Financial System as a network: Comparison of US,UK, Germany and Japan

A fab paper by Richard Sylla and Robert  Wright. They first look at how the different financial system structure came up in the 4 economies.

Each had a unique structure though Japan was more similar to Germany and US to UK. Then they look at the financial system from a network perspective and name each financial system as per one kind of a network.

If it is correct to generalize that, historically, Germany and Japan  have had bank-oriented or bank-dominated financial systems,  while Great Britain and the United States have had more marketoriented financial systems, then different network structures may  have characterized these pairs’ financial systems. We explore that  possibility, along with a few possible reasons that might account  for such differing network characteristics. We also consider if viewing modern financial systems as networks and examining  their network externalities might support some scholars’ contentions that economic growth, both historically and in recent  decades, was somewhat dependent on well-functioning financial systems and may even have been finance led.

First the differences in fin systems:

Business historians tend to agree that Anglo-American financial systems  differed from their counterparts in Germany and Japan. In Germany and  Japan, external financing traditionally came from banks with which  borrowers had long-standing and deep relationships. In both Germany  and Japan, banks held significant equity stakes in non-financial firms and  often exerted some degree of managerial control over borrowers.  

Although banks were also an important source of external business  financing in Great Britain, British bankers traditionally did not attempt to  own equity stakes in or attempt to exert managerial control over their business borrowers, preferring to maintain “arms-length” or market-based relationships. The same held true for most U.S. banks, although there have been documented cases of “insider lending” in some regions of the country. Moreover, many British and U.S. firms obtained a good deal of  their external financing directly from the capital and money markets via  stock and bond issues. We accept those stylized differences between bankoriented (German and Japanese) and market-oriented (British and U.S.)  financial systems as having some validity, or at least adherents. However,  the nature of the differences and why they emerged require further explication and explanation. 

Why did these differences emerge? In Japan it was mainly because of Zaibatsu System (large corporates) who controlled everything in Japan. Then Japanese economy depended on relational contacts and not contract:

Briefly, relational contracts are characterized by “contact, not contract.” Considerably less expensive than formal, attorney-created,  court-mediated “classical” contracts, relational contracts arise in any   society when the parties to a contract feel that they can “trust” each other. Trust arises from three main sources. The first is incentive alignment, as in a repeated, profitable “game.” Examples include extensive cross shareholdings and other forms of taking “financial hostages.”The trillions of dollars of foreign exchange contracts traded on oral contracts  each day are a modern example of such a repeated, profitable game.

Second, are reputation effects, the long-term dealings that have reduced information asymmetry over time. Zaibatsu, keiretsu, and other  forms of business networks are some obvious examples.

The third source is low societal rates of default. Some societies  exhibit lower levels of moral hazard than others; that is, ceteris paribus, in  some countries it is less likely than in others that a party to a contract will  engage in opportunistic behavior.


The system changed post WWII:

Until the 1920s, Japan was home to a few relatively large zaibatsu banks and numerous smaller banking institutions. Structural and legal  changes following the Great Kanto Earthquake spurred a wave of exits of  smaller banks in the 1920s and 1930s. Most of the surviving deposits  shifted to Japan’s postal savings system, but some ended up in the  zaibatsu banks. By 1940, only 357 banks remained, down from about  1,400 in 1927. The shift to fewer, larger banks before Pearl Harbor set the stage for Japan’s postwar banking system.  After the war and occupation, Japan developed a system in which  “main banks” supplied most external business finance. Of particular  interest is the network of firms or keiretsu of which the main bank itself  may have been a component.

A keiretsu is a non-familial but nonetheless  zaibatsu-like conglomeration characterized by “extensive intra-group  trade and a capital structure with elaborate cross-holdings of debt and equity, a strong domination for the group’s main bank in corporate borrowing, and historically high levels of gearing in member firms.”  According to one study, up to 84 percent of the firms listed on the 1981  Tokyo stock exchange were keiretsu member.

Postwar Japanese main banks possessed three main characteristics.  First, they were major lenders to their main-bank clients (who received  more than 25 percent of total loans). Second, they held fairly substantial  blocks of shares (5 -10 percent) of their clients’ equity. Third, main banks  were represented in their clients’ management, particularly during times of distress.

In Germany, bank’s control on corporates was even more:

In addition, as in Japan, German businesses were often subject to the strong influence of “universal” or “great” banks that made loans to them, arranged securities sales for them, and played major roles in corporate control and governance. The main institutional force in the German case was that owners of corporate shares traditionally deposited their shares in the banks and ceded their voting rights by proxy to the great banks.

As in Japan, German businesses often clustered into  groups. Unlike in Japan, however, German banks took direct, if partial, control of their clients and borrowers, overseeing firms (as was sometimes  said) from the cradle to the grave. In Japan, banks were generally  considered part of broader, consensual keiretsu decision-making  processes, whereas in Germany the banks were often viewed as the  primary decision makers.

US/UK were near similar with some differences. US firms tapped markets more than  UK firms etc. It was more market based than UK..

Which fin system is like which network? German is like mainframe computer, Japanese like a client-server model and Us?UK like a neural network..

Superb reading.

Though don’t buy their idea that all development is finance led. This is a problem with historians. Whichever field of econ history the are  from (financial, political, institutional etc), they will make you believe their side of story. Development is fa more comprehensive and complicated than imagined. It is a combination of many factors and led by multiple factors…


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