The present section provides an in-depth review of the literature concerning financial development. The literature review is divided into two broad parts, including the discussion of financial development as a concept and the discussion of the financial development index. In the first section, the definition of financial development is provided to describe the complexity of the concept, the importance of studying the matter is stated, and the impact of financial development on the economy and environment is discussed. The first section also includes a comparison of the impact of financial development on the economy in oil-dependent countries and non-oil-dependent countries. The second section is subdivided into a broad discussion of the financial development index and a focused examination of financial market indexes and financial institutions indexes. A summary of findings is provided at the end of the present section.
Financial development has been a matter of increased interest for scholars for more than 30 years. While definitions utilized by various researchers may differ, there is a common idea behind all of them. Financial development can be broadly defined as “the development of financial institutions, financial markets and financial instruments” (Yurtkur, 2019, p. 463). Weili (2021) states that financial development is connected with constant improvement of the financial systems achieved by expansion of financial transactions. Reduction of financial repression, improvement of financial structure, and promotion of innovation in the financial sector are the crucial features of financial development, according to Weili (2021). At the same time, Ibrahim and Alagidede (2018) tie the definition of financial development with the cost incurred by the financial system. The researchers see financial development as the gradual reduction of costs of information acquisition, contracts execution, and transactions making (Ibrahim and Alagidede, 2018). Altay and Topcu (2020) connect the definition of financial development with institutions, instruments, and markets that facilitate the investment process.
One of the most extensive discussions concerning the definition of the concept of financial development was given by Eryılmaz, Bakır, and Mercan (2015). The researchers viewed the concept as the improvement in the dissemination of information concerning the possibility of investments, trading, and management of risks. The researchers also connected financial development with mobilization of savings and easing the exchange of goods and services (Eryılmaz, Bakır, and Mercan, 2015). These improvements are expected to lower the cost of financial institutions and the market’s operations (Eryılmaz, Bakır, and Mercan, 2015). Financial development is facilitated by technological advancements in the sphere (Eryılmaz, Bakır, and Mercan, 2015). In summary, while the definitions of financial development utilized by different researchers vary, they share a common idea that financial development is the process of improvement in functionating of financial institutions and markets that lead to decreased costs of financial services achieved through innovation.
Studying the topic of financial development is crucial, as it is associated with significant benefits. Numerous studies discovered a link between the development of the financial sector and economic development in general (Beck, Demirgüç-Kunt, and Levine, 2010). The reduction of the cost of financial services and improved methods for accumulating and disseminating finance-related information leads to increased utilization of financial services (Eryılmaz, Bakır, and Mercan, 2015). As a result, financial development promotes capital accumulation and technological progress through growing savings, encouragement of inflow of foreign capital, and optimization of capital allocation (Çetin et al., 2015). Research confirmed that there is a causal relationship between financial development and economic growth are causal, meaning that these concepts are not just covariates (Beck, Demirgüç-Kunt, and Levine, 2010). This implies that financial development is not a product of economic growth; instead, it is a predictor. In other words, economic growth is directly affected by manipulations with financial development.
Financial development is also crucial for decreasing poverty. Financial development promotes the improvement of production efficiency through investment in innovation. Jalilian and Kirkpatrick (2002) investigated data from developing countries between 1966 and 2000, and results revealed that the banks’ ability to facilitate transactions has proven to have a positive effect on the reduction of poverty. However, financial development was found to promote financial instability, which may negatively affect the poor (Jalilian and Kirkpatrick, 2002). However, the benefits of financial development for people living below the poverty line outweigh the negative effects (Jalilian and Kirkpatrick, 2002). The relationship between poverty and financial development was found indirect, as economic growth was the mediator between the two variables (Jalilian and Kirkpatrick, 2005). Rewilak (2017) argued that the negative effect of financial development on poverty is not evident. Alternative measures of economic stability demonstrated that financial development had a minor effect on economic stability (Rewilak, 2017). This implies that the primary effect of financial development on poverty is positive, meaning that increased financial development leads to decreased number of people in a country living below the poverty line.
