Summary of„Finance, Financial Sector Policies, and Long-Run-Growth“by Asli Demirgüç-Kunt and Ross Levine (2008)

Philipp Wahlen

October 9, 2008

Oct 9, 2008 2

Introduction• Is there an important impact of financial

development on growth?– leading growth-textbooks ignore the financial sector– Merton Miller: there is a very obvious contribution of

financial markets to growth– Robert Lucas: role of finance has been overstressed

• Paper Contents– first part provides overview about theoretical and

empirical research regarding above question– second part summarizes historical and policy

determinants of financial development

Oct 9, 2008 3

Agenda

• summary of paper contents– review of theoretical works– review of empirical works

Oct 9, 2008 4

Term „Financial Development“

• focus on five broad functions of the financial system:(1) produce information and allocate capital(2) monitor investments and exert corporate governance(3) facilitate trading, diversification and management of risk(4) mobilize and pool savings(5) ease the exchange of goods and services

• „Financial Development“ = lower information, transaction and enforcement costs~ better performance on financial functions

information,transaction,enforcement

coststax,

legal,regulatory

system

financialcontracts,markets,

intermediaries influence onallocation ofresources andthus growth

Oct 9, 2008 5

(1) Producing Information and Allocating Capital

• large information costs in evaluating of firms, management and market conditions before granting a loan– Financial Intermediaries bundle efforts and reduce

costs (Boyd and Prescott, 1986)– FI produce better information and fund more

promising firms and technologies (Greenwood and Jovanovic, 1990)

– FI identify better entrepreneurs and innovators (several papers)

– large and liquid stock markets set incentives to research for unique information (several papers)

– imperfect capital markets impede efficient investment in human capital (Galor and Zeira, 1993)

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(2) Monitoring firms and exerting CG• Corporate Governance determines the degree to

which shareholders can monitor and influence the use of their capital– asymmetric information– principal agent problems– „free rider“ problems among minor shareholders

• research on concentrated ownership• research on the role of financial intermediaries

– economies of scale in monitoring (Bencivenga and Smith, 1993)

– better handling of informational asymmetries (Sussman, 1993; Harrison, Sussman, and Zeira, 1999)

– monitoring of innovative activities (De La Fuente and Marin, 1996)

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(3) Risk amelioration (cross-sectional risk)

• diversification allows risk-averse investors to invest in riskier, higher-return investments (Gurley and Shaw, 1955; Patrick, 1966; Greenwood and Jovanovic, 1990)

• diversification can stimulate innovative activity and thus technological change (King and Levine, 1993)

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(3) Risk amelioration (liquidity risk)

• liquidity = cost and speed of conversion of financial instruments to purchasing power

• some high-return projects require a long-run commitment of capital– Hicks (1969), Bencivenga, Smith and Starr

(1995) on Industrial Revolution– Levine (1991) on the effects of liquid capital

markets on steady-state growth– Bencivenga and Smith (1991) on the role of FI

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(4) Pooling of Savings

• Pooling = process of agglomerating capital from many savers for investment– works on the emergence and role of

institutions:• investment banks (Carosso, 1970)• banks (Sirri and Tufano, 1995; Boyd and Smith,

1992; Lamoreaux, 1995)

– pooling enables production at efficient scales (Sirri and Tufano, 1995)

– works by Bagehot (1873)

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(5) Easing trade

• higher specialization allows for technological invention and growth (Smith, 1776)– requires more transactions– transaction and information costs

• emergence of money (Smith, 1776; King and Plosser, 1986; Williamson and Wright, 1994)

• Greenwood and Smith (1996) on connections between exchange, specialization, and innovation

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Critique on the Theory Part

• in their introduction the authors claim that the reviewed theoretical studies lead to very different results

• however, all presented studies seem to support the thesis that financial development directly fosters growth

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Agenda

• summary of paper contents– review of theoretical works– review of empirical works

Oct 9, 2008 13

Overview• 4 types of studies are reviewed

(1) cross-country studies(2) studies using panel data(3) microeconomics-based studies(4) individual country studies

• main results:– better developed financial systems and liquid stock

markets liquid stock exchanges enhance growth• there is no simultaneity bias in this result

– better developed FS ease the financing constraints that impede industrial expansion

• shortcomings in empirical studies on the topic:– there is no reliable proxy for „financial development“

Oct 9, 2008 14

(1) Cross-Country Studies on Financial Intermediaries

• aggregation of growth over long periods• studies by King and Levine (1993)

– build on Goldsmith (1969)– 77 countries, 30-year horizon for growth (1960-1989)– control for initial income, educational attainment,

inflation, black market exchange rate premia, government spending, openness to trade, and political instability

– proxy for financial development: DEPTH = liquid liabilities of the financial system divided by GDP

