The Manchester School  Vol 0 No.

0   1–22  August 2018

doi: 10.1111/manc.12240

FINANCIAL STRUCTURE, INDUSTRIAL STRUCTURE,

AND ECONOMIC DEVELOPMENT: A NEW STRUCTURAL
ECONOMICS PERSPECTIVE

by
QIANG GONG
Zhongnan University of Economics and Law
JUSTIN YIFU LIN
Peking University
and
YILIN ZHANG †
Southwestern University of Finance and Economics

We investigate the evolving relative importance of banks and equity

markets during different stages of economic development. Unlike pre-
vious studies, we propose a demand-side theory on the appropriate fi-
nancial structure for an economy. We show that a bank-based financial
structure is more appropriate than a market-based structure for devel-
oping countries, and that for developed countries, a market-based fi-
nancial structure is more appropriate than a bank-based structure.
This is due to the industrial structures of countries and the different
advantages of banks and equity markets for serving the real economy.
Our findings are consistent with recent empirical facts and provide new
perspectives to understand the structural change of a country’s finan-
cial system.

1  Introduction
Financial structure varies greatly across countries, with a common rule that
the more developed the economy, the higher the chance that its financial
structure is market based1 (Fig. 1). Is a financial market more efficient than
the bank as the core of financial system? Should developing countries imi-
tate the financial structure of developed countries to catch up with or even

* Manuscript received 15.12.2017; final version received 20.05.2018

†
We would like to thank Yinyin Kong and Xiaokai Wu for their able assistance. We also ac-
knowledge financial support from National Natural Science Foundation of China
(71703131, 71773143), China Ministry of Education of Humanities and Social Science
Foundation (16YJC790141) and China Postdoctoral Science Foundation (2016M590896,
2017T100708). All opinions and any errors are the authors’.
1
Financial structure is the composition of financial institutional arrangements in a financial
system, typically including the bank-based financial structure (represented by Germany,
Japan, India, and China) and the market-based financial structure (represented by the
United States and the United Kingdom).
© 2018 The University of Manchester and John Wiley & Sons Ltd.

1
2 The Manchester School

Fig. 1.  Financial St r uct ur e and Economic Devel opment

Note: We show the evolution of financial structure across income groups and over time.
The financial structure indicator, stru_activity, is measured as stock market value traded
divided by private credit by banks and other financial intermediaries. For each income group
(1: period 1976–1989; 2: period 1990–1999; 3: period 2000–2007), we present the mean of stru_
activity in each of the three periods (1976–1989, 1990–1999, and 2000–2007).
Source: World Bank Financial Structure database and World Development Indicators.

surpass them in the development level of their financial markets? Is there an

optimal financial structure for a country? What is the fundamental factor
that determines the optimal financial structure? The earliest research on
financial structure can be traced to Goldsmith (1969), since which many
scholars have explored the relationship between financial structure and
economic development theoretically and empirically. However, economists
are still far from reaching consensus on this key issue even after a half-cen-
tury-long exploration.
This paper probes into the appropriate financial structure for an econ-
omy from the perspective of the New Structural Economics (NSE). The NSE
is based on a point that economic development is essentially a process of
continuous technological and industrial innovation and structural transfor-
mation. The NSE is different from traditional development theories which
treat economic structure as exogenous or emphasize government failure
and free market while neglect the issues of economic structure and its evolu-
tion. The NSE proposes that a country’s economic structure is endogenous
to the economy’s factor endowment structure, and it also proposes using a
neoclassical approach to study economic structure and its evolution, as well

© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 3

as the role of government and market in this process (Lin, 2009; 2012; Lin
et al., 2013). A key point of NSE is that an optimal industrial structure exists
at each developmental stage, matching the factor endowment structure; and
as the economy develops and the factor endowment structure changes, the
optimal industrial structure evolves correspondingly. The NSE can explain
why countries vary enormously in industrial structures, and can provide
a reference for a country’s financial and industrial policies. The theory of
Optimal Financial Structure derived from the NSE, further indicates that
because industries vary in scale and risk characteristics and each financial
institution, such as banks and stock market, has its own advantages and dis-
advantages in mobilizing savings, allocating capital, and diversifying risks,
each industry has its own suited financial channels and tools, and each
country has an optimal financial structure, in a sense that fully meeting the
financial needs of firms, in line with its industrial structure. Furthermore,
the appropriate financial structure may vary among countries depending
on their stage of development, which is usually associated with particular
industrial structures.
Our research shows that whether banks or financial markets are suit-
able for a certain industry is determined by the industry’s risk character-
istics. When evaluating the efficiency of a country’s financial system we
should examine whether the financial structure matches the overall indus-
trial structure instead of unilaterally emphasizing the degree of financial
deepening. A country’s financial structure and level of economic devel-
opment are positively correlated, and the fundamental reason is that eco-
nomic development brings about changes in industrial structure, hence
leading to the evolution of the financial structure. The leading industries
in high-income countries are usually at the technology frontier (Acemoglu
et al., 2006). Industrial development relies on a great deal of technolog-
ical R&D and product innovation, which involve considerable risks and
huge demand for diversifying risks (Acemoglu and Zilibotti, 1997). Thus
financial markets usually play a more important role in developed coun-
tries. Financial structure is generally bank based in developing countries,
where the mature labor-intensive sectors dominate in the industrial struc-
ture and economic development mainly relies on the latecomer advantage.
In developing countries, banks can overcome information asymmetry
more effectively and achieve higher financial allocation efficiency owing
to mature industry with lower risk. If developing countries blindly pursue
a high development level of financial markets without considering their
stage of development, they will incur efficiency losses. Worse, this choice
may hinder their economic growth or even lead to instability in the finan-
cial system.
The existing research mainly focuses on the effects of financial struc-
tures on economic development, namely, whether a bank-based or

