FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN DEVELOPING COUNTRIES

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CHAPTER 3 FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN DEVELOPED COUNTRIES

Introduction

This chapter surveys financial sector development and economic growth experiences and trends in the United States of America (USA), the United Kingdom (UK) and Australia. The chapter is divided into five major sections. Section 3.2 covers financial development in the USA (bank-based financial development and stock market development). Under bank-based financial development the following are addressed: an overview of the USA’s banking sector; its bank-based financial sector reforms; trends in banking sector growth and economic growth in the USA; as well as challenges facing its bank-based financial development. Under stock market development in the USA, the following issues are discussed: the origin of the American stock market; stock market reforms; trends in stock market growth and economic growth; and finally, challenges facing stock market development in the USA.
Section 3.3 focuses on financial development in the United Kingdom (UK). This section is divided into two sub-sections – bank-based financial development and stock market development in the UK. Under bank-based financial development the following are presented: an overview of the UK’s banking sector; bank-based financial sector reforms; trends in banking sector growth and economic growth; and the challenges facing bank-based financial development in the UK. Under stock market development in the UK the following issues are discussed: the origin of its stock market; stock market reforms; trends in its stock market growth and economic growth; and challenges facing stock market development in the UK.
Section 3.4 presents financial development in Australia. This section is divided into two sub-sections – bank-based financial development and stock market development. Under bank-based financial development the following issues are discussed: an overview of Australia’s banking sector; bank-based financial sector reforms; trends in banking sector growth and economic growth; and the challenges facing bank-based financial development in Australia. Under stock market development in Australia the following issues are discussed: the origins of its stock market; stock market reforms; trends in stock market growth and economic growth; and challenges facing stock market development in Australia. Finally, some concluding remarks are presented in Section 3.5.

Financial Development in the United States of America (USA)

By any standard, modern or otherwise, the speed and success with which a banking system and capital markets emerged in the United States as mobilisers of domestic and international resources after 1790 is nothing short of remarkable. To date, the USA has a highