Appunti comparing financial systems

Comparing financial systems

Prof. Giovanni Scarano

a.y. 2020-2021

Lorenzo Guglielmetti

Course started 23/09/2020

Course overview

The lessons will be 1h30m without pause.

Objectives of the course

• To analyse the major differences in financial systems over the world;
• To understand the globalization and convergence processes in financial systems;
• To analyse some structural features and functions of fund channeling.

Program

• 23/09 Introduction 2h: Premises for a comparative study, Forms of fund channeling, Classification of financial system, Changes in today’s financial systems
• 24/09 The historical development of financial systems 2h: The first stages of financial systems, Credit vs mutual aid (aid = help, assistance), Early financial systems, The birth of modern financial systems
• 25/09 30/09 The UK financial system 4h: Banks in the UK, Building societies, Insurance companies, Pension funds, Unit trusts, Investment trusts
• 7/10 8/10 The US financial system 4h: Deposit-taking institutions, The Federal Reserve system, Non-depository institutions
• 9/10 The German financial system 2h: Banks and other deposit-taking institutions, Non-deposit institutions, The use of bond and equity markets in Germany
• 14/10 The French financial system 2h: The banking system, Special and non-deposit institutions, Financial markets in France
• 15/10 The Italian financial system 2h: The development of the Italian financial system, The current position of the Italian financial system
• 16/10 21/10 Financial systems in northern Europe 4h: Banking systems, Other financial intermediaries, The evolution and integration of financial systems in Scandinavia, Monetary policy strategies
• 22/10 Financial systems in Central and Eastern Europe 2h
• 23/10 Europe’s financial structure 2h: Money markets and monetary policies 2h, The eurozone and the banking union 2h
• 28/10 The Japanese financial system 2h, China’s banking and financial markets 2h, The Russian banking and financial system 2h, Islamic finance 2h, African financial system: an overview 2h

Follow-up issues

• The limitation of markets: the classical view 2h
• Bubbles and financial crises 6h
• The role of corporate governance 4h
• Self-financing firms 2h
• Corporate savings 2h
• Financialization 6h
• Liquidity in asset markets and market crashes 2h

References

Main textbooks

Final test

7 multiple choice questions and 3 open-ended questions. Multiple-choice questions are on all the topics of the course. The open-ended questions will be pulled out from a list of questions previously published on the website of the course. Each right answer to a multiple-choice question is worth 3 points. Each answer to an open question is evaluated from 0 to 6 points.

Starting with some general definitions

Usually, in mainstream theoretical approaches, finance is presented to us as "the study of how economic agents allocate scarce resources over time". Two features distinguish financial decisions from other resource allocation decisions:

• The costs and benefits are spread out over time (intertemporal choice);
• The costs and benefits are not known with certainty in advance (uncertainty).

From this viewpoint, finance seems to be a form of universal and natural human behavior. According to this definition, economic agents, in implementing their decisions, make use of financial systems: the set of markets and other institutions used for financial contracting and the exchange of assets and risk. A basic tenet of this approach is that the ultimate function of the system is to satisfy people’s consumption preferences (consumer sovereignty). Financial institutions seem to exist to facilitate the achievement of this ultimate function.

Some premises for a comparative approach

However, in practical terms, "finance" donates the several ways of proving money funds to a consumer or firm. Finance presupposes the existence of a money economy. It is the result of the historical development of market-oriented economic systems. In fact, finance was very undeveloped in pre-capitalist economic systems. And still today, in many developing and emerging economies, finance is undeveloped because a market-oriented economy concerns only a limited part of the overall economic system.

What a financial system consists of

In modern advanced capitalist economies, a financial system is a set of markets for financial instruments and the individuals and institutions who trade in those markets, together with the regulators and supervisors of the system. The users of the system are people, firms, and other organizations who wish to make use of the facilities offered by a financial system. These facilities are:

• Intermediation between surplus and deficit units;
• Financial services such as insurance and pensions;
• A payment mechanism;
• Portfolio adjustment facilities.

Financial systems are crucial for the allocation of resources in an advanced economy. They channel household savings to the corporate sector and allocate investment funds among firms. They allow intertemporal smoothing of consumption by households and expenditure by firms. They allow both firms and households to share risks. All these functions appear to be common to most developed economies.

