Markets and institutions in financial intermediation: National characteristics as determinants

Journal of Banking & Finance 33 (2009) 1770–1780

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Markets and institutions in financial intermediation: National characteristics as determinants Raj Aggarwal, John W. Goodell * Department of Finance, University of Akron, Akron, OH 44325-4803, USA

a r t i c l e

i n f o

Article history: Received 17 July 2008 Accepted 10 March 2009 Available online 16 March 2009 JEL classification: G10 G20 N20 O16

a b s t r a c t Given the importance of financial intermediation and the rise of globalization, there is little prior research on how national preferences for financial intermediation (markets versus institutions) are determined by cultural, legal, and other national characteristics. Using panel analysis for data on a recent 8-year period for 30 countries, this paper documents that national preferences for market financing increase with political stability, societal openness, economic inequality, and equity market concentration, and decreases with regulatory quality and ambiguity aversion. We confirm with robustness tests that our result for regulatory quality is independent of differences in national wealth and that our result for political stability is independent of both wealth and political legitimacy. These results should be of much interest to managers, scholars, regulators, and policy makers. Ó 2009 Elsevier B.V. All rights reserved.

Keywords: Financial institutions Banks Financial markets Universal banks Comparative financial systems Legal traditions Uncertainty avoidance Trust Property rights

1. Introduction The channeling of funds from savers to investors, or financial intermediation, is a necessary function in all countries and is generally undertaken primarily through financial institutions and/or through financial markets. Either financing channel must resolve the issues of asymmetric information, adverse selection, and agency costs involved in financing contracts that cover the monitoring and collection of funds provided by savers to investors. Given that all optimal contracts are incomplete, the efficacy and efficiency of overcoming these contracting costs depends not only on the legal environment, but also on ethical and other informal conventions, industrial structure, and social and cultural values. As these differ from country to country, and given that institutions and markets differ in how they enforce incomplete contracts, financial institutions may be optimal in some combinations of ethical, cultural, and social conditions while financial markets may be * Corresponding author. Tel.: +1 330 972 5361; fax: +1 330 972 5970. E-mail addresses: [email protected] (R. Aggarwal), [email protected], [email protected] (J.W. Goodell). 0378-4266/$ - see front matter Ó 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2009.03.004

optimal in other conditions. Thus, financial institutions may be favored in some countries while financial markets are favored in other countries. As noted by Demirguc-Kunt and Levine (2001), debate among economists regarding the relative merits of markets and institutions as mechanisms for financial intermediation, has focused mainly on four countries: the USA and UK, as examples of market-based systems, and Germany and Japan, as examples of bank-based systems. The more interesting question seems to be why do countries more generally differ in the composition of financial intermediation, some relying on banks more while others relying more on markets? It would seem that such differences among countries may be related to the legal, cultural, and other such national characteristics, but these national characteristics as have been largely ignored in the literature even though knowledge of such determinants would be important to policy makers and scholars. For instance, is it true that societies with more regulation or with more democratic institutions or with more legal protections have more market-based financial intermediation? Knowledge of the accuracy of such associations would help policy makers avoid

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predicating strategic changes and regulations based on assumptions that may be incorrect, inaccurate, or wrong. Similarly, multinational companies, international banks, and global portfolio managers would also find such information very useful. These issues can indeed have important implications as the nature of the financial system has been shown to influence economic growth rates (Hasan et al., 2009), access to financial services (Honohan, 2008), and the nature of enterprise finance (Islam and Mozumdar, 2007). Unlike prior literature in this area, this paper focuses on the cultural, social, legal, political, and regulatory determinants of national differences in financial intermediation. We use panel data for the recent 8-year period, 1996–2003, from 30 countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, India, Indonesia, Ireland, Italy, Japan, Korea, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Philippines, Portugal, Singapore, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, the United Kingdom and the United States. Annual estimates of market financing relative to financing by institutions is used as the dependent variable in panel regressions to assess the determinants of the preferred national choice of financial intermediation. This paper documents for the first time that national preferences for market financing increase with political stability, openness, equity market concentration, and economic inequality, and decreases with regulatory quality and ambiguity aversion. Some evidence is also found that nations with less official supervision of banking and more private monitoring of banking are more market oriented. We confirm with robustness tests that our results for regulatory quality are independent of differences in national wealth. We also confirm with additional testing that our results for political stability are independent of both wealth and political legitimacy. Given the current heightened interest, regarding the role of regulation in capital markets, and given long-standing discussions regarding linkages between democracy and capital markets, our results should be of great sociological, political, and economic interest.

2. Determinants of financial intermediation 2.1. Cross-country financial intermediation differences Recent discussion of bank-based versus market-based intermediation has focused on comparisons of the financials systems of the US and the UK (primarily market-based) with those of Japan and Germany (primarily bank-based). These differences have been noted to have been associated with the manner of information sharing in these different systems. For example, Kester (1992) notes that main banks in Japan are integral to keiretsu networks that share information regarding firms. Being the largest supplier of capital to the firms in the network, these main banks are also the most informed about the profitability and other financial details of such firms. Kester (1992) also notes that such groups also facilitate information sharing among firms in the network through reciprocal equity ownership. As part of such networks, suppliers can exchange information regarding each other and their customer manufacturers. Similarly, Franks et al. (2006) suggests that banks in Germany, whether alone or within networks, evolved toward custodial ownership of equity for other investors. Both Kester (1992), Franks et al. (2006) suggest that the financial systems of Japan and Germany, in contrast to the US and the UK, are certainly different in part due to differing national styles of regulation. Franks et al. (2006) also suggest that, given the central nature of information sharing in these networks, differing mechanisms of trust are of considerable importance. While it has been suggested

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that information sharing and trust are important in determining the nature of financial intermediation in a country, other related national characteristics have not been examined. Indeed, in spite of much interest in the possible reasons for differences in financial intermediation between market oriented systems in the US and the UK versus the bank oriented systems in Germany and Japan, there has been surprisingly little investigation of the systematic reasons for national differences in financial intermediation. Financing contracts involve monitoring and collection of funds provided by savers to investors and result in a separation of control between the provider and users of funds. They must resolve the resulting fiduciary problems arising from asymmetric information, adverse selection, and agency costs especially since (as noted by Hart (2001) and others) all optimal contracts are incomplete. Two contrasting mechanisms have evolved to solve the financial intermediation problems associated with incomplete financing contracts, financial institutions and financial markets. Both mechanisms must perform the essential functions involved in financial intermediation, i.e., collection of stable deposits, selection of fund recipients, the design of financing contracts, monitoring of the fund recipients, and finally collection of the returns from the financing activity. In fact, institutions and markets usually co-exist in each country and are both complementary and competing channels for financing economic activity. However, the relative efficacy of each of these functions and of the overall process of financial intermediation under incomplete contracting may be quite different depending on the business, economic, legal, social, and cultural environments. Indeed, the proportion of financing provided in a given country by banks and other financial institutions versus that provided by financial markets can be expected to depend on relative transactions costs of enforcing incomplete contracts that are in turn determined by national behavioral, ethical, social, political, and economic characteristics. 2.2. Transaction costs and financing Of course, as noted by Coase (1960), in a theoretically ideal financial system it would make no difference whether financing was privately done through banks or publicly through markets. However, in reality other factors must also be considered. According to North (1990), the costliness of information needed for measurement and enforcement of exchanges creates ‘‘transaction costs.” Transaction costs involve costs of defining property rights and costs of enforcing contracts—including costs of acquiring and processing relevant information. ‘‘Transformation costs” are the costs associated with using technology and the efficiency of factor and product markets and are reflected in transactions costs. Whether institutions lower or raise overall transactions costs has to do in part with the ability of participants to be informed and to understand the nature of the particular institutional environment. This includes not just understanding the nature of contracts and their enforceability, but also the temperament and motivations of other participants. As noted by Williamson (1988) and others, e.g. Aggarwal and Zhao (2009), Transaction Cost Economics (TCE) suggests that when the costs of market exchange are sufficiently high, firms can obtain cheaper financing through some other means. The alternative to market financing is typically through some sort of a prescribed arrangement, such as a bank loan or, more broadly, through a prescribed transfer of resources through a horizontal or vertical network. Williamson (1988) along with Hart (2001, 1995) suggest that, from the point of view of the firm, the choice between debt financing versus equity financing resolves to a choice between respectfully the costs of complying with rules versus the costs of ensuring contract reliability. Hart (2001, 1995) recognize that the primary transactions costs of market exchanges stem from the

