Finance Case

As most developing countries, especially emerging markets are in the process of financial liberalization in order to sustain their economic development and connect to the industrialized world. However, financial liberalization also carries tremendous risks and challenges to those economies. It is imperative for them to accurately diagnose problems in their systems and thus better prepare for further liberalization. And financial structure is one of the game changers that have to be taken into account.

Countries or economies can be classified as either bank-based financial system or market-based financial system. There are different views on why countries have different financial systems, arguments including divergent legal system development and industrialization patterns. But the origin does not matter here, characteristics do.

In bank-based systems, banks serve as the most important intermediary to mobilize national savings, allocate capital to the entities in need; it is also responsible to monitor investment risks on the corporate level and provide risk management solutions. Most of the financial assets in this system are long-term loans provided by banks. Banks monitor borrowers based on institutional ties and long-term relationships with the counterparty. Banks also tend to have large block holding in the corporations it lends to, just so they can assert certain level of control and supervision over the borrowers. Countries with typical bank-based system include Germany, France, Japan and most developing countries. But they all have unique characteristics from one to another.

In market-based systems, banks have lesser role than capital markets (equity and bond markets). Capital markets mobilize and allocate capital in a more direct fashion compared to bank-based systems. Market-based system funds economy mainly through securities, bonds, and short-term and long-term loans. Its monitoring enforcement tends to be impersonal and arms-length; stakes in borrowers are dispersed and therefore shareholders have less influence on corporate governance. One of the key features of market-based system is that there are many non-bank intermediaries such as rating agencies, insurance companies, investment funds and so on. Those intermediaries facilitate efficient capital allocation and reduce transaction costs. Countries with typical bank-based system include