Economic, Political, and Legal Factors in Financial System Development: International Patterns in Historical Perspective

Abstract

Financial systems are often described either as bank-based, universal, and relational or as market-based, specialized, and arms-length; and for many years academics and policymakers have debated the relative merits of these different types of systems. This paper inquires into the underlying causes of financial system structure and development. Older theories dictated that financial institutions developed in relationship to the economy's level of development. Newer work has brought political and legal factors to the fore: hypothesizing specific relationships between banking structure and state centralization and between financial development and legal tradition. This study classifies countries by type of financial system, and in doing, indicates that few banking systems fit the extreme paradigms of universal-relationship or specialized-arms length banking. On the other hand, despite several cases of temporary upheaval, and recent widespread movement toward conglomeration, banking system structure has remained remarkable stable over the last 100 to 150 years. Economic factors in the late nineteenth century provide relatively strong explanatory power for financial system development, market orientation, and banking structure at the eve of World War I and in the present day. Banking specialization and market orientation appear strongly associated with legal tradition, though it seems more likely that the three characteristics are jointly determined or that the legal system variable simply proxies for a close or historical tie to the exporter of many political-economic institutions, England. Legal orientation exerted little impact on financial institution growth at the turn of the century and provides no consistent prediction of real economic growth rates over the past 150 years. Finally, political structure relates significantly to market orientation but not to banking system design or legal tradition. Nonetheless, many individual country histories make it clear that political forces played important roles in shaping regulations that in turn altered the course of financial institutions and markets. The results here simply suggest that these political forces appeared inconsistently and had no traceable, uniform relationship to the overall political system in place in the nineteenth century. The results underscore two principal themes: the weight of history in determining the growth and design of financial institutions and markets, and the importance of idiosyncratic forces that buffet institutions over time. Despite obvious connections among political, legal, economic, and financial institutions, robust, long-term, causal relationships often prove to be elusive.