Ross Levine, "Financial Development and Economic Growth: Views and Agenda

Journal of Economic Literature, Vol. 35, No. 2 (Jun., 1997), pp. 688-726

Journal of Econonzic Literature
Vol. XXXV (June 1QQ7),pp. 688-726

Financial Development and Economic

Growth: vi6ws and Agenda

University of Virginia

I thank, u ~ t h o u zmplzcat~ng,
t Gerard Capno, iMarza Carkoo~c,Daozd Cole, Robert Cull, WII-
lzam Easterly, Mark Gertler, Fabzo Schzantarellz, Mary Shzfley, Bruce Smzth, and Kenneth
Sokolofffor crztzczsms, guzdance, and encouragement T h ~ ps aper was wrltten u,lz~le I was at
the World Bank Opznzons expressed are those of the author and do not necessarzly reflect the
ozews of the World Bank, zts staff, or nrember countries

DoesJ'znance make a difference . . .? Raymond Goldsmith (1969, p. 408)

I. Introduction: Goals and Boundaries of financial factors in economic growth,
while development economists fre-

E CONOMISTS HOLD startlingly dif-
ferent opinions regarding the im-
portance of the financial system for eco-
quently express their skepticism about
the role of the financial system by ignor-
ing it (Anand Chandavarkar 1992). For
nomic growth. Walter Bagehot (1873) example, a collection of essays by the
and John Hicks (1969) argue that it "pioneers of development economics,"
played a critical role in igniting industri- including three Nobel Laureates, does
alization in England by facilitating the not mention finance (Gerald Meir and
mobilization of capital for "immense Dudley Seers 1984). Furthermore,
works." Joseph Schumpeter (1912) con- Nicholas Stern's (1989) review of devel-
tends that well-functioning banks spur opment economics does not discuss the
technological innovation by identifying financial system, even in a section that
and funding those entrepreneurs with lists omitted topics. In light of these con-
the best chances of successfully imple- flicting views, this paper uses existing
menting innovative products and pro- theory to organize an analytical frame-
duction processes. In contrast, Joan Rob- work of the finance-growth nexus and
inson (1952, p. 86) declares that "where then assesses the quantitative impor-
enterprise leads finance follows." Ac- tance of the financial system in economic
cording to this view, economic develop- growth.
ment creates demands for particular Although conclusions must be stated
types of financial arrangements, and the hesitantly and with ample qualifications,
financial system responds automatically the preponderance of theoretical reason-
to these demands. Moreover, some ing and empirical evidence suggests a
economists just do not believe that the positive, first-order relationship between
finance-growth relationship is important. financial development and economic
Robert Lucas (1988, p. 6) asserts that growth. A growing body of work would
economists "badly over-stress" the role push even most skeptics toward the be-

Levine: Financial Development and Economic Growth 689

lief that the development of financial ing the trading of risk, allocating capital,
markets and institutions is a critical and monitoring managers, mobilizing sav-
inextricable part of the growth process ings, and easing the trading of goods,
and away from the view that the financial services, and financial c o n t r a c t s . V h e
system is an inconsequential side show, basic functions remain constant through
responding passively to economic growth time and across countries. There are
and industrialization. There is even evi- large differences across countries and
dence that the level of financial devel- time, however, in the quality of financial
opment is a good predictor of future services and in the types of financial in-
rates of economic growth, capital accu- struments, markets, and institutions that
mulation, and technological change. arise to provide these services. While fo-
Moreover, cross country, case study, in- cusing on functions, this approach does
dustry- and firm-level analyses document not diminish the role of institutions. In-
extensive periods when financial devel- deed, the functional approach highlights
opment-or the lack thereof-crucially the importance of examining an under-
affects the speed and pattern of eco- researched topic: the relationship be-
nomic development. tween financial structure-the mix of
To arrive at these conclusions and to financial instruments, markets, and insti-
highlight areas in acute need of addi- tutions-and the provision of financial
tional research, I organize the remainder services. Thus, this approach discourages
of this paper as follows. Section I1 ex- a narrow focus on one financial instru-
plains what the financial system does and ment, like money, or a particular institu-
how it affects-and is affected by-eco- tion, like banks. Instead, the functional
nomic growth. Theory suggests that fi- approach prompts a more comprehen-
nancial instruments, markets, and insti- sive-and more difficult-auestion: what

tutions arise to mitigate the effects of is the relationship between financial
information and transaction costs.' Fur- structure and the tunctioning of the fi-
thermore, a growing literature shows nancial system?3
that differences in how well financial Part I11 then turns to the evidence.
systems reduce information and transac- While many gaps remain, broad cross-
tion costs influence saving rates, invest- country comparisons, individual country
ment decisions, technological innova- studies, industry-level analyses, and
tion, and long-run growth rates. Also, a firm-level investigations point in the
comparatively less developed theoretical
literature demonstrates how changes in 2For different ways of categorizing financial
economic activity can influence financial functions, see Cole and Betty Slade (1991) and
systems. Robert C. Merton and Zvi Bodie (1995).
3 The major alternative approach to studying fi-
Section I1 also advocates the func- nance and economic growth is based on the semi-
tional approach to understanding the nal contributions of John Gurley and Edward
role of financial systems in economic Shaw (1955), James Tobin (1965), and Ronald
McKinnon (1973). In their mathematical models,
growth. This approach focuses on the as distinct from their narratives, they focus on
ties between growth and the quality of money. This narrow focus can restrict the analysis
the functions provided by the financial of the finance-growth nexus, and lead to a mis-
leading distinction between the "real" and finan-
system. These functions include facilitat- cial sectors. I n contrast, the functional a proach
highli hts the value added of the financiarsector.
The Enancia1 system is a "real" sector: it re-
1 These frictions include the costs of acquiring searches firms and managers, exerts corporate
information, enforcing contracts, and exchanging control, and facilitates risk management, ex-
goods and financial claims. change, and resource mobilization.

690 Journal of Economic Literatr are, Vol. XXXV (June 1997)

same direction: the functioning of finan- of the geographic source of those ser-
cial systems is vitally linked to economic vices. In measuring financial develop-
growth. Specifically, countries with ment, however, researchers often do not
larger banks and more active stock mar- account sufficiently for international
kets grow faster over subsequent de- trade in financial services. Second, the
cades even after controlling for many paper does not discuss policy. Given the
other factors underlying economic links between the functioning of the fi-
growth. Industries and firms that rely nancial system and economic growth, de-
heavily on external financing grow dis- signing optimal financial sector policies
proportionately faster in countries with is critically important. A rigorous discus-
well-developed banks and securities sion of these policies, however, would
markets than in countries with poorly require a long article or book by itself.5
developed financial systems. Moreover, Instead, this paper seeks to pull together
ample country studies suggest that dif- a diverse and active literature into a co-
ferences in financial development have, herent view of the financial system in
in some countries over extensive periods, economic growth.
critically influenced economic develop-
ment. Yet, these results do not imply 11. The Functions o f t h e Financial
that finance is everywhere and always ex- System
ogenous to economic growth. Economic
A. Functional Approach: Introduction
activity and technological innovation un-
doubtedly affect the structure and qual- The costs of acquiring information and
ity of financial systems. Innovations in making transactions create incentives
telecommunications and computing have for the emergence of financial markets
undeniably affected the financial ser- and institutions. Put differently, in a
vices industry. Moreover, "third factors," Kenneth Arrow (1964)-Gerard Debreu
such as a country's legal system and po- (1959) state-contingent claim framework
litical institutions certainly drive both fi- with no information or transaction costs,
nancial and economic development at there is no need for a financial system
critical junctures during the growth pro- that expends resources researching proj-
cess. Nevertheless, the weight of evi- ects, scrutinizing managers, or designing
dence suggests that financial systems are arrangements to ease risk management
a fundamental feature of the process of and facilitate transactions. Thus, any the-
economic development and that a satis- ory of the role of the financial system in
factory understanding of the factors un- economic growth (implicitly or explic-
derlying economic growth requires a itly) adds specific frictions to the Arrow-
greater understanding of the evolution Debreu model. Financial markets and
and structure of financial systems. institutions may arise to ameliorate the
As in any critique, I omit or treat cur- problems created by information and
sorily important issues. Here I highlight transactions frictions. Different types
First, I do not discuss the relation- and combinations of information and
ship between international finance and transaction costs motivate distinct finan-
growth. This paper narrows its concep- cial contracts, markets, and institutions.
tual focus by studying the financial ser-
vices available to an economy regardless " The financial policy literature is immense. See,
for example, Philip Brock (1992), Alberto Giovan-
4 Also, the theoretical review focuses on purely nini and Martha D e Melo (1993), Caprio, Isak Ati-
real economies and essentially ignores work on fi- yas, and James Hanson (1994), and Maxwell Fry
nance and growth in monetary economies. (1995).

In arising to ameliorate transaction
and information costs, financial systems
serve one primary function: they facili-
tate the allocation of resources, across
space and time, in an uncertain environ-
ment (Merton and Bodie 1995, p. 12).
To organize the vast literature on fi-
nance and economic activity, I break this
primary function into five basic func-
Specifically, financial systems
- facilitate the trading, hedging, diver-
sifying, and pooling of risk,
- allocate resources,
- monitor managers and exert corpo-
rate control,
- mobililize savings, and
- facilitate the exchange of goods and
This section explains how particular
market frictions motivate the emergence
of financial markets and intermediaries
that provide these five functions, and ex-
plains how they affect economic growth.
I examine two channels through which
each financial function may affect eco-
Levine: Financial Development and Economic Growth

- information costs
- transaction costs

Financial markets

and intermediaries

Financial functzons
- mobilize savings
- allocate resources
- exert corporate control
- facilitate risk management
- ease trading of goods,

senices, contracts

Channels to growth
- capital acculnulation
technological innovation


Figure 1. A Theoretical Approach to Finance
and Growth

nomic growth: capital accumulation and Aghion and Peter Howitt 1992). In these
technological innovation. On capital ac- models, the functions performed by the
cumulation, one class of growth models financial system affect steady-state
uses either capital externalities or capital growth by altering the rate of technologi-
goods produced using constant returns cal innovation. Thus, as sketched in Fig-
to scale but without the use of nonrepro- ure 1, the remainder of this section dis-
ducible factors to generate steady-state cusses how specific market frictions
per capita growth (Paul Romer 1986; motivate the emergence of financial con-
Lucas 1988; Sergio Rebelo 1991). In these tracts, markets, and intermediaries and
models, the functions performed by the how these financial arrangements pro-
financial system affect steady-state growth vide five financial functions that affect
by influencing the rate of capital forma- saving and allocations decisions in ways
tion. The financial system affects capital that influence economic growth.
accumulation either by altering the sav-
B. Facilitating Risk Amelioration
ings rate or by reallocating savings among
different capital producing technologies. In the presence of specific information
On technological innovation, a second and transaction costs, financial markets
class of growth models focuses on the in- and institutions may arise to ease the
vention of new production processes and trading, hedging, and pooling of risk.
goods (Romer 1990; Gene Grossman and This subsection considers two types of
Elhanan Helpman 1991; and Philippe risk: liquidity and idiosyncratic r i s k .

