Financial Structure and Incentives

By Cihak, Martin; Demirguc-Kunt, Asli | National Institute Economic Review, July 2012 | Go to article overview

Financial Structure and Incentives


Cihak, Martin, Demirguc-Kunt, Asli, National Institute Economic Review


The article connects two streams of recent research on the financial sector. The first is the regulation literature, which emphasises the central role of incentives in the financial sector. It points out that the challenge of financial sector regulation, highlighted by the global financial crisis, is to align private incentives with public interest without taxing or subsidising private risk-taking. The second stream of research relates to financial structures and examines the mix of financial institutions and financial markets in an economy. It finds that, as economies develop, services provided by financial markets become comparatively more important than those provided by banks. The article brings these two streams together, pointing out that--as financial systems develop from bank-based to market-based--a traditional regulatory approach that relies on banking ratios becomes less effective. There is thus a greater need for properly monitoring and addressing the underlying incentive weaknesses in market-based systems.

Keywords: Financial sector; financial systems; economic development

JEL Classifications: G00; GOI; G10; G20; O16

Introduction

This article addresses the theme of this Review- financial structure--from the viewpoint of incentives. The field of financial structure has generated many interesting debates over the past few decades, one of them being the relative benefits of bank-based as opposed to market-based financial systems. This article focuses on reassessing the received wisdom on this topic in the light of the global financial crisis.

One issue brought into relief in the global financial crisis is that, in the financial sector, incentives play a crucial role. The challenge of financial sector regulation is to align private incentives with public interest without taxing or subsidising private risk-taking. Credible threats of market entry and exit, healthy competition, robust corporate governance, and disclosure of quality information are essential in getting this balance right. The incentive breakdowns during the global financial crisis led to calls for regulatory approaches to be re- oriented to have at their core identification of the underlying incentive problems in the financial sector (Cihak, Demirguc-Kunt and Johnston, 2012).

What does this mean from the viewpoint of financial structure? A wide body of theoretical and empirical literature suggests that, as economies develop, services provided by financial markets become relatively more important than those provided by banks. In the current article, we provide updated empirical evidence to support this finding and also illustrate that less bank- centric financial systems tend to be less prone to systemic financial crises. We point out that, as financial sectors develop from bank-based to market-based systems, the 'Basel-style' regulatory approach, which largely relies on requiring compliance with regulatory ratios, becomes less and less effective. There is therefore a greater need for properly monitoring and addressing the underlying incentive weaknesses in market-based systems, as illustrated for example by the incentive breakdowns that contributed to the sub-prime meltdown.

The remainder of the article proceeds as follows. First, we review and present findings on financial structure, indicating that, with economic development, services provided by financial markets become comparatively more important than those provided by banks. Second, we summarise lessons from the crisis, highlighting the importance of incentives in the financial sector. Finally, we bring these two lines of literature together, pointing out the increasing importance of incentive issues as financial systems develop towards more market-based systems.

Financial structure

Several strands of economic theory suggest that financial institutions provide services to the economy that are different from--though sometimes complementary to--those delivered by financial markets.

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