Financial deepening

Financial deepening is a term used often by economic development experts. It refers to

the increased provision of financial services with a wider choice of services geared to all
levels of society.
It also refers to the macro effects of financial deepening on the larger economy. Financial
deepening generally means an increased ratio of money supply to GDP or some price
index. It refers to liquid money. The more liquid money is available in an economy, the
more opportunities exist for continued growth.
It can also play an important role in reducing risk and vulnerability for disadvantaged
groups, and increasing the ability of individuals and households to access basic services
like health and education, thus having a more direct impact on poverty reduction. The
association between economic growth and financial deepening has been a wide-ranging
subject of experiential research. The practical evidence suggests that there is a significant
positive relationship between financial development and economic growth. The question,
therefore, is whether financial deepening causes economic growth or vice versa. It is
found that the relationship between financial development and economic growth in
Indian context using various software, methodology by world noted economists.
Financial Deepening, measured by ratio of gross domestic capital formation to GDP, ratio
of gross domestic savings to GDP. Financial development in India has a stronger role in
the growth process. Government has to intensify the financial sector and carry out crucial
measures to reinforce the long run relationship between financial deepening and
economic growth in order to maintain sustainable economic growth. These measures
embrace more financial integration, minimization of government intervention in the
financial systems, escalating the status of financial institutions, etc. It is recommended
that financial systems need developed financial markets, which may complete its
deepening to affect economic growth optimistically. For financial deepening, not only
multiplicity in financial institutions, but also diversity in financial instruments is
imperative.

Financial Deepening in India

There is a general consensus among economists that financial development spurs
economic growth. Theoretically, financial development creates enabling conditions for
growth through either a supply-leading (financial development spurs growth) or a
demand-following (growth generates demand for financial products) channel. A large
body of empirical research supports the view that development of the financial system
contributes to economic growth (Rajan and Zingales, 2003). Empirical evidence
consistently emphasises the nexus between finance and growth, though the issue of
direction of causality is more difficult to determine. At the cross-country level, evidence
indicates that various measures of financial development (including assets of the financial
intermediaries, liquid liabilities of financial institutions, domestic credit to private sector,
stock and bond market capitalisation) are robustly and positively related to economic

growth (King and Levine, 1993; Levine and Zervos, 1998). Other studies establish a
positive relationship between financial development and growth at the industry level
(Rajan and Zingales, 1998). Even the recent endogenous growth literature, building on
'learning by doing' processes, assigns a special role to finance (Aghion and Hewitt, 1998
and 2005).
A developed financial system broadens access to funds; conversely, in an underdeveloped
financial system, access to funds is limited and people are constrained by the availability
of their own funds and have to resort to high cost informal sources such as money
lenders. Lower the availability of funds and higher their cost, fewer would be the
economic activities that can be financed and hence lower the resulting economic growth.
Some of the recent concerns on financial inclusion have emanated from the results of the
All-India Debt and Investment Survey (AIDIS), 2002. Over a period of 40 years, the
share of non-institutional sources of credit in sources of credit for cultivator households
had declined sharply from about 93 per cent in 1951 to about 30 per cent in 1991, with
the share of money lenders having declined from 69.7 per cent to 17.5 per cent. In 2002,
the AIDIS revealed, however, that the share of money lenders had again increased to 27
per cent, while that of non-institutional sources overall rose to 39 per cent. In other
words, notwithstanding the outreach of banking, the formal credit system has not been
able to adequately penetrate the informal financial markets; rather it seems to have
shrunk in some respects in recent years. Coincidentally, it is also true that the rate of
agricultural growth during the last decade has slowed down and it is particularly striking
in respect of foodgrains production. Since the green revolution, banks have been mainly
focused on financing crop loans connected largely with food grains. There is, therefore,
reason to believe that financial exclusion may actually have increased in the rural areas
over the last 10-15 years.
Some Important Aspects 1. One of the key features of financial deepening is that it
accelerates economic growth through the expansion of access to those who do not have
adequate finance themselves. Typically, in an underdeveloped financial system, it is the
incumbents who have better access to financial services through relationship banking.
Moreover, incumbents also finance their growth through internal resource generation.
Thus, in an underdeveloped financial system, growth is constrained to the expansion
potential of incumbents. In mature financial systems on the other hand, financial
institutions develop appraisal techniques, and information gathering and sharing
mechanisms, which then enable banks to even finance those activities or firms that are at
the margin, thereby leading to their growth-inducing productive activities in addition to
the incumbents. It is this availability of external finance to budding entrepreneurs and
small firms that enables new entry, while also providing competition to incumbents and
consequently encouraging entrepreneurship and productivity. 2. RBI view on Financial
Inclusion plans must be integrated with the normal business plans of the banks. We
believe that banking to the poor is a viable business opportunity but costs and benefit
exercise needs to be attempted by the banks to make financial inclusion congruent with
their business models. Banks must view financial inclusion as a huge business
opportunity and perfect their delivery models.**

