Rethinking Financial Deepening: Stability and Growth in Emerging Markets

Abstract

Financial development increases a country's resilience and boosts economic growth. It mobilizessavings, promotes information sharing, improves resource allocation, and facilitates diversificationand management of risk. It also promotes financial stability to the extent that deep and liquidfinancial systems with diverse instruments help dampen the impact of shocks. But is there a pointbeyond which the benefits of financial development begin to decline and costs start to rise, andhave emerging markets (EMs) reached these limits? This paper takes stock of where EMs are on thestability-growth tradeoff that financial development entails, and considers whether there is furtherscope for financial development, and how EMs can secure a safe process of financial development.The 2008 global financial crisis raised some legitimate questions about financial deepening andfinancial development, given that the crisis originated in advanced economies (AEs), where thefinancial sector had grown both very large and very complex. Are there limits to financialdevelopment for growth and stability? Is there a right pace of development? Are there tradeoffs?What is the role of institutions in promoting a safe financial system? Are there lessons for EMs fromAEs' experience to reap the benefits from financial development, while avoiding the pitfalls? In thisregard, this study provides five key policy-relevant findings:First and foremost, using a new, broad, measure of financial development, this study underscoresthat many benefits in terms of growth and stability can still be reaped from further financialdevelopment in most EMs. Financial development is defined as a combination of depth (size andliquidity of markets), access (ability of individuals to access financial services), and efficiency (abilityof institutions to provide financial services at low cost and with sustainable revenues, and the levelof activity of capital markets).Second, the effect of financial development on economic growth is bell-shaped: it weakens at higherlevels of financial development. This weakening effect stems from financial deepening, rather thanfrom greater access or higher efficiency. The empirical evidence also suggests that this weakeningeffect reflects primarily the impact of financial deepening on total factor productivity growth, ratherthan on capital accumulation.The third and related finding of the study is that the pace of financial development matters. When itproceeds too fast, deepening financial institutions can lead to economic and financial instability. Itencourages greater risk-taking and high leverage, if poorly regulated and supervised. In otherwords, when it comes to financial deepening, there are speed limits. This puts a premium ondeveloping good institutional and regulatory frameworks as financial development proceeds.The fourth finding relates to the potential tradeoffs of financial regulation. One view is that tighterand more regulation to help safeguard financial stability can hamper financial development. Thisstudy provides a new angle. It finds that, among a large number of regulatory principles, there is asmall subset that is critical for financial development as well as for financial stability. In other words,there is very little or no conflict between promoting financial stability and financial development.Better regulation is what promotes financial stability and development.The fifth finding is that there is no "one-size-fits-all" in the sequencing of developing financialinstitutions versus markets, though as economies evolve the relative benefits from institutionsdecline and those from markets increase.