Download Finance and Growth The growing body of

Finance and Growth
The growing body of empirical research, using
di¤erent statistical procedures and data sets, produces remarkably consistent results.
First, countries with better-developed …nancial
systems tend to grow faster— speci…cally, those
with (i) large, privately owned banks that funnel
credit to private enterprises and (ii) liquid stock
exchanges. The levels of banking development
and stock market liquidity each exert a positive
in‡uence on economic growth.
Second, simultaneity bias does not seem to be
the cause of this result.
Third, better-functioning …nancial systems ease
the external …nancing constraints that impede
…rm and industrial expansion. Thus, access to
external capital is one channel through which …nancial development matters for growth because
it allows …nancially constrained …rms to expand.
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King and Levine (1993b) (henceforth KL) study
77 countries over the period 1960-89.
To measure …nancial development, KL focus on
DEPTH, which equals the size of the …nancial intermediary sector. It equals the liquid liabilities
of the …nancial system (currency plus demand
and interest-bearing liabilities of banks and nonbank …nancial intermediaries) divided by gross
domestic product (GDP).
An important weakness of this measure of …nancial development is that DEPTH measures
the size of the …nancial intermediary sector. It
may not, however, represent an accurate proxy
for the functioning of the …nancial system. It
may not proxy for how well bank research …rms
exert corporate control or provide risk management services to clients. See Demirguc-Kunt and
Levine 2008.
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Recent evidence, however, suggests that focusing on domestic …nancial markets is relevant.
Guiso, Sapienza, and Zingales (2002) study the
e¤ects of di¤erences in local …nancial development within an integrated …nancial market, Italy.
They …nd that local …nancial development (i)
enhances the probability an individual starts his
own business, (ii) increases competition, and (iii)
promotes the growth of …rms.
They instrument for …nancial development with
its determinants, such as the level of judicial inef…ciency. Since there are no obvious reasons why
measures of judicial ine¢ ciency (average duration
of a trial and number of pending trials divided
by population) should be correlated for example
with the level of entrepreneurship that may vary
by region, they represent good instruments.
As predicted by theory, these e¤ects are weaker
for larger …rms, which can more easily raise funds
outside of the local area. Thus, the authors’results suggest that local …nancial development is
an important determinant of the economic success of an area even in an environment where
there are no frictions to capital movements.
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Financial development correlated with :
Probability of Starting New Firms:
Local Competition and Pro…t Margins
Self-Employment
Firm Size.
Authors use instrumental variables to proxy for
…nancial variables.
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Using Instrumental Variables To Deal with Simultaneity Bias
To assess whether the …nance-growth relationship is driven by simultaneity bias, recent research uses instrumental variables to extract the
exogenous component of …nancial development.
To do this, one needs instrumental variables
that explain cross country di¤erences in …nancial
development but are uncorrelated with economic
growth beyond their link with …nancial development.
Then, one can use standard instrumental variable procedures to examine the …nance-growth
relationship while formally controlling for endogeneity.
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Levine (1998, 1999) and Levine, Loayza, and
Beck (2000) use the La Porta, Lopez-de-Silanes,
Shleifer, and Vishny (1998) (henceforth LLSV)
measures of legal origin as instrumental variables.
In particular, LLSV show that legal origin—
whether a country’s commercial/company law derives from British, French, German, or Scandinavian law— importantly shapes national approaches
to laws concerning creditors and the e¢ ciency
with which those laws are enforced.
Since …nance is based on contracts, legal origins that produce laws that protect the rights of
external investors and enforce those rights e¤ectively will do a correspondingly better job at promoting …nancial development.
Indeed, LLSV trace the e¤ect of legal origin
to laws and enforcement and then to the development of …nancial intermediaries. Since most
countries obtained their legal systems through occupation and colonization, legal origin variables
may be treated as exogenous.
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Levine, Loayoza and Beck (2000, Journal of
Monetary Economics) follow up on LLSV and use
Legal Origins as Instruments for Financial Development to avoid the simultaneity, or cause and
e¤ect problem.
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The major message is that countries with a
German legal origin have better developed …nancial intermediaries.
While countries with a French legal tradition
tend to have less well-developed institutions than
other countries on average, this result does not
hold when controlling for the overall level of economic development.
Also, as indicated by the P-values of the Ftest, the legal origin variables explain a signi…cant fraction of the cross-country variation of the
…nancial intermediary development indicators.
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"To examine whether cross-country variations
in the exogenous component of …nancial intermediary development explain cross-country variations in the rate of economic growth, the legal origin indicators are used as instrumental variables
for FINANCE (Private Credit, Commercial-Central
Bank, Liquid Liabilities)"
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Industry Level Study by Rajan and Zingales
Better-developed …nancial systems ameliorate
market frictions that make it di¢ cult for …rms to
obtain external …nance.
Thus, industries that are naturally heavy users
of external …nance should bene…t disproportionately more from greater …nancial development than
industries (Drugs, Plastics Computers) that are
not naturally heavy users of external …nance (Tobacco, Leather, Pottery).
If researchers can identify those industries that
rely heavily on external …nance in an economy
with few market frictions— i.e., “naturally heavy
users” of external …nance— then this establishes
a natural test:
Do industries that are naturally heavy
users of external …nance grow faster in
economies with better developed …nancial systems?
