Fostering Capital Markets in a Bank-based Financial System: A Review of Major Conceptual Issues

The paper presents a review of major conceptual issues as a framework in which to conceptualize the rationales and strategies for fostering capital markets in a largely bank-based financial system. As elsewhere in the developing world, the relative underdevelopment of capital markets in developing Asia can be attributed to inadequate market and legal infrastructure, which, in the presence of informational problems, raises the cost of external finance. In such an environment, bank finance is often a less costly means of external finance because it can minimize informational problems by establishing a long-term monitoring relationship with borrowers. On the other hand, the benefits of capital market finance rise with economic development, which tends to increase the complexity and dispersion of information held in the economy. Price signals provided by market finance can lead to a better allocation of resources by allowing better investment and saving decisions. With the passage of time, an equity market will become particularly beneficial as a means of financing new and complex economic activities, as equity finance does not require fixed assets and can better reward risk taking activities. The paper concludes by discussing several conceptual issues that are important in designing an optimal financial structure.