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Financial Development and
Economic Growth
Recent research has found that an important reason many developing countries or
ex-communist countries like Russia (which are referred to as transition countries)
experience very low rates of growth is that their financial systems are under-
developed (a situation referred to as financial repression).
1
The economic analysis of
financial structure helps explain how an underdeveloped financial system leads to
a low state of economic development and economic growth.
The financial systems in developing and transition countries face several diffi-
culties that keep them from operating efficiently. As we have seen, two important
tools used to help solve adverse selection and moral hazard problems in credit mar-
kets are collateral and restrictive covenants. In many developing countries, the sys-
tem of property rights (the rule of law, constraints on government expropriation,
absence of corruption) functions poorly, making it hard to use these two tools effec-
tively. In these countries, bankruptcy procedures are often extremely slow and cum-
bersome. For example, in many countries, creditors (holders of debt) must first sue
the defaulting debtor for payment, which can take several years; then, once a favor-
able judgment has been obtained, the creditor has to sue again to obtain title to the
collateral. The process can take in excess of five years, and by the time the lender
acquires the collateral, it may well may have been neglected and thus have little value.
In addition, governments often block lenders from foreclosing on borrowers in polit-
ically powerful sectors such as agriculture. Where the market is unable to use col-
lateral effectively, the adverse selection problem will be worse, because the lender
will need even more information about the quality of the borrower so that it can
screen out a good loan from a bad one. The result is that it will be harder for lenders
to channel funds to borrowers with the most productive investment opportunities.
There will be less productive investment, and hence a slower-growing economy.
Similarly, a poorly developed or corrupt legal system may make it extremely diffi-
cult for lenders to enforce restrictive covenants. Thus, they may have a much more
limited ability to reduce moral hazard on the part of borrowers and so will be less will-
ing to lend. Again the outcome will be less productive investment and a lower growth
rate for the economy. The importance of an effective legal system in promoting eco-
nomic growth suggests that lawyers play a more positive role in the economy than
we give them credit for (see the Mini-Case box, “Should We Kill All the Lawyers?”)
Governments in developing and transition countries often use their financial sys-
tems to direct credit to themselves or to favored sectors of the economy by setting
interest rates at artificially low levels for certain types of loans, by creating devel-
opment finance institutions to make specific types of loans, or by directing existing
institutions to lend to certain entities. As we have seen, private institutions have
an incentive to solve adverse selection and moral hazard problems and lend to bor-
rowers with the most productive investment opportunities. Governments have less
Chapter 7 Why Do Financial Institutions Exist?
153
incentive to do so because they are not driven by the profit motive and thus their
directed credit programs may not channel funds to sectors that will produce high
growth for the economy. The outcome is again likely to result in less efficient invest-
ment and slower growth.
In addition, banks in many developing and transition countries are owned by their
governments. Again, because of the absence of the profit motive, these state-owned
banks have little incentive to allocate their capital to the most productive uses. Not
surprisingly, the primary loan customer of these state-owned banks is often the gov-
ernment, which does not always use the funds wisely for productive investments to
promote growth.
We have seen that government regulation can increase the amount of informa-
tion in financial markets to make them work more efficiently. Many developing and
transition countries have an underdeveloped regulatory apparatus that retards the
provision of adequate information to the marketplace. For example, these countries
often have weak accounting standards, making it very hard to ascertain the quality
of a borrower’s balance sheet. As a result, asymmetric information problems are more
severe, and the financial system is severely hampered in channeling funds to the most
productive uses.
The institutional environment of a poor legal system, weak accounting standards,
inadequate government regulation, and government intervention through directed
credit programs and state ownership of banks all help explain why many countries
stay poor while others, unhindered by these impediments, grow richer.
M I N I - C A S E
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