Banking Systems and Economic Growth: Lessons from Britain and Germany in Pre-World War I Era / Commentary

By Fohlin, Caroline; Temin, Peter | Review - Federal Reserve Bank of St. Louis, May/June 1998 | Go to article overview

Banking Systems and Economic Growth: Lessons from Britain and Germany in Pre-World War I Era / Commentary


Fohlin, Caroline, Temin, Peter, Review - Federal Reserve Bank of St. Louis


Regulation of the financial system has occupied economists and policymakers since the beginning of financial history. Such attention has been warranted because of the crucial role of these institutions in economic life. There remains, however, much disagreement over the ways financial and real variables interact and the extent to which financial development can promote economic growth. Modern growth theory has made strides in modeling the relationship between financial development and economic growth, but a causal relationship is difficult to verify empirically.1

Despite the burgeoning research on finance and growth, the importance of financial-system structure has yet to be determined. Much of the debate over banking reform in the United States hinges on the assumption that certain types of financial systems allocate an economy's resources more efficiently than others. There is a widespread ser,se in the United States and Great Britain that the universal banking systems of Germany and Japan have given those countries an advantage in industrial development and economic growth over much of the past 150 years.

The structure of the German banks, in particular, has been viewed as a key ingredient in Germany's industrial development before World War I. Universal banking, because it combines all phases of finance in one institution, is thought by many to have yielded economies of scope and greater efficiency Such efficiency has been argued in turn to have increased the volume and reduced the costs of finance, thus promoting industrial investment.2 Furthermore, German banks are often assumed to have maintained close, long-term relationships with industrial firms. Equity positions are thought to have aligned the incentives of banks and firms and encouraged multiperiod optimization of their behavior. In contrast, a long line of detractors has chastised the British banks for avoiding engagement with domestic industry and leaving firms to seek financing from other sources. Firms' resultant recourse to securities markets is argued to have served investors' short-term profit motives at the expense of long-term growth.3 As a result, the banks have been blamed for the apparent underperformance of the British economy since the late nineteenth century.

Two lines of historical investigation may shed light on the continuing debates over the relative efficacy of German and British banking systems. The first step is to determine whether the German banks offered the advantages that have been ascribed to them; the second step is to ascertain whether the provision of these services by universal banks fueled economic growth. In comparing the two systems, however, it is important to acknowledge that the British banks were not prohibited from combining functions or from pursuing long-term relationships with industrial firms. Thus, research on the real effects of financial structure must accept that, if the British banks' organization and activities were suboptimal for industrial growth, such inefficiency stemmed from market failures of one sort or another: rationing relatively low-return or high-risk ventures or failing, to perceive or act upon favorable prospects.

This study uses aggregate bank balance sheet data to investigate systematic differences in the financial makeup and activities of universal and specialized banks. By explicitly comparing British and German banks, it takes steps toward quantifying the possible disparity in financial-system growth effects over the decades leading up to World War I. Financial systems are thought to influence both the quantity and quality of investment. Thus, this paper first measures the rate of expansion and the ultimate magnitude of capital mobilized by British and German banks. The study then investigates the makeup of the banks' asset portfolios and estimates the extent of direct involvement by the two types of banks in equity ownership.

The findings suggest that, compared to British banks, German banks maintained at least as much liquidity relative to their short-term liabilities, mobilized a smaller share of the economies' capital, and held approximately the same (small) proportion of their assets in the form of nongovernment securities.

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