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The ways in which firms raise funds
Unit 3
Bank-based vs. Market-based
Bank-based and Market-based Financial
Systems
• Bank-based: Banks & other MFIs play large role in
corporate finance
– banks play a leading role in mobilizing savings, allocating
capital, overseeing the investment decisions of corporate
managers, and providing risk management vehicles.
• Market-based : Firms financed mostly by issue of
securities held by NDTIs & individuals.
– securities markets share center stage with banks in getting
society's savings to firms, exerting corporate control, and
easing risk management.
Arguments in Favor of Bank-based Finance
• Financial intermediaries improve information
acquisition and monitoring of managers by
creditors, and provide standard channels for
fund mobilization and risk reduction.
• Market-based financial system is not effective
in information acquisition
– Developed markets reveal information very
quickly so that investors have little incentives to
search and select investment opportunities. Banks
can provide finance without the need to reveal
information immediately (Stiglitz 1985).
– Borrowing from the banks (or other intermediaries)
– Issuing new securities (bonds & equities)
– Drawing on retained earnings
Why distinction is important?
1) Behavior of a firm:
- Bank giving L/T loans to firm can take long-term
view of firm & its development (wait for repay).
- Contrary: Shareholders may free themselves from
ownership of firm quickly & easily, own another
firm. If owners sell & prices of firm fall, the firm
becomes target of takeover.
2) Bank-based system offers fewer shares to savers.
Forced to hold interest-bearing bank deposits/
corporate or Government bonds
3) Has implication on ways pension funding is done.
Arguments in Favor of Bank-based Finance
• Financial markets are not effective in monitoring
managers:
– Insider information: insiders know more about their
companies than outsiders do. Moreover, the board of
directors may be controlled the management and does
not represent shareholders’ interests.
– Liquid markets encourage hostile takeovers which can
have adverse social consequences.
– The high liquidity of financial markets results in a
diversed ownership structure which inturn reduces the
incentive to monitor managers on the part of each
individual shareholder..
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Arguments in Favor of Market-based Finance Banks and Financial Markets Are

• A market-based financial system provides many instruments
for risk management, which are suited for both standard and
non-standard transactions. In contrast, a bank-based system
only provides basic risk management solutions (although at
lower costs).
• In a bank-based system, banks can have too much power on
companies permitting them to charge high fees.
• Banks tend to limit themselves in lending safe projects. This
behavior can stifle/smother innovation and growth
opportunities of young enterprises.
• Banks may collude (join together) with companies that they
lend money to and help the managers of those companies to
keep their positions even though their performance is poor.
Complementary – The Financial Service View
• Market imperfections in a financial system create the need to
establish financial contracts, markets, and intermediaries.
• In return, various components of the financial system provide
financial services including fund mobilization, project evaluation,
company monitoring, risk management, etc.
• The task of a financial system is to provide financial services through
banks or markets or both.
• Financial markets and banks can provide the same financial services
or service which are complementary to one another.
• For example, securities markets can increase competition in the
provision of company monitoring instruments; they can also reduce
the negative effects created by the excessive power of banks as they
provide an alternative investment channel.

Financial Structure in Developed Countries

Bank-Based or Market-Based
• Market-based financial system Commercial bank assets/Stock
market capitalization (1992-1997)
– UK & US 5.1
– The financial system is
dependent on markets to
provide capital and monitor 1.9
companies. 0.8 1.0

• Bank-based financial system

– Germanny’s universal banks Germany Japan US UK

– Japan’s main banks 10.5

• Which model should developing

countries follow?
2.2 1.6 1.3

India China S. Korea Thailand

Cross-country comparison of the relative

stock market and bank development Empirical Study – Levine (2000)
Cross-sectional econometric model
• Banks dominate (1) G = a’X + bS + U(1)
the financial (2) G = c’X + dF + U(2)
system in almost (3) G = f’X + hS + jF + U(3)
all of the  G is the growth rate of GDP per capita
developing
countries.  X is the conditioning set (i.e. determinants in a standard growth model)
• There is a  S is the set of financial structure indicators (larger S means that the
general tendency system is more tilted towards bank-based finance, and vice versa).
for the  F is the set of financial development indicators.
market-to-bank  U(i) is the error term.
ratio to increase Bank-based finance view: b<0, d>0, h<0, j>0
with the level of
development. Market-based finance view: b>0, d>0, h>0, j>0
Financial service view: b=0, h=0, d>0, j>0

Source: WB, “Finance for Growth”, 2001.

