In designing policies aimed at developing their financial systems to stimulate economic growth, African countries must address two related but distinct questions. First, what are the best strategies for fostering financial development? Second, which financial structure – bank-based or stock market-based, or a combination of the two – is most appropriate to their national objectives and their specific economic environment? While the first question has attracted substantial attention both in academia and in policy circles, the issue of financial structure has received relatively less consideration. Nonetheless, there are good reasons for why African countries must take this issue seriously. Some of these reasons are highlighted below
First, historical evidence suggests that there is a connection between a country’s stage of development and the structure of its financial system. In the early stages of development, banks play a predominant role in financing investment in infrastructure, which stimulates the growth process. As a country reaches higher levels of income, it is expected that stock markets play an increasing role. This argument has been supported both by historical studies on industrial growth (Cameron et al. 1967; Gerschenkron 1962) 25 The conventional assumption is that central bankers are more conservative (have a stronger tolerance level for the costs associated with achieving low inflation) than the society as whole (Rogoff 1985). This 27 and by more recent studies using broad data sets on financial structure around the world (Demirgüç-Kunt and Levine 1999). These studies find that more developed countries tend to have relatively larger and more liquid stock markets while the financial systems of less developed countries tend to be predominantly bank-based. Second there is a close connection between financial structure and the type of investment finance supplied by the financial system. Banks tend to specialize in debt finance, while stock markets provide equity finance. Both forms of finance are needed for private sector activity and the economy will prosper better when both forms of finance are available. Empirical research shows that bank loans constitute the primary source of outside funding for the corporate sector. For instance, U.S. banks provided about 62 percent of total outside finance for nonfinancial firms on average for the 1970-1998 period, while stock issues accounted for only two percent (Hubbard 2000: 8).26 Banks play a predominant role in supplying both short-term and long-term credit. By providing liquidity through short-term credit that can be used to finance working capital, banks allow businesses to release their own internal funds to finance fixed long-term capital. Banks and firms may also enter into explicit agreements whereby short-term loans are periodically renewed, which ultimately converts these loans into long-term finance. Such financing arrangements were prevalent during the English industrial revolution (Cameron et al 1967).
At their current level of development and given their immense needs for financing physical capital accumulation in infrastructure, African countries will benefit from fostering the development of a sound banking system. Some scholars have suggested that African countries should explicitly emphasize banking sector development over stock market development. For example, Ajit Singh (1999: 343) unequivocally concludes that for many African countries, pursuing stock market development is “a costly irrelevance which they can ill afford” (also see Singh and Weiss 1998). It is certainly difficult to reach a consensus on the right model of financial system that is most appropriate for African countries. The emphasis should be on promoting the right macroeconomic and institutional environment that facilitates financial intermediation in general. In such an environment, both banks and stock markets are likely to prosper.