The Evolving Importance of Banks and Securities Markets

In our recent NBER working paper, The Evolving Importance of Banks and Securities Markets, we evaluate empirically the changing importance of banks and securities markets as economies develop. In particular, we focus on assessing whether economies increase their demand for the types of services provided by securities markets relative to the services provided by banks as countries grow. To empirically test whether the economic development “returns” to improvements to both bank and securities market development change as economies grow, we use data on 72 countries over the period from 1980 through 2008 and aggregate the data in 5-year averages (data permitting), so that we have a maximum of six observations per country. We use several measures of bank and securities market development, including standard indicators such as bank credit to the private sector as a share of gross domestic product (GDP), the value of stock market transactions relative to GDP, and the capitalization of equity and private domestic bond markets relative to GDP.

The primary methodological contribution of this paper is using quantile regressions to assess how the sensitivities of economic activity to both bank and securities market development evolve as countries grow (Koenker and Basset, 1978). Ordinary least squares (OLS) regressions provide information on the association between, for example, economic development and bank development for the “average” country, the country at the average level of economic development. But, quantile regressions provide information on the relationship between economic activity and bank development at each percentile of the distribution of economic development. Thus, we assess how the associations between economic development and both bank and securities market development change during the process of economic development.

Besides confirming that both banks and securities markets become larger relative to the size of the overall economy as countries grow, the paper’s major findings are that as countries develop economically (1) the association between an increase in economic output and an increase in bank development becomes smaller, and (2) the association between an increase in economic output and an increase in securities market development becomes larger. Put differently, as economies develop, the marginal increase in economic activity associated with an increase in bank development falls, while the marginal boost to economic activity associated with an increase in securities market development rises. Although instrumental variables are not employed to identify a causal effect, these results are consistent with the predictions emerging from a large body of theoretical research: as economies develop economically, the services provided by securities markets will become more important for future economic development, whereas those provided by banks will become less important.

This research is policy relevant. First, if the optimal mixture of banks and markets changes as an economy develops, such a relationship is an indication of the costs of policy and institutional impediments to the evolution of the financial system. This is the first paper to show that the association between economic activity and stock market development increases as economies grow, whereas the association between economic activity and bank development decreases. Furthermore, this work suggests that the associations between economic activity and both bank and securities market development change with economic development. This change implies that the estimated elasticities from previous research regarding the impact of changes in bank or stock market development on economic development will yield misleading information about countries with incomes that are far from the sample average. Previous studies do not account for the evolving importance of banks and markets during the process of economic development.

Indeed, empirical research has been largely unsuccessful at clarifying the evolving importance of banks and markets during the process of economic development, as exemplified by Beck and Levine (2002), Demirguc-Kunt and Maksimovic (2002), and Levine (2002). Demirguc-Kunt and Levine (2001) show that banks and securities markets tend to become more developed as economies grow and that securities markets tend to develop more rapidly than banks. Thus, financial systems generally become more market-based during the process of economic development.

However, this pattern could reflect reverse causality. Economic progress may boost the development of securities markets more than it boosts the development of banks. The observation that financial systems tend to become more market-based as economies develop does not necessarily imply that securities markets exert a larger impact on economic activity in more economically advanced economies.

Yet, our findings are inconsistent with simple reverse causality scenarios. Although such a scenario might predict that economic development increases the size of banks and securities markets relative to the size of the overall economy and that securities markets grow faster than banks, it does not yield predictions about the differential change in the association between economic activity and bank and securities market development as economies grow. That is, a simple reverse causality scenario does not predict that the association between economic activity and bank development diminishes in magnitude while the association between economic activity and securities market development increases in magnitude as countries develop economically.

This paper is one step in deriving a better understanding of the dynamic relationships among economic development, financial institutions, and securities markets. In this paper, we show that both the “supply” of securities market services and the economic development “returns” to securities market development increase as economies grow. This implies that the relative demand for securities market services increases with economic development. As such, this research suggests that policies and institutions that impede the evolution of the structure of financial systems as economies grow can have detrimental ramifications for economic development.

The full paper is available for download here.