XXXV (Tune 1997) Liquidity is the ease and speed with market liquidity. a fraction of the discussion. civenga. Bruce Smith. tween two investments: an illiquid. there. States are typically more liquid than capital markets transform these liquid fi- those traded on the Nigerian Stock Ex. . savers receiving shocks industrial revolution had been invented much earlier. low- the liquidity of long-term investments. 6The financial revolution included the emer- gence of joint-stock com anies with nonredeem- Many of these existing inventions. if project produces. are markets where it is relatively 1966. pp. issue and trade securities-to emerge. some in.6 inexpensive to trade financial instru. and equities in the United access to their savings. These frictions create in. Thus. Simultaneously. spark sustained growth. tion required large commitments of capi- mational asymmetries and transaction tal for long periods. Those receiving shocks want ac- savers do not like to relinquish control of cess to their savings before the illiquid their savings for long periods. The link between liquid. 243). required large injections and long. With liquid capital mar- which agents can convert assets into pur. the financial revolution" (Valerie Ben- quidity. this liquidity transformation. or demand deposits-that they real estate is typically less liquid than can sell quickly and easily if they seek equities. how these financial markets affect eco- Before delving into formal models of nomic growth. Infor. rules out state-contingent insurance con- gated liquidity risk were primary causes tracts and creates an incentive for finan- of the industrial revolution in England. chasing power at agreed prices. Liquid capital markets. Indeed. return projects. Vol. The model assumes that less investment is likely to occur in the it is prohibitively costly to verify whether high-return projects. Economists have recently modeled the ments and where there is little uncer. p. the products manu. Because the industrial revolu- assets into a medium of exchange. how. the industrial revo- costs may inhibit liquidity and intensify lution may not have occurred without liquidity risk. and Ross Starr fore. made capital ermanent in 1609. For example. In factured during the first decades of the Levine (1991). in Douglas liquidity and economic activity. and Cromwell run commitments of capital. cial markets-markets where individuals According to Hicks. but project. "The indus- centives for the emergence of financial trial revolution therefore had to wait for markets and institutions that augment li. Sir John another individual has received a shock Hicks (1969. 143-45) argues that the or not.692 Journal of Economic Literatrare. technological inno- vation did not. able capital The DutcR East India Company ever. The critical made the Eng8sh East India Company capital per- manent in 1650. This risk creates in- the financial system does not augment centives for investing in the liquid. nancial instruments into long-term capi- change. These financial innovations new ingredient that ignited growth in formed the basis of liquid equity markets (Larry eighteenth century England was capital Neal 1990). low-return a long-run commitment of capital. savers receive shocks after choosing be- ity and economic development arises be. high- cause some high-return projects require return project and a liquid. emergence of financial markets in re- tainty about the timing and settlement of sponse to liquidity risk and examined those trades. This information cost assumption capital market improvements that miti. kets. Thus. Thus. Liquidity risk arises due to the tal investments in illiquid production uncertainties associated with converting processes. Diamond and Philip Dybvig's (1983) tuition and history may help motivate seminal model of liquidity. bonds. savers can hold assets-like equity.

ship be transferred throughout the life all agents will use equities. then deposits and choosing an appropriate mix- greater stock market liquidity induces ture of liquid and illiquid investments. If illiquid projects enjoy turn investments. banks can increase nologies may have a wide array of gesta. As discussed above. p . B. Thus.7 As savers and undertake a mixture of liquid. may be reluctant to re. only insignificant delay. Thus. illiquid tion periods for converting current out. while firms have perma. however. to turn into cash without or with higher. incentive compatible state-contingent in- nent access to the capital invested by the surance contracts. equity holders can readily individuals. banks provide complete insurance to sav- Thus far. this context. different production tech. stock markets do them very inconvenient for purchase and sale not replicate the equilibrium that exists when in." . Smith. faster steady-state growth. and Dybvig's (1983) model assumes it is sonal stock exchanges. provide liquidity if there are sufficiently ship claims is costly. They have the addi- 'Frictionless stock markets. Thus. In. technologies enjoy greater returns. so it is impossible to write sell their shares. 396) notes that "Claims against financial institutions are generally easier to will induce a shift to longer-gestation. Banks replicate istence of stock markets. do not a tional reat advantage of being completely divis- ible. w ereas primary securities are usually issued in fixed amounts and often in amounts that make eliminate liquidity risk. Under these condi- initial shareholders. high-re- return project. There is a problem. Trading costs the equilibrium allocation of capital that can also highlight the role of liquidity. nating liquidity risk. are involved. By facilitating trade. banks can offer liquid deposits to stock markets reduce liquidity risk. asset and accelerate growth (Bencivenga put into future capital. more low-return investments to satisfy de- investment occurs in the illiquid.return technologies. and cost) than Besides stock markets. tions. Thus. however. financial inter. banks will only emerge to and Starr 1995). Diamond not. information costs-the costs ers against liquidity risk while simulta- of verifying whether savers have re. If exchanging owner. of banks as reducing liquidity risk. liquidate (i. participants simply trade in imper. if equity markets exist. ties markets (Gary Gorton and George tractive.e. in high-return projects. where longer-run and B. Levine: Financial Development a n d Economic Growth 693 can sell their equity claims on the profits mediaries-coalitions of agents that com- of the illiquid production technology to bine to provide financial services-may others. By providing demand sufficiently large externalities. then longer-run large impediments to trading in securi- production technologies will be less at. in securities markets (Bencivenga. are primary debt securities. none will use of the production process in secondary banks (Charles Jacklin 1987). Greater liquidity 8Goldsmith (1969.. Smith 1991). exists with observable shocks. with this description of the role vestors. formality. compatible if agents can trade in liquid duction technologies require that owner. Market participants do not verify also enhance liquidity and reduce liquid- whether other agents received shocks or ity risk.8 secondary market trading costs-affects production decisions. merous individual purchase and sale transactions serving whether an agent receives a shock or not. neously facilitating long-run investments ceived a shock-have motivated the ex. stock market transaction costs fall. That is. with liquid prohibitively costly to observe shocks to stock markets. mands on deposits and illiquid. however. The linquish control of their savings for very banking equilibrium is not incentive long periods. long-gestation pro. liquidity-as measured by Pennacchi 1990). when lenders have small resources and when nu- surance contracts can be written contingent on ob. investment in the high-return. By elimi- For example. high. equity markets.

and securities market speculation. 1993~). have theoretically ambiguous ef- affects savings rates (David Levhari and fects on saving rates as noted above. could fall sufficiently so that overall wel- ates with greater liquidity (Tullio Jap.694 Journal of Economic Literature. however. Michael Devereux and lowers uncertainty. finan. Gregor Smith 1994. or means to collect and process cized. Besides yielding pooling. managers. more efficient capital allocation. however. successful inno- nancial system's ability to provide risk di. fu- tures contracts. and diversifying risk. Acquiring Information About l o sim8arly. versification can also affect technological firms. vation accelerates technological change. versification services can affect long-run Engaging in innovation is risky. Resources quidim ~ ay induce a reallocation of investment out o initiating new capital investments and into I t is difficult and costly to evaluate purchasing claims on ongoing projects. Agents are continuously trying Banks. in 1688! activities about which there is little reli- . nomic growth (Robert King and Levine Yet. Srinivasan 1969).10 tion. turn projects. when coupled with an externality-based Indeed. profits to the innovator. N. and market conditions erate growth (Bencivenga. Besides the link between risk diversifi- cial systems may also mitigate the risks cation and capital accumulation. Higher returns am. financial sys- tems that ease risk diversification can ac- 9 T h e analyses described thus far focus on the celerate technological change and eco- links between liquidity and ca ital accumulation. mutual funds. Thus. Thus. C. fare falls with greater risk diversifica- pelli and Marco Pagano 1994). Individual savers may not have the time. managers. although greater liquidity unambi. change.11 The fi. profitable market niche. and Maurice biguously affect saving rates due to well. Obstfeld 1994). risk averse agents). smith: and Starr as discussed by Vincent Carosso (1970). The T. financial markets hanced liquidity has an ambiguous affect that ease risk diversification tend to in- on saving rates and economic growth. 1995). in a model with physical capital or linear growth model. information on a wide array of enter- tracts is by no means recent. high-return ing innovative activities (with sufficiently projects tend to be riskier than low-re. saving savings rate could fall enough so that. Vol. capacity. Besides reducing liquidity risk. countries. so that growth actually deceler. tions. rates may rise or fall as liquidity rises. how- Further. etc. the development of these financial con. economic growth by altering resource al. to make technological advances to gain a kets all provide vehicles for trading. The basic of innovative projects reduces risk and intuition is straightforward. Thus. The ability to hold a diversified portfolio location and the saving rates. regions. With externalities. industries. Savers will be reluctant to invest in Confusion de Confusiones. more li. XXXV (June 1997) Theory. greater liquidity (a) with higher expected returns (Gilles increases investment returns and (b) Saint-Paul 1992. growth enough. overall economic externalities. risk di- associated with individual projects. sources to research and development promote technolo ical innovation. Greater risk sharing and known income and substitution effects. Investments and Allocating guously raises the real return on savings. and securities mar. B. saving rates could fall growth falls. 1lAlthough the recent uses of options and fu- tures contracts to hedge risk have been well publi. This ma lower the rate of real investment enough to dece[ firms. and economic condi- Vega published a treatise on options contracts. lower uncertainty ambiguously ever. liquidity may also affect 8 e rate of techno- logical change if long-run commitments of re.9 In duce a portfolio shift toward projects most models. While savers promotes investment in growth-enhanc- generally do not like risk. suggests that en. Josef Penso de la prises.

In 1 9 9 3 ~ )As . ple. [to quiring and processing information innovate]. in the name of society as it were. which helped it enjoy compara- flowing to its highest value use. capital also did a good job at identifying profitable ven- runs as surely and instantly where it is most tures in other countries. ticipants may have greater incentives to tion. . mation about firms. cial intermediaries. to information acquisition. But in ordinary countries this is a slow pro- 12 Indeed.12 Information acquisition costs create Besides identifying the best produc- incentives for financial intermediaries to tion technologies. acquire information about firms. and fi- economists say that capital sets towards the nally to aggregate long-run economic most profitable trades. have not yet assembled the links of the [England's financial] organization is so useful chain from the functioning of stock mar- because it is so easily adjusted. Bagehot (1873. . As stock markets be- diary can do it for all its members. p. and Bengt Holm- mation about investment opportunities strom and Jean Tirole 1993). In England. finan. . however. for cal innovation by identifying those example. and Australia during the 19th cen- of it. More- ing firms and managers will induce a over. an interme. Without intermediaries. financial intermediar- emerge (Diamond 1984. . the wanted. He authorises peo- aries to economize on the costs of ac. . however. therefore. tury. this improved information about more efficient allocation of capital and firms should improve resource alloca- faster growth (Jeremy Greenwood and tion substantially with corresponding Boyan Jovanovic 1990). as water runs to find its level. liquid stock markets can stimulate better at selecting the most promis. Intui- The ability to acquire and process in. it formation may have important growth is easier for an agent who has acquired implications. . existing theories ago. such as Canada. Assume. . the acquisition of information. peter (1912. England was able to "export" financial ser- vices (as well as financial ca ital) to many econo- England's financial system did a better mies with underdevelopeg financial systems job at identifying and funding profitable (Lance Davis and Robert Huttenback 1986). . eloquently stated by Schum- response to this information cost struc. and that it rapidly growth. . Political kets. . information and make money. tively. come larger (Sanford Grossman and Economizing on information acquisition Joseph Stiglitz 1980) and more liquid costs facilitates the acquisition of infor. market par- and thereby improves resource alloca. 53) expressed this view over 120 years ton 1987). Levine: Financial Development and Economic Growth 695 able information. implications for economic growth (Mer- p. 74). Stock markets may also influence the vidual acquiring evaluation skills and acquisition and dissemination of infor- then conducting evaluations. ture. tively greater economic success. England's advanced financial system cess. about investments. that there is a fixed cost to entrepreneurs with the best chances of acquiring information about a product. However. with larger more liquid markets. successfully initiating new goods and ion technology. Instead of each indi. and where there is most to be made United States. and John Boyd ies may also boost the rate of technologi- and Edward Prescott 1986). Because many firms and information to disguise this private entrepreneurs will solicit capital. production processes (King and Levine each investor must pay the fixed cost. high in. leaves the less profitable non-paying trades. Consequently. marily a middleman. is not so much pri- form (or join or use) financial intermedi. groups of individuals may The banker. ventures than most countries in the mid- formation costs may keep capital from 1800s. and markets that are large. Thus. . . (Albert Kyle 1984. .

