The Case for a Bank Based Financial System

Most economists in the world believe that the market system is the most efficient way of allocating resources. However, there are some economists who believe that a German-style bank-based financial system has considerable merits over the market-based system.

These economists believe that empirical reasoning is not valid when it comes to gauging the efficacy of a particular financial system. This is because the type of financial system is not the only variable. Instead, there are several other variables that come into play viz. legal policies, macroeconomic policies, and so on.

The proponents of the bank-based financial system use theoretical reasoning in order to explain why it has the potential to be a better financial system.

Some of the theoretical arguments commonly made by the pro-banking economists are as follows:

Commitment: It is important that businesses make decisions that are in the best long term interests of the company. This long term attitude needs to be built into the DNA of the business. Often, businesses face a problem since their short term objectives are not aligned with their own long term objectives.

If businesses operate in a market-based paradigm, they are forced to make decisions to meet the short term needs of their shareholders. This is because shareholders and markets, by nature, have a short term orientation. If a particular company does not provide them with the rewards that they are looking for, then they simply sell the stock and move on to another company.

This is not the case when banks are involved. The loans provided by banks are long term in nature. Hence, banks have a long term horizon. Hence, they do no exert pressure on companies to pursue short term goals. Also, it is a known fact that firms get more efficient when their relationships with suppliers and employees improve. In a market-based system, hostile takeovers are common, and hence employees and suppliers always find themselves at risk. As such, this relationship never really develops.

Governance: It is also argued that the existence of debt creates a better governance structure within the company. The existence of debt means that some amount of cash flows, as well as control, remain outside the firm.

Economists also argue that banks are the best creditors. This is because since the scale of their operations is so large, they can advise the shareholders about how to manage businesses in times of financial duress.

It also needs to be understood that banks act as a balancing influence. This is because the objective of the shareholders is to maximize profits. It is possible that they may take several risks in order to do so.

On the other hand, the objective of banks is to ensure the solvency of the firm so that the interest payments continue unabated during the tenure of the loan.

Bank loans, therefore, act as a balancing influence since they force the company to keep some amount of cash handy. It can, therefore, be said that bank loans perform governance tasks and ensure that the funds and other resources of the firm are deployed in a manner that ensures consistency.

Efficient Monitoring

The monitoring of investments is one of the most important functions performed by the investing community. This too, can be done better by banks. When individuals invest in the stock or bond market, they do not have the individual capacity to keep a check on the working of the firm.

Since banks make large scale investments in the firm, they can keep a closer check on the firm. Also, banks have more resources and capabilities actually to measure the firm’s performance.

From a macro-economic point of view also, banks are more efficient. When individual investors spend money to monitor the performance of a firm, they are just duplicating their expenses. This duplication can be avoided by using the services of banks.

In many cases, equity investors also use the performance monitoring services provided by banks.

Conclusion

There have been many debates which have been held in the recent past regarding which system is more beneficial. They have all reached the same conclusion. It is correct to call one system better than the other since each has its own merits and also its shortcomings. The reality is that countries following extreme systems are starting to mend their ways and are moving towards a convergence.

For instance, in the United States, several problems are being reported in the market-based economy. For instance, since individual shareholders have relatively small amounts of money invested in the company, they do not take much interest in the way the firm is run. This passivity leads to negligence and even losses in the long run.

Also, hostile takeovers, which have been celebrated as disciplinary actions, are now being viewed as expensive and disruptive measures if the intention is only to discipline the firm.

The bottom line is that both types of systems have their pros and cons. It is just that the American system is being followed by a larger number of countries worldwide. However, that does not make the German system redundant since it has its own merits, as explained in the article above.