Corporate Governance

A Global Perspective

5 Corporate Governance,
Types of Financial Systems and Economic
Growth

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018
 Lecture Aims

This lecture aims to review the link between capital market

development, corporate governance and economic growth. The
lecture contrasts the two main financial systems, the bank-based
system and the stock-market based system. It assesses the
advantages and disadvantages of each system and draws
conclusions as to the types of industries that are likely to flourish in
each. Finally, the lecture discusses the link between trust and
economic growth.

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 2
 Learning Outcomes

 This lecture focuses on the link between financial systems and

economic growth
 We distinguish between the bank-based system and the market-
based system
 Assess the importance of strong and efficient institutions in
promoting economic growth
 Comprehend the impact of trust on economic growth

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 3
 Introduction

 An extensive body of the literature investigates the issue of the

direction of causality between financial development and economic
growth
 It is generally accepted that the former drives the latter
 However, some sceptics argue that financial markets grow in
anticipation of future economic growth
 Nevertheless, we assume that financial development drives
economic growth.

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 4
 The Functions of Financial Markets and Institutions

 Financial markets and institutions deal with market imperfections,

in particular
– asymmetric information, and transaction costs
 Their five main functions are
– Collecting savings and turning them into larger loans
– Risk sharing
– Facilitating the exchange of goods and services
– The monitoring of corporate managers
– The allocation of economic resources
 We concentrate on the latter two

5
Bank-based versus Market-based Systems
 Bank-based versus Market-based Systems

 Both banks and stock markets may reduce the monitoring which
individual investors have to expend
 Banks have better monitoring skills than small investors true false
 They also benefit from economies of scales in terms of monitoring
 The high diversification of their portfolios of loans reduces the
monitoring by savers
 Banks also often have long-term relationships with borrowers,
reducing information problems

7
 Bank-based versus Market-based Systems

 Hence, the bank-based system is also sometimes called the

relationship-based system
 This system is thought to overcome weak law via agreements
between parties and reputation building
 Stock markets also reduce the need for monitoring by individual
investors for two main reasons
1. The firm’s stock price enables its owners to monitor the management and to
incentivise.
2. The market for corporate control provides a disciplining mechanism

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 8
 Bank-based versus Market-based Systems

 However, doubts have been raised about the monitoring role of

stock markets
1. The reason behind hostile takeovers does not seem to be bad performance
2. Stock markets may promote takeovers that result in so called breaches of
trust whereby the new management violates implicit contracts the
incumbent management had with the employees
3. Stock markets may promote exit rather than voice
4. Stock markets may be myopic

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 9
 Bank-based versus Market-based Systems

 The relationship-based system thrives on opacity whereas the

market-based system relies on transparency ‫األشياء اللي باألخضر تبينا‬
‫نركز عليها أكثر‬
 Opacity protects the close relationships banks have with firms from
the banks’ competitors
 However, the lack of transparency also makes it difficult for the
firm to judge whether the cost of borrowing charged by the bank is
justified
 As a result of the differences between relationship- and bank-based
systems, firms are likely to specialise in those assets favoured by
their system

10
The Link between Types of Financial
Systems
and Economic Growth
The Link between Types of Financial Systems
and Economic Growth

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 12
 The Link between Types of Financial Systems
and Economic Growth

 These theories are

– The information collection theory
– The renegotiation theory
– The corporate governance theory

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 13
The Information Collection Theory

14
 The Renegotiation Theory

 According to this theory, financial systems with many small banks

impose tighter budget constraints than those with few large banks
 Hence, the former tend to favour short-term projects and the latter
long-term projects
 Young and high-tech industries will thrive in systems with many
small banks
 More mature industries, where innovation is incremental, will
prosper in systems with few large banks
 ‫تكون افضل للبنوك الصغيرة (عشان الفوائد للبنوك الكبيرة ضخمة والبنوك الصغيرة‬
)‫تكون محدودة‬

15
 The Corporate Governance Theory

 A large shareholder overcomes the free-rider problem and the lack

of monitoring‫يكون مجاني‬
 However, the large shareholder may interfere too much with the
management of the firm
 The large shareholder may also expropriate the minority
shareholders
 The theory predicts that dispersed ownership ‫ فصل الملكية‬can more
credibly commit not to interfere with the management

For use with Corporate Governance: A Global Perspective by Marc

Goergen © Cengage EMEA, 2018 16
 The Corporate Governance Theory

 Hence, dispersed ownership will fare better with activities requiring

investments from management and other stakeholders
 Concentrated ownership is better suited for activities requiring
active monitoring