© 2018 The University of Manchester and John Wiley & Sons Ltd.
4 The Manchester School

financial-­based financial structure is more conducive to economic develop-

ment.2 Studies in support of a bank-based structure argue that banks are
more efficient in capital regulation and supervision. Normally, banks re-
quire collateral from firms when making loans, so as to partially recover the
losses or reduce the risk of loans in the case of default or bankruptcy.
Mortgage and liquidation not only protect the interests of banks and savers,
but also help banks overcome adverse selection and moral hazard caused by
asymmetric information and promote the allocation efficiency of financial
resources (Aghion and Bolton, 1992; Bolton and Freixas, 2000; Manove et
al., 2001; Benmelech and Bergman, 2009). What is more, banks have the
function of ‘delegated monitor’, conducting filtering and supervision over
financing enterprises on behalf of individual savers. Because they can give
full play to the scale advantages and avoid the problems of ‘free riding’ and
incompatibility of incentives that usually occur with individual supervi-
sion, banks can obtain and process relevant information more effectively3
and carry out prior screening and ex-post supervision (Gerschenkron, 1962;
Diamond, 1984; Boyd and Prescott, 1986; Allen, 1990; Boot et al., 1993;
Boot and Thakor, 1997; Holmstrom and Tirole, 1997; Rajan and Zingales,
1998). Song et al. (2011) investigate the impacts of the banking system on
China’s economic growth, return on investment, trade surplus, and redistri-
bution of factors, and find that banks are more inclined to support the de-
velopment of export industries under the condition of asymmetric
information.
Some studies have pointed out that banks also have comparative ad-
vantages in financial regulation over financial markets. Financial markets’
supervision mechanisms include direct supervision by shareholders, acqui-
sition threat, and information disclosure. The effectiveness of shareholders’

2
Yet some studies have suggested that financial structure has no significant effects on eco-
nomic growth, and it is only the overall development level of the financial system that
matters (Merton, 1995; Merton and Bodie, 1995; Demirgüç-Kunt and Levine, 2004).
However, if the financial structure is not the key factor, then why does the financial
structure seem to be growing in importance with economic development? Demirgüç-
Kunt and Levine (2004) also found that financial markets were much more active and
efficient than banks in high-income countries, and the financial structure tended to be
market-based in countries with a sound legal system.
3
Adequate information collection can help overcome information asymmetry and is critical
to the efficiency of financing. The returns and costs of information collection determine
the funding providers’ investment. Studies have indicated that banks can obtain infor-
mation and use it as reference privately to provide financing to an enterprise, which al-
lows banks to equalize the payoff and return on information collection; thus, they have
sufficient incentives to collect information related to enterprises, managers, and the
business environment (Gerschenkron, 1962; Boot et al., 1993). In contrast, investors in
financial markets are faced with problems of ‘free riding’ of information collection
(Stiglitz, 1985). Sharpe (1990) pointed out further that the external financing constraints
of enterprises could be eased through establishing a long-term relationship with banks,
which can reduce the cost of information collection.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 5

supervision depends on the concentration of equity. An overdecentralized

ownership structure could cause free riding in supervision, while over-
concentration of ownership could provide substantial shareholders with
opportunities to grab enterprise resources, thus impairing the interests of
the minority shareholders (DeAngelo and DeAngelo, 1985; Zingales, 1994).
Researchers have suggested that acquisition threat is an effective gover-
nance mechanism (Scharfstein, 1988; Stein, 1988). However, as the enter-
prise has information superiority on its actual value, the purchaser usually
has to pay a higher premium to complete the acquisition; in addition, an
information leak can hardly be avoided during the acquisition, which would
bring in outside investors, making it much harder to complete the acqui-
sition, hence the effectiveness of the acquisition threat is quite limited in
practice (Grossman and Hart, 1980; Stiglitz, 1985). Information disclosure
required by financial regulators plays a vital role in reducing information
asymmetry, while the cost is so high that enterprises with a smaller financ-
ing scale cannot afford it.
Researchers advocating developing financial markets have argued that
financial markets can promote innovation more efficiently than banks. Due
to the great uncertainty in the returns of innovative projects, the reduc-
tion in stock returns in the short term will not cause project liquidation or
the enterprise’s bankruptcy through market financing; while in the case of
bank financing, the debts have to be paid and the innovative enterprises are
faced with great risks of liquidation or bankruptcy (Morck and Nakamura,
1999; Lin et al. 2013). Moreover, investors may hold disparate information
and opinions in financial markets, and innovative firms with higher risks
have higher chances of obtaining financing. In contrast, banks are better
positioned to get and process standardized information and often less effi-
cient when financing for innovative technologies and products with higher
risks (Weinstein and Yafeh, 1998; Allen and Gale, 1999). When it comes to
risk management, financial markets can provide diversified services, while
banks can only implement basic risk control; thus financial markets work
better when flexible risk management is needed to improve the efficiency
of fundraising (Levine, 2005). Besides, studies have found that in a bank-
based financial system, banks are more prone to hold excessive sway over
the market, thus enterprises have to surrender substantial profits to obtain
financing, which reduces their incentives to initiate innovative and profit-
able projects (Hellwig et al., 1991; Rajan, 1992).
Although these studies have looked at institutional differences between
banks and financial markets, they neglected the variation in characteristics
of industries in various stages of development and the structural differences
in demand for banks and financial markets. It would be difficult to provide
a satisfactory explanation for the basic facts of financial structure and the
inherent relations between financial structure and economic development
if we ignored the specific needs of the real economy for financial systems.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
6 The Manchester School

