FINANCIAL INNOVATIONS IN BANKING: IMPACT ON
FINANCIAL INNOVATIONS IN BANKING: IMPACT ONREGIONAL GROWTHSantiago Carbó Valverde*Rafael López del PasoFrancisco Rodríguez FernándezDepartment of Economics, University of Granada, SpainAbstract:This article contributes to the literature on the relationship between finance andgrowth by analysing the relationships between financial intermediation and economicgrowth within the regions of one country, rather than different countries. The focus onregions is relevant since regional information is more homogeneous, the legal andinstitutional factors are similar, and the relevant financial market is more accuratelydefined. Our study also incorporates the effects of a set of banking innovations. Theanalysis is undertaken for the Spanish regions. The results show that product andservice delivery innovations contribute positively to regional GDP, investment andgross savings growth. (100 words)JEL Classification: R11, G21Keywords : economic growth, financial intermediation, regions.*Corresponding author:Santiago Carbó ValverdeDepartamento de Teoría e Historia EconómicaFacultad de Ciencias Económicas y EmpresarialesUniversidad de GranadaCampus de Cartuja s/n18071 GRANADA (SPAIN)Tel: 34 958 243717Fax: 34 958 249995e-mail: scarbo@ugr.es
1. INTRODUCTIONThe links between financial intermediation and economic growth haveconcentrated a great deal of academic attention during the last fifteen years. Thisliterature highlights the role of banks and the financial system as a key ingredient of theeconomic development puzzle. Most of the finance-growth studies follow aSchumpeterian view of financial intermediaries as agents that monitor, finance andfoster entrepreneurship -and, hence, investment and growth- based on the grounds of theseminal contribution of Goldsmith-McKinnon-Shaw1. According to this view, thebanking sector alters the path of economic development by affecting the allocation ofsavings although not necessarily by altering the saving rate. Thus, the Schumpeterianview of finance and development highlights the impact of banks on productivity growthand technological change. Alternatively, a number of studies on development economicsargue that capital accumulation is the key factor explaining economic growth.According to this view, banks influence growth primarily by raising domestic savingrates and attracting foreign capital. In parallel, many cross-country empirical approacheshave been undertaken prompted by institutions such as the World Bank2 or theInternational Monetary Fund3. These studies show the relevance of financialintermediaries development in explaining the differences in economic growth acrosscountries.The geographical scope is relevant since it conditions the methodology, theempirical evidence and the subsequent policy implications of any economic or financialanalysis4. The present study analyses the relationship between financial intermediationand growth from a regional perspective, rather than from a cross-country viewpoint. Ourpaper incorporates two major innovations with regard to the existing empirical literaturein this field. First of all, the use of regions within a country implies that the institutional,2
legal and cultural factors are more adequately controlled5, the availability andhomogeneity of financial information is larger and the relevant (financial) market ismore accurately defined than for previous cross-country research. Moreover, it has beendemonstrated that the significance of the relationship between financial developmentand economic growth depends on the level of financial development itself while crosscountry studies usually consider a set of heterogeneous countries jointly independentlyof their level of financial development (RIOJA and VALEV, 2004). Secondly, weconsider various financial innovations that have emerged in recent years and that arelikely to have affected the financial intermediation-economic growth nexus (MAYER,1988). Specifically, the effects of the different level of business and technologicaldevelopments in the regional banking sectors on regional growth are also studied.The paper is divided in three main sections following this introduction. Section 2establishes the theoretical and empirical grounds. In section 3, we discuss the (dynamicpanel) methodology, the data and variables used and the relevance of employing regionsin this context. The main empirical findings are identified in Section 4. The paper endswith the main conclusions in Section L APPROACH2.1. Financial intermediation-growth nexus: theoretical backgroundThe financial intermediation-growth nexus has been modelled recently from twoperspectives, neoclassical and endogenous growth models. Although both approachesappear to be valid in the aim of evaluating the effects of banking sector development oneconomic growth, the endogenous growth perspective has dominated the analysis inrecent years (BENHABIB and SPIEGEL, 2000). Under the endogenous growth view,3
