Cultural and Political Contexts Make a Difference for Finance25 Jan 2016
Prof. Elvira co-authored this paper with Sebastian Lavezzolo (Institute of Political Economy and Governance (IPEG)) and Carlos Rodríguez-Lluesma (IESE).
How much does culture affect a national financial system?
Financial systems are strongly influenced by the ways in which people culturally deal with uncertainty because finance is essentially about relationships. Culture is defined as those customary beliefs and values that ethnic, religious, and social groups transmit fairly unchanged from generation to generation. Although current financial systems are large and complex, the fundamentals of a financial transaction remain the same: a contract between a borrower and a lender tied by the expectation of future compliance, that is, trust.
Therefore, the ways in which people relate financially should be influenced by their degrees of uncertainty aversion. When deciding how to manage their savings, debts or investments, people must deal with an uncertain future, and the ways they do this are strongly defined by their cultural values. Hence, attitudes toward uncertainty in a financial transaction are very likely be influenced by cultural priors.
Some national financial systems are based mostly on financial intermediaries such as banks, while others rely mostly on markets. There is a negative relationship between the level of uncertainty avoidance in a society and the market orientation of its financial system. The capability of financial intermediaries to smooth inter-temporal risk makes banks more attractive in societies with low levels of uncertainty tolerance.
So, culturally-based social preferences regarding uncertainty avoidance help explain cross-national differences in this financial system configuration, and we propose a theory in which political institutions condition this relationship.
What does "uncertainty avoidance" mean?
Hofstede, an influential social psychologist and developer of the cultural dimensions theory, defines “uncertainty avoidance” as the extent to which the members of a culture feel threatened by uncertain or unknown situations. A society’s degree of uncertainty avoidance can be quantified by the Uncertainty Avoidance Index (UAI). The UAI reflects the shared mental programming of people in that society.
Previous studies conjectured that countries characterized by strong uncertainty avoidance are more likely to be compatible with bank-based systems, whereas national cultures that score highly on uncertainty tolerance may be more inclined to adopt market-based structures.
Along this line, we claim that the association between uncertainty avoidance in a society and the preferred configuration of the financial system might be weakened in a political context in which the government is unconstrained.
So, then, culture isn't the only differentiating factor in this matter?
Culture is an important, though not the only key factor. Divergences in legal traditions, structures for risk sharing, and endowments or informational frictions in countries’ economies-, among other factors-, loom large. However, national culture as a long-term force had remained largely underexplored as a potential explanation for the configuration of financial systems.
Connecting research on political institutions with that on cultural studies, we argue that the political context matters for the relationship between culture and finance because of the pivotal role played by the financial system in the allocation of an economy’s resources. Besides, a negative relationship still holds for those political systems in which the presence of actors controlling the government is stable, that is, when the percentage of veto players who drop out from the government in any given year is close to zero.
Examining another aspect regarding the stability of actors who have the power to constrain the government, we find that the political context has an effect on the relationship under study. According to our simulation, in political contexts in which the volatility of veto players is the norm, the relationship between culture and finance is attenuated or even reversed, although we cannot make a general inference over these values.
In addition, the legal environment appears to be crucial in explaining market- versus bank-based systems. For example, previous studies have shown that countries whose legal systems are based on Common Law tend to have market-based systems, whereas countries whose legal systems are based on Roman Law have smaller and narrower capital markets.
How did you carry out the research?
We collected data on financial systems for 41 countries along all continents, where 27 belong to the civil law tradition, using The World Bank Global Financial Development Database for the period 1990-2008, which allowed us to test whether the prior findings are biased because of the short period of observation. We developed an index of financial architecture on the basis of the size, activity and efficiency of the stock market in each country relative to banks and run cross-sectional regressions to evaluate the effect of culture on financial system configuration. Then, we explored the conditional effect of the political context via interactions between uncertainty avoidance and a set of variables that are commonly used as proxies for the ability of political institutions to constrain governments.
What implications might this study have for managers, investors and political leaders?
First, managers, investors and political leaders have to know that uncertainty avoidance is a good predictor of the financial structure of a country, but a certain level of time stability for the veto players is needed. One-point increase of UAI is associated with movement toward a more bank-based system or, conversely, that a one-point decrease in the UAI is associated with movement towards a market-based configuration.
Second, we find that the longer the tenure of the veto players, the stronger the effects of cultural prescriptions are. The negative association between anxiety levels in a society when facing uncertain situations on the one hand and the way in which financial relationships are structured on the other is conditioned by the maximum tenure of the veto players in the political system. In those scenarios in which a political actor enjoys his or her ability to constrain governmental policy over a long period of time, the relationship between the UAI and the financial architecture index is negative and statistically significant.
Finally we present evidence of the conditional role of politics in evaluating the relationship between culture and finance as a function of market concentration in the banking sector. We find that if the banking sector is captured, then financial intermediaries are no longer credible in terms of their ability to smooth inter-temporal risk.
In the presence of a competitive market in the banking sector, the cultural approach is consistent with previous findings. For low levels of market concentration in the banking system, the relationship between the UAI and the financial architecture index is negative and statistically significant. Conversely, as the sector becomes less competitive – that is, when the three major banks in a country accumulate more than 50% of the market share – the relationship becomes weaker in magnitude and in terms of statistical relevance.
In line with Von Glinow, Shapiro, & Brett we believe managers, investors, and political leaders, among others, need to value the opportunities and constraints established by the environmental framework in which social, political and economic actors operate. Both the effect of culture and the conditional role of politics may modestly assist such actors in describing and theoretically understanding the mechanisms and outcomes of the social organization of finance, contributing to the emergent concept of “polycontextualization”.