Theoretical
Underpinning
There
is ample theoretical evidence reinforced by a number of empirical works, which supports a positive relationship between
financial sector development and growth. Principally, the financial system
functions to mobilize and channel financial resources through institutions or
intermediaries from surplus economic units to deficit units. A well-developed
financial system enhances investment by identifying and funding good business
opportunities, mobilizing savings, enabling trading, hedging and diversifying
risk, and facilitating the exchange of goods and services.
These functions result in a more efficient allocation of resources, rapid accumulation
of physical and human capital, and faster technological progress, which in turn
result in economic growth and, by extension, the development of the real
sector.
An efficient financial system is one of the foundations for building sustained
economic growth and an open, vibrant economic system. In the early neoclassical
growth literature, financial services were thought to play only a passive
role of merely channeling household savings to investors. However, many later
studies have been associated with more positive roles for the financial sector.
Schumpeter (1912) in his theoretical link between financial development and economic
growth opines that the services provided by financial intermediaries are the
essential drivers for innovation and growth. His argument was later formalized
by McKinnon (1973) and Shaw (1973), and popularized by Fry (1988) and Pagano
(1993). The McKinnon-Shaw paradigm postulates that government restrictions on
the operations of the financial system, such as interest rate ceiling, direct
credit programs and high reserve requirements may hinder financial deepening,
and this may in turn affect the quality and quantity of investments and, hence,
have a significant negative impact on economic growth.
Therefore, the
McKinnon-Shaw financial repression paradigm implies that a poorly functioning
financial system may retard economic growth. The endogenous growth literature
also supports this argument that financial development has a positive impact on
the steady-state growth (Bencivenga and Smith, 1991; Bencivenga, et al., 1995;
and Greenwood and Jovanovic, 1990, among others). Well-functioning financial
systems are able to mobilize household 34 Central Bank of Nigeria Economic
and Financial Review December 2010 savings, allocate resources efficiently,
diversify risks, induce liquidity, reduce information and transaction costs and
provide an alternative to raising funds through individual savings and retained
earnings. These functions suggest that financial development has a positive
impact on growth. McKinnon (1973) and Shaw (1973) are the most influential
works that underpin this hypothesis and suggest that better functioning
financial systems lead to more robust economic growth. McKinnon (1973)
considered an outside money model in which all firms are confined to
self-finance.
Hence, physical capital has a lumpy nature where firms must
accumulate sufficient savings in the form of monetary assets to finance the
investment projects. In this sense, money and capital are viewed as complementary
assets where money serves as the channel for capital formation ‗complementarity
hypothesis‘. The ‗debt-intermediation‘ view proposed by Shaw (1973) is based on
an inside money model. He argues that high interest rates are essential in
attracting more savings. With more supply of credit, financial intermediaries
promote investment and
raise output growth through borrowing and lending.
Also, King and Levine(1993a) find that higher levels of financial development are associated with faster economic growth and conclude that finance seems to lead growth. Neusser and Kugler (1998) and Choe and Moosa (1999) reach the same conclusion. More specifically, the roles of stock markets and banks have been extensively discussed in both theoretical and empirical studies (See Levine (2003) for a survey of the literature). The key findings of studies are that countries with well developed financial institutions tend to grow faster; particularly the size of the banking system and the liquidity of the stock markets tend to have strong positive impact on economic growth.
Also, King and Levine(1993a) find that higher levels of financial development are associated with faster economic growth and conclude that finance seems to lead growth. Neusser and Kugler (1998) and Choe and Moosa (1999) reach the same conclusion. More specifically, the roles of stock markets and banks have been extensively discussed in both theoretical and empirical studies (See Levine (2003) for a survey of the literature). The key findings of studies are that countries with well developed financial institutions tend to grow faster; particularly the size of the banking system and the liquidity of the stock markets tend to have strong positive impact on economic growth.