The growth of the financial sector can positively affect the development of small and medium enterprises (SMEs). The major difference between SMEs and larger companies is that SMEs are labor-intensive (Beck, Demirgüç-Kunt, and Levine, 2010). Additionally, SMEs are highly dependable on the availability of relatively cheap credits (Beck, Demirgüç-Kunt, and Levine, 2010). Financial development reduces the cost of financial services, which makes it easier for SMEs to operate and maintain profitability (Ibrahim and Alagidede, 2018). Thus, financial development is crucial for the financial health of SMEs.
In summary, the importance of studying financial development is difficult to underestimate. Knowing the ways to manipulate financial development can positively affect economic development, reduce poverty and support the prosperity of SMEs. However, it should be noticed that financial development goes beyond the facilitation of practices, decreasing costs, and promotion of technological innovation. Having robust financial policies is crucial for a country to be on the way to stable financial development (Beck, Demirgüç-Kunt, and Levine, 2010).
Financial development has a significant impact on different spheres. It has been mentioned previously in the present paper that financial development is often cited as the major predictor of economic development. A large body of evidence has been generated to confirm the link between the two concepts. Greenwood, Sanchez, and Wang (2013) created a costly state verification model of financial intermediation to quantify the impact of effective and efficient financial practices on economic development using data on the development of companies, economy, and financial institutions in the US between 1974 and 2004. The results revealed that financial development might significantly improve the economic growth of developing countries (Greenwood, Sanchez, and Wang, 2013). For instance, countries like Uganda can improve their economic output by 180% (Greenwood, Sanchez, and Wang, 2013). However, such improvement accounts for only 40% of Uganda’s potential output (Greenwood, Sanchez, and Wang, 2013).
Bojanic (2012) also assessed the relationships between financial development and economic growth based on the data from Bolivia. Various quantitative tests revealed a strong causal relationship between indicators of economic growth and financial development and economic growth and trade openness (Bojanic, 2012). Thus, the results of the research suggested long-term interrelations between development, economic growth, and trade openness in Bolivia (Bojanic, 2012). Saud, Chen, and Haseeb (2019) examined the impact of financial development on economic growth and environmental quality. The results were mixed; as on the one hand, financial development had a positive impact on economic growth and environmental quality (Saud, Chen, and Haseeb, 2019). At the same time, economic development increased energy consumption and had a negative effect on environmental quality (Saud, Chen, and Haseeb, 2019). These findings suggest that relationships between financial growth and the environment are complicated.
Shoaib et al. (2020) examined a large sample of data on developing and developed countries to study the effect of financial development on carbon oxide (CO2) emissions. The study revealed strong positive relationships between the two variables, demonstrating that the higher the level of financial development, the higher are the CO2 emissions (Shoaib et al., 2020). The study suggested that while financial development is crucial, it is also central to invest in clean energy projects and promote sustainable development to decrease the environmental impact of financial development (Shoaib et al., 2020). Boutabba (2014) confirmed these findings using the data acquired from India. In particular, Boutabba (2014) concluded that financial development had a significant negative impact on energy consumption and the environmental situation.
However, Jalil and Feridun (2011) demonstrated that carbon emissions are moderated by the level of income, energy consumption, and trade openness, while financial development had a positive impact on the environmental situation. However, since financial development was positively correlated with the level of income, energy consumption, and trade openness, it had a negative on the environment indirectly (Jalil and Feridun, 2011). In summary, while all the studies agree that financial development has a positive impact on the economic development of countries, there is no univocity in the question of its impact on the environment.
Financial Development, Economic Growth, and Oil Dependency
The idea that the effect of financial development on the economy was not homogeneous for all countries is discussed in current literature. Samargandi, Fidrmuc, and Ghosh (2014) examined the effect of financial development on Saudi Arabia as an example of an oil-dependent country. The researchers assessed the effect of financial development on the oil sector and non-oil sectors. The results revealed that financial development had a significant positive impact on non-oil sectors, while the oil sector was negatively or insignificantly affected by the financial development (Samargandi, Fidrmuc, and Ghosh, 2014). Thus, the results demonstrated that resource-dominated economies were affected differently by financial development.