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uncertainties of contracts. From the point of view of the equity investor, obtaining reliable information about firms is innately costly and, to some degree, fallible. These costs will be shared with the supplier of equity, causing equity financing to be more costly for the firm. This view is supported by Bhattacharya and Thakor (1993) who suggest that a unifying thread amongst a great number of papers on banking is that ‘‘intermediation is a response to the inability of market-mediated mechanisms to efficiently resolve informational problems.” Modigliani and Perotti (2000) theorize that when societies’ enforcement regimes are not adequate, bank financing is favored. In this instance the binding of transactions becomes more private than public. Such private binding is concomitant with firms having long-term relationships with banks. Modigliani and Perotti (2000) suggest that when the rights of minority (or outside) investors are limited, less equity investment will be available for new enterprises (see Myers, 1977). According to Modigliani and Perotti (2000), in such societies there will be more bank lending instead of financing with public equity. Modigliani and Perotti (2000) also suggest that banks, because of an emphasis on collateral, are less likely or able to differentiate firms with good future prospects versus those with poor future prospects. Alternatively, markets with good governance are better able to distinguish between these types of firms – a view supported by recent literature. For instance, Shirai (2004) reports that, because of improvements in official oversight for the period 1997–2001, Indian capital markets improved significantly in being able to differentiate high-quality firms from low-quality firms. As noted by Modigliani and Perotti (2000), and earlier by Rajan (1992), it is where contract enforcement is weak that collateral is emphasized more, leading to an advantage for bank financing. However, Rajan (1992) notes there are consequences of this: more emphasis on collateral can lead to such an informational advantage for banks that they can charge excessively high interest rates which can weaken economic development. Diamond (1984), Rajan and Zingales (1998) note that when reliable information about firms is too difficult or costly for the general public to obtain, banks provide delegated monitoring. 2.3. Polities and financing The notion that the development of financial markets and institutions is related to the nature of social and political institutions extends at least as far back as Granovetter (1985), who posited that all forms of economic interaction are centered in social relations. Economic and societal environments operate according to same principles and Fligstein (2001) suggests that market participants primarily value stable worlds and that markets are societal solutions to competition. According to Fligstein (2001), governance, property rights, and control rules of exchange for markets develop out of the same societal processes that evolve political institutions. As observed by Modigliani and Perotti (2000), governments have a great deal of power to determine the ‘‘rules of the game.” Further, political influence on governance, and therefore potentially on financial structure, is not limited to codified laws. They suggest a host of possible influences including ‘‘legislation on the role of the supervisory board and its composition”; ‘‘the bankruptcy code”; ‘‘the creation of legal liability for intervening creditors”; ‘‘the rights of banks to represent small shareholders in corporate control”; and ‘‘the ability of large shareholders to act in concert.” While Fligstein (2001) and others do not necessarily suggest that all societies evolve toward the same political solutions, it is natural to consider that national financing predilections are closely related to aspects of respective polities. North (1990) posits that institutions are not necessarily created to provide economic efficiency, but rather to serve the interests of

those with the residual control rights and if economies realize gains from trade by creating efficient institutions, it is only because circumstances provide incentives for those with bargaining strength to alter institutions in ways that coincidently turned out to be economically efficient. Rajan and Zingales (2003c) suggest that incumbents form self-interest groups that influence the polity to impede new competition.1 Rajan and Zingales (2003a) also suggest bank financing rather than market financing is better for channeling explicit and implicit government guarantees so that governments often try to politically control financial intermediaries such as banks. The view that financial incumbents may have influence over respective polities is central to the discussion of the benefits of official supervision of banking. Beck et al. (2006) offer a counterargument to the advocacy of official supervision of banking. They note that ‘‘politicians may act to divert the flow of credit to politically connected firms, or powerful banks may ‘capture’ politicians and induce official supervisors to act in the best interests of banks rather the best interests of society.” The notion that special interest groups can influence the polity to their advantage (e.g. Olson, 1982) or that incumbent firms can lobby to impede healthy capitalist competition (e.g. Rajan and Zingales, 2003c) has also been well discussed in recent literature. Consequently, it has been suggested that private monitoring of banks can replace or supplement the official supervision of banks to improve the efficiency of financial intermediation. This can occur either through an independent government agency requiring accurate information disclosure and/ or the encouragement of the use of subordinated debt by banks which leads to greater private scrutiny. 2.4. Prior evidence on determinants of national financing choices As is clear from the previous section, we suggest that there is much reason to suspect that not only do national cultural, social, legal, and institutional norms play a role in the relative development of alternative financing mechanisms, but so do national political and regulatory structures. However, while previous literature has discussed several theories of how banks and markets are different, as the next section indicates, it generally has not focused on the role of these national factors in determining relative national financing through banks versus markets. There is relatively little prior literature in this area. While Levine (1998) provides a connection between financial system design, laws and regulations, Ergungor (2004) extends this to show that civil-law countries are more likely to be bank-based. Ergungor (2004) argues that this is a result of common-law countries being more adaptable in an environment of incomplete contracts as ‘‘civil-law courts are less effective than their common-law counterparts in resolving conflicts. This is likely as civil-law courts have less flexibility in interpreting the laws and creating new rules.” Ergungor (2004) further argues that in civil-law economies, banks emerge to act as ‘‘primary contract enforcers” while common-law courts provide ‘‘more detailed creditor and shareholder protection laws” encouraging common-law countries to have more developed financial markets compared with civil-law countries. In an extension examining cultural factors that influence financing channels, Kwok and Tadesse (2006) find that nations’ that have a higher level of uncertainty avoidance are more likely to be bank-based while confirming that earlier findings of the significance of legal origin in determining bank-based systems. Aggarwal and Goodell

1 Even though such acts impede the creative/destructive cycle that Schumpeter (1939) described as a benefit of capitalism, and leading to lower levels of innovation and economic growth. According to North (1990), because institutions are not necessarily designed for the sake of efficiency, some inefficient institutional norms may persist for a long time, deprecating the economy.

