Financial Development (2024)

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Financial development

Financial sector is the set of institutions, instruments, markets, as well as the legal and regulatory framework that permit transactions to be made by extending credit. Fundamentally, financial sector development is about overcoming “costs” incurred in the financial system. This process of reducing the costs of acquiring information, enforcing contracts, and making transactions resulted in the emergence of financial contracts, markets, and intermediaries. Different types and combinations of information, enforcement, and transaction costs in conjunction with different legal, regulatory, and tax systems have motivated distinct financial contracts, markets, and intermediaries across countries and throughout history.

The five key functions of a financial system are: (i) producing information ex ante about possible investments and allocate capital; (ii) monitoring investments and exerting corporate governance after providing finance; (iii) facilitating the trading, diversification, and management of risk; (iv) mobilizing and pooling savings; and (v) easing the exchange of goods and services.

Financial sector development thus occurs when financial instruments, markets, and intermediaries ease the effects of information, enforcement, and transactions costs and therefore do a correspondingly better job at providing the key functions of the financial sector in the economy.

Importance of financial development

A large body of evidence suggests that financial sector development plays a huge role in economic development. It promotes economic growth through capital accumulation and technological progress by increasing the savings rate, mobilizing and pooling savings, producing information about investment, facilitating and encouraging the inflows of foreign capital, as well as optimizing the allocation of capital.

Countries 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: financial development is not simply an outcome of economic growth; it contributes to this growth.

Additionally, it reduces poverty and inequality by broadening access to finance to the poor and vulnerable groups, facilitating risk management by reducing their vulnerability to shocks, and increasing investment and productivity that result in higher income generation.

Financial sector development can help with the growth of small and medium sized enterprises (SMEs) by providing them with access to finance. SMEs are typically labor intensive and create more jobs than do large firms. They play a major role in economic development particularly in emerging economies.
Financial sector development goes beyond just having financial intermediaries and infrastructures in place. It entails having robust policies for regulation and supervision of all the important entities. The global financial crisis underscored the disastrous consequences of weak financial sector policies. The financial crisis has illustrated the potentially disastrous consequences of weak financial sector policies for financial development and their impact on the economic outcomes. Finance matters for development‐‐both when it functions well and when it malfunctions.

The crisis has challenged conventional thinking in financial sector policies and has led to much debate on how best to achieve sustainable development. Reassessing financial sector policies after the crisis in an important step in informing this process. To help achieve this, publications such as the World Bank’s Global Financial Development Report can play a role. Chapter 1 and the Statistical Appendix of the reportpresent data and knowledge on financial development around the world.

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.
In practice, however, it is difficult to measure financial development as it is a vast concept and has several dimensions. Empirical work done so far is usually based on standard quantitative indicators available for a long time series for a broad range of countries. For instance, ratio of financial institutions’ assets to GDP, ratio of liquid liabilities to GDP, and ratio of deposits to GDP.

Nevertheless, as the financial sector of a country comprises a variety of financial institutions, markets, and products, these measures are rough estimation and do not capture all aspects of financial development.
The World Bank’s Global Financial Development Database developed a comprehensive yet relatively simple conceptual 4x2 framework to measure financial development around the world. This framework identifies four sets of proxy variables characterizing a well-functioning financial system: financial depth, access, efficiency, and stability. These four dimensions are then measured for the two major components in the financial sector, namely the financial institutions and financial markets:

Financial InstitutionsFinancial Markets
  • Private Sector Credit to GDP
  • Financial Institutions’ asset to GDP
  • M2 to GDP
  • Deposits to GDP
  • Gross value added of the financial sector to GDP
  • Stock market capitalization and outstanding domestic private debt securities to GDP
  • Private Debt securities to GDP
  • Public Debt Securities to GDP
  • International Debt Securities to GDP
  • Stock Market Capitalization to GDP
  • Stocks traded to GDP
  • Accounts per thousand adults(commercial banks)
  • Branches per 100,000 adults (commercial banks)
  • % of people with a bank account (from user survey)
  • % of firms with line of credit (all firms)
  • % of firms with line of credit (small firms)
  • Percent of market capitalization outside of top 10 largest companies
  • Percent of value traded outside of top 10 traded companies
  • Government bond yields (3 month and 10 years)
  • Ratio of domestic to total debt securities
  • Ratio of private to total debt securities (domestic)
  • Ratio of new corporate bond issues to GDP
  • Net interest margin
  • Lending-deposits spread
  • Non-interest income to total income
  • Overhead costs (% of total assets)
  • Profitability (return on assets, return on equity)
  • Boone indicator (or Herfindahl or H-statistics)
  • Turnover ratio for stock market
  • Price synchronicity (co-movement)
  • Private information trading
  • Price impact
  • Liquidity/transaction costs
  • Quoted bid-ask spread for government bonds
  • Turnover of bonds (private, public) on securities exchange
  • Settlement efficiency
  • Z-score
  • Capital adequacy ratios
  • Asset quality ratios
  • Liquidity ratios
  • Others (net foreign exchange position to capital etc)
  • Volatility (standard deviation / average) of stock price index, sovereign bond index
  • Skewness of the index (stock price, sovereign bond)
  • Vulnerability to earnings manipulation
  • Price/earnings ratio
  • Duration
  • Ratio of short-term to total bonds (domestic, int’l)
  • Correlation with major bond returns (German, US)

Suggested reading:

Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2000. “A New Database on the Structure and Development of the Financial Sector.” World Bank Economic Review 14 (3): 597–605.

Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2010. “Financial Institutions and Markets across Countries and over Time.” World Bank Economic Review 24 (1): 77–92.

Čihák, Martin, Asli Demirgüç-Kunt, Erik Feyen, and Ross Levine. 2012. “Benchmarking Financial Development Around the World.” Policy Research Working Paper 6175, World Bank, Washington, DC.

Demirgüç-Kunt, Asli, and Ross Levine. 2008. “Finance, Financial Sector Policies, and Long- Run Growth.” M. Spence Growth Commission Background Paper 11, World Bank, Washington, DC.

Levine, Ross. 2005. “Finance and Growth: Theory and Evidence.” In Philippe Aghion and Steven Durlauf(eds. ) Handbook of Economic Growth, 865–934.

World Bank. 2012. Global Financial Development Report 2013: Rethinking the Role of the State in Finance. World Bank, Washington, DC (

Financial Development (2024)


What do you mean by financial development? ›

Financial development involves improvements in such functions provided by the financial systems as: (i) pooling of savings; (ii) allocating capital to productive investments; (iii) monitoring those investments; (iv) risk diversification; and (v) exchange of goods and services (Levine, 2005).

How do you measure financial development? ›

Measurement of financial development
  1. Private Sector Credit to GDP.
  2. Financial Institutions' asset to GDP.
  3. M2 to GDP.
  4. Deposits to GDP.
  5. Gross value added of the financial sector to GDP.

What is the financial development of an organization? ›

Financial development means some improvements in producing information about possible investments and allocating capital, monitoring firms and exerting corporate governance, trading, diversification, and management of risk, mobilization and pooling of savings, easing the exchange of goods and services.

What is the meaning of development finance? ›

Development finance is the efforts of local communities to support, encourage and catalyze expansion through public and private investment in physical development, redevelopment and/or business and industry.

What are the components of financial development? ›

Financial development has many dimensions, such as financial depth, financial efficiency, financial structure, financial stability, and financial inclusion (Cihak et al.

What are the financial development factors? ›

1. Introduction. There is a large number of factors that affect financial development: openness, political stability, financial liberalization, national regulatory factor, etc.

What are the 5 financial measures? ›

According to The Harvard Business Review Project Management Handbook: How to Launch, Lead, and Sponsor Successful Projects by past PMI Chair Antonio Nieto-Rodriguez, there are 5 common financial metrics: opportunity costs, payback period, IRR, NPV and ROI. Let's take a look at those.

What is the best measure of financial success? ›

The 6 Best Ways to Measure Your Financial Health
  • Net worth. Your net worth is the value of all your assets minus all your liabilities. ...
  • Savings rate. The portion of your income that you save every month is your savings rate. ...
  • Debt-to-income ratio. ...
  • Credit score. ...
  • Retirement fund. ...
  • Income. ...
  • Putting it all together.
Jul 17, 2021

What are the four measures of financial performance? ›

The four statements that are extensively studied are a company's balance sheet, income statement, cash flow statement, and annual report.

What are the 5 roles of financial markets? ›

The 5 roles of financial markets are ensuring a low cost of transactions and information, ensuring liquidity by providing a mechanism for an investor to sell the financial assets, providing security to dealings in financial assets, and providing facilities for interaction between the investors and the borrowers.

What are development financial institutions in simple words? ›

The development finance institutions or development finance companies are organizations owned by the government or charitable institution to provide funds for low-capital projects or where their borrowers are unable to get it from commercial lenders. Development finance institutions (DFIs) occupy an intermediary space ...

What are the stages of financial development? ›

Six stages of financial development can be distinguished, corresponding to specific overall economic development attributes: (1) Pre-financial, (2) Financial embryogenesis, (3) Traditional monetary, (4) Transitional non-monetary, (5) Take-off financing, (6) Mature financial intermediation, and (7) Decaying financial ...

What is the difference between economic and financial development? ›

As a general social science, the focus of economics is more on the big picture, or general questions about human behavior around the allocation of real resources. The focus of finance is more on the techniques and tools of managing money.

Is the first development financial? ›

IFCI was the first Development Financial Institution of India set up to propel economic growth through development of infrastructure and industry. Since then, IFCI has contributed significantly to the economy through its incessant support to projects in various spheres of growth & development viz.

What is the financial development index measurement? ›

Financial Development index (FD) is a relative ranking of countries on the depth, access, and efficiency of their financial institutions and financial markets.

What is the best way to measure economic development? ›

One of the most common is GDP, which stands for gross domestic product. It is often cited in newspapers, on the television news, and in reports by governments, central banks, and the business community. It has become widely used as a reference point for the health of national and global economies.

How do you measure financial value? ›

To calculate your net worth, you subtract your total liabilities from your total assets. Total assets will include your investments, savings, cash deposits, and any equity that you have in a home, car, or other similar assets. Total liabilities would include any debt, such as student loans and credit card debt.

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