Financial systems should match with industrial characteristics; this paper

explores the differences between banks and financial markets in serving
industries based on a theoretical framework including enterprises, banks,
and financial markets, and then reveals the functions of banks and financial
markets at various stages of economic development.
Our research finds an optimal financial structure corresponds to a spe-
cific industrial structure. The upgrading of the industrial structure could
increase the risks (including technical and market risks) of leading indus-
tries.4 In this situation, enterprises’ financing costs through bank loans in-
crease significantly, because they need to pay higher interest to compensate
for the bank’s loan risk, and they are faced with higher risks of liquidation
and bankruptcy resulting from the increase in uncertainty of returns.
Therefore, bank financing is effective only when the risk for the industry is
relatively low. Financial markets can work better in diversifying innovation
risks than banks, because the risks are shared by both investors and enter-
prises, and the enterprises’ technology development and product innova-
tion can receive sustained support even in case of short-term decline in
profits. In this way, financial markets contribute to the success of innova-
tive enterprise with higher risks. When the risk is quite high, financial mar-
kets are relied upon or become the only source for enterprises to obtain
financing.
For an economy, the optimal financial structure is endogenously deter-
mined by the economic development level. Most of the leading industries in
developing countries have not reached the forefront of the world’s technol-
ogy, which means great latecomer advantages can be exploited. That is to
say, they can introduce mature technologies and products from developed
countries and imitate and innovate on this basis so as to minimize the risk
of industrial development and achieve faster economic development (Lin
et al., 2013). As banks have more advantages in serving mature industries
with lower risks, a bank-based financial structure is more effective in pro-
moting economic growth in developing countries. Compared to developing
countries, developed countries possess cutting-edge technologies in their
leading industries, and the innovation of technologies and exploration of
new markets are the main sources of economic growth, which bring high
risks that bank financing cannot match. However, financial markets can
provide effective support for enterprises’ innovation, as they are good at
dispersing risks. Therefore, the financial structure should be market based
in developed countries.

4
Industrial risks include technological innovation and market risks (i.e., risks of product in-
novation). The former refers to the risks associated with the technological innovation
activities of an enterprise, and the latter refers to the uncertainty of whether the prod-
ucts will be accepted by the market. Industrial risk depends on the technical character-
istics of the industry (Lin, 2009; Lin et al., 2013).
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 7

Further, we find that financial markets have greater demand for the
institutional environment compared to banks, which means that the evolu-
tion of the financial structure should be supported by improvement in the
institutional environment, whose qualities are related to the relevant laws,
credit system, property rights protection, and information disclosure sys-
tem and other soft infrastructures(La Porta et al., 1998; Tadesse, 2002).5 In
financial markets, mortgage and liquidation have little effect on moral re-
straints, because investors adopt equity financing, thus a sound institu-
tional environment is needed to protect their interests. The imperfections in
laws, credit, and other related systems result in investors’ lack of incentives
to supply capital, thus enterprises have to surrender lots of equity to obtain
financing. Compared to financial markets, banks can protect their own in-
terests more effectively and impose moral restraint on enterprises by requir-
ing them to provide mortgage loans and reserving the right of default
settlement. This paper shows that when the effectiveness of financial mar-
kets is inhibited by the institutional environment, bank financing is more
effective in promoting the development of mature industries with lower
risks; however, the efficiency of bank financing decreases significantly in
cases of innovative industries with higher risks, where the financial market
can only support the industries well by improving the institutional
environment.
Our conclusions are consistent with recent empirical studies that find
that the effects of banks and financial markets differ significantly at differ-
ent economic development levels. To be specific, financial systems in less
developed countries are bank based, which is more conducive to promot-
ing economic growth; as the economy reaches a higher level of develop-
ment, the importance of financial markets continues to rise (Harris, 1997;
Tadesse, 2002; Demirgüç-Kunt and Levine, 2004; Demirgüç-Kunt et al.,
2012; Kpodar and Singh, 2011; Rioja and Valev, 2012; Cull and Xu, 2013;
Lin et al., 2013). For example, Demirgüç-Kunt et al. (2012) investigate the
development performance of 72 developed and developing countries over
the previous 30 years and find that as the economy grows, the correlation
between total output and bank development decreases, while the correla-
tion between total output and the financial market increases. Cull and Xu
(2013) find that in low-income countries, the more active the loan trans-
actions, the faster the labor force grows; while in high-income countries,
faster labor growth originates from larger financial markets. The empirical
studies of La Porta et al. (1998) find that how well investors’ interests are
protected is determined by the legal system and its executive power, and
when the quality of a country’s legal system is poor, the shareholding ratio
of investors in financial markets is higher and the ownership structure of

5
The institutional environment is a kind of ‘soft’ infrastructure (Lin, 2009, 2012 , 2013).
© 2018 The University of Manchester and John Wiley & Sons Ltd.
8 The Manchester School

enterprises more concentrated. Our research shows that improvement in

the legal system contributes to the reduction of enterprises’ financing cost
in financial markets. A sound legal environment is particularly important
for the effective operation of financial markets, while banks are more effi-
cient in overcoming defects in the legal environment. In summary, banks
and financial markets are not the same institutional arrangements, and the
efficiency of the financial system can be maximized only when their institu-
tional characteristics are suited to the economic development level.
The policy implication of this paper is that when measuring the effi-
ciency of a country’s financial system, it is essential to examine whether
the financial structure matches the economic development level. Studies on
financial structures have mainly focused on the institutional distinctions
between banks and financial markets, while ignoring systemic distinctions
in demand based on the industries and risk structures at different economic
development levels. However, this paper shows that the financial structure
most suitable for a country is endogenously determined by its economic de-
velopment level and industrial structure. In developing countries where ma-
ture industries play a dominant role, banks can allocate financial resources
more efficiently, and the bank-based financial system is more conducive to
economic growth. If developing countries blindly try to catch up with or
surpass the developed countries in terms of development level of financial
markets, they will incur efficiency losses. On the contrary, this would be
contrary to the financial needs of the real economy and would distort the
efficient allocation of financial resources.
The rest of the paper is as follows. Section illustrates the theoretical
framework. Section examines the accessible conditions for enterprises to
obtain financing from banks and financial markets. Section explores the
impacts of industrial risks and institutional environment on enterprises’ fi-
nancial demands and on the matching of financing demand and supply. The
last section concludes the paper and gives some policy recommendations.

