Corporate Governance
A Global Perspective
5 Corporate Governance,
Types of Financial Systems and Economic
Growth
For use with Corporate Governance: A Global Perspective by Marc Goergen ©
Cengage EMEA, 2018
Lecture Aims
This lecture aims to review the link between capital market
development, corporate governance and economic growth. The
lecture contrasts the two main financial systems, the bank-based
system and the stock-market based system. It assesses the
advantages and disadvantages of each system and draws
conclusions as to the types of industries that are likely to flourish in
each. Finally, the lecture discusses the link between trust and
economic growth.
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Learning Outcomes
This lecture focuses on the link between financial systems and
economic growth
We distinguish between the bank-based system and the market-
based system
Assess the importance of strong and efficient institutions in
promoting economic growth
Comprehend the impact of trust on economic growth
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Introduction
An extensive body of the literature investigates the issue of the
direction of causality between financial development and economic
growth
It is generally accepted that the former drives the latter
However, some sceptics argue that financial markets grow in
anticipation of future economic growth
Nevertheless, we assume that financial development drives
economic growth.
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The Functions of Financial Markets and Institutions
Financial markets and institutions deal with market imperfections,
in particular
– asymmetric information, and transaction costs
Their five main functions are
– Collecting savings and turning them into larger loans
– Risk sharing
– Facilitating the exchange of goods and services
– The monitoring of corporate managers
– The allocation of economic resources
We concentrate on the latter two
5
Bank-based versus Market-based Systems
Bank-based versus Market-based Systems
Both banks and stock markets may reduce the monitoring which
individual investors have to expend
Banks have better monitoring skills than small investors true false
They also benefit from economies of scales in terms of monitoring
The high diversification of their portfolios of loans reduces the
monitoring by savers
Banks also often have long-term relationships with borrowers,
reducing information problems
7
Bank-based versus Market-based Systems
Hence, the bank-based system is also sometimes called the
relationship-based system
This system is thought to overcome weak law via agreements
between parties and reputation building
Stock markets also reduce the need for monitoring by individual
investors for two main reasons
1. The firm’s stock price enables its owners to monitor the management and to
incentivise.
2. The market for corporate control provides a disciplining mechanism
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Bank-based versus Market-based Systems
However, doubts have been raised about the monitoring role of
stock markets
1. The reason behind hostile takeovers does not seem to be bad performance
2. Stock markets may promote takeovers that result in so called breaches of
trust whereby the new management violates implicit contracts the
incumbent management had with the employees
3. Stock markets may promote exit rather than voice
4. Stock markets may be myopic
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Bank-based versus Market-based Systems
The relationship-based system thrives on opacity whereas the
market-based system relies on transparency األشياء اللي باألخضر تبينا
نركز عليها أكثر
Opacity protects the close relationships banks have with firms from
the banks’ competitors
However, the lack of transparency also makes it difficult for the
firm to judge whether the cost of borrowing charged by the bank is
justified
As a result of the differences between relationship- and bank-based
systems, firms are likely to specialise in those assets favoured by
their system
10
The Link between Types of Financial
Systems
and Economic Growth
The Link between Types of Financial Systems
and Economic Growth
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The Link between Types of Financial Systems
and Economic Growth
These theories are
– The information collection theory
– The renegotiation theory
– The corporate governance theory
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The Information Collection Theory
14
The Renegotiation Theory
According to this theory, financial systems with many small banks
impose tighter budget constraints than those with few large banks
Hence, the former tend to favour short-term projects and the latter
long-term projects
Young and high-tech industries will thrive in systems with many
small banks
More mature industries, where innovation is incremental, will
prosper in systems with few large banks
تكون افضل للبنوك الصغيرة (عشان الفوائد للبنوك الكبيرة ضخمة والبنوك الصغيرة
)تكون محدودة
15
The Corporate Governance Theory
A large shareholder overcomes the free-rider problem and the lack
of monitoringيكون مجاني
However, the large shareholder may interfere too much with the
management of the firm
The large shareholder may also expropriate the minority
shareholders
The theory predicts that dispersed ownership فصل الملكيةcan more
credibly commit not to interfere with the management
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Goergen © Cengage EMEA, 2018 16
The Corporate Governance Theory
Hence, dispersed ownership will fare better with activities requiring
investments from management and other stakeholders
Concentrated ownership is better suited for activities requiring
active monitoring
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The Link between Types of Financial
Systems
and Economic Growth
The Link between Types of Financial Systems
and Economic Growth
Wendy Carlin and Colin Mayer tests the validity of the above three
theories as well as the classic theory
They study 27 different manufacturing industries across 14
developed and 4 less developed OECD countries for 1970-95
In their regression analysis, they explain GDP growth, fixed
investment, and R&D by two sets of variables
الثالث أشياء هذي اكيد بتجي الزم نفرق بينها واالسماء ماتهمها والمطلوب وش توصلوا
له بالنظرية
– Country characteristics
– Industry characteristics
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The Link between Types of Financial Systems
and Economic Growth
The country characteristics consist of three measures, one for each
of the above three theories
– The quality of accounting standards (information collection theory)
– The concentration of the banking industry (the renegotiation theory)
– Ownership concentration (corporate governance theory)
بتجي
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The Link between Types of Financial Systems
and Economic Growth
The industry characteristics are
– The industry’s dependence on equity finance
– Its dependence on bank finance
– Its dependence on other stakeholders (i.e. employees)
Carlin and Mayer decompose deviations of country growth rates
from world averages into three distinct effects
– The share effect
– The growth effect
– The interactive effect
– ضروري نعرف هالثالث تأثيرات
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The Link between Types of Financial Systems
and Economic Growth
The share effect measures the contribution to economic growth via
the deviation of a country’s initial share of an industry from the
world average in 1970
Hence, this effect measures the validity of the classic theory
The growth effect is the contribution to growth of the deviation of
the country’s growth rate from the world average assuming initial
shares are world averages
كم عدد الدول األسماء األرقام كلها ماتهمها
22
The Link between Types of Financial Systems
and Economic Growth
The interactive effect accounts for the possibility that economic
growth may be higher given that the country’s initial allocation was
higher
Carlin and Mayer find that differences in country growth are
entirely due to the growth effect
This suggests that the classic theory is unlikely to have much
explanatory power
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How Trust and Other Factors Influence Economic
Growth
24
How Trust and Other Factors Influence Economic
Growth
During the lecture on the taxonomies of corporate governance
systems, we reviewed La Porta et al.’s theory about the quality of
law
According to this theory, the main driver of economic growth is
investor protectionصح او خطأ
Other factors driving economic growth include trust and religion
Trust may be a means of overcoming situations dominated by
asymmetric information where the actions of the agent cannot be
directly observed
25
How Trust and Other Factors Influence Economic
Growth
Paul Zak and Stephen Knack study the link between trust and
economic performance for 44 countries
They allow for two types of trust
1. Trust towards fellow citizens
2. Trust of the government
They measure the latter by the strength of property rights
This measure is similar to La Porta et al.’s measure of investor
protection
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How Trust and Other Factors Influence Economic
Growth
They find that
– Investment increases with trust and the level of incomes, but decreases with
the price of investment goods
– Trust increases economic growth
– While growth is positively related to the strength of property rights, trust
remains significant
They identify the following determinants of trust
– There is a link between ethnic homogeneity and trust
– Trust increases with property rights
– It decreases with income and land property inequality
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How Trust and Other Factors Influence Economic
Growth
In another study, Stephen Knack and Philip Keefer allow for trust to
be a substitute for weak institutions
They find that
– Trust has a positive impact on both economic growth and investment
– This impact is higher in poorer countries where formal institutions and the
quality of law are weaker, suggesting that trust is a substitute for the latter two
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How Trust and Other Factors Influence Economic
Growth
Rafel La Porta and others find that trust has a positive impact on
– The efficiency of government
– The participation in civic organisations
– The performance of large companies
– Social efficiency
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How Trust and Other Factors Influence Economic
Growth
Hence, there is consistent evidence that
– Trust has a positive effect on economic growth, investment and institutional
performance
– Trust is influenced by income inequality, ethnolinguistic or ethnic diversity,
and hierarchical religions
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Conclusions
Bank-based versus market-based systems
The link between industrial activities and type of financial system
The impact of trust on economic growth
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