In the previous note on the lecture series of financial institutions and markets, we learned about the financial system that is broadly classified into the financial markets and financial institutions. We have seen how the supply and demand of funds affect the financial market and why financial market equilibrium is required. We have also seen why the financial market should be efficient and measure market efficiency. In this note, we will learn about the measures of financial development in an aggregate sense (the whole economy of a nation).
Financial development is very much required in the economic growth process, and it plays a vital role in the overall economic development of a nation.
Aggregate Financial Development Indicators
In this section, we will discuss both quantitative and qualitative measures. First, we will discuss qualitative measures, and these are as follows:
Financial Ratio (FR)
The ratio of total issues of primary and secondary claims to national income. It is used by the researches, academicians and the policy makers to know whether the financial market is developed or not.
For example, whenever a particular security comes to the market at the first time, we call it as an instrument of the primary market. Once it is listed and it shifted to the secondary market then automatically the price will be changed and adjusted based on demand and supply issued by the different market participants.
The securities are issued in terms of the primary issues in the financial market itself that includes the money market like the capital market or the stock market and also the bond market. FR is popularly used as one of the broad indicators for financial development.
Financial Inter-relation Ratio (FIR):
The ratio of financial assets with respect to the physical assets in the economy.
In simple words, it is a relative measure of how the financial market is developed with reference to the other sectors in the economy. The other sectors can be the manufacturing sector, real-state, etc., mainly those sectors that produce tangible products and the market participants demand those.
If the FIR ratio is higher, we can say that financial assets perform better than the physical assets existing in that economy.
New Issue Ratio (NIR)
The ratio of primary market issues to the physical capital formation indicates how far direct issues have financed investment to the savers by the investing sectors, whenever we provide the savings or any kind of capital to the economy, which is used as an investment and subsequency development of an economy at large.
The new issue market is more important in the sense that it provides the real value addition to the economy. It gives some addition to the economy in the sense that the secondary market valuations depend upon the demand and supply of that existing security. However, the new issue gives addition to the system as a whole. Thus, the new issue is very important from the development perspective.
Intermediation Ratio (IR)
The ratio of secondary issues to primary issues, which indicates the extent of development of financial institutions as mobilisers of funds relative to real sectors as direct mobilisers of funds. It indicates institutionalisation of the financial activity in the economy.
It compares total money available in the secondary market and the primary market. Thus, this intermediation ratio gives the extent of development of the financial institutions as mobilizers of the funds related to the real sector as direct mobilizers of the funds.
Money to the National Income
The higher this ratio the greater the financial development because it indicates the extent of monetisation and the size of exchange economy in the country.
The definition of money can be in terms of narrowway or in terms of the broadway. So, we have different measures such as M1, M2, M3, and M4, which RBI uses to measure money supply. This ratio can be used to measure how much money is flown to the system as compare to the total national income in the particular market or economy. It indicates that the extent of monetization and the size of exchange economy in that country. If more money is circulated in the system, we say that the behaviour or the consumption behavious or the investment behaviour of that system is increasing and the flow or exchange size of the exchange economy has been increasing.
Current Account Deficit
The proportion of which is financed by market related flows. We have different kind of deficits in terms of the balance of payments. We have a system where the always the asset shoud be equal to liabilities. Whenever we talk about the balance of payment, there are different type of deficit we face, one is current account deficit and another is the capital account deficit. The current account is the difference between export and import. Whereas, the capital account is a difference between inflow and outflow is there in terms of capital. Capital means, we are talking about the FDI and FII.
What is a current account deficit, and how it is filled?
If there is a current account deficit, so it can be filled by borrowing the money, depreciating the money, or government policy measures, etc. If government is filling the current account deficit, then it does not give us any idea that market is developed and market is taking care of the particular system itself. The another way of filling the current account deficit is by development of the economic development of market related factors. Even market is basically responsible for the currency fluctuations, and demand and supply factors which is affecting the export and demand activities that takes care of the current account deficit.
If market mechanism itself is taking care of the deficit or proporting of current account deficit is financed by the market related flows then we say that the market is developed. However, if the government has to intervene and has to take certain measures to fill that particular gap then we can say that the market is not that matured to take care of the whatever deficits they are facing in the system.
Developed financial sector is fully integrated domestically as well as internationally
There are different type of market which exist in the particular domestic economy like debt market, equity market, money market. So, if the market is developed, then there must be a proper integration and all the markets are highly integrated. If anything goes wrong with the one market then generally that can spill over to another market. On the other hand, if one market does well then other market should have positive impact as well. So if the market is integrated that is a good sign that the market is developed domestically as well as internationally.
