Key Terms Explained
Financial sector is the set of institutions, instruments, markets, as well as the legal and regulatory framework that permit transactions to be made by extending credit. Fundamentally, financial sector development is about overcoming “costs” incurred in the financial system. This process of reducing the costs of acquiring information, enforcing contracts, and making transactions resulted in the emergence of financial contracts, markets, and intermediaries. Different types and combinations of information, enforcement, and transaction costs in conjunction with different legal, regulatory, and tax systems have motivated distinct financial contracts, markets, and intermediaries across countries and throughout history.
The five key functions of a financial system are: (i) producing information ex ante about possible investments and allocate capital; (ii) monitoring investments and exerting corporate governance after providing finance; (iii) facilitating the trading, diversification, and management of risk; (iv) mobilizing and pooling savings; and (v) easing the exchange of goods and services.
Financial sector development thus occurs when financial instruments, markets, and intermediaries ease the effects of information, enforcement, and transactions costs and therefore do a correspondingly better job at providing the key functions of the financial sector in the economy.
Importance of financial development
A large body of evidence suggests that financial sector development plays a huge role in economic development. It promotes economic growth through capital accumulation and technological progress by increasing the savings rate, mobilizing and pooling savings, producing information about investment, facilitating and encouraging the inflows of foreign capital, as well as optimizing the allocation of capital.
Countries with better-developed financial systems tend to grow faster over long periods of time, and a large body of evidence suggests that this effect is causal: financial development is not simply an outcome of economic growth; it contributes to this growth.
Additionally, it reduces poverty and inequality by broadening access to finance to the poor and vulnerable groups, facilitating risk management by reducing their vulnerability to shocks, and increasing investment and productivity that result in higher income generation.
Financial sector development can help with the growth of small and medium sized enterprises (SMEs) by providing them with access to finance. SMEs are typically labor intensive and create more jobs than do large firms. They play a major role in economic development particularly in emerging economies.
Financial sector development goes beyond just having financial intermediaries and infrastructures in place. It entails having robust policies for regulation and supervision of all the important entities. The global financial crisis underscored the disastrous consequences of weak financial sector policies. The financial crisis has illustrated the potentially disastrous consequences of weak financial sector policies for financial development and their impact on the economic outcomes. Finance matters for development‐‐both when it functions well and when it malfunctions.
The crisis has challenged conventional thinking in financial sector policies and has led to much debate on how best to achieve sustainable development. Reassessing financial sector policies after the crisis in an important step in informing this process. To help achieve this, publications such as the World Bank’s Global Financial Development Report can play a role. Chapter 1 and the Statistical Appendix of the reportpresent data and knowledge on financial development around the world.
Measurement of financial development
A good measurement of financial development is crucial to assess the development of the financial sector and understand the impact of financial development on economic growth and poverty reduction.
In practice, however, it is difficult to measure financial development as it is a vast concept and has several dimensions. Empirical work done so far is usually based on standard quantitative indicators available for a long time series for a broad range of countries. For instance, ratio of financial institutions’ assets to GDP, ratio of liquid liabilities to GDP, and ratio of deposits to GDP.
Nevertheless, as the financial sector of a country comprises a variety of financial institutions, markets, and products, these measures are rough estimation and do not capture all aspects of financial development.
The World Bank’s Global Financial Development Database developed a comprehensive yet relatively simple conceptual 4x2 framework to measure financial development around the world. This framework identifies four sets of proxy variables characterizing a well-functioning financial system: financial depth, access, efficiency, and stability. These four dimensions are then measured for the two major components in the financial sector, namely the financial institutions and financial markets:
|Financial Institutions||Financial Markets|
|Depth|| || |
|Stability|| || |
Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2000. “A New Database on the Structure and Development of the Financial Sector.” World Bank Economic Review 14 (3): 597–605.
Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2010. “Financial Institutions and Markets across Countries and over Time.” World Bank Economic Review 24 (1): 77–92.
Čihák, Martin, Asli Demirgüç-Kunt, Erik Feyen, and Ross Levine. 2012. “Benchmarking Financial Development Around the World.” Policy Research Working Paper 6175, World Bank, Washington, DC.
Demirgüç-Kunt, Asli, and Ross Levine. 2008. “Finance, Financial Sector Policies, and Long- Run Growth.” M. Spence Growth Commission Background Paper 11, World Bank, Washington, DC.
Levine, Ross. 2005. “Finance and Growth: Theory and Evidence.” In Philippe Aghion and Steven Durlauf(eds. ) Handbook of Economic Growth, 865–934.
World Bank. 2012. Global Financial Development Report 2013: Rethinking the Role of the State in Finance. World Bank, Washington, DC (http://www.worldbank.org/financialdevelopment).