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Empirical Results LOOKING AT DATA (UK)

– Both bank-based and market-based finance support • Which Institutions funding long-term to UK firms and Government?
economic growth. – NDTIs much more active funding long-term to firms & Government
than banks.
– Firms in successful economies have found a mixture of – Banks have very short-term liabilities; hold more liquid assets & having
equity market and bank development that suits their own less variation in capital value.
particular financing needs and institutional structure. Total assets held:
Banks – 7417 bn; Building Societies— 341 bn
• The trend for a general increase in the share of NDTIs— 3055 bn Long-term funding
market finance with economic development does Banks— 1026 bn Long term funding

not appear to be causal. Largest NDTIs : Main Funders

• Differences in the financial structure (i.e. finance
based more on banks or on markets) are not
statistically significant in explaining the economic
growth variations across countries.
• Long-term Insurance companies
• Pension Funds
• Hedge Funds ( may be major holders of company securities). Detail
information not easily available.

Vietnam Banking System - Number of banks

Vietnam’s Financial System (by 31/12/2011)
• 5 State-owned credit institutions
– Vietcombank: Joint Stock Commercial Bank for Foreign Trade of
Vietnam
DTIs—Banks NDTIs – Vietinbank: Vietnam Bank for Industry and Trade
• State-owned credit • Insurance Companies – Agribank: Vietnam Bank for Agriculture and Rural Development
– BIDV: Bank for Investment and Development of Vietnam
institutions • Finance Company – MHB: Housing Bank of Mekong Delta
• JSBs, JVBs • Leasing Companies • 35 Joint stock commercial banks: Eximbank, ACB,
Sacombank, …
• F-banks • Security companies • 50 Foreign bank’s branches
• People’s Credit Funds • 4 Joint venture banks: VID PUBLIC BANK, INDOVINA
BANK LIMITTED, VINASIAM BANK, Vietnam-Russia
Joint Venture Bank
• 5 Wholly Foreign-owned Banks: HSBC, Standard
Chartered, Shinhan, ANZ, Hong Leong (malaysia)

Vietnam Banking System - Number of banks Vietnam’s Financial System

(by 31/12/2011) Total Assets

• 18 finance companies
• 12 financial leasing companies 24.30%
18.80%
Agribank
BIDV

• 51Representative offices of foreign

Vietcombank
Viettinbank
ACB

Banks.
11.50%
2.20% Sacombank
techcombank

• 926 People’s credit funds (micro finances)

MB
2.20% 9.90%
3.60% eximbank

2.50% 3.60% maritimebank

2.50% 4.00% VIB
9.40%
6.50%
SCB
40 ngân hàng khác

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Vietnam’s Financial System Vietnam’s Financial System

Total Deposits
Total Credits

Agribank

BIDV

Vietcombank Agribank
15.50% 13.60% BIDV
1.00% Viettinbank
1.10%
Viettinbank
1.10% ACB
1.50% 1.00% Vietcombank
13.80%
21.20% techcombank
1.70% 1.30% ACB
1.80% Sacombank 1.30%
10.80% Sacombank
1.90% 1.30%
MB techcombank
1.90% 12.10% Eximbank Eximbank
2.10%
VIB Đông Á bank
1.80%
2.50% SCB SCB
10.90% 9.40%
2.60% 2.00% 2.50% MB
5.60% Maritimebank
9.60% 2.80%
3.90% 2.10% VIB
Đông Á 3.90% 4.10%
Maritimebank
4.00% HSBC 2.30%
MHB
Ocean bank
Southermbank
VP bank
37 ngân hàng khác
An bình bank

MHB

34 ngân hàng khác

Vietnam’s Financial System Vietnam’s Financial System

Vietnam’s Financial System Financial Intermediaries in UK,

Overall features USA, France, Germany
• Dominance of Banking sector & SOCBs
– Share in Deposits
– Share in Credits
– Total Assets They differ in size and composition
Overall features:
• Poor Capital and Reserve
• Poor risk management
• Inadequate Managerial skills

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Financial Intermediaries in Comparison of Banks

