Impact of Banking and Finance on Growth: Theoretical and Empirical Arguments

This paper explores the theoretical and empirical arguments through which finance affects growth. It compiles findings and views of relevant studies on how banks contribute to economic growth.

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Impact of banking and finance on growth
ECONOMICS ASSIGNMENT
WHAT ARE THEORETICAL AND/OR EMPIRICAL
ARGUMENTS THROUGH WHICH FINANCE AFFECTS
GROWTH?

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Impact of banking and finance on growth
Table of contents
Introduction ................................................................................................................................ 3
Literature review ........................................................................................................................ 3
Conclusion ................................................................................................................................. 6
Reference ................................................................................................................................... 8

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Impact of banking and finance on growth
Introduction
The financial sector of any economy is the most important sector when it comes to the
contribution towards the growth. The financial sector is the custodian of the wealth of an
economy and it fosters the economic development and the growth. The distribution of funds
among different commercial and non-commercial entities of the economy is done by the
banks. Apart from that, the specialised financial services of the bank make its value itself as
well. The basic question of the research is,
 What are theoretical and/or empirical arguments through which finance affects
growth?
This paper takes the subtopic of how banks contribute to economic growth and compile the
findings and views of other relevant studies done on the same topic.
Literature review
How important are banks for development? National banks in the United States 1870–
1900
This study presented by Fulford (2015) focuses on the empirical study on the importance of
the bank using the data from 1870- 1900. The main objective of the study is to focus on the
basics of banking considering a simple economy that it was back in the time for which the
study has been carried out. The study shows that financial regulation has been a crucial tool
used by the government since the historical days. Therefore, the banks and their contribution
were important in the economies as early as 1870. Apart from that, since this time, the
government have been using the services of the public banks to redistribute the wealth of the
nation. Feldenkirchen (2017) pointed out that, bank reaches to the core of economic system
providing the government a better reach. This study also highlights that banking expansion in
the US during this time has been one of the reasons for the economic growth and the
development in this area. The banks helped in the flow of funds and internal trade between
the states of the US.
The study collected the sample of the national banks between the years 1870 and 1900 along
with the details of each of the banks including the balance sheet and the amount of money
that each of the banks issued to the public. The study found out that the national banks helped
the marginal states of USA with an increase of 10% in the GDP. Fund distribution and
allocation have positively impacted the growth through the farming and the manufacturing

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Impact of banking and finance on growth
sector of the country during the selected years (Akyol, Tatoğlu & Ustaoğlu, 2017). The
introductions of short-term loans during this time by the national banks of the US also
contributed to the increased aggregate demand and economic transaction.
Impact of commercial banking sector development on economic growth in small Pacific
countries: A case study of the Vanuatu economy
This study carried out by Ragonmal (2016) considers the case of the Vanuatu Economy to
observe the importance of banking in the economy. This study takes the data from 1983 to
2013 for the Vanuatu Economy to study the contribution of the financial sector in the growth
and the development of the economy. The analysis makes use of the tools such as the unit
root test, cointegration check, and the granger non-causality test. The short run and the long
run relationships of the financial sector of the Vanuatu Economy has also been observed
using the Vector Error Correction Model as well. This study finds out that, the economy of
Vanuatu has responded to the expansion and impressive performance of the financial sector.
The monetary policy transmission has also been found to be weak corresponding to
premature money market of the economy. The result of the causality test finds out that the
short run contribution to the economy is done though the financial intermediaries while in the
long run, the contribution takes the channel of private sector credit.
The study shows the evidence that the size of the financial sector and the deepening is
interrelated. This deepened financial sector further fosters the private sector credit leading to
a higher economic transaction and hence the growth (Cecchetti & Kharroubi, 2015). The size
of the financial sector and the economic growth increased hand in hand since the year 1983
for the Vanuatu Economy which suggests that banking and other financial sectors had a
significant contribution towards the economic expansion and the growth. However, the study
also sheds light on the negative impacts of the interest rate spread as it was detrimental to the
economic performance of the island. The spread increases the borrowing keeping the lending
unchanged leading to instability of the sector.
The Financial Sector and The Role Of Banks In Economic Development
Drigă & Dura (2014) in their study furnishes the role of the banking system in the economy
and the main functions that are important for growth and development. The study states that
mobilisation of capital and money to the appropriate and efficient economic activities is
ensured by the functions of the banks. According to the analysis of the paper, the financial
market creates a channel between the entities that have money and the entities that have
productive resources to make use of that money more efficiently. This adequate allocation is

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Impact of banking and finance on growth
done by the financial system which maximises the capabilities of the economies. Zirek,
Celebi & Hassan (2016) noted that the movement of funds between the borrower and lender
is drastically lowered by the banking system that positively influences the economic
performance of an economy.
The finding of this paper highlights that banks work like a mirror to the development of the
economy. According to the paper, the banking sector contributes to the economy in two
different ways, either directly or indirectly. The banks influence the economic activity
directly by expanding the balance sheet of the businesses in the economy. Apart from that
through financing and loans, the banks also provide necessary funds for the operation of the
different economic activities that further contribute to the economic growth. Further, the
study finds out that while the well performing banks can be important for the economic
growth, the banks that do not perform properly can be an obstacle in the path of growth and
the development of the economy (Young, 2015). This paper also explores the importance of
banking through the study of Romanian economy after the banking sector of the countries
failed drastically following the global economic crisis of the year 2008. Thus, the study
concludes that the banking and financial sectors are the backbone to an economy and hence
have the capability to control the performance of all the sectors of the economy together.
Role of Commercial Banks in the Economic Development of India
This study by Saini & Sindhu (2014) depicts the process of the contribution of banks towards
economic growth taking the context of India. The banks have a crucial role in stimulating the
demand for the deposited money which can be utilised in a productive sector. The study finds
out that most of the banks of India follow the norms of Basel III that allows them to mobilise
the capital in the most effective way. Apart from that, the banks also help in maintaining a
balance between availabilities and requirements through adequate physical resources.
Another advantage of the banking sector is that it diversifies the investment and the idle
deposits of the country to different sectors such as agriculture, manufacturing and many
more. Given the vast size of the agricultural sector, this diversification not only expands
economic activities but also helps in job creation in the case of the Indian economy.
Historically, India suffered from expensive credit and the irregularities in the unorganised
financial market of India. With the expansion of the public banks in rural areas of the country
the credit availability to the tillers and the self help groups have increased. These have
boosted the rural economy which further added to the national economy of India. Apart from

