# **II. METHODOLOGICAL ISSUES**

# **a. Why look at FDIs?**

A large empirical literature has shown the importance of financial sector development for economic growth and poverty reduction. Countries with higher levels of financial development grow faster and experience faster reductions in poverty levels.<sup>3</sup> Finance is thus not only pro-growth, but also pro-poor. This calls for policy makers’ attention towards policies that promote financial development, which in turn requires that the latter be defined and measured properly.

The core activity of financial systems is to engage into _financial contracts_ through which individual agents exchange money today for the promise of money or risk coverage tomorrow. To facilitate this enormous leap of faith into an uncertain future, financial institutions and markets provide two key accompanying services: i) by acquiring and processing _information_ about borrowers (including enterprises) and possible investment projects, they help allocate society’s savings and risk absorption capacity to their most productive use; and ii) by helping monitor the use of funds and exerting _corporate governance_ , they limit the scope for moral hazard and a wasteful use of resources. At the same time, financial institutions also provide _transactional_ (payment and trading) services that ease the preparation, trading and payment of financial contracts, as well as the exchange of goods and services.

Financial systems do not function in a vacuum, however. Instead, their performance depends on a proper _enabling environment_ , whose key components include: i) a sound and effective contractual framework that appropriately defines and enforces creditor and debtor rights; ii) a smooth information framework, including accounting and auditing standards, and effective arrangements for debtor and collateral information sharing; iii) adequate macroeconomic management, including a sound fiscal policy, a transparent and credible monetary policy, and deep government bond markets; iv) competitive and contestable markets; and v) effective prudential oversight, including a well-functioning safety net.<sup>4</sup> Indeed, it is the enabling environment, rather than financial development in itself, which is directly influenced by policy. The chain of causality goes therefore from policy to the enabling environment to financial sector development to economic development and welfare, with clear feedback processes along the chain (Figure 1).

Given that financial development is one step removed from policy, the question arises as to why benchmarking it matters for policy purposes. Indeed, the alternative would be to focus exclusively on measuring and benchmarking progress in improving the enabling environment, perhaps using indicators such the Doing Business indicators or other enabling environment indicators (EEIs). The policy process could then limit itself to improving those indicators irrespective of how well or how poorly the financial system is doing.

> 3 See for example, Beck, Levine and Loayza (2000) and Beck, Demirguc-Kunt and Levine (2007). 4 See Beck (2006) for a literature survey on policies associated with financial sector deepening.

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