The credit system

Credit constitutes a fundamental component of fund channeling in market-oriented economies. The principal forms and functions of the credit system emerge spontaneously in the process of facilitating good and service transactions. Contrary to popular belief, the core foundation for credit systems in advanced economies is provided by "idle" money capital (excess cash) generated in the turnover of capital in the production process. Very often, in fact, households are lenders only as business capital owners. Excess cash usually emerges in the form of depreciation funds for fixed capital, reserves for the expansion of fixed capital, serves guarding against price fluctuations, and reserves that help maintain the continuity of production in the face of the constant alternation between production and circulation of commodities.

The banking system

Banks, originally, were institutions that accepted deposits from those who wished to save and to lend them to borrowers on terms that were attractive to the latter. Successively, they began to offer a means of payment facility, based initially upon written cheques but now largely electronic. Today, in developed countries, to have access to the current payments mechanism, one needs to hold bank deposits and these can be on-lent. Banking system features are one of the major analysis objects in comparing financial systems.

A comparative curiosity

According to Schumpeter, the issue to entrepreneurs of new means of payment created ad hoc by banks (i.e. bank credit) in market-oriented economies is what corresponds to the order issued by the central authority in centrally planned economies. In these economies, like China some years ago, the central authority controls all existing means and all it has to do in case it decides to set up new real investments is simply to issue orders to those in charge of the productive resources to apply the quantities to the new purposes. In market-oriented economies, instead, the new means of production required for investment are privately owned and must be bought in their respective markets. Therefore, the new means of payment created by banks have the function of anticipating the material resources on the basis of banks’ reputation.

Other forms of fund channeling

However, finance is broader than credit because it further relates to the mobilization through the capital market of money funds in the form of joint-stock capital, rather than simply as lending and borrowing. Insurance companies and pension funds, for instance, have a primary purpose which is to offer people a means of managing the risk of some major, adverse events. However, the contributions made by policyholders create a fund which is usually invested in a wide range of securities. This purchase of securities involves a flow of funds (directly or indirectly) to those who issued the securities as a means of raising funds. Moreover, portfolio adjustment facilities, comprising those supplied to smaller investors by ‘mutual funds’, have to provide wealth-holders with a quick, cheap, and reliable way of buying and selling a wide variety of financial assets. However, when wealth-holders buy financial assets they are lending (directly or indirectly) to those who issued the assets.

The financial intermediaries

Therefore, all kinds of financial activity have the effect of channeling funds from lenders to borrowers. The financial intermediaries are intermediate borrowers and lenders, which also borrow and lend but only in order to channel funds between end users. Economists are usually interested in the way in which a financial system channels funds between the end users of the system, that is, between ultimate borrowers and lenders, rather than the intermediate borrowers and lenders. However, financial intermediaries provide a third channel for the transmission of funds between borrowers and lenders. The complex structure of the credit system and capital market taken together are the financial systems of an advanced economy. Intermediaries are crucial traders in organized markets; most financial markets are dominated by intermediaries. The features and behaviors of financial intermediaries and organized markets are very crucial in fund channeling.

Organized financial markets

Many economists view markets as the ideal mechanism for allocating resources. Among the most important markets, of course, there are the stock market and other financial markets. In the USA and UK, at first sight, this characterization seems appropriate. However, there are a number of serious problems with this view in the rest of the world. In most countries:

• Stock markets are unimportant;
• Financial markets are primarily markets for government debt;
• The external funds firms need for investing are obtained from banks.

In all countries, including the USA and UK, internally generated funds are far more important than external finance raised through markets and banks. In all countries, the ideal of frictionless markets is rarely achieved in practice. A comparison of different countries’ financial systems indicates that the focus of standard economic models on financial markets as a means of allocating resources is misplaced. The main aim of this course is to outline theories that better capture how resources are allocated in practice and understand the normative properties of different financial systems. When we look at different countries, however, we observe very different financial systems. Taking account of some broad comparisons, the USA and Germany can be viewed as polar extremes. In the USA, financial markets play an important role in allocating resources, while in Germany they are relatively unimportant. In Germany, banks play by far the most important role. The three major universal banks Deutsche, Dresdner, and Commerzbank dominate the allocation of resources in the corporate sector. In contrast, the USA has long pursued a vigorous policy of promoting competition among banks. As a result, the banking system is less concentrated than in Germany, particularly regarding providing services to the corporate sector. Universal banking was prohibited by the Glass-Steagall Act, so the commercial and investment banking sectors have long been separate.

