There has been a considerable debate among economists on the role of financial development in
economic growth and poverty reduction, but the balance of theoretical reasoning and empirical
evidence points towards a central role of finance in socio-economic development. Economies with
higher levels of financial development grow faster and experience faster reductions in poverty
levels. This section introduces the concept of financial development and provides a brief review of
the literature on the linkages between financial development, economic growth, and poverty
reduction.
Markets are imperfect. It is costly to acquire and process information about potential investments.
There are costs and uncertainties associated with writing, interpreting, and enforcing contracts.
And, there are costs associated with transacting goods, services, and financial instruments. These
market imperfections inhibit the flow of society's savings to those with the best ideas and projects,
It is the existence of these coststhese market imperfectionsthat creates incentives for the
emergence of financial contracts, markets and intermediaries. Motivated by profits, people create
financial products and institutions to ameliorate the effects of these market imperfections. And,
governments often provide an array of servicesranging from legal and accounting systems to
government owned bankswith the stated goals of reducing these imperfections and enhancing
resource allocation. Some economies are comparatively successful at developing financial systems
that reduce these costs. Other economies are considerably less successful, with potentially large
instruments, markets, and intermediaries mitigate - though do not necessarily eliminate - the effects
of imperfect information, limited enforcement, and transactions costs. For example, the creation of
credit registries tended to improve acquisition and dissemination of information about potential
borrowers, improving the allocation of resources with positive effects on economic development.
As another example, economies with effective legal and regulatory systems have facilitated the
development of equity and bond markets that allow investors to hold more diversified portfolio
than they could without efficient securities markets. This greater risk diversification can facilitate
the flow of capital to higher return projects, boosting growth and enhancing living standards.
Defining financial development in terms of the degree to which the financial system eases market
imperfections, however, is too narrow and does not provide much information on the actual
functions provided by the financial system to the overall economy. Thus, Levine (1997 2005) and
others have development broader definitions that focus on what the financial system actually does.
At a broader level, financial development can be defined as improvements in the quality of five key
financial functions: (a) producing and processing information about possible investments and
allocating capital based on these assessments; (b) monitoring individuals and firms and exerting
corporate governance after allocating capital; (c) facilitating the trading, diversification, and
management of risk; (d) mobilizing and pooling savings; and (e) easing the exchange of goods,
services, and financial instruments. Financial institutions and markets around the world differ
markedly in how well they provide these key services. Although this paper sometimes focuses on
the role of the financial systems in reducing information, contracting, and transactions costs, it
primarily adopts a broader view of finance and stresses the key functions provided by the financial
Economists have long debated the role of the financial sector in economic growth. Lucas (1988),
(1952, p. 86) quipped that "where enterprise leads finance follows." From this perspective, finance
responds to demands from the non-financial sector; it does not cause economic growth. At the other
extreme, Miller (1988, p.14) argued that the idea that financial markets contribute to economic
growth "is a proposition too obvious for serious discussion." Bagehot (1873) and others rejected
the idea that the finance-growth nexus can be safely ignored without substantially limiting the
Recent literature reviews (e.g., Levine 2005) conclude that the preponderance of evidence suggests
a positive, first-order relationship between financial development and economic growth. In other
words, well-functioning financial systems play an independent role in promoting long- run
economic growth: economies with better-developed financial systems tend to grow faster over long
periods of time, and a large body of evidence suggests that this effect is causal (e.g., Demirgu9-
Moreover, research sheds light on the mechanisms through which finance affects growththe
financial system influences growth primarily by affecting the allocation of society's savings, not
by affecting the aggregate savings rate. Thus, when financial systems do a good job of
identifying and funding those firms with the best prospects, not those firms simply with the
strongest political connections, this improves the capital allocation and fosters economic
growth. Such financial systems promote the entry of new, promising firms and force the exit of
less efficient enterprises. Such financial systems also expand economic opportunities, so that the
allocation of creditand hence opportunityis less closely tied to accumulated wealth and
more closely connected to the social value of the project. Furthermore, by improving the
governance of firms, well-functioning financial markets and institutions reduce waste and fraud,
boosting the efficient use of scarce resources. By facilitating risk management, financial
systems can ease the financing of higher return endeavours with positive reverberations on
living standards. And, by pooling society's savings, financial systems make it possible to exploit
economies of scale getting the biggest development bang for available resources.
financial sector and understand the impact of financial development on economic growth and
poverty reduction.
The first measure, Liquid Liabilities (LLY), is one of the major indicators used to measure the
size, relative to the economy, of financial intermediaries, including three types of financial
institutions: the central bank, deposit money banks and other financial institutions. It is calcu-
lated as the liquid liabilities of banks and non-bank financial intermediaries (currency plus
demand and interest-bearing liabilities) over GDP. Liquid liabilities are also known as broad
money, or M3. They Include bank deposits of generally less than one year phis currency. Liquid
liabilities are the sum of currency and deposits in the central bank (MO), plus transferable
deposits and electronic currency (Ml), plus time and savings deposits, foreign currency
transferable deposits, certificates of deposit, and securities repurchase agreements (M2), plus
travellers checks, foreign currency time deposits, commercial paper, and shares of mutual funds
or market funds held by residents. The ratio of "quid liabilities to GDP indicates the relative size
of these readily available forms of moneymoney that the owners can use to buy goods and
services without incurring any cost. The average value for Nigeria during that period was 20.1
percent with a minimum of 9.32 percent in 1970 and a maximum of 39.69 percent in 2009
(figure 1).
Figure 1: Nigeria Liquid Liabilities to GDP
The second indicator, Private Credit (PRIVO), is defined as the credit issued to the private sector
by banks and other financial intermediaries divided by GDP, excluding credit issued to
government, government agencies and public enterprises, as well as the credit issued by the mon-
etary authority and development banks. It measures general financial intermediary activities
provided to the private sector. Domestic credit to private sector (% of GDP) in Nigeria was 14.21
in 2015 (figure 2), according to the World Bank. Domestic credit to private sector refers to
financial resources provided to the private sector, such as through loans, purchases of non-equity
securities, and trade credits and other accounts receivable, that establish a claim for repayment. For
The third, Commercial-Central Bank (BTOT), is the ratio of commercial bank assets to the sum
of commercial bank and central bank assets. It proxies the advantage of financial intermediaries in
The Fourth, Financial Systems Deposits to GDP is the ratio of all checking, savings and time
deposits in banks and bank-like financial institutions to economic activity and is a stock indicator
of deposit resources available to the financial sector for its lending activities. The International
Monetary Fund provides data for Nigeria from 1960 to 2014. The average value for Nigeria during
that period was 14.14 percent with a minimum of 5.67 percent in 1960 and a maximum of 34.66
The Fifth, Stock Market Capitalization to GDP, which equals the value of listed shares divided
by GDP. It indicates the size of the stock market relative to the size of the economy. The World
Bank provides data for Nigeria from 1993 to 2015. The average value for Nigeria during that
period was 19.96 percent with a minimum of 4.02 percent in 2002 and a maximum of 51 percent in
the economy, as it shows which share of base money is not held in the form of deposits with the
banking system. Not surprisingly, low-income countries had the highest ratio of Currency outside
Banking System to Base Money with a median of 39% in 2007, while upper-middle income
countries had the lowest ratio, with a median of 26% (Figure 5). The ratio has decreased over the
past decades, from 40% in 1980 to 30% in 2007 (Figure 6). The level and change in currency
outside the banking sector is often used as basis for estimations of the size of the informal sector
Figure 5: Financial System Size Indicators Median Values by Income Group in 2007
The Seventh, Private Bond Market Capitalization to GDP, which equals the total amount of
outstanding domestic debt securities issued by private or public domestic entities divided by GDP.
Given the limited underlying raw data, this indicator is available only for 42 countries and since
1990. This indicator varies positively with the level of economic development and has steadily
increased over the past two decades, from a median of 14% in 1990 to 29% in 2007. Both high-
and middle-income countries have seen deepening of private bond markets; unfortunately, we do
not have data available for low-income countries (Beck, Fuchs and Uy, 2009).
Next are four efficiency measures for the banking sector. First, Bank Credit to Bank Deposits is
the ratio of claims on the private sector to deposits in deposit money banks. It thus gauges the
extent to which banks intermediate society's savings into private sector credits. It shows a large
variation in 2007 between 21% in Congo and 307% in Denmark. It increases not only with the
level of economic development (Figure 8) but also with the level of financial development.
Financially less developed countries thus do not only attract relatively less deposits into banks, but
also intermediate a smaller share of these deposits into private sector credits. While a high loan-
deposit ratio indicates high intermediation efficiency, a ratio significantly above one also suggests
that private sector lending is funded with non-deposit sources, which could result in funding
instability as currently experienced by many banks and countries in Central and Eastern Europe.
Second, the net interest margin equals the accounting value of a bank's net interest revenue as a
share of its total earning assets, while overhead cost equals the accounting value of a bank's
overhead costs as share of its total assets. Higher levels of net interest margins and overhead costs
indicate lower levels of banking efficiency, as banks incur higher costs and there is a higher wedge
between lending and deposit interest rates. Poorer countries have typically higher net interest
margins and overhead costs (Figure 7). Net interest margins have shown a decreasing trend over
time in the median country, from 4.4% in 1995 to 3.1% in 2007, while overhead costs first
increased then rapidly decreased after 2002 (Figure 8). There are different patterns across different
income groups; while net interest margins have been low and relatively stable in high-income
countries, with somewhat of a slight decrease in the last years, there has been a significant
downward trend in net interest margins in upper-middle countries. Net interest margins in the
median low and lower-middle income countries, on the other hand, have shown a decreasing trend
only in recent years (Figure 9). Overhead costs have shown a decreasing trend across all income
groups.
The final indicator of banking efficiency is the cost-income ratio that measures the overhead costs
relative to gross revenues, with higher ratios thus indicating lower levels of cost efficiency. As in
the case of net interest margins and overhead costs, data on cost-income ratios are based on bank-
level data. Banks in richer countries have typically lower cost-income ratios (Figure 8). There has
not been much change in the cost-income ratio over time (Figure 8).
Figure 7: Financial Intermediation Efficiency Indicators Median Values by Income Group in
2007
Figure 8: Financial Intermediation Efficiency Indicators Median Values over Time (1995-
2007)
Figure 9: Net Interest Margin - Median Values by Income Group over Time (1995-2007)