Vous êtes sur la page 1sur 31



Monetary Economics in Developing Countries (FE3178), 2009-


Lecture 2

Finance, growth, and development

Chapter 2 GSF


The financial system plays a key role in promoting economic efficiency.

How? Mainly by overcoming pervasive information asymmetries in

lender-borrower relationships.

Financial institutions match:

Economic agents who can supply otherwise idle financial resources

Others who demand these resources for investing in specific projects

⇒ That is how financial institutions contribute to achieving better resource

allocation and faster long-run economic growth.

Financial institutions’ key operations include

• Risk pooling -aggregating the risk of many creditors helps in

diversifying away overall risk


• Maturity shifting -effectively matching borrowers and lenders with

different financial needs in terms of timing

• Promoting specialisation and innovation

• Providing liquidity

Through these and other related functions that financial institutions

contribute to achieving better resource allocation in the economy.

This process implies that scarce funds are channelled towards the sector in

which their return is highest.

E.g. financial institutions played a key role in promoting new technologies

during the industrial revolution in England.

Funding illiquid, long-term, projects like railway building.

The financial system is also central to the effectiveness of monetary policy

and to overall macroeconomic stability.


Implementing market-based monetary policy demands well functioning

interbank markets.

This lecture focuses on financial development and financial structure, and

on their linkages to economic growth and development.

Further distinguishing between the literatures on financial development

and financial structure is important.

There is ample theoretical and empirical work on how financial

development affects economic growth

We know much less about financial structure -i.e. an economy’s mix of

financial intermediaries, institutions, and markets- and how it affects

economic growth and development

⇒ The lecture contains three parts explaining:


1. Why and how financial intermediaries can play an important role in

the economy, and how this role is related to economic growth and


2. The importance of legal and other factors in determining financial

structure, and introduce issues related to banking regulation and


3. Empirical evidence on financial development and growth.

⇒ Financial intermediaries

How do financial intermediaries foster economic growth and


Gurley and Shaw (1955) ⇒ the function of financial institutions is to

transform financial contracts and securities.

Banks take deposits from households and transform them into loans to

firms and entrepreneurs.


Probably the key reason why banks are useful in providing this service is

the presence of transactions costs.

These costs, in turn, imply potential economies of scale in the provision of

the transactions technology.

Diamond and Dybvig (1983) ⇒ banks are important because they offer

households a sort of insurance against liquidity shocks.

The key to this argument is that these shocks are only privately observed.

Bencivenga and Smith’s (1991) ⇒ (developing arguments from Diamond

and Dybvig) banks lead to higher investment productivity by channelling

funds to illiquid but high-yielding technologies, and by reducing potential

losses arising from early liquidation.

Adopting these new technologies can lead to faster economic growth.


Diamond (1984) ⇒ financial intermediaries process information for all the

potential investors –a ‘delegated monitoring’ function.

This role facilitates allocating funds to firms likely to succeed in a given

project, and is why some types of loans are better made by financial


Gorton and Pennacchi (1990) ⇒ banks can help in overcoming adverse

selection problems related to the creation of safe demand deposits.

But banks are not the only institutions that can provide that type of service.

In advanced economies there usually exist various types of public and

private bonds with relatively low default risk.

However, in developing countries where the government’s financial

position tends to be rather weak, and where corporate bonds are not as

prevalent, banks indeed play a prominent role.

The models developed by Townsend (1978, 1983) and Greenwood and

Jovanovic (1990) highlight intermediation costs.


These costs may take the form of fixed expenses to enter the financial

system, as well as marginal costs for undertaking subsequent transactions.

** Acemoglu and Zilibotti (1997) ⇒ an economy’s level of development

is critical in determining economic outcomes.

Model’s features ⇒ at early stages of development an economy’s growth

prospects are held back by project indivisibilities and by the related


The scarcity of financial resources characterising these economies implies

that fewer projects will be implemented, which in turn slows down the

process of economic development, the level of productivity in these

economies will be endogenously lower.

Since diversification possibilities are limited, the chosen projects will

likely have to bear risk that would be potentially diversifiable in a more

developed financial context.


So financial deepening moves alongside economic development. The

related higher level of intermediation and the presence of adequate

diversification can help to reduce the variability of economic growth.

Diamond and Rajan (2001) ⇒ argue that the liquidity risk inherent in the

banking business, although usually seen as banks’ main weakness, is likely

to be a vital characteristic of these institutions

⇒ Banks’ commitment to honouring deposits creates liquidity because

these institutions possess loan collection skills.

In instances of illiquidity, arising, for instance, from an adverse shock, a

bank has the capacity to raise liquidity from other depositors through the

use of its collection skills as the fragile nature of its capital structure would

otherwise lead to a run on the bank.

In Diamond and Rajan’s model creating liquidity is in fact facilitated by

banks’ inherent financial fragility.


As in Holstmröm and Tirole (1997, 1998), in Diamond and Rajan’s

model firms may be denied funding because their future profits are not

likely to be readily transferable to outsiders to the project.

Banks help in overcoming this problem by making adequate use of the

collateral pledged ex-ante in the contractual agreement between the

borrower and the bank.