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(2009) find for a sample of 16 developing economies that a predilection for market financing is associated with increased control of corruption and the particular emerging market being Asian; a decreased predilection for market financing is associated with greater governmental supervision of banking; as well as economic and social openness and an English legal origin. Even though the finance literature has started to show some interest in examining the determinants of national financing structures, this area of study remains under-researched. This paper extends the work of Ergungor (2004), Kwok and Tadesse (2006) as it focuses specifically on the determinants of national financing channels using a range of independent variables that reflect our discussion of the role of national cultural, social, and political norms and how regulation can interact with particular governance environments. This paper also significantly extends the work Aggarwal and Goodell (2009) as it focuses on a wide sample of developed and emerging economies rather than just a sample of emerging markets. Further, unlike Aggarwal and Goodell (2009), this paper uses a 2-stage procedure (discussed below) to control for wealth effects; as well as drawing from recent research distinguishing between political legitimacy and political stability. This paper contributes significantly to our understanding of what partially determines national financing channels using a range of independent variables that reflect governance and regulation as well as national cultural, social, and political aspects. 3. Methodology Our empirical models and their estimates are based on the following equation

X X X yit ¼ ai þ b1  X1it þ b2  X2it þ b3  X3it X þ b4  X4it þ eit

ð1Þ

In Eq. (2), y is domestic stock market capitalization divided by domestic assets of deposit money banks, while X1 represents a number of structural variables, X2 cultural variables, X3 governance variables, and X4 regional variables. The assessment of national financing predilection for markets versus institutions can and should be based on the relative sizes of financial institutions and financial markets in a country as such size measures are more likely to be stable and more representative of inter-national variations (Demirguc-Kunt and Levine, 2001). Our dependent variable, therefore, is the domestic stock market capitalization relative to domestic assets of deposit money banks. This relative measure is constructed by dividing the ratio of domestic stock market capitalization relative to GDP and domestic assets of deposit money banks relative to GDP. Data for these values are obtained from Beck et al. (2000) and Table 1 displays their means and standard deviations. Rajan and Zingales (2003a) suggest that larger firms benefit more from market (‘‘arms-length”) financing than smaller owner operated firms. In indirect support of this view, Kumar et al. (2001) note that amongst European countries, the UK has relatively larger firms and is also relatively more market-based. To account for relative firm size and equity market concentration we establish a Herfindahl index for each country for each year. A Herfindahl index close to 1 would suggest that most market capitalization for a particular country in a given year is due to a small number of firms. This variable being a measure of market concentration is labeled MKT_CONC. Market capitalization data is obtained from the Institutional Brokers Estimate System (I/B/E/S) of Thomson Financial. We speculate in advance of empirical findings that country/years with high market capitalization concentration will be more market-based—that few large firms favor markets while a larger number of smaller firms favor banks.

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In support of this view, Leland and Pyle (1977) argue that banks can communicate inside information about entrepreneurs at lower cost than public lenders or individual entrepreneurs. This arises naturally as firms inevitably exaggerate their positive qualities to the market and further verification of information is costly or very difficult. Leland and Pyle (1977) also argue that informational asymmetries can be significantly assuaged by the signaling effect of investment by known insiders or entities expected to have inside information. In this sense then banks are information brokers (Ramakrishnan and Thakor, 1984). It is reasonable to suppose that both these functions or information collection and verification by banks are very useful in an environment of many smaller firms as opposed to an environment dominated by a few large firms. It is simply more efficient for the marketplace to disseminate information about firms when market capitalization is concentrated in fewer firms. Other literature arguably in support of this view includes Diamond (1991) who suggests that banks benefit new borrowers more than firms with established reputations. Market concentration is also important in controlling for concentrated ownership resulting in the potential for existing owners to influence respective nations’ polity. Further, it has been contended that governments are more efficiently able to exercise political control over a small number of firms directly while a larger number of smaller firms are more efficiently influenced through banks aligned to the polity. La Porta et al. (2002) note that governments can gain control of banks in order to exchange favors for rents. Beck et al. (2006) summarize that ‘‘politicians may act to divert the flow of credit to politically connected firms, or powerful banks may ‘capture’ politicians and induce official supervisors to act in the best interests of banks rather than the best interests of society.” Thus, we can expect nations with higher capital market concentration to be more marketbased. We also include a measure of national economic inequality using the Gini coefficient from the 2005 CIA World Fact Book. Perotti and Von Thadden (2006) offer a ‘‘Median-Voter Theorem” wherein if wealth is concentrated in a rich minority (wealth skewed) ‘‘the median voter has relatively more at stake in the form of firm-specific human capital, and therefore supports dominance by banks.” Further, economic inequality may increase social ‘‘fractionalization” and so lower public trust (Bjornskov, 2008). A lowering of trust would increase the transaction costs of market involvement. However, if the median voter has wealth above a certain tipping point then voting support for equity markets is engendered. In a contrasting view, nations with higher economic inequality may likely be more inclined to have a higher concentration of equity markets. We have already suggested above that a higher concentration of equity will be associated with nations being more market-based. Nations with greater economic inequality might favor market financing as wealthy families may play a significant role in both firm ownership and in the nations polity, alleviating or substituting for the political role of banks (see Roe, 2003; Morck et al., 2000). And so it is unclear from a theoretical view as to whether economic inequality will favor markets or banks. We also examine the ‘‘Anti Self-Dealing” index of Djankov et al. (2008b) (ANTI_SELF_DEAL). This measure seeks to combine into one index, barriers to many forms of investor expropriation that may not explicitly fall into established categories such as consumption of perquisites, managerial effort, and over-investment (Djankov et al., 2008b). Based on a wide survey of attorneys in each country, the ANTI_SELF_DEAL measure does not focus directly on legal measures of investor protection but focuses on other channels for self-dealing activities. Boot and Thakor (1997) posit that societies with fewer barriers to self-dealing will be more bankbased because banks are good monitors. As discussed above, TCE

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Table 1 Summary of data sources. Variable

Mean

Standard deviation

Source

Domestic stock market capitalization divided by domestic assets of deposit money banks GINI WEALTH GLOBALIZATION LEGITIMACY MKT_CONC

0.94

0.73

Ratio formed from measures from Beck et al. (2000)

38.09 3.42 3.28 5.81 0.14

9.54 0.93 0.93 1.27 0.12

TAX DEPOSIT_INS

0.60 0.83

2.49 0.37

UNCERTAIN_AVOID ENGLISH_LEGAL POL_STAB REG_QUAL DEBT_EFFICIENCY ANTI_SELF_DEAL OFFICIAL_POWER PRIV_MONITOR ACT_RESTRICT

62.81 0.36 0.63 1.02 67.41 0.52 72.18 85.60 79.36

24.00 0.48 0.89 0.64 26.17 0.24 8.06 17.18 11.65

Gini coefficient from the 2005 CIA World Fact Book Nations classified according to wealth from Beck et al. (2000) And index of social and economic openness from Dreher (2006) An index of political legitimacy from Gilley (2006) Herfindahl index for each country/year created for this paper. Value close to 1 would suggest that most market capitalization for a particular country in a given year is being reflected by a small number of firms Dividend-tax advantage of La Porta et al. (2000) Dummy variable that gets a ‘‘1” if the nation has deposit insurance and zero otherwise. From Demirguc-Kunt and Sobaci (2001) Uncertainty avoidance from Hofstede (2001) La Porta et al. (2006) Kaufmann et al. (2008) Kaufmann et al. (2008) Efficiency of debt enforcement from Djankov et al. (2008a) Anti Self-Dealing index of Djankov et al. (2008b) Index of Official Power from Beck et al. (2000) Index of private monitoring from Beck et al. (2000) Index of activity restriction from Beck et al. (2000)

