metadata: authors: 0: author: Pasali,Selahattin Selsah
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docna: 0: docna: Where is the cheese ? synthesizing a giant
            literature on causes and consequences of financial sector development
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Industrial Economics,Economic Growth,Financial Economics,Finance and Development,Financial Sector Policy,Access to Finance
teratopic: Macroeconomics and Economic Growth,Finance and Financial Sector Development,Private Sector Development
abstracts: cdata!: A likely image of the current state of
            the literature on financial sector development is that of a
            Swiss cheese with many holes inside important areas of
            knowledge. The aim of this synthesis paper is to map the
            current knowledge and ignorance (i.e., holes) in the
            literature by providing a narrative for the empirical
            findings of a comprehensive literature review concerning the
            quantitative effects of financial development on economic
            growth and employment, and various determinants of financial
            sector development. The literature was restricted mostly to
            high-quality academic research that focuses on developing
            countries over the period 1960-2012. Because of data
            constraints, this review also includes cross-country
            analyses, in which developed and developing countries are
            considered together. The main findings include (i) a
            positive relationship between financial development and
            economic growth and employment, subject to a number of
            qualifications; (ii) a complicated relationship of
            regulations and supervision to financial sector development;
            and (iii) a positive relationship between an enabling
            institutional environment and financial sector development.
            This review also identifies some missing avenues in the
            literature and provides a number of suggestions for future work.
repnme: repnme: Where is the cheese ? synthesizing a giant
            literature on causes and consequences of financial sector development
display_title: Where is the cheese synthesizing a
            giant literature on causes and consequences of financial
            sector development
listing_relative_url: /research/2013/10/18403525/cheese-synthesizing-giant-literature-causes-consequences-financial-sector-development
topicv3: Economic Growth m1326241 471,Monetary and Financial Stability m1327169 1098,Finance and Growth m1327404 1081,Access to Finance m1327464 1249,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2013-10-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Finance and Financial Sector Development,Private Sector Development
no_of_pages: 68
author_keys: 0: author_key: 1242418
model_extractions: WPS6655 Policy Research Working Paper 6655 Where Is The Cheese?

Synthesizing a Giant Literature on Causes and Consequences of Financial Sector Development _Selahattin Selşah Paşalı_ The World Bank Finance and Private Sector Development The Financial Sector Reform and Strengthening Initiative October 2013
Policy Research Working Paper 6655

# **Abstract**

A likely image of the current state of the literature on financial sector development is that of a Swiss cheese with many holes inside important areas of knowledge. The aim of this synthesis paper is to map the current knowledge and ignorance (i.e., holes) in the literature by providing a narrative for the empirical findings of a comprehensive literature review concerning the quantitative effects of financial development on economic growth and employment, and various determinants of financial sector development. The literature was restricted mostly to highquality academic research that focuses on developing countries over the period 1960–2012. Because of data constraints, this review also includes cross-country analyses, in which developed and developing countries are considered together. The main findings include (i) a positive relationship between financial development and economic growth and employment, subject to a number of qualifications; (ii) a complicated relationship of regulations and supervision to financial sector development; and (iii) a positive relationship between an enabling institutional environment and financial sector development. This review also identifies some missing avenues in the literature and provides a number of suggestions for future work.

This paper is a product of The Financial Sector Reform and Strengthening Initiative, Finance and Private Sector Development. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank. org. The author may be contacted at Jpatino2@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Where Is The Cheese?**

# Synthesizing a Giant Literature on Causes and Consequences of Financial Sector Development

Selahattin Selşah Paşalı<sup>1</sup>

**Keywords** : Finance-growth nexus, finance-employment nexus, determinants of financial sector development, contractual savings institutions and economic growth, regulations and financial stability, supervision and financial stability, access to finance, financial efficiency

**JEL Classification** : C00, E44, G00, G2, O1, O4, O5

**Sector Board** : Financial Sector (FSE)

> 1 Selahattin Selşah Paşalı is a PhD candidate at the Graduate Institute of International Studies in Geneva, Switzerland (selsahpasali@gmail.com). This paper was prepared for the Financial Sector Reform and Strengthening Initiative (FIRST) at the World Bank. I am heavily indebted to Jorge Patino for identifying the policy relevant questions and providing excellent guidance. I am grateful to Asli Demirguc-Kunt, and Maria Soledad Martinez Peria for their extremely useful and critical comments. I also thank the participants of the meeting organized by the Center for Finance and Development at the Graduate Institute welcoming the members of the Conseil de la Fondation Pictet pour le Developpement for their suggestions. All remaining errors belong to the author.
# **1. Introduction**

The importance of finance in the economic development trajectories of developing countries is by now widely recognized. The motivation behind this synthesis paper is to investigate causes and consequences of financial sector development by establishing an inventory of high-quality academic research with special emphasis on quantitative implications of finance for economic development in developing countries. The idea is to acquire an understanding of what has been established in the literature and to provide insights for policy making. Essentially two questions drive the motivation for this paper:

- How does a country’s financial system affect its economic development?

- How can countries improve their financial systems?

The Financial Sector Reform and Strengthening (FIRST) Initiative<sup>2</sup> at the World Bank has identified these questions as highly policy-relevant on the basis of its comprehensive conceptual framework for financial sector reform. The underlying premise is that once the statistically significant and economically meaningful effects of finance on economic development are established, it is crucial to identify what types of policies are associated with financial development. The main lessons drawn from the literature can help the FIRST Initiative provide further assistance to its clients based on their context-specific profiles.

Before moving any further, we should first clarify these two questions. By _economic development_ , we restrict our attention to economic growth and employment and initially set aside other dimensions such as inequality and poverty. By _financial systems_ , we adhere to a broader definition that includes banking sectors, capital markets, and contractual savings institutions. By _improving_ a financial system, we mean increasing financial depth, efficiency, and inclusion while ensuring financial stability.<sup>3</sup> Against this backdrop, the aim of this synthesis paper is to narrate the quantitative evidence on (i) the effect of financial sector development on economic growth and employment, and (ii) the determinants of financial sector development, with specific attention to policy variables such as regulations, supervision, and an enabling institutional environment.

In total, 184 of more than 200 high-quality academic research papers were selected for this narrative. While about 100 papers address the finance-growth nexus, only a handful examine the finance-employment nexus. The remaining papers dwell upon the determinants of financial sector development. In our selection, we focused solely on empirical academic articles with specific attention to developing countries.<sup>4</sup> The findings of this literature review are briefly summarized as follows:

> 2 The Financial Sector Reform and Strengthening Initiative (FIRST) is a multi-donor grant facility that funds technical assistance (TA) to promote financial sector development in the low- and middle-income countries. FIRST is supported by the Canadian International Development Agency (CIDA), the Department for International Development of the United Kingdom (DFID), the International Monetary Fund (IMF), the Ministry of Foreign Affairs of the Netherlands, the State Secretariat for Economic Affairs of Switzerland (SECO), the Swedish International Development Cooperation Agency (SIDA), the Germany’s Federal Ministry of Economic Cooperation and Development (BMZ), the Ministry of Finance of Luxembourg, and the World Bank.

> 3 Although the first two components are commonly scrutinized, the latter two require more attention from academic literature.

> 4 Because the literature is dominated by cross-country studies, we broadened our criteria to empirical analyses that stack developed and developing countries together.

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- **Finance-Growth Nexus:** Financial sector depth (i.e., banking sector, capital markets, and contractual savings industry) has a statistically significant and economically meaningful positive effect on economic growth. The magnitude of this effect is an acceleration of about 1 percentage point in annual growth of real gross domestic product (GDP) per capita; however, this effect is subject to numerous qualifications. A stable and efficient financial system with accessibility also contributes positively to economic growth.

- **Finance-Employment Nexus:** Financial sector depth has a statistically significant positive effect on employment. Unfortunately, this conclusion derives from only a few papers that have not scrutinized the relationship as much as the papers addressing the finance-growth nexus relationship.

- **Determinants of Finance** : Institutions (e.g., creditor rights, credit registries, accounting standards, rule of law, quality of contract enforcement, etc.) matter for the depth, stability, efficiency, and inclusiveness of the financial sector. Only some types of regulations and supervision are positively related to financial sector development (e.g., timely and easily accessible and comprehensible disclosure of information, removal of entry barriers into financial system, less extensive deposit insurance). While the extent of government ownership of banks is associated with less deep, inefficient, and unstable financial systems, the opposite holds for foreign ownership. Last but not least, although the effect of concentration on financial sector development is not yet resolved, more competitive and contestable financial systems are associated with greater financial sector development.