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If they do, then this supports the view that …nancial development spurs growth by facilitating
the ‡ow of external …nance. RZ (Rajan and Zingales) work under three maintained assumptions:
(i) …nancial markets in the United States are
relatively frictionless,
(ii) in a frictionless …nancial system, technological factors in‡uence the degree to which an
industry uses external …nance, and
(iii) the technological factors in‡uencing external …nance are reasonably constant across countries.
RZ use the external …nancing of industries in
the United States as a benchmark of the external
…nancing needs of industries in a comparatively
frictionless …nancial system.
They then develop methods to assess
whether industries that are naturally heavy
users of external …nance grow comparatively faster in countries that are more
…nancially developed.
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Consider the equation
Growthi,k=aC+bI+cSharei,k+d(Externalk*FDi)+ui,k
Growthi,k is the average annual growth rate of
value added in industry k and country i over the
period 1980-90. C and I are matrices of country and industry dummies for all countries and
industries, respectively.
Sharei,k is the share of industry k in manufacturing in country i in 1980.
Externalk is the fraction of capital expenditures not …nanced with internal funds for U.S.
…rms in industry k between 1980-90. FDi is an
indicator of …nancial development for country i.
RZ interact the external dependence of an industry (External) with …nancial development (FD),
where the estimated coe¢ cient on the interaction, d, is the focus of their analysis. Thus, if
d is signi…cant and positive, then this implies
that an increase in …nancial development (FD)
will induce a bigger impact on industrial growth
(Growthi,k) if this industry relies heavily on external …nance (Externalk) than if this industry is
not a naturally heavy user of external …nance.
This approach allows RZ (i) to study a particular mechanism, external …nance, through which
…nance operates rather than simply assess links
between …nance and growth and, (ii) to exploit
within-country di¤erences concerning industries.
RZ use data on 36 industries across 41 countries.
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To measure …nancial development, RZ examine
(i) total capitalization, which equals the summation of stock market capitalization and domestic credit as a share of GDP, and
(ii) accounting standards.
As RZ discuss, there are problems with these
measures.
Stock market capitalization does not capture
the actual amount of capital raised in equity markets.
RZ use the accounting standards measure as a
positive signal of the ease with which …rms can
raise external funds, while noting that it is not a
direct measure of external …nancing.
Beck and Levine (2002) con…rm the RZ …ndings
by using alternative measures of …nancial development.
Rajan, Raghuram G. and Zingales, Luigi. “Financial Dependence and Growth.”American Economic Review, June 1998, 88(3), pp. 559-86.
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Benhabib-Spiegel, JOEG 2000
The …rst variable is DEPTH, a proxy for the
size of the formal …nancial intermediary sector,
measured as the ratio of liquid liabilities of the
…nancial sector to GDP.
The second is BANK, the ratio of deposit-money
bank domestic assets to deposit-money bank assets plus central-bank domestic assets. King and
Levine (1993a,1993b) introduce it to emphasize
risk-sharing and information services.
Third variable is PRIV/Y, ratio of claims on
the non…nancial private sector to GDP, indicating
the share of credit funneled through the private
sector.
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FINANCIAL REFORM: FRANK-DODD WALL STREET REFORM AND
CONSUMER PROTECTION ACT, July 21, 2010
HIGHLIGHTS OF THE LEGISLATION
Consumer Protections with Authority and Independence: Creates
a new independent watchdog, housed at the Federal Reserve, with
the authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and
other …nancial products, and protect them from hidden fees, abusive
terms, and deceptive practices.
Ends Too Big to Fail Bailouts: Ends the possibility that taxpayers
will be asked to write a check to bail out …nancial …rms that threaten
the economy by: creating a safe way to liquidate failed …nancial
…rms; imposing tough new capital and leverage requirements that
make it undesirable to get too big; updating the Fed’s authority to
allow system-wide support but no longer prop up individual …rms;
and establishing rigorous standards and supervision to protect the
economy and American consumers, investors and businesses.
Advance Warning System: Creates a council to identify and address systemic risks posed by large, complex companies, products,
and activities before they threaten the stability of the economy.
Transparency & Accountability for Exotic Instruments: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated – including loopholes for over-the-counter
derivatives, asset-backed securities, hedge funds, mortgage brokers
and payday lenders.
Executive Compensation and Corporate Governance: Provides
shareholders with a say on pay and corporate a¤airs with a nonbinding vote on executive compensation and golden parachutes.
Protects Investors: Provides tough new rules for transparency
and accountability for credit rating agencies to protect investors
and businesses.
Enforces Regulations on the Books: Strengthens oversight and
empowers regulators to aggressively pursue …nancial fraud, con‡icts
of interest and manipulation of the system that bene…ts special interests at the expense of American families and businesses.
Volcker Rule: Requires regulators implement regulations for banks,
their a¢ liates and holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity
funds, and to limit relationships with hedge funds and private equity funds. Nonbank …nancial institutions supervised by the Fed
also have restrictions on proprietary trading and hedge fund and
private equity investments. The Council will study and make recommendations on implementation to aid regulators.
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