2  Model
We consider an economy that consists of homogeneous risk-neutral enter-
prises, banks, and investors. The enterprise, owned by its operator, needs
to finance a project by choosing bank loans (bank financing) or issuing
shares in the financial markets (market financing).6 For the sake of sim-
plicity, we consider the case of an enterprise that can only choose one type
of financing. The banks and financial markets are perfectly competitive.
We first describe the financing process, then define the industry’s risk and
institutional environment, and finally describe the information structure

6
Following the literature on financial structure, the financial markets in the theoretical
framework refer to the stock market (Allen and Gale, 2000; Levine, 2005).
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 9

t=0 t=1 t=2

The enterprise If the enterprise The enterprise

chooses between chose bank repays the bank
bank and market financing, the bank loan or pays out
financing. decides whether to dividends to the
liquidate the project investors.
at t=1.

Fig. 2.  Financing Timing.

between the enterprise and the funding providers, bank, and financial
market investors.7

2.1 Timing
Financing is divided into three stages (Fig. 2). In stage t = 0, the enterprise
finances the project with investment amount I. The enterprise agrees the
interest with a bank or the equity ratio with investors, and then the bank or
the investors decide whether to provide the funds. If the enterprise chooses
to finance from the bank, the bank can choose to liquidate the project in
t = 1. At the end of stage 2, the enterprise pays the bank interest or issues
dividends to investors.
Following Bolton and Freixas (2000), the enterprise owner invests his
or her own funds w≤I in stage t = 0. The remaining I−w, which is standard-
ized to 1, is obtained from banks or financial markets. In stage t = 2, the
project may succeed or fail. The project profit 𝜋 is a random variable, the
distribution of which is shown below. If the project succeeds, the enterprise
pays interest or dividends, whereas if the project fails, there is no surplus.
If the project continuously operates in stage t = 2, the enterprise owner,
regardless of success or failure, earns private income b, which is very small
but can cover w (w < b≤1). In addition, b cannot be transferred to the outside.
If the enterprise chooses bank financing in stage t = 1, banks may liq-
uidate the project and get the liquidation residual A < 1. In this case, no
surplus is produced in the enterprise and the project is over. If the{bank}
does not liquidate the project in stage t = 2, the enterprise repays min R,𝜋
to the bank, { where} R is the summation of principal and interest, and re-
tains 𝜋 − min R,𝜋 . The project’s liquidation value in stage t = 2 is 0. If

7
Instead of using a macro general equilibrium model, we chose to use a simple partial equilib-
rium model as the micro foundation for the Optimal Financial Structure theory. This
partial equilibrium framework is in line with the Optimal Capital Structure theory, but
has a distinguished feature from existing corporate finance model. Specifically, we de-
liberately distinguish between two types of risk of a firm: the innovation risk and entre-
preneurial risk. We study the different effects of these two risks on the optimal financing
channel of firms and derive a demand-side micro foundation for the Optimal Financial
Structure theory.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
10 The Manchester School

the enterprise chooses market financing, the project is not liquidated. The
enterprise pays dividends s𝜋 to investors and retains (1 − s) 𝜋 in stage t = 2.

2.2  Industry Risk

Two risks to the project’s success are incurred: technological innovation
risk and product innovation risk (also known as market risk). The former
refers to the risk associated with the enterprise’s technological innova-
tion activities, i.e. whether the enterprise can successfully develop new
technologies. The latter refers to the uncertainty of whether the products
produced by the enterprise can be accepted by the market, which depends
to a large extent on the industry’s technical characteristics. For industries
in the forefront of technology, the success of the project depends more
on original technology innovation and product innovation, which car-
ries more risk. On the contrary, for industries that have not reached the
technological frontier and for technologies and products that are more
mature, the R&D density and the corresponding risks are relatively low
(Lin, 2009).
To characterize industry risk, we consider two types of projects. Let
L denote the project with low risk and H denote the project with high risk
(Fig. 3). In stage t = 1, L generates profit, while H does not generate profit
in t = 1 (Bolton and Freixas, 2000). In stage 2, L and H may succeed or
fail, which is uncertain. If the project succeeds, the probability that L and
H generate profit is pL and pH , respectively, and the corresponding profit
is 𝜋L and 𝜋H . We assume that pH < pL and 𝜋H > 𝜋L > I . If the project fails, it
generates no profit, regardless of H or L.

Fig. 3.  Accessibil it y of Bank and Mar ket Financing

Notes: vdenotes institutional environment, 𝜃 denotes industrial risk, B indicates that the
enterprise has accessibility to bank financing, and E indicates that the enterprise has
accessibility to market financing. B means bank financing is not accessible, and E means that
market financing is not accessible.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 11

Let 𝜃 denote the industry risk, which is the likelihood that the project is
H. Higher 𝜃 means that the success of the project depends more on original
R&D and product innovation, and the technical risk and market risk are
higher. The success probability is low, and the profit in success is high.

2.3  Institutional Environment

Consider a good enterprise and a bad enterprise in the market. The income
and risk of the good enterprise is described above, while the bad enterprise
does not generate profits in both t = 1 and t = 2. The liquidation value of
the bad enterprise in any period is 0, which is the main difference between
the bad enterprise and the good. Following Bolton and Freixas (2000), if
the bad enterprise continues operating until t = 2, it can get private income
b > w, which cannot be transferred to the outside. Therefore, the bad en-
terprise has incentives to imitate the good enterprise at t = 0 by investing
its own funds w and raising funds externally. As a result, liquidation has a
significant impact on the bad enterprise.
Let v denote the market environment, which represents the proportion
of good enterprises in the market. The institutional environment reflects the
perfection of relevant laws and regulations, the credit system, and informa-
tion disclosure in protecting investors’ rights and interests in the financial
system. A good institutional environment can effectively reduce informa-
tion asymmetry and restrict entrepreneurs’ moral hazard, increasing the
proportion of good enterprises in the market. Without loss of generality, the
total number of enterprises is standardized to 1. Naturally, we only look at
good enterprises’ financing decisions.