The structure of this paper is as follows. Section 2 presents the finance-growth nexus in six subsections that reflect the angles that academic literature has taken to examine this nexus. Section 3 briefly reviews the empirical evidence on the finance-employment nexus. Section 4 reviews determinants of each component of financial sector development. Section 5 briefly discusses the causes and consequences of insurance and pension sector development. Section 6 concludes with suggestions for future work.

# **2. Finance and Growth**

The lion's share of the references cited in this synthesis paper relate to the finance-growth nexus, which also has the longest history among the topics covered in this paper. Despite that history, the literature is definitely not satiated, as it is not difficult to come across very recent papers attempting to contribute to it. Given that we were faced with a large volume of papers, we used an intuitive categorization to ease the process of navigating through this document.<sup>5</sup>

> 5 A comprehensive survey of empirical and theoretical research on the finance-growth nexus is presented by Levine (2005), who also offers various critiques of empirical methodologies and findings.

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First, we start by synthesizing academic research that examines the relationship between financial depth and economic growth. Without a doubt, this relationship has received the most attention in the literature. In the first subsection, we cover articles that focus on banking sector depth. Since we are mostly concerned with developing countries, the selected articles mostly focus on banking sectors, or the dominant sector in financial systems of developing countries. Having said that, there are a few articles that examine the relationship between stock market development and contractual savings institutions on one hand and economic growth on the other, including in emerging and developing countries.

Second, we allocate some space to the critiques of initial findings about the financegrowth nexus and discuss various forms of nonlinearities and heterogeneities found therein. Recently, it has been found that the effect of finance on economic growth does not increase monotonically and that various thresholds such as the level of income, financial development, and inflation affect the strength of the association found in the early literature. We also recognize important heterogeneities, as empirical evidence is sensitive to variation across regions and periods.

Third, we focus on the second hottest topic related to the finance-growth nexus, namely the effect of financial stability on economic growth. Because financial stability is a part of overall financial sector development, it would be a grave mistake to miss the important consequences of financial fragility in the form of growth collapses or reversals and output losses. In this context, we start by reporting the effect of financial liberalization on economic growth, then take into account the destabilizing effects of financial liberalization and emphasize the significant negative effects of financial fragility. We end this subsection by referring to papers that examine the relationship and the trade-offs between regulations and economic growth. Last but not least, we present interesting results from the rather narrow literature that examines the effects of financial efficiency and inclusion on economic growth.

There are a number of caveats worth mentioning. First, this review does not include a major strand of the literature, one that examines the finance-growth nexus with timeseries econometric methodologies (e.g., vector-auto regression models). Because our focus is quantitative effects, it will not be helpful to consult this strand of literature, which is heavily polarized without much consensus. Second, the coefficient estimates reported in the body of the text and in our inventory should be considered with a healthy dose of caution, because usually they are not fully exploitable elasticities. For our purposes, the ideal article would use the most relevant data (i.e., only developing countries for a long period of time) with a robust identification strategy; such an article does not exist. Nevertheless, quite a number of papers come close to our ideal and provide some very useful insights. Last but not least, our inventory of empirical results appears in the appendix, which consists of 18 tables associated with at least one hypothesis within each subsection. We do not refer to every article in our tables, so we recommend that the reader consult these tables while reading the associated subsection.

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# **2.1 Financial Depth and Economic Growth**

# **2.1.1 Banking Sector Development and Economic Growth**

The empirical literature on the relationship between financial sector development and economic growth essentially starts with the seminal work by King and Levine (1993).<sup>6</sup> Apart from opening Pandora's box, they also have set the standards for the use of variables in empirical research. On the left-hand side, they used the growth rate of real GDP per capita and attempted to explain cross-country variation in growth rates by the variation in various indicators of financial sector development, including financial depth or size and financial intermediation. Their first measure of financial depth is the ratio of liquid liabilities to GDP (i.e., M3/GDP).<sup>7</sup> Second, they consider the ratio of deposit money bank domestic assets to deposit money bank domestic assets plus central bank domestic assets. This indicator aims to measure the level of risk sharing and information services provided by money banks. Third, they focus on financial intermediation, proxied by the proportion of credit allocated to private enterprises by the financial system (i.e., the ratio of claims on the nonfinancial private sector to GDP and also to total domestic credit). These three variables are the most commonly used proxies for financial development in academic research.<sup>8</sup> A large variety of formal econometric methodologies is used in this literature, subject to the availability of data. Among them we can list ordinary least squares (OLS), two-stage least squares (2SLS), instrumental variables (IV), and three-stage least squares (3SLS) estimators for cross-sectional data. Dynamic panel methods such as difference or system generalized method of moments (GMM) are used for panel data. Before moving to the results shown in this literature, consider the following descriptive insight that is often cited in the literature. As Rioja and Valev (2004a) put it, countries that do not increase their financial depth experience negative growth rates (e.g., Haiti and Senegal), but countries with moderate levels of financial depth experience high and positive growth rates (e.g., Thailand and Cyprus). However, this positive relationship disappears when highly developed countries are considered. For instance, the effect of a marginal increase in financial depth has not much effect on growth in Switzerland or in the United States. The importance of this insight will become more clear when we discuss nonlinearities in the finance-growth nexus.

Table 1 in our inventory presents empirical results extracted from a body of highly cited academic research that addresses the following empirical question: To what extent does financial sector development, proxied by the banking sector depth, affect economic growth rates? Theoretically, there could be positive, negative, or no effects of finance on growth. Empirically, the literature presents evidence for each option but the positive

> 6 At least two influential empirical articles precede King and Levine (1993), namely Goldsmith (1969) and McKinnon (1973). However, formal econometric procedure is first used by King and Levine (1993), whose analysis represents the first attempt to move away from simple correlations to potential causation.

> 7 Some articles also rely on (M3−M1)/GDP.

> 8 An interesting recent study by Beck et al. (2012) finds that in the finance-growth nexus, what matters is credit to enterprises, not credit to households. In addition, Japelli and Pagano (1994) show that relaxing the liquidity constraints of households during the financial deregulation period of the 1980s lowered growth rates in countries of the Organization for Economic Co-operation and Development (OECD).

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effect of finance is clearly dominant.<sup>9</sup> King and Levine (1993); Levine (1998); Levine and Zervos (1998); Levine, Loayza, and Beck (2000); Beck, Levine, and Loayza (2000); and Beck, Demirguc-Kunt, and Maksimovic (2004) all provide frequently cited positive effects of financial depth on economic growth. Table 1 clearly shows that the quantitative effects vary from study to study, as they use different financial development proxies, econometric specifications, and data. In general, the overwhelming majority of the literature has found significant positive effects of banking sector depth on economic growth.

To give a bird's eye view, let us suggest the following upper and lower bounds for the quantitative effects:

- **Upper Bound:** A 10 percentage point increase in financial depth accelerates annual economic growth rate by an additional 1 percent, at best. Accumulating over a sample period, say five years, the best-case scenario is that real output would be 5 percent more than what it actually was. This is an economically significant phenomenon.

- • **Lower Bound:**<sup>10</sup> There is no significant relationship between finance and growth, or the effect is too small to be considered economically meaningful.<sup>11</sup>

Quite a few problems are associated with cross-country growth regressions. Usually, academic research moves toward panel data methods to deal with some of these wellknown weaknesses but it is also helpful to look at country studies, where the internal validity of econometric procedures tends to be more robust, at the expense of external validity.<sup>12</sup> Table 2 in our inventory presents some evidence on the finance-growth nexus from within countries such as Brazil, China, India, and Vietnam. The articles find quite sizable effects of finance on growth. For instance, Anwar and Nguyen (2011) estimate that economic growth in Vietnam would accelerate by 18.3 percent as a consequence of a 10 percentage point increase in banking sector development.

So far, the focus has been on the effect of financial development on the first moment of economic growth, but economists also consider the effect of financial development on growth volatility. The articles cited in Table 3 make it clear that increasing financial depth significantly lowers growth volatility and thus performs a stabilizing role in developing countries. Another interesting question is to what extent financial deepening can accelerate the convergence of growth rates across the world. The key insight from the remaining articles in Table 3 is that developing countries with higher financial sector development are more likely to catch up and transition to the high-income group.

> 9 The reader should keep in mind that identification of the causal relationship between finance and growth is a very difficult task and even the most frequently cited articles explicitly accept this weakness.

