The Role of Bank-based and
Market-based Financial Development on
Economic Growth of Nepal
Surya Bahadur Rana1
Abstract : This study examines the empirical relationship between
economic growth and various measures of stock market and banking
development in Nepal over the sample period 1987/88 to 2015/16 using
a framework of endogenous growth model suggested by Romer (1986),
Rebelo (1991) and Pagano (1993). The study finds that stock market size,
liquidity and banking development measures predict the economic growth
in the context of Nepal. Similalry, the study results show the important role
of banking development on economic growth process of Nepal because all
indicators of banking development have positive and significant impact
on growth. The study results shed light on the fact that both the level
of stock market development and the level of banking development can
influence the economic growth of Nepal. This finding supports the notion of
Levine (1996) which articulates that stock market and banking sector are
independently as well as jointly significant in promoting economic growth.
Key Words: Banking Development, Stock Market Development, Economic Growth
I. INTRODUCTION
The relationship between financial sector development and economic growth has
been one of the extensively discussed issues in finance and development literatures. The
finance-growth nexus is not only a matter of academic debate but also a crucial policy
issue. Financial development can be of two types - the bank-based development and
the market-based development. The proponents of bank-based financial development
believe that banks are better at managing liquidity risk and promote sound corporate
control. These factors lead an efficient allocation of capital and ultimately boost up
economic growth (Bencivenga & Smith, 1991). In similar line, Rajan and Zingales (1998)
1. Dr. Rana is Lecturer at Tribhuvan University, Faculty of Management, Butwal
Multiple Campus, Butwal. He is also a member of Finance Subject Committee at
FOM, T.U. He can be reached at surryabrana@gmail.com
,6 PYC Nepal Journal of Management, August 2019, Vol. XII, No. 1
argue that powerful banks may have the ability to persuade firms to release information
about their activities and pay debts better than the stock markets. At early stages of
establishment, firms usually face capital constraints, which may put at risk the firm’s
current and future activities. At this stage, banks become crucial to firms’ growth because
they can better provide external finance to new innovative projects than markets. Rajan
and Zingales (1998) also assert that in the absence of efficient legal systems and sound
institutions, powerful banks can force firms to repay their debts while markets cannot. For
this reason, bank-based system is believed to be a better system to boost up economic
growth.
In contrast, the supporters of market-based view argue that efficient markets
positively impact growth, because stock market liquidity allows for easy and quick trade
of assets. It also simultaneously allows savers to become less reluctant to give up their
savings in markets while ensuring that firms have permanent access to capital (Levine &
Zerovs, 1996). Greenwood and Smith (1997) argue that high transaction and information
costs associated with pulling funds from various savers to the end users can be overcome
by the services provided by stock markets since it can reduce the costs associated with
mobilizing savings and thus can improve investment in most productive technologies.
Furthermore, Obstfeld (1995) argues that stock markets ease risk management, which
improves the resource allocation and accelerates the rate of economic growth. In this way,
the proponents of market-based system defend stock markets as crucial determinants for
economic growth.
There are competiting views on the relative importance of bank-based and
market-based financial development in predicting economic growth. Thus, main
policy issue is: which type of financial development policy should the government
priorotise? The proponents of the bank-based financial system argue that banks can
avoid the shortcomings of the market-based financial systems. For example, the
agency problem due to asymmetry of information between the actors is less severe
in the bank-based system than in the market-based type. The market-based view,
on the other hand, insists that a well-functioning stock markets foster growth and
profit incentives and help in risk management more efficiently than the bank-based
system does (Levine, 2002). The financial structure changes as a country goes
through different stages of development. It is argued that at the advanced stages of
development, the market-based structures are more effective than the bank-based
ones in fostering economic growth in a country (Boyd & Smith, 1998). Bencivenga,
Smith and Starr (1996) demonstrate theoretically that a more developed stock market
may provide liquidity that lowers the cost of foreign capital essential for development,
especially in low-income countries that cannot generate sufficient domestic savings.
However, arising from cross-country studies on relative importance of bank-based
and market-based structure on predicting economic growth, Levine (1997 & 2003)
and Beck and Levine (2004) show that financial structure is irrelevant to economic
growth. They assert that neither bank-based nor market-based financial structure
alone can explain growth; rather it is the overall provision of financial services both in
, The Role of Bank-based and Market-based Financial Development ... : Rana 7
banks and capital market taken together that affect growth. In this sense, instead of
bank and market substituting each other, they complement each other and contribute
to economic growth.
Nepal has already undertaken financial sector reforms and structural adjustment
programs. But, it is yet to emerge out of the status of least developed country. This
situation calls for investigating into the role of bank-based and market-based financial
development in the process of economic development of Nepal. In this backdrop, this
study proposes a reasonable framework for studying some elements of endogenous
growth that relate to the main aspects of functions of financial sector, especially
stock market and banking sector. In particular, this study attempts to make two main
contributions. First, it extends a simple model of Romer (1986), Lucas (1988), Rebelo
(1991), and Pagano (1993) type of endogenous growth economy in order to incorporate
the effect of financial sector development.
In the empirical arena, Bencivenga and Smith (1991) and Levine (1991) were among
the first to propose endogenous growth models to identify the channels through which
financial sector affects long-run economic growth. Both studies emphasized that financial
sectors help diversify agents’ liquidity and investment risk, attract more savings into
productive investment and prevent the premature withdrawal of physical capital invested
in the long-run projects. With the existence of financial markets and institutions, more
capital can be kept in productive investments, which raises the rate of economic growth.
King and Levine (1993b) suggested another approach to identifying the channel
of transmission between finance and growth. Their model identified innovation as the
engine of growth. Financial markets and institutions evaluate the potential innovative
projects, finance the most promising ones and monitor the carrying out of the investment.
Therefore, an economy with well functioning financial markets will experience a higher
growth rate of productivity.
In a modern economy, banks and stock markets constitute a major part of the
financial system. Although they may perform different roles in the process of economic
growth, their uniqueness is hardly emphasized within the framework of economic
growth. The channel suggested by King and Levine (1993b) cannot distinguish
between the roles of stock markets and banks. As far as capital accumulation is
concerned, both stock markets and banks provide source of external financing for
firms. For the function of resource allocation, both stock markets and banks create
information to guide the allocation of resources. In this regard, based on the review
of theoretical literature, this study argues that the degree to which financial sector,
both stock market and bank, influence economic growth depends on how effectively
they improve capital accumulation, facilitate resource mobilization and increase the
productivity of capital investment. Second, this study attempts to estimate and test
the model with regard to individual country Nepal. This study, therefore, proposes a
different effort to investigate the role of market-based and bank-based development
of financial sector on fostering the economic growth of Nepal.