This table lists the mean, standard deviations and sources of variables used in panel regressions which are reported in Tables 2 and 3.

would suggest that transaction costs of market participation are reduced if the contracts inherent in market participation are made more secure. For related reasons we include a dummy 0, 1 variable for legal origin, English or other (ENGLISH_LEGAL) with a value of 1 if the country has an English legal origin (La Porta et al. (2006). This variable is included because many theorize that common-law systems offer better investor protection (e.g. Johnson et al. (2002). Additionally, prior research, namely Ergungor (2004), Kwok and Tadesse (2006), find legal origin to be significant in partially determining whether nations are either market- or bank-based. Because of its relation to TCE and perceived risks of expropriation as discussed above we include uncertainty avoidance (UNCERTAIN_AVOID) from the cultural dimensions of Hofstede (2001) as an independent variable. As also noted above, Kwok and Tadesse (2006) find that uncertainty avoidance is a significant determinant of nations’ financing choices such that nations with higher uncertainty avoidance favor institutions over markets. We also include a more pointed measure of regulatory efficiency, a factor for the efficiency of debt enforcement from Djankov et al. (2008a) (DEBT_EFFICIENCY). This variable captures the efficiency of creditor rights enforcement in the case of a business in default. We expect that improved efficiency of debt enforcement will favor banking and so this variable is included to help determine if improved regulatory quality improves markets more than banks. In many countries tax rates on dividends and capital gains differ with lower rates on capital gains. Such tax laws are likely to favor equity investments by imposing a lower tax rate on capital gains while the tax rates on dividends is the same as for interest income from debt. Thus, we control for this factor with a variable TAX where TAX is the dividend-tax advantage as defined and assessed in La Porta et al. (2000). We expect countries with more of a dividend-tax advantage to favor banking as in such cases the advantage of lower capital gains taxation is less. We begin our period of study in 1996 as there is insufficient data from I/B/E/S for many countries prior to 1996 to calculate our Herfindahl index measure of market concentration. Another important reason, however, is that the measures we use for political stability and regulatory from Kaufmann et al. (2008) are only available from 1996. Generally, our sample is restricted to those country/years which have sufficient data reported by I/B/E/S and

are included by Kaufmann et al. (2008). However, we feel our sample of countries has a great deal of breadth across regions, cultures, legal origins and difference in national wealth. Table 1 presents the means, and standard deviations of the variables used in our models. Together these independent variables reflect the factors we described earlier that may affect nations’ financing predilections: cultural and social measures, governance, and economic inequality, as well as factors controlling for market concentration, taxation, deposit insurance, efficiency of debt enforcement, and legal origin.2 We estimate models that focus on structural variables then add in turn a regional variable, and then cultural, governance, and security protection variables. In selecting these independent variables we have managed to avoid excess correlation among them and all estimated models have variance inflation factors (VIF) of less than 10 for all regressors indicating that any multicollinearity is unlikely to be a problem. In subsequent robustness checks we also address other specific correlations amongst particular pairs of independent variables. For all of our models, Hausman tests are insignificant and so we report randomeffects estimates. 4. Results 4.1. Determinants of financial institutions versus markets Table 2 shows the results of regressions using relative size of financial institutions versus financial markets as the dependent variable. For independent variables, Model 1 uses just the structural variables: economic inequality (GINI) and concentration of equity market capitalization (MKT_CONC); as well as controlling for a dividend-tax advantage (TAX) and the presence of deposit insurance (DEPOSIT_INS). Results show MKT_CONC positively significant at the 1% level. This suggests that concentration of equity market capitalization is associated with nations being more market-based. No other variables are significant in this model. With all models in Table 2, a Wald Chi-Square test is significant at the 2 In selecting these independent variables to capture governance, security laws and other factors we have tried to avoid excess correlations among the independent variables (described further below is how we have avoided multicollinearity while ensuring a comprehensive model).

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R. Aggarwal, J.W. Goodell / Journal of Banking & Finance 33 (2009) 1770–1780 Table 2 Cross-national determinants of the relative market versus institutional financing: results of panel data regressions 1996–2003. Dependent variable: domestic stock market capitalization relative to domestic assets of deposit money banks

Model 1

2

3

4

5

INTERCEPT GINI MKT_CONC TAX DEPOSIT_INS UNCERTAIN_AVOID ENGLISH_LEGAL POL_STAB REG_QUAL DEBT_EFFICIENCY ANTI_SELF_DEAL REGION_EUROPE Observations (countries) Hausman Wald chi2

0.89 (0.331) 0.02 (0.173) 3.75*** (0.000) 0.99 (0.162) 0.32 (0.379)

0.80 (0.444) 0.02 (0.244) 3.75*** (0.000) 0.99 (0.171) 0.34 (0.378)

0.85 (0.399) 0.03 (0.112) 3.74*** (0.000) 0.87 (0.190) 0.01 (0.976) 0.01** (0.024) 0.09 (0.785)

1.25 (0.340) 0.03 (0.234) 3.78*** (0.000) 0.98 (0.180) 0.03 (0.940) 0.01** (0.029) 0.11 (0.797) 0.32*** (0.003) 0.29** (0.021) 0.00 (0.769)

227 (30) 0.13 (0.715) 95.99*** (0.000)

0.06 (0.850) 227 (30) 0.12 (0.728) 95.66*** (0.000)

0.16 (0.576) 227 (30) 0.15 (0.698) 106.10*** (0.000)

0.05 (0.896) 220 (29) 0.42 (0.935) 117.76*** (0.000)

1.62 (0.277) 0.02 (0.335) 3.78*** (0.000) 0.96 (0.197) 0.01 (0.988) 0.01** (0.036) 0.37 (0.564) 0.32*** (0.004) 0.29** (0.019) 0.00 (0.723) 0.54 (0.589) 0.03 (0.937) 220 (29) 0.80 (0.849) 117.54*** (0.000)

GINI is the Gini coefficient from the 2005 CIA World Fact Book; UNCERTAIN_AVOID is uncertainty avoidance from Hofstede (2001), ENGLISH_LEGAL is a dummy that gets 1 if nation has English legal origin, MKT_CONC is a Herfindahl index of market concentration; TAX is the dividend tax advantage of La Porta et al. (2000); DEPOSIT_INS is a dummy that gets 1 if nation explicitly has deposit insurance; ANTI_SELF_DEAL is the Anti Self-Dealing index of Djankov et al. (2008b); POL_STAB and REG_QUAL are from Kaufmann et al. (2008); DEBT_EFFICIENCY is the efficiency of debt enforcement from Djankov et al. (2008a); REGION_EUROPE is a dummy that gets 1 if nation is European. Randomeffects estimations reported. All variance inflation factors less than 10. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level.