> 10 In this giant literature, a few papers find a negative relationship between financial intermediation and economic growth. For instance, Shen and Lee (2006) suggest that a 10 percentage point increase in financial depth leads to a 0.5 percent decrease in the GDP growth rate. This negative effect is exacerbated in middle-income countries with insufficient creditor protection and countries that suffer from banking or currency crises, especially in Latin America and Sub-Saharan Africa.

> 11 We should note that the sample period considered in these studies is usually long, 20–40 years, so even if the effect is close to zero, over time the impact on output is substantial.

> 12 Specifically, country-level studies help improve the identification of a causal relationship but results cannot be generalized to other contexts.

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# **2.1.2 Stock Market Development and Economic Growth**

Capital markets play a crucial role in the finance-growth nexus. Because financial sectors in developing countries are dominated heavily by banking sectors, however, we can refer to only a few articles that estimate the effect of capital markets on economic growth in developing countries.<sup>13</sup> Table 3 in our inventory on the quantitative effects of stock market development on economic growth shows that unlike for banking sector development, this subliterature does not find any negative or insignificant effects. Specifically, the effect of stock market liquidity on economic growth is significantly positive and ranges between 0.5 and 1.14 percent in response to a 10 percentage point increase in a stock market proxy. Stock market liquidity is found to be more robustly (both statistically and economically) associated with economic growth than is stock market capitalization. Shen and Lee (2006) argue that the effect of stock market development is higher than the effect of banking sector development on economic growth. Yet they argue that this positive effect is higher for developed countries. A tempting question is whether banking structure plays an important role in economic growth. Levine (2002) and others offer an important insight: what actually matters is the level of financial activity, which includes both stock market liquidity and banking sector depth.

# **2.1.3 Contractual Savings Institutions and Economic Growth**

The finance-growth nexus is not limited to the growth effects of banking sector or stock market development. A burgeoning literature<sup>14</sup> has focused on the impact of growth in the insurance and pensions sectors on economic growth. For the insurance-growth nexus, various mechanisms are hypothesized to link insurance development and growth. Essentially, an insurance market is an institutional investor that can (i) offer risk diversification; (ii) mobilize savings, encourage accumulation of new capital, and simplify the efficient allocation of existing capital in the domestic economy; and (iii) contain financial fragility.<sup>15</sup> In terms of data, two proxy variables are used to measure the level of insurance sector development, namely insurance penetration (i.e., the ratio of insurance premium volume to GDP) and insurance density (i.e., premiums per capita). This growing literature mostly focuses on life insurance penetration and density. Table 5 in our inventory shows some conflicting results: some papers identify growth effects of insurance sector development greater than the growth effects of banking sector and stock market development, while others find smaller effects. While some argue that the effect is larger in developed countries, others provide evidence for higher growth effects in lowincome countries. Overall, this small literature finds a significant and positive effect of insurance sector development on economic growth. The magnitude of the effects is, at times, too good to be true.

> 13 The literature has often used stock market depth and liquidity to measure stock market development (i.e., the ratio of total value traded to GDP and the ratio of stock market capitalization to GDP).

> 14 For a literature review of 80 empirical papers, we refer the reader to Outreville (2011). Because our focus is only developing countries without time-series econometrics, our inventory is much smaller.

> 15 Even though the papers in Table 5 do not attempt to specifically identify each channel, they still try to identify whether there is an overall association between the two variables.

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For the pensions-growth nexus, the main mechanism cited by the selected papers is that growth rates accelerate with higher saving rates, better capital markets, and lower labor market distortions. An additional channel for economic growth is the improvement of corporate governance in response to the accumulation of pension assets. While Holzmann (1997) and Hu (2005) focus on pension sector reform (i.e., a switch from pay-as-you-go systems toward funded systems), Davis and Hu (2008) and others consider the effect of pension sector assets on economic growth and find positive effects from pension sector reform and development. Consequently, our reading of the literature suggests that development of both the insurance and the pensions sector is positively associated with economic growth. Further research is necessary, however, to clarify the conflicting results found in the literature.

# **2.1.4 Nonlinearities and Heterogeneities**

Recent research has challenged the implicitly held assumption that the relationship between finance and growth is linear and has presented evidence for various forms of nonlinearities. For instance, the positive effect of finance for countries disappears beyond a certain threshold, be it the level of income, financial development, inflation, or employment in the financial sector. Also, more and more region-specific analyses are being conducted, including in Latin America and in the Middle East and North Africa. Table 6 in our inventory presents some very interesting results from the literature.<sup>16</sup> The hottest topic in nonlinearities relates to the threshold for the level of financial development. This topic has received quite a bit of attention, especially during the recent global financial crisis. A legitimate question is whether the positive effect of finance on growth turns insignificant or negative beyond a certain threshold. Focusing on financial depth, Arcand, Berkes, and Panizza (2012) estimated that finance starts exerting a negative effect on economic growth when financial depth reaches 100 percent of GDP. Eschenbach and Francois (2005) estimate this threshold between 70 and 100 percent. Aghion, Howitt, and Mayer-Foulkes (2005) present an interesting descriptive statistic in that the positive effect of finance on growth vanishes after a country goes beyond the level of financial depth in Greece (e.g., the ratio of private credit to GDP exceeds 39 percent). Using a different proxy of financial depth (ratio of liquid liabilities to GDP), Rousseau and Wachtel (2011) estimate the critical threshold at about 40 percent. Even though there is convincing evidence that financial development beyond a certain threshold is not good for economic growth, it is not yet clear why this is the case. Further research should clarify various mechanisms that could generate such nonlinearities.

The level of income is yet another threshold that complicates the effect of finance on economic growth. One hypothesis suggests that the effect of finance on growth should be larger in developing countries than in developed countries, because developed countries already have highly developed financial sectors. However, a competing hypothesis conjectures that the positive effect of finance on economic growth is conditional on

> 16 Interestingly, there is some decent literature on the finance-growth nexus in Sub-Saharan Africa. Yet this literature heavily relies on time-series econometrics and hence is excluded from this survey.

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institutional quality. Because developing countries have on average lower institutional quality than developed countries, the effect of finance on growth may be higher in developed countries. Another hypothesis, put forward by Rioja and Valev (2004a), is that the positive effect of finance on growth in developing countries operates through accelerated capital accumulation, while the positive effect in the developed countries operates through productivity growth.

Unfortunately, there is not yet consensus on the sign of the relationship for countries at other stages of development. For instance, Rousseau and Wachtel (2011) and Rioja and Valev (2004a) find that the magnitude of the effect of finance on growth is higher for developed countries. However, Rioja and Valev (2004b) and Demirguc-Kunt, Feyen, and Levine (2011) find that the effect is higher for countries in the lower and/or middle of the distribution than at the higher end. Another interesting result is that while diminishing returns hit earlier for banking sector development, they take longer to occur for stock market development. The latest evidence from Beck, Degryse, and Kneer (2013) suggest that while financial intermediation is associated with lower volatility in low-income countries, financial nonintermediation activities are associated with higher volatility in high-income countries.

Two other interesting thresholds were discovered by recent research. First, Rousseau and Wachtel (2002), Rousseau and Yilmazkuday (2009), Yilmazkuday (2011), and Huang et al. (2010) all study whether there is an inflation threshold beyond which the positive effect of finance on growth disappears or switches sign. The quantitative evidence confirms the expectation that such a threshold exists and shows that countries with inflation rates higher than the threshold experience slower growth because high inflation rates pull down the level of financial development. While Rousseau and Wachtel (2002) find this inflation threshold to be about 13–25 percent, others have found even lower thresholds (about 6–8 percent). Second, Cecchetti and Kharroubi (2012) estimate that if the financial sector represents more than 3.5 percent of total employment (i.e., employment in financial sector divided by total employment), further increases in financial sector depth are detrimental to economic growth. They find that growth in financial sector employment of about 1.6 percent per year reduces annual economic growth by about 1 percentage point.

Last but not least, heterogeneities in the finance-growth nexus are detected across time and regions. For instance, Rousseau and Wachtel (2011) find that a positive effect of finance on growth existed in the 1960–89 period (i.e., a similar period as in King and Levine [1993]) but not in the 1990–2004 period. Their explanation for this “fading link” is that the latter period was ridden with financial crises that pulled down the positive effect of finance on growth. Dabos and Gantman (2010) confirm these results using an extended sample and dynamic panel methods. The latest results are reported by Beck, Degryse, and Kneer (2013), who find evidence for this fading link in the 1995–2007 subsample. Consequently, although the recent papers have focused on shorter horizons and found evidence for a fading link between finance and growth, the positive association between finance and growth remains significant and positive in the long run.