both the demand for and supply of loanable and investment funds are assumed to beinterdependent and mutually reinforcing. It is assumed that there is asymmetricinformation, agency problems and uncertainty so that the relationship between financeand the economy is non-neutral. These imperfections may cause misallocations of fundsso that financing and equity gaps may arise and SMEs and households may findthemselves at a disadvantage in accessing funds (KLAGGE AND MARTIN, 2005).According to endogenous growth models, the contribution of banks to economic growthresults from their screening and monitoring functions which permit an easier, moreefficient and faster access to external finance for households and firms. This role ofbanks is particularly relevant when capital markets are not sufficiently developed(BENCIVENGA and SMITH, 1991)6. DOW and RODRÍGUEZ FUENTES (1997) andRODRIGUEZ FUENTES (2006, pp.61-65) have also highlighted another importantdimension of the financial intermediation-growth nexus, the bank’s ability to extendlending based upon superior local information and knowledge. This role can becomeone of the factors explaining credit availability at the regional or local level. Due toregional segmentation in credit markets –and considering that banks are not constrainedby prior saving or a fixed amount of reserves- local and regional banks have a specialrole in creating credit at this geographical level. In this context, the role of banks isextended beyond screening and monitoring by incorporating a more direct function ascredit creators, although this function is frequently ignored in the literature.Within the endogenous growth framework, some previous studies haveidentified three main specific contributions of financial intermediaries to economicgrowth (PAGANO,1993; THIEL, 2001) 7. First of all, an efficient banking systemreduces the leakage of resources in funnelling savings to firms. Secondly,intermediation ameliorates the allocation of funds since banks discriminate among bad4
and good projects, choosing those with a higher marginal productivity of capital8,9.Third, both the level and the growth rate of savings can also be affected by financialintermediation However, these effects are ambiguous since the savings rate mayincrease or decrease. As bank markets develop, the availability of consumer ormortgage lending to households is higher and –if insurance markets develop in parallelthe need of precautionary savings may diminish. In any event, the net effect ofintermediary development on savings depends on the risk-return properties of consumerutility function10. The risk-return combination of savers portfolios improves with bankefficiency. Nevertheless, the impact on the level of savings will depend upon the effectsof the expectation of higher returns (or lower risk) and on the relationship betweenpresent and future consumption.All in all, the fraction of savings “lost” with financial intermediation depends onseveral variables. Firstly, any kind of market power in the banking industry is likely toincrease the amount of savings that are “lost” with intermediation (DEMIRGÜÇ-KUNTet al., 2004). Secondly, efficiency at banks is also important in the sense that managerialabilities (X-efficiency, scale/scope efficiency) can also modify bank prices. Bankrelationships established by certain intermediaries may then play an important role. Inparticular, BERGER et al. (2005) have shown that greater market shares and efficiencyranks of small, private, domestically-owned banks are associated with better economicperformance. Similarly, the diffusion of financial innovation also affects saving rates. Ifbanks offer non-traditional products or new technological services, consumers towardsthesenew products and services and banks diversify their sources of income so that they canafford lower interest margins.5
Banks collect information allowing financial flows of investment to grow untilthe marginal cost of monitoring/screening equals the marginal utility of investment inphysical capital. The transformation function of banks permits a significant share offinancial (savings) flows that would be invested in short-term projects and these can beinvested in long-term (high-yielding) projects (GREENWOOD and JOVANOVIC,1990; BENCIVENGA and SMITH, 1991). Banks also increase the productivity ofcapital when they act as brokers, allowing savers to diversify their portfolio by investingin products such as shares, mutual and pension funds or insurance services. Therefore,regulation –allowing broad banking activities- and the diffusion of financial innovation–developing new services- are also relevant in promoting capital productivity andinvestment.Together with bank lending availability, an additional importantdimension of the finance growth nexus is credit quality. Lending quality is a keyingredient in the efficiency of financial intermediation although it largely depends oncertain institutional characteristics of the different territories such as the existence ofpublicly available credit bureaus (as in the case of the US) or credit registries localinstitutions.LAULAJAINEN (1999) shows the existence of important differences in the quality ofbank credit rating, screening and monitoring functions across countries. LEYSHON andPOLLARD (2000), however, pointed out that credit rating and screening functions bybanks become more centralized as banks extend their geographical bounds, therebyloosing some the informational advantages attributed to specialized financialinstitutions.The regional perspective is increasingly important within the context of thefinance-growth nexus. WILLIAMS and GARDENER (2003) indicate that the Europeanfinancial system has evolved into two tiers: (i) a pan-national tier contested by large6
