Bank efficiency and financial system evolution: An analysis of complementary problems in transitional and state-dominated economies

In this paper, a simple model to examine the problems faced by emerging economies in developing their financial systems is presented. The two main findings are as follows. First, the combination of corporate governance and management entrenchment problems in the real sector with monitoring inefficiency in banking leads to impediments in the development of the capital market. Second, banks both compete with and complement capital markets. If banks are sufficiently inefficient, they attract all the borrowers away from the market, and the market does not develop. Improvements in bank efficiency, up to a point, lead to borrowers accessing the market, so that banks complement the market. Beyond that point, banks and the market compete, and further improvements in bank efficiency lead to more borrowers approaching banks. This framework is used to extract policy implications for financial system design in transitional and state-dominated economies.