Do banking sector and stock market development matter for economic growth?


Financial development as a concept is multifaceted with no clear measurement or definition. Inference via individual proxies may result in an incomplete understanding of the relationship between financial development and economic growth, since sole proxies are unlikely to capture the true capacity of financial development. To address this issue, this paper utilizes a multiple indicators multiple causes (MIMIC) model to create a more complete measure of financial development. In doing this, we treat banking sector and stock market developments as two latent indicators of financial development and use the MIMIC model to predict them which are used as their proxies. Using data from 101 countries over the period 1990–2014, we use the predicted values of the two latent variables as regressors, among other controls, in the growth regression. We find a robust negative relationship between banking sector development and economic growth, whereas the effect of stock market development on economic growth is positive up to a threshold after which the effect becomes negative.

This is a preview of subscription content, access via your institution.

Fig. 1
Fig. 2


  1. 1.

    Financial depth in general refers using private credit as a fraction of GDP as a measure; but the concept of financial development is much broader (see de la Torre et al. 2011 for details).

  2. 2.

    For details see Levine (2002).

  3. 3.

    Differently, Rose and Spiegel (2012) used the MIMIC model to examine the causes and consequences of 2008 financial crisis.

  4. 4.

    See Arellano and Bover (1995) and Blundell and Bond (1998) for details.

  5. 5.

    See Čihák et al. (2012) for details and various update of the same data set over the years.

  6. 6.

    For both banking sector and the stock market, we used different indicators to measure depth and efficiency. The results remain qualitatively similar to those reported in the paper.

  7. 7.

    For details on these indicators and classification, see Čihák et al. (2012).

  8. 8.

    The reasons for not including accessibility measure as accessibility are completely different from the other measures that have been used.

  9. 9.

    These income groups are defined in the World Bank database.

  10. 10.

    In our sample, around 31% of observations has stock market turnover higher than the overall average, whereas 50% of observations is above the median.

  11. 11.

    Results are not reported here to save space but are available from the authors upon request.


  1. Arcand JL, Berkes E, Panizza U (2012) Too much finance? IMF Working Paper 12/161

  2. Arellano M, Bover O (1995) Another look at the instrumental-variable estimation of error-components models. J Econom 68:29–52

    Article  Google Scholar 

  3. Arestis P, Demetriades P (1997) Financial development and economic growth: assessing the evidence. Econ J 107: 783–799

    Article  Google Scholar 

  4. Arestis P, Demetriades PO, Luintel KB (2001) Financial development and economic growth: the role of stock markets. J Money Credit Bank 33:16–41

    Article  Google Scholar 

  5. Beck T, Levine R (2004) Stock markets, banks, and growth. J Bank Finance 28:423–442

    Article  Google Scholar 

  6. Beck T, Levine R, Loayza N (2000) Finance and the sources of growth. J Financ Econ 58:261–300

    Article  Google Scholar 

  7. Beck T, Buyukkarabacak B, Rioja F, Valev N (2008) Who gets the credit? and does it matter? household vs. firm lending across countries. Policy Research Working Paper Series 4661, The World Bank

  8. Bencivenga V, Smith BD (1991) Financial intermediation and endogenous growth. Rev Econ Stud 58:195–209

    Article  Google Scholar 

  9. Bhide A (1993) The hidden costs of stock market liquidity. J Financ Econ 34:31–51

    Article  Google Scholar 

  10. Blundell R, Bond S (1998) Initial conditions and moment restrictions in dynamic panel data models. J Econom 87:115–143

    Article  Google Scholar 

  11. Bollen KA (1989) Structural equations with latent variables. Wiley, London

    Book  Google Scholar 

  12. Boot AW, Thakor AV (1997) Financial system architecture. Rev Financ Stud 10:693–733

    Article  Google Scholar 

  13. Boyd JH, Smith BD (1998) The evolution of debt and equity markets in economic development. Econ Theor 12:519–560

    Article  Google Scholar 

  14. Calderon C, Liu L (2003) The direction of causality between financial development and economic growth. J Dev Econ 72:321–334

    Article  Google Scholar 

  15. Cecchetti SG, Kharroubi E (2012) Reassessing the impact of finance on growth. BIS working paper number 381

  16. Čihák M, Demirgüç-Kunt A, Feyen E, Levine R (2012) Benchmarking financial development around the World.” World Bank Policy Research Working Paper 6175, World Bank, Washington, DC

  17. Claessens S, Demirgüç-Kunt A, Huizinga H (2001) How does foreign entry affect the domestic banking system? J Bank Finance 25:891–911

    Article  Google Scholar 

  18. de la Torre A, Ize A, Schmukler S (2011) Financial development in Latin America and the Caribbean: the road ahead. The World Bank Latin American and Caribbean Studies

  19. Demetriades P, Law SH (2006) Finance, institutions and economic development. Int J Finance Econ 11:245

    Article  Google Scholar 

  20. Demirgüç-Kunt A, Levine R (2008) Finance, financial sector policies, and long-run growth. World Bank Policy Research Working Paper No. 4469, World Bank, Washington, DC

  21. Demirgüç-Kunt A, Córdova EL, Pería MSM, Woodruff C (2011) Remittances and banking sector breadth and depth: evidence from Mexico. J Dev Econ 95:229–241

    Article  Google Scholar 

  22. Do Q-T, Levchenko AA (2004) Trade and financial development. Policy Research Working Paper Series 3347, The World Bank

  23. Goldberger AS (1972) Structural equations methods in the social sciences. Econometrica 40:979–1001

    Article  Google Scholar 

  24. Hanh PTH (2010) Financial development, financial openness and trade openness: new evidence. FIW working paper no. 60

  25. International Monetary Fund (2015) Pan-African banks: opportunities and challenges for cross-border oversight, prepared by a staff team led by Charles Enoch et al., Washington, D.C., International Monetary Fund