USA & Europe Banks Branches Total Popn/ Popn/ Popn
France: Licensing done by Credit Institutions & Assets bank branch density/km2
Investment Committee (CECEI) UK 401 12,880 € 9651 bn 150,955 4,700 247
Types of Banks:
France 829 40,013 5,728 bn 76,231 1,579 115
1. AFB Banks (Assoc. of France Banks)—Offer full
range of financial services Germany 2050 40,282 7,122 bn 40,179 2,045 231
2. Mutual or Cooperative Banks MFIs: Deposits
USA 8195 $ 13301 bn (All Commercial Banks+All Savings
3. Savings & Provident Institutions incl. in Money Institutions = 11,969 bn + 1,251 bn)
4. Municipal Credit Banks supply. € 9440 bn 36.9 /Km2

5. Financial Companies Restricted Vietnam ? (Find out)

6. Specialists Financial Companies range of
services

Conclusion
• Germany has large No. of banks, much larger than French Mutual Funds Nov. 2009 € 1,251.2 bn
France & very much larger than UK
• French Insurance (L/T + General) € 1,403.9 bn
But fewer branches per bank
• UK has few banks & few branches • USA Insurance $ 5,921 bn
Out of 401, many are wholesale banks with one • USA Pension Fund $ 4,600 bn
branch
• Insurance sector very similar to that of UK
• FRANCE : Insurance Companies
Mutual Funds
• But mutual fund sector is larger because :
No Pension Funds It substitutes in part role of UK Pension Fund
• So PAYG state pensions are much more important.
• Private savings for retirement by accumulating bank
products or L/T Insurance or Mutual Funds

Germany
- Bank-based financial system.
- Large No. of Banks—largest European Banking sector
- Least concentrated, largest 5 holding only 22% of assets.
Banks are divided into:
1. Universal Banks (very much the norm in Germany)
2. Specialized Credit Institutions
Universal Banks: provide a full range of banking services & many other
services (that elsewhere would be called financial rather than banking
services) offer the usual range of retail banking services but also
engage in wholesale and investment banking
• Commercial Banks
• Land Banks
• Savings Banks
• Regional Institutions of Credit Cooperatives
• Credit Cooperatives

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GERMANY
Specialized Credit Institutions:
• Mortgage Banks
• Buildings & Loan Associations
• Banks with special functions
NDTI’s : Absence of Pension Fund
• German households must do L/T savings by
Time Deposits with banks or buy more equity-
based products through Insurance co. or
Investment Funds
•France + UK: Closed & Open-ended funds
• German Mutual Funds mainly open-ended
• German Mutual Fund sector: much larger than
UK
•German Mutual Fund : € 795,051 m (end July 2009)
•French : € 1251,000 m (end Nov. 2009)
•UK : £ 593,000 m
(€ 677,000 m)

World Mutual Fund Assets by Region,

2006
Total Net Assets of European Mutual Funds, 2006 in €
billion = 5974 bn
Other Americas 5%
Africa and Asia Pacific 12% UK : 10,3% = € 615 bn
Europe 36% Ireland : 9,5%
United States 48% Italy : 5,1%
Spain : 3,8%
Austria : 2,2%

• Why does Germany have a very small pension • Recent Structural Changes in Financial
fund sector? Systems (up to 2007)
• Explanation similar to France: state takes
larger role in pension provision than UK &
USA
• Pension PAYG basis

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Recent Structural Changes in Financial

Systems (up to 2007) France Germany UK USA
1995: 1469 3785 500 10,000
• Common Themes in Financial System Evolution
Now: 829 2050 400 8,195
• Deregulation: Initial competition
• Use of Technology: to speed+ cheapen processes & • decline not dramatic—many Mer. & Acqui.
development of financial products • Generally a shrinkage: ATMs + Banking on-line
• Growth of “Disintermediation” (increasing use of taken up  Sharp decline of branches in UK
Fin. Markets) • National Bank System less competitive
 Consequences: Steady Decline of No. of National Authorities may become unwilling to
Banking Institutions allow mergers

Europe : M & A: Banks merging with other Fin.