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In terms of regional variation, consider the evidence presented by Roubini and Sala-iMartin (1992), who find that financial repression in Latin America explains the relatively slower growth performance over the 1960–85 period. De Gregorio and Guidotti (1995) find a different result in that banking sector deepening is negatively associated with economic growth in Latin America over the same period. Moreover, Barajas, Chami and Yousefi (2012) demonstrate that the effect of finance on growth in the Middle East and North Africa is lower than in comparable regions, even when the level of financial development is similar. They also find that the effect of finance on growth diminishes as the level of financial development increases, but at a faster rate for the Middle East and North Africa than for other regions.

# **2.2 Financial Stability and Economic Growth**

A critical component of financial sector development is financial stability. Deepening the financial system without paying attention to potential negative consequences in the form of financial fragility is obviously suboptimal. Consequently, this section starts with the effect of financial liberalization on economic growth and then moves to the costs of such liberalization in terms of the incidence and severity of financial crisis. We conclude with the effects of regulation on economic growth because regulations are often the immediate responses to financial fragility. The aim of this section is to clarify whether the positive effects of finance on growth are worthwhile given the costs associated with financial fragility.<sup>17</sup> We should note that there are differential effects on growth of capital account liberalization, equity market liberalization, and full-fledged financial liberalization that includes the former two and banking sector reforms. To capture financial liberalization, academics have come up with various indices based on specific reforms.<sup>18</sup> One clear message emanating from Table 7 in our inventory is that the magnitude of the effect of financial liberalization on economic growth is higher than the effects found in the previous subsections. Specifically, the effect of financial liberalization on economic growth reaches a more than 3 percentage point acceleration in the annual economic growth rate. As Bekaert, Harvey, and Lundblad (2005) demonstrate, however, the effect is higher for countries with good-quality institutions. In addition, the effect of equity market liberalization seems to have higher effects than capital account liberalization, which is usually associated with financial fragility, especially in developing countries. A very relevant article for the purposes of this section is presented by Tornell, Westermann, and Martinez (2004), who find that the effect of liberalization on growth is lower once financial fragility is accounted for. Nevertheless, they find that the net effect remains significantly positive and economically meaningful. Comparing India, an emerging

> 17 One could argue that the effect of financial liberalization on economic growth operates through each component of financial development (i.e., depth, stability, efficiency, and inclusion). We focus on financial liberalization in this section simply to bridge a number of strands in the literature. Otherwise, we have no intention to claim that financial liberalization breeds fragility. There is an established literature emphasizing the role of institutions in the success or failure of liberalization.

> 18 Usually, authors refer to de facto or de jure financial liberalization. De facto financial liberalization is measured by gross capital flows as a share of GDP, as in Levchenko, Ranciere, and Thoenig (2009) and de jure financial liberalization refers to various indices constructed by authors based on policy reforms, as in Bakaert, Harvey, and Lundblad (2005).

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market with a risk-averse attitude toward financial liberalization, with Thailand, a country that has gone through many booms and busts owing to fragility, they find that long-run growth increases by 0.54 percentage point in response to Thailand's pro-finance trajectory.

Nonetheless, the consequences of financial fragility on economic growth remain significantly negative. In terms of growth collapses, consider Loayza and Ranciere (2005), who estimate that an increase in financial volatility (frequency of systemic banking crisis) by one standard deviation leads to a decrease of 0.3 (0.7) percentage point in the annual growth rate of GDP per capita. Similarly, Ranciere, Tornell, and Westermann (2006) find that financial liberalization raises the probability of a twin crisis, thereby restraining economic growth. Bonfiglioli and Mendicino (2004) demonstrate that countries with nonsystemic banking crisis episodes grow 4 percent more than countries with systemic banking crisis. However, they find that countries with capital account restrictions are more exposed to the negative effects of banking crises than financially open economies. Johnston and Pazarbasioglu (1995) show that countries that reform their financial systems without experiencing banking crisis register higher average growth rates.

So far, we have ignored the potential of reverse causality in the relationship between financial stability and economic growth. Although the majority of the papers cited in our inventory look at the effect of financial fragility on economic growth and output, we understand that episodes of rapid growth may lead to instability. Even though we have not come across empirical papers studying this reversed link,<sup>19</sup> we understand that faster economic growth—especially in emerging markets—may lead to financial booms which, in the absence of good institutions and relevant regulations, can lead to financial fragility.

Table 8 in our inventory presents some quantified negative effects of financial, banking, and currency crises in terms of output losses in developed and developing countries.<sup>20</sup> One common message is that the costs of crises vary with the features of the crises and the profiles of the countries. For instance, as Cerra and Saxena (2008) show, while on average banking crises are more costly than currency crises, low-income countries experience the largest output losses relative to high-income countries from very frequent currency crises. By contrast, although countries with high levels of financial development experience higher costs, countries with better institutions experience lower costs. Historically, the largest output loss, about 29 percent, was recorded in the United States during the Great Depression, according to Reinhart and Rogoff (2009). Argentina follows, with 22 percent of GDP lost in 2001.<sup>21</sup> The Basel Committee on Banking Supervision (2010) suggests that reducing crisis probability helps countries save a significant amount of their output. In this context, an

> 19 Some of the papers in our inventory on the growth-stability nexus recognize the potential of this reverse causality and address it with the use of dynamic panel data methods.

> 20 If more country-specific examples are needed, one can easily access information on the quantified costs of crises.

> 21 These are larger numbers than those listed in table 8. The difference derives from the way costs are computed. For instance, some compute the cumulative effect of crisis on output over the entire crisis period rather than focusing on the first year of crisis. Also, some focus on banking crisis and others on currency crisis.

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immediate policy-relevant question is to what extent regulations and supervision, financial structure, and ownership can help mitigate the negative effects of crisis on economic growth. Even though we have not come across empirical studies that address this specific question, we report various estimates of the effects of regulations, financial structure, and ownership on economic growth in table 9 of our inventory. The first two papers relate to the effect of regulations on output. There is consensus that the higher the capital adequacy ratios, the lower the output. However, note that capital adequacy ratios can lower the crisis probability as well. Even though banking supervision seems not to be directly associated with economic growth, there is some evidence for indirect positive effects through financial stability.

Regarding financial structure and ownership, Fernandez, Gonzalez, and Suarez (2010) find that concentration in the banking system has negative effects on economic growth but that regulations in the form of activity restrictions lower the amplitude of these negative effects. In a seminal paper, La Porta, Lopez de Silanes, and Shleifer (2002) find that in developing countries there is a negative relationship between the extent of government ownership and economic growth. As Andrianova, Demetriades, and Shortland (2012) show, however, the earlier results are not robust to different specifications. Last but not least, regulations that ease the entry of foreign banks into the domestic market help improve economic growth through direct and indirect effects.<sup>22</sup>

# **2.3 Financial Efficiency and Inclusion and Economic Growth**

In this section, we focus on the two remaining components of financial sector development, namely efficiency in the financial sector and access to finance, mostly by firms. As evident in tables 9 and 10 in our inventory, there is limited research on these two components. Partly, this lack of evidence is due to data availability, because the proxy variables used for efficiency and access are not readily available for many developing countries.<sup>23</sup> For efficiency, the usual proxy variables include net interest margins between lending and deposit rates, overhead costs in proportion to total assets, noninterest income in proportion to total income, and various other indicators for profitability of banks, such as return on assets. Demirguc-Kunt, Levine, and Min (1998) find that a one standard deviation decrease in their efficiency proxy (i.e., overhead costs per total assets) raises economic growth by 1 percentage point. Koivu (2002) finds a similar effect (i.e., 1.2 percentage points) in response to a decrease in interest rate margins in a sample of transition economies.

For access, by contrast, researchers usually rely on the World Bank Enterprise Survey to capture financing constraints on firms. In addition, the penetration of banks and ATM

> 22 As will be discussed later, foreign bank entry is associated with higher efficiency in the banking sector, which is positively related to economic growth.

> 23 The recently established Global Financial Database, however, offers a great opportunity for research, as it provides information on each component of financial sector development for 200 countries since the 1960s.

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machines are used as proxies for access to finance by households. Access to finance has significant effects on economic growth. This is evident from the findings of the strand in the literature that conducts firm-level analysis. The main message is that access to finance is a robust determinant of firm growth that matters more for small firms than for larger firms. Beck and Levine (2005), however, find that as the level of financial development increases, the importance of financing constraints for small firms’ growth decreases.