  26. Jansen MC, Murphy KJ (1990) Performance pay and top-management incentives. J Polit Econ 98:717–738

    Google Scholar 

  27. Joreskog KG, Goldberger AS (1975) Estimation of a model with multiple indicators and multiple causes of a single latent variable. J Am Stat Assoc 70:631–639

    Google Scholar 

  28. Joreskog KG, Sorbom D (1999a) LISREL 8: structural equation modeling with the SIMPLIS command language. Scientific Software International, Lincolnwood, p 9

    Google Scholar 

  29. Joreskog KG, Sorbom D (1999b) LISREL 8 user’s reference guide. Scientific Software International, Lincolnwood

    Google Scholar 

  30. King GR, Levine R (1993) Finance and growth: Schumpeter might be right. Q J Econ 108:717–737

    Article  Google Scholar 

  31. La Porta R, Lopez-de-Silanes F, Shleifer A, Vishny RW (1998) Law and finance. J Polit Econ 106:1113–1155

    Article  Google Scholar 

  32. Levine R (1997) Financial development and economic growth: views and agenda. J Econ Lit 35:688–726

    Google Scholar 

  33. Levine R (2002) Bank-based versus market-based financial systems: which is better? J Financ Intermed 11:398–428

    Article  Google Scholar 

  34. Levine R (2005) Finance and growth: theory and evidence, chap 12. In: Aghion P, Durlauf S (eds) Handbook of economic growth, vol 1, vol 1. Elsevier, Amsterdam, pp 865–934

    Google Scholar 

  35. Levine R, Zervos S (1998) Stock markets, banks and economic growth. Am Econ Rev 88:537–558

    Google Scholar 

  36. Levine R, Loayza N, Beck T (2000) Financial intermediation and growth: causality and causes. J Monet Econ 46:31–77

    Article  Google Scholar 

  37. Loayza N, Ranciere R (2006) Financial development, financial fragility and growth. J Money Credit Bank 38:1051–1076

    Article  Google Scholar 

  38. Lucas R (1988) On the mechanics of economic development. J Monet Econ 22:3–42

    Article  Google Scholar 

  39. Merton RC, Bodie Z (1995) A conceptual framework for analysing the financial environment. In: Crane DB et al (eds) The global financial system: a functional perspective. Harvard Business School, Boston

    Google Scholar 

  40. Miller MH (1998) Financial markets and economic growth. J Appl Corp Finance 11:8–14

    Article  Google Scholar 

  41. Pesaran MH, Smith RP (1995) Estimating long-run relationship from dynamic heterogeneous panels. J Econ 68:79–113

    Article  Google Scholar 

  42. Pesaran MH, Shin Y, Smith RP (1999) Pooled mean group estimation of dynamic heterogeneous panels. J Am Stat Assoc 94:621–634

    Article  Google Scholar 

  43. Rajan RG (2005) Has financial development made the world riskier? NBER working paper no. 11728

  44. Rioja F, Valev N (2004) Does one size fit all? An examination of the finance and growth relationship. J Dev Econ 74:429–447

    Article  Google Scholar 

  45. Rodrik D (2008) Second-best institutions. Am Econ Rev 98:100–104

    Article  Google Scholar 

  46. Rodrik D, Subramanian A (2009) Why did financial globalization disappoint? IMF Staff Papers 56:112–138

    Article  Google Scholar 

  47. Rose AK, Spiegel MM (2012) Cross-country causes and consequences of the 2008 crisis: early warning. Jpn World Econ 24:1–16

    Article  Google Scholar 

  48. Rousseau PL, Wachtel P (2002) Inflation thresholds and the finance–growth nexus. J Int Money Finance 21:777–793

    Article  Google Scholar 

  49. Rousseau PL, Watchtel P (2011) What is happening to the impact of financial deepening on economic growth? Econ Inq 49:276–288

    Article  Google Scholar 

  50. Saksonova S (2014) The role of net interest margin in improving banks’ asset structure and assessing the stability and efficiency of their operations. Proc Soc Behav Sci 150:132–141

    Article  Google Scholar 

  51. Stiglitz J (1985) Credit markets and the control of capital. J Money Credit Bank 17:133–152

    Article  Google Scholar 

  52. Stulz R (2002) Financial structure, corporate finance, and economic growth. In: Demirguc-Kunt A, Levine R (eds) Financial structure and economic growth: cross-country comparison of banks, markets and development. MIT Press, Cambridge, pp 143–188

    Google Scholar 

  53. Tobin J (1984) On the efficiency of the financial system. Lloyds Bank Rev 153:1–15

    Google Scholar 

Download references

Author information



Corresponding author

Correspondence to Subal C. Kumbhakar.

Ethics declarations

Conflict of interest

We declare that we have no conflict of interest.

Ethical approval

This article does not contain any studies with human participants or animals performed by any of the authors.

Additional information

Publisher’s Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

We would like to thank Bertrand Candelon, Editor-in-Chief and an anonymous referee for helpful comments.


Appendix 1

See Figs. 3, 4.

Fig. 3

Relationship between banking sector and stock market deveopment predicted latent construct all countries (1990–2014)

Fig. 4

Relationship between banking sector and stock market deveopment predicted latent construct all countries (1990–2014)

Appendix 2

See Table 6.

Table 6 Subsample analysis for all countries

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

Cave, J., Chaudhuri, K. & Kumbhakar, S.C. Do banking sector and stock market development matter for economic growth?. Empir Econ 59, 1513–1535 (2020).

Download citation


  • Financial development
  • Economic growth
  • Multiple indicators multiple causes

JEL Classification

  • C22
  • G20
  • O40