Do Capital Markets Matter and Why?

In an influential study published two decades ago, John Zysman popularized the idea that financial systems can be divided into three types: a system based on capital markets (the United States and Great Britain), a credit-based system administered by the government (France and Japan), and a credit-based system dominated by financial institutions (Germany). Zysman himself was interested in this distinction because he believed that financial systems influence governments’ capacity to intervene in the economy and the types of political conflicts that emerged.¹

In the economics field, an equally influential book by Franklin Allen and Douglas Gale looked at the same five countries. Their aim, however, was to criticize standard economic theory about the allocation of resources through financial markets. They set out “to develop theories that better capture how resources are allocated in practice and understand the normative properties of different systems.” They were also interested in comparing the advantages and disadvantages of market-based versus credit-based (intermediated) systems, although they came to the conclusion that different institutions can perform the same function and that the ideal system relies on both.²

A third book of interest for our topic, an edited volume by Asli Demirguc-Kunt and Ross Levine, brings two new elements to the discussion of banks and markets. First, they move away from the industrial countries and address the topic with respect to the developing world. (In this sense, they look back more to Raymond Goldsmith than to the authors just mentioned.³) Second, they set out to provide empirical data, including a new database, to compare the operation of the two types of systems. Echoing Allen and Gale, they do not find either type to be superior; rather the key is how well either functions.⁴

Developing countries tend to be on one extreme of the spectrum between banks and markets, since the requirements for setting up a banking system are much less stringent than for markets. Thus, even moving toward Allen and Gale’s ideal of a combined system requires additional effort to promote capital markets. By the late 1990s, many calls were being heard – from economists, business people, government officials, and the international financial institutions (IFIs) – for more movement in this direction. In particular, the calls focused on the “missing market” – that for government and corporate bonds. Indeed, stock markets have been more common than bond markets in developing countries, in part because the upside of a bond is limited by the interest rate, while an equity claim has an unlimited upside and so can compensate for high risk.⁵

Those calling for support for the “missing market” offer a variety of reasons to explain the importance of an active bond market. First, a bond market is the only way to establish a market-determined interest rate, which will help investors calculate the opportunity costs of various investments. Second, without a bond market savers will have fewer investment choices and thus a lower volume of savings may be mobilized. Third, firms will face higher cost of funds without a bond market and, in trying to match maturities, may be biased toward short-term investments. Fourth, to compensate for the lack of a domestic bond market, firms and governments may borrow abroad and thus take excessive foreign exchange risks. Fifth, in the absence of a deep bond market, the banking sector will be more significant than it would otherwise be and thus make the economy more vulnerable to crisis.⁶

Other experts have concentrated on more specific institutional needs to justify the call for more emphasis on bond markets. From the government’s perspective, a bond market is useful to finance fiscal deficits without increasing inflation or taking on exchange rate risk and for running monetary policy. Borrowers, both firms and households, also need access to bond markets to obtain long-term finance for investment or mortgages.

Finally, combining some of the justifications above, an argument that has become increasingly common is that domestic capital markets can be an alternative to borrowing abroad with the risks that the latter entails. The head of the International Monetary Fund (MF) capital market division recently stated, “The efforts to develop local securities markets have been motivated by a number of considerations, especially the desire to provide an alternative source of funding in order to self-insure against reversals in capital flows.”⁷ He goes on to quote Alan Greenspan’s well-known comment that smoothly functioning bond markets can act as a “spare tire” for when other sources of funds dry up.

Following up on this latter argument, the Asian governments have been especially eager to promote the growth of bond markets since the crisis, believing that the absence of a deep bond market was one of the causes of the crisis. Various regional organizations, including the Asian Development Bank (ADB), the Asian Development Bank Institute (ADBI), and the U.N. Economic and Social Commission for Asia and the Pacific (ESCAP), have carried out studies and made recommendations on how the strengthen the bond markets.⁸ The arguments in favor are similar to the ones already mentioned. Latin American governments have been less concerned with these issues, although the Inter-American Development Bank recently published a volume on the capital markets.⁹ Also, the Bank itself has sponsored programs to stimulate the development of financial markets.