The global financial crisis has cast doubts about the benefits of financial sector development. A wave of financial innovation triggered the meltdown of the US financial system, which almost brought the global financial system and world economy to its knees. But in financially backward developing Asia, in contrast to global financial centers such as US or UK, financial development does not refer to complex, sophisticated, state-of-the-art financial innovations. Instead, it refers to the much more basic task of building sound, efficient, well-regulated financial systems.

The Asian Development Outlook 2015 highlights how developing Asia’s financial development still lags the advanced economies by a wide margin despite good progress. Since the Asian financial crisis, the region’s financial systems—banks and capital markets—have become larger, deeper, and more robust. The improvement served the region well during the global financial crisis, which the region’s financial systems weathered remarkably well. Yet developing Asia’s bank deposits equal only 60% of regional GDP, compared with the average of 110% in advanced economies, and its bond markets equal less than half of GDP, a third of the 140% found in advanced economies. Asia may be somewhat more financially developed than Latin America, but it still endures relatively costly capital and difficult access to finance. This may inhibit future growth.

Figure 1. Financial development in developing Asia, Latin America, and OECD. Source: ADB (2015)

Empirical evidence points to growth benefits from closing the finance gap. For example, boosting developing Asia’s average ratio to GDP of liquid liabilities—currency plus checking and interest-bearing accounts in financial institutions—from about 65% to 75% adds almost 0.4 percentage points to average annual GDP growth per capita. On average, a 10% increase in developing Asia’s average ratio of private credit to GDP is associated with higher growth in GDP per capita by about 0.3% per year. The evidence indicates that growth can come from developing either banks or capital markets.

The approach to developing the financial sector must fit each country’s circumstances. The region’s low-income economies have financial systems based heavily on banks. They can benefit from banking system reforms that mobilize domestic savings, lowers the cost of credit, improve access, and promote the allocation of credit to the most productive sectors. The successful reforms of state-owned banks in the PRC are a case in point. Middle-income economies can reap productivity gains by deepening their financial markets. Policies that further develop their equity and bond markets can lower the cost of long-term capital to facilitate investment and innovation.

Figure 2. Financial development and inequality. Source: ADB (2015)

Financial development must be accompanied by financial inclusion to promote inclusive growth. Financial deepening can either widen the income gap, if its benefits accrue largely to the wealthy by enhancing returns to capital or the earnings of senior finance professionals, or it can narrow the gap if the poor gain greater access to financial services or jobs. Empirical evidence reflects this dichotomy. While financial development tends to alleviate inequality in its early stages, it tends to worsen inequality in its later stages. Since financial development does not necessarily reduce inequality, inclusive growth calls for concerted government efforts to strengthen financial inclusion. A good example is India’s Aadhaar biometric identification program, which can address the lack of proper identification and thus facilitate the access of the poor to financial services

Financial stability enhances both growth and equity. While financial development is generally beneficial, it sometimes destabilizes financial systems. Financial instability can seriously undermine economic growth, especially when financial crises result. It can also undermine the inclusiveness of growth since the poor are disproportionately defenseless against financial crises. While sound banking regulation remains the first line of defense against financial instability in the region, macroprudential policies can also play a valuable supporting role.

Figure 3. Growth rates before and after the Asian financial crisis in selected Asian economies. Source: International Monetary Fund, World Economic Outlook Database (2014)

Regulators will be challenged, however, to find the right balance between growth and stability. They must carefully weigh the benefits of strong regulation, which protects stability by preventing the accumulation of systemic risks, against the benefits of flexible regulation that promotes investment, productivity, innovation, and economic growth.