Elhannani, Boussalem, and Benbouziane (2016) studied the effect of financial development on Algeria, an oil-rich economy. The researchers suggested that, in general, oil-dependent countries have low financial development, which makes them extremely volatile (Elhannani, Boussalem, and Benbouziane, 2016). The results of the research demonstrated that Algeria’s efforts to improve its financial development found limited success (Elhannani, Boussalem, and Benbouziane, 2016). In particular, the reforms aimed at improving financial undertaken between 1980 and 2014 had a significant positive impact on economic growth in Algeria (Elhannani, Boussalem, and Benbouziane, 2016). However, financial development could not influence the negative effect of oil rents (Elhannani, Boussalem, and Benbouziane, 2016). Thus, financial development is less impactful on the economic development of oil-dependent countries.
Similar results were received after examining the data from Yemen, another oil-dependent country. Badeeb and Lean (2017) aimed at examining the effect of oil dependence on the relationship between financial development and economic growth. The researchers utilized the ARDL approach for cointegration and the Granger causality test to assess the causal effect of oil dependency on economic growth. The results revealed that oil dependence had a negative impact on economic development (Badeeb and Lean, 2017). In other words, oil dependency diminished the influence of financial development on economic growth.
Nili and Rastad (2007) also noted that oil-dependent countries experienced a gradual fall in GDP per capita despite benefiting from increased investment rates. The authors claimed that the primary reason for the matter was the decreased financial development of these countries (Nili and Rastad, 2007). The problem is that all the investments in oil-dependent countries targeted oil companies instead of financial development (Nili and Rastad, 2007). As a result, the financial institutions in these countries were weak, which served as a barrier to successful economic development (Nili and Rastad, 2007). In other words, investments in resource-rich countries were directed to increasing oil revenues instead of developing the financial sector, which could have improved the efficiency of use funds.
Ilo, Elumah, and Sayanolu (2018) examined the relationship between oil dependency, economic growth, and financial development. The research took into consideration the banking sector and capital market forces between 1981 and 2015. Oil rent was found to have a short-term effect on the development of the banking sector (Ilo, Elumah, and Sayanolu, 2018). At the same time, oil rent was found to have no effect on the development of financial markets (Ilo, Elumah, and Sayanolu, 2018). In other words, additional income earned from selling oil had no effect on financial development.
Such relationships between oil dependency and financial development can be explained by the theory of crowding out effect and the theory of financial repression. The crowding-out effect assumes that when commodity and money markets and money markets are in equilibrium, an increase in government spending can lead to increased interest rates and decrease investments in the private sector (Ilo, Elumah, and Sayanolu, 2018). Beck (2011) explains this from the supply and demand side. On the one hand, the abundance of natural resources provides the opportunity to make significant investments in financial services (Beck, 2011). On the other hand, the Dutch disease can lead to the expansion of consumer credit, which increases interest rates (Beck, 2011).
Financial repression explains the situation in a similar way. High income from oil often leads to increased government spending and expansion of the public sector, increasing the budget deficit in the non-oil sector (Ilo, Elumah, and Sayanolu, 2018). Expansionary fiscal policy leads to increased demand for money, which increases the interest rates (Ilo, Elumah, and Sayanolu, 2018). The government tries to control the interest rates by restricting the banking system, which makes it difficult to receive credit (Ilo, Elumah, and Sayanolu, 2018). Thus, financial repression dominates to overcome the negative effects of expansionary fiscal policy.
Financial Development Index
The financial development index (FDI) is a measure of financial development introduced by the International Monetary Fund (IMF). The index is based upon multiple dimensions to acquire a holistic approach to the matter (Svirydzenka, 2016). FDI is divided into two sub-indexes, including financial institutions and financial markets (Svirydzenka, 2016). FI and FM measurements include three aspects – depth (FID and FMD), access (FIA and FMA), and efficiency (FIE and FME). The multimodal approach is based upon the definition of financial development provided by Čihák et al. (2012), which states that the financial development is a combination of depth (markets’ size and liquidity), access (the ability of individuals and firms to use the financial service freely), and efficiency (the ability to provide financial services at a low cost and remain profitable). The multimodal approach to measuring financial development minimizes possible biases in measurements.