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 17
The Link between Types of Financial
Systems
and Economic Growth
 The Link between Types of Financial Systems
and Economic Growth

 Wendy Carlin and Colin Mayer tests the validity of the above three
theories as well as the classic theory
 They study 27 different manufacturing industries across 14
developed and 4 less developed OECD countries for 1970-95
 In their regression analysis, they explain GDP growth, fixed
investment, and R&D by two sets of variables
 ‫الثالث أشياء هذي اكيد بتجي الزم نفرق بينها واالسماء ماتهمها والمطلوب وش توصلوا‬
‫له بالنظرية‬
– Country characteristics
– Industry characteristics

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 19
 The Link between Types of Financial Systems
and Economic Growth

 The country characteristics consist of three measures, one for each

of the above three theories
– The quality of accounting standards (information collection theory)
– The concentration of the banking industry (the renegotiation theory)
– Ownership concentration (corporate governance theory)
 ‫بتجي‬

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 20
 The Link between Types of Financial Systems
and Economic Growth

 The industry characteristics are

– The industry’s dependence on equity finance
– Its dependence on bank finance
– Its dependence on other stakeholders (i.e. employees)
 Carlin and Mayer decompose deviations of country growth rates
from world averages into three distinct effects
– The share effect
– The growth effect
– The interactive effect
– ‫ضروري نعرف هالثالث تأثيرات‬

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 21
 The Link between Types of Financial Systems
and Economic Growth

 The share effect measures the contribution to economic growth via

the deviation of a country’s initial share of an industry from the
world average in 1970
 Hence, this effect measures the validity of the classic theory
 The growth effect is the contribution to growth of the deviation of
the country’s growth rate from the world average assuming initial
shares are world averages
 ‫كم عدد الدول األسماء األرقام كلها ماتهمها‬

22
 The Link between Types of Financial Systems
and Economic Growth

 The interactive effect accounts for the possibility that economic

growth may be higher given that the country’s initial allocation was
higher

 Carlin and Mayer find that differences in country growth are

entirely due to the growth effect
 This suggests that the classic theory is unlikely to have much
explanatory power

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 23
How Trust and Other Factors Influence Economic
Growth

24
 How Trust and Other Factors Influence Economic
Growth

 During the lecture on the taxonomies of corporate governance

systems, we reviewed La Porta et al.’s theory about the quality of
law
 According to this theory, the main driver of economic growth is
investor protection‫صح او خطأ‬
 Other factors driving economic growth include trust and religion
 Trust may be a means of overcoming situations dominated by
asymmetric information where the actions of the agent cannot be
directly observed

25
 How Trust and Other Factors Influence Economic
Growth

 Paul Zak and Stephen Knack study the link between trust and
economic performance for 44 countries
 They allow for two types of trust
1. Trust towards fellow citizens
2. Trust of the government
 They measure the latter by the strength of property rights
 This measure is similar to La Porta et al.’s measure of investor
protection

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 26
 How Trust and Other Factors Influence Economic
Growth

 They find that

– Investment increases with trust and the level of incomes, but decreases with
the price of investment goods
– Trust increases economic growth
– While growth is positively related to the strength of property rights, trust
remains significant
 They identify the following determinants of trust
– There is a link between ethnic homogeneity and trust
– Trust increases with property rights
– It decreases with income and land property inequality

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 27
 How Trust and Other Factors Influence Economic
Growth

 In another study, Stephen Knack and Philip Keefer allow for trust to
be a substitute for weak institutions
 They find that
– Trust has a positive impact on both economic growth and investment
– This impact is higher in poorer countries where formal institutions and the
quality of law are weaker, suggesting that trust is a substitute for the latter two

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 28
 How Trust and Other Factors Influence Economic
Growth

 Rafel La Porta and others find that trust has a positive impact on
– The efficiency of government
– The participation in civic organisations
– The performance of large companies
– Social efficiency

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 29
 How Trust and Other Factors Influence Economic
Growth

 Hence, there is consistent evidence that

– Trust has a positive effect on economic growth, investment and institutional
performance
– Trust is influenced by income inequality, ethnolinguistic or ethnic diversity,
and hierarchical religions

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 30
 Conclusions

 Bank-based versus market-based systems

 The link between industrial activities and type of financial system
 The impact of trust on economic growth

For use with Corporate Governance: A Global Perspective by Marc Goergen ©

Cengage EMEA, 2018 31