liquid stock mar. and market conditions can observe stock (2) reviews how these financial arrange- prices that reflect the information ob. r. and monitoring and corporate control. These verification costs Also. higher leverage implies greater risk of cordance with the interests of outside default and higher verification expendi- creditors. insiders pay r to out- rate control ex post. Because this vast literature enhancing the creation and distribution has been carefully reviewed (Gertler information about firms. tracts. Specifi- arise to mitigate the information acquisi. "outside" creditors-banks. there cation costs. This creates important frictions tion gains from large. however. for example. Insiders have incentives to misrepresent because stock markets quickly reveal in. Monitoring Managers and Exerting costs that are independent of project Corporate Control quality). the optimal contract between Besides reducing the costs of acquir. it is socially ineffi- will be few incentives for spending private cient for outsiders to monitor in all resources to acquire information that is circumstances. resource allocation. this subsection (1) through published prices. XXXV (June 1997) Debate still exists over the importance investments (Stiglitz and Andrew Weiss of large. liquid. is sufficiently high. project returns to outsiders. With "costly state verifi- almost immediately publicly available. kets are small.. returns. accumulation.e. cation" (and other assumptions including risk-neutral borrowers and verification D. that informa. For example. Stiglitz (1985) argues that. financial con. Ben Bernanke and . and institutions improve cesses of evaluating firms. Consider. impede investment decisions and reduce and bond holders-that do not manage economic efficiency. nancial contracts that lower monitoring trol may impede the mobilization of sav. rate. and Andrei Shleifer and Robert aggregate and disseminate information Vishny. managers. markets. This public goods as. Even agents notes a few ways in which financial con- that do not undertake the costly pro. ments for monitoring influence capital tained by others. cally. society to devote too few resources to in. firm owners When project returns are insufficient. Verification costs firms on a day-to-day basis will create fi. forthcoming). such that when the project return ing firm managers and exerting corpo. markets. i. tures by lenders. outsiders and insiders is a debt contract ing information ex ante. Thus. Stock markets 1988. Vol. collateral and fi- rangements that enhance corporate con. will create financial arrangements that the borrower defaults and the lenders compel firm managers to manage the pay the monitoring costs to verify the firm in the best interests of the owners. 1983). efficient stock markets in 1981. and Douglas tracts. and enforcement costs reduce impedi- ings from disparate agents and thereby ments to efficient investment (Stephen keep capital from flowing to profitable Williamson 1987b. the activity. the simple as- formation acquisition. and pect of acquiring information can cause long-run growth. that can motivate financial development. equity. there is an equilibrium interest tion and enforcement costs of monitor. (Robert Townsend 1979. and intermediaries may Gale and Martin Hellwig 1985). The absence of financial ar. Given verifi- formation through posted prices.696 Journal of Economic Literature. The public goods sumption that it is costly for outsider feature of the information thus disclosed investors in a project to verify project may be sufficiently large. project's return. after financing siders and outsiders do not monitor. imply that outsiders constrain firms from nancial arrangements to compel inside borrowing to expand investment because owners and managers to run firms in ac.

p. Firms may therefore diversify out of exist and shows that the intermediary arrangement bank financing to reduce their vulnerability economizes on monitoring costs. Levine: Financial Development and Economic Growth 697 Gertler 1989. borrower is monitored only by the inter. and Boyd and B. Ernst-Ludwig von more. firm. if the ban% breaks its ties to the liamson 1986. firm's profits. creates a potential problem: who Kevin Murphy 1990). rangements that improve corporate con- ings of many individuals and lends these trol tend to promote faster capital accu- resources to project owners. 1990. financial ar- nancial intermediary mobilizes the sav. compensation to stock prices. intermediaries may keep rates low and the bank may have bar aining power over the ration credit using non-price mechanisms (Wil. The well diversified).13 firms develop long-run relationships. a financial system that facili. The fi. 14). how. 1987a). This firms allows owners to link managerial in turn makes feasible efficient speciali. financial intermediaries can tion costs. lic trading of shares in stock markets that sible the efficient separation of owner. may further reduce veri- fication costs (Bernanke and Gertler 1989. Smith 1994). tic monitoring. and Jensen and ever. The ers with those of owners (Diamond and delegated monitor arrangement. i n d e r s verify Stochas- by lowering monitoring costs. so that deposi- tors never have to monitor the bank. With a well-diversified threat of a takeover will help align mana- portfolio. Furthermore. Linking zation in production according to the stock performance to manager compen- principle of comparative advantage" sation helps align the interests of manag- (Merton and Bodie 1995. terms of long-run growth. the intermediary can always gerial incentives with those of the own- meet its promise to pay the deposit in- terest rate to depositors. stock markets may also promote corpo- mond 1984). The reduction in information reduce information costs even further. cause the h a d is well informed ahout the firm. Robert Verrecchia 1982. over.15 In economize on monitoring costs. mediary. For example. however. well-diversified financial inter. Because higher interest rates are linked and client ma impose a cost on the client. forming firms are fired following a take- mediary if the intermediary holds a di. mulation and growth by improving the gated monitor" arrangement economizes allocation of capital (Bencivenga and B. Besides reducing duplicate rate control (Michael Jensen and Wil- monitoring. pub- tates corporate control "also makes pos. then better stock markets can pro- versified portfolio (and agents can easily mote better corporate control by easing verify that the intermediary's portfolio is takeovers of poorly managed firms. (1986) shows how intermediaries arise endogen- ously. if take- will monitor the monitor (Stefan Krasa overs are easier in well-developed stock and Anne Villamil 1992)? Savers. If asymmetries can in turn ease external borrowers must obtain funds from many funding constraints and facilitate better outsiders. other investors will be reluctant to invest in 14Diamond (1984) assumes that intermediaries the firm. Be- with a higher probability of default and monitor. markets and if managers of under-per- ever. Besides debt contracts and banks. ing costs. 13 Costly state verification can produce credit 1s The long-run relationships between a banker rationing. financial intermediaries can resource allocation (Sharpe 1990). liam Meckling 1976).l4 Further. Williamson (Raghurman Rajan 1992). in which state verification roceeds nonstochasti- mediaries can foster efficient investment cally: if borrowers default. this Besides particular types of financial can further lower information acquisi- contracts. as financial intermediaries and Thadden 1995). This "dele. efficiently reflect information about ship from management of the firm. I have only discussed models Thus. on aggregate monitoring costs because a Smith 1993). . Similarly. how. do not have to monitor the inter. not all individual savers (Dia.

about the importance of stock markets in Moreover. To the extent that well-functioning This will induce others to bid for shares. Thus. This argues against an with long-run economic growth. deterioration in the efficiency of re- served by other market participants source allocation. agglomeration of capital from disparate over. liquid stock markets may it would have to pay if "free-riding" reduce incentives for owners to monitor firms could not observe its bid. less well informed outsiders involves a change in management. courages more diffuse ownership with taining information and making effective fewer incentives and greater impedi- takeover bids. there may be a the results of this research will be ob. Shleifer. Third. and the share from improvements in stock markets to price rises. First. XXXV (June1997) ers (David Scharfstein 1988. (Shleifer and Vishny 1986). allow hostile takeovers that lead to a fall pended resources obtaining information in the efficiency of resource allocation. stock market liquidity en- formation will reduce incentives for ob. . Inside investors prob. Thus. must. I am not aware of models current managers often can take strate- that directly link the role of stock mar. ing exit costs. liquid equity markets that corporate control. Thus. gic actions to deter takeovers and main- kets in improving corporate governance tain their positions. If theoretical signs on the links in the chain the takeover succeeds. fall. While lots of resources obtaining information. if an acquiring firm expends firm stakeholders to themselves. Vol. which will re. the crease the incentives for takeovers. Overall welfare may when the acquiring firm bids for shares. Thus. A takeover typically company. Stiglitz (1985) makes owners and managers to break implicit three additional arguments about take. Thus. agreements and transfer wealth from overs. Stein 1988). promoting sound corporate governance. however. value-increasing takeovers may fail because the acquiring firm will 16Some research also suggests that excessive stock trading can induce "noise" into the market have to pay a high price. facilitate takeovers may hurt resource al- ably have better information about the location (Shleifer and Lawrence Sum- corporation than outsiders. By reduc- rapid public dissemination of costly in.698 Journal of Economic Literature. new owners may profit. this may so that the price rises. asymmetric information bind new owners and managers to the may reduce the efficacy of corporate same extent that they bound the original takeovers as a mechanism for exerting managers. Mobilizing Savings creates an incentive for existing share- holders to not sell if they think the value Mobilization-pooling-involves the of the firm will rise following the take. equity markets help takeovers. and Randall Morck. a takeover allows new corporate control. therefore. Second. This E . important role for liquid stock markets in There are disagreements. 1989). The firm that ex. and Jeremy the hopes of taking them over. mers 1988. informed owners are willing to sell their and Vishny 1990). and hinder efficient resource allocation (Bradford duce incentives for researching firms in De Long e t al. there is a public ments to actively overseeing managers good nature to takeovers that may de.16 profit without expending resources. the managers (Amar Bhide 1993). and (Stewart Myers and Nicholas Majluf other stakeholders in the firms do not 1984). Thus. suppliers. if well. Exist- may demand a premium to purchase the ing implicit contracts between former firm due to the information asymmetry managers and workers. pay a higher price than Furthermore. then those original equity better corporate control to faster eco- holders who did not sell make a big nomic growth are still ambiguous.

therefore. tablishing stellar reputations or govern- ment backing. A citizen of Long advertisements. many production pro. As early as the mid-1880s. relinquishing control of their savings. pooling may also occur (a) overcoming the transaction costs as.17 Specifically. At this moment. p. lation. Without pooling. mobilizing meant). better savings mobilization can some investment banks used their Euro. Besides the direct effect of better means employed by investment banks to savings mobilization on capital accumu- raise capital. By enhancing risk diversifi. mobi. Without access to ings to the intermediary (De Long 1991. In light of the transaction and infor- cally inefficient scales (Erik Sirri and mation costs associated with mobilizing Peter Tufano 1995). for investment in the United States. It involves contracts. costs associated with multiple bilateral rate savers is costly. and to tween productive units raising capital increase asset liquidity. "mobilizers" had to countries. Thus. ing. gate these frictions and facilitate pool- ments provide opportunities for house. These instru. Moreover. cesses would be constrained to economi. in colonies and all rude costs. The household's would have to buy and sell joint stock company in which many indi- entire firms. Furthermore. through intermediaries as discussed sociated with collecting savings from dif. in. . Levine: Financial Development and Economic Growth 699 savers for investment. taking likely to pay. or is more common in most countries. and out of which you can make diaries are generally concerned about es. much of Carosso's (1970) history tive at pooling the savings of individuals of Investment Banking in America is a can profoundly affect economic develop- description of the diverse and elaborate ment. there is not fund from which you investments. for you would have not been able to resources involved a range of transaction collect the capital with which to make them. numerous fi- lization involves the creation of small nancial arrangements may arise to miti- denomination instruments. Financial systems that are more effec- deed. savings from many agents. represents a prime example of mul- firms. the emergence of financial intermediaries. above. liquidity. the cation. about entrusting their sav. And. would have sales force that traveled through every thought that it was no use inventing railways state and territory selling securities to (if he could have understood what a railway individual households. mobilization may holds to hold diversified portfolios. improve resource allocation and boost pean connections to raise capital abroad technological innovation (Bagehot 1873. In. Toward this end. yet no idea was capital. To econo- source allocation (Sirri and Tufano 1995).C and 1I. 3-4): Other investment banks established close We have entirely lost the idea that any under- connections with major banks and indus. so that savers feel 17See Sections 1I. and a vast in Queen Elizabeth's time . viduals invest in a new legal entity. still others used newspaper more familiar to our ancestors. immense works. interme. and seen to be likely. mobilization improves re. where thousands of investors en- ferent individuals and (b) overcoming trust their wealth to intermediaries that the informational asymmetries associated invest in hundreds of firms (Sirri and with making savers feel comfortable in Tufano 1995. tiple bilateral mobilization. can trialists in the United States to mobilize perish for want of money. . . 83). there is no large sum of transfer- convince savers of the soundness of the able money.D for citations on comfortabl. and Naomi Lamoreaux 1994). can borrow. however. and the size of feasible firm. involve multiple bilateral contracts be- vest in efficient scale firms. multiple investors. mize on the transaction and information Mobilizing the savings of many dispa. and agents with surplus resources. pp. pamphlets.