But in addition to using the collateral efficiently, in Diamond and

Rajan’s model banks actually enhance the collateral’s value.


⇒ How do stock markets help in promoting growth and


Stock markets are increasingly more important in understanding the

finance-growth link, particularly in developing economies.

Stock markets can foster economic growth and development through

several channels.

Facilitating equity trading, and by reducing the risk implicit in long term

investment projects.

But that lower risk may also work by reducing savings and capital

accumulation, and may actually end-up reducing growth prospects.

Stock market liquidity also helps in trimming down the costs involved in

undertaking long term projects yielding higher returns; those higher

returns imply higher returns on savings.


The problem with this channel is that the second round effects may lead to

economic agents opting to save less –because they now get more returns

from a given amount of savings. And that could ultimately slow down

economic growth.

Stock market liquidity may adversely affect economic growth by reducing

the amount of time economic agents devote to monitoring firms and


However, stock market liquidity could also lead to more intensive

monitoring, in which case the economy will ultimately gain (e.g.

Holmström and Tirole, 1993).

** The message from the above arguments is that ex-ante it is not

possible to make unambiguous predictions about stock markets and

their likely impact on the economy.

Even though stock markets are considered alongside banks as a potential

source of finance for developing economies these institutions are still

much less important in relative terms.


This is true regardless of the fact that stock market capitalisation in

developing countries has grown considerably over the last two decades or

so, partly as a result of capital market liberalisation efforts (e.g. Henry,

2000a, 2000b).

Häusler, Mathieson, and Roldos (2003) argue that activity in domestic

capital markets has not expanded enough to provide a solid alternative to

banking or international markets.

According to these authors, this situation arises largely due to the

underdevelopment of related markets, such as that for government bonds.

** Fostering bond markets is important for:

Securing funding to undertake long-term government projects;

Designing and implementing a market-based monetary policy strategy like

inflation targeting;

Protecting the government and the rest of the economy from adverse

economic shocks;

Fostering financial intermediation and competition in the financial system;

Promoting and safeguarding financial stability.

It important to note that, for instance, Singh (1997) argues that the

volatility characterizing stock market activities is unlikely to be helpful in

fostering investment in a developing economy context.

Also, pervasive interactions among the exchange rate market and the stock

market in the face of adverse economic shocks may actually aggravate

economic instability and slow down economic growth.

Further, banks in many developing countries are relatively successful, and

developing stock markets may generate adverse effects on these


But banks and stock markets may well provide complementary financial


⇒ Theory

Even if we are not sure that stock markets can actually help developing

countries in fulfilling their financial needs it is important to understand the

mechanics behind their operation.

Levine’s (1991) model employs elements from the endogenous growth

(highlighting human capital investment) and the financial structure

(particularly liquidity risk) literatures.

In Levine’s modelling a stock market arises to distribute productivity

and liquidity risks.

The framework predicts that economic agents will react to liquidity shocks

by selling shares to other investors in the stock market, i.e. by trading

ownership of firms. So in an economy with a stock market a firm’s

financial backing is less likely to be liquidated prematurely.

Such an outcome is possible because not all firms face liquidity shocks at

the same time.


This liquidity role is important, because financing illiquid projects is not

curtailed by uncertainty concerning investors’ short-term liquidity


Moreover, in the model, withdrawing funds from projects actually implies

less human capital accumulation and consequently lower economic


Furthermore, portfolio diversification in the stock market implies that the

risk individuals face is lower than in their absence.

Stock markets may be useful technologies to foster investment in illiquid,

but relatively more productive, projects.

Thus, for an economy as a whole, stock markets can increase overall

investment productivity and steady state economic growth rates.

Saint-Paul (1992) advances further interesting insights on financial

development and on how it affects economic outcomes.


Saint-Paul’s key argument is that stock markets allow firms to adopt

riskier technologies which, by their nature, demand greater division of


Thus, portfolio diversification via the stock market, which works by

spreading the risk inherent in the greater division of labour demanded by

the riskier technologies, can actually lead to higher steady-state growth.

This modelling seems to be useful for explaining why some countries may

be trapped in what Saint-Paul calls low output equilibrium –i.e. one

characterised by little division of labour and by a correspondingly

underdeveloped financial market.

In contrast, countries that are able to develop sound financial markets will

also achieve a high level of division of labour and faster economic growth


Given the costs involved in developing a sound financial market, Saint-

Paul’s analysis implies that there may be a rationale for government

intervention to support financial development.


⇒ Law and finance

There is a growing literature stressing the importance of a solid legal

environment in determining economic outcomes.

This research effort basically concludes that economic development

benefits from a system in which law and order effectively protect

investors’ rights.

La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) contribute to

the law and finance approach to financial development by investigating the

relationship between a country’s legal system and its financial structure.

Their extensive research employs data on 49 economies and concludes that

a country’s legal origin is relevant in explaining a country’s financial


⇒ Banking regulation and supervision

Care should be paid to strike the right balance when designing, operating,

and reforming the legal frameworks regulating financial institutions.

Barth, Caprio, and Levine’s (2005) provide a detailed analysis of

banking regulation and supervision.