2. USA :
Institutions– “Bankassurance” Cos. By 2000 : M&A of Deposit Banks + Investment
Banks allowed
USA: Strict separation of Deposit Banking
from others Also allowed easy “Securitization” for
Banks
Two quite different Regulations :
Loans funded by securities NOT Deposits
1. EU: to create a Single Market in Fin. Services
Wider Market—Greater advantage to the most
efficient producer; No Barrier to Competition :
More competition ► Lower cost of
intermediation in EU ► Lower cost of capital
►More Investment ►More rapid Econ. growth

Securitization: “process of combining together a  Borrowers still go to Banks for loans

collection of similar loans & selling them on to
another institution. Buying institution often
finances purchases by issuing ‘Bonds’ (securities)
& not by deposits
 Later developments allowed these ‘bonds’ be
insured against default by issue of CDSs (Credit
Default Swaps)
 Securitization : major contributor to
‘disintermediation’
 Lending moved from Banks to Markets
 Funding come from Buyers of Bonds in
Fin. Markets (Investment Cos.)
 Bank “Originate & Distribute” Model
 Banks organize Loans, then sell it on to
wider market (Institutions for funding)
 All these developed till 2007. 2008 crisis to
some extent depended upon structure of
Fin. Systems

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Effects of 2008 Fin. Crisis
Size of crisis differed substantially for—
Market-based System(UK, USA)
Bank-based System (Europe, Japan)
- No. of Fin. Institutions reqd. Govt. assistance
(Amt. of support reqd. to prevent collapse)
- Large “Finance” part —greater impact on
economy
Size of Loan
Loan to Income = -----------------------
Borrower’s Income
Traditionally 3 – 4 times
 Sub-prime borrowers could not meet
criteria
 Home loans offered for 100% of value of
property
 In USA it even exceeded 100%
 Some lenders gave up asking for income.
Borrowers only self-certify, simply state income
 In simple banking, loans default, destroy single
bank’s capital
 In new regime, poor quality loans distributed
all across Fin. System (securitization)
 Loans held by all forms of Fin. Intermediaries
 Much harder to know who owns loans, who is
exposed to default?
 Purchasers of loans against Bonds knew about
possible default in future
 So insured themselves by selling “Credit
Default Swaps”(CDSs)
 CDS—same assets insured many times over
5/9/2012
 Banks take more risks
 To have a higher profits
 Banks’ expect Govt. intervention prevent failure
 Sub-prime lending—trigger for crisis
US Banks + Savings Inst. lent to borrowers not
qualifying ‘Creditworthiness’.
Much of trouble from ‘Housing Market’
Traditional criteria used: ‘Loan to Value’ ratio
‘Loan to Income’ multiple
Size of Loan
Loan to Value = -------------------
Value of property purchased
Normally 0.75—0.8 (ratio)
CONSEQUENCES (USA) :
 House price fell, loans defaulted, massive
losses for banks
 100% value of property, security inadequate
 Once widespread, houses not sold at all
 Many Institutions exposed to default of same
single loan
 Problem began, panic spread
 Panic + negative wealth effects as asset prices
crashed led to:
--Banks stop lending to each other
--Freezing of credit market
--Transmission of fin. crisis to economy
Greater Impact of Crisis on UK & USA
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Reaction to Crisis
 Recession: UK US Euro
 Many countries - Crisis & Recession followed worst badly shortest-least
 Need to look at changes in regulations  Gov.+ Regulators + Central Banks= their
 “Innocent taxpayers compensating rich bankers” responses not markedly different
 Cost of crisis varied widely  Regulatory changes require some “coordination
 Cost of support packages in US$ Trillions & agreement
 UK= 1.71 tn; US= 10.48 tn; Euro = 2.97 tn SOME SUGGESTIONS:
 Merely a summary of explicit cost of 1) Cap Bankers’ bonuses—performance-linked
supporting
2) Increase competition within Banking System by
 No account of ‘cost to real economy’- GDP ↓ reducing barriers to entry. Large banks behave
 Cost to GDP% : UK - 74% ; US - 73% ; Euro – recklessly; small banks less secure, behave more
18% responsively

3) Oblige Banks to make ‘Living Will’- document

showing bank’s obligations to other Fin. Institutions
4) Require Banks to hold Larger Capital
5) A ‘Tobin-type’ tax: Tax on selected (or all) Fin.
Transactions—raise costs—reduce qty of
transactions—shrinkage of size (cf. to Economy)
6) Force more ‘over-the-counter’ deals onto
organized “exchanges”—easier monitoring
7) Improve regulatory oversight —relocate
responsibilities, increase power of regulators. E.g.
In UK, from FSA back to Bank of England