(Smith 1776. 17). it " and thereby expanding the of set pro. Thus. in the 1800s. to Karl Brunner and Allan have been originally owing to the division of Meltzer (1971). workers are more likely to in. 3) human capital accumulation is not subject to di- . to is so much facilitated and abridged. XXXV (June 1997) Thus. Thus. Because it is costly to anced investment needed to adopt the new evaluate the attributes of goods. Besides easing savings mobilization however.e. and Jose D e Gregorio 1996). therefore.19 cialization. The links between facilitating (Lamoreaux and Sokoloff 1996. Access to external financial re. that the in. Without this access. Smith 1992. Charles Plosser 1986. may continue to fall through a variety of ments of Adam Smith's (1776) Wealth of mechanisms. This intu. and Williamson ward marginal variations within the tradi. 19 Financial systems can also promote the accu- easier and readier methods of attaining any mulation of human capital by lowering the costs of object. exchange is very costly. With greater spe. by effectively mobilizing resources The critical issue for our purposes is for projects. an easily sources is likely to be necessary over the one recognizable medium of exchange may or two years when the change takes place. for the accumulation of skihs (Thomas Cooley a n 3 than when it is dissipated among a great vari. p. For example. gence of money. same channels illuminated over 200 tivity improvements. 26-27). however. transaction and information costs and economic growth were core ele. Facilitating Exchange fall when economies move to money. B. Men are much more likely to discover viewed by Joseph Ostroy and Starr (1990). If ety of things.. barter technology. financial arrangements that technology in the market that enabled lower transaction costs can promote spe. Smith phrased his The farmer could provide his own savings to argument about the lowering of transac- increase slightly the commercial fertilizer tion costs and technological innovation that he is now using. and Randall Wright 1994). 13): autarkic environment. seems to Stanley Jevons (1875). Smith (1776. 7) argued that tutional development continually boost division of labor-specialization-is specialization and innovation via the the principal factor underlying produc. innovation. Vol. Adam Smith argued that adoption of better technologies and lower transaction costs would permit thereby encouraging growth. The drop in transaction and informa- tion costs is not necessarily a one-time F. is the virtual impossibility of a poor farmer's financing however. when the whole attention of their intertemporal trade. p. from Adam Smith (1776). l*This focus on money as a medium of ex- vent better machines or production change that lowers transaction and information processes. to more formal models as re- labour. the financial system may that the financial system can promote play a crucial role in permitting the specialization. years ago by Adam Smith. p. may also motivate the emer- from his current savings the whole of the bal. Information costs. barter (pp. creative individuals to specialize in and cialization.700 Journal of Economic Literat~ ure. costs by overcomin the "double coincidence of wants problem" a n f by acting as an easily recog- I shall only observe. transactions. The important point. and the return on this in terms of the advantages of money over marginal new investment could be calculated. technological innovation. so that financial and insti- Nations. specialization. p. and become more productive at invention" growth. i. b facilitating borrowin minds is directed towards that single object. nizable medium of exchange enjoys a long history vention of all those machines by which labour in monetary theory.18 tional technology. the constraint of self- arise to facilitate exchange (King and finance sharply biases investment strategy to. greater specialization because specializa- ition was clarified 100 years later by tion requires more transactions than an McKinnon (1973. was primarily the development of insti- duction technologies available to an tutions that facilitated the exchange of economy.

this motes specialized production technolo. economic development can nance and growth. markets that cus on individual functions and impede promote exchange encourage produc. with specialized labor and capital. In this way. This does not explain the emergence of However. Earlier authors often provided illustra- kets. More specialization requires more transactions. spur the development of financial mar. the synthesis of these distinct functions tivity gains. however. This. Consequently. who has just devel- ments to arise and to function well or oped a design for a new truck that ex- tracts rocks from a quarry better than ex- isting trucks. and in. Schumpeter used the re- model. pp. even Schumpeter and McKin- financial instruments or institutions that non did not amalgamate all of the finan- lower transaction costs and thereby pro. Leuine: Financial Development and Economic Growth 70 1 Modern theorists have attempted to il. specialization. Because each transaction is Thus far. A Parable 1997). tive stories of the ties between finance This approach to linking financial mar. There may also be feedback into a coherent understanding of the from these productivity gains to finan. and McKinnon "market" as a system for supporting highlighted its importance in promoting more specialized production processes. then higher income per capita ual functions performed by the financial implies that these fixed costs are less system. financial system's role in economic de- cial market development. Also. and what are the implications for luminate more precisely the ties be. and development. This is important because we want nancial functions into a simple parable to understand the two links of the chain: about how the financial system affects what about the economic environment economic growth. the use of better agricultural techniques. peter (1912. 5-18) provide broad descrip- innovation. and development. Smith's (1997) specialization. subsection synthesizes the individual fi- gies. If there are velopment. transaction costs will facilitate greater may encourage an excessively narrow fo- specialization. creates incentives for financial arrange. financial system in choosing and adopt- tractive. cial arrangements? novation (Greenwood and B. 58-74) and McKinnon mally completed Adam Smith's story of (1973. pp. I have discussed each finan- costly. This is not a necessary impli- fixed costs associated with establishing cation. For example Schum- kets with specialization has not yet for. alist to illustrate the importance of the tion processes that are economically at. That is. Consider Fred. Smith G. cial functions into their stories of finance duce an environment that naturally pro. economic activity of the emerging finan- tween exchange. poorly. Instead. ter a more complete understanding of fi- come. nancial system in economic develop- does not stimulate the invention of new ment. the model defines better ing new technologies. Thus. by identifying the individ- markets. financial arrangements that lower cial function in isolation. the functional approach can fos- burdensome as a share of per capita in. financial ar- rangements that ease human capital creation help trucks requires an intricate assembly line accelerate economic growth. . a better market-a tions-parables-of the roles of the fi- market with lower transactions costs. His idea for manufacturing minishing returns on a social level. lower transaction costs lationship between banker and industri- expand the set of "on the shelf' produc. In fact. Just as Smith (1776) used the pin and better production technologies in factory to illustrate the importance of Greenwood and B.

sufficiently rigorous understanding of one in his town and neighboring commu. vative project. functions. XXXV (June 1997) Highly specialized production processes mies of scope. He would find it prohibitively termediary to mobilize savings for his costly to pay his workers and suppliers new truck plant. tor managers and exert corporate con- liquid project. Financial structure-the mix can mobilize savings more cheaply than of financial contracts. To fund the truck plant. Thus. nomic implications of different financial Banks and investment banks. if potential investors feel that savings for unplanned events. outside creditors must have distaste for risk and desire for liquidity confidence that Fred will run the truck create incentives for him to (a) diversify plant well. or run the luctant to tie up his savings in the truck plant poorly. he would not wish reliable information about Fred's idea to put all of his savings in one risky in. Thus. may keep savings from flowing to Fred's actions will allow and promote special. nancial intermediaries-require informa- over. ment. the fi- ization and thereby permit him to nancial intermediaries-and savers in fi- organize his truck assembly line. however. In fact. First. Fred's duced by easier transactions may foster ability to implement the design.702 Journal of Economic Literature. T he Theory of Finance and Moreover. and di. the financial system must moni- commit too much of his savings to an il. interact to promote economic develop- versification will help him start his inno. Thus. for a long time. While this parable does not contain all portionately in his illiquid truck project. I high- costly and time consuming to collect sav. Thus. in mobilizing savings tween the functioning of the financial for Fred's truck company. or misrepresent profits. and in. This information is tasks. Also. the increased specialization in. econo. and eco- nities even though his idea is sound. it provides one cohesive story nism for managing risk. lighted areas needing additional re- ings from individual savers. First. truck. Two additional problems ("frictions") ments and markets that facilitate trans. H . His Fred's idea. before funding the truck plant. risk pooling. Vol. for Fred to receive the family's investments and (b) not funding. would be difficult without a medium of Fred may seek the help of a financial in- exchange. which will not yield profits. the Production requires capital. development. the project may of how the five financial functions may die. tion about the truck design. Fred does search. he is re. More. tutions-varies across countries and . aspects of the discussion of financial he may forgo his plan. it is very system and economic growth. phasizing. markets. structures. liquidity. like producing a new trol. and experience. if Fred must invest dispro. Further- vestment. project. Financial instru. he wants ready access to more. and learning-by-doing and innovation by the whether there is a sufficient demand for workers specializing on their individual better quarry trucks. Fred may steal the funds. using barter exchange. Even if financial system must be able to acquire Fred had the savings. project. the emergence. To finance does yield profits. difficult to obtain and analyze. Without a mecha. if it they will not provide funding. however. connections. we do not have a formation to collect savings from every. Fred will require outside Economic Growth: Agenda funding if he has insufficient savings to initiate his truck project. There are In describing the conceptual links be- problems. and insti- Fred due to economies of scale. Two more areas are worth em- not have the time.

if any. size of the financial system is positively gies and monitor managers may be very correlated with the provision and quality different in a service-oriented economy of financial services. opment under the assumption that the quired to evaluate production technolo. In this way. The seminal work in this 1990). ~ k i l d i no~ h ~ u Patrick ~ h (1966). B. while and Growth: Cross-Country Studies the foymation of financial intermediaries accelerates growth by enhancing the al. and technological change. and research involves the influence of the there is even evidence that the level of level and growth rate of the economy financial development is a good predic- on the financial system. Thus. Levine: Financial Development and Economic Growth changes as countries develop (Boyd and 111. we need models that elucidate the markets and intermediaries-and the conditions. assume that there is a fixed cost to join. future re- search may improve our understanding of (2) there are even indications in the few the impact of growth on financial systems. Furthermore. Evidence B. econo. the costs and skills re. Differences in legal ment and structure importantly associ- tradition (Rafael LaPorta et al. growing body of work demonstrates a ing information and transaction costs. (1) a rough parallelism can be observed be- creenwood and J~~~~~~~~ (1990). economic growth. Greenwood and Smith (1997). A. is more this fixed cost and more people join. Economic development may af. Then. and tween economic and financial development if periods of several decades are considered. The Questions cial structures emerge or why financial Are differences in financial develop- structures change. growth rates? To assess the nature of the ments that produce different political finance-growth relationship. under which different functioning of the financial system. The Level of Financial Development moting financial intermediaries. inconclusive. positive link between financial A second area needing additional development and economic growth. 1996) and ated with differences in economic differences in national resource endow. capital accumulation. Some models tor of future economic development. financial tween economic growth and aggregate and economic development are jointly measures of how well the financial sys- determined (Greenwood and Jovanovic tem functions. economic growth provides the means for the formation of growth-pro. Using data on 35 from that of a manufacturing-based countries from 1860 to 1963 (when avail- economy or an aericultural-based econ. however. 48) finds: omy. I evalu- mists need to develop an analytical basis ate existing evidence on the ties between for making comparisons of financial struc. A financial structures are better at mitigat. countries for which the data are available that . financial structure-the mix of financial tures. He uses the fect the financial system in other ways value of financial intermediary assets di- that have not yet been formally modeled. p. area is by Goldsmith (1969). Yet. able) Goldsmith (1969. Smith 1996). we do not have adequate theories of why different finan. Consider first the relationship be- location of capital. vided by GNP to gauge financial devel- For example. cial development. I first de- and institutional structures (Stanley scribe research on the links between the Engerman and Sokoloff 1996) might be functioning of the financial system and incorporated into future models of finan. Economic nancial structure and the functioning of growth then reduces the importance of the financial system. strong. Evidence on the relationship between fi- ing financial intermediaries.

