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Market Based And Bank Based Financial System Finance Essay

There are two different types of financial system around the world. The first one is market-based financial system. This system depends on market so that firms expect to get long-term funds in the capital market. Therefore, relationship between firms and banks is so weak that firms have to hold a large amount of internal funds for daily transactions rather than rely on abundant loans.

As we know, U.S. and U.K. has a large stock market, as well as corporate bond market. Markets are relatively more important in the U.S. and U.K. Thus they are typically said to have a market-based financial system. In U.S. most householders prefer to hold portfolios directly in equity securities, therefore, individuals could play an important role in corporate governance. According to the corporation law of American, there is usually just one class of common stock, and each share has one vote, no matter how many shares a shareholder own. Just like in Microsoft, a valuable company in U.S. has three large shareholders: the co-founders Bill Gates who owns 23.7 percent of the shares, another one is Paul Allen who owns 9 percent and Steven Ballmer with 5 percent (Rafael L.P., 1998). However, Bill Gates may have significant influence than other two people, that’s just because he has more shares. Moreover, managers have a fiduciary duty to the shareholders, in other words, they are legally required to maximum shareholders’ profit and interests. For instance, General Electric, another one of the most valuable firms in U.S... In its governance principle it says that the most important qualification of directors is that they should be committed to representing the long-term interests of the shareowners and the board of directors is supposed to represent shareholders’ demands. (GE, 2010)

Although there two countries are always portrayed as typical market-based system, there are many differences between U.K. and U.S. for example, company law. Because of different states in America, the U.S. has a set of laws for each state. Corporations could choose them by themselves. This is not permitted in U.K. since its government. Moreover, U.S. law has nothing relevant with protection to family control ( Andrew T, 2005) therefore, pressure from outside shareholders will be less effective than U.K.

Another type of financial system is called bank-based financial system. This kind of system always fit in transactions between banks, in this way, the main financial method is loan. Not like market-based system, firms could gain not only long-term loan but also short-term from bank. In other words, “the firms’ dependency on the bank is high”. ( Mitsuaki Okabe, 2004) Therefore, banks play role as both lender and shareholder, they could manage their client companies to a certain extent.

Japan and Germany………

Table 1

Shareholder rights index

Creditor rights index

Bank/GDP

Market

GDP

United States

5

1

0.75

1

19998

United Kingdom

5

4

1.13

1

13067

Japan

4

2

1.31

0

23467

Germany

1

3

1.19

0

17804

In table 1, 4 countries have been contracted in 5 characteristics. It is not hard to find out that shareholder rights are much more in U.S and U.K. compare with Germany. Although Japan get high score in this index, it is just because corporation law in Japan resembles that in the U.S. meanwhile, U.K and U.S. are all close to market when Japan and Germany get high proportion in Bank/GDP. These observations are exactly the difference I have mentioned.

In any comparison of systems, people always want to make a judgment that which one is better or which one is the best. Here Table 2 lists some characteristics of market-based and bank-based and compares them in different ways.

Type of financial system

Insider-dominated(market-based)

Outsider-dominated(bank-based)

Share of insider-dominated finance

High

Low

Financial markets

Small

Large

Share of all firms listed on exchanges

Small

Large

Ownership of debt and equity

Concentrated

Dispersed

Investor orientation

Control-oriented

Portfolio-oriented

Use of mechanisms for separating control and capital base

Frequent

Limited

Role of board of directors

Limited

Important

Role of hostile take-overs

Very limited

Potentially important

Source: Bergl¨of (1997), pp. 93–123, Table 1.

Here, insider-dominated system means bank-based system and outsider is market-based system.

Through this table, we can conclude these two different systems have different features.

In this paper, I think each system has advantages and disadvantages. One may be optimal in this sense; the other could be the best in other firms. For instance, Solomon think in developing country and in countries consisted with small firms bank-based system may be more suitable. On the other hand, in developed country and those countries have old firms or international firms, market-based system would be the better choice. (Solomon T, 2000) Moreover, Rajan argues that information feedback is also important to choose system for companies. Because bank is power enough to protect interest so market information is less effective for them, it is better where feedback is lacking. Market-based financial system fit well where information environments are mature.(Rajan R, 1998)

After all, different system fits different environment, these two lead financial system are all useful and powerful when they can be set in optimal situation.

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