Financial Sector Development
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Financial sector development in developing countries and
emerging markets An emerging market (or an emerging country or an emerging economy) is a market that has some characteristics of a developed market, but does not fully meet its standards. This includes markets that may become developed markets in the future or were ...
is part of the private sector development strategy to stimulate economic growth and reduce poverty. The
Financial sector Financial services are the economic services provided by the finance industry, which encompasses a broad range of businesses that manage money, including credit unions, banks, credit-card companies, insurance companies, accountancy companies ...
is the set of institutions,
instruments Instrument may refer to: Science and technology * Flight instruments, the devices used to measure the speed, altitude, and pertinent flight angles of various kinds of aircraft * Laboratory equipment, the measuring tools used in a scientific l ...
, and markets. It also includes the legal and
regulatory framework Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. Fo ...
that permit transactions to be made through the extension of
credit Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a de ...
. Fundamentally, financial sector development concerns overcoming “costs” incurred in the
financial system A financial system is a system that allows the exchange of funds between financial market participants such as lenders, investors, and borrowers. Financial systems operate at national and global levels. Financial institutions consist of complex ...
. This process of reducing costs of acquiring information, enforcing
contract A contract is a legally enforceable agreement between two or more parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, services, money, or a promise to ...
s, and executing transactions results in the emergence of financial contracts,
intermediaries An intermediary (or go-between) is a third party that offers intermediation services between two parties, which involves conveying messages between principals in a dispute, preventing direct contact and potential escalation of the issue. In la ...
, and markets. Different types and combinations of information, transaction, and enforcement costs in conjunction with different regulatory, legal and tax systems have motivated distinct forms of contracts, intermediaries and markets across countries in different times. The five key functions of a financial system in a country are: (i) information production ex ante about possible investments and capital allocation; (ii) monitoring investments and the exercise of corporate governance after providing financing; (iii) facilitation of the trading, diversification, and management of risk; (iv) mobilization and pooling of savings; and (v) promoting the exchange of goods and services. Financial sector development takes place when financial instruments, markets, and intermediaries work together to reduce the costs of information, enforcement and transactions. A solid and well-functioning financial sector is a powerful engine behind economic growth. It generates local savings, which in turn lead to productive investments in local business. Furthermore, effective banks can channel international streams of private
remittances A remittance is a non-commercial transfer of money by a foreign worker, a member of a diaspora community, or a citizen with familial ties abroad, for household income in their home country or homeland. Money sent home by migrants competes wit ...
. The financial sector therefore provides the rudiments for income-growth and job creation.


Importance of Financial Sector Development

There are ample evidence suggesting that financial sector development plays a significant role in
economic development In the economics study of the public sector, economic and social development is the process by which the economic well-being and quality of life of a nation, region, local community, or an individual are improved according to targeted goals a ...
. It promotes economic growth through
capital accumulation Capital accumulation is the dynamic that motivates the pursuit of profit, involving the investment of money or any financial asset with the goal of increasing the initial monetary value of said asset as a financial return whether in the fo ...
and technological advancement by boosting savings rate, delivering information about investment, optimizing the allocation of capital, mobilizing and pooling savings, and facilitating and encouraging foreign capital inflows. A meta-analysis of 67 empirical studies finds that financial development is robustly associated with economic growth. Countries with better-developed financial systems tend to enjoy a sustained period of growth, and studies confirm the causal link between the two: financial development is not simply a result of economic growth; it is also the driver for growth. Additionally, it reduces poverty and inequality by enabling and broadening access for the poor and vulnerable groups, facilitating risk management by reducing their vulnerability to shocks, and raising investment and productivity that generates higher income. Financial sector development also assists the growth of small and medium-sized enterprises (SMEs) by giving them with access to finance. SMEs are typically labor-intensive and create more jobs than large firms, which contributes significantly to economic development in emerging economies. Additionally, financial sector development also entails establishing robust financial policies and regulatory framework. The absence of adequate financial sector policies could have disastrous outcome, as illustrated by the
global financial crisis Global means of or referring to a globe and may also refer to: Entertainment * ''Global'' (Paul van Dyk album), 2003 * ''Global'' (Bunji Garlin album), 2007 * ''Global'' (Humanoid album), 1989 * ''Global'' (Todd Rundgren album), 2015 * Bruno ...
. Financial sector development has heavy implication on economic development‐‐both when it functions and malfunctions. The crisis has challenged conventional thinking in financial sector policies and sparked debate on how best to achieve sustainable development. To effectively reassess and re-implement financial policies, publications such as Global Financial Development Report (GFDR) by the World Bank and Global Financial Stability Report (GFSR) by the IMF can play an important role. The Global Financial Development Report, a new initiative by the World Bank, highlights issues that have come to the forefront after the crisis and presents policy recommendation to strengthen systems and avoid similar crisis in the future. By gathering data and knowledge on financial development around the world, the GFDR report aims to put into spotlight issues of financial development and hopes to present analysis and expert views on current policy issues. In Malaysia, the Asian Institute of Finance was established by Bank Negara Malaysia and Securities Commission Malaysia to develop human capital in the financial services industry.


