Culture - The sculptor of Financial Structure?
USA and Japan are the two largest economies in the world today. Have you ever wondered why one has a predominant market centric economy and why the other is dominated by its banks? Why do countries differ so drastically in the configuration of their financial systems? Read on…
In modern economies, financial systems play a major role in allocating scarce resources. They help channel household savings to the corporate sector and allocate investment funds among companies. When these companies make profits, the system also helps funnel some of the returns back to the individual savers. But financial systems in different countries have evolved in different ways in serving this function in the nation’s economy. My contention here is that the culture prevalent in the country plays a major role in this evolution.
Culture is the software of the mind, shaped and reinforced by our daily interactions, education, friends, upbringing, religious beliefs and other factors. Philosophers like Aristotle and Descartes have believed in the concept that every individual has patterns of thinking, the software of the mind, which he picks up during the course of his lifetime. This explains for example, the differences in behavior of a Chinese man and an American woman at a party. Based on a study conducted for IBM in 72 different countries, Geert Hoefstede has identified five dimensions, or differences in mental programming. For want of a quantifiable measure of culture, I will be falling back on this model particularly the Uncertainty Avoidance dimension. I conjecture that countries with stronger uncertainty avoidance as a cultural dimension are more likely to be associated with a bank-based financial system.
A quick literature review throws up two broad alternate explanations for the disparity of financial systems across countries: legal-system (Rajan & Zingales 1998, Boot & Thakor 1997) and risk-reduction (Allen & Gale 1997). However, these two explanations are not mutually exclusive. The former theory contends that markets require supporting enforcement mechanisms in the form of strong laws. Where laws are weak, banks arise to internalize the transactions because they can enforce contracts extra judicially via their market standing. The latter theory argues that bank-based systems may have a comparative advantage in providing a better mechanism in smoothing financial risks over time. This article takes off from here by putting forward the idea that the culture of a country determines the extent to which people want their risks to be smoothened. Businesses emerge to satisfy people’s needs. Thus, it is but natural that in countries where there is a compelling need to smoothen financial risks, there is a lot of business opportunity for banks.
We can proceed to conduct a regression analysis of the Equity Market Capitalization / GDP ratio of the country with its UAI index. We take the EMC/GDP ratio in order to nullify the differences in the scale of the GDP. We note a significant standard error in this analysis. This indicates that there are other factors in addition to risk-reduction that explain the differences in financial structure. This supplements the existence of legal-based theories.We can now use this regression model to nullify the cultural aspects and then proceed to judge the legal climate of countries and its impact on the financial structure. We do this by estimating the best-fitting regression line. It was found to be
Equity Market Capitalization = { UAI * -0.004792991 + 0.912064436 } * GDP
Using this regression line, we can proceed to calculate the estimated market capitalization of each country using its UAI index. This estimation takes into account the cultural differences among countries. Hence, whatever discrepancy remains can be attributed solely to the legal climate of the country.
To take an example, our analysis shows that currently Japan has a EMC/GDP ratio of 0.66 and US has a ratio of 1.22. The discrepancy is to the extent of 0.56. After standardizing for cultural effects, the corresponding ratios are calculated to be 0.5 and 0.7. The discrepancy here is to the extent of 0.2. We contend that this 0.2 difference is on account of differences in legal climate of the two countries and the remaining 0.36 is on account of cultural factors.
In countries where the UAI index is high, the people are more risk averse and prefer to invest in safe avenues like fixed deposits. This leads to a higher lending to the industry. On the other hand, in countries like US where the UAI index is low, investors demand high returns and save in riskier assets like stocks. This leads to very well-developed markets, around which the entire financial system is structured.
We can observe these factors in India’s brief history. In the 1960’s, India was largely pro-Russia which has a UAI score of 95. India’s key industries were nationalized, and the nationalized banks dominated the financial landscape of the country. Compare that to the situation now, when India has very high economic and strategic alliances with the US. This cultural orientation has played a major part in the India that we see today, one where several key industries have opened up to FDI and one where investors flock to the stock markets. In fact, recently a research by Morgan Stanley has put forward the idea that reducing risk premiums have largely been responsible for the bull runs that we’ve witnessed in the recent past. Cultural factors??? Could be!!!