1% level and the Hausman test is insignificant and so only the random-effects estimation is reported. Model 2 adds a regional dummy variable for Europe (REGION_EUROPE) to the independent variables of Model 1. As discussed above, it is theorized that the banking environment of Europe has many unique aspects. MKT_CONC is still significantly positive at the 1% level. Other variables, including REGION_EUROPE are not significant. Model 3 adds two cultural variables to the independent variables used in Model 2: a dummy for English legal origin and a measure of uncertainty avoidance from Hofstede (2001). MKT_CONC is again significantly positive at the 1% level. ENGLISH_LEGAL is not significant. On the other hand, UNCERTAIN_AVOID is negatively significant at the 5% level. Supporting earlier research, this suggests that nations with greater uncertainty avoidance are more bank-based. Model 4 adds to the independent variables of Model 3, variables that capture efficiency of governance: political stability (POL_STAB), regulatory quality (REG_QUAL) and efficiency of debt enforcement (DEBT_EFFICIENCY). POL_STAB is significantly positive at the 1% level, suggesting that nations with more political stability are more market-based. REG_QUAL is significantly negative at the 5% level, suggesting that nations with greater regulatory quality are more bank-based. This might suggest that improvements in regulatory efficiency (as measured by Kaufmann et al. (2008) advance banking efficiency more than market efficiency. DEBT_EFFICIENCY is not significant. As before, MKT_CONC is again significantly positive at the 1% level. UNCERTAIN_AVOID is again significantly negative at the 5% level. Model 5 adds to the independent variables of Model 4, a variable that measures comprehensively the barriers to self-dealing (ANTI_SELF_DEAL). ANTI_SELF_DEAL is not significant.3 As before, 3 However the correlation of ANTI_SELF_DEAL is 0.79 with ENGLISH_LEGAL. We address this issue of correlation in subsequent robustness models presented in Table 3. There are other noteworthy correlations that consequently addressed further in the discussion of Table 3.

MKT_CONC is again significantly positive at the 1% level. UNCERTAIN_AVOID is again significantly negative at the 5% level. POL_STAB is again significantly positive at the 1% level, while REG_QUAL is again significantly negative at the 5% level. The results presented in Table 2 indicate that MKT_CONC is positively significant at the 1% level in all models. UNC_AVOID is negatively significant at the 5% level all models in which it is present. POL_STAB is positively significant at the 1% level all models in which it is present. REG_QUAL is negatively significant at the 5% level all models in which it is present. These consistent results document that societies are more market-based if they have higher concentration in equity market capitalization, greater political stability, lower regulatory quality, and lower uncertainty avoidance. 4.2. Robustness checks: Determinants of markets versus institutions As noted above, as governance factors, we have included in our models in Table 2 independent variables measuring regulatory quality and political stability. These measures are initially taken from Kaufmann et al. (2008). However, we report in Table 3 results designed to test whether the significance we have reported for these variables in Table 2 is independent of effects of crossnational variation in wealth. In order to do this we employ a two-stage model. We first regress the respective independent variable (either regulatory quality index or political stability index of Kaufmann et al. (2008)) on our measure of wealth along with other related cultural variables. Specifically we regress regulatory quality on wealth (WEALTH) as well as on dummy variables that respectively are assigned ‘‘1” in the nation’s dominant religion is Protestantism (PROTESTANT) and ‘‘1” if the nation’s dominant religion is Catholicism (CATHOLIC). This follows from Stulz and Williamson (2003) who find that religion is an important determinant of cross-national creditor rights and other regulatory aspects. We then use the residuals from these regressions as our independent variables in Eq. (1). Our WEALTH variable assigns a number 1–4 based on income group and is from Beck et al.

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Table 3 Cross-national determinants of the relative market versus institutional financing: results of robustness panel data regressions 1996–2003. Dependent variable: domestic stock market capitalization divided by assets of deposit money banks

Model R1

R2

R3

R4

R5

INTERCEPT GINI GLOBALIZATION WEALTH MKT_CONC TAX UNC_AVOID ORTHOG_POL_STAB ORTHOG_POL_LEGIT ORTHOG_REG_QUAL PRIV_MONITOR ACT_RESTRICT OFFICIAL_POWER DEPOSIT_INS DEBT_EFFICIENCY ANTI_SELF_DEAL Observations (countries) Hausman Wald chi2

0.10 (0.924) 0.04*** (0.009) 0.22** (0.010) 0.06 (0.635) 3.97*** (0.000) 0.82 (0.175) 0.01*** (0.004) 0.23** (0.028) 0.07 (0.639) 0.47*** (0.000)

0.27 (0.814) 0.04*** (0.005) 0.20** (0.023) 0.18 (0.259) 4.11*** (0.000) 1.14* (0.092) 0.01*** (0.034) 0.22** (0.038) 0.06 (0.684) 0.45*** (0.001) 0.30 (0.113) 0.02 (0.645) 0.16* (0.063)

0.11 (0.928) 0.04*** (0.004) 0.19** (0.026) 0.18 (0.262) 4.10*** (0.000) 1.06 (0.127) 0.01** (0.026) 0.22** (0.038) 0.05 (0.755) 0.45*** (0.001) 0.35* (0.085) 0.03 (0.565) 0.16* (0.068) 0.27 (0.453)

0.13 (0.938) 0.04** (0.015) 0.19** (0.042) 0.20 (0.436) 4.11*** (0.000) 1.17 (0.169) 0.01** (0.040) 0.21* (0.060) 0.03 (0.862) 0.47*** (0.001) 0.34 (0.142) 0.03 (0.621) 0.16* (0.094) 0.26 (0.509) 0.00 (0.927)

203 (27) 5.19 (0.268) 140.17*** (0.000)

195 (26) 3.62 (0.460) 151.36*** (0.000)

195 (26) 3.87 (0.424) 151.18*** (0.000)

195 (26) 3.12 (0.538) 142.59*** (0.000)

0.16 (0.916) 0.05*** (0.007) 0.02** (0.031) 0.17 (0.347) 4.08*** (0.000) 1.09 (0.171) 0.01** (0.031) 0.19* (0.083) 0.05 (0.751) 0.48*** (0.001) 0.43* (0.098) 0.02 (0.737) 0.14 (0.134) 0.16 (0.693) 0.00 (0.860) 0.48 (0.536) 188 (25) 7.81* (0.099) 147.17*** (0.000)

This table adds banking-regulation variables to the set of independent variables used in Table 2. OFFICIAL_POWER, PRIV_MONITOR, ACT_RESTRICT are indices of official power, private monitoring and activity restriction from Barth et al. (2001). GINI is the Gini coefficient from the 2005 CIA World Fact Book; GLOBALIZATION is an index of social and economic openness from Dreher (2006). WEALTH is the classification of nations’ wealth from Beck et al. (2000). MKT_CONC is a Herfindahl index of market concentration; TAX is the dividend tax advantage of La Porta et al. (2000); UNCERTAIN_AVOID is uncertainty avoidance from Hofstede (2001); ORTHOG_POL_STAB and ORTHOG_REG_QUAL are measures of political stability and regulatory quality original taken from Kaufmann et al. (2008) but made orthogonal to wealth. ORTHOG_POL_LEGIT is a measure of political legitimacy from Gilley (2006) but made orthogonal to wealth. Consistently significant variables are in bold. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level.

