Two concepts of financial development (and two different measures)

A commentary in the VoxEU Debate Why do we need a financial sector?

Posted By Thorsten Beck, Tilburg University on 31 October 2011

This is an important and relevant topic as many observers have started to doubt the contribution of finance to growth after the current crisis. And there are two inter-related questions in this respect – what concept of the financial sector and how to measure these concepts?
On the one hand, there is the academic literature on focusing on the relationship between financial intermediation and growth. Interestingly, the level of financial development is not measured by its contribution to GDP but rather by outstanding credit to the private sector relative to GDP. Certainly an imperfect measure of financial intermediation, but one that gets closer to the functions of finance, as described by Ross Levine and others: (i) easing the exchange of goods and services,(ii) mobilizing and pooling savings from a large number of investors, (iii) allocating society's savings to its most productive use, and (iv) diversifying and reducing liquidity and intertemporal risk.
On the other hand, there is the financial center view, i.e. the concept of the financial sector as an export sector based on a comparative advantage in providing financial services (through skill base, regulatory policies etc.). This is certainly captured in the share of value added in a country’s GDP or the share of employment or wage level. That there can be a significant difference between the two concepts is best illustrated by Nigeria in the 1980s. After financial sector liberalization in 1986, the number of banks tripled from 40 to nearly 120 employment in the financial sector doubled and the contribution of the financial system to GDP almost tripled. The financial sector boom, however, was accompanied by financial dis-intermediation. Deposits in financial institutions and credit to the private sector, both relative to GDP, decreased over the same period. The increasing number of banks and human capital in the financial sector was channeled into arbitrage and rent-seeking activity rather than financial intermediation. By 1990, the bubble started to burst (Beck et al., 2005). 
While theory does not really point to obvious growth benefits from having a large financial sector (beyond the intermediation services outlined above), there are important non-linearities even in the intermediation-growth relationship, as pointed out by several papers. There is some evidence that most of the growth benefit comes through enterprise credit, while most of the credit growth in advanced countries over recent years has been in household credit (Beck et al., 2009). And there are also the negative externalities by bank failure pointed out by Wouter that can lead to distorted incentives towards van overextension of credit by financial institutions.
I think the crisis points to important lessons from the finance and growth literature for banking sector reform: focus again on the intermediation growth-enhancing functions and reshape regulatory policies so that negative externalities are internalized by financial institutions. One final important point is that one size does not fit all. Additional financial deepening might not have much of an impact in high income countries, but it is critical for economic growth and poverty alleviation in many developing countries.
Thorsten Beck, CentER and European Banking Center, Tilburg University
Note: This comment is partly based on on-going research with Hans Degryse and Christiane Kneer, both at Tilburg University.
Beck, Thorsten, Robert Cull, and Afeikhena Jerome. 2005. “Bank Privatization and Performance: Empirical Evidence from Nigeria”, Journal of Banking and Finance 29, 2355-2379.
Beck, Thorsten, Berrak Buyukkarabacak, Felix Rioja and Neven Valev. 2009. “Who Gets the Credit? And Does it Matter? Household vs. Firm Lending Across Countries”  CentER Discussion Paper, Tilburg University

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