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Banking Systems and Economic Growth

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Banking Systems and Economic Growth MAY/JUNE 1998 Caroline Fohlin is an assistant professor of economics at the California Institute of Technology. The author is grateful to Lance Davis, Michael Edelstein, Barry Eichengreen, John Latting, Peter Temin, and David Wheelock as well as conference participants at the St. Louis Federal Reserve Bank Annual Economic Policy Conference for helpful comments and discussions, and to the National Science Foundation for funding this research. The structure of the German banks, in Banking Systems particular, has been viewed as a key ingre- dient in Germany’s industrial development and Economic before World War I. Universal banking, because it combines all phases of finance Growth: Lessons in one institution, is thought by many to have yielded economies of scope and greater from Britain efficiency. Such efficiency has been argued in turn to have increased the volume and and Germany in reduced the costs of finance, thus pro- moting industrial investment.2 Furthermore, the Pre-World German banks are often assumed to have maintained close, long-term relationships War I Era with industrial firms. Equity positions are thought to have aligned the incentives of banks and firms and encouraged multi- Caroline Fohlin period optimization of their behavior. In contrast, a long line of detractors has chas- egulation of the financial system has tised the British banks for avoiding engage- occupied economists and policymak- ment with domestic industry and leaving Rers since the beginning of financial firms to seek financing from other sources. history. Such attention has been warranted Firms’ resultant recourse to securities 1 Greenwood and Smith (1997) because of the crucial role of these institu- markets is argued to have served investors’ offer what may be the most tions in economic life. There remains, short-term profit motives at the expense of reasonable compromise on the however, much disagreement over the long-term growth.3 As a result, the banks question of causality: a model ways financial and real variables interact have been blamed for the apparent under- in which financial markets arise and the extent to which financial develop- performance of the British economy since after some period of real devel- ment can promote economic growth. the late nineteenth century. opment, and in which the Modern growth theory has made strides Two lines of historical investigation expansion of those markets in modeling the relationship between may shed light on the continuing debates fuels further real growth. A logical implication of this model financial development and economic over the relative efficacy of German and is that exogenous creation of a growth, but a causal relationship is British banking systems. The first step is financial system with advanced 1 difficult to verify empirically. to determine whether the German banks features may not spur real Despite the burgeoning research on offered the advantages that have been growth. The problem then for finance and growth, the importance of ascribed to them; the second step is to implementing development financial-system structure has yet to be ascertain whether the provision of these policy is determining how to determined. Much of the debate over services by universal banks fueled economic get poor countries to the point banking reform in the United States growth. In comparing the two systems, at which financial systems will hinges on the assumption that certain however, it is important to acknowledge arise endogenously. types of financial systems allocate an econ- that the British banks were not prohibited 2 Most recently, Calomiris (1995) omy’s resources more efficiently than from combining functions or from pur- has advanced this idea. others. There is a widespread sense in suing long-term relationships with industrial 3 For a review of the literature the United States and Great Britain that firms. Thus, research on the real effects of on British banking and indus- the universal banking systems of Germany financial structure must accept that, if the trial development, see Collins and Japan have given those countries an British banks’ organization and activities (1991). Also see Capie and advantage in industrial development and were suboptimal for industrial growth, Collins (1992). For a critical economic growth over much of the past such inefficiency stemmed from market appraisal of the British banking 150 years. failures of one sort or another: rationing system, see Edwards (1987). FEDERAL RESERVE BANK OF ST. LOUIS 37 MAY/JUNE 1998 relatively low-return or high-risk ven- past decade to formalize the link between tures or failing to perceive or act upon financial-system functioning and the growth favorable prospects. of the real economy.4 In comparison to the This study uses aggregate bank balance traditional growth models—in which output sheet data to investigate systematic differ- was seen as a function of capital, labor, and ences in the financial makeup and activities disembodied technological progress—the of universal and specialized banks. By current models provide a richer frame- explicitly comparing British and German work for interpreting the potential impact banks, it takes steps toward quantifying the of financial systems. For their motivation, possible disparity in financial-system growth nearly all appeal to the observed correla- effects over the decades leading up to World tions between financial-system develop- War I. Financial systems are thought to ment and industrial growth uncovered by influence both the quantity and quality of economic historians and development investment. Thus, this paper first measures economists during the 1960s and ’70s.5 the rate of expansion and the ultimate mag- Pagano (1993) provides a simple way to nitude of capital mobilized by British and summarize the newer models of finance and German banks. The study then investigates growth. Using several simplifying assump- the makeup of the banks’ asset portfolios tions, the model yields the growth rate of and estimates the extent of direct involve- output per capita as a function of three vari- ment by the two types of banks in ables: savings rate, return on investment, equity ownership. and costs of intermediation. Thus, financial The findings suggest that, compared institutions may enhance economic growth to British banks, German banks maintained by raising the total quantity of financial cap- at least as much liquidity relative to their ital available to entrepreneurs, improving short-term liabilities, mobilized a smaller the quality (productivity) of investments, share of the economies’ capital, and held and increasing the efficiency of intermedia- approximately the same (small) proportion tion (lowering costs) between the sources of their assets in the form of nongovernment and uses of funds. securities. Furthermore, the German banks This framework can help in comparing seem to have held only a limited number of the effectiveness of the German and British industrial equities in their portfolios and banking systems, but further refinement is often did so merely because of insufficient required to clarify the ways financial insti- markets for new issues. tutions affect the variables in the growth The results offer insights into both formula. The following sections take some differences and similarities in the organiza- first steps at comparing the impact of spe- tion of banking in Germany and the United cialized and universal banking systems on Kingdom, specifically, and into the historical the quantity and quality of investment. importance of financial structure, more gen- erally. The findings suggest that the gulf between specialized and universal banking QUANTITY OF INVESTMENT in terms of their influence on economic Banks influence the accumulation of growth and industrial development is physical capital by directing funds to entre- less than commonly believed. preneurs who wish to invest. Such capital 4 For an overview of some of mobilization proceeds in two stages: capital the literature, see Pagano collection through deposit-taking or sales (1993) and Galetovic (1996). THE LINK BETWEEN BANK of equity shares, and fund dispersal through Greenwood and Smith (1997) STRUCTURE AND GROWTH loans or advances. By repeating this process, provide more technical details. The primary purpose of banks is to the banking system multiplier expands the 5 Cameron (1967), Goldsmith mobilize otherwise idle resources for use money supply and redistributes the econo- (1969), McKinnon (1973), in productive investment. A wide array my’s capital. These banking functions and Shaw (1973) are the of theoretical models has appeared in the increase the share of resources targeted to standard references. growth and development literature in the productive investment. F EDERAL RESERVE BANK OF ST. LOUIS 38 MAY/JUNE 1998 The German universal banks are cred- Figure 1 ited with mobilizing significant amounts of capital from the public and thereby pro- Total Joint-Stock Bank Liabilities Less moting industrial growth. The British banks, Total Cash Holdings, United Kingdom by comparison, are typically presumed to and Germany, 1880-1913 have participated less aggressively in the Liabilities Less Cash/GNP accumulation of funds. Total assets of finan- 0.6 cial institutions as a share of gross national product grew substantially in both Britain 0.5 U.K. and Germany between 1860 and 1913, but 0.4 Goldsmith’s (1969) figures indicate that this ratio expanded more in the latter than in the 0.3 former. Furthermore, while Britain’s ratio 0.2 exceeded Germany’s in 1860, the British 0.1 lagged the Germans by 1900. The gap Germany 6 grew to over 50 percent by World War I. 0 Nonetheless, the Goldsmith data indicate 1880 83 86 89 92 95 98 1901 04 07 10 13 that the British deposit banks accounted for NOTES: The British data come from the Economist series as reported in Sheppard (1971) and a greater share of their country’s GNP than include private banks, starting in 1891. The solid line represents an estimation of the joint- did the German universal banks at each stock banks' liabilities from 1880 to 1913, based on the ratio of private to joint-stock banks in 1891, but that ratio likely declined significantly between 1891 and 1913.
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