For example, Indian stock market can be integrated with US stock markets or any other emerging market. So, if there is a integration happening within the market we call that market is developed. Thus, financial integration also can be used as a indicator of the financial market development.
Lower the transaction cost and information cost
Whatever information we are getting from the market that information should be free. Even though, if there is some cost involved in the information then it should be a minimal and that cost should be borne by all the market participants.
Private banking and non public sector banking is predominant
with the public sector banks, private sector banks should also be developed. It means, only government should not own all the banks which are operating in system. There must be some kind of private banking system to minimize risk in the particular system. So more the participation of the private banks, it should be ensure that the market become more transparent, the corporate governance system will be more robust. In that context, the investors or the market participants should create the confidence in the market which automatically ensure that the market is developed or the system is developed.
We should have a strong and effective system of supervision, inspection, auditing, and regulation. To create the confidence in the mind of the market participants the supervision is very much required and periodically it souhlbe audited and regular regulatory norm should be very strong and very stringent. All kind of grievances must be addressed that may be raised by the investors or market participants periodically manner.
That is the reason, we have a regulatory bodies like RBI for banking and SEBI for market, PFRDA for pension accounts, and IRDA for insurance, etc. These agency job is to ensure that the market is well enough or market privides all kind of information to the all the market participant in such as way that, the investor can use that information for their participantion in the market. There is time to time the regulation has been taken for the betterment of the system. As well as all the grievances have been addressed by the different regulatory bodies so that investors confidence or the market participants confidence increases.
Presence of strong, active, large-sized non-bank financial sector comprising stock market, debt market, insurance companies, pension funds, mutual funds, etc. High level of current and capital account openess or convertibility and minimum restrictions on foreign ownership of assets. Effective and quick enforcement of financial contracts, and recovery of loans. Use of indirect rather than direct techniques of monetory policy.
RBI Instruments Monetary Policy
RBI use instrument to make the system stable or to increase the growth rate of the economy or to control the inflation. So, we have direct instruments and indirect instruments. The indirect instruments are interest rate or Repo rate, CRR, etc. For example, we can take Repo, which RBI follows and it is basically a indirect instrument. When the Repo rate increase, then call money rate increases, and once call money rate increase, it impacts other market, like leanding rate of the commerical banks. Money supply gets affected, then if money supply gets affected (declined) then investment gets affected (declined) so like that it will take the reverse trend.
So the Repo rate is indirect instrument which affect the money supply or flow in the market. It is effective also to reach the outcome variables like our growth and inflation control or stability of the price, then we can say that system is better system to ensure that the market is highly developed.
Dimensions of Financial Sector Development
The financial sector development is depended on development of financial institutions and financial markets. These developments are measured based on the different dimensions such as Depth, Access, Efficiency and Stability which are recommended by the World Bank as a guideline to measure the development of a particular system.
| Category | Financial Institutions | Financial Markets |
| Depth | 1) Private sector credit to GDP 2) Mutual fund assets to GDP 3) Pension fund assets to GDP 4) Nonbank financial assets to GDB | 1) Stock market capitalization to GDP 2) Stock market total value traded to GDP 3) International debt issues to GDP 4) Outstanding domestic private debt securities to GDP 5) Outstanding domestic public debt securities to GDP |
| Access | 1) Bank branches per 100000 adults 2) ATMs per 100000 adults 3) Working capital financed by banks | 1) Market capitalization excluding 10 top largest companies to total market capitalization 2) Non-financial corporate bonds to total bonds 3) Investments financed by equity or stock sales |
| Efficiency | 1) Bank net interest margin 2) Bank lending deposit spread 3) Non-investment income to total income 4) Return on assets 5) Return on equity 6) Bank cost to income ratio 7) Bank overhead cost to total assets | 1) Stock market turnover ratio (stocks traded to capitalization) |
| Stability | 1) Bank Z-score 2) Non-performing loans to total loans 3) Bank credit to bank deposits 4) Capital to risk-weighted assets | 1) Stock price volatility |
Subjective Parameters of Development
Apart from various parameters recommended by World Bank, there are some subjective indicators proposed by Richard D (International Monatory Fund) and these are as follows:
- Whether institutions find the most productive investments?
- Do institutions revalue their asssets and liabilities in response to changed circumstances?
- Do investors and financial institutions expect to be bailed out of mistakes and at what price?
- Whether institutions facilitate the management of risk by making available the means to insure, hedge, and diversify risks?
- Do institutions effectively monitor the performance of their users, and discipline those not making proper and effective use of their resources?
- How effective is the legal, regulator, supervisory, and judical structure?
- Whether financial institutions publish consistent and transparent information?
References
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