commercial banks and central measures of "the level of financial devel. held about two-thirds of a year's income aries may not accurately measure the in liquid assets in formal financial inter- functioning of the financial system. lend to the government or public enter- Nouriel Roubini and Xavier Sala-i. of tion of credit. As shown. There is a strong correlation causality. The third and fourth measures par- 20Goldsmith (1969) recognized these weak. The intuition underly- lation and productivity growth channels. in 1985. vided by bank credit plus central bank run growth.) They use four contrast. measures the size of financial intermedi- volves limited observations on only 35 aries and equals liquid liabilities of the countries. banks allocate about the same amount of opment" to more precisely measure the credit in the poorest quartile of coun- tries. and the in the richest quartile of countries. cial development. i. citizens of financial development is associated with the richest countries-the top 25 per- productivity growth and capital accumu. while citizens of the poorest (e) the close association between the size countries-the bottom 25 percent-held of the financial system and economic only a quarter of a year's income in liq- growth does not identify the direction of uid assets. cial intermediaries providing valuable fi- ductivity growth. cated to private enterprises to total do- tion of economic development or whether finan. The fourth measure. Vol. cent on the basis of income per capita- lation. however. the period 1960-1989. and ana. measures the For example. The second measure of finan- to address some of these weaknesses. King and Levine (1993a. mestic credit (excluding credit to banks). prises. has sev. The first measure. systematically BANK equals the ratio of bank credit di- control for other factors affecting long. equals the ratio of credit allo- nancial factors were responsible for the accelera. marizes the values of these measures relative to real per capita GDP (RGDP) Goldsmith's work. BANK. equals 48).704 Journal of Economic Literature. velopment predicts long-run economic however. PRIVY. Gertler and Andrew Rose 1994. (d) the size of financial intermedi. and pro. capital accumulation. ing this measure is that banks are more construct additional measures of the likely to provide the five financial func- level of financial development. researchers have taken steps DEPTH. cial development reflected economic growth whose mainsprings must be sought elsewhere" (p.g.20 between real per capita GDP and Recently. of deciding whether fi. and interest-bearing liabilities of banks nomic growth (Levine and David Renelt and nonbank financial intermediaries) 1992). In overview by Pagano 1993. see Alan Gelb nancial functions and banks may simply 1989. "there is no possibility. There are two lyze whether the level of financial de.e. though not without ex. tions than central banks. by an above-average rate of financial development.. The third measures. (Also. tially address concerns about the alloca- nesses. Table 1 sum- ception. 1993c) study 80 countries over commercial banks are allocating credit. eral weaknesses: (a) the investigation in. degree to which the central bank versus 1993b. and mediaries.. notable weaknesses with this measure. Goldsmith's size measure. Banks are not the only finan- growth. credit to private enterprises divided by . examine the capital accumu. establishing with confidence the direction of the causal mechanisms. Easterly 1993. DEPTH. PRIVATE. however. domestic assets. (b) it does not systematically financial system (currency plus demand control for other factors influencing eco. e. XXXV (June1997) periods of more rapid economic growth have functioning of the financial system than been accompanied. (c) it does not examine whether divided by GDP. BANK is greater than 90 percent Martin 1992.

nus (0. or productivity assess the strength of the empirical rela. income per capita. As depicted in Table 1.OOOl) BANK 0. BANK. 1993c) then ita capital stock growth.58 0.91 0. and (3) total productivity erting corporate control.0001) PRIVY 0. mobilizing sav. GO') the extent to which loans are directed to represents the value of the jth growth in- the private sector.26 0. indicators of exchange riod.39 0. and three growth indicators (e.71 0. (2) the average allocate more credit to private firms are rate of growth in the capital stock per more engaged in researching firms. per cap- King and Levine (199310. Levine: Financial Development and Economic Growth 705 TABLE 1 FINANCIAL DEVELOPMENT AND REALPERCAPITA GDP IN 1985 Correlation with Real per Capita GDP in Indictors Very rich Rich Poor Very poor 1985 (P-value) DEPTH 0.52 0.20 0.0001) PRIVATE 0. statistically significant correla. and X represents a matrix of condi- cators of the level of financial develop. P R I W . . F .51 0. The assumption underlying these as follows: (1) the average rate of real measures is that financial systems that per capita GDP growth.53 0. litical stability.67 0. po- also averaged over the 1960-1989 pe. person.13 0. education. 1989. and facilitating transactions than fi. fiscal. ex. there is a dicator of financial development positive.31 0.58 (0.70 (0. growth) averaged over the period 1960- tionship between each of these four indi. trade. G. PRIVATE) av- tion between real per capita GDP and eraged over the period 1960-1989.47 0. (DEPTH.73 0. In other words. tioning information to control for other ment averaged over the 1960-1989 factors associated with economic growth period. The three growth indicators are rate. and monetary policy)..57 0. providing risk growth. fined as real per capita GDP growth mi- ings. which is a "Solow residual" de- management services. dicator (per capita GDP growth. to the government or state owned enter. if F ( i ) represents the value of the ith in- prises.51 (0.3) times the growth rate of the nancial systems that simply funnel credit capital stock per person.51 (0.g.0001) RGDP85 13053 2376 754 241 Observations 29 29 29 29 Source: King and Levine (1993a) Very rich: Real GDP per Capita > 4998 Rich: Real GDP per Capita > 1161 and < 4998 Poor: Real GDP per Capita > 391 and < 1161 Very poor: Real GDP per Capita < 391 DEPTH = Liquid liabilities to GDP BANK = Deposit money bank domestic credit divided by deposit money bank + central bank domestic credit PRIVATE = Claims on the non-financial private sector to domestic credit PRIW = Gross claims on private sector to GDP RGDP85 = Real per capita GDP in 1985 (in constant 1987 dollars) GDP.37 0.

F(i).05 level. to examine whether finance Not only are all the financial develop.10 level. The difference between the slowest There is a strong positive relationship growing 25 percent of countries and the between each of the four financial devel.706 Journal of Economic Literature.2) to the mean of the fastest growing pendent variable is. the coefficient of 0. [p-values in brackets] Observations = 77 DEPTH = Liquid liabilities to GDP BANK = Deposit bank domestic credit divided by deposit money bank + central bank domestic credit PRIVATE = Claims on the non-financial private sector to total claims PRIVY = Gross claims on private sector to GDP Productivity Growth = Real Per Capita GDP Growth . the rise in DEPTH capita growth rates.o~o"" 0.52 Real Per Capita Capital Stock Growth 0. and ratio of export plus imports to GDP. fastest growing quartile of countries is opment indicators. ratio of government consumption expenditures to GDP. and productivity improvements on DEPTH implies that a country that over the next 30 years. inflation rate. Ig.011] [0. simply follows growth. Table 2 growth difference. real per .long-run real per 30 year period.001] [0.(0. then the following 12 regressions are run quartile of countries (0. alone eliminates 20 percent of this tion.007] [0.52 0. log of initial secondary school enrollment rate. """ significant at the 0.65 0.022""* 0. capital accumula. King and Levine ment coefficients statistically significant. In the three slowest growing quartile of countries regressions reported in Table 3. This is large.5 0.025""" [0. the de- (0.001] R2 0. "" significant at the 0. XXXV (June1997) TABLE 2 AND CONTEMPORANEOUS GROWTH FINANCIAL INDICATORS.62 0. Vol.01 level. of economic growth. capital accumula- noring causality. (199313) study whether the value of fi- the sizes of the coefficients imply an nancial depth in 1960 predicts the rate economically important relationship. 1960-1989 Dependant Variable DEPTH BANK PRIVATE PRIVY Real Per Capita GDP Growth 0. and productivity growth. G ( j )= a + PF(i) + yX + E.62 0.012] [0.64 Productivity Growth R2 Source: King and Levine (1993b) " significant at the 0. Table 3 summa- increased DEPTH from the mean of the rizes some of the results. and the three about five percent per annum over this growth indicators G(i).032""" [0.3)"RealPer Capita Capital Stock Growth Other explanato y variables included i n each of the 12 regressions: log of initial income.024""" 0.032""" 0.002] R2 0. summarizes the results on the 12 P's.022"" o.6) would have in- on a cross-section of 77 countries: creased its per capita growth rate by al- most one percent h e r rear.005] [0. Thus. respectively.5 0.002] [0.024 tion.034""" 0. Finally.

more sophisticated time series studies. .682] [0. The regressions indicate that efficiency improvements over the next 30 financial depth in 1960 is significantly years even aftkr controlling for income.001] [0.022*"* in 1960 [0.238] [0. data from LaPorta et al. PRIVATE.001] [0. Levine: Financial Development and Economic Growth TABLE 3 GROWTHAND INITIAL FINANCIAL DEPTH. time series data. Granger-causes economic performance (Paul cients to be the same across decades. BANK in 1960 and so on for tions find that financial sector development the other two decades.001] [0.004* -0.001] Log (Secondary school 0.015""" Person in 1960) [0. long-run growth.002 0. cross cators of the legal treatment of creditors taken section.239] [0. of monetary. and 1980s.05 level.051] [0. thus.07* 0.292] (Imports plus Exports)/GDP -0.22 1989. trade. they use data averaged over the 1960s.58 Source: King and Levine (1993b) sipficant at the 0. ed- correlated with each of the growth indi. for example.001] Log (Real GDP per -0. and economic I 1960. physi- regressions is the value of DEPTH in cal c a ~ i t a laccumulation. and economic effi.001] Government 0. King and Levine (1993b) use pooled. though disagreement exists observations per count They then relate the (Woo Jun 1986 and Philip Arestis and Panicos value of growth averager'over the 1960s with the Demetriafes 1995).003 -0.068] [0. and PRIVY in 1960 to ZZThese broad cross-country results hold even extend the analysis in Table 3 to these variables. and measures cators averaged over the period 1960. nous component of financial development (Levine 1970s.013""" 0. real per capita capi.0115** enrollment in 1960) [0. ""significant at the 0.029 [0. measures of the size of the financial system (Klaus ciency improvements over the next ten years after Neusser and Maurice Kugler 1996).1960-1989 Per Capita GDP Per Capita Capital Per Capita Productivity Growth.: good redictor of subsequent rates oPeconomic added provided by the financial system instead of capital accumulation. and productivity growth suggest that the initial level of financial averaged over the period 1960-1989.028""" 0. *"" significant at the 0.63 0. there are potentially three 1997).056" consumption/GDP in 1960 [0.034""" [0. 1960-1989 Growth. development is a good predictor of sub- The financial indicator in each of these sequent rates of economic growth. 1996-to extract the exoge- permitting. 1960-1989 Growth.076] Inflation in 1960 0. [p-values in brackets] Observations = 57 capita GDP growth. For each country.02 0.016""" -0.003 in 1960 [0. political stability. These results are that the initial level of financial develo ment is a ticularly strong when using measures of the va?".019""" 0. when using instrumental variables-primarily indi- Thus.61 0. They find Wachtel Rousseau 1995). They restrict the coeffi.01 level. 1960-1989 Constant 0.10 level. tions on BANK. Furthermore.007""" 0.604] [0.064] [0.049* 0.001] R2 0. plus those from controlling for many other factors associated with 21There is an insufficient number of observa.001 -0.037 0.001] [0. tal stock growth.001] [0.035""" 0. many time-series investiga- value of.767] [0. ucation. and fiscal policy.603] DEPTH (liquid liabilities) 0." These results.001] [0.