******************************************************
this blog is based on some amount of quantitative data crunching.. dint put that here for fear of boring ppl out of this page... interested ppl can mail me for that....
In modern economies, financial systems play a major role in allocating scarce resources. They help channel household savings to the corporate sector and allocate investment funds among companies. When these companies make profits, the system also helps funnel some of the returns back to the individual savers. But financial systems in different countries have evolved in different ways in serving this function in the nation’s economy. My contention here is that the culture prevalent in the country plays a major role in this evolution.
Culture is the software of the mind, shaped and reinforced by our daily interactions, education, friends, upbringing, religious beliefs and other factors. Philosophers like Aristotle and Descartes have believed in the concept that every individual has patterns of thinking, the software of the mind, which he picks up during the course of his lifetime. This explains for example, the differences in behavior of a Chinese man and an American woman at a party. Based on a study conducted for IBM in 72 different countries, Geert Hoefstede has identified five dimensions, or differences in mental programming. For want of a quantifiable measure of culture, I will be falling back on this model particularly the Uncertainty Avoidance dimension. I conjecture that countries with stronger uncertainty avoidance as a cultural dimension are more likely to be associated with a bank-based financial system.
A quick literature review throws up two broad alternate explanations for the disparity of financial systems across countries: legal-system (Rajan & Zingales 1998, Boot & Thakor 1997) and risk-reduction (Allen & Gale 1997). However, these two explanations are not mutually exclusive. The former theory contends that markets require supporting enforcement mechanisms in the form of strong laws. Where laws are weak, banks arise to internalize the transactions because they can enforce contracts extra judicially via their market standing. The latter theory argues that bank-based systems may have a comparative advantage in providing a better mechanism in smoothing financial risks over time. This article takes off from here by putting forward the idea that the culture of a country determines the extent to which people want their risks to be smoothened. Businesses emerge to satisfy people’s needs. Thus, it is but natural that in countries where there is a compelling need to smoothen financial risks, there is a lot of business opportunity for banks.
We can proceed to conduct a regression analysis of the Equity Market Capitalization / GDP ratio of the country with its UAI index. We take the EMC/GDP ratio in order to nullify the differences in the scale of the GDP. We note a significant standard error in this analysis. This indicates that there are other factors in addition to risk-reduction that explain the differences in financial structure. This supplements the existence of legal-based theories.We can now use this regression model to nullify the cultural aspects and then proceed to judge the legal climate of countries and its impact on the financial structure. We do this by estimating the best-fitting regression line. It was found to be
Equity Market Capitalization = { UAI * -0.004792991 + 0.912064436 } * GDP
Using this regression line, we can proceed to calculate the estimated market capitalization of each country using its UAI index. This estimation takes into account the cultural differences among countries. Hence, whatever discrepancy remains can be attributed solely to the legal climate of the country.
To take an example, our analysis shows that currently Japan has a EMC/GDP ratio of 0.66 and US has a ratio of 1.22. The discrepancy is to the extent of 0.56. After standardizing for cultural effects, the corresponding ratios are calculated to be 0.5 and 0.7. The discrepancy here is to the extent of 0.2. We contend that this 0.2 difference is on account of differences in legal climate of the two countries and the remaining 0.36 is on account of cultural factors.
In countries where the UAI index is high, the people are more risk averse and prefer to invest in safe avenues like fixed deposits. This leads to a higher lending to the industry. On the other hand, in countries like US where the UAI index is low, investors demand high returns and save in riskier assets like stocks. This leads to very well-developed markets, around which the entire financial system is structured.
We can observe these factors in India’s brief history. In the 1960’s, India was largely pro-Russia which has a UAI score of 95. India’s key industries were nationalized, and the nationalized banks dominated the financial landscape of the country. Compare that to the situation now, when India has very high economic and strategic alliances with the US. This cultural orientation has played a major part in the India that we see today, one where several key industries have opened up to FDI and one where investors flock to the stock markets. In fact, recently a research by Morgan Stanley has put forward the idea that reducing risk premiums have largely been responsible for the bull runs that we’ve witnessed in the recent past. Cultural factors??? Could be!!!
******************************************************
this blog is based on some amount of quantitative data crunching.. dint put that here for fear of boring ppl out of this page... interested ppl can mail me for that....
Labels: Finance
posted by Rishi at
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