Manual Finance & Development, June 1964

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Myron Slovin, place a relatively high or low shadow Marie Sushka, and John Polonchek value on internal funds based on their show that the banks' impending response to taxes Calomiris and Hub- insolvency negatively affected the stock bard , and whether regulations prices of its client firms and that the restrict bank credit allocation Fidel FDIC's rescue efforts positively affected Jaramillo, Schiantarelli, Weiss ; the stock prices of those same clients.

In sum, when outsiders view that the durability of bank-bor- find it expensive to evaluate and fund rower relationship is valuable.


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The evi- particular firms, those firms find it dence directly indicates an important relatively difficult to raise capital for in- role for financial intermediaries in re- vestment and rely disproportionately on ducing informational asymmetries be- internal sources of finance. Thus, finan- tween firm insiders and outside inves- cial innovations or policies that lower tors.

Indirectly, the evidence suggests information asymmetries ease firm fi- that countries with financial institutions nancing constraints on more efficient that are effective at relieving informa- firms. Specifically, firms F. Patterns of Financial Development with close ties to banks tend to be less constrained in their investment decisions I now turn to the question: Does fi- than those with less intimate, less ma- nancial structure change as countries de- ture banking relationships as shown for velop and does it differ across countries?

With Taiwan included, the middle-income stock trading ratio becomes He traced the and economic development for approxi- relationship between the mix of financial mately 50 countries over the period intermediaries and economic develop- This work finds that finan- ment for 35 countries over the period cial structure differs considerably across The World Bank and countries and changes as countries de- Demirguq-Kunt and Levine b re- velop economically. While one must be hesitant in liabilities of financial intermediar- drawing conclusions about patterns of fi- ies relative to GDP; nancial development, an even greater 2 banks grow relative to the central degree of hesitancy is called for in link- bank in allocating credit; ing financial structure to economic growth.

Financial Structure and Economic nance companies, and private pen- Grou;th sion funds-grow in importance; There exists considerable debate, with and sparse evidence and insufficient theory, 4 stock markets become larger, as about the relationship between financial measured by market capitalization structure and economic growth. After relative to GDP, and more liquid, briefly outlining the major examples as measured by trading relative to used in discussions of financial structure, GDP, market capitalization, and I describe the major analytical limita- stock price variability.

The lenge to financial theorists, they must be classic controversy involves the compari- treated cautiously because the data suf- son between Germany and the United fer from numerous problems. For exam- Kingdom. Starting early in this century, ple, it is difficult to distinguish private economists argued that differences in from public banks and development the financial structure of the two coun- banks from commercial banks in many tries help explain Germany's more rapid countries. Similarly, the definition of a economic growth rate during the latter bank and of a non-bank are not always half of the 19th century and the first consistent across countries.

Further- decade of the 20th century Alexander more, there is nothing causal about these Gerschenkron The premise is as relationships. These patterns alone do follows. Germany's bank-based financial not suggest that poor countries can ac- system, where banks have close ties to celerate their growth rates by changing industry, reduces the costs of acquiring the structure of their financial systems. This makes it Finally, many differences exist across easier for the financial system to identify countries at similar stages of economic good investments, exert corporate con- development World Bank For ex- trol, and mobilize savings for promising ample, the assets of deposit banks com- investments than in England's more se- posed 56 percent of financial system as- curities market oriented financial sys- sets in France, while the comparable tem, where the ties between banks and number in the United Kingdom was 35 industry are less intimate.

Indeed, quite percent. The assets of contractual sav- a bit of evidence suggests that German ings institutions composed 26 percent bankers were more closely tied to indus- of total financial system assets in the try than British bankers.


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Unlike En- United Kingdom, while in France the gland, nearly all German bankers started figure was only 7 percent in Thus, as merchants. XXXV June paratively close bonds between bankers and German bankers tend to be more in- and industrialists. For example, German tricately involved in the management of bankers frequently "mapped out a firm's industry than U. Fur- capital increases" Gerschenkron , thermore, historical evidence suggests p. Private German bankers also or- that German universal banks were more ganized and promoted an impressive ar- efficient lower cost of capital than U.

