Economic Performance in Bank-Based and Market-Based Financial Systems: Do Non-Financial Institutions Matter?

Based on a sample of 87 countries, this paper shows that non-financial institutions, specifically rule of law, do matter for the relative merits of bank-based and market-based financial systems. Market-based systems work better in low rule of law countries, while bank-based systems are more efficient in high-rule of law countries. These results are consistent with the premise that market-based systems’ superiority in solving the incomplete information problem dominates over bank-based systems’ superiority in solving the moral hazard and contract enforcement problems, which are expected to be more prevalent in low rule of law countries. Additionally, the level of financial development also matters in the relative performance of market-based and bank-based financial systems. Marketbased systems function better in financially developed economies, while bank based systems are better in financially under developed economies. The findings of this paper can explain the co-existence of market-based and bank-based systems through out the world across both developed and under developed economies. The findings also have policy implications for developed and developing countries with regard to giving priority to improving their markets or banking systems.