Financial Markets: If they are important, why don’t they develop?

Most of the research on financial markets focuses on capital structure, asset pricing, volatility etc. I used to like this research for some point of time but after understanding that most of the research depends on the time period taken to study and on some fancy model (which mostly doesn’t work when applied) my interests have moved onto something more basic which is financial systems. I have posted about some work on the subject here and here .

I came across this another superb paper from the deadly combo – Rajan and Zingales. It is titled The Great Reversals: The Politics of Financial Development in the 20th Century.

In their typical style they go on and give a very different theory of financial development. The paper is old and was written in 2001 but is very interesting and relevant. The abstract:

“We show that the development of the financial sector does not change monotonically over time. In particular, we find that by most measures, countries were more financially developed in 1913 than in 1980 and only recently have they surpassed their 1913 levels. This pattern is inconsistent with most recent theories of why cross-country differences in financial development do not track differences in economic development, since these theories are based upon time-invariant factors, such as a country’s legal origin. We propose instead an ‘interest group’ theory of financial development. Incumbents oppose financial development because it breeds competition. The theory predicts that incumbents’ opposition will be weaker when an economy allows both cross-border trade and capital flows. This theory can go some way in accounting for the cross-country differences and the time series variation of financial development.”

To understand why the paper is different, we need to understand the papers so far on financial development. The reason attributed initially to financial markets development was common law vs civil law. The countries having former were considered to have better financial systems as they offered better investor protection rights.

The paper which popularised this approach was developed by Shleifer et al and the model was popularly called LLSV (after the first alphabet of the 4 authors’ surname). The paper can be read here

R & Z offer a different explanation. Their idea is that in 1913 Fin Markets in France were more developed than in US. And France had a civil law system, then how come it had a better financial system? Also why it took so long to reach the 1913 levels?

R & Z say it is because people who are already well-off (established indsutrialists etc) do not want reforms as it would lead to competition and eroding of their market shares. Further they say:

“Incumbent interests are least able to co-ordinate to obstruct or reverse financial development when a country is open to both trade and capital flows. When a country is open to neither, they are likely to be able to coordinate to keep finance under heel. Matters are unlikely to be much better when a country is open only to capital flows or only to trade. In the former case, incumbent industrial interests may hold back financial development, fearful of the domestic competition that might be financed, while in the latter case, both industrial and financial incumbents may want to strengthen existing financial relationships to combat the foreign threat. Free access and transparency are likely to get short shrift at such times.”

Well the analysis offers a very realistic explanation of financial sector development. Most papers exclude politics while talking of development and moreso when talking of developments in finance but this paper includes it in a very interesting manner.

The paper clearly forms the basis of their book “Saving Capitalism from the Capitalists” .

The paper also forms the basis for their food for thought paper I reviewed in my previous post. In that paper the idea is different i.e. underdevelopment is due to initital factor endowments but approach is same that people may not be interested in development as it does not help them.

A must read for finance professionals.

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