Besides this en- U. In trepreneurial role, some evidence sug- contrast, the U. These observations suggest into longer-term securities more easily that the German bank-based system may in Germany Tilly , pp. While bank- control more effectively. In contrast, the industry relationships may have been United States' securities market-based closer in Germany, this does not imply financial system may offer advantages in that the German financial system was terms of boosting risk sharing opportuni- better at risk management, providing ties Allen and Gale While this liquidity, or facilitating exchange.

Although about the dominance of one financial German manufacturing production grew structure over another. Thus, aggregate growth dif- Japanese bankers are more closely tied ferences are not very large, the signifi- to industrial clients than U. Thus, the structure of the Japanese fi- The debate concerning bank-based nancial system is sometimes viewed as versus market-based systems eventually superior to the financial structure of the expanded to include comparisons with 30 Park compares the structure and func- the United States.

Levine: Financial Development and Economic Growth United States and an important factor in Axis powers may simply have been con- Japan's faster growth rate over the last verging to the income levels of the four decades. Interestingly, however, the United States, such that observed recent banking problems and slower growth rate differentials have little to do growth in Japan have led some to argue with financial structure. Thus, before that the absence of a credible takeover linking financial structure with economic threat through efficient stock markets growth, researchers need to control for has impeded proper corporate gover- other factors influencing long-run nance and competitiveness.

These con- growth. The financial systems. First, existing re- however, suggest that this dichotomy is search on financial structure does not inappropriate. The data indicate that quantify the structure of financial sys- both stock market liquidity-as meas- tems or how well different financial ured by stock trading relative to GDP systems function overall. For example, and market capitalization-and the level German bankers may have been more of banking development-as measured closely connected to industrialists than by bank credits to private firms divided their British counterparts, but less capa- by GDP predict economic growth over ble at providing liquidity and facilitating subsequent decades Levine and Zervos transactions.

Similarly, while Japanese Thus, it is not banks or stock mar- Keiretsu may lower information acquisi- kets; bank and stock market develop- tion costs between banks and firms, this ment indicators both predict economic does not necessarily imply that the Japa- growth. Perhaps, the debate should not nese financial system provides greater focus on bank-based versus market- risk sharing mechanisms or more accu- based systems because these two compo- rately spot promising new lines of busi- nents of the financial system enter the ness.

Furthermore, while Japan is some- growth regression significantly and pre- times viewed as a bank-based system, it dict future economic growth. It may be has one of the best developed stock mar- that stock markets provide a different kets in the world Demirguq-Kunt and bundle of financial functions from those Levine a. Thus, the lack of quanti- provided by financial intermediaries. For tative measures of financial structure example, stock markets may primarily and the functioning of financial systems offer vehicles for trading risk and boost- make it difficult to compare financial ing liquidity.

In contrast, banks may fo- structures. This United Kingdom, and the United States, is merely a conjecture, however. There it is analytically difficult-and perhaps are important overlaps between the ser- reckless-to attribute differences in vices provided by banks and stock mar- growth rates to differences in the finan- kets. As noted above, well-functioning cial sector.

XXXV June provide instruments for diversifying risk firmed by firm-level studies. In relatively and enhancing liquidity. Thus, to under- pooi- countries, enhanced stock market stand the relationship between financial liquidity actually tends to boost corpo- structure and economic growth, we need rate debt-equity ratios; stock market li- theories of the simultaneous emergence quidity does not induce a substitution of stock markets and banks and we need out of debt and into equity finance empirical proxies of the functions per- Demirgq-Kunt and Maksimovic a. The United States, Germany, Ja- row from banks that depend on the over- pan, and the United Kingdom have all level of economic development.

Thus, basically the same standard of living.

Finance and Development: A Tale of Two Sectors

Av- we need considerably more research eraged over a sufficiently long time pe- into the links among stock markets, riod, they must also have very similar banks, and corporate financing deci- growth rates. Thus, comparisons of fi- sions to understand the relationship be- nancial structure and economic develop- tween financial structure and economic ment using only these countries will tend growth. Conclusions economic development. Future studies will need to incorporate a more diverse Since Goldsmith documented selection of countries to have even a the relationship between financial and chance of identifying patterns between economic development 30 years ago, the financial structure and economic devel- profession has made important progress.

Rigorous theoretical work carefully illu- Finally, there are important interac- minates many of the channels through tions between stock markets and banks which the emergence of financial mar- during economic development that have kets and institutions affect-and are af- not been the focus of bank-based versus fected by-economic development. A market-based comparisons. As noted, growing body of empirical analyses, in- greater stock market liquidity is associ- cluding firm-level studies, industry-level ated with faster rates of capital forma- studies, individual country-studies, and tion.

