Financial development

Abstract

Financial sector is the set of institutions, instruments, markets, as well as the legal and regulatory framework that permit transactions to be made by extending credit. Fundamentally, Ḩnancial sector development is about overcoming " costs " incurred in the Ḩnancial system. This process of reducing the costs of acquiring information, enforcing contracts, and making transactions resulted in the emergence of Ḩnancial contracts, markets, and intermediaries. DiṀerent types and combinations of information, enforcement, and transaction costs in conjunction with diṀerent legal, regulatory, and tax systems have motivated distinct Ḩnancial contracts, markets, and intermediaries across countries and throughout history. The Ḩve key functions of a Ḩnancial system are: (i) producing information ex ante about possible investments and allocate capital; (ii) monitoring investments and exerting corporate governance after providing Ḩnance; (iii) facilitating the trading, diversiḨcation, and management of risk; (iv) mobilizing and pooling savings; and (v) easing the exchange of goods and services. Financial sector development thus occurs when Ḩnancial instruments, markets, and intermediaries ease the eṀects of information, enforcement, and transactions costs and therefore do a correspondingly better job at providing the key functions of the Ḩnancial sector in the economy. Importance of Ḩnancial development A large body of evidence suggests that Ḩnancial sector development plays a huge role in economic development. It promotes economic growth through capital accumulation and technological progress by increasing the savings rate, mobilizing and pooling savings, producing information about investment, facilitating and encouraging the inṀows of foreign capital, as well as optimizing the allocation of capital. Countries with better-developed Ḩnancial systems tend to grow faster over long periods of time, and a large body of evidence suggests that this eṀect is causal: Ḩnancial development is not simply an outcome of economic growth; it contributes to this growth. Additionally, it reduces poverty and inequality by broadening access to Ḩnance to the poor and vulnerable groups, facilitating risk management by reducing their vulnerability to shocks, and increasing investment and productivity that result in higher income generation. Financial sector development can help with the growth of small and medium sized enterprises (SMEs) by providing them with access to Ḩnance. SMEs are typically labor intensive and create more jobs than do large Ḩrms. They play a major role in economic development particularly in emerging economies. Financial sector development goes beyond just having Ḩnancial intermediaries and infrastructures in place. It entails having robust policies for regulation and supervision of all the important entities. The global Ḩnancial crisis underscored the disastrous consequences of weak Ḩnancial sector policies. The Ḩnancial crisis has illustrated the potentially disastrous consequences of weak Ḩnancial sector policies for Ḩnancial development and their impact on the economic outcomes. Finance matters for development‐‐ both when it functions well and when it malfunctions. The crisis has challenged conventional thinking in Ḩnancial sector policies and has led to much debate on how best to achieve sustainable development. Reassessing Ḩnancial sector policies after the crisis in an important step in informing this process. To help achieve this, publications such as the World Bank's Global Financial Development Report can play a role. Chapter 1 and the Statistical Appendix of the reportpresent data and knowledge on Ḩnancial development around the world. Measurement of Ḩnancial development A good measurement of Ḩnancial development is crucial to assess the development of the Ḩnancial sector and understand the impact of Ḩnancial development on economic growth and poverty reduction. In practice, however, it is diṀcult to measure Ḩnancial development as it is a vast concept and has several dimensions. Empirical work done so far is usually based on standard quantitative indicators available for a long time series for a broad range of countries. For instance, ratio of Ḩnancial institutions' assets (http://en.wikipedia.org/wiki/Assets) to GDP, ratio of liquid liabilities to GDP, and ratio of deposits to GDP.