Over the past 20 years, economists have accumulated a substantial body of empirical evidence that financial sector deepening is a critical part of the economic development process. This shows a well-functioning financial system is a conditio sine qua non for modern market economies to flourish. What started with simple cross-country regressions, as used by King and Levine (1993), has developed into a large literature using an array of different techniques to look beyond correlation and controlling for biases arising from endogeneity and omitted variables. These studies provided a consistent result – financial deepening is a critical part of the overall development process of a country (see Levine 2005, for an overview and Beck 2009, for a detailed discussion of the different techniques).

The findings of this literature, however, sit uncomfortably with the recent experience of many developed countries. It is not just the Global Crisis of 2007/8 that has shed doubts on the finance-growth paradigm, but there are more fundamental questions on the relationship between financial development and economic growth. Aghion et al. (2005) show that the relationship turns insignificant at higher levels of economic development, while Arcand, Berkes and Panizza (2012) show that the relationship even turns negative at very high levels of financial development.

Understanding the link between finance and growth

What are the reasons for this insignificant or even negative relationship between finance and growth across high-income countries? Recent papers have put forward several explanations. While these are not necessarily incompatible with each other, they have different policy implications.

  • First, the measures of financial depth and intermediation the literature has been using might be simply too crude to capture quality improvements at high levels of financial development.1

Some authors have argued that it is not so much the quantity of financial intermediation, but the quality that matters (Hasan, Koetter and Wedow 2009). The question is, however, whether there are limits to these efficiency gains, as there are to the volume of intermediation. In addition, the financial sector has gradually extended its scope beyond the traditional activity of intermediation towards so-called 'non-intermediation' financial activities (Demirgüc-Kunt and Huizinga 2010). As a result, the usual measures of intermediation services have become less and less congruent with the reality of modern financial systems. The literature has not developed yet good gauges of these non-intermediation services to properly assess their relationship with economic growth.

  • A second explanation focuses on the beneficiaries of the credit.

While the theoretical and most of the empirical finance and growth literature has focused on enterprise credit, financial systems in high-income countries provide a large share of their services, including credit, to households rather than enterprises. In several countries, including Canada, Denmark, and the Netherlands, household credit constitutes more than 80% of overall bank credit – mostly mortgage credit. Theory makes ambiguous predictions about the effects on the relationship between household credit and growth, and initial empirical evidence shows an insignificant relationship between the two (Beck et al. 2012). The relationship between financial deepening and economic growth goes through enterprise credit, and the fact that much of the financial deepening in high-income countries over the past 20 years has been in household credit can partly explain the insignificant relationship between finance and growth in these countries.

  • A third explanation posits the financial system might actually grow too large relative to the real economy if it extracts excessively high informational rents, and in this way attracts too much young talent towards the financial industry (Bolton et al. 2011, Philippon 2010).

Kneer (2013a,b) provides empirical evidence for this hypothesis, showing that industries relying more on human capital suffer more in their productivity as the financial system expands. This hypothesis thus clearly points to a trade-off between the intermediation function a financial sector provides to the real economy and a drain on talent needed by the same real economy.

Which view of the financial system?

Related to this last hypothesis is the question on the concept of the financial sector. While academics have focused mostly on the facilitating role of the financial sector, as described so far, policymakers – especially before the crisis and more in some European countries than others – have often focused on financial services as a growth sector in itself. This view towards the financial sector sees it more or less as an export sector, i.e. one that seeks to build an – often – nationally centred financial centre stronghold by building on relative comparative advantages, such as skill base, favourable regulatory policies, subsidies, etc. Based on a sample of 77 countries for the period 1980-2007, Beck, Degryse and Kneer (2014) find that intermediation activities increase growth and reduce volatility in the long-run, while an expansion of the financial sectors along other dimensions has no long-run effect on real sector outcomes. Over shorter-time horizons, a large financial sector stimulates growth at the cost of higher volatility in high-income countries. While these results were obtained for the period before 2007, recent experiences - including the 2008 collapse of the Icelandic banking system and the collapse of the Cypriot banking system in 2012 - have confirmed the high risk of pursuing national financial-centre strategies.

Banking as put option

The same mechanism, through which finance helps growth, also makes finance susceptible to shocks and, ultimately – fragility. Agency conflicts, inter-linkages, and herding trends make banking susceptible to aggressive risk-taking and boom-bust cycles. There is thus not only a cross-country variation in the degree to which financial systems are too shallow or too large, but the same variation exists within countries over time. A poorly designed financial safety net, however, can distort risk-taking incentives even further, as was the case in many high-income countries before the Global Financial Crisis (and continues to be, some would argue). Bailout expectations and procyclical regulatory standards can explain an overexpansion of the banking system in good times, and an excessive retrenchment in bad times. Regression analysis that focuses on shorter-term relationships between finance and growth might capture such cyclical behavior, as shown by Loayza and Ranciere (2006).