celerated real per capita growth rates ments. Similarly. gal traditions (LaPorta et al. external finance (in the United States) mated coefficients suggest that if in 1960 grow relatively faster in countries that Bolivia had increased its financial depth begin the sample period with better de- from 10 percent of GDP to the mean veloped financial systems. There is a statistically faster rates than they could have grown significant and economically large em. the esti. then examine industries across a large Douglass North 1981) may be driving both financial development and eco- 23 These examples do not consider causal issues nomic growth rates. even after controlling for other growth cial development has sometimes created determinants (Jith Jayaratne and Philip a "poverty trap" and thus become a se. insufficient finan. knowledge about the causal relationships Not surprisingly. Rajan and sue of causality. Asli Demir- economic growth does not simply reflect guq-Kunt and Vojislav Maksimovic contemporaneous shocks that affect both (199613) argue that firms with access to financial development and economic more developed stock markets grow at performance. 1996). For example. laxed intrastate branching restrictions. Furthermore. more. This benchmark of future economic growth. trade. Vol. ies do not unambiguously resolve the is- nomic growth. The countries that start with relatively weak strong link between the level of financial financial systems. then Bolivia would have funding grow comparatively faster in grown about 0. Further- country then defines each industry's effi. differences in political systems. without this access.and in- vere obstacle to growth even when a dustrial-level data for a broad cross- country has established other conditions section of countries and data on indi- (macroeconomic stability. the or how to increase financial development. the rate and structure of economic de- Some recent work has extended our velopment. or in- vestment minus internal cash flow). They find that value for developing countries in 1960 industries that rely heavily on external (23 percent). when pirical relationship between the initial individual states of the United States re- level of financial development and fu. Nevertheless. ture rates of long-run growth. these empirical stud- between financial development and eco. They stitutions (Engerman and Sokoloff 1996. so that by 1990 real per capita diaries (as measured by PRIVY) and GDP would have been about 13 percent stock markets (as measured by stock larger than it was. capital this boosted bank lending quality and ac- accumulation. Strahan 1996). Thus. may predict growth simply because fi- cial markets in the United States are nancial systems develop in anticipation relatively frictionless. using firm- development and the rate of long-run level data from 30 countries. countries with well-developed interme- num. Financial development Luigi Zingales (1996) assume that finan. openness to vidual states of the United States. body of evidence would tend to push . finance does market capitalization) than they do in not merely follow economic activity. le- cient demand for external finance (in. etc." Thus. Furthermore. For example. using firm. and productivity improve. XXXV (June 1997) The relationship between the initial sample of countries and test whether the level of financial development and industries that are more dependent on growth is large.) for recent research presents evidence con- sustained economic development (Jean. educational attainment.4 percent faster per an.708 Journal of Economic Literature. sistent with the view that the level of fi- Claude Berthelemy and Aristomene nancial development materially affects Varoudakis 1996).

Germany. By 1845. they document critical inter. services because nonfinancial enterprises the researchers carefully examine the le. mal financial intermediation omit. Rondo Cameron et integral part of the United Kingdom. Conse- provide a detailed description of the evo. however. Belgium growth. Oth- dustrialization of these seven countries. Germany (1815-1870). ers argue that Scotland had rich natural Typically. For example. Scotland began the period with per cap- tionship and that difference in financial ita income of less than one-half of En- development can alter economic growth gland's. however. Cameron (1967b) con- cludes that especially in Scotland and Ja. resources. While emphasiz. a well-educated work force. Then. Country-Case Studies event affecting Scotland's potentialities Country-case studies provide a rich for economic development was the complement to cross-country compari. economic access to British colonial markets. ne Checkland (1975) and Tyler Cowen and Ran- Debate exists. and financial structure at the started from a much lower level of in- start of the period of analysis. and Russia. case studies. country-case studies rely heavily on Kerr first argued in 1884 that Scotland subjective evaluations of banking system enjoyed a better banking system than performance and fail to systematically England from 1750 until 1844. Union of 1707. scribing the political system. a well-functioning financial system and and the financing of industrialization. still other researchers dis- actions among financial intermediaries. While recognizing that the "dominant political C. but also in Belgium. the de- control for other elements determining bate about whether Scottish banking ex- economic development. per capita in- rates over ample time horizons. Scotland (1750.24 Other analysts disagree with (1800-1875). they come per capita than England. For more on Scottish banking. economic. toward England's income per capita Finally. Finally. and Japan (1868. 24It is also worth noting that Scottish banking pan. Thus. finance-growth link is a first-order rela. level. government policies. and conditions. the case studies start by de. Instead. suffer- gland. argues that ships between banking development and Scotland's superior banking system is the early stages of industrialization for one of the few noteworthy features that England (1750-1844). the banking system ing fewer and less severe panics than its southern neighbor. tish system (Sidney Pollard and Dieter ment to broad cross country compari. (1967) dissect the historical relation. the "facts" underlying this conclusion. the period 1750-1845 continues today. it is not surprising that Scotland lution of the financial system during a enjoyed a period of rapid convergence period of rapid economic development. growth-inducing role. Russia (1860-1914). Some researchers suggest that England 1914). These country-case studies do not did not suffer from a dearth of financial use formal statistical analysis. provided financial services in England gal. . agree with the premise that Scotland had financial markets. come was about the same. plains its faster economic growth over ing the analytical limitations of country. although Andrew sons. quently. En. p. that Cameron's (1967a) measures of for- tween banks and industry during the in. France (1800-1870). emphasize the deficiencies in the Scot- While providing an informative comple." al. Ziegler 1992). Cameron (1967a. and financial linkages be. was comparatively stable over this period. which made Scotland an sons. Consider the d a i Kroszner (1989). Lezjine: Financial Dezjelopment and Economic Growth 709 many skeptics toward the view that the case of Scotland between 1750 and 1845. see Syd- played a positive. 60). can help explain its comparatively rapid 1845).

Financial Functions and Growth: Mexico than it was in Brazil. XXXV (June 1997) The relationship between financial cially. . in some cases during some time periods. Indonesia. long-term investments. [and that a] lack of access cial functions and economic growth. see Cole and Yung Park which may facilitate the concentration of eco. which "relied that. In contrast. Nonetheless. Substan- three banks control the same fraction of commer. the de. Haber Liquidity and Risk (1996. I now turn to evidence on the ties be- nificant impact on the rate of growth of tween measures of the individual finan- industry.710 Journal of Economic Literature. For example. and Patrick and Park (1994). tries and specific periods. He finds that capital non interprets the mass of evidence market development affected industrial emerging from these country-case stud- composition and national economic per. about two-thirds. in economic growth was much weaker in D. the largest individual security on its price. Disagreement 1889 and formed the First Republic. Ger- capital market development in Brazil. Chile. Deposit-taking of poorly developed capital markets was banks can provide liquidity by issuing a non-negligible obstacle to industrial liquid demand deposits and making illiq- development in the nineteenth cen. economists have studied ex- 25 Interestin ly these political and legal im- pediments to &&cia1 development are appar. For more on Asia. nomic decision making. McKinnon's (1973) seminal book and economic development has been Money and Capital in Economic Devel- carefully analyzed for many other coun. ies as strongly suggesting that better formance. 561). as they did 100 years a o Also. tensively the effects of the liquidity of an ently difficult to change. Vol. Thus. small in-group of powerful financial well-functioning financial systems have. 1996) compares industrial and opment in Argentina. As a result. and Taiwan in Mexico. cial functions performed by banks. p. tion between the liquidity of an asset est ranking of the fegal protection of minority shareholder rights of any country in La Porta et 2 6 F o r more on Mexico see Robert Bennett al. Isolating this t~ry. and it is extremely difficult to iso- on Brazilian financial markets. consider liquidity. The liber. cline in concentration and the increase greatly spurred economic growth. . Specifically. (1983). 40) concludes that "differences in capital market development had a sig."~5 liquidity function from the other finan- Finally. Fry (1995) provides additional citations. Mexico has the low. it exists over many of these individual also dramatically liberalized restrictions cases. Industrial concentra. (1963). Haber shows that functioning financial systems support when Brazil overthrew the monarchy in faster economic growth. tion was much more mild under the Diaz the body of country-studies suggests dictatorship (1877-1911). how- ever. McKin- 1830 and 1930. While Mexico also liberalized sionistic and specific to particular coun- financial sector policies. Brazil. uid.26 external finance. Stephen Haber the financial system and economic devel- (1991. Park (1993). the liberaliza. has proven prohibitively difficult. opment studies the relationship between tries. and the United States between the post World War I1 period. late the importance of any single factor alization gave more firms easier access to in the process of economic growth. many. .'s (1996) detailed comparison of 49 countries. tial evidence suggests a positive correla- cial banking activity today. Korea. while the financial system responds on the financial and political support of a to demands from the nonfinancial sector. . to institutional sources of capital because First. capitalists" (p. I n Mexico. but perhaps most influen. any statements about causality tion fell and industrial production are-and will remain-largely impres- boomed.

50% Emt 0. Levine: Financial Development and Economic Growth 711 TABLE 4 STOCKMARKET LIQUIDITY MEASURES: SELECTEDCOUNTRIES.026 0.044 0.537 0.144 5. ANNUAL AVERAGES 197&1993 Turnover Value Per Capita Ratio Traded Ratio GDP Growth Low-income Bangladesh 0.13% Zimbabwe 0.65% Chile 0.32% Upper-middle-income Argentina 0.193 0.498 0.123 1.67% Sources: International Finance Corporation.75% Switzerland 0.43% Norway 0.154 0.48% Spain 0.013 0.266 0.42% Netherlands 0.207 0.008 3.186 9.256 0.216 0.20% Israel 0.000 1.95% Costa Rica 0.21% Thailand 0.89% Indonesia 0.015 0.11% Pakistan 0.590 in 1993 Upper-middle-income economies = average GNP per capita of $4.67% Malaysia 0.028 0.001 0.370 in 1993 High-income economies = average GNP per capita of $23.003 1.372 0.006 0.010 -0.085 3.490 0.90% Turkey 0.406 3.318 0.124 1.021 3.156 0.028 2.467 0.087 0.250 0.89% Cote d'lvoire 0. and Morgan Stanley Capital International Turnover Ratio = Value of Domestic Equities Traded on Domestic Exchanges Divided by Market Capitalization Value Traded Ratio = Value of Domestic Equities Traded on Domestic Exchanges Divided by GDP Income classifications from the World Bank's 1995 World Development Report Low-income economies = average GNP per capita of $380 in 1993 Lower-middle-incomeeconomies = average GNP per capita of $1.001 -2.669 0.000 -0.68% Japan 0.059 0.013 0.253 0.010 4.95% Great Britian 0.43% Nigeria 0.253 1.97% Lower-middle -income Colombia 0.01% Philippines 0.442 1.045 1.059 2.22% Brazil 0.299 1.72% Italy 0.060 0.57% Germany 0.469 0.144 1.75% Hong Kong 0.18% Jordan 0.041 0.030 3.61% Korea 0.16% United States 0.014 2.493 0.85% Portugal 0.739 0.85% High-income Australia 0.059 0.004 1.060 0.704 0.56% India 0.108 0.243 4.355 0.036 2.090 in 1993 .471 6.832 0.105 0.230 0.76% Mexico 0.27% Mauritius 0.349 0.026 2.