commercial banks that provide universal banking services to customers, includingcorporations and high net worth individuals; and (ii) a regional tier that comprise localbanking markets with banks servicing mostly retail customers like households andSMEs. Within this context, the spatial segmentation of financial systems has beenshown to be correlated with higher regional GDP growth rates (MACKAY andMOLYNEUX, 1996). Households and many small and medium-size firms tend tooperate in local or regional markets where specialized institutions -regional banks establish long-term relationship with them. Specialized institutions display not only aneconomic commitment with local development. They also contribute to the promotionof social capital and local or regional empowerment very frequently (FULLER andJONAS, 1998). Although technology may be progressively blurring the role ofgeographical distance, the territorial bounds of financial activities are still relevant forhouseholds and firms (MOORE, 1998).Although comparisons across regions of a single country appear to be moreadequate than cross-country analyses in order to accurately ‘hold constant’unobservable differences in monetary, legal and cultural environments, someidiosyncratic characteristics at the country level should be also recognized in thiscontext. KLAGGE and MARTIN (2005) distinguish between two types of financialsystems in order to analyse the role of banks in economic development. On the onehand, there are countries where the financial system is entirely dominated by a national‘global’ centre and there are no separate regional capital markets (eg. the UK). In thistype of countries, SMEs frequently face access restrictions to capital mainly due to theabsence of specialized regional financial institutions. On the other hand, there arecountries where both regional capital markets and financial centres exist (eg. Germany).In these countries, there are both regional banks that serve local SMEs and households7
and also nationwide capital markets (for the larger financial institutions) that may stilldraw business away from the regional centres through internal capital markets.Nevertheless, as noted by ZAZZARO (1997), the rationale for the existence of abanking system in the economy is that banks are able to function as financialintermediaries between those savers and borrowers who are excluded from participatingin the centralized financial market. Local borrowers very often prefer to establish alending-relationship with small banks, which own better information about the localeconomic conditions. As opposed to the ‘hard’ information provided by large firms(stock market valuations, ratings, ) SMEs produce ‘soft’ (non-elaborated) information.Banks need to provide the market with a steady stream of relevant information on theeconomic prospects of the enterprises and households (KLAGGE and MARTIN, 2005).Small regional banks have higher incentives to invest in ‘soft’ information about localfirms than their larger counterparts due to their accumulated knowledge about localmarket conditions (PETERSEN and RAJAN, 1995). As shown by MARTIN (1999, pp.3-28), these relationships define the role of specialized financial institutions in the spaceeconomy and their autonomy to create not only economic but also social relations.Thus, the development of retail banking in some territories is not trivial and depends onthe evolutionary economic transformation of those areas –with certain banks leadingfinancial innovation - and on the interactions between conventions in bank practices andindividual bank strategies (LEYSHON and POLLARD, 2000). Information gatheringby small banks is, therefore, spatially-sensitive and these institutions are more effectivewhen performed in close proximity to borrowers. Therefore, banking structures arepartially allocated across economic space so that that credit can be made available toSMEs and households (ZAZZARO, 1997; DOW and RODRÍGUEZ FUENTES, 1997).Moreover, SMEs and households appear to be aware of these advantages and this8