# **3. Finance and Employment**

A clear finding of this literature review is that only a handful of articles focus on the effects of financial sector development on employment in developing countries. Even when the sample is expanded to developed countries, it is difficult to find empirical analyses that address this important nexus. Table 11 in our inventory for this subsection lists a few papers that focus on developing countries.

The seminal paper on the finance-employment nexus is the theoretical and empirical analyses conducted by Gine and Townsend (2004) in Thailand between 1976 and 1996. They provide convincing evidence that financial deepening helped a substantial part of the workforce move from the agriculture sector to formal labor markets in urban centers, thereby raising average household income 17–34 percent. In terms of the direct effect of financial depth on employment, consider the recent paper by Pagano and Pica (2012), who find a positive effect on the order of 0.23–0.83 percent increase in employment growth.<sup>24</sup> In terms of the effect of financial stability on employment, Reinhart and Rogoff (2009) estimate that banking crises increase unemployment rates by 7 percentage points and recovery to pre-crisis levels takes a long time. The record is again held by the United States during the Great Depression with a 20 percentage point increase in the unemployment rate. World Bank (2009) surveys some descriptive evidence on the rise of unemployment rates across the world after the global crisis. Last but not least, Choudry, Marelli, and Signorelli (2010) suggest that a 1 percent increase in the systemic crisis index lowers the employment rate by 0.394 percentage point. When their sample is restricted to only high- and upper-middle-income countries, they estimate the effects to be 1.32 and 1.01 percentage point decreases, respectively.

In terms of the effect of access to finance on employment, Aterido, Hallward-Driemeier, and Pages (2007) find that not only sophisticated but also simpler forms of finance have significant positive effects on employment growth. Aterido and Hallward-Driemeier (2010) document that access to finance is a crucial constraint for micro firms in SubSaharan Africa but surprisingly find that employment growth is not curtailed by financing constraints.<sup>25</sup> In Bangladesh, Rabbani and Suleiman (2005) evaluate the effectiveness of BRAC's small and medium-sized enterprise (SME) lending program from an

> 24 The lack of empirical analyses in this nexus is evident in the literature review section of this paper. 25 Their explanation for this anomaly is the lack of competition and market access for micro firms. When they repeat the same exercise for countries outside Sub-Saharan Africa (e.g., comparable developing countries), they find that employment growth is curtailed by lack of access to finance.

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employment perspective and find that SMEs that borrow repeatedly from BRAC manage to generate more employment.

The finance-growth nexus suggests that the growth effects of finance operate through either capital accumulation or productivity growth. The findings presented in this section provide yet another mechanism, employment growth. Unfortunately, this literature is still in its infancy and more research is necessary to test a variety of hypotheses using a multitude of empirical methodologies.

# **4. Determinants of Financial Sector Development**

The preceding sections have shown that various components of financial sector development have significant positive effects on economic growth and employment. In this section, we are interested in distilling main messages from the established literature to answer a crucial question: what are the determinants of financial sector development in general and each component in particular? We restrict the aim of this section to gathering as much empirical evidence as possible that links _policy_ variables to financial sector development. Within these policy variables, the focus is set primarily on regulations, supervision, and the enabling institutional environment. In setting this restriction, we refrain from investigating historical legal determinants over which policy makers have no control.<sup>26</sup> As in Section 2, we investigate the determinants of financial sector development by focusing on a component in each of the following four subsections. Each subsection starts by discussing how regulations and supervision affect financial sector development and then moves to other determinants such as the institutional and legal environment (e.g., creditor protection and credit registries, among others) financial openness and banking reforms, financial structure (i.e., concentration and competition), ownership of banks (i.e., government or foreign ownership), and finally engagement with the World Bank and the International Monetary Fund. In table 13, panels A–E present empirical results for determinants of each component.

Before starting with the empirical evidence, some general remarks will be useful. First, it is only recently that academic researchers have managed to get their hands on data related to regulation and supervision. Although some papers use author-constructed indexes (e.g., compliance with the Basel Core Principles or Regulatory Governance Index based on Financial Sector Assessment Program), the majority of this literature relies on data collected by Barth, Caprio, and Levine (2000). The most recent literature review by Levine (2012) provides very important insights regarding the effects of regulatory framework on financial sector development. The common finding in the literature is that each component of financial sector development is positively related with the following key regulatory factors:

> 26 Note, however, that the institutional determinants listed later in this subsection are endogenous to legal origins. Beck, DemirgucKunt, and Levine (2001) offer an excellent review of legal theories and conduct empirical tests on various channels through which legal origins affect financial sector development. For a critical review of the literature, also see Beck and Levine (2005).

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- Timely and easily accessible and comprehensible disclosure of information

- Equity and debt holders incentivized to oversee financial institutions<sup>27</sup>

- Removal of barriers to competition

James Barth, Gerard Caprio, and Ross Levine are the leading researchers on the effects of banking sector regulations and supervision on financial sector development, including financial depth, stability, and efficiency. They have collected data since the late 1990s and early 2000s from regulatory agencies across the world and compiled a very useful data set on the quantity and quality of regulations and supervision in a large sample of countries.<sup>28</sup> They have frequently published empirical analyses of the regulationsfinancial sector development nexus, and they confirm the insights listed above from Levine (2012). Another important insight from these authors is that for many developing countries, compliance with the Basel II accords—let alone Basel III—should not be a benchmark strategy as it is better for these countries first to develop their legal, information, and incentive systems and then think about specific regulations. The empirical evidence we cite below on the importance of institutions in financial sector development clearly supports this insight.

# **4.1 Financial Depth**

In the finance-growth nexus, academic researchers often approximate the effect of financial depth on growth by using an exogenous increase in financial depth on the order of 10 percentage points or one standard deviation. A crucial question then is how countries can increase their financial depth.<sup>29</sup> This section surveys empirical literature that attempts to answer this important question. In general, the following key factors are found to be associated with financial depth:

- **Regulations and Supervision:** The key insight from the analyses of Barth, Caprio, and Levine is that certain regulations have either negative or no effects on financial deepening. For instance, restrictions on commercial bank activity reduce financial depth, but capital requirements have no significant effect. Although official supervision increases financial depth, this positive effect exists only in countries with a high level of political openness.<sup>30</sup> This result holds only in countries with no government presence in the financial sector. Detragiache, Gupta, and Tressel (2008) complement Barth, Caprio, and Levine (2004, 2012) in that they also find that more stringent regulatory and supervisory requirements<sup>31</sup>

> 27 In other words, as Barth et al. (2009) argue, private supervisory systems are more optimal than official supervisory power, especially in countries with greater voice and accountability.

> 28 These authors collect data on a variety of regulations such as capital and disclosure requirements, and regulations that restrict commercial banks from engaging in securities, insurance, and real estate activities and from mixing with nonfinancial firms.

> 29 As a reminder, financial depth—or, more correctly, intermediation—is often measured by credit from banks to the private sector divided by GDP. A few papers listed in this section look at stock market depth as well.

> 30 One mechanism that comes to mind is that in such countries, the expansion of the official supervisory branch is not subject to corruption.

> 31 In this article, regulations and supervision are measured by accounting, discipline and disclosure, restrictions on banking activities, audit requirements, and deposit insurance.

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reduce financial depth. In addition, explicit deposit insurance schemes reduce financial depth.

- **Regulatory Reforms:** Giustiniani and Kronenberg (2005) find that compliance with conditionalities imposed by the International Monetary Fund (IMF) increases the level and growth of financial depth. However, the intensity and hardness of the conditionalities are not associated with better banking performance. Cull and Effron (2005) find that countries that borrowed adjustment loans from the World Bank for reforms related to regulation and supervision experienced faster growth in liquid liabilities but slower growth in the ratio of private credit to GDP. Moreover, Detragiache and Tressel (2008) construct an aggregate index of banking sector reform<sup>32</sup> and find that banking sector reforms are associated with large, positive, and long-lasting effects on banking sector depth.<sup>33</sup>

- **Financial Openness:** Chinn and Ito (2002, 2006) and Ito (2006) look at the relationship between financial openness (i.e., capital account openness) and stock market liquidity. They find that more open financial systems are also more active and developed. An important caveat is that this relationship works more robustly and significantly for countries with better institutions. Bonfiglioli and Mendicino (2004) focus on banking sector development and find that countries with open capital accounts have deeper financial sectors.

- **Ownership:** La Porta, Lopez de Silanes, and Shleifer (2002) find that the higher the share of assets owned by government banks, the less deep the financial sector. In low-income countries Detragiache, Gupta, and Tressel (2008) find that the larger the foreign presence in the banking system, the less deep the banking sector.