• drawback: measures size but not performance of financial system

• two alternative proxies used, which verify results

Oct 9, 2008 15

(1) Cross-Country Studies on Financial Intermediaries

• studies by King and Levine (1993), continued– three growth indicators:

• average rate of real per capita GDP growth• average rate of growth in the capital stock p. pers.• total productivity growth („Solow-Residual“)

– results:• significant and large impact of DEPTH on all growth

indicators• DEPTH eliminates 20 percent of difference between mean

growth of quartile of slowest countries compared to quartile of fastest

• value of DEPTH in 1960 was a good predictor for subsequent growth even after controlling for income, education and policy

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(1) Cross-Country Studies on Financial Intermediaries

• studies by King and Levine (1993), continued– problems

• DEPTH does not directly measure the ability of the financial system

• causality issues are left out• focus only on banks

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(1) Cross-Country Studies on Stock Markets and Banks

• Levine and Zervos (1998)– based on Atje and Jovanovic (1993)– examine an 18-years period (1976-1993)– add measures of stock market development:

• turnover ratio = turnover of shares / stock market capitalization (and others)

• problems:– does not measure actual costs of trading– other services than liquidity provision are cut out– physical location of stock markets

– add measure of bank development:• Bank Credit = bank credits to private sector / GDP

Oct 9, 2008 18

(1) Cross-Country Studies on Stock Markets and Banks

• Levine and Zervos (1998), continued– results

• support theories that emphasize positive impact of liquid stock markets on growth

• bank and stock market development have different effects on growth

• both impacts are large– stock markets: 1 SD higher turnover ratio 0,8% higher

annual growth– banks: 1 SD higher Bank Credit 0,7% higher annual

growth

Oct 9, 2008 19

(1) Cross-Country Studies on Stock Markets and Banks

• Levine and Zervos (1998), continued– problems

• causality issues are left out• exclusion of bond markets and financial services

by nonfinancial firms• problems with turnover ratio as described above

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(1) Cross-Country Studies: Causality issue

• studies by Levine (1998, 1999) and Levine, Loayza and Beck (2000)– use of instrumental variable– the IV should be uncorrelated with growth indicators

except through the financial system measures and conditioning variables

– LLSV (1998) - measures of legal origin as instrumental variables

Variable Z?

Design of Financial System

Economic/Capital/Productivity Growth

G(j) = a + b*F + u E(u|F) = E(u) ?

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(1) Cross-Country Studies on Stock Markets and Banks

• studies by Levine (1998, 1999) and Levine, Loayza and Beck (2000), continued– results

• strong connection between „exogenous part of financial development“ and growth

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(2) Panel Studies on Finance and Growth

• advantages compared to cross-sectional studies– substantial additional variability in the data

(time dimension)– filtering of country- and time-specific

unobserved effects

• disadvantage– growth measured in short time periods,

problematic when interested in long-term-growth

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(2) Panel Studies on Finance and Growth

• studies:– Beck, Levine and Loayza (2000)– Rousseau and Wachtel (2000)– Beck and Levine (2002)– Arestis, Demetriades, and Luintel (2000)

• results– more or less strong positive impact of used

financial development measures (e.g. turnover ratio) on growth indicators

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(3) Microeconomic Studies of Finance and Growth

• seek to resolve causality issues by unveiling mechanisms through which finance might influence economic growth

• industry level study by Rajan and Zingales (1998)– idea: better-developed financial systems lower

market frictions easier access for firms to external finance

– industries that heavily rely on external finance should profit most from financial development

– regression of average annual growth rate of industry on

• fraction of external capital in industry * indicator of financial development

• several controlling variables

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(3) Microeconomic Studies of Finance and Growth

• industry level study by Rajan and Zingales (1998), continued– financial measures used

• total market capitalization• accounting standards

– results• coefficient for External * Total Capitalization is significant and

economically large

• firm-level study by Demirgüç-Kunt and Maksimovic (1998)– result: banking system development and stock market

liquidity have an important impact on growth of firms

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(4) Country-Case Studies

• advantages/disadvantages:– reduction of concerns about biases, omitted variables

and endogeneity– applicability, low variation in explaining variables

• Guiso, Sapienza, and Zingales (2002): effect of local financial development on economic activity in Italy

• Haber (1997): comparison of industrial and capital market development in Brazil, Mexico and the U.S. between 1830 and 1930

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(4) Country-Case Studies

• Jayaratne and Strahan (1996): impact of bank branch reform in the U.S. in the 1970s

• Bertrand, Shoar and Thesmar (2004): impact of 1985 deregulation in France

– both latter studies investigate the impact of exogenous policy changes

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Summary and Qualifications

• problems in research– identification problem ( instrumental variables,

panel techniques, research for microeconomic mechanisms, country analyses)

– measurement of financial development– non-linearities and threshold effects– some country evidence (e.g. China)

• however, accumulation of evidence suggests that financial development is crucial for growth

• policy-makers schould devote attention to policy-determinats of financial development