knowledge reinforces their links with local financial institutions (MCKILLOP andBARTON, 1995).As noted by KLAGGE and MARTIN (2005), concepts such as ‘local capitalmarkets’, ‘spatial funding’ or ‘equity-gaps in the demand for and supply of finance’ areonly possible under the non-neutrality assumption that financial markets by themselvesprovide and imperfect allocation of capital between firms and across the spaceeconomy. Thus, the concentration of capital (or loan) markets in a central location willhave detrimental effects on the allocation of funds to domestic business and theseeffects will be asymmetric depending on the financial conditions of the regions wherethe firm is located.2.2. Empirical approaches: review and reassessmentThe empirical evidence in cross-country studies has shown, so far, a closerelationship between financial intermediation and economic growth. Financialdeepening and financial dependence are two key elements in this context. Financialdeepening can be defined as the level of development and innovation of traditional andnon-traditional financial services. Most of previous studies employed a bank creditvariable as a measure of financial deepening (MACKAY and MOLYNEUX, 1996). Inthis context, KING and LEVINE (1993) find: i) a positive and significant correlationbetween bank credit development, and, ii) faster economic growth and also a positiveinfluence of financial liberalization on bank efficiency reducing intermediation costs.Similar results have been obtained in other recent empirical studies. ROSSEAU andWACHTEL (1998) show that financial development enhances long-run economicgrowth in early stages of industrial development, Similarly, RIOJA and VALEV (2004)9
find a positive relationship between financial development and growth although itssignificance is found to vary depending on the starting level of financial development.Unobservable individual (country) effects have been taken into account as a keyfactor in this type of empirical research. BECK et al. (2000) and LEVINE et al. (2002)demonstrated that omitted variables, simultaneity or reverse causality do not alter themain finding of a positive correlation between intermediaries development and growthif unobservable effects are appropriately controlled. Considering these individualeffects, BENHABIB and SPIEGEL (2000) estimate various growth equations under theunderlying framework of both neoclassical and endogenous models showing thatfinancial development (deepening) indicators are positively correlated with total factorproductivity growth and investment.Financial dependence is related to the extent to which households and firms relyon bank finance to undertake their investment projects. Therefore, financial dependenceimplies a lack of financial sources different from bank credit for a substantial proportionof private agents. RAJAN and ZINGALES (1998) analyse these relationships findingthat financial intermediation reduces external finance costs of most dependent firms.CETORELLI and GAMBERA (2002) study dependence including market structureconsiderations. Their results are somewhat paradoxical since higher marketconcentration (employing a Herfindahl-Hirschman index) is found to be beneficial forbank credit-dependent industrial sectors and improves credit conditions for junior firmsentering the market. CARBÓ et al.(2003) found that there is no evidence of causalitybetween bank concentration and growth when regions of one country are employed andconcluded that there might be other factors that might influence both variables, such asthe number of bank branches.10
Differences between bank-based or market-based financial systems could implydiversity in growth patterns. According to LEVINE (2002) there is evidence of positiveeffects of intermediary (or financial system) development in both cases. Interestingly,DERMIGÜC-KUNTZ and MAKSIMOVIC (2002) undertake a cross-country analysisemploying microdata to show that the (positive) contribution of banks to growth is morelikely to occur in the short-run while financial markets development effects frequentlyshow up in the long-run.As for bank deepening, legal and institutional factors may also contribute toexplain the growth effects of financial dependence according to recent studies. Recentliberalization of bank activities (with a trend towards broad banking in most financialsystems) has been shown to increase financial intermediation efficiency and enhancetheir contribution to economic growth (ARESTIS and DEMETRIADES, 1997;JAYARATNE and STRAHAN, 1996; LA PORTA et al., 1998, 2002; CARBÓ andRODRÍGUEZ, 2004).3. REGIONAL GROWTH REGRESSIONS: EMPIRICAL ESPECIFICATION3.1. The benefits of the regional perspective: a closer look at the financegrowth nexusThere are three major potential advantages of a regional analysis (within acountry) compared with cross-country studies: (i) persistent heterogeneity acrossregions within a single country is lower and more easily controlled than acrosscountrie
of their level of financial development (RIOJA and VALEV, 2004). Secondly, we consider various financial innovations that have emerged in recent years and that are likely to have affected the financial intermediation-economic growth nexus (MAYER, 1988). Specifically, the eff
financial innovations from positive to negative, and on the other hand, the literature on financial innovation had touched upon different attributes of financial innovations. Finding the roots of post-1980 financial innovations is one of the most important topics among st
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