Effect of Financial Soundness on Growth and Financial Development

The issue of whether financial sector soundness influences growth has received little attention in cross-country empirical research. There is a growing consensus that more finance (i. e., a larger financial sector) causes more growth.23 Recent empirical evidence suggests that countries with better-developed financial systems indeed tend to grow faster. Specifically, the size of the banking system and the liquidity of stock markets are each positively linked with economic growth. Better functioning financial systems ease the external financing constraints that impede corporate and industrial expansion.24

Even though empirical cross-country studies on the issue are limited, there are cases of countries with protracted output losses because of financial sector crises. There is ample case-study evidence (e. g., from the Asian crisis25 or bank restructuring episodes in the Central and Eastern Europe [CEE] countries in the late 1990s) suggesting that financial sector problems can result in significant or protracted output losses. Although few empiri­cal cross-country studies directly address the issue, there seems to be a consensus that is based on the theory and the analysis of country cases that, in the medium to long run, financial soundness is positively related to economic growth.

In the short run, country authorities may be faced with a tradeoff between economic growth and financial sector soundness. Fast growth can make financial markets vulnerable to shocks, constraining potential output.26 In particular, rapid credit expansion may, at times, exceed banks’ capacity to assess risks, thereby leading to reduced asset quality. At the same time, credit expansions can be only a symptom of rapid financial deepening.27 In a country experiencing rapid credit growth and rapid output growth, the key is to determine whether the credit growth can be interpreted as a structural and positive development (e. g., if it follows a period of financial liberalization and bank restructuring). Even if credit growth is determined to be the result of structural developments., as has arguably been the case in some transition countries in the late 1990s and early 2000s,28 policy makers have to evaluate carefully its implications for financial stability and macroeconomic developments. In particular, they need to distinguish to what extent a rapid financial sector growth reflects improvements in access to finance and to what extent the growth reflects a loosening in risk management practices and supervision.

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