such as Bangladesh. try. while for whether stock market liquidity predicts Mexico and India it was about 0.04.28 uidity for a broad cross-section of 49 The researchers then assess the countries over the period 1976-1993. the level of banking sector devel- equals the total value of shares traded on opment (bank credit to private enter- a country's stock exchanges divided by prises divided by GDP) measured in stock market capitalization (the value of listed shares on the country's ex. The subsequent economic growth.5. gree to which agents can cheaply. fiscal. trade. . age annual value traded ratio of 0. value traded ratio because a small. These measures seek to stock market liquidity and national measure liquidity on a macroeconomic growth rates. the value between each liquidity measure and the traded ratio. and monetary policy) to see ing the 1976-1993 period. omy's productive technologies. six basic regressions are rect measure of trading costs or the un. the value traded ratio ciated with economic growth (initial in- varies considerably across countries. Namely. ratio is about one-tenth the size of the To evaluate the relationship between United States'. For come per capita. but India's value traded growth rates. liquid set that is difficult to sell. and Gregory liquid markets. a small value traded ratio.712 Journal of Economic Literature. tantly. trading relative to the size of the market. political sta- example. the United States had an aver. and then on the turnover ratio in 1976 civenga. over ratio divided by stock return volatility. market will have high turnover ratio but rity-level studies of the relationship be.3 dur. and Starr 1995). 0 28Levine and Zervos 11996) also construct and ~t also exhibits substantial cross-country examine two measures of stock trading relative to stock price movements: (1)the value traded ratio active markets such as divided by stock return volatility. while for less Haim Mendelson 1989. theoretical over the 1976-1993 period are regressed models of liquidity and growth directly first on the value traded ratio in 1976 motivate the value traded ratio (Ben. and Egypt they are 0.7) reflects the explosion in stock market trans- changes). Levine and Sara Zervos (1996) build on quickly. tween the liquidity of individual India's average turnover ratio of 0. B. equals the total value of three growth indicators: economic growth. Kadlec and John McConnell 1994). agents must be compensated The turnover ratio may differ from the with a lower price for purchasing an as. run: economic growth. Germany's very large turnover ratio (0.27 differently. scale: the objective is to measure the de- and rates of technological change. For example. bility. Yakov Amihud and over ratios of almost 0. 27 Note. and productivity growth averaged tling equity transactions. Impor- second indicator. strength of the empirical relationship The first liquidity indicator. education.g. The value growth.06 or less. tion. and productivity changes divided by GDP. They conduct a cross-country traded ratio measures trading relative to analysis with one observation per coun- the size of the economy. do the 1976-1993 is greater than the not link liquidity with national long run United States'. Put Chile. indicators of exchange rate. As while controlling for various factors asso- shown in Table 4. the turnover ratio. While not a di. capital accumula- certainty associated with trading and set. Smith. capital accumulation.. however.5 over securities and their prices. The turnover ratio measures actions during unification. and (2) the turn- Japan and the United States have turn. Vol. XXXV (June 1997) and its price (e. shares traded on a country's stock ex. capital accumulation rates. These secu. and confidently trade ownership Raymond Atje and Jovanovic's (1993) claims of a large percentage of the econ- study and focus on two measures of liq.

Leuine: Financial Development and Economic Growth 713 TABLE 5 GROWTHAND INITIAL STOCKMARKET LIQUIDITY. initial black market exchange rate premium. implies each Mexican would have en- sess the independent link between stock joyed an almost 8 percent higher income market liquidity and growth after con. initial ratio of government expenditures to GDF'. The initial level of stock mar. The sizes of the coefficients also Besides the difficulty of assigning a suggest an economically meaningful rela. suring it accurately (Sanford Grossman age value traded ratio in 1976 (0. 1976-1993 Value Traded Turnover Dependant Variable Ratio Ratio Real Per Capita GDP Growth 0.098""" 0. causal role to stock market liquidity. per capita GDP would have grown at a 29Stock market size.022""" [0.4 percent faster rate (0. initial ratio of commercial bank lending to private enterprises divided by GDP 1976 is included in the regressions to as.04"0.34 Real Per Capita Capital Stock Growth 0. this !' re a ted with growth. and Merton Miller 1988. would not both enter the growth regres- and productivity growth over the next 18 sions significantly). is not robustly cor- 0.29 years.030] Adjusted R2 0.10 level.027""" [0.33 0.01 level. "" significant at the 0.001] [0. financial services from those provided by is a statistically significant predictor of financial intermediaries (or else they economic growth. [p-values in brackets] Observations = 42 Value Traded Ratio = Value of domestic equity transactions on domestic stock exchanges divided by GDP Turnover Ratio = Value of domestic equity transactions on domestic stock exchanges divided by domestic market capitalization. log of initial secondary school enrollment.005] [0. Ac- cumulating over the 18 year period.35 Productivity Growth 0. as measured by market ca italization divided by GDP.05 level. in- itial inflation rate.093""" 0.044) in. Other explanatoy uariables included in each of the six regressions: log of initial income. capital accumulation. capital accumulation. the views that the liquidity services pro- velopment. and Stephen stead of its realized 1976 value (0.006] Adjusted R2 0.38 0.098). dently important for long-run growth ket liquidity-measured either by the and that stock markets provide different turnover ratio or the value traded ratio.003] [0. The results are summarized vided by stock markets are indepen- in Table 5.004).023] Adjusted R2 0.020"" [0. .075""" 0.21 Source: Levine and Zervos (1996) ' significant at the 0. in 1994. tionship. For example. the results imply there are important limitations to mea- that if Mexico had had the sample aver. The results are consistent with trolling for other aspects of financial de.21 0. """ significant at the 0. and productivity improvements.

system may generate a misleading indi- omy. nological. first economy has an active stock ex- sarily matter. The physical location of the through financial intermediaries. information about a firm rise. Thus. Stock mar. diversification services primarily through actions on a country's national stock ex. Thus. The stock market. studies test uity markets. Vol. Bond markets and financial whether the investment decisions of intermediaries may also provide mecha. Moreover. The first for providing liquidity. This measurement problem will cator of the functioning of the whole fi- increase over time if economies be. equity markets. fore investment and monitoring manag- industries. kets. idiosyncratic risk. The reverse may omit important financial arrangements hold in a second economy. York Stock Exchange were to move to In contrast. a firm's in- One common weakness in empirical vestment decisions become more tightly work on liquidity. Theory suggests that econo. Moreover. firms. Besides liquidity risk. the only study of the firm level studies provide insights into relationship between economic growth the role played by financial intermediar- and the ability of investors to diversify ies in easing information asymmetries risk internationally through equity mar. come more financially integrated and E . however. the economy may provide liquidity and risk liquidity indicators measure stock trans. the financial sys. ify the second economy as financially un- ing of equities on a country's exchanges derdeveloped. Theory suggests kets yields inconclusive results (Levine that as the costs to outsiders of acquiring and Zervos 1996). existing studies would class- Los Angeles. nancial system is comparatively adept at tion services with long-run economic reducing information acquisition costs growth.714 Journal of Economic Literature. While ers and projects after funneling capital a vast literature examines the pricing of to those projects. high while the costs of conducting equity measures of stock market liquidity might transactions are low. measures of the trad. and tax differences mies will benefit from the ability to across countries may imply that different trade ownership of an economy's pro. (Schiantarelli 1995). there exists very little empirical evi. Theory strongly suggests that financial tem also provides mechanisms for hedg. the costs to outsiders of acquiring infor- . nancial system. regulatory. so that existing empirical studies and firms would probably not have would classify it as providing substantial greater access to liquidity if the New liquidity and risk diversification services. financial structures arise to provide liq- ductive technologies easily. uidity and risk diversification vehicles. are only one mechanism For example. firms with particular traits that proxy for nisms for diversifying risk. That is. Indeed. ficult to measure whether a country's fi- dence that directly links risk diversifica. however. measuring the per- may not gauge fully the degree of stock formance of one part of the financial market liquidity available to the econ. sectors. Although it is very dif- risk. Financial Functions and Growth: firms list and issue shares on foreign ex- Information changes. in one economy the costs for providing liquidity. intermediaries play an important role in ing and trading the idiosyncratic risk as. should not neces. researching productive technologies be- sociated with individual projects. Thus. Californian savers change. and constrained by retained earnings and economic growth is that it focuses on eq. Thus. and countries. while the second does it changes. Banks and bond of establishing an intermediary may be markets may also provide liquidity. tech. XXXV (June 1997) Wells 1994). current cash flow.

nancial structure change as countries de- ture banking relationships as shown for velop and does it differ across countries? Japan (Takeo Hoshi. Gertler and be exemplified by Continental Illinois' Simon Gilchrist 1994). whether they troubles in the mid-1980s. The sam. Finally. This conclusion Gregory Udell 1995). Schiantarelli. and Allen Berger and outsiders to monitor. When banks sign loan agree- Calomiris. In sum. financing constraints. and Miranda These findings are consistent with the Siregar 1994). Thus. and Bruce Peterson McConnell 1989. insolvency negatively affected the stock bard 1995). Leuine: Financial Development and Economic Growth 715 mation are more sensitive to cash flow Scharfstein 1990). and whether regulations prices of its client firms and that the restrict bank credit allocation (Fidel FDIC's rescue efforts positively affected Jaramillo. and Again. a large nomic growth through more investment body of work shows that when firms have than countries with financial systems close ties to financial intermediaries. the United States (Petersen and Rajan ies. finan. and ple selection criterion varies across stud. those firms find it dence directly indicates an important relatively difficult to raise capital for in. Anil Kashyap. The value of the information Whited 1995). tween firm insiders and outside inves- cial innovations or policies that lower tors. and Alessandro Sembenelli 1996). Italy (Schiantarelli than firms without those traits. Goldsmith pioneered the cross- . Myron Slovin. whether they are large or obtained by banks about firms can also small (James Tybout 1983. the stock prices of those same clients. Charles borrowers. less ma. Indirectly. firms F. this that are less effective at obtaining and reduces information costs and eases firm processing information. Weiss 1996. John Harris. and John Polonchek value on internal funds based on their (1993) show that the banks' impending response to taxes (Calomiris and Hub. when outsiders view that the durability of bank-bor- find it expensive to evaluate and fund rower relationship is valuable. Specifically. pher James 1987. tion barriers will promote faster eco- More relevant for this section. and James and Peggy 1988. Patterns of Financial Development with close ties to banks tend to be less constrained in their investment decisions I now turn to the question: Does fi- than those with less intimate. and ments with borrowers. role for financial intermediaries in re- vestment and rely disproportionately on ducing informational asymmetries be- internal sources of finance. Kashyap. Furthermore. 1994). stock price holds when firms are classified according evidence also indicates that banks pro- to whether they have received bond duce valuable. Schiantarelli. The evi- particular firms. place a relatively high or low shadow Marie Sushka. borrower-firm Wachtel 1995). Hubbard. that countries with financial institutions nancing constraints on more efficient that are effective at relieving informa- firms. Scott Lummar and Glen Hubbard. borrowers with The empirical evidence suggests that longer banking relationships pay lower the investment decisions of firms with interest rates and are less likely to more severe asymmetric information pledge collateral than those with less problems are more sensitive to cash flow mature banking relationships (Petersen than those where it is less expensive for and Rajan 1994. private information about ratings (Toni Whited 1992. the evidence suggests information asymmetries ease firm fi. Charles Himmelberg. whether they are issuing stock prices respond positively (Christo- large or small dividends (Steven Fazzari. and Weir 1990).

Financial Structure in Low-. cently extended Goldsmith's work by Four basic findings emerge from examining the association between the these studies.3percent. (3) Financial depth is measured by currency held outside financial institutions plus demand deposits and interest-bearing liabilities of banks and nonbank financial intermediaries. Vol. and stock exchanges. This work finds that finan- ment for 35 countries over the period cial structure differs considerably across 1860-1963. Zaire. the United Kingdom. Nigeria. Middle-. India. Brazil. Zambia. and the United States) data permitting. banking commissions. (2) Non-bank financial institutions include insurance companies. Denmark. country work in this area. Bolivia. Mexico. Tunisia. 1970-1993. Germany. Guatemala. Sweden. Egypt. IFC (Emerging Markets Data Base).Canada. He traced the and economic development for approxi- relationship between the mix of financial mately 50 countries over the period intermediaries and economic develop. Greece. XXXV (June1997) " Financial Central Con~mercial Nonbank Stock Market Stock Market Depth Bank Assets Bank Assets Assets Capitalization Trading I Low Income Middle Income High Inconle Figure 2. and Venezuela). low-income economies had an average GDP per capita of $490. Singapore. With Taiwan included. Uruguay. mutual funds. Costa Rica. The Netherlands. Kenya. (4) For stock market trading as a percentage of GDP. and Zimbabwe).and high-income economies. As countries get richer over . brokerage houses. Notes: (1)The data are for 12 low-income economies (Bangladesh. The Philippines. Ghana. Malaysia. markets. Spain. In 1990.Turkey. El Salvador. the Republic of Korea. $2. 1990 Sources: IMF (International Financial Statistics). Colombia. pension funds. The World Bank (1989) and countries and changes as countries de- Demirguq-Kunt and Levine (1996b) re. $20. and individual country reports by central banks. Thailand. Taiwan. Chile. Guyana. and High-Income Economies. middle-income economies. velop economically. Indonesia. Jamaica. Paraguay. which are illustrated in mix of financial intermediaries. Pakistan. Japan. the Dominican Republic. 716 Journal of Economic Literature. Taiwan is omitted because its trading/GDP ratio in 1990 was almost ten times larger than the next highest trading/GDP ratio (Singapore). Figure 2. Italy. and 14 high-income economies (Australia. the middle-income stock trading ratio becomes 37. and investment banks.740. 22 middle-income economies (Argentina.457. Finland.