(2000). Our CATHOLIC and PROTESTANT values are from Stulz and Williamson (2003).

X X regulatory qualityit ¼ ai þ b1  WEALTHit þ b2  PROTESTANTit X þ b3  CATHOLICit þ eit ð2Þ X X political stabilityit ¼ ai þ b1  WEALTHit þ b2  PROTESTANTit X þ b3  CATHOLICit þ eit ð3Þ We then include the residuals from Eqs. (2) and (3) as substitute independent variables for REG_QUAL and POL_STAB respectively. We refer to these variables as orthogonal regulatory quality (ORTHOG_REG_QUAL) and orthogonal political stability (ORTHOG_POL_STAB) as they are effectively orthogonal against wealth. In our robustness tests we also control for ‘‘political legitimacy,” using an index established by Gilley (2006). This index is the result of the testing of a number of major theories of legitimacy. Based on tests, scores of legitimacy are based on good governance, democratic rights, and welfare gains. Controlling for legitimacy is motivated by a desire to further dissect our political stability results in Table 2. We also orthogonalize our measure of political legitimacy (ORTHOG_POL_LEGIT) as we have done for political stability and regulatory quality (see Eq. (4)).

X political legitimacyit ¼ ai þ b1  WEALTHit X þ b2  PROTESTANTit X þ b3  CATHOLICit þ eit

ð4Þ

In Table 3, we also control for market openness with the Index of Globalization of (Dreher, 2006). This index incorporates a large variety of measures to assess economic, political and social openness: barriers to trade and tariffs, portfolio investment, foreign direct investment, as well as social factors as outgoing telephone traffic amount of foreign population, and data on information flows

such as internet use, as well as membership in international organizations, and number of embassies.4 Hausler (2002) observes that globalization is changing the nature of banking, encouraging banks to merge with other banks as well as with securities and insurance firms in efforts to remain competitive. More importantly, Hausler (2002) asserts that globalization has led to a greater amount of financial intermediation to occur via tradable securities rather than bank loans and deposits noting that globalization has not only led to banks underwriting more corporate bond and equity issues but also that banks are increasingly turning to capital markets to raise funds for their investment and lending activities. Globalization of the banking industry may be strongly associated with cross-border capital flows and with the development and adoption of international banking regulatory standards. Table 3 also reports results of models which include independent variables from Barth et al. (2001). We use three measures of banking regulation: an official power index (OFFICIAL_POWER), an index of private monitoring of banks (PRIV_MONITOR) and an index of activity restrictions faced by banks (ACT_RESTRICT). The official power index is a composite measure of the legal authority of the supervising agency overseeing banks. Such measures include whether the supervisory agency has the power to meet with external auditors, or take action against them for negligence, or whether it can remove and replace directors or management, or force other new provisions, or suspend dividends. Beck et al. (2006) associates a higher OFFICIAL_POWER score with a lower need for firms to have corrupt ties with banks in order to get loans. The Private Monitoring Index is a composite measure of legal regulations that facilitate the private monitoring of banks. These measures include publishing and auditing requirements for banks and the requirement for bank officials to be legally liable for the accuracy of dis-

4 The list of variables used with relative weights is at http://globalization.kof.ethz.ch/static/pdf/variables_2008.pdf.

R. Aggarwal, J.W. Goodell / Journal of Banking & Finance 33 (2009) 1770–1780

closed statements. It also includes a dummy variable for whether subordinated debt is allowed. Beck et al. (2006) associates a higher Private Monitoring Index with more incentives for private monitoring of banks. The activities restriction is an index of regulatory restrictions regarding banks holding non-financial assets. Additionally, the model estimates presented in Table 3 remove some independent variables with high correlations with another independent variable used in these new models. For instance, we remove from the models our dummy variable REGION_EUROPE as its correlation with GINI is –0.66. Similarly, we also remove ENGLISH_LEGAL as the correlation between this variable and ANTI_SELF_DEAL is 0.79. Pearson correlations coefficients are presented in Appendix 1. Model R1 of Table 3 uses the structural and cultural independent variables GINI, GLOBALIZATION, WEALTH, MKT_CONC, TAX, UNC_AVOID, as well as our three variables that are orthogonal against wealth: ORTHOG_POL_STAB, ORTHOG_POL_LEGIT, ORTHOG_REG_QUAL. The results show a number of significant variables. GINI, ORTHOG_REG_QUAL, MKT_CONC, UNC_AVOID are all significant at the 1% level while GLOBALIZATION and ORTHOG_POL_STAB are significant at the 5% level. Model R2 adds to the independent variables in Model R1 the three banking-regulation variables OFFICIAL_POWER, PRIV_MONITOR, and ACT_RESTRICT. These additions result in little change to the significance of the independent variables: ORTHOG_POL_STAB is still positively significant at 5% level, and ORTHOG_REG_QUAL is still negatively significant at the 1% level. GINI is still positively significant at the 1% level. UNC_AVOID is still negatively significant, now at the 5% level. TAX and OFFICIAL_POWER are negatively significant at the 10% level. MKT_CONC is again positively significant at the 1% level, while GLOBALIZATION is again positively significant now at the 5% level. Model R3 adds the variable for deposit insurance to the variables in Model R2. This again results in little change to the significance of the independent variables: ORTHOG_POL_STAB is again positively significant at 5% level, and ORTHOG_REG_QUAL is still negatively significant at the 1% level. GINI is still positively significant at the 1% level. UNC_AVOID is now negatively significant at the 5% level. OFFICIAL_POWER is still negatively significant at the 10% level, while TAX is not significant. PRIV_MONITOR is now positively significant at the 10% level, suggesting that greater private monitoring is associated with nations being more market-based. This is intuitively reasonably as much private monitoring occurs through documentation that ensues through issuing securities. MKT_CONC is again positively significant at the 1% level, while GLOBALIZATION is again positively significant now at the 5% level. Model R4 adds the variable for efficiency of debt enforcement to the variables in Model R3. This results in ORTHOG_POL_STAB being significant now only at the 10% level. However, ORTHOG_REG_QUAL remains negatively significant at the 1% level. UNC_AVOID is still negatively significant at the 5% level. OFFICIAL_POWER is still negatively significant at the 10% but PRIV_MONITOR is now not significant. MKT_CONC is again positively significant at the 1% level, while GLOBALIZATION is again positively significant at the 5% level. GINI is again significantly positive but now only at the 5% level. Model R5 adds the variable ANTI_SELF_DEAL to the variables in Model R4. This results few changes. PRIV_MONITOR is again significant at the 10% level, as it was in Model R3, while OFFICIAL_POWER is no longer significant. All other variables remain as significant as they were in Model R4. Overall, the results of robustness checks presented in Table 3 extend and support the evidence presented in Table 2: societies are more market-based if they have higher concentrations in equity market capitalization, more political stability, less regulatory quality, and less uncertainty avoidance. Table 3 also documents that when adding banking-regulation variables to the independent

