Comparative Analysis Of “Market-Based” And “Bank-Based” Financial Systems

Each country pursues its own financial system – specifically, it is a set of institutions, which allow the exchange of funds between savers and spenders. Essentially, this system allows funds to be transferred from lenders to borrowers. Two types of financing are identified: the first one is operating via financial markets, with money flows directed from individual borrowers straight to savers; the second one is operating indirectly through financial institutions or intermediaries. They are also called as “market-based” and “bank-based” systems.

Indeed, direct financing is referred either to borrowing money or to purchasing stocks and bonds. The key issue is that investors lend their money directly without using financial intermediaries, or banks. In terms of its characteristics, this type is riskier, as there is no intermediary to assure each of the party in the mutual benefits of the deal. Furthermore, there are risks for spender, as lender could charge higher interest; and for saver respectively, as his borrower could default. Indirect financing, in its turn, is referred to intermediaries that purchase securities with its duration and other features from spenders and then transform them to the different securities, that will be sent to the savers. In terms of risk, this type of financing is safer. Through maturity transformation banks make long-term loans and fund them by issuing short-term deposits. Additionally, the intermediaries remove the risk of default by monitoring payment abilities of each user of financing institution.

Comparing these two financing types in terms of duration, it is evident that indirect financing is more convenient – it creates different maturity loans for borrower to choose, with an interest rate suitable for this option, whereas direct financing operates at floating market interest rate and often has a short-term duration of the loans. As it was stated earlier, different countries choose their own way to construct the financial system. For instance, direct financing is prevailing in the US, where market-based economy seems to be more suitable than bank-based. The market capitalization there is more than three times larger than its banks claims. The two most prominent stock exchanges in the United States are the NYSE, located on Wall Street, and the Nasdaq. The regulatory body for stock market is independent federal agency – Securities and Exchange Commision. The mission of the SEC is stated as: "to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation". Shortly after the stock market crash of 1929, the birth of the Securities and Exchange Commission set a goal to restore investor faith in the financial sector.

Although corporate financing via capital markets is on the rise, Germany’s financial system remains mostly bank-based, with bank loans as the predominant form of funding for firms. German banking system operates at different levels, it can provide investment, insurance and trust properties. Basically, there are three tiers: private banks, publicly-owned savings banks and member-owned credit unions. German banks’ profitability is increasingly under pressure given the very low interest rates, high cost structures and increasing compliance costs. The risk is minimized due to the fact they hold money mainly in cash and bonds.