Internationalization of finance

In recent years, there has been a remarkable growth and internationalization of finance. There is empirical evidence from a number of countries that at a certain stage of economic development, the financial sector grows faster than the economy as a whole (financial deepening or financialization). Today, under the global pressures with free movement of capital, national financial systems are coming to look more and more alike. However, it is not yet quite true that all financial systems are the same. The differences lie mainly in the institutions and in approaches to the regulation of financial activity. By contrast, financial markets and the instruments traded in those markets are remarkably similar from one country to another. Today, the financial instruments (bills, bonds, equities, and so on) fulfill a common purpose wherever they are traded and priced according to the same principles in all countries. Most of the instruments are internationally traded with the result that US equities are close substitutes for German equities in the portfolio of a French investor.

Main differences in financial systems

The few differences that exist between markets in different developed countries amount to differences in size and differences in institutional arrangements for the trading of instruments. Differing reactions to the instability associated with financial markets, historically speaking, lead to two broad types of financial systems:

• Market-based
• Bank-based

Classification of financial systems

In the economic literature, financial systems are widely interpreted as lying somewhere along a continuum, with ‘market-based’ systems at one end and ‘bank-based’ systems at the other. However, the position on this continuum tends to be associated with other important characteristics. If financial markets play a large part in corporate financing and those markets are particularly active, takeovers, often hostile, will likely be commonplace in disciplining firms (and managements) which underachieve. Market-based systems tend to encourage a degree of ‘short-termism’ in the decisions of managers who are conscious of the need continuously to maximize shareholder returns, with implications for corporate governance. If markets play a small role, firms will be more dependent upon banks for finance. Banks will therefore have to take a close interest in firm behavior, suggesting an alternative form of corporate discipline, and they may have to be structured differently from banks which operate in a ‘market-based’ system. Thus, an effective classification system requires additional dimensions. If we wish to classify financial systems, we need to think not just about the role of markets, but also about the nature of the banking system and the style of corporate governance.

Corporate financing

What this means is that banks provide a markedly larger share of corporate funds in bank-based systems than do markets. But we need to be careful not to exaggerate the role of banks and markets in each system. In the bank-based systems (France, Germany, and Japan) banks provide typically something approaching 20% of net corporate financing, while markets provide only 3-4%. In the market-based systems (UK and USA) it is true that banks provide very little financing (virtually no long-term financing) but at the same time the issue of new equity and bonds accounts for only 10-15%. In neither system does external finance, bank and market-based combined, contribute more than 20% of the total. The bulk of corporate finance comes from internally generated funds, in all systems.

The nature of banking systems

When it comes to the nature of banking systems, different countries have very different histories. In the USA, the banking system is characterized by a large number of independent, competitive banks because of a deep-seated, historical dislike of the centralization of economic power. Regulations therefore restricted banks to operating within their home state and prevented the development of a nationwide system of branch banking. The Glass-Steagall Act prevented banks from helping firms to make new issues of securities (a legacy ultimately of the 1929 Wall Street crash). Although these restrictions were progressively lifted in the 1980s, their effect has been to limit banking activity to short-term lending to firms and to consumer credit and home loans. By contrast, banking in the other main countries is highly centralized. In the UK, it is dominated by the big four: Barclays, Lloyds-TSB, RBS-NatWest, and HSBC. In Germany, it is dominated by the big three. In Japan and France, the situation is similar. But in Germany and France, there is a large mutual/cooperative banking sector which had its origins in providing (cheap) credit for particular trades and activities. In France and Italy, the dominant commercial banks have often been owned by the state, although they have been successively privatized, first in France (1982) and then in Italy (1992). In Germany, the major banks are universal banks providing a full range of financial services to firms and households. In the UK, in France and in Italy, the tradition was one of specialization (hence the terms retail banks contrasting with wholesale or investment banks), but they too are moving in the German direction (universal banks).

Corporate governance

When we distinguish between ‘market-based’ and ‘bank-based’ financial systems, the main distinction lies in the implications for corporate governance rather than in crude measures of the proportions of funds raised. In most countries, the boards of directors of large corporations are legally responsible to shareholders for their conduct of the firm. However, it is only in the UK and USA that boards of directors accept that the maximizing of shareholder value is the main day-to-day objective. Japanese companies have traditionally tried to maintain stable conditions of employment for their employees, and this has been accepted by shareholders. In Germany, a system of ‘co-determination’ means that workers are represented on the supervisory boards of companies and therefore have some influence over decision-making processes.