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Financial Development and Financial Fragility: Two Sides of the Same Coin?

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Abstract

The paper puts forward three interrelated reasons that account for the recent breakdown of the finance–growth nexus, comprising the use (or abuse) of the relationship by policymakers, capture by ruling elites and institutional constraints. Evidence consistent with these hypotheses is provided from a recent European banking crisis. It concludes that in order to restore the ability of finance to promote growth, the influence of ruling elites on the rule of law, financial regulation and supervision needs to be minimized.

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Notes

  1. See, for example, Demetriades and James (2011) and Andrianova et al. (2015a, b, 2017).

  2. See, for example, EBRD (2016).

  3. See, for example, Demetriades et al. (2016).

  4. See, for example, Demetriades and Hussein (1996) or Arestis and Demetriades (1997) who provide evidence that questions results claiming causality from finance to growth in cross-country regressions.

  5. For example, Rioja and Valev (2004).

  6. A simple model that can generate a positive relationship between finance and growth as a reduced form is the AK model presented by Pagano (1993). In that model, the growth rate can be shown to depend on the savings rate and the proportion of saving funnelled to investment by the financial sector (φ). As φ can be influenced by financial sector policies, the relationship can disappear when the wrong types of policies are used.

  7. Evidence that larger banking systems are more prone to crises is provided in recent research by Demetriades et al. (2017), which shows that the ratio of private credit to GDP is among the strongest determinants of the probability of a systemic crisis in a sample of 121 countries over 1999–2011.

  8. By comparison, in 2005 Cyprus occupied the sixth position in this world ranking. The top five countries were Iceland, Japan, USA, Canada and Denmark. Of these, Iceland and USA experienced crises.

  9. It is noteworthy that much of the research promoting the notion that finance in general and big banks in particular promote growth, which became dominant in the literature, was sponsored and largely funded by the World Bank. As such, it could hardly be considered independent.

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Correspondence to Panicos O. Demetriades.

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Andrianova, S., Demetriades, P.O. Financial Development and Financial Fragility: Two Sides of the Same Coin?. Comp Econ Stud 60, 54–68 (2018). https://doi.org/10.1057/s41294-017-0047-z

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