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What Is the Relationship between Banks and Economic Growth?

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  • Written By: Kenneth W. Michael Wills
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 02 September 2016
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Examining the relationship between banks and economic growth often points to conflicting conclusions based on the banking system’s ability or inability to spur economic growth. Over the years, in particular since 1976, there have been multiple research studies carried out to examine this relationship. Results from this research most often conclude that the more developed a banking system is in a nation, the more efficient and healthy will be that nation’s economic growth. Leading economists most often cite sound financial reforms, sound legal framework, a reliable infrastructure to support the banking system, and prudent macroeconomic management and policy as being central to a healthy banking system that aids economic growth. Nation’s that focus on developing and refining these keys areas often enjoy consistent economic growth, with economies that usually grow at a faster rate.

Banking systems bring five major responsibilities to an economy, which rely on the aforementioned principles cited by leading economists: information production required for asset allocation and investments; overseeing effective corporate governance; encouragement of diversification, trading and risk management; providing a vehicle for savings; and facilitating the exchange of goods and services. Each key area relates directly to uninhibited growth opportunity. For example, sound financial reforms and transparent legal structure help to stem corruption, thereby encouraging investment, innovation and lending. As another example, reliable infrastructure facilitates the efficient production and dissemination of information often required to make decisions regarding the allocation of assets or investment.

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Macroeconomic policy and prudent management decisions in relation to macroeconomics is also crucial for the development of a sound banking system that encourages economic growth. A government that decides on, effectively implements, and efficiently monitors macroeconomic policies that encourage growth of the financial sector free from corrupt practices, will at the same time, strengthen the banking system. While researchers do not always agree on the exact relationship between banks and economic growth, causality of this relationship is evident in that sound banking systems either spur economic growth or encourage investment that results in increased productivity and economic output.

Mechanisms that solidify the relationship between banks and economic growth are also debated among researchers; however, evidence does suggest that some mechanisms are inherent to the relationship. Policy that effectively reduces financial constraints helps firms that rely on outside financing to advanced projects, thereby directly linking banks and economic growth. Whether a cancer research center relying on funding, a new corporation relying on investments in its stock, or the many businesses that rely on the banking system for loans to grow, access to capital is crucial and the banking system is the prime influencer in this domain. Noted as well, this may account for differences in the rate of economic growth between smaller and larger communities, where banking policy may differ substantially, with larger banks reducing constraints for accessing capital, while smaller banks in smaller communities may do the opposite to minimize exposure to risk.

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ddljohn
Post 3

I know that in developing countries, one of the prerequisites for foreign investment is a sound banking system. Investment is essential for economic growth and investors don't invest in countries with reliable banking systems. So we can say banks are essential to this process.

donasmrs
Post 2

@bluedolphin-- I agree with you. I think the main issue is that instead of making the banking sector work for the welfare of the economy and people, it has become the opposite. People and the economy are now serving banks.

The issue with this is that banks only care about profits and have little interest in social welfare. But social welfare is in fact very important for economic growth. By overpowering banks, I think that we may be harming economic growth rather than supporting it. I won't even talk about nepotism and the role that banks play in the political sphere. Like I said, we are serving banks when they should be serving us.

bluedolphin
Post 1

Ever since the US banking crisis of 2007-2008, I've developed dislike for banking institutions. Because of poor choices by US banks, so many sectors of the economy suffered. People also suffered as they lost their homes and jobs. But instead of facing the consequences of their mistakes and paying for them, the banks were bailed out by the US government. Unfortunately, the government did not bail out American citizens who were forced to deal with the consequences of a depressed economy.

Banks are supposed to encourage economic growth, not the opposite. If the government continues to support banks that had deserved to go bankrupt and disappear a long time ago, Americans will have to continue to bear the negative impact. I'd stop using banks altogether if I could.

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