Financial Institutions

Financial Institutions

Q1: Why financial institutions are necessary in an economy?

The recent economic difficulties in Southeast Asian economies are often linked to the financial sector in these countries. The business and popular press around the world are replete with stories connecting the economic crisis with difficulties in the financial sectors in these economies. The connection between the troubled banking sector and the economic slowdown is especially stressed. Asian economies that have been less impacted by the economic crisis, for example Taiwan, are often characterized as having more stable financial institutions then their neighbors.

Yet this is not the first time “financial difficulties” have been linked with poor macroeconomic performance. More recently the dramatic economic slowdown in the 1980s in the state of Texas in the United States are often linked to the banking and savings and loan crisis that gripped the state at the same time. This raises the question, what is the link between financial institutions and the macroeconomic performance of an economy?

Economists hold dramatically different views regarding this question. From a much earlier time, Bagehot (1873), and Schumpeter (1911) argued that an efficient financial system greatly helped a nation's economy to grow. As Ross Levine has pointed out it was Schumpeter's contention that well-functioning banks spurred technological innovation by offering funding to entrepreneurs that have the best chances of successfully implementing innovative products and production processes.

More recent economists have more skeptical about the role of the financial sector in economic growth. Joan Robinson (1952) asserted that economic growth creates (emphasis added) demand for financial instruments and that where enterprise leads finance follows. Robert Lucas (1988) has also dismissed the finance-economic growth relationship stating that economists “badly over-stress” the role financial factors play in economic growth.

However in recent years thanks to the work of Ross Levine (1997, 1998), Robert King (King and Levine 1993a, 1993b, 1993c) and others (Pagano 1993), economists are again reexamining the role financial markets play in economic growth. On the theoretical side complex models have been developed to illustrate the many channels through which the development of financial markets affect and are affected by economic growth. These channels include the facilitation of trading hedging, diversifying, and pooling of risk; the efficient allocation of resources; the monitoring of managers and exerting corporate control; the mobilization of savings; and the facilitation of the exchange of goods and services.

On the empirical side a growing body of studies at the firm-level, industry-level, country-level and cross-country comparisons have demonstrated the strong link between the financial sector and economic growth. King and Levine's (1993a, 1993b, and 1993c) research has shown that level of financial depth (defined as the ratio of liquid assets to GDP) does in fact help to predict economic growth. Other work by Levine (1997, 1998) has shown that financial intermediary development does positively influence economic growth, these results are shown to be robust, that is the relationships still hold when other factors that are know to influence economic growth are held constant.

In many ways the current research has opened ...