(3) non-banks-such as insurance companies. the assets of deposit banks com. For ex. system. Further. investments than in England's more se- posed 56 percent of financial system as. as about the relationship between financial measured by market capitalization structure and economic growth. The assets of contractual sav. ing financial structure to economic growth. son between Germany and the United fer from numerous problems. where the ties between banks and number in the United Kingdom was 35 industry are less intimate. Similarly. curities market oriented financial sys- sets in France. market capitalization. nancial development. Indeed. there are important excep- (1) financial intermediaries get larger tions and differences within income as measured by the total assets or groups. the definition of a economic growth rate during the latter bank and of a non-bank are not always half of the 19th century and the first consistent across countries. GDP. For exam. The premise is as relationships. Germany's bank-based financial not suggest that poor countries can ac. drawing conclusions about patterns of fi- ies relative to GDP. This makes it Finally. and mobilize savings for promising ample. Kingdom. many differences exist across easier for the financial system to identify countries at similar stages of economic good investments. as merchants. Grou. and private pen. information about firms. The evolution from entre- while there is a general trend involving preneur to banker may explain the com- . it is difficult to distinguish private economists argued that differences in from public banks and development the financial structure of the two coun- banks from commercial banks in many tries help explain Germany's more rapid countries. there is nothing causal about these Gerschenkron 1962). decade of the 20th century (Alexander more. Levine: Financial Dezjelopment and Economic Growth 717 time or as one shifts from poor to richer financial structure and the level of GDP countries. where banks have close ties to celerate their growth rates by changing industry. There exists considerable debate. they must be classic controversy involves the compari- treated cautiously because the data suf. G. per capita. trol. a bit of evidence suggests that German ings institutions composed 26 percent bankers were more closely tied to indus- of total financial system assets in the try than British bankers. reduces the costs of acquiring the structure of their financial systems. quite percent. Thus. tions impeding research on financial While these "patterns" pose a chal. (4) stock markets become larger. and I describe the major analytical limita- stock price variability. while the comparable tem. While one must be hesitant in liabilities of financial intermediar. ple. After relative to sion funds-grow in importance. Unlike En- United Kingdom. fi. Financial Structure and Economic nance companies. nearly all German bankers started figure was only 7 percent in 1985. with and sparse evidence and insufficient theory. while in France the gland. and more liquid. Starting early in this century. an even greater (2) banks grow relative to the central degree of hesitancy is called for in link- bank in allocating credit. briefly outlining the major examples as measured by trading relative to used in discussions of financial structure. investment banks. structure and economic growth. exert corporate con- development (World Bank 1989). These patterns alone do follows. The lenge to financial theorists.

economists disagree over vant issues. decided on major technological in.S. which may foster plain industry specific growth differen. to industrial clients than U. the U.K. p. Japanese bankers are more closely tied ferences are not very large. 178-81). period 1850 to 1913 (Goldsmith 1969. contrast. For example. 179).S. These observations suggest into longer-term securities more easily that the German bank-based system may in Germany (Tilly 1967. Although about the dominance of one financial German manufacturing production grew structure over another. thermore. that German universal banks were more ganized and promoted an impressive ar. German banks are tioning of the financial systems of Korea and Tai- larger as a share of GDP than U. the signifi.S. Private German bankers also or.S. While bank. This closer connection may mitigate in- try specific. While this liquidity. various pieces of evidence suggest thereby allow banks to allocate capital a closer relationship between banker and more efficiently and to exert corporate industrialist in Germany. better investment and faster growth. 406-07). 137). or facilitating exchange. In contrast. cant differences that do exist are indus. For example. and other factors besides formation asymmetries (Hoshi. functional approach highlights the rele- Furthermore. . and novations. markets with more equities held by Short-term credits could be transformed households. control more effectively. Germany's bank-based versus securities market- overall per capita GNP growth rate was based financial systems have been used 1. Franklin Allen and Gale 1995. research suggests that pp. Thus.55 while the U. Besides this en. and arranged for mergers and Demirguq-Kunt and Levine 1996a).30 noticeably faster than Britain's in the six Many of the arguments involving decades before World War I.718 Journal of Economic Literature. historical evidence suggests p. U. banking system (Calomiris 1995). bankers (Randall paths of growth. some evidence sug. reduce information asymmetries and Thus. more active securities ing of their clients than English bankers. financial system is gests that German bankers tended to be typically characterized as having a com- more committed to the long-term fund. the structure of the Japanese fi- The debate concerning bank-based nancial system is sometimes viewed as versus market-based systems eventually superior to the financial structure of the expanded to include comparisons with 30 Park (1993) compares the structure and func- the United States. Thus. differences in financial structure may ex.'s was 1. tials over this period. providing ties (Allen and Gale 1995). ray of major manufacturing companies banks over the 1870-1914 period and during the mid-19th century (Richard suffered less systemic problems than the Tilly 1967. the industry relationships may have been United States' securities market-based closer in Germany.S. bankers.35 over the to compare Japan and the United States. aggregate growth dif.S. XXXV (June 1997) paratively close bonds between bankers and German bankers tend to be more in- and industrialists. German tricately involved in the management of bankers frequently "mapped out a firm's industry than U. Vol. paratively larger. and Sharfstein 1990). this does not imply financial system may offer advantages in that the German financial system was terms of boosting risk sharing opportuni- better at risk management. Kasyap. efficient (lower cost of capital) than U. substantially more research whether the growth differential between is needed before drawing conclusions the two was really very large. banks wan in relation to their industrial composition. In trepreneurial role. pp. conceived farsighted Pozdena and Volbert Alexander 1992. plans. Fur- capital increases" (Gerschenkron 1968.

First. Perhaps. the governance of major corporations. kets. this ment indicators both predict economic does not necessarily imply that the Japa. while Japanese 1996). the devastated tion acquisition costs. while Japan is some. such that observed recent banking problems and slower growth rate differentials have little to do growth in Japan have led some to argue with financial structure. over the post stock markets may ameliorate informa- World War I1 period. This United Kingdom. Levine: Financial Development and Economic Growth 719 United States and an important factor in Axis powers may simply have been con- Japan's faster growth rate over the last verging to the income levels of the four decades. There it is analytically difficult-and perhaps are important overlaps between the ser- reckless-to attribute differences in vices provided by banks and stock mar- growth rates to differences in the finan. Thus. As noted above. Furthermore. Thus. based systems because these two compo- rately spot promising new lines of busi. the debate should not nese financial system provides greater focus on bank-based versus market- risk sharing mechanisms or more accu. it dict future economic growth. well-functioning cial sector. Interestingly. existing re. banks may fo- structures. For tative measures of financial structure example. nomic performance. The financial systems. is merely a conjecture. current debate focuses on bank-based There are severe analytical problems systems versus market-based systems. Thus. however. bank and stock market develop- tion costs between banks and firms. It may be has one of the best developed stock mar. but less capa. and the United States. however. and market capitalization-and the level German bankers may have been more of banking development-as measured closely connected to industrialists than by bank credits to private firms divided their British counterparts. tion costs and enhancing corporate fluencing growth in Germany. both stock market liquidity-as meas- tems or how well different financial ured by stock trading relative to GDP systems function overall. before that the absence of a credible takeover linking financial structure with economic threat through efficient stock markets growth. and banks may . Similarly. provided by financial intermediaries. with linking financial structure to eco. The data indicate that quantify the structure of financial sys. it is not banks or stock mar- Keiretsu may lower information acquisi. given the array of factors in. however. suggest that this dichotomy is search on financial structure does not inappropriate. Some aggregate and firm level evidence. growth. flicting analyses highlight the need for A third factor that complicates the better empirical measures of financial analysis of financial structure and eco- structure and the functions provided by nomic growth is more fundamental. kets. cus on ameliorating information acquisi- Second. the lack of quanti. that stock markets provide a different kets in the world (Demirguq-Kunt and bundle of financial functions from those Levine 1996a). For example. the United States. nents of the financial system enter the ness. growth. other factors influencing long-run nance and competitiveness. researchers need to control for has impeded proper corporate gover. Moreover. by GDP predict economic growth over ble at providing liquidity and facilitating subsequent decades (Levine and Zervos transactions. growth regression significantly and pre- times viewed as a bank-based system. stock markets may primarily and the functioning of financial systems offer vehicles for trading risk and boost- make it difficult to compare financial ing liquidity. Japan. These con. In contrast.

row from banks that depend on the over- pan. or that positively associated with investment. Conclusions economic development. tween financial structure and economic ment using only these countries will tend growth. pooi. enhanced stock market stand the relationship between financial liquidity actually tends to boost corpo- structure and economic growth. (Demirgq-Kunt and Maksimovic 1996a). for industrialized countries. growing body of empirical analyses. XXXV (June1997) provide instruments for diversifying risk firmed by firm-level studies. we need considerably more research eraged over a sufficiently long time pe. riod. Germany. minates many of the channels through tions between stock markets and banks which the emergence of financial mar- during economic development that have kets and institutions affect-and are af- not been the focus of bank-based versus fected by-economic development. financial systems. Nonetheless. opment. Av.720 Journal of Economic Literature. Thus. structure and economic growth is that The evidence suggests complex interac- researchers have focused on a few indus. tions between the functioning of stock trialized countries due to data limita. Future studies will need to incorporate a more diverse Since Goldsmith (1969) documented selection of countries to have even a the relationship between financial and chance of identifying patterns between economic development 30 years ago. cluding firm-level studies. comparisons of fi. quidity rises. This raises and automatically-responds to industri- a quandary: stock market liquidity is alization and economic activity. financial development is an inconse- but equity sales do not finance much of quential addendum to the process of this investment. new equity sales do broad cross country comparisons. In relatively and enhancing liquidity. basically the same standard of living. Thus. formed by the different con~ponentsof However. Thus. stock market li- theories of the simultaneous emergence quidity does not induce a substitution of stock markets and banks and we need out of debt and into equity finance empirical proxies of the functions per. I believe that we will . industry-level ated with faster rates of capital forma. sions to understand the relationship be- nancial structure and economic develop. economic growth. there are important interac. and tion. dem- not finance much of this new investment onstrate a strong positive link between (Colin Mayer 1988). into the links among stock markets. studies. though important the functioning of the financial system differences exist across countries (Ajit and long-run economic growth. Rigorous theoretical work carefully illu- Finally. Most new and evidence make it difficult to con- corporate investment is financed by clude that the financial system merely- retained earnings and debt. stock market liquidity in- standing of the links between financial duces a substitution out of debt finance. Theory Singh and Javed Hamid 1992). A market-based comparisons. individual country-studies. This quandary is con. The United States. debt-equity ratios fall as stock market li- A fourth factor limiting our under. to suggest that financial structure is un- related to the level and growth rate of IV . to under. and corporate financing deci- growth rates. in- greater stock market liquidity is associ. the financial structure and economic devel. and the United Kingdom have all level of economic development. Vol. Ja. they must also have very similar banks. we need rate debt-equity ratios.countries. As noted. profession has made important progress. markets and corporate decisions to bor- tions.

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