The need for introducing a new FDI index emerged shortly after the financial crisis of 2008. The problem was that the financial crisis emerged in financially developed countries, which posed a question about limitations to financial development (Sahay et al., 2015). Thus, in-depth research was conducted to understand the essence of financial development. The results of the study by Sahay et al. (2015) revealed that emerging markets can still benefit from financial development despite its limitations. At the same time, the study revealed that financial development was bell-shaped, which implied that its effect weakened at higher levels (Sahay et al., 2015). The weakening stemmed from financial deepening rather than efficiency and access (Sahay et al., 2015). Finally, the speed of financial development was also found to be crucial, as a faster pace of financial development often promotes instability in the economic growth (Sahay et al., 2015). A measure that could capture all these nuances to conduct adequate assessments of financial and economic development.
Since the 1970s, before the study conducted by Sahay et al. (2015), financial development was assessed by two measures of financial depth. These measures included the ratio of private credit to GDP and the ratio of stock market capitalization to GDP (Svirydzenka, 2016). While being valuable indexes, these two measures fail to describe the complexity of financial development. Banks are no the only institutions that can provide funds, as insurance companies, mutual funds, pension funds, and venture capital firms can also provide financial services to both private and corporate clients (Svirydzenka, 2016). At the same time, financial markets evolved in such a way that firms can raise money from stocks, bonds, and wholesale money markets (Svirydzenka, 2016). Thus, financial development is a multimodal concept that requires measurement from all sides.
Today, FDI includes information on banks, insurance companies, mutual funds, and pension funds as financial institutions and stock and bond markets as financial markets (Svirydzenka, 2016). The index and all sub-indexes are calculated for 183 countries on an annual basis (Svirydzenka, 2016). The data utilized for calculating the index is acquired from Global Financial Development Database (GFDD), BIS) debt securities database, Dealogic corporate debt database, and IMF Financial Access Survey (Svirydzenka, 2016). Thus, FDI uses diverse data to conduct its calculations.
Financial institutions are measured using a total of 12 subindexes. In particular, FID is measured by four ratios, extending the original total credit to GDP ratio (Svirydzenka, 2016). These ratios include private-sector credit to GDP, pension fund assets to GDP, mutual fund assets to GDP, and insurance premiums (life and non-life) to GDP (Svirydzenka, 2016). Insurance premiums were used as the indicator for assessing insurance companies, as the data was available in a large majority of countries (Svirydzenka, 2016).
Access and efficiency were more bank-specific due to the lack of data on other institutions (Svirydzenka, 2016). In particular, access was measured by the number of bank branches and ATMs per 100,000 adults (Svirydzenka, 2016). Additional measures, including the number of bank accounts per 1,000 adults and the percentage of firms with credit lines, were considered; however, due to the lack of sufficient and reliable data, these measures were dismissed (Svirydzenka, 2016). Thus, the measurements of FIA are somewhat limited.
Efficiency was measured using net interest margin, lending-deposits spread, non-interest income to total income, overhead costs to total assets, return on assets and return on equity. All the data for efficiency measurement was acquired from FinStats 2015 database. Banking system concentration ratios were not included in measurements FIE, as there was no univocity in the scholarly literature about the relationship between concertation of banking and efficiency (Svirydzenka, 2016). However, these ratios may still be useful for assessing the potential impact of major economic disruptions on financial development. Table 1 below demonstrates the data sources for the utilized indexes.
Table 1. Sources for financial institutions measurement (Svirydzenka, 2016)
|Depth||Private-sector credit to GDP||FinStats 2015|
|Pension fund assets to GDP||FinStats 2015|
|Mutual fund assets to GDP||FinStats 2015|
|Insurance premiums, life and non-life to GDP||FinStats 2015|
|Access||Bank branches per 100,000 adults||FinStats 2015|
|ATMs per 100,000 adults||IMF Financial Access Survey|
|Efficiency||Net interest margin||FinStats 2015|
|Lending-deposits spread||FinStats 2015|
|Non-interest income to total income||FinStats 2015|
|Overhead costs to total assets||FinStats 2015|
|Return on assets||FinStats 2015|
|Return on equity||FinStats 2015|
The assessment of financial markets was based on analysis of stock market and debt market development. FMD was measured using five indicators (Svirydzenka, 2016). Stock market to GDP and stock traded to GDP ratios were used to analyze the depth of stock markets. Stock market to GDP ratio was used to evaluate the size of the market, while stock traded to GDP ratio demonstrated the level of activity on the market (Svirydzenka, 2016). International debt securities of government to GDP, total debt securities of financial corporations to GDP, and total debt securities of nonfinancial corporations to GDP were used to assess the depth of debt markets (Svirydzenka, 2016). These indicators were used due to the availability of data (Svirydzenka, 2016).