2.4  Information Structure and Information Updates

In stage t = 0, both industry risk and institutional environment are common
knowledge, which means that all participants know exactly the size of 𝜃 and
v, but the funding provider does not know the specific type of the project.8
Note that in t = 0, all participants, including the good enterprises, do not
know whether the project is H or L, and only know the probability distribu-
tion is 𝜃. In t = 1, if the project generates profit, it can be confirmed as L;
otherwise it is H. Funding providers can observe whether the enterprise is
profitable, so the provider can identify the L project. However, because
both H and bad projects do not generate profits in t = 1, funding providers
cannot distinguish between H and the bad enterprise. As many experts have
pointed out, low-risk industries are usually labor-intensive industries with
less capital investment and intensive labor inputs. They exist or have existed

8
Similar assumptions can be found in studies such as Jovanovic and Rousseau (2001) and
Pástor and Veronesi (2005).
© 2018 The University of Manchester and John Wiley & Sons Ltd.
12 The Manchester School

in the market, are more likely to benefit in the short term, and are also eas-
ier to identify and monitor. In contrast, in the high-risk industries where
R&D and product innovation are more intensive, companies usually have
more difficulty generating profit in the short term. Fund providers are more
difficult to effectively monitor and identify (Allen and Gale, 1999; Lin et al.,
2013). Therefore, we examine the situation where fund providers can iden-
tify L but cannot distinguish between H and bad projects in t = 1. In stage
t = 2, the success of the project and the benefits of success are common
knowledge.

3  Analysis the Accessibility of Banking and Financial Markets

Based on the above theoretical framework, we explore how industrial risks
and market conditions can affect enterprises’ availability of bank
financing and market financing, in other words, whether enterprises’
financing needs can be met. As mentioned, we assume that the banks and
financial markets are fully competitive and the risk-free interest rate is 0.
To further clarify the main idea of this article, our analysis is based on the
following assumptions.9
( ) ( )
( Assumption
) 1:(H and
) L have the same expected profit, i.e. E 𝜋̃H = E 𝜋̃L ,
E 𝜋̃H = pH 𝜋H , E 𝜋̃L = pL 𝜋L.
Assumption 2: When v = 1 and 𝜃 = 0 (when only L is in the market), the
bank provides financing, i.e. R ≤ 𝜋L.
We first analyze bank financing, then compare market financing with
bank financing.

3.1  Bank Financing

Banks lend money to an enterprise and make a tradeoff between earnings
(interest) and loan risk (failure of the project that leads to default). In a
risk-neutral environment, the bank provides financing if and only if the ex-
pected return of the loan is greater than or equal to 1. In stage t = 1, the
bank recognizes L but cannot distinguish between H and bad projects and
reserves the right to liquidate the project. The following lemma shows that
the bank will not liquidate L.
Lemma 1: The bank will never liquidate project L.
Lemma 1 shows that because the bank can recognize L, it gets A from
liquidation. If the bank discovers that the project is L and does not liqui-
date, it obtains pL R> 1 >A at t = 2. Therefore, the bank will not liquidate.

9
Under the more general assumption, the basic conclusion of this article still holds. Due to
limited space, this article considers the most typical case, which is helpful in simplifying
the model and exploring related issues.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 13

Because banks cannot differentiate between bad projects and H, they

do not liquidate non-L projects to prevent the principal from being re-
claimed.10 At this point, bad enterprises cannot get private income b (thus
are unable to recover their own funds w) and do not enter in t = 0, leaving
only the good businesses in the market. Thus, by choosing bank financing,
the bank’s liquidation system helps distinguish good enterprises from bad
businesses, thereby reducing the information costs caused by asymmetric
information (to make up for bank loan interest expenses). However, due to
the uncertainty of whether the project is H or L, good enterprises face the
liquidation risk when choosing bank financing.
The objective function of bank financing for the enterprise is as fol-
lows: the enterprise pays the bank interest to maximize the profit,
[ ( ) ]
maxR (1 − 𝜃) E 𝜋̃L − pL R

s.t. (1) 𝜃A + (1 − 𝜃) pL R ≥ 1

(2) pH R ≤ A

Condition 2 is the incentive compatibility condition for banks to liq-

uidate bad projects, which means that the liquidation residual A is greater
than the expected return pH R of not liquidating, when the bank finds that
the project is not L. Under bank financing, bad enterprises cannot get pri-
vate income b and do not enter the market, which helps good enterprises
reduce the interest they need to cover the banks’ loan risk. However, the
enterprise
[ ( ) faces]liquidation risk at this time, causing the enterprise to lose
𝜃 E 𝜋̃H − pH R , the profit of project H. Condition 1 is the bank’s participa-
tion constraint, 𝜃A+ (1−𝜃) pL R with R being the banks’ expected return in
t = 0, 𝜃A is the assets remaining by liquidating H, and (1−𝜃) pL R is the total
revenue, including principal and interest, when L succeeds. The conditions
under which an enterprise can make bank financing are:
Lemma 2: There exists 𝜃̂ that (1) when 𝜃 ≤ 𝜃̂ bank financing is ac-
1−𝜃A
cessible for enterprises, R = (1−𝜃)p , and the enterprise’s expected profit
L
is 𝜋 = (1 − 𝜃) pL 𝜋L +𝜃A−1 at t = 0; (2) when 𝜃 >𝜃̂ bank financing is not
B

accessible.
Lemma 2 shows that bank financing is accessible for enterprises
when the industry’s risk is low. When the industry’s risk is low, 𝜕R∕𝜕𝜃 > 0,

10
According to the MM theorem (Modigliani and Miller, 1958), it can be shown that if a bank
does not liquidate non-L projects, the profits from market financing are always not less
than those of bank financing. In other words, market financing is always better than
nonliquidity bank financing. Therefore, the bank liquidates non-L projects.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
14 The Manchester School

indicating that enterprises need to pay higher interest rates to cover the
bank’s loan risk as the risk increases. Because bank liquidation can pre-
vent bad enterprises from entering, good enterprises can reduce the inter-
est expense caused by the imperfect institutional environment (𝜕R∕𝜕v = 0)
through bank financing. When the industry risk is high, the interest is so
large that it is beyond the enterprise’s reach (R), greater than 𝜋L, in contra-
diction with Assumption 3, or causes the incentive compatibility Condition
2 to no longer hold.

