative shares vary both between developing and emerging countries and also within developed and emerging countries. There is no sound reason as to which one of these two components is to be preferred. Evidence points out that the development of the banking sector tends to strengthen the securities market and vice-versa. It is fair to say that banking is more deeply rooted in developing countries relative to securities markets although the distinction between banks, investment banks, corporate brokerage houses is getting blurred. At lower levels of per-capita income, it has been empirically found that the value of banks’ assets tends to be a much large multiple of stock market capitalization than in higher income countries. How do these two sources of financing differ and in what ways do they influence firm performance? Firms tend to behave differently when they fund themselves through bank credits or through securities market. Banks typically finance established businesses with good track record and provide financing for short term. Banks are neither geared nor willing to extend their time horizon nor equipped to take risk on innovative and not fully known ways of businesses. Capital markets bring together a range of investors with differing perceptions and risk-bearing capacities. These investors are thus willing to provide more long term capital for financing new business or technology. Governments have in the past attempted to fill in this demand for long term financing by providing subsidized and directed credit administered though development financial institutions but by and large these institutions (DFIs) have been a failure and distorted the markets. Most developing countries are therefore abandoning this model of state-owned and managed DFIs and turning to Commercial Banks and capital markets for development finance.

Notes

Keynote address delivered at 10th General Meeting of Asia-Pasific CDC Group held at Karachi on November-9, 2006. This paper has liberally drawn upon the research carried out by the IMF on Asian Bond Markets.

Download

Share

COinS