Financial liberalization, financial development and economic growth in LDCs

Abstract The objective of this paper is to survey what is actually known about the finance–growth relationship based on theory and empirical work. We point out that traditional theoretical models linking financial development and economic growth do not pay sufficient attention to insights emerging from modern information economics. Markets with asymmetric information are not in general constrained Pareto efficient; and increased banking sector competition, following financial liberalization, will not necessarily induce efficient financial intermediation. Increased competition is likely to erode franchise values, which may, in turn, generate an unstable banking environment where gambling behaviour on the part of the banks is prevalent. Increased competition can also discourage relationship‐banking, and it disturbs what may actually be a constrained efficient mode of contracting in a dynamic setting characterized by asymmetric information. We argue that these problems are further aggravated by the massive task of building an appropriate institutional and regulatory framework designed to effectively curb imprudent bank behaviour. Turning to the empirical evidence, it is shown that the alledged first‐order effect whereby financial development causes growth is not adequately supported by econometric work. The empirical evidence on the finance–growth nexus does not yield any clear‐cut picture. By way of conclusion, we question whether financial development, in the sense of increased formal financial sector intermediation in a deregulated environment can be expected to act as ‘engine of growth’ in the development process; and we argue in favour of a more cautious approach to financial sector reform. © 2016 The Authors. Journal of International Development published by John Wiley & Sons, Ltd.