(Capasso, Ohnsorge, and Yu 2022). However, the direction of causality has yet to be identified, especially in a multi-country context. This section aims to demonstrate the presence of a causal link from financial development to informality by employing an instrumental variable approach. However, before we move on to the instrumental variable estimation, we document the association between output informality and financial development without any presumption of causality.

# **2.1 Data**

As summarized by Svirydzenka (2016), financial development materializes in different forms— as also reflected in the wide range of indicators of financial development used in the literature. Indicators range from domestic credit to the private sector to GDP ratios to equity market capitalization, bond market turnover, and the number of commercial bank branches per 100,000 adults, among others. Virtually all of these indicators, except those relating to equity market development, are significantly correlated with a range of informality measures (Capasso, Ohnsorge, and Yu 2022).

Here, for our purpose, we focus on banking sector development and, specifically, access to banking services. Informal workers tend to be lower-income and lower-skilled, and informal firms tend to be smaller, less productive, and active in less capital-intensive sectors (Ohnsorge and Yu 2021). Hence, the main point of interaction of informal workers and firms with the financial system is likely to be banks, not equity or bond markets. Their transactions with banks, if any, are likely to be small in magnitude and founded on relationship banking since relationship banking, which can also be measured by a denser branch network, can decrease the probability of credit rationing despite higher screening and monitoring costs (Presbiter and Rebelotti 2014). This is the reason why, in the presence of a larger number of opaquer borrowers, banks can grant more credit by employing relationship lending technologies. One study for India, for example, showed that greater banking system access, including branch density, was associated with significant increases in enterprises in the informal sector (Raj, Sen, and Kathuria 2014).

As such, we deliberately avoid using domestic credit to the private sector— a measure of banking sector depth rather than access— since aggregate credit tends to be dominated by large loans to large firms ( Č ihák et al. 2013). One study for the United States, for example, showed that the largest 8 percent of firms account for 68 percent of bank credit (Chorodow-Reich et al. forthcoming). Domestic credit to the private sector also tends to be highly cyclical for reasons unrelated to financial development (Claessens, Kose, and Terrones 2012). In contrast, our interest here is in financial development, stripped of its cyclical component to the extent possible and focused on the financial services relevant to informal workers and firms. That said, in Section 4.2, we test the robustness of our results by using domestic credit to the private sector as an alternative measure of financial development.

Specifically, our proxy for financial development is the number of commercial bank 5