Abstract
This paper presents empirical support for the existence of wealth effects in the contribution of financial intermediation to economic growth, and offers a theoretical explanation for these effects. Using GMM dynamic panel data techniques applied to study the growth-promoting effects of financial intermediation, we show that the exogenous contribution of financial development on economic growth has different effects for different levels of income per capita. We find that this contribution is generally increasing with the level of income per capita of the economy, up to a relatively high level of income. This contribution is consistently lower for poor countries; and for some low levels of income per capita it can be negative. We provide a model to account for these wealth effects. The model is a overlapping generations growth model where financial intermediaries implement liquidity risk sharing among depositors. We show that at early stages of economic development, a bank can increase welfare of its depositors only at the cost of lowering investment and growth. However, once the economy has crossed certain wealth threshold, the liquidity role of banks becomes unambiguously growth enhancing. As wealth increases, banks offer improving liquidity insurance, and higher growth; however, for high levels of wealth, growth generated by financial intermediation declines as the economy attains the optimal level of consumption risk sharing.
The central empirical finding of the paper is that the effect of financial development on growth depends in a non linear way on the level of income of countries. This effect varies from negative in low-income countries to positive above a certain wealth threshold; it reaches a maximum among middle-income countries before declining for richer countries. This result is robust to the inclusion of fixed effects and to the control for the growth costs associated with banking crises episodes.
We provide a theoretical explanation for this finding that relies on the growth consequences of the liquidity risk-sharing provided by financial intermediaries at different level of income in a neo-classical context. When countries are poor and returns to long term projects high, even when liquidated, banks perform risk-sharing among agents by increasing the share of long term projects. Risk-sharing implies then lower growth. This result is similar to the growth depressing effect of a reduction in precautionary saving in models with incomplete markets (e.g. Ayagari (2000)). When countries become richer and returns are lower, it becomes optimal for banks to increase risk sharing by using liquid investments to finance early consumption needs. Then risk-sharing implies lower liquidation, higher long term investment and higher growth. In growth accounting terms, the reduction of liquidation corresponds to an increase in total factor productivity that result from bank’s efficient match between the liquidity needs and preferences of agents and the timing of the highest returns of the technologies.
Because financial autarky is also equivalent to a monopolistic banking system and financial intermediation to a fully competitive banking system, our results provide elements in the debate on the optimal timing of domestic financial liberalization. In particular, poor economies could benefit to wait before fully liberalizing their banking sectors.
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