Market capitalization outside the top 10 largest companies was used to measure. The idea behind the metric was that increased concentration of the stock market would mean excessive difficulties in accessing the stock market (Svirydzenka, 2016). The total number of bond issuers per 100,000 people was used to measure the access to the bond market (Svirydzenka, 2016). The idea behind using this measure was that the increased number of firms that use bonds to finance their development would mean greater availability of bonds for the general population (Svirydzenka, 2016).
FDI measures the efficiency of financial markets by assessing the stock market turnover ratio. This ratio is calculated by dividing total stocks traded by the total capitalization of all the companies in the country (Svirydzenka, 2016). Higher liquidity indicates that there is higher liquidity of financial markets. Moreover, high turnover ratios demonstrate that relative activity on the financial market is high, which signifies their health (Svirydzenka, 2016). Table 2 below shows the sources of data for the assessment of financial markets.
Table 2. Sources of data for assessing financial markets
|Depth||Stock market capitalization to GDP||FinStats 2015|
|Stocks traded to GDP||FinStats 2015|
|International debt securities of government to GDP||BIS debt securities database|
|Total debt securities of financial corporations to GDP||Dealogic corporate debt database|
|Total debt securities of nonfinancial corporations to GDP||Dealogic corporate debt database|
|Access||Percent of market capitalization outside of top 10 largest companies||FinStats 2015|
|Total number of issuers of debt (domestic and external, nonfinancial and financial corporations) per 100,000 people||FinStats 2015|
|Efficiency||Stock market turnover ratio||FinStats 2015|
Limitations of FDI
There are several limitations to FDI that should be acknowledged. The primary limitation of the index is the limitation of available data. For instance, the importance of shadow banks in emerging markets is rising (Sahay et al., 2015). However, there is no reliable data about these banks that can be analyzed (Sahay et al., 2015). Additionally, Svirydzenka (2016) mentions that alternative forms of payments, such as credit transfers, direct debits, and mobile banking, should also be assessed. However, there is no reliable data for these matters.
It is also crucial to emphasize the scope of FDI to understand the caveats on the conceptual side. FDI does not take into consideration the drivers and outcomes of financial systems; instead, it focuses on their characteristics (Svirydzenka, 2016). Second, FDI can overstate the level of financial development, as the measures may reflect government controls (Svirydzenka, 2016). Finally, FDI does not take into consideration the characteristics of every specific country, which may imply that a higher index is not always a good thing (Svirydzenka, 2016). High FDI may mean that the country’s financial sector is stretched beyond structural and regulatory capabilities, which may lead to unfavorable outcomes (Svirydzenka, 2016). In short, IMF does not insist that FDI is a perfect measure for financial development, as the are many improvements to be made in the future.
The literature review demonstrated that the concept of financial development is a matter of increased attention among scholars, policymakers, and practitioners. While financial development can be broadly defined as the development of financial institutions, markets, and instruments, there are many nuances that should be included in the definition. These nuances include depth, access, and efficiency of financial institutions and markets. This definition was used to measure FDI, which is believed to be the most appropriate approach for measuring financial development. The importance of financial development is difficult to overstate, as it positively affects economic development, reduces poverty, and facilitates the development of SMEs. At the same time, financial development may have a negative effect on the environment due to increased energy consumption. The literature review also revealed that oil-dependent countries benefit less from financial development than non-oil-dependent countries. This phenomenon can be explained by the theory of the crowding out effect and the theory of financial repression.
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