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variables of Table 2 and removing some correlation amongst the variables, GINI is consistently positively significant. This suggests that nations with more economic inequality are more marketbased. The results of Table 3 also evidence that nations that are more open as measured by our variable for globalization are more inclined toward market financing. In particular, the results presented in Table 3 support that our evidence of Table 2 for the association of more regulatory quality with nations being less market-based, is independent of wealth effects. Table 3 also generally affirms that our results for the association of political stability with nations being more market-based is independent of both wealth and political legitimacy—although our orthogonal variable for political stability is positively significant at only the 10% level in the more comprehensive models. 4.3. General discussion of results As observed above, we document that our measure of regulatory quality from the indicators of governance of Kaufmann et al. (2008) is negatively significant at the 5% level for all models in Table 2 in which it is present. Further our measure of regulatory quality that is orthogonal to wealth is negatively significant at the 1% level for all models in Table 3. We interpret this as suggesting that over a broad sample of countries, improved regulatory quality favors banking efficiency more than market efficiency. As mentioned above, we find political stability to be positively significant. This result is independent of effects of wealth and political legitimacy. Fligstein (2001) suggests that market participants primarily value stable worlds and that markets are state directed societal solutions to competition. According to Fligstein (2001), governance, property rights, control rules of exchange develop out of the same societal processes that evolve political institutions. We suggest this result is consistent with the notion that the transfer of both information and political-services through financial systems is primarily done by banks when markets are not able to efficiently also do these functions. And so, to lessen the importance of banks in supporting these functions, societies require political stability. We should note that while our results show a strong association of political stability with a predilection for markets, so far we have not demonstrated causality. Fligstein (2001) suggests both that stable worlds develop markets and that markets cause political worlds to be more stable. Further it is possible that the development of markets assists the development of regulation. In this regard, we note that the correlation coefficients between our dependent variable and our measures of political stability and regulatory quality are 0.13 and 0.19 respectively. However, the correlation between our dependent variable and our orthogonal measures of political stability and regulatory quality are only 0.02 and 0.07 respectively. Further our results indicate a negative association of our dependent variable and regulatory quality and not a positive association. Also, our dependent variable is not capturing market development per se but rather the relative development of markets as compared to banking. And so we suggest that our results for political stability and regulatory quality, particularly the results for the orthogonal versions of these variables reported in Table 3, are unlikely to be unduly influenced by endogeneity. We document that our Herfindahl index for concentration of market capitalization is positively significant at the 1% level for all models in which it is present. This strongly supports our theoretical contention that, because of more efficient dissemination of information, nations with higher market capitalization concentration tend to be more market-based. This finding is interesting in light of the observation of Tadesse (2002) that ‘‘countries dominated by small firms grow faster in bank-based systems and those dominated by larger firms in market-based systems.” This finding

5 Additionally, Djankov et al. (2008a) note that quality of debt enforcement is correlated with quality of legal protection. However for our sample the correlation coefficient for this set of variables as reported in Appendix 1, is only 0.23. 6 Rajan and Zingales (2003b) note that in the beginning of 20th century, civil law countries had relatively more developed securities markets.

1 1 0.206 1 0.106 0.059 1 0.187 0.123 0.007 1 0.197 0.316 0.136 0.430 1 0.296 0.079 0.013 0.046 0.023 1 0.369 0.525 0.236 0.098 0.189 0.122 1 0.796 0.245 0.705 0.122 0.346 0.208 0.339 1 0.574 0.720 0.539 0.575 0.083 0.161 0.087 0.085

OFFICIAL_POWER PRIV_MONITOR ANTI_SELF_DEAL DEBT_EFFICIENCY ORTHOG_POL_LEGIT OTHOG_REG_QUAL REG_QUAL ORTHOG_POL_STAB POL_STAB

1 0.820 0.816 0.591 0.399 0.710 0.008 0.370 0.115 0.286 POL_STAB ORTHOG_POL_STAB REG_QUAL ORTHOG_REG_QUAL ORTHOG_POL_LEGIT DEBT_EFFICIENCY ANTI_SELF_DEAL PRIV_ MONITOR OFFICIAL_POWER ACT_RESTRICT

is also consistent with the idea of North (1990) that markets are more likely to be self-enforcing when there is a smaller number of participants. These results are also consistent with the assertion of Rajan and Zingales (2003a) that that larger firms benefit more from markets (see also Kumar et al., 2001). We find no significance of the Gini coefficient in Table 2. However, in Table 3 where we introduce banking-regulation variables and eliminate some more correlated variables, GINI is consistently positively significant. This suggests that, in contrast to Perotti and Von Thadden (2006), greater economic inequality is associated with nations being more market-based. Kwok and Tadesse (2006) do not find a variable for trade openness to be significant in their study. However, we find GLOBALIZATION, which, as discussed above is a much broader measure of openness than other measures previously used, to be consistently significantly positive. We interpret our results for globalization as suggesting that societal openness is generally associated more with the development of markets than with the development of banking. Our evidence strongly affirms the conclusion of Kwok and Tadesse (2006) that nations’ with higher uncertainty avoidance (Hofstede, 2001) are more bank-based. We find uncertainty avoidance to be consistently negatively significant at the 5% level. However, unlike prior research (Ergungor, 2004; Demirguc-Kunt and Levine, 2001; Kwok and Tadesse, 2006), we do not find legal origin to be significant in determining nations’ financing choices as perhaps our use of a wider set of independent variables subsumes the impact of legal origin. It is perhaps relevant in this context that we include measures of banking regulation and the more recent index of Anti Self-Dealing of Djankov et al. (2008b) which incorporates most advantages of English legal origin, i.e., higher protection against minority stockholder expropriation.5 Dam (2006) suggests that if legal origins theory is correct, the Kaufmann et al. (2008) governance measure for Rule of Law should in theory be well correlated with legal origin. For our sample, the coefficient of correlation of the Rule of Law measure from Kaufmann et al. (2008) with our dummy variable for common law is only 0.05. Related to this, Pagano and Volpin (2005) suggest that the ‘‘new political economy” view disputes the theory of legal origins as it considers laws changeable by constituents responding to self-interests.6 We find that the private monitoring of banks (Barth et al., 2001) is positively significant at the 10% level for some of the models in which it is present. Societies with highly monitored banks are more likely to be oriented to financial markets. We also find, at the 10% level, of official supervision of banking and societies being more bank-based. Regarding TCE as a theoretical underpinning of why societies choose particular financing, we do find some but limited evidence. The strongest evidence we have on this point is the consistently negative significance of uncertainty avoidance. Nations with more uncertainty avoidance are more bank-based. As discussed above, we interpret uncertainty avoidance as raising the transaction costs for financial-markets participation. Similarly, improved regulatory quality that lowers transactions costs for banks is robustly associated with nations being more bank-based. However, we find considerable evidence that nations’ financing choices are related to issues of political economy. We find a positive association of political stability with a predilection for markets. Controlling for political legitimacy, we find this association to be due to simply the ability of state to continue functioning as distinct from pro democratic or antiauthoritarian aspects of governance. Our finding of a negative association of regulatory quality

ACT_RESTRICT

R. Aggarwal, J.W. Goodell / Journal of Banking & Finance 33 (2009) 1770–1780

Table A1 Pearson correlation coefficients of cultural, governance, securities and banking variables.

