Financial Development

Updated on March 26, 2024
Article byShrestha Ghosal
Edited byShrestha Ghosal
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Financial Development?

Financial development is an evolutionary process by which a country’s financial system advances and becomes more evolved. This progression encompasses various aspects, including the expansion and diversification of financial institutions. It also involves the expansion of financial markets and the enhancement of financial instruments and services.

Financial Development

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A developed financial structure plays a crucial role in promoting economic growth. It aids in the efficient allocation of resources, enhances risk mitigation, and facilitates capital mobilization. Moreover, this development enables individuals and businesses to access a broader range of financial products and services, assists in promoting entrepreneurship, and supports innovation.

Key Takeaways

  • Financial development is an ongoing process by which a country’s financial system evolves, expands, and improves over time.
  • This evolution encompasses the growth and diversification of financial institutions such as credit unions, banks, and non-banking financial institutions.
  • Furthermore, this growth includes the growth and strengthening of financial markets, which include capital markets, bond markets, and stock markets.
  • It acts as an indicator of economic advancement and an impetus for sustainable growth, raising living standards, lowering poverty rates, and improving a country’s overall economic well-being.

Financial Development Explained

Financial development is the dynamic process through which a country’s financial system evolves, transforms, and becomes increasingly advanced over time. This progression encompasses numerous elements, and each contributes to the overall growth and efficiency of the financial sector. This development involves the expansion and diversification of financial institutions, including banks, credit unions, and non-banking financial institutions. These entities serve as intermediaries between lenders and borrowers by boosting the flow of funds within the economy.

Moreover, financial development extends to the deepening and broadening of financial markets, comprising stock exchanges, bond markets, and money markets. A robust financial market facilitates the trading of a variety of financial instruments, including stocks, bonds, and derivatives. It aids in providing investors with diverse opportunities for capital allocation. This development plays a significant role in promoting economic growth by efficiently mobilizing and allocating capital. It is a marker of economic progress and acts as a catalyst for sustainable development, lifting living standards, reducing poverty, and enhancing economic well-being within a nation.

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Measures

Some measures of financial development include the following:

  1. Financial Institutions: This measure comprises components like the number and size of banks and other financial institutions. Additionally, it comprises the ratio of domestic credit to the private sector as a percentage of GDP. Furthermore, the level of deposits and loans in the banking sector is one of the measures of financial development.
  2. Financial Markets: The market capitalization of the stock market, turnover and liquidity in the stock and bond markets, and the size and activity of money markets indicate this development.
  3. Financial Access: This measure encompasses elements like the percentage of the population with access to banking services and the extent of credit information infrastructure.
  4. Regulatory Environment: The strength and effectiveness of financial regulatory bodies is an indicator of this development. Moreover, the transparency and clarity of financial regulations and enforcement of laws related to financial transactions are some additional measures.
  5. Financial literacy: This development can be measured by the level of financial education and awareness among the population. Furthermore, its access to financial advice and information can be an indicator of this development.

Examples

Let us go through the following financial development examples to understand this concept:

Example #1

Suppose there is a small town where the development is at an early stage. Initially, there was a single traditional bank offering essential savings and loan services. As the town grew, more banks and credit unions emerged and provided a variety of financial products. A stock market developed that enabled local businesses to raise capital by selling shares. Additionally, a microfinance institution started extending small loans to budding entrepreneurs. Technological advancements facilitated online banking and made financial services accessible to a broader population.

Example #2

At the Paris Finance Summit, UN President António Guterres stated that developing nations are unable to revive their economy due to their enormous debt loads and exorbitant credit rates. The head of the UN demanded increased access to liquidity for developing countries through the International Monetary Fund’s Special Drawing Rights. Moreover, a debt relief mechanism that permits payment suspensions, longer lending terms, and lower interest rates to make borrowing more affordable for less wealthy countries was also suggested.

Importance

The importance of financial development is as follows:

  1. A developed financial system efficiently allocates capital by channeling savings into productive investments. This capital is essential for businesses to expand, innovate, and create job opportunities, which contributes to overall economic growth.
  2. This development provides entrepreneurs with access to diverse sources of funding, promotes innovation, and facilitates the development of new businesses. This enhances competition, productivity, and economic development.
  3. An advanced financial framework offers a range of instruments for risk management. It aids businesses and individuals to hedge against economic uncertainties. The risk mitigation strategies contribute to economic stability by reducing the impact of unforeseen events.
  4. Nations with well-developed financial systems are often more attractive to foreign investors. This development enhances a country’s global competitiveness by providing a stable and transparent investment environment.
  5. Robust financial institutions and practical regulatory frameworks contribute to economic stability. Sound banking practices, prudent fiscal policies, and efficient financial markets help prevent financial crises and recessions.

Financial Development vs Economic Development

The differences between the two are as follows:

Financial Development

  1. Financial development focuses on the growth of a country’s financial system. It comprises the evolution of financial institutions, markets, instruments, and services.
  2. The emphasis is on improving the efficiency, depth, and accessibility of financial mechanisms.
  3. A well-developed financial sector facilitates the efficient allocation of resources and risk management. It plays a crucial role in promoting entrepreneurship, innovation, and economic stability.

Economic Development

  1. Economic development is a broad concept that encompasses overall improvements in a nation’s economic well-being.
  2. It includes factors like infrastructure, education, healthcare, and institutional development.
  3. This development aims to enhance the standard of living, reduce poverty, and promote sustainable growth. Several factors, including technological progress, human capital development, and social welfare programs, contribute to this development.

Frequently Asked Questions (FAQs)

1. Has financial development made the world riskier?

This development brings about several benefits. However, it also introduces complexities and interconnectivity that can amplify risks. The rise of complex financial instruments, globalized markets, and rapid technological advancements has made the world more vulnerable to financial shocks. Occurrences like financial crises, market meltdowns, and cyber threats can pose substantial challenges for regulators and policymakers.

2. Does local financial development matter?

Yes, local development significantly matters as it directly influences the economic well-being of a community. A solid local financial system boosts entrepreneurship by providing access to capital for small businesses and individuals. Moreover, it contributes to job creation, innovation, and overall economic growth. Furthermore, financial institutions and services customized to local needs enhance financial inclusion by ensuring that a broader segment of the population can benefit from them.

3. What are the models of financial development?

Several models can help study this development, including the Financial Intermediation Theory, the Modernization Theory, and the Institutional Theory. The Financial Intermediation Theory focuses on the role of financial intermediaries in economic development. Modernization Theory suggests that development is a natural outcome of economic growth and societal modernization. The Institutional Theory highlights the importance of effective institutions in shaping financial frameworks.

This has been a guide to what is Financial Development. We explain its examples, importance, measures, and comparison with economic development. You can learn more about financing from the following articles –

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