These authors aim at contributing to a better understanding of which

modality of banking supervision and regulation works best in practice.

They put together a substantial amount of information to gain insights on

banking regulation and supervision in over 150 countries.

Barth, Caprio, and Levine’s plan involves considering institutional, and

particularly political, issues underlying a country’s decision on how to

shape its financial regulation and supervision structure.


Such considerations are important because a series of agency problems

usually arise between bankers, regulators, and other market participants.

For instance, banking supervision institutions, in principle, aim at

monitoring banks as effectively as possible. But that supervisory role may

in fact be influenced by the political interests of those appointing or

monitoring the supervising officials.

Barth, Caprio, and Levine’s extensive data collecting exercise reveals

substantial heterogeneity between regulatory and supervisory systems


That is an important conclusion because it implies that formulating

banking regulation frameworks at an international level will probably

reach dead-ends or lead to undesirable results as diverse individual

economies attempt to implement these policies.

The study also draws concrete conclusions regarding Basel II and its likely

impact on adopting economies.


Interestingly, they find that capital requirements do not seem to have a

significant impact on a banking system’s development, efficiency, or even

that it helps in preventing banking crises.

What they do find is that strengthening banking system monitoring helps

in developing the banking sector, making it more efficient and less prone

to crises. But care should be taken in relation to deposit insurance policies.

The authors find that generous schemes tend to be related to a higher

probability of observing currency crises.

The channel underlying this problem works via the moral hazard arising

when depositors feel that their savings are safe and as a result do not

screen financial institutions adequately.

Finally, Barth, Caprio, and Levine’s most striking conclusion is that

merely increasing the powers of supervisory agents may not be enough to

improve the overall performance of banking systems.


Note the clash with the spirit of Basel II’s recommendations on

strengthening the powers of banking supervision bodies.

On the contrary, increased supervision may actually generate adverse


That is a reasonable finding if one thinks about an economy in which

institutions are weak, and where those in charge of supervising the

financial system already have significant authority and are prone to


But that does not imply that improving banking regulation according to

Basel II is an outright bad idea.

What it does imply is that reforming banking system regulation and

supervision should ideally proceed alongside wider-ranging improvements

in a country’s institutions.

In fact, work by Acemoglu et al (2003) finds that weak institutions

(notably political institutions that do not constrain politicians and political


elites) tend to be related to poor macroeconomic policies and are a key

element in determining an economy’s volatility.


⇒ Empirical evidence on finance and growth

Goldsmith’s (1969) investigation is an early contribution to this area of

research. One of his main findings is that banks’ relative size tends to

increase alongside an economy’s development.

He also shows that stock markets and other financial intermediaries grow

in size relative to banks as an economy develops.

However, based on empirical analysis using data comprising 35 countries,

he does not reach a clear conclusion on the causality amongst financial

development and economic growth.

That question is the focus of a large and growing literature following

Goldsmith’s work.

A further problem faced by that early literature and which still lingers is

upon agreeing on a satisfactory definition of financial development.


*** King and Levine (1993) study a large sample of countries over the

period 1960-1989, focusing on the role of financial intermediaries.

They examine the following indicators of financial development:

(1) Financial depth defined as the ratio of liquid liabilities to GDP;

(2) The importance of deposit money banks vis-à-vis the central bank; and

two measures of commercial banks’ credit allocation to the private sector;

(3) Claims on the non-financial private sector to total claims;

(4) Gross claims on private sector to GDP.

King and Levine explore the relationship between these indicators and

long-run average real per capita GDP growth.

They also examine the link between the financial development indicators

and alternative measures of economic growth. The latter exercise aims at


throwing further light on the channels via which the finance-growth link

potentially works.

To that end they analyse physical capital accumulation (average rate of

growth of real per capita capital stock) and a society’s efficiency in

allocating capital (total productivity growth).


⇒ The paper’s empirical strategy involves estimating the following

econometric model

G j = δ + αFi + ηX + ξ

In the equation all the variables are averaged over the period 1960-1989.

The variables’ definitions are as follows:

Growth indicators, with the subscript standing for each of the

G j

three different measures as detailed above;

Financial development indicators, with the subscript standing

F i
for each of the four different measures as detailed above

Ancillary variables included to control for other elements

expected to influence economic growth: initial income, initial

secondary school enrolment rate, ratio of government

consumption expenditure to GDP, inflation, and the ratio of

export plus imports to GDP.

Note that King and Levine’s exercise involves running a total of 12

regressions (thus generating twelve s, one for each growth measure as a

function of each financial development indicator plus the ancillary

variables) using a data set comprising a cross-section of 77 countries.

The econometric modelling finds that all the financial development

coefficients ( s) are statistically significant.


Thus financial development is associated with higher economic growth,

physical capital accumulation and improvements in efficiency.


These results hold after controlling for a battery of ancillary variables

accounting for country and policy characteristics ( ).


King and Levine further show that the predetermined components of the

financial development indicators are positively linked to future rates of

economic growth, physical capital accumulation and improvements in


They interpret that evidence as supporting the Schumpeterian view on the

financial sector’s critical role in explaining economic performance.