controlling for poverty should help neutralize its direct impact on financial development, thereby enhancing the link between the regression’s residuals and policy.

Some additional controls are needed to control for key structural characteristics such as size (as determined by population), population density, or cross-border operations. More densely populated countries have deeper financial systems, reflecting lower infrastructure costs, such as communications and branch networks. On the other hand, reflecting scale and networking effects, key components of financial development may be lagging in smaller economies, relative to larger countries at comparable levels of economic development. A substantial exception needs to be made, however, for offshore financial centers whose financial systems are comparatively larger than would be warranted in relation to the size of their economy. Inversely, oil exporters tend to have smaller financial sectors than non oil exporters with similar levels of income, reflecting the fact that: i) oil exports can boost GDP without requiring a proportional increase in economic and financial activity; and ii) the heavier reliance on international trade enhances crossborder financial activity at the expense of domestic intermediation.

Finally, the question arises as to whether regional controls should also be introduced. To the extent that regional differences reflect deeply ingrained cultural or sociological characteristics, there is a good argument in favor of introducing such controls. However, regional differences may also reflect policy differences. As the latter are not necessarily set in stone, there are clear benefits to comparing countries across regions without adjusting for regional effects. In practice, it is most informative to provide both types of benchmarks (with and without regional controls).

# **c. Which benchmarks?**

The most natural way of measuring a financial system’s performance would be along functional lines, i.e., how well it fulfills each of the key functions (underlined above) that it is supposed to deliver. In particular, where one form of intermediation may gradually replace another but the timing of the transition is uncertain, functional indicators should be more stable and predictable than institution or market-based indicators. In some cases, functions can arguably be measured in a meaningful way. For example, the financial system’s capacity to provide effective transactional services could be assessed based on key statistics on payment services or core broker systems.

However, functions such as the ability to contract away resources from lenders to borrowers, efficiently allocate risk among market participants, exert appropriate governance, or ensure an adequate extraction and use of information, are hard to define, and much harder if not impossible to measure, at least based on the information currently available. Should sufficient micro data be available at the firm and household level, one could attempt to measure financial performance based on the level of services agents are provided with (i.e., whether they have access to the services they need at a fair price). But the availability of such data at this time is too sparse to be used meaningfully.

8