3.2  Market Financing

An enterprise issues shares and maximizes profits:
[ ( ) ( )]
max0≤s≤1 (1 − s) 𝜃E 𝜋̃H + (1 − 𝜃) E 𝜋̃L

[ ( ) ( )]
s. t.vs 𝜃E 𝜋̃H + (1−𝜃) E 𝜋̃L ≥ 1

[ Constraints
( ) are( )] investors’ participation constraints, where
vs 𝜃E 𝜋̃H + (1−𝜃) E 𝜋̃L is investors’ expected return in t = 0. No liqui-
dation risk exists in market financing. Lemma 3 gives feasibility conditions
for market financing.
Lemma 3: There exists v̂ that (1) when v < v̂ market financing is not
accessible; (2) when v ≥ v̂ market financing is accessible, s = vp 1𝜋 , and enter-
prise’s expected profit is 𝜋 E =pL 𝜋L − 1v at t = 0.
L L

Lemma 3 shows that a good institutional environment is a necessary

condition for the financial markets to function effectively. When the insti-
tutional environment is bad (v < v̂ ), investors lack incentives to enter the fi-
nancial markets due to the lack of effective self-protection. Only when the
market conditions are good enough, with v ≥ v̂ , can an enterprise raise funds
in the financial markets. With 𝜕s∕𝜕v < 0 and 𝜕𝜋 E ∕𝜕v > 0, the deterioration
of the institutional environment leads an enterprise to transfer more equity
because of the increase of financing costs caused by information asymme-
try. Although financial markets have a high degree of dependence on the
institutional environment, under market financing, enterprises and finan-
cial market investors share the risk and the financing cost, and enterprise
investment returns are more stable (𝜕s∕𝜕𝜃 = 0, 𝜕𝜋 E ∕𝜕𝜃 = 0). The post-analy-
sis shows that when the risk is high, the financial market is the first priority
and the only viable financing channel for enterprises.

3.3  Comparison Between Bank Financing and Market Financing

We have compared the viable conditions for bank financing and market
financing. We have shown that banks can use the liquidation system to

© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 15

overcome the constraints of the institutional environment, but the increase

in industry risk reduces the feasibility of bank financing. In contrast, mar-
ket financing has greater dependence on the institutional environment but is
less sensitive to industrial risks. We summarize the following propositions:
Proposition 1: There exist 𝜃̂ and v̂ . (1) In region I = {(𝜃,v)|𝜃 ≤ 𝜃,v
̂ ≥ v̂ },,
both market financing and bank financing are accessible. (2) In region
̂ > v̂ }, only market financing is accessible. (3) In region
II = {(𝜃,v)|𝜃 > 𝜃,v
̂ ≥ v̂ }, only bank financing is accessible. (4) In region
III = {(𝜃,v)|𝜃 < 𝜃,v
̂ < v̂ }, neither bank nor market financing is accessible.
IV = {(𝜃,v)|𝜃 > 𝜃,v
The conclusion of this proposition can be illustrated by Fig. 3. Region
IV in the figure corresponds to the situation where the industry risk is high
and the institutional environment is bad. In this case, the high industry risk
inhibits the banks’ effectiveness, and the institutional environment is not
conducive to market financing. For the economy in this state, the efficiency
of the financial system can often only result by reducing industrial risks or
improving the institutional environment to meet the enterprises’ financing
needs. If the institutional environment remains unchanged and the industry
risks reduce, bank financing becomes viable. If the industry risks remain
unchanged and the institutional environment improves, the financial mar-
kets become viable. If the industry risk lowers and the institutional envi-
ronment improves, both banks and financial markets can provide financial
support to the enterprises. Next, we examine the optimal choice of enter-
prises in Region I where both approaches are accessible.

4 Optimal Financing Choice

In this section we further examine the impact of industrial risk and institu-
tional environment on enterprises’ optimal financing options. The follow-
ing propositions show enterprises’ optimal financing pattern when market
financing and bank financing are accessible.
Proposition 2: In region I = {(𝜃,v)|𝜃 ≤ 𝜃,v
̂ ≥ v̂ }, where both bank fi-
nancing and market financing are accessible, there exists 𝜃 (v) that (1)
when 𝜃 <𝜃 (v), 𝜋 B >𝜋 E , enterprise chooses bank financing; (2) when 𝜃 ≥ 𝜃 (v),
𝜋 B ≤ 𝜋 E and enterprise chooses market financing.
In region I of Fig. 3, both market financing and bank financing are
accessible. At this time, the industrial risk determines enterprises’ optimal
financing pattern, the enterprises’ demand for financing channels. When
the risk is low (𝜃 < 𝜃 ), enterprises have a lower liquidation risk of bank fi-
nancing, and bank financing is a better choice because the bank’s liquida-
tion system can reduce the information cost. However, when the risk is high
(𝜃 > 𝜃 ), enterprises choosing bank financing not only need to pay higher
interest rates but also face higher liquidation risk, while in the financial
markets, enterprises and investors share risks, and enterprises can obtain
financing at financial markets at lower costs.
© 2018 The University of Manchester and John Wiley & Sons Ltd.
16 The Manchester School

