How can financial development successes and gaps relative to benchmark be explained? Is it due to demand effects, supply effects, or the lasting impact of past financial turbulence? To address these issues, we add policy controls to the regressions of financial development indicators (FDIs) and test the impact of credit crashes on financial development. More specifically:

- On the demand side, we add past output growth, as a proxy for the investment-related demand for loanable funds and equity (i.e., the supply of “bankable” projects).

- On the supply side, we use four enabling environment indicators (EEIs), credit information<sup>27</sup> , enforcement costs<sup>28</sup> , creditor rights<sup>29</sup> and property rights<sup>30</sup> .

- For financial turbulence, we define mild, strong and severe credit crashes as annual drops in private credit to GDP of 5 to 10 percent, 11to 20 percent and over 20 percent, respectively.<sup>31</sup> To eliminate the effect of recurrent volatility, we also include in the regressions the standard deviation of normalized private credit.

In all cases, we first filter these policy variables (effectively we also “benchmark” them) using the same set of controls as for FDIs. We then include the residuals as additional controls to explain financial development.

# **_b. Results_**

Table 2, which reports the results of the EEI benchmarking, provides revealing insights on how the underlying frictions that affect the development process are themselves affected by financial development. In particular, we find that the quality of the informational environment (as proxied by credit information) is _concave but subject to scale effects_ . In contrast, the quality of the contractual environment (creditor and property rights) is _convex but not subject to scale effects_ .

This suggests that informational frictions are of a mostly technological nature. Because of fixed costs, they are easier to implement in larger countries. However they are solvable with adequate investments and ready-made imports from abroad. Moreover, once the required investments are in place, there are decreasing returns to further informational improvements as developmental levels rise. In contrast, contractual frictions cannot be solved by technological investments or imports. They are mostly institutional and reflect collective action frictions that

> 27 Source: Depth of Credit Information Index (Doing Business Indicators, World Bank)

> 28 Source: we merge Number of Procedures, Time to Resolution, and Costs as percent of Claim into a single indicator using the first principal component (all three indices are from Doing Business Indicators, World Bank).

> 29 Source: Strength of Legal Rights, Doing Business Indicators (World Bank).

> 30 Source: Property Rights, Heritage Foundation.

> 31 We depart from most of the crisis literature by studying multiple _annual_ credit crashes instead of focusing on a “before and after analysis” based on financial crisis _periods_ . All three crash variables are defined as the percentage of years a country experienced a given type of crash. We average all data for 2005-07 and add each crash variable separately to the regressions of private credit to GDP.

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