state this literature does not provide robust evidence of a relation between financial development and volatility. The results are sensitive to the measure of financial development and to details such as the periods used to pool the data, the set of controls and instruments used, and the estimation technique. The instability of the results is very likely to be related to the omitted variables and endogeneity problems typically present in cross country regressions, as well as to the problems of estimating a stable relation between financial development and volatility without controlling for a specific transmission channel. Beck et al. (2001b) recognize the difficulty of finding an stable aggregate relation and attempt to estimate the effect of financial institutions in the propagation of different types of shocks. They build a stylized theoretical model based on Bachetta and Caminal (2000), predicting that the development of financial institutions should amplify productivity shocks and dampen monetary shocks. However, they are unable to provide strong evidence of the mechanism. Finally, Acemoglu et al. (2002) find in a recent paper that in a cross country regression financial development, measured as the ratio of M2 over GDP, has no effect on volatility after controlling for measures of the quality of institutions. This paper adds to this literature by using an econometric approach that reduces significantly the scope of the omitted variable bias and endogeneity problems and that tests the implications of one particular mechanism relating financial development and volatility.

On the theoretical side, this paper is related to Caballero and Krishnamurty (2001) who present a model that shows that underdeveloped financial markets reduce the availability of liquid funds during crises and exacerbate their impact on output. This paper provides evidence consistent with this type of mechanism, showing that sectors with larger liquidity needs are those that are relatively more volatile in financially underdeveloped countries. In a broader perspective, this paper is also related to the literature on financial development and volatility (e.g. Greenwood and Jovanovic (1990); Acemoglu and Zilibotti (1997); Aghion et al. (1999); Bachetta and Caminal (2000)), and to the literature on credit market imperfections and output fluctuations (Bernanke and Gertler (1989); Kiyotaki and Moore (1997)).

The rest of the paper is organized as follows. Section 2 presents a simple model that formalizes the intuition behind the hypothesis that financial development reduces the relative volatility of sectors with large liquidity needs. Section 3 describes the empirical strategy used to estimate the effect of financial underdevelopment on the volatility of sectors with different degrees of liquidity needs. Section 4 discusses the assumptions that are required to build a measure of an industry’s liquidity needs using data from U.S. corporate firms, and describes how the measure is built. Section 5 briefly describes the data and the procedure used to build the measures of volatility, depth of crises, and financial development. Section 6 presents the main results, which document the relation between financial development and liquidity needs across sectors and shows that sectors with larger liquidity needs are relatively more volatile in less financially developed countries. Section 7 investigates the robustness of the effect of financial development on sectorial volatility, and explores some mechanisms 4