Thus, the efficiency of bank financing and market financing vary de-
pending on the industries they serve. Depending on their stage of develop-
ment, countries correspond to optimal financial structures. In developing
countries, due to their latecomer advantages, the technology and prod-
ucts of the leading industries are relatively mature. The real economy has
a higher demand for bank financing services, and therefore, the bank-led
financial structure is more conducive to supporting the rapid development
of the real economy. Unlike in developing countries, most industries in de-
veloped countries have reached the technological frontiers. They need to
expand their technological frontiers through original R&D of technologies
and open up new markets through new products. The industry risk is high
and banks’ effectiveness is limited. At this moment, market financing is
needed to diversify the high risk. The financial system in developed coun-
tries is dominated by market financing, which can further promote sus-
tained economic growth.
According to Proposition 2 we can explain the empirical findings re-
lated to the financial structure. The financial structure best suited to the
stage of economic development can fully meet the financial needs of the real
economy, promote the allocation of financial resources to the most compet-
itive production sectors, and maximize economic development. Due to the
different industrial structures in developing and developed countries, their
optimal financial structures vary (Lin et al., 2013). For example, if a country
has more firms that prefer bank financing, the country’s banking system
is likely to be relatively larger than the countries where more firms prefer
equity financing, under the condition of controlling other factors like num-
bers of firms, culture, geographical characteristics, etc. Moreover, since the
characteristics of firms’ financial demand are determined by the firms’ risk
characteristics and the latter depends on the development stage of the coun-
try, we may see from Fig. 1 that there is a positive correlation between a
country’s financial structure and its development stage.
Naturally, the aggregate output of developing countries is associated
with a higher level of development of the banking system, while developed
countries depend more on financial markets (Demirgüç-Kunt et al., 2012).
In addition, the most competitive enterprises in the economy have better
absorbed the labor force. The optimization of the financial structure can
promote the allocation of resources to these enterprises, resulting in an
increase of total labor demand, the effective mobilization of an idle labor
force, and an effective increase of labor income (Kpodar and Singh, 2011;
Cull and Xu, 2013).
A question worth discussing is what we see from Fig. 1 is positive
correlation or causal effect between economic development and financial
structure? This question has important policy implication because if it is
causal effect, then it means that a market-based financial structure is bet-
ter than bank-based financial structure, not only for developed countries
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 17

but also for developing countries. In this situation, government should pro-
mote the development of equity market regardless of the country’s develop-
ment stage. Instead, if it is just positive correlation, then government need
to carefully decide what kind of financial structure is appropriate for the
country. It is easy to see that the analysis above supports the causality view.
The policy implication here is that government should take a look at the
country’s development stage and firms’ risk characteristics and financial
demand characteristics, and then think about what kind of financial struc-
ture is more in line with the industrial structure.
Next we examine the impact of industry risk and institutional environ-
ment on enterprises’ optimal financing pattern.

4.1  Impacts of Industrial Risks

Corollary 1: There exist v̂ and v ≥ v̂ that (1) when v <̂v, enterprise shifts from
bank financing to nonfinancing as the industrial risks increase; (2) when
v >v, enterprise shifts from bank financing to market financing as the in-
dustrial risks increase.
When the institutional environment is less desirable (v <̂v), banks could
distinguish good enterprises from bad ones through liquidation system.
However, as the industrial risks increase, the feasibility of bank financing
declines. When the intuitional environment is relatively desirable (v >v), it
is easier for investors to reduce information asymmetry via credit system
and protect their own interests by laws , meaning that the effects of banks’
liquidation system decline while solid market environment become more
favorable for the development of financial markets. As the industrial risks
increase, enterprises need to share the risks with investors, making finan-
cial markets become the preferred financing channel.

4.2  Impacts of Institutional Environment

Corollary 2: There exist 𝜃̃1 and 𝜃̃2 > 𝜃̃1 that (1) when 𝜃 <𝜃̃1, the enterprise shifts
from bank financing to market financing as the institutional environment
improves, (2) when 𝜃 >𝜃̃2, enterprises switch from nonfinancing to market
financing as the institutional environment improves.
When the legal system, property rights protection, credit system, and
information disclosure of the financial system are imperfect, it is difficult for
investors to protect their rights and interests. For mature industries (𝜃 <𝜃̃1)
with low risk, banks can exert their institutional characteristics and reduce
the information costs of enterprises, so enterprises have greater demand
for bank financing. When the institutional environment improves, the mar-
ket financing availability improves and the demand for market financing
increases due to risk diversification. When enterprises’ technological level
reaches the world frontier (𝜃 >𝜃̃2), the huge innovation risk makes it difficult
for the bank to provide continuous financial support to the enterprise. At
© 2018 The University of Manchester and John Wiley & Sons Ltd.
18 The Manchester School

this time the financial market becomes the key to enterprise development.
However, the effective functioning of the market requires a good institu-
tional environment as a prerequisite (𝜃 (̂v) >𝜃̃).

