Financial Sector Development, Economic Growth, and Poverty Reduction: A Literature Review

46 Pages Posted: 31 May 2010

See all articles by Juzhong Zhuang

Juzhong Zhuang

Asian Development Bank

Herath M. Gunatilake

University of Peradeniya; Asian Development Bank

Yoko Niimi

Asian Growth Research Institute

Muhammad Ehsan Khan

Binghamton University

Yi Jiang

Asian Development Bank

Rana Hasan

Asian Development Bank; University of Maryland - Department of Economics

Niny Khor

affiliation not provided to SSRN

Anneli Lagman Martin

Asian Development Bank - Economic Research

Pamela Bracey

affiliation not provided to SSRN

Biao Huang

Massachusetts Institute of Technology (MIT); Arizona State University (ASU) - School of Life Sciences

Date Written: October 2009

Abstract

This paper reviews the theoretical and empirical literature on the role of financial sector development, with a view to deepening understanding of the rationale of development assistance to the financial sector of developing countries. The review leads to the following broad conclusions: (i) there are convincing arguments that financial sector development plays a vital role in facilitating economic growth and poverty reduction, and these arguments are supported by overwhelming empirical evidence from both cross-country and country-specific studies; (ii) there are however disagreements over how financial sector development should be sequenced in developing countries, particularly the relative importance of domestic banks and capital markets and, in developing the banking sector, the relative importance of large and small banks; (iii) while broadening the access to finance by microenterprises, small and medium-sized enterprises (SMEs), and vulnerable groups is recognized as critically important for poverty reduction, it is also widely believed that microfinance and SME credit programs need to be well designed and targeted to be effective. In particular, these programs need to be accompanied by other support services such as provision of training and capacity building, assistance in accessing markets and technologies, and addressing other market failures; and (iv) financial sector development and innovation will bring risks, and it is therefore essential to maintain sound macroeconomic management, put in place effective regulatory and supervisory mechanisms, and carry out structural reforms in developing the financial sector. The paper argues that these conclusions provide a strong justification for development assistance to target financial sector development as a priority area, and that, like any public sector intervention, such assistance should be designed to address market and nonmarket failures. The paper also highlights several areas where more research is urgently needed, in particular, how to sequence financial sector development, how to balance the need for financial innovation and that for economic and financial stability, and how to make microfinance and SME credit programs work better to reduce poverty.

Suggested Citation

Zhuang, Juzhong and Gunatilake, Herath M. and Niimi, Yoko and Khan, Muhammad Ehsan and Jiang, Yi and Hasan, Rana and Khor, Niny and Martin, Anneli Lagman and Bracey, Pamela and Huang, Biao, Financial Sector Development, Economic Growth, and Poverty Reduction: A Literature Review (October 2009). Asian Development Bank Economics Working Paper Series No. 173. Available at SSRN: https://ssrn.com/abstract=1617022 or http://dx.doi.org/10.2139/ssrn.1617022

Juzhong Zhuang (Contact Author)

Asian Development Bank ( email )

6 ADB Avenue, Mandaluyong City 1550
Metro Manila
Philippines

Herath M. Gunatilake

University of Peradeniya

Peradeniya
Sri Lanka

Asian Development Bank ( email )

6 ADB Avenue, Mandaluyong City 1550
Metro Manila
Philippines

Yoko Niimi

Asian Growth Research Institute ( email )

11-4 Ohtemachi, Kokurakita-ku
Kitakyushu, Fukuoka 803-0814
Japan

Muhammad Ehsan Khan

Binghamton University ( email )

PO Box 6001
Binghamton, NY 13902-6000
United States

Yi Jiang

Asian Development Bank ( email )

6 ADB Avenue, Mandaluyong City 1550
Metro Manila
Philippines

Rana Hasan

Asian Development Bank ( email )

6 ADB Avenue, Mandaluyong City 1550
Metro Manila
Philippines

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States
808-944-7590 (Phone)
808-944-7399 (Fax)

Niny Khor

affiliation not provided to SSRN ( email )

Anneli Lagman Martin

Asian Development Bank - Economic Research ( email )

6 ADB Avenue, Mandaluyong City 1550
Metro Manila
Philippines

Pamela Bracey

affiliation not provided to SSRN ( email )

Biao Huang

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

Arizona State University (ASU) - School of Life Sciences ( email )

Tempe, AZ
United States

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