Nonetheless, new equity sales do broad cross country comparisons, dem- not finance much of this new investment onstrate a strong positive link between Colin Mayer , though important the functioning of the financial system differences exist across countries Ajit and long-run economic growth. Theory Singh and Javed Hamid Most new and evidence make it difficult to con- corporate investment is financed by clude that the financial system merely- retained earnings and debt.

This raises and automatically-responds to industri- a quandary: stock market liquidity is alization and economic activity, or that positively associated with investment, financial development is an inconse- but equity sales do not finance much of quential addendum to the process of this investment. This quandary is con- economic growth. Finance, June , 44 2 , pp. Technological improvements lower Econ.

Monetary Apr. Lombard street. Homewood, IL: Richard D. Irwin, [] Edition. Smith ; Roubini and Sala-i- Growth," Rev. Econ Stud. Martin Legal systems affect finan-. Svs- cial systems LaPorta et al. Further- in an Endogenous Growth Model," J. Dy- more, economic growth alters the nam. Control, Jan.

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E con. Jovanovic While economists have Finance, Dec. Why does financial structure , 18 4 ,pp. Much more information about the deter- Press, , p p Stochastic 21 2 , p State Verification Environment," J. Press, Theory of value. New York: Bank Econ. Wiley, ICS Press, An Economist's Perspective change Economy," Amer. Chicago: U. Finance, July , 44 3 , pp. Policy, Econ. June , 42, pp. Evidence from the Undistributed Profits Tax of Rev. Bankin in the early Growth," Int. New York: Cambridge U. Investment banking in J. Cambridge, MA: Harvard U. Finance, May opment: Neglected and Unsettled Questions," ,37, pp.

World Devel. Glasgow: Collins, Press, , pp. Money, interest, and banking in Amer. Baltimore: John Hop- Stanford U. Cambridge: Harvard U. Liberalization on the Capital Structure and In- Continuity in histoy and other essays. A tReoiyif rconomic history. AND Econ. AND Financial structure Firm Investment," J. Money Credit Banking, and development. Finance, Mar. Minneapolis: U. Crexit Rationing. Fi- rowing Relationships, Intermediation, and the nance, July ,43 3 , pp. Cost of Issuing Public Securities," J.

Academy of Science, Nov. Paper No. July Agency Costs, and Ownership Structure," J. Finance, Sept. London: Appleton, Change, Jan. Glasgow, ; 3rd ed. Loan Agreements," J. Money and capital in eco- of Europe. Research, a, p Pio- -. New York: Oxford U. Be Right," Quart. Finance, July , 42 3 , pp. Applied Corporate Finance, Win- Monet. Theory, Environment," in The globalfinancial system: A June , 57 1 , pp.

Boulder, CO: Westview, , pp. Cambridge U. Run Growth," T. New York: Norton, Transactions Role of Money," in, Handbook of Econ. Growth: An Overview," Europ.

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Takeovers," Rev. Methodological experience. New Yorf: Oxford U. Leverage and Investment Equations. Boston: Baker Library, Harvard Graduate School of Business, Fi- European history Debt," J. London: Macmillan, , pp. An inquiry into the nature and Econ. London: W. Cadell, Historical Comparison of the U.

Control of Capital," J. Information," Amer. A study in comparative economic history. Econometrica, Oct. Theory, Oct. World development report Wash- If you are trying to access articles from an off-campus location, you may be required to first logon via your library web site to access JSTOR. Please visit your library's website or contact a librarian to learn about options for remote access to JSTOR. Gurley; E. Boyd; Bruce D. Smith The Journal of Business, Vol. Summers; Robert J. Waldmann The Journal of Finance, Vol. Bennett The Journal of Finance, Vol.

Berger; Gregory F. Udell The Journal of Business, Vol. Calomiris; R. Devereux; Gregor W. Smith International Economic Review, Vol. Diamond; Philip H. Diamond; Robert E. Verrecchia The Journal of Finance, Vol. May, , pp. Grossman; Merton H. Miller The Journal of Finance, Vol. Grossman; Joseph E. Jensen; Kevin J. Kadlec; John J. Lamoreaux; Kenneth L. Merton The Journal of Finance, Vol. Vishny The Journal of Finance, Vol. Petersen; Raghuram G. Rajan The Journal of Finance, Vol. Sharpe The Journal of Finance, Vol. Slovin; Marie E. Sushka; John A. Polonchek The Journal of Finance, Vol.