- **Institutions:** Institutions are crucial for determinants of financial sector depth. Djankov, McLiesh, and Shleifer (2007) refer to creditor protection and information sharing.<sup>34</sup> Essentially, creditors that know that they are protected in case of default, to a certain extent, are willing to extend more credit to enterprises. Also, having access to information regarding the financial history of firms and households helps contain the negative effects of asymmetric information and moral hazard.

- **Creditor Rights:** Levine (1998) considers the effect of creditor rights,<sup>35</sup> contract enforcement, and rule of law on banking sector depth and finds that an increase of one standard deviation in both creditor rights and

> 32 This index is based on credit controls, reserve requirements, interest rate controls, entry barriers, state ownership, and banking supervision. 33 Specifically, removing restrictions on credit allocation, lowering reserve requirements, removing limits on credit growth, facilitating entry into the banking system, and removing branching restrictions all increase banking sector depth. They do not find any evidence for positive effects of improvements in banking regulation and supervision.

> 34 These two are not mutually exclusive, as they might be substitutes in certain contexts.

> 35 He measures creditor rights as having an automatic stay on the assets of the firm upon filing a reorganization petition, whether the firm continues to manage its property pending the resolution of the reorganization process, and whether secured creditors rank first in the distribution of the proceeds. For enforcement, he considers the International Country Risk Guide (ICRG) law-and-order risk component, the risk that government will and can modify a contract after it has been signed.

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contract enforcement leads to a sizable (0.45 percentage point) increase in financial depth.

- **Credit Registries:** The seminal work by Japelli and Pagano (2002) finds that countries with information-sharing credit bureaus have financial depth 20 percentage points higher than those without any such institutions. In addition, they find that former countries have lower credit risk which in turn is positively associated with nonperforming loans (NPLs). Djankov, McLiesh, and Shleifer (2007) provide more robust empirical evidence on both hypotheses with a larger data set of 129 countries over 25 years.

- **Accounting Standards:**<sup>36</sup> Levine, Loayza, and Beck (2000) find that accounting standards explain a large portion of the variation in financial depth across countries. For instance, if Uruguay could push its accounting standards to the level of Chile’s, then Uruguay could enjoy greater banking sector depth than Chile.

Consequently, the coefficient estimates suggest that the effect of institutional factors can help countries achieve significant financial deepening which, as reported in section 2, leads to higher economic growth. The effect of regulations on financial sector depth is less pronounced, given that there is no relationship between capital requirements and official supervision on one hand, and financial depth on the other, while activity restrictions curtail financial deepening. Nevertheless, intense banking sector reforms seem to be strongly and significantly associated with financial depth, giving legitimacy to engagements with international organizations to pursue further reforms to strengthen financial sectors.

# **4.2 Financial Stability**

In the finance-growth nexus, financial stability is the second most frequently used indicator of financial sector development. Earlier, we discussed the findings of the literature, suggesting that financial fragility has significant negative effects on economic growth and output. This section attempts to identify a list of factors that are found to be robust determinants of financial stability. Our inventory offers quantitative effects of the following key determinants on financial stability.<sup>37</sup>

- **Regulations and Supervision**

- **Capital Requirements and Activity Restrictions:** Barth, Caprio, and Levine (2012) find that capital requirements are associated with lower NPLs but this association disappears when government banks are considered. The Basel Committee on Banking Supervision (2010) argues that introducing Basel III is

> 36 Accounting standards are measured by an index that ranks the comprehensiveness of company reports.

> 37 The literature usually uses NPL ratios as well as the probability of crisis to measure financial stability. In addition, various indices are constructed for financial soundness (either individual bank level or systemic) based on NPL, capital adequacy ratios, and Moody's z-scores for banks.

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expected to lower the probability and severity of crisis.<sup>38</sup> Angkinand (2009) suggests that raising capital requirements reduces the severity of financial crisis, while raising activity restrictions increases the output cost of crises, except in countries with a precrisis credit boom. Schaeck, Cihak, and Wolfe (2009) fail to find a significant effect of various regulations on the timing of the crisis but they suggest that activity restrictions significantly increase crisis probability. A complementary finding is presented by Bystrom (2004), who argues that restrictive regulations are positively related to banking sector fragility as perceived by the market before the crisis.

- **Supervision:** According to de Haan and Shehzad (2009), better supervision reduces the positive effect of financial liberalization on financial fragility, especially after interest rate liberalization. Their findings are quite important because while they observe that non-OECD countries have closed the gap with OECD countries in terms of financial openness in the past decade, the former group has not taken sufficient steps to improve supervision of their financial systems.<sup>39</sup> Barth, Caprio, and Levine (2012) argue that supervision by shareholders and creditors is more effective than official supervision when it comes to reducing financial fragility. Specifically, while they find no relationship between official supervision and financial stability, they find that private monitoring exerts a larger negative effect on financial fragility than capital requirements.

- **Compliance with Basel Core Principles:** Sundararajan, Marston, and Basu (2001); Demirguc-Kunt, Detragiache, and Tressel (2008); and Podpiera (2006) question whether compliance with Basel Core Principles help countries improve financial stability. Whereas Sundararajan, Marston, and Basu find no significant association between the two,<sup>40</sup> Demirguc-Kunt, Detragiache, and Tressel find that moving from largely compliant status to materially noncompliant status lowers banks' soundness. They argue that among the Basel Core Principles, the ones that matter most for financial stability are entry barriers and disclosure requirements.<sup>41</sup> Das, Quintyn, and Chenard (2004) use a different measure for regulations based on Financial Sector Assessment Program (i.e., regulatory governance index) and find that countries that score higher values in this index have more sound financial systems. They also argue that the strength of this relationship is conditional on the overall quality of public sector governance. Last but not least, Papi, Presbitero, and Zazzaro (2012) find that countries that signed an IMF

> 38 However, they note an important nonlinearity. For instance, raising the capital ratio from 7 percent to 8 percent reduces the banking crisis probability by 1.6 percentage points, but raising the capital ratio from 10 percent to 11 percent is not nearly as effective in reducing crisis probability. Because raising capital adequacy ratios also decreases output, a trade-off exists, and the authors do not recommend raising the requirements more than necessary.

> 39 In a related manner, Barth, Caprio, and Levine (2013) argue that regulatory and supervisory approach to banking system has not converged across countries over time.

> 40 Note that Sundararajan, Marston, and Basu (2001) detect a statistically significant association between the Basel Core Principles and financial stability in countries with high loan growth rates. Demirguc-Kunt and Detragiache (2011) confirm these results

> 41 In this context, an interesting study by Cihak and Podpiera (2006) show that having a fully integrated supervisory approach to financial system helps countries comply more with the Basel Core Principles and have more effective supervision of not only banking sector but also capital markets and contractual investors.

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lending agreement and complied with the conditionalities on financial sector reform enjoy an 18.9 percent lower probability of banking crisis.

- **Explicit Deposit Insurance Schemes** : Demirguc-Kunt and Detragiache (2002) argue that the larger the coverage of the deposit insurance scheme, the higher the probability of banking crisis. They find significant reductions in the probability of crisis for a variety of countries, had these countries reduced the extent of the deposit insurance to that of Switzerland. Angkinand (2009), however, demonstrates that deposit insurance schemes are associated with lower output costs of financial crises. Bystrom (2004) also finds some evidence that deposit insurance schemes are associated with a lower probability of banking failure.

Let us conclude the discussion of the role of regulations and supervision on financial stability by reviewing the findings of a recent paper by Cihak et al. (2012), who compare 21 crisis and 122 noncrisis countries based on their own categorization with respect to the recent global financial crisis. They find that crisis countries had less stringent capital requirements and activity restrictions on banks. In addition, bad loans were treated less strictly in crisis countries with weaker incentives for private monitoring of banks and more extensive deposit insurance schemes. Our reading of the literature provides additional conclusions. Although activity restrictions and deposit insurance schemes increase financial fragility, regulations and supervision are effective tools for containing fragility in the aftermath of financial liberalization.

- **Banking Structure and Ownership**

- **Ownership** : Whereas the presence of foreign banks in domestic banking sector is associated with a lower probability of crisis, the extent of government ownership is associated with a higher probability of crisis. For instance, according to the coefficient estimates from La Porta, Lopez de Silanes, and Shleifer (2002), moving from the average share of government ownership of assets in the banking sector in countries with French legal origin to the share in those with British legal origin (i.e., about a 30 percent decrease) raises the stability index by 38 percent. As for foreign ownership, Yeyati and Micco (2007) find that increasing the share of assets held by foreign banks reduces the probability of systemic crisis by about 3.5 percent. The suggested mechanism is that the entry of foreign banks raises the degree of product differentiation in the sector, which then reduces competition, yielding higher profits and a higher charter value of banks and hence less appetite for risk taking. Gonzalez (2005) confirms the latter relationship, finding that the higher the charter value of a bank, the less risk the bank would take. Interestingly, he also finds that bank charter values are lower in countries with more extensive deposit insurance and stronger regulations.

