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Name: Olufisayo Babalola

Matric Number: 169025002

Course: Fin 913

Question: Discuss the Indices of Financial Development


1.0 The Concept of Financial Development and Its Importance

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.

1.1 Concept of Financial Development

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,

curtailing economic development and retarding improvements in living standards.

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

effects on economic development.


At the most basic, conceptual level, therefore, financial development occurs when financial

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

system to the overall economy.


1.2 Financial Development and Economic Growth

Economists have long debated the role of the financial sector in economic growth. Lucas (1988),

for example, dismissed finance as an over-stressed determinant of economic growth. Robinson

(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

understanding of economic growth.

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-

Kunt and Levine 2008).

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.

1.3 Measurement of financial development

A good measurement of financial development is crucial to assess the development of the

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

Source: World Bank

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

some countries these claims include credit to public enterprises.


Figure 2: Nigeria Domestic Credit to the private sector

Source: World Bank

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

channelling savings to investment, monitoring firms, influencing corporate governance and

undertaking risk management relative to the central bank.

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

percent in 2009 (Figure 3).


Figure 3: Nigeria Financial system deposits, percent of GDP

Source: World Bank

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

2007 (figure 4).

Figure 4: Nigeria Stock market capitalization, percent of GDP

Source: Word Bank


The Sixth, Currency outside Banking System to Base Money is an indicator of monetization of

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

(Schneider and Ernste, 2000).

Figure 5: Financial System Size Indicators Median Values by Income Group in 2007

Source: World Bank


Figure 6: Financial System Size Indicators Median Values over Time (1980-2007)

Source: World Bank

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)

Source: World Bank

Figure 9: Net Interest Margin - Median Values by Income Group over Time (1995-2007)

Source: World Bank