This study aims to identify policies that influence the development of financial institutions as measured across three dimensions: depth, efficiency, and stability. Applying the concept of the financial possibility frontier, developed by Beck & Feyen (2013) and formalized by Barajas et al (2013a), we determine key policy variables affecting the gap between actual levels of development and benchmarks predicted by structural variables. Our dynamic panel estimation shows that inflation, trade openness, institutional quality, and banking crises significantly affect financial development. Our analysis also helps identify potential complementarities and trade-offs for policy makers, based on the effect of the policy variables across the different dimensions of financial development.

The debate on the effects of finance on economic growth has been active for decades, raising opinions ranging from inconsequential and “very badly over-stressed” (Lucas, 1988) to seemingly obvious (Miller, 1998). Bagehot (1873) and Schumpeter (1911) have argued, more conservatively, that the interplay between finance and growth is positive and non-trivial. Goldsmith (1969) was one of the first studies to empirically investigate this relationship, finding a positive correlation between financial development (as measured by the size of the financial sector) and long-run growth. He (and later, Bencivenga & Smith, 1991) explained this correlation by asserting that intermediation leads to savings being better channeled into productive investment. In their treatises on financial liberalization, Shaw (1973) and McKinnon (1973) posited that eliminating financial repression would enhance growth, as the elimination of interest rate ceilings would increase the quantity of savings in the economy. However, these studies did not address the issue of causality in either direction.