The policy lessons

These findings are interesting not just for the academic debate, but also relevant for the financial reform debate, currently under way across the globe. The different explanations for the insignificant, or even negative relationship recently observed in high-income countries send important policy messages:

  • Policies that refocus the financial system on intermediation, and especially on enterprise credit, can be helpful.
  • This does not imply policies to expand small and medium enterprise (SME) lending in an unsustainable manner, but avoiding policies that favour investment in government bonds or mortgage credit.
  • Policies aiming at creating a financial centre do not necessarily bring long-term growth benefits.
  • This refers especially to tax and regulatory subsidies.
  • Policies that force financial institutions and market participants to internalise the downside risks, including externalities imposed through their failure, can help the financial system grow to a sustainable system.
  • Such policies do not just refer a resolution framework that bails-in rather than bails-out, but also macroprudential regulation dampening the procyclicality of bank credit.

Finance is a powerful tool for economic development but with important non-linear effects. Critically, poorly designed regulatory framework can reinforce the fragility inherent in financial systems, and cause economic damage. This also implies that the financial sector can grow too large for society’s benefits. Even twenty to thirty years after financial liberalisation, high-income countries still have to learn how to live with the genies they let out of the bottle and harness it to the benefit of their societies.


Aghion, Philippe, Peter Howitt, and David Mayer-Foulkes (2005) “The Effect of Financial Development on Convergence: Theory and Evidence.” Quarterly Journal of Economics 120, 173–222.

Arcand, Jean Louis, Enrico Berkes, and Ugo Panizza (2012), “Too Much Finance?” IMF Working Paper 12/161,

Beck, Thorsten (2009) “The Econometrics of Finance and Growth.” In Palgrave Handbook of Econometrics, vol. 2, ed. Terence Mills and Kerry Patterson, 1180–1211. Houndsmill: Palgrave Macmillan.

Beck, Thorsten (2013), “Finance, Growth, and Fragility: The Role of Government”, CEPR Discussion Paper 9597.

Beck, Thorsten, Berrak Büyükkarabacak, Felix K. Rioja, and Neven T. Valev. (2012), “Who Gets the Credit? And Does it Matter? Household vs. Firm Lending across Countries.” B.E. Journal of Macroeconomics: Contributions 12

Beck, Thorsten, Hans Degryse and Christiane Kneer (2014), “Is More Finance Better? Disentangling Intermediation and Size Effects of Financial Systems”, Journal of Financial Stability forthcoming.

Bolton, Patrick, Tano Santos and Jose Scheinkman (2011), “Cream Skimming in Financial Markets.” National Bureau of Economic Research Working Paper 16804.

Demirgüç-Kunt, Asli and Harry Huizinga (2010), “Bank activity and funding strategies: The impact on risk and returns” Journal of Financial Economics 98, 626-650.

Hasan Iftekhar, Michael Koetter, and Michael Wedow (2009) “Regional growth and finance in Europe: Is there a quality effect of bank efficiency?” Journal of Banking and Finance, 33, 1446–1453.

King, Robert G., and Ross Levine (1993a) “Finance and Growth: Schumpeter Might Be Right.” Quarterly Journal of Economics 108, 717–738.

Kneer, Christiane (2013a) “Finance as a Magnet for the Best and Brightest: Implications for the Real Economy” DNB Working Paper 392.

Kneer, Christiane (2013b) “The Absorption of Talent into Finance: Evidence from US Banking Deregulation”, DNB Working Paper 391.

Levine, Ross (2005) “Finance and Growth: Theory and Evidence.” in Handbook of Economic Growth, ed. Philippe Aghion and Steven N. Durlauf, 865–934. Amsterdam: Elsevier.

Loayza, Norman V and Romain Rancière (2006), “Financial Development, Financial Fragility, and Growth.” Journal of Money, Credit and Banking 28, 1051–1076.

Phillipon, Thomas (2010), “Financiers vs. Engineers: Should the Financial Sector be Taxed or Subsidized?” American Economic Journal: Macroeconomics, 158–82.

1 More recently, several papers have proposed measures of banking-sector quality, focusing on the profit or cost efficiency of financial institutions.

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