Theories of Financial Sector Development

Acemoglu, Johnson and Robinson emphasize the importance of the distribution of political power in shaping the differing paths of financial sector development in the United States and Mexico in the 19th and early 20th century. They note that in the United States banking and financial services grew rapidly because American politicians did not have the power to create monopolies in the banking sector that they could appropriate rents from. The federal nature of the US political system meant that states ended up competing with each other to attract inward investment. This in turn, made the restriction of competition in the banking sector untenable. In Mexico, on the other hand, power was centralized in the hands of
Porfirio Díaz José de la Cruz Porfirio Díaz Mori ( or ; ; 15 September 1830 – 2 July 1915), known as Porfirio Díaz, was a Mexican general and politician who served seven terms as President of Mexico, a total of 31 years, from 28 November 1876 to 6 Decem ...
, the dictator who came to power in 1910. Suffrage was highly restricted and there were no competing federal states which meant that political power was not widely spread. As a result, "the central government granted monopoly rights to banks" which enabled them to "raise revenue and redistribute rents to political supporters." Only businesses with close personal connections to the banks and the politicians were able to gain access to finance which hindered the development of arms length finance. Rajan and Zingales focus on the power of interest groups to explain cross-sectional and time-series variation in financial sector development. They argue that incumbents in industry and the financial sector have an incentive to oppose the availability of arms-length finance and greater competition in the financial sector because that would lower their market share and profit margins. Cross border capital flows limit the government's ability to direct credit and give out subsidies to these firms is restricted. The arrival of new foreign firms will cause banks to push for improved disclosure standards and contract enforcement because they would not have personal connections with foreign firms. Incumbent firms will be unable to rely on connections in the banking sector to provide them with loans and will therefore push for more competition and lower barriers to entry in the financial sector so their access to finance improves. In this model, increased trade and capital flows are an exogenous shock that can change the incentives of the economic elite. They now have an incentive to level the playing field and ensure that everyone plays by the same set of rules.


Measurement of Financial Development

A good measurement of financial development is crucial in evaluating the progress of financial sector development and understanding the corresponding impact on economic growth and poverty reduction. However, in practice, it is difficult to measure financial development given the complexity and dimensions it encompasses. Empirical work done so far is usually based on standard quantitative indicators available for a longer time period for a broad range of countries. For instance, ratio of financial institutions’
assets In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...
to GDP, ratio of liquid liabilities to GDP, and ratio of deposits to GDP. However, since the financial sector of a country comprises a variety of financial institutions, markets and products, these measures only serve as a rough estimate and do not fully capture all aspects of financial development. The World Bank's Global Financial Development Database (GFDD) developed a comprehensive yet relatively simple conceptual 4x2 framework to measure financial development worldwide. This framework identifies four sets of proxy variables characterizing a well-functioning financial system: financial depth, access, efficiency, and stability. These four dimensions are then broken down for two major components in the financial sector, namely the financial institutions and financial markets:


References


External links


World Bank GFDR Report

Ten-Year Framework and Strategies for Development of Islamic Financial Services
{{DEFAULTSORT:Financial Sector Development International development