Bank-based vs Market-based Financial System: Analysis and Evaluation

This report analyzes and evaluates the differences between bank-based and market-based financial systems, their advantages and disadvantages, and the criteria for their application. It also highlights the positive roles of banks and the importance of effective corporate governance mechanisms.

Running head: INTRODUCTION TO FINANCE
Introduction to Finance
Name of the Student
Name of the University
Author’s Note

1INTRODUCTION TO FINANCE
Table of Contents
Introduction................................................................................................................................2
Requirement [a]..........................................................................................................................2
Requirement [b].........................................................................................................................4
Conclusion..................................................................................................................................4
References..................................................................................................................................5

2INTRODUCTION TO FINANCE
Introduction
The presence of two types of financial system can be seen in the countries all over the
world; they are Bank-based financial system and Market-based financial system. Both the
systems have different structure along with certain advantages as well as disadvantages. In
addition, countries are needed to consider certain criteria at the time of the application of
these financial system. The main aim of this report is the analysis and evaluation of different
dimensions of these two financial systems.
Requirement [a]
It needs to be mentioned that there are certain differences between the general
financial structure of the countries with bank-based and market-based financial system. It can
be observed that in the countries with higher income, the banks do not become smaller or
larger relative to the size of the stock market. Under the structure of the bank-based financial
systems, the banks of the countries play a crucial role in the economic growth and
development of those countries along with reviving the shortcomings as well as failure of the
market-based financial system (Nyasha and Odhiambo 2014). Under the bank-based financial
system, the banks helps in the removal of the difficulties caused from unbalanced information
with the help of the establishment of long-term relationship. For this reason, it leads to the
optimal allocation of financial resources. On the contrary, it can be seen that the countries
with higher income have more efficient domestic market related to the domestic banks. For
this reason, in the economy of these countries, the financial markets play a crucial role in the
development of the overall economic system. For this reason, the richer countries tend to
have higher level of stock market development as compared to the development of the
banking system (Sawyer 2014).

3INTRODUCTION TO FINANCE
It needs to be mentioned that there are certain advantages and disadvantages of both
the bank-based and market-based financial systems. They are discussed below:
Bank-based Financial System: Bank-based financial system leads to improved allocation of
capital along with the effective implementation of corporate governance mechanism. In
addition, this system helps in efficient investments. It becomes possible for the creation of
economies of sales in the presence of bank-based financial system. Lastly, it helps in
promoting growth of the developing countries (Oima and Ojwang 2013).
It case of disadvantages, ban-based financial system can prevent innovation in the
financial system. At the same time, it leads to the possibility to collusion. Weakness of this
type of financial system can be seen where markets are well-developed and can process
strong rights of the shareholders (Oima and Ojwang 2013).
Market-based Financial System: The main advantage of market-based financial system is
that it leads to the reduction in the cost of production by providing the scope of implementing
effective methods. It helps in promoting technological innovation in the financial reporting
process. In addition, it has the ability to provide economic freedom (Hardie and Howarth
2013).
It has certain disadvantages also. The main disadvantage of market-based financial
system is that it leads to the creation of misrepresentation of investments. This type of
financial system often makes the whole economic system unstable. At the same time, market-
based financial system can contribute to the promotion of social as well as economic
inequalities (Hardie and Howarth 2013).
In this context, it needs to be mentioned that the countries are needed to follow certain
criteria for the application of these financial system. The criteria is the country’s environment
as it defines which financial system needs to be adopted for the betterment of the economy.

4INTRODUCTION TO FINANCE
On a more specific note, the countries need to consider three specific criteria for the selection
of either bank-based or market-based financial system; they are government, regulation of the
government and public demand of various products and services (Beck and Feyen 2013).
Requirement [b]
It can be seen from the above discussion that both the bank-based and market-based
financial system is crucial and both of them has certain advantages and disadvantages. Bank-
based financial system helps in highlighting the positive roles of the banks in the acquisition
of financial information about the companies and managers with the aim to bring
improvement in the process of capital allocation along with effective implementation of
corporate governance mechanism. It also helps the countries in the effective management of
cross-sectional and liquidity risk with the aim to enhance investment efficiency as well as
economic growth. Bank-based financial system also assists in the deployment of capital with
the aim to exploit economies of scale. Solving the financial shortcomings is another major
role of ban-based financial system (Berger and Bouwman 2013).
At the same time, market-based financial system also plays an enhancing role as it
fosters greater incentives to the firms since it is an easy process to earn profit from trading in
the big and liquid market. At the same time, market-based financial system enhances the
mechanism of corporate governance by making it easy to takeovers and managerial
compensation. In addition, market-based financial system assists in the development of
effective risk-management policies (Wilson and Post 2013). Hence, it can be seen from the
above discussion that both the bank-based and market-based financial systems are good for
the countries. However, the countries are needed to consider the application criteria before
adopting either of the financial system.

5INTRODUCTION TO FINANCE
Conclusion
It can be seen from the above discussion that there are differences between the
structure of the financial systems under both bank-based and market-based. Thus, the
countries are needed to consider the advantages, disadvantages and applicability criteria
before adopting these systems.
References
Beck, T. and Feyen, E., 2013. Benchmarking financial systems: introducing the financial
possibility frontier. The World Bank.
Berger, A.N. and Bouwman, C.H., 2013. How does capital affect bank performance during
financial crises?. Journal of Financial Economics, 109(1), pp.146-176.
Hardie, I. and Howarth, D. eds., 2013. Market-based banking and the international financial
crisis. Oxford University Press.
Nyasha, S. and Odhiambo, N.M., 2014. Bank-based financial development and economic
growth: A review of international literature. Journal of Financial Economic Policy, 6(2),
pp.112-132.
Oima, D. and Ojwang, C., 2013. Market-based and bank-based financial structure on
economic growth in some selected Ecowas countries. International Journal of Education and
Research, 1(2), pp.1-10.
Sawyer, M., 2014. Bank-based versus market-based financial systems: a critique of the
dichotomy (No. wpaper19).
Wilson, F. and Post, J.E., 2013. Business models for people, planet (& profits): exploring the
phenomena of social business, a market-based approach to social value creation. Small
Business Economics, 40(3), pp.715-737.