- **Concentration and Competition:** The focus on charter values of banks brings us to the important role of banking structure in financial stability.

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The relevant question in this context is whether more concentrated and less competitive banking systems perform better than others in terms of financial stability. Beck (2008) provides an excellent review of the relevant theoretical and empirical literature and distills the following key messages:

- The existing literature has so far mistakenly associated the notion of concentration with competition. The proxies for these two phenomena yield different results for stability.<sup>42</sup>

- Related to this point, although the literature on the concentrationstability hypothesis finds mixed results, the effect of competition on stability is considered positive.<sup>43</sup>

- The enabling institutional environment is crucial for the positive effect of competition on stability. Hence, the policy course is to enhance the institutional environment while maintaining the competitiveness of the financial system.

The mixed results on the concentration-stability hypothesis are evident in our inventory. For instance, Beck, Demirguc-Kunt, and Levine (2006b) find statistically significant and economically large positive effects of concentration on stability.<sup>44</sup> Boyd, de Nicolo, and Jalal (2006), however, show that more concentrated systems are more likely to incur banking failures. Noy (2004) argues in favor of a similar mechanism, in that financial liberalization lowers the monopoly power of incumbent banks and encourages them to take excessive risks. He finds, however, that better supervision during financial liberalization leads to a lower probability of banking crisis.<sup>45</sup>

# **4.3 Financial Efficiency**

Intuitively, we expect that a deep and stable financial sector is likely to be an efficient one, even though this survey has not found a formal test of this statement. We find that the determinants of financial efficiency are not different than the determinants of other aspects of financial sector development. Our inventory offers findings on the quantitative effects of the following key determinants on financial efficiency:<sup>46</sup>

> 42 See Beck, Demirguc-Kunt, and Levine (2006a), who show that bank concentration is not a good indicator of lack of competition.

> 43 See Schaeck, Cihak, and Wolfe (2009), who argue that more competitive banking systems are associated with a lower probability of banking crisis.

> 44 In addition, they demonstrate negative effects of various regulatory restrictions (e.g., entry barriers and activity restrictions) on banking stability. Interestingly, they also find that more banking freedom and more economically competitive environments are less likely to experience banking crisis. A better institutional environment (proxied by the World Bank’s World Governance Indicators) is associated with a lower probability of systemic crisis. 45 We refrain from digging deeper into the reasons for the mixed results in this nexus but our understanding from Beck (2008) is that results are not robust to the use of different proxies for financial stability (e.g., individual bank level or systemic risk).

> 46 The common trend in the literature is to measure financial efficiency by net interest margins between lending and deposit rates, overhead costs in proportion to total assets, noninterest income in proportion to total income, and various other indicators for profitability of banks such as return on assets

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- **Regulations**

- **Capital Requirements and Activity Restrictions:** Demirguc-Kunt, Laeven, and Levine (2004) find that various regulatory indicators<sup>47</sup> increase net interest margins, thereby decreasing financial efficiency. However, once institutional quality is accounted for, regulations cease to have a significant impact. In fact, they find that what essentially matters for financial efficiency is the quality of the institutional environment as proxied by the Economic Freedom Index of the Heritage Foundation or the World Governance Index of the World Bank.

- **Supervision:** Barth, Caprio, and Levine (2012) find that the private monitoring index reduces overhead costs and net interest margins, while official supervision is not significantly related to financial efficiency. However, Podpiera (2006) finds that compliance with the Basel Core Principles lowers the net interest margins in a statistically significant fashion. In addition, Pasiouras, Tanna, and Zopounidis (2009) find that capital requirements, market discipline, and official supervisory power are negatively associated with cost and profit inefficiency.

- **Regulatory Reforms:** Giustiniani  and Kronenberg (2005) and Cull and Effron (2005) examine whether financial sector development is tangibly affected by support from international organizations such as the World Bank or the IMF for financial sector reforms in favor of better regulations and supervision. While the former finds that IMF conditionalities on banking sector reform have a positive effect on banking sector performance (i.e., return on assets), the latter finds that countries that did not borrow from the World Bank for regulatory reforms experienced larger increases in interest margins than countries that did borrow for this purpose.

# • **Banking Structure and Ownership**

- **Concentration:** Demirguc-Kunt, Laeven, and Levine (2004) find that more concentrated banking systems happen to be more inefficient ones as well. Whereas Martinez Peria and Mody (2004) find that higher concentration raises bank spreads and administrative costs, Detragiache, Gupta, and Tressel (2005) find evidence for the contrary in developing countries.

- **Foreign Ownership:** Table 13, Panel C, in our inventory suggests that the literature on the determinants of financial efficiency is dominated by ownership patterns. While the penetration of domestic banking system by foreign banks is estimated to increase financial efficiency in the entire

> 47 Among others, they focus on fraction of entry denied, activity restrictions, and reserve requirements.

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sector, there is also some evidence on negative effects of government ownership. Demirguc-Kunt and Detragiache (1997); Denizer (2000); Barajas, Steiner, and Salazar (2000); Claessens, Demirguc-Kunt, and Huizinga (2001); Martinez Peria and Mody (2004); Bayraktar and Wang (2004); and Haber and Musacchio (2012) find similar results in terms of the positive effects of the presence of foreign banks on financial efficiency measured by reductions in profitability, net interest margins, and overhead costs, among others.<sup>48</sup> Among the various reasons for these effects, Claessens, Demirguc-Kunt, and Huizinga (2001, 892) suggest that foreign entry may "(i) improve the quality and availability of financial services in the domestic financial market by increasing bank competition, and enabling the greater application of more modern banking skills and technology, (ii) serve to stimulate the development of the underlying bank supervisory and legal framework, and (iii) enhance a country access to international capital." For instance, Denizer (2000) provides some anecdotal evidence from Turkey, where penetration of foreign banks increased the level and use of technology in the sector and attracted a more qualified workforce. Bhattacharya (1993) notes that various fees in the banking system decreased significantly after foreign entry in Turkey.

- **Government Ownership:** In contrast to foreign ownership, the extent of government ownership in the financial sector is associated with lower efficiency. La Porta, Lopez de Silanes, and Shleifer (2002) find that overhead costs and net interest margins increase in response to an increase in government ownership. Mian (2003) and Micco and Panizza (2006) also confirm that government banks are less efficient than their foreign and private domestic counterparts, more likely to be bailed out, and have excessive employment.

# **4.4 Financial Inclusion**

Financial inclusion is a key component of financial sector development. Even though the effect of financial inclusion on economic growth is not as heavily scrutinized as the effects of financial depth or stability, it is crucial to survey the determinants of financial inclusion, as there are many financially constrained firms and households across the world. Our inventory offers evidence for the quantitative effects of the following key determinants of financial inclusion:

# • **Regulations**

- **Entry Barriers and Activity Restrictions:** According to Barth et al. (2009), entry restrictions in the banking system raise the probability of firms reporting bank corruption as a major obstacle. Disclosure and

> 48 An interesting insight from this literature is that whereas foreign banks have lower interest margins, overhead expenses, and profitability in developed countries, the opposite holds in developing countries.

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auditing requirements lower bank corruption and ease firms financing constraints. Beck, Demirguc-Kunt, and Maksimovic (2004) suggest that the probability of firms reporting finance as a major obstacle increases with the intensity of the activity restrictions.<sup>49</sup>

- **Supervision:** According to Cull, Demirguc-Kunt, and Morduch (2011), the cost of compliance with regulations in the form of adapting to regular on-site supervision leads micro-finance institutions to curtail their outreach so as to maintain financial self-sufficiency. As Beck, DemirgucKunt, and Levine (2011) demonstrate however, supervision in the form of private monitoring improves firms’ access to finance.

- **Deposit Insurance:** While Barth et al. (2009) find that the existence of deposit insurance schemes raise the probability that a firm will report bank corruption as a major obstacle to its growth, Allen et al. (2012) show that the probability of households owning and using a bank account increases with the coverage of the deposit insurance schemes.

