Financial Sector Development Policy: The Importance of Reputational Capital and Governance

The performance and effectiveness of financial institutions are important considerations for policy-makers concerned about economic growth. Growth, after all, is heavily dependent on investment, and a significant fraction of all investment flows through financial institutions. Furthermore, incidences of financial instability in some countries have shown that poor financial policies can have serious consequences. For example, when the Southern Cone countries liberalized financial markets before achieving macroeconomic stability and low inflation, banks in those countries performed disastrously. In the United States the partial deregulation of the savings and loans (S&L) industry invited a great deal of gambling and looting of depositors ' funds, ultimately costing taxpayers hundreds of billions of dollars. Partly because the financial sector of the east Asian high-growth economies grew substantially, financial development has received special attention recently in several developing countries. King and Levine (1993a, 1993b) demonstrated in a broad cross-country study that financial deepening had strong explanatory power for differential growth performance. If financial stability and financial deepening are worthy goals, what are the mechanisms that policy-makers can employ to achieve such goals?