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 bankbased systems are better in financially underdeveloped economies. The findings of this paper can explain the co-existence of market-based and bank-based systems throughout the world across both developed and underdeveloped economies. The findings also have policy implications for developed and developing countries with regard to giving priority to improving their markets or banking systems. -- financial institutions ; financial structure ; market-based financial systems ; bank-based financial systems ; financial development ; rule of law