# • **Institutions**

- **Creditor Rights and Credit Registries:** Institutions matter for increasing firms’ and households’ access to finance, as they lower the monitoring costs incurred by formal financial institutions. Galindo and Micco (2005) find that the higher the creditor rights, the easier the access of small firms to finance. Beck, Demirguc-Kunt, and Martinez Peria (2007) find that the higher the credit information index, the higher the penetration of bank branches across the country. Barth et al. (2009) similarly argue that the existence of private credit bureaus lowers corruption in lending but that public credit bureaus have no significant association. An important distinction emphasized by Love and Mylenko (2003) is that while public registries may be associated with financial depth, they are less likely to be associated with access to finance. In their empirical study, they confirm this hypothesis and find a negative association between the presence of private credit registries and financing constraints perceived by firms. Brown, Jappelli, and Pagano (2009) study a similar hypothesis using firmlevel panel data covering transition countries and present more robust results. They document positive and significant effects of information sharing on access to finance, but this effect is more pronounced for opaque firms and countries with weaker protection of creditor rights.

- **Bank Branch and ATM Penetration:** Allen et al. (2012) and Beck, Demirguc-Kunt, and Martinez Peria (2007) study the impact of distance barriers and pro-access policies on the probability of households owning a bank account and firm managers reporting finance as an obstacle to firm

> 49 Not only firms but also households are negatively affected by activity restrictions.

23
growth. Both studies identify the crucial positive impacts of bank branch and ATM penetration on access to finance for firms and households. In addition, Allen et al. (2012) consider various pro-access policies<sup>50</sup> that lower the negative perceptions associated with opening and using a bank account. For instance, they find that the probability of using bank accounts is three times higher in countries where the government makes payments through bank accounts as well as in countries where savings schemes and tax incentive programs are established.

# • **Banking Structure and Ownership**

- **Concentration:** Beck, Demirguc-Kunt, and Maksimovic (2004) find that higher concentration in the banking sector raises the probability that firms report financing as a major obstacle, especially for small firms. Yet they emphasize that this relationship is subject to various nonlinearities. For instance, the negative effect of concentration on access to finance is more prominent in low-income countries and in countries with a weak institutional environment. They also suggest that the existence of credit registries lowers the negative effect of concentration on firms’ access to finance. Barth et al. (2009) finds a complementary result in that as banking concentration increases, the probability that a firm rates bank corruption as a major obstacle to its growth increases significantly.

- **Government versus Foreign Ownership:** La Porta, Lopez de Silanes, and Shleifer (2002) find that countries with a higher government stake in the banking sector provide more restrictive access to finance (i.e., exclusive access to top-ranking firms). Detragiache, Gupta, and Tressel (2008), however, suggest that in low-income countries, the larger the share of foreign bank assets, the lower the number of bank branches and ATMs, loans, and deposits per capita. Gormley (2007) confirms this result and suggests that because of information costs the clientele of foreign banks is restricted to firms that are located at the top of the distribution of firms in terms of their profitability. From a different perspective, Clarke, Cull, and Martinez Peria (2006) find that increasing the share of foreign banks in a country leads to reductions in the negative perceptions of managers about firms’ access to finance (e.g., interest rate and long-term financing opportunities) and that this result applies to firms of all sizes. Barth et al. (2009) also argue that greater private or foreign ownership reduces bank corruption, which is a key constraint for firms.

> 50 Among others, they consider policies that require banks to offer basic or low-fee accounts, exempt some depositors from costly documentation requirements, and use bank accounts to make government payments.

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# **5. Causes and Consequences of Insurance and Pension Sector Development**

Initially, the aim of this section was to present a list of academic articles that study the determinants of insurance and pension sector development. Unfortunately, this literature is in its infancy. Apart from Beck and Webb (2003) and Feyen, Lester, and Rocha (2011), this survey could not find any papers that examine the regulatory and institutional determinants of the development of the pension and insurance sectors. In fact, these two papers focus only on the insurance sector, leaving the pension sector unexplored. Table 14 in our inventory, therefore, presents only five papers that examine the effect of pension sector development on banking sector and capital market development.

Focusing on the insurance sector first, the recent paper by Feyen, Lester, and Rocha (2011) examines the factors associated with life insurance market activity. They find that life insurance markets are more active and developed in countries with better institutions (e.g., creditor rights) and a well-developed banking sector. In addition, they find that insurance sectors that are less concentrated and that are dominated by the private sector are more active than those that are more concentrated and dominated by the public sector. Beck and Webb (2003) argue that countries with more developed banking sectors and better institutions have larger insurance sectors. They also suggest that life insurance and other forms of contractual savings might foster the development of capital markets through demand for long-term financial investment. In fact, the remaining articles in table 14 provide evidence for this link but use contractual investors as a proxy for pension funds. More specifically, they consider the aftermath of pension reforms that result in significant increases in the ratio of pension assets to GDP. For instance, Davis (2000) draws attention to the significant increases in the pension sector in Chile and Malaysia in the aftermath of pension reforms toward funded systems. For more specific mechanisms on the relationship between pension reforms and economic growth through capital market development, see Davis (2000), Meng and Pfau (2010), and Hu (2005).

Impavido, Musalem, and Tressel (2003) find a positive effect of pension sector development (i.e., proxied as the share of pension assets in total financial assets) on stock and bond market capitalization but not on stock market liquidity. They find the effects to be larger in countries with mandatory pension systems. Hu (2005, 2012) also finds a positive and significant effect of pension sector development on stock market capitalization as well as on stock market liquidity. Meng and Pfau (2010) find similar results but also detect the effect to be nonlinear, conditional on the level of overall financial development. Last but not least, Walker and Lefort (2002) study indirect effects of pension sector development on capital markets. Specifically, they find that the more developed the pension sector, the lower the cost of capital and market volatility.

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# **6. Conclusion and Ideas for Future Work**

More than 180 papers have been surveyed for this literature review to get a glimpse of the quantitative findings of various strands of a giant literature. Leaving the demanding econometric qualifications aside, the following points can provide helpful insights for policy making:

- **Finance-Growth Nexus:** Financial sector depth has a statistically significant and economically meaningful positive effect on economic growth. The magnitude of this effect can be quantified as an acceleration of about 1 percentage point in annual growth of real GDP per capita, when banking sector depth is considered. Larger effects are detected for stock market development and financial liberalization. In addition, contractual savings institutions have positive effects on economic growth. However, the positive effect of finance on growth is sensitive to various forms of thresholds such as level of income, financial development, and inflation and varies across regions and periods. Furthermore, a stable, efficient, and inclusive financial system contributes positively to economic growth.

- **Finance-Employment Nexus:** Financial sector depth has a statistically significant positive effect on employment. Whereas financial fragility is associated with higher unemployment, easing firms’ access to finance contributes positively to employment growth. Unfortunately, these conclusions derive from only a few papers that have not scrutinized this relationship as much as papers have examined the finance-growth nexus.

- **Determinants of Finance** : Our reading of the literature suggests that institutions (e.g., creditor rights, credit registries, and accounting standards) are crucial for each component of financial sector development. However, only some types of regulations and supervision are positively related to financial sector development (i.e., timely and easily accessible and comprehensible disclosure of information, removal of barriers to entry into the financial system, less extensive deposit insurance schemes, and fewer activity restrictions). While the extent of government ownership is associated with less deep, inefficient, and unstable financial systems, the opposite holds for the extent of foreign ownership. Last, the effect of concentration in the financial system on financial sector development is not yet resolved but there is strong evidence for positive effects of competition.

A definitive conclusion of this synthesis paper is that there is room for further work. First, as we have mentioned throughout the text, quite a few empirical weaknesses in the literature could be circumvented with the use of a larger empirical toolbox and alternative data sets. Cutting-edge econometric methodologies can be applied to improve the robustness of the results, especially in the relationship between regulations and financial stability.

Second, a "perfect" paper that caters to the specific questions raised in the beginning of this survey does not yet exist. For instance, we still do not know the quantitative effects 26
of overall financial sector development on economic growth. To gain rich insights for policy design, knowing how each component of financial sector development is associated with economic growth should indeed be the ultimate aim. That said, what about a measure of financial development that varies across countries and time and that incorporates each component of financial sector development? To our knowledge, no such statistic exists. In a related manner, we still do not know how the various policies discussed in Section 4 could affect economic growth through their effect on financial sector development. Addressing this gap would require a system-of-equations approach that could link the two questions we raised originally.

Third, a variety of research questions can be answered within the finance-employment nexus. In essence, whatever is researched in the finance-growth nexus can essentially be studied within the finance-employment nexus.

We hope to address these issues in our future work and contribute to this giant literature with further empirical evidence, specifically from developing countries.

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