# **Further Evidence on the Linkbetween Finance and Growth: An International Analysis of Community Banking and Economic Performance**

An important research development of the last decade has been the affirmation of a strong<sup>link between</sup> the financial system of a nation and the performance of that nation's economy. Starting<sup>with King and Levine</sup> (1993), the research has generally found that countries with "better" financial<sup>systemstendtohavefaster</sup> economic growth. However, this research has not come to consensus regarding exactly<sup>whichdimensions of the</sup> financial system matter most - the size, efficiency, competitiveness, and regulation of<sup>banks; the roles of nonbank</sup> financial institutions, such as finance companies, buyout funds, venture capital funds,<sup>and insurance companies;</sup> the scale and liquidity of public debt and equity markets; the legal rights of shareholders<sup>and creditors;and so</sup> forth. As well, the exact transmission mechanism from the financial<sup>system to real activity is less thanperfectly</sup> transparent from the research results. It is not completely clear the extent to<sup>which abetterfinancialsystem</sup> improves economic growth primarily through higher levels of investment, or primarily<sup>through targeting</sup> investments to more productive uses.' We try to contribute to the finance-growth literature by focusing on one dimension of the financial<sup>system</sup> and how its effects may be transmitted into economic growth. Specifically, we test<sup>hypothesesabout how the</sup> health of community banks relative to other banks affects a nation's economy. We<sup>hypothesizethat relatively</sup> large market shares and relatively high efficiency for community banks may promote<sup>economicgrowth.One</sup> transmission mechanism may be through improved financing opportunities for small<sup>andmediumenterprises</sup> (SMEs). Community banks may provide more credit to SMEs and may target their credit<sup>toward more productive</sup> SMEs, given the advantages that community banks may have this type of lending. A<sup>stronger SME sector may, in</sup> turn, be an engine of economic growth through enhanced entrepreneurship and<sup>risk-taking, increasedprivate</sup> ownership of businesses, potentially high productivity of these firms, and/or increased<sup>competition that reduces</sup> the market power of entrenched large firms and stimulates their productivity. A<sup>secondmode of transmission may</sup> be through greater overall flows of bank credit. Healthier community banks may<sup>not only have provide greater</sup> credit flows from their own portfolios, but might also compete more effectively with<sup>therestof the banking</sup> industry and reduce the market power of other banks, encouraging them to reduce<sup>pricesand expandlending.</sup> We test the hypotheses using data on 49 nations from 1993-2000, representing<sup>a rich mixture of economic</sup> conditions, market structures, and degrees of development. Our key exogenous<sup>variablesmeasuring the relative</sup> I In the interest of brevity, we will not review the finance-growth literature here.<sup>SeeWachtel(2003)fora recent review.</sup>