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R. Aggarwal, J.W. Goodell / Journal of Banking & Finance 33 (2009) 1770–1780 Table A2 Pearson correlation coefficients of structural and regional variables.

ENGLISH_LEGAL UNC_AVOID GINI WEALTH GLOBALIZATION DEPOSIT_INS MKT_CONC TAX REGION_EUROPE

ENGLISH_LEGAL

UNC_AVOID

GINI

WEALTH

GLOBALIZATION

DEPOSIT_INS

MKT_CONC

TAX

REGION_EUROPE

1 0.494 0.222 0.082 0.059 0.595 0.042 0.006 0.440

1 0.124 0.143 0.322 0.214 0.060 0.040 0.068

1 0.384 0.589 0.154 0.047 0.120 0.662

1 0.457 0.150 0.063 0.352 0.358

1 0.060 0.016 0.135 0.453

1 0.046 0.265 0.400

1 0.225 0.088

1 0.130

1

with a predilection for markets is consistent with the so-called ‘‘new political economy.” In this view, regulation and its enforcement result from a balance of power between political and economic constituencies, with policy makers being self-interested agents. And so regulation is typically flawed, stifling financial markets and entrenching incumbents (Pagano and Volpin, 2005). Our findings that nations that have a high concentration of equity ownership and low regulation are more inclined toward markets is also consistent with the observation of Pagano and Volpin (2005) that for larger firms that rely on internal finance, the cost of equity is a sunk cost. And so any effect of poor regulation on the cost of equity is diminished in importance. 5. Conclusions The legal, cultural, and other national determinants of why a society is bank-based or market-based have been largely ignored in the literature. Knowledge of such determinants would be important to policy makers and scholars especially in countries where the financial system is still very much in evolution. This paper focuses on the financing system choices in 30 markets: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, India, Indonesia, Ireland, Italy, Japan, Korea, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Philippines, Portugal, Singapore, South Africa, Spain, Sweden, Switzerland Thailand, Turkey, the United Kingdom and the United States. Annual estimates for a recent 8year period (1996–2003) of relative financing through markets and institutions for these 30 countries are used in panel estimates. This paper documents for the first time that national preferences for market financing increase with political stability, societal openness, economic inequality and equity market concentration, and decreases with regulatory quality and ambiguity aversion. We confirm with robustness tests that our result for regulatory quality is independent of differences in national wealth. We also confirm that our result for political stability is independent of both wealth and political legitimacy. Given the current heightened interest, particularly in the United States, regarding the role of regulation in capital markets, and given long-standing discussions regarding linkages between democracy and capital markets, our results are likely to be of great policy and practical interest. For example, these results are likely to be of interest in assessing the impact of political and sociological developments on banks and other financial institutions. Thus, scholars in political economy and sociology, in addition to scholars in finance and banking, are likely to find these results interesting as are managers of multinational firms, international banks, and global portfolios. Acknowledgements The authors are grateful to A. Akhigbe, R. Barniv, M. Boschi, S. Dow, M. Ellis, I. Ismailescu, F. Laurin, J. Thornton, participants at

the 2008 INFINITI Conference at Trinity College in Dublin, and other colleagues for useful comments but remain solely responsible for the contents. Appendix A See Tables A1 and A2. References Aggarwal, R., Goodell, J.W., 2009. Markets versus institutions in developing countries: National attributes as determinants. Emerging Markets Review 10, 51–66. Aggarwal, R., Zhao, S., 2009. The diversification discount puzzle: Empirical evidence for a transactions cost resolution. Financial Review 44, 113–135. Barth, J.R., Caprio, G., Levine, R., 2001. The regulation and supervision of banks around the world: A new database. In: Litan, R.E., Herring, R. (Eds.), BrookingWharton Papers on Financial Services. Washington DC, Brookings Institution. Beck, T., Demirguc-Kunt, A., Levine, R., 2000. A new database on financial development and structure. World Bank Economic Review 14, 597–605. Beck, T., Demirguc-Kunt, A., Levine, R., 2006. Bank supervision and corruption in lending. Journal of Monetary Economics 53, 2131–2163. Bhattacharya, S., Thakor, A.V., 1993. Contemporary banking theory. Journal of Financial Intermediation 3, 2–50. Bjornskov, C., 2008. Social trust and fractionalization: A possible reinterpretation. European Sociological Review 24, 271–283. Boot, A.W.A., Thakor, A.V., 1997. Financial system architecture. Review of Financial Studies 10, 693–733. Coase, R.H., 1960. The problem of social cost. Journal of Law and Economics 3, 1–44. Dam, K.W., 2006. The Law-Growth Nexus: The Rule of Law and Economic Development. Brookings Institution Press, Washington, DC. Demirguc-Kunt, A., Levine, R., 2001. Bank-based and market-based financial systems: Cross-country comparisons. In: Demirguc-Kunt, A., Levine, R. (Eds.), Financial Structure and Economic Growth: A Cross-Country Comparison of Banks, Markets, and Development. MIT Press, Cambridge, Massachusetts. Demirguc-Kunt, A., Sobaci, T., 2001. Deposit insurance around the world: A new development database. The World Bank Economic Review 15, 481–490. Diamond, D.W., 1984. Financial intermediation and delegated monitoring. Review of Economic Studies 51, 393–414. Diamond, D.W., 1991. Monitoring and reputation: The choice between bank loans and directly placed debt. Journal of Political Economy 99, 689–721. Djankov, S., Hart, O., McLiesh, C., Shleifer, A., 2008a. Debt enforcement around the world. NBER Working Paper 12807. Djankov, S., La Porta, R., Lopez-de-Silvanes, F., Shleifer, A., 2008b. The law and economics of self-dealing. Journal of Financial Economics 88, 430–465. Dreher, A., 2006. Does globalization affect growth? Evidence from a new index of globalization. Applied Economics 38, 109–1110. Ergungor, O.E., 2004. Market- vs. bank-based financial systems: Do rights and regulations really matter? Journal of Banking and Finance 28, 2869–2887. Fligstein, N., 2001. The Architecture of Markets: An Economic Sociology of TwentyFirst-Century Capitalist Societies. Princeton University Press, Princeton, NJ. Franks, J., Mayer, C., Wagner, H., 2006. The origins of the German corporation– finance, ownership and control. Review of Finance 10, 537–585. Gilley, B., 2006. The determinants of state legitimacy: Results for 72 countries. International Political Science Review 27, 47–71. Granovetter, M., 1985. Economic action and social structure: The problem of embeddedness. American Journal of Sociology 91, 481–510. Hart, O., 1995. Firms, Contracts, and Financial Structure. New York, Oxford University Press. Hart, O., 2001. Financial contracting. Journal of Economic Literature 39, 1079–1100. Hasan, I., Wachtel, P., Zhou, M., 2009. Institutional development, financial deepening and economic growth: Evidence from China. Journal of Banking and Finance 33, 157–170. Hausler, G., 2002. The globalization of finance. Finance and Development 39, 10–12. Hofstede, G., 2001. Culture’s Consequences. London, Sage Publications.

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