Comparing Financial Systems

Financial systems are crucial to the allocation of resources in a modern economy.They channel household savings to the corporate sector and allocate investment funds among firms;they allow intertemporal smoothing of consumption by households and expenditures by firms; and theyenable households and firms to share risks. These functions are common to the financial systems ofmost developed economies. Yet the form of these financial systems varies widely. In the UnitedStates and the United Kingdom competitive markets dominate the financial landscape, whereas inFrance, Germany, and Japan banks have traditionally played the most important role.Why do differentcountries have such different financial systems? Is one system better than all the others? Dodifferent systems merely represent alternative ways of satisfying similar needs? Is the currenttrend toward market-based systems desirable?Franklin Allen and Douglas Gale argue that the view thatmarket-based systems are best is simplistic. A more nuanced approach is necessary. For example,financial markets may be bad for risk sharing; competition in banking may be inefficient; financialcrises can be good as well as bad; and separation of ownership and control can be optimal. Financialinstitutions are not simply veils, disguising the allocation mechanism without affecting it, but arecrucial to overcoming market imperfections. An optimal financial system relies on both financialmarkets and financial intermediaries.

Franklin Allen is the Nippon Life Professor of Finance and Economics at the Wharton School, University of Pennsylvania.