5 Conclusions
This paper studies the relationship between financial structure and eco-
nomic development and finds that different financial structures are suit-
able for different economic development stages. Specifically, a bank-based
financial structure is more effective in developing countries. Because devel-
oping countries are rich in labor and scarce in capital, labor-intensive and
mature manufacturing are in line with the comparative advantages deter-
mined by the factor endowment structure. Banks have advantages in servic-
ing these low-risk mature industries. A bank-based financial structure more
closely matches the industrial structure of developing countries.
In the real world, however, establishing a financial system is not free
but rather expensive and resource-consuming. A worth-thinking question is
that, for those poor and less developed countries, say poor African countries
like Zimbabwe and Liberia, should the limited resources of these countries
be devoted to the establishment of banking system or to the establishment
of stock market? Given the limited resources and budget constraint for all
countries in the world face, countries in different development stages should
adopt different financial development strategies when making policies re-
lated to the financial structure. Any country should seriously consider its
own industrial structure, which determines the real economy’s (firms’) fi-
nancial demand structure, and based on this choose the most suitable fi-
nancial structure, ultimately helping firms to meet their financial needs, so
as to achieve the fastest industrial upgrading and economic development.
With economic development and the structural upgrading of factor en-
dowments in developing countries, the effect of financial markets in promot-
ing industrial upgrading is enhanced. In the economic transition of developing
countries, the industrial structure changes from labor-intensive industries to
capital- and technology-intensive industries. Original R&D of technology
and product replace the strategy of technical imitation. With rising risks, the
demands of the real economy for financial markets increase. When develop-
ing countries reach a certain development stage, efficient financial markets
are needed to achieve further economic development and industrial upgrad-
ing. Efficient financial markets can fulfill the financial needs of qualified in-
novative enterprises and make the real economy more innovative.
A good market investment environment is the key to giving full play
to the effect of the financial market on industrial upgrading. Compared
to the banking system, financial markets are inadequate to protect inves-
tors’ interests, especially small and medium-sized investors’ interests. Until
relevant laws and investor protection systems are fully improved, investors
© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 19

may lack sufficient incentives to invest in financial markets. So high-quality

innovative enterprises cannot easily obtain effective support in financial
markets. Improving the investment environment in financial markets, in-
cluding IPO, information disclosure, and related legal systems, is not only a
necessary prerequisite for the effective operation of financial markets, but is
of crucial importance for the economic development and industrial upgrad-
ing in developing countries.
After World War II, many developing countries have imitated de-
veloped countries’ economic systems. This paper shows that countries in
different development stages have different optimal financial structures.
Financial markets play an important role in developed countries’ financial
systems, which are endogenously determined by their stage of development
and their institutional environment. If developing countries imitate the de-
veloped world’s financial structure, not only will their real economy’s fi-
nancial needs not be met, but financial resources may be misallocated and
the risk in the financial system will increase. To achieve better economic
growth, developing countries need to make full use of their latecomer ad-
vantages, effectively reduce the risks of industrial development, and give
full support to the real economy.
As for the role of government, a country’s government should play
active roles in improving institutional environment during the process of
the economic development and industrial upgrading due to the following
reasons: (1) The industries may become more and more technology- and
capital- intensive and firms’ (technological and product) innovation risk
increases; (2) Since innovation risk increases, more and more firms may
shift from bank financing to equity financing; (3) While the equity financ-
ing is more sensitive to institutional environment, such as investor protec-
tion laws, than bank financing, it is almost impossible for any individual
firm to improve institutional environment due to the free-rider and coor-
dination problems inherited in the process of institutional transformation.
Therefore, it is necessary for the government to lead the continuous im-
provement of the institutional environment along economic development
and industrial upgrading. To summarize, government should and can play
important roles in shaping optimal financial structure, but the role is not
encouraging bank-based or market-based financial structure, but trying to
identify the firms’ risk characteristics and financial demand characteristics,
and improving the institutional environment when the industrial structure
keeps upgrading as more and more firms shift from bank financing to eq-
uity financing.

© 2018 The University of Manchester and John Wiley & Sons Ltd.
20 The Manchester School

APPENDIX

Proof of Lemma 1:  The bank is capable to identify L, and gets A from liquidating it.
Under Assumption 2, if the bank discovers one program is L and choose not to liqui-
date, it is due to obtain R > 1 > A for sure. Hence, the bank definitely not to liquidate
L. Q.E.D.

1−𝜃A
Proof of Lemma 2: Let 𝜃A + (1 − 𝜃)pL R = 1, I get R = (1−𝜃)p and
L
B
(1 − 𝜃) p}L 𝜋L +𝜃A−1. According to Assumption 2 and Condition 2, letting R≤
𝜋 ={
min pA ,𝜋L , I get:
H { }
pL min pA −1
𝜃̂ ≡ { H} ,  (A1).
pL min pA −A
H

Q.E.D.

( ) ( )
Proof of Lemma 3:  As is shown above, I assume that pL 𝜋L = 𝜃E 𝜋̃H + (1−𝜃) E 𝜋̃L .
[ ( ) ( )]
Whenvs 𝜃E 𝜋̃H + (1−𝜃) E 𝜋̃L = vspL 𝜋L = 1, I get:

v̂ ≡ sp 1𝜋 , (A2),
L L

[ ( ) ( )] ( 1
)
besides, whenv ≥ v̂ , max0≤s≤1 (1 − s) 𝜃E 𝜋̃H + (1 − 𝜃) E 𝜋̃L = 1 − pL 𝜋L,
vp 𝜋 L L
I get:
𝜋 E =pL 𝜋L − 1v  (A3)

Proof of Proposition 1:  I am done by illustrate Fig. 3 more clearly. According to

̂ , bank
Lemma 2 and Lemma 3, when v ≥ ṽ , market financing is accessible, when 𝜃 ≤ 𝜃,
financing is accessible, and vice versa. Q.E.D.

Proof of Proposition 2: According to Lemma 2 and Lemma 3,

𝜋 B = (1 − 𝜃) pL 𝜋L +𝜃A−1 and 𝜋 E =pL 𝜋L − 1v. In Region I, let 𝜋 B = 𝜋 E , I get:
1
−1
𝜃(v) ≡ p v
, (A4).
L 𝜋L −A

Again, if 𝜋 B > 𝜋 E , I get:

1
−1
𝜃 (v) > p v
= 𝜃(v)  (A5),
L 𝜋L −A

when enterprise chooses bank financing. If 𝜋 B < 𝜋 E ,

1
−1
𝜃 (v) < p v
= 𝜃(v)  (A6),
L 𝜋L −A

when enterprise chooses market financing. Q.E.D.

© 2018 The University of Manchester and John Wiley & Sons Ltd.
Financial Structure, Industrial Structure, and Economic Development 21

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