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# **1. Introduction**

A growing body of evidence suggests that financial institutions (such as banks and insurance companies) and financial markets (including stock markets, bond markets, and derivative markets) exert a powerful influence on economic development, poverty alleviation, and economic stability (Levine 2005). For example, when banks screen borrowers and identify firms with the most promising prospects, this is a key step that helps allocate resources, expand economic opportunities, and foster growth. When banks and securities markets mobilize savings from households to invest in promising projects, this is another crucial step in fostering economic development. When financial institutions monitor the use of investments and scrutinize managerial performance, this is an additional ingredient in boosting the efficiency of corporations and reducing waste and fraud by corporate insiders. But, that is not all. When equity, bond, and derivative markets enable the diversification of risk, this encourages investment in higher-return projects that might otherwise be shunned. And, when financial systems lower transactions costs, it facilitates trade and specialization—fundamental inputs to technological innovation (Smith 1776).

But, when financial systems perform these functions poorly, they tend to hinder economic growth, curtail economic opportunities, and destabilize economies. For example, if financial systems simply collect funds with one hand, and pass them along to cronies, the wealthy, and the politically-connected with the other hand, this slows economic growth and prohibits many potential entrepreneurs from even attempting to realize their economic dreams. And, if financial institutions fail to exert sound corporate governance over the firms that they fund, this makes it easier for managers to pursue projects that benefit themselves rather than the firm and the overall economy. When financial institutions create complex financial instruments and sell them to unsophisticated investors, this might boost the bonuses of the financial engineers and executives associated with marketing the new-fangled instruments while simultaneously distorting the allocation of society‘s savings and impeding economic prosperity.

Although the evidence on the role of the financial system in shaping economic development is substantial and varied, there are serious shortcomings associated with measuring the central concept under consideration: the functioning of the financial system. Researchers do not have good cross-country, cross-time measures of the degree to which financial systems (a) enhance the quality of information about firms and hence the efficiency of resource allocation, (b) exert sound corporate governance over the firms to which they funnel those resources, (c) provide effective mechanisms for managing, pooling, and diversifying risk, (d) mobilize savings from disparate savers so these resources can be allocated to the most promising projects in the economy, and (e) facilitate trade. Instead, researchers have largely—though not exclusively— relied on measures of the size of the banking industry as a proxy. But, size is not a measure of quality, or efficiency, or stability. And, the banking sector is only one component of financial systems.

A key contribution of this paper therefore lies on the data front. The effort to put together, improve, and analyze data on financial systems is an important motivation for this paper, and for the associated online database tools. In recent years, substantial efforts have gone into improving various aspects of these data, and the paper makes use of these improved data. This paper is accompanied by a newly launched Global Financial Development Database, an extensive worldAugust 31, 2012 (9:27 PM)