Financial Systems

This paper elucidates the key debates surrounding the optimal design of financial systems and institutions: bank-based versus market-based; universal versus specialized banking; relationship versus arms-length banking. The paper also examines the historical pattern of financial system development – explaining the economic, legal, and political factors that influenced the shape of these systems as well as the long-run growth outcomes observed among the group of economies that underwent industrialization prior to World War I. The extensive evidence and analyses available indicate that financial systems historically took on a wide and complex range of forms that are difficult to categorize narrowly, yet provided similar functions; thus arguing for a functional, rather than institutional, approach to financial system design and regulation. Moreover, the research to date strongly supports the idea of persistence and path dependency in financial system design, that economic conditions at the time of industrialization help set the initial conditions that shape financial system and banking institution design, and historical political conditions, such as centralization of power, plays an ancillary role via the extent of regulation on banks and the development of free capital markets. In other words, history matters.