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Robert Calabro. Greed, Power and Politics. Daniel Cameron. Finance and Development, June External Relations Dept. Finance and Development, September Section IV outlines econometric methodology. Section V discusses empirical findings, and finally summary and conclusion are drawn in Section VI. Figure 1 depicts some principal indicators of financial development and macroeconomic variables of the selected economies during to The principal indicators of financial development used in the study include variables representing both the development of banking sector as well as stock market of an economy.

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Banking sector development indicators include:. The stock market indicators include: stock market size SS , a measure of stock market size is measured as total value of all listed shares of stock market as a percentage of GDP;. Economic growth, a macroeconomic variable is measured as per capita income PCI growth Levine, Also, following the existing literature, some macroeconomic control variables used in the study are inflation INF , exports as percentage of GDP and the log of number of enrolment in secondary education of the selected economies.

From Figure 1 , it is observed that the average growth rate of PCI of the selected economies ranged between 1. From Figure 1 , it is observed that the FDP has been increasing since for the selected economies. Similarly, the ratio of commercial bank assets to deposit money bank assets plus central bank assets has increased over the study period. The average size of the banking sector of South Africa is about The mean CDR of China CPS, another measure of banking sector development, shows that the mean value of the variable for South Africa Next, the examination of the stock market development indicators of the selected economies shows that the mean SS for South Africa is about Further, value of shares traded, a proxy for the stock market liquidity indicates that the mean value of the variable during the study period is about Finally, the mean turnover ratio is found to be highest in China Among the selected control variables, inflation was unexpectedly high for Brazil and Russia in early s which smoothed in subsequent years.

The mean inflation of China is about 4. Next, exports expressed as a ratio of GDP, an indicator of the relative importance of international trade in the economy indicates that the mean value of the variable during the study period is highest in case of Russia Finally, the mean growth of number of enrolments in secondary education is found to be promising in case of India, Brazil and South Africa compared to Russia and China. The seminal exertion by Schumpeter , Goldsmith , McKinnon and Shaw underscores the relevance of financial development for economic growth for some considerable time.

To begin with, Goldsmith sought to investigate first how economic growth leads to changes in financial structure, which is the assortment of financial instruments, intermediaries and markets. Second, Goldsmith tried to examine the impact of financial development on economic growth. In other words, does the mixture of financial intermediaries and markets functioning in an economy influence economic development. For the first issue, Goldsmith found that development of economies leads to the evolution of and improvements in the financial system.

Particularly, he stated that banks tend to grow bigger relative to national output along with economic development. For the second issue, Goldsmith was not fully successful in evaluating the nexus between the level of financial development and economic growth. In his work, he took a panel of 35 countries using data prior to and documented a positive correlation between financial development and the level of economic activity, but he refrained clearly from drawing causal interpretations from his graphical analysis.

Thus, Goldsmith always refrained from asserting any causal inference that runs from financial development to economic growth. Finally, for the third issue, because of cross-country data limitations, Goldsmith failed to substantiate much on the association between economic development and the combination of financial intermediaries and markets operating in an economy.

For example, to begin with, late s and early s, most of the studies attempted to investigate the association between financial development, economic growth and reduction of poverty. Specifically, subsequent literature has embodied additional findings on the finance—growth relationship and engulfs the wider approach on causal association where cross-country, firm-level and industry-level studies suggest that economic growth is positively driven by a developed financial system.

The main contention of structuralists is the quantity, composition and structure of financial variables that prompt economic growth by mobilization of savings, which in turn increases capital formation leading to economic growth thereby reducing poverty Guha-Khasnobis and Mavrotas, They contended that an appropriate rate of return on account of financial liberalization on the real cash balances is a driver of economic growth. The fundamental principle of their hypothesis is that a low or negative real interest rate will dampen savings which will shrink the supply of loanable funds for investment, which will in turn pull back the growth rate.

Therefore, the McKinnon—Shaw model states that financial liberalization will amplify competition, induce an increase in savings by raising interest rates and thereby promote investment and consequently promote economic growth. After the early debate on the relationship between financial development and economic growth, many subsequent empirical studies using recent data have found mixed results with respect to the association of financial development and growth. Also, later some empirical studies attempted to establish a cause and effect relationship between the two and made an attempt to make certain predictions on the basis of the nature of association.

