Financial soundness and development : a multi-country analysis using panel data

A large body of the literature argues that the soundness of financial system is largely determined by the economic and institutional environment in which the financial system works. Drawing on this theoretical underpinning, research in this thesis models financial soundness indicators (FSIs) across the globe in terms of a set of macroeconomic and institutional variables. We have considered three core aspects of the health of financial intermediaries namely capital adequacy, asset quality and profitability. After controlling for timeinvariant country specific heterogeneities in the panel data, our econometric analysis reveals a strong influence from the business cycle, inflation, and real effective exchange rates, and size of the industry on capital adequacy. Moreover, by incorporating rarely changing variables in the econometric models, we have found that the variation of financial soundness across countries can largely be explained by institutional and political characteristics. Furthermore, our analyses provide evidence that banks’ profitability is determined by a combination of macroeconomic, bank specific and industry characteristics such as business cycle, inflation, credit risk and capital adequacy, and the level of competition. Empirical research in the thesis also considers whether increases in aggregate money balances with banks and aggregate credits provided by them to the private sectors directly help alleviate poverty. Our results suggest that other than the indirect effect that trickles down to the poor through growth, an increase in the ratio of private credits to GDP does not directly translate into improved living conditions of the poor. Our analysis provides evidence that if financial development has any direct effect on the poor at all, that is realized through the McKinnon’s conduit effect captured by the ratio of M3 to GDP. Our analysis also predicts a positive correlation between the level of financial development and financial instability, implying that the latter may seriously downsize the potential conduit effect. Furthermore, in our analysis, corruption appears as a threat to both the direct and the indirect effects of financial development.