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Impact of banking and finance on growth
that, the banks in India also helped in the abolishment of the intermediaries in the financial
sector that reduced the cost of mobilisation of capital within the country. It is important to
note that, banks in India have contributed to the economy mainly through rural areas and the
agricultural sector. Easy and convenient credit available to the tillers has increased
agricultural production by 26% in the last 40 years (Hou & Cheng, 2017). This increased
productivity has positively contributed to the economic expansion of the economy of India
given the fact that agriculture accounts for 18% of the overall GDP of the country. However,
the study also finds out that banks have a lot of potential gaps to fill through investment in the
irrigation which has not received much support as of now.
Linking Banks and Strong Economic Growth
Harper (2011) established the causality between the health of the banking sector and the
health of the Australian economy. The study aims to answer how the functions of banks help
in the achievement economic goals of a country. The study furnishes that, economic growth
can be achieved mainly through two ways, extensive way of using resources and intensive
way of using resources. The banks have a crucial role in both the process of the economy as it
diversifies the capital among different sectors of the economy. Apart from that, it also
measures the availability and the requirements of capital in different sectors as well.
The study finds out that health of the banking and the financial sector is important for its
effective contribution towards the economic growth and the development of the country. It
states that the main objective of making an economy grow is to realise productivity gains on
the resources that are either extensively or intensively used in the production process of the
economy. It also shows that, during the year 1990, the country experienced a high
productivity growth owing to the above the average performance of the banking and the
financial sector of the Australian economy. The recent deterioration of the banking sector
compared to the level of 1990 due to the financial crisis also have impacted on the economy
in the form of slow economic growth and development (Cojocaru et al. 2016). The
inappropriate banking performance also reduced the potentiality of the country to rip benefits
from the mining boom as well. Therefore, the banking sector plays an important role in the
growth and development of the economy.
Conclusion
This literature review compiles the findings and analysis of previous studies on the chosen
topic. While Fulford (2015) has shown the importance of banking in a basic economic

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Impact of banking and finance on growth
framework, Ragonmal (2016) furnishes how the banks contribute to a small economy of an
island. Drigă & Dura (2014) finds out that, banking creates a channel that fosters the growth
and Saini & Sindhu (2014) shows how banks work in the economic scenario of India. Lastly,
Harper (2011) states that the health of the bank reflects the health of the economy as it helps
in increasing productivity gains.

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Impact of banking and finance on growth
Reference
Akyol, M., Tatoğlu, F. Y., & Ustaoğlu, M. (2017). Financing Economic Growth by Dual
Banking in Malaysia: Empirical Evidence. In Balancing Islamic and Conventional
Banking for Economic Growth (pp. 69-84). Palgrave Macmillan, Cham.
Cecchetti, S. G., & Kharroubi, E. (2015). Why does financial sector growth crowd out real
economic growth?.
Cojocaru, L., Falaris, E. M., Hoffman, S. D., & Miller, J. B. (2016). Financial system
development and economic growth in transition economies: New empirical evidence
from the CEE and CIS countries. Emerging Markets Finance and Trade, 52(1), 223-
236.
Drigă, I., & Dura, C. (2014). The financial sector and the role of banks in economic
development. In 6th International Multidisciplinary Symposium “Universitaria
SIMPRO (pp. 10-11).
Feldenkirchen, W. (2017). Banking and Economic Growth: Banks and Industry in Germany
in the Nineteenth Century and their Changing Relationship During Industrialisation.
In German industry and German industrialisation (pp. 116-147). Routledge.
Fulford, S. L. (2015). How important are banks for development? National banks in the
United States, 1870–1900. Review of Economics and Statistics, 97(5), 921-938.
Harper, B. (2011). Linking Banks and Strong Economic Growth. Australian Bankers
Association Occassional Paper.
Hou, H., & Cheng, S. Y. (2017). The dynamic effects of banking, life insurance, and stock
markets on economic growth. Japan and the world economy, 41, 87-98.
Ragonmal, L. (2016). Impact of commercial banking sector development on economic
growth in small Pacific countries: a case study of the Vanuatu economy (Doctoral
dissertation, Lincoln University).
Saini, P., & Sindhu, J. (2014). Role of Commercial Bank in the Economic Development of
India. International Journal of Engineering and Management Research, 4(1), 27-31.

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Impact of banking and finance on growth
Young, N. (2015). Formal banking and economic growth: Evidence from a regression
discontinuity analysis in India. Working Paper, Boston University, April.
Zirek, D., Celebi, F., & Hassan, M. K. (2016). The Islamic Banking and Economic Growth
Nexus: A Panel VAR Analysis for Organization of Islamic Cooperation (OIC)
Countries. Journal of Economic Cooperation & Development, 37(1).