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For instance, King and Levine a , using the data for 77 countries over the year period from to , established the presence of statistically significant positive relationship between FDP with growth in real per capita GDP, real per capita capital stock and total productivity, respectively.

However, very recently, Saci et al. However, it was found that in the presence of stock market development indicators, banking sector development negatively influenced economic growth. Recently, Leitao found a positive correlation of financial development with economic growth for 27 European Union Countries and five BRICS countries between and Again, Adusei using dynamic GMM model for 24 selected African countries over the period found a positive relationship between financial development and economic growth.

Further, using pairwise granger causality testing, they supported the evidence of bidirectional causality between financial development and economic growth. With respect to causality between financial development and growth studies like Jung found a bidirectional causality between real and financial variables on the basis of data collected for 56 countries in the postwar period, including 19 developed industrial economies.

Also, King and Levine a find that financial development is not the outcome of economic growth, rather finance leads to growth. Further, Wachtel and Rousseau stated that financial development does Granger-causes growth.


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  8. Also, Luintel and Khan found bidirectional causality between financial development and economic growth for a sample of ten economies. Similarly, Wolde-Rufael found bidirectional causality between economic growth and each of the financial development variables. However, conversely, Demetriades and Hussein conducting causality analysis found little evidence on the causality flowing from financial development to economic growth. They note that causality patterns vary across countries.

    Further, studies like Levine and Zervos have shown that bank loans to private enterprises as a proportion of GDP, stock market turnover ratio and value of shares traded are robust predictors of economic growth, productivity growth and capital accumulation. Also, Bhanumurthy and Singh did not find a long-run equilibrium relationship between bank branches and state domestic product for India.

    Finally, Menyah et al. As mentioned before, the nexus between financial development and growth is investigated for a panel of five countries, viz. The economies selected in the panel are largely heterogeneous with respect to their geographical region, culture, political and financial structures leading to high variation in explanatory variables to perform the panel regressions. The period of analysis is from to which covers mainly an era of liberalization, rapid economic growth and volatile world markets. In the present study, real GDP per capita growth PCI is the dependent variable, a proxy which measures the growth of the selected economies.

    Also, the stock market indicators such as SS, turnover ratio TOR and value of shares traded VT are the selected explanatory variables which measure the stock market development. All the independent variables barring inflation are expected to have a positive impact on the growth rate. In equation 1 , the dependent variable is lagged, and we have time invariant country-specific fixed effects. If the country fixed effects in the panel data estimation are omitted, it will lead to biased and inconsistent ordinary least squares OLS estimators in levels Hsiao, Further, several right-hand side explanatory variables can be endogenous.

    Therefore, to avoid the simultaneity problem, one must control for endogeneity of the explanatory variables in the regression model Hao, Levine and Zervos used initial values of explanatory variables as instruments to get rid of simultaneity problem. However, this results in information loss as well as potential consistency loss rendering the estimation inefficient Beck and Levine, Thus, for the model to be efficient and consistent, proper instruments should be used in place of the initial values of the explanatory variables.

    Further, to aggravate the problem, the selected explanatory variables may be endogenous as noted before. Thus, Arellano and Bond impose the following moment restrictions which rules out the possibility of endogeneity within the model. However, the above moment restrictions are applied under the assumptions that: the disturbance term is serially uncorrelated; and. Therefore, the valid instruments would be lagged values of explanatory variables. Also, as noted before, OLS estimation of equation 2 will be biased and inconsistent, because the dependent variable in the equation can be correlated with the disturbance term.

    Table I reports the correlation matrix of the selected variables used in the study.

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    The selected explanatory variables, viz. FDP is positively and significantly correlated with bank size, CDR, private credit, value of shares traded and turnover ratio, whereas negatively and significantly correlated with inflation but uncorrelated with other two control variables, namely, exports and educational enrolment. Similarly, BS is positively and significantly correlated with CDR, private credit, value of shares traded and exports.

    However, BS moves in the opposite direction of turnover ratio, inflation and educational enrolment. Again, CDR has significant and positive correlation with private credit, value of shares traded and turnover ratio, whereas the former does not move in the same direction of inflation and educational enrolment.