Part of the reason for the debate is conceptual. Economic theory did not--until recently--link financial services with long-run growth in ways that pass the profession's litmus test of rigor. And part is empirical. Little evidence had been assembled to establish that finance causes growth.
Now there is evidence to support Schumpeter's view: financial services promote development.
Consider investments in firms. There are large research, legal, and organizational costs associated with such investment. These costs can include evaluating the firm, coordinating financing for the firm if more than one investor is involved, and monitoring managers.
The costs might be prohibitive for any single investor, but an intermediary--such as a bank, mutual fund, or pension fund--could perform these tasks for a group of investors and lower the costs per investor. So, by researching many firms and allocating credit to the best ones, intermediaries can improve the allocation of society's resources.
Intermediaries can also diversify risks and exploit economies of scale. For example, a firm may want to fund a large project with high expected returns, but the investment may require a large lump-sum capital outlay. An individual investor may have neither the resources to finance the entire project nor the desire to devote a disproportionate part of savings to a single investment. Thus profitable opportunities can go unexploited without intermediaries to mobilize and allocate savings.
Intermediaries do more than passively decide whether to fund projects. They can initiate the creation and transformation of firms' activities. Intermediaries also provide payment services. Modern economies--replete with complex interactions--require secure mechanisms to settle transactions. Without these services, many activities would be impossible, and there would be less scope for specialization--with a corresponding loss in efficiency.
In addition to improving resource allocation, financial intermediaries stimulate individuals to save more. The securities most useful to entrepreneurs--equities, bonds, bills of exchange--may not have the liquidity, security, and risk characteristics savers desire. By offering attractive financial instruments to savers--deposits, insurance policies, mutual funds--intermediaries can increase the fraction of resources that individuals save and the fraction of society's output devoted to productive activities. Intermediaries also tailor financial instruments to the needs of firms. Thus firms can issue--and savers hold--financial instruments more attractive to their needs than if intermediaries did not exist.
Growth can also spur the development of financial services. Improvements in computers and communications have triggered financial innovations over the past 20 years. Perhaps, more important for developing countries, growth can increase the demand for financial services, sparking their adoption.
Is it necessarily the case that financial services cause growth or that growth stimulates financial development? No. Other factors may be determining both economic and financial development with little direct impact of finance on growth or growth on finance. For example, the legal and political infrastructure may be driving--or impeding--both economic and financial development.
Rather than focus on causality, past empirical work has relied largely on comparative case studies to document the links between financial and economic development. The studies range from a spirited debate on the role of banks in explaining the different growth rates of Scotland, England, and France in the 18th and 19th centuries to the role of intermediaries in igniting Korea's growth since the early 1960s.
This evidence strongly suggests that financial depth--the ratio of broad money (currency plus checking, savings, and time deposits) to GDP--almost always accompanies economic growth. It also suggests that highly restrictive policies toward financial institutions can thwart both financial and economic development.
In recent cross-country work, Bank staff have attempted to improve our understanding of such links between growth and finance in three ways. The work uses an expanded set of measures of financial services. It controls for other phenomena that may also explain economic development. And it extracts the "exogenous" component of financial intermediary services to provide better evidence on whether financial intermediary services contribute independently to growth.
One measure of financial services--call it BANKS--is the credit issued by banks divided by the credit issued by banks plus the credit issued by the central bank. This measure attempts to distinguish intermediaries that provide risk management and information gathering services from those that do not. Banks are more likely to offer these services than is a central bank.
There are statistical and conceptual problems with accurately measuring BANKS. Banks are not the only organizations that provide financial services, and in many countries banks are strongly influenced by the government and central bank, blurring the distinction between banks and central banks.
A second indicator--call it PRIVATE--measures the extent to which credit goes to the private sector. It is the credit issued to nonfinancial private firms divided by total credit.
Intermediaries that finance private firms probably provide more services than a system that simply funnels resources to the government or state-owned enterprises.
As with BANKS, measuring PRIVATE is subject to error. In addition, PRIVATE may simply reflect government borrowing from financial institutions or the size of the private sector and therefore not accurately indicate the provision of financial services.
These two indicators nevertheless improve on the traditional measure--financial depth.
Using the two indicators, we studied whether financial intermediary services separately contribute to growth. We address two questions. After explaining everything we can about growth using a wide assortment of factors, do our measures of financial services provide additional help in predicting the rate of economic growth? If yes, do financial services promote growth by increasing savings or by increasing the efficient allocation of savings?
The results are remarkable. The exogenous component of financial depth, BANKS, and PRIVATE explains much of the part of growth unexplained by the many variables and policies commonly thought to determine economic development.
The results imply that financial services have an independent, positive effect on growth. They also imply that the more intermediation that is done by banks and not the central bank and the more credit that goes to the private sector, the greater is economic growth, other things remaining the same.
Other work (not shown) finds that these financial indicators are linked to both the efficiency of capital allocation and the savings rate. In short, finance tends to stimulate growth by improving efficiency and increasing the savings rate.
Another way to find out whether finance improves allocative efficiency is to examine changes in the allocation of credit following financial reforms. Schiantarelli and others used firm-level data to investigate the impact of financial reform on credit allocation, focusing on technical efficiency (measured by total factor productivity). For Ecuador there has been a significant increase in the extent to which efficient firms obtain credit, even after correcting for firm age, size, and market orientation and even when firms' efficiency is judged solely on the basis of pre-reform data.
Not only does average efficiency rise dramatically, but the dispersion of efficiency among firms declines, suggesting that market-based financing may increase competition and eliminate inefficient producers.
For Indonesia not only did credit flow to more efficient firms. There is also convincing evidence that small firms--precisely those that might be expected to be discriminated against by formal directed credit programs and that also might be the source of future output gains--benefited most from reforms. Moreover, although interest rates rose after the onset of reforms, the premium diminished for external finance paid by small firms relative to that by large.
None of the results is probative. Those who wish to believe that finance is relatively unimportant to economic development can continue to do so. But the cross-country and firm-level data are beginning to tell a compelling story: finance matters.
Gerard Caprio Ross Levine
Banks, finance, and growth
Key elements of financial reform programs 