bank-based/RBFS **.** Arguments based on firm specific characteristics (see e.g. Rajan and Zingales (2001)) likewise point to bank-based systems as the type of firms most likely to prefer and be able to access capital markets as source of external finance – large well established firms seeking diversified sources of external finance, start-ups in new sectors and firms with large intangible assets – constituted a small share of the overall universe of firms in the early transition period.

# _Current Financial System Structure_

The historical experience with financial systems suggests that structures, once established, display strong persistence. Future changes in the region are thus most likely to complement the current bank-based structures. With this caveat, the significant changes over the last two decades have raised the scope for arms-length financial market elements. In particular, sustained growth differentials relative to the EU-15 (though disrupted by the financial crisis) have narrowed the productivity gap and increased the share of firms with characteristics thought to be more amenable to external financing through capital markets. Supporting institutions have strengthened, though significant gaps in institutional infrastructure relative to advanced market economies remain for a number of countries in the region, with de facto standards often lagging behind de jure standards.<sup>14</sup> Yet despite the strengthening of factors viewed as supporting the development of capital markets<sup>15</sup> , stock and private bond markets remain fairly small and illiquid alongside a scarcity of domestic currency long-term instruments, raising the question whether the causes are to be sought primarily on the demand or the supply side.<sup>16</sup>

# _International Integration_

The theoretical literature reviewed above primarily focuses on the structure of the domestic financial systems. For the ECA region, the particularly pronounced degree of international financial integration also requires a close look at the role played by foreign financial institutions (notably banks) in the domestic financial system and the options available to domestic financial institutions, firms and households to access foreign financial markets.<sup>17</sup> As noted above, subsidiaries of foreign banks account for an unusually large share of the banking system in a number of ECA region countries (Schoenmaker (2011)). In

> 14 See the annual ratings and discussions in the EBRD Transition Report. Gaps are on average larger for countries that are not current or potential EU member states and may thus constitute one reason for the underdevelopment of capital markets in this group, but are less pronounced and thus arguably play a lesser role for current and potential EU member states (Adarov and Tchaidze (2011)).

> 15 In addition, the cross-country evidence suggests that banking system and financial market growth are positively associated. See Demirgüç-Kunt and Maksimovic (1996), Demirgüç-Kunt and Levine (2001b) and Schepers (2011).

> 16 See EBRD (2010) for the region and Adarov and Tchaidze (2011) on the role of institutional features and other factors in explaining relative financial development in the CE4.

> 17 The latter caveat is particularly important for equity markets, where economies of scale have led to a gradual move from regional to national to cross-national exchanges.

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