Financial Deepening for Macroeconomic Stability and

Sustained Growth
Promoting well-managed financial deepening in low-income countries (LICs) can
enhance resilience and capacity to cope with shocks, improve macroeconomic policy
effectiveness, and support solid and durable inclusive growth. Financial deepening and
macro-stability has been identified as a priority area in the years ahead for the Fund, as
reflected in its Financial Surveillance Strategy paper. Managing Volatility and Supporting
Low-income Country Growth Enhancing macro-economic policy effectiveness Shallow
financial systems limit fiscal, monetary, and exchange rate policy choices; hamper
macroeconomic policy transmission; and impede opportunities for hedging or
diversifying risk. This is of particular concern because LICs are vulnerable to external
shocks, such as sharp swings in commodity prices and fluctuations in external financing.
Limited policy space and instruments to mitigate the ensuing macroeconomic volatility
often translate into large growth and welfare costs for these countries. Fostering inclusive
growth. More varied and accessible financial services also support growth and reduce
poverty and inequality. Financial development enables bigger investments and more
productive allocation of capital, which lead to higher income growth. At the same time,
better and cheaper services for saving money and making payments allow firms and
households to avoid the cost of barter or cash transactions, cut the costs of remitting
funds, and provide the opportunity to accumulate assets and smooth income. Current
State of Play Financial systems in LICs have grown and become more inclusive over the
past two decades, but they still remain relatively small and undiversified (Chart 1).
Encouragingly, although they have much lower levels of financial depth than high- and
middle-income countries, low-income countries are experiencing financial deepening at
rates far faster than higher income countries. But financial deepening will be of low
quality if financial services are available to only a few firms or households. Access to
finance is as pivotal as the depth of the financial system. Here again, there are
encouraging signs, but more could be done.
Challenges for Deepening How far can and should LICs go in promoting financial
deepening? How realistic is it to expect LICs to deepen and diversify their financial
systems to the levels observed in emerging market countries? Structural characteristics of
countries, policy factors, and exogenous influences (e.g., the technology available,
sociopolitical conditions) determine the environment within which financial deepening
may either flourish or stagnate. High fixed costs in financial provision explain why
larger low-income country economies can sustain more diversified financial systems and
why, for instance, small island economies tend to have shallow systems. Similarly, low
national incomes, a high degree of informality, and low population density are factors
that increase the costs and risks for financial institutions. These structural factors work to
exclude large segments of the population from formal financial services and explain why
many LICs have underdeveloped financial systems. A confluence of demand and supply
factors constrains financial deepening in LICs . For example, low mobilization of
deposits, financial illiteracy, and high fees and documentation requirements can limit
financial intermediation. Similarly, for a wide variety of LICs persistent macroeconomic

instability, weak collateral regimes, limited completion, and regulatory restrictions often
act as barriers to the deepening and diversifying of their financial systems.
These impediments not only affect macro-financial stability but also reduce the growth
dividends from deepening. At the same time, unsustainable expansion of financial
systems can pose risks for stability. Weak and limited supervisory and regulatory
frameworks and capacity, deficient early warning and resolution systems, and governance
problems in LICs increase the risks of such fragility. The considerable heterogeneity
among LICs, however, suggests that there is no "one-size-fits-all" solution. Different
areas and approaches may be needed to promote financial deepening generally. Policies
Matter Cross-country experiences in emerging market and low-income countries suggest
that targeted and balanced initiatives to encourage competition, put in place information
and market infrastructure, address collateral issues, limit excessively intrusive public
sector interventions and dominance, maintain macroeconomic stability, and exercise
appropriate macro-prudential oversight to avoid creating new sources of instability can
help overcome specific impediments to increasing the depth, breadth, and inclusion of
financial systems.***

References

Shaw, Edward (1973). Financial Deepening in Economic Development. Oxford

University Press.
o http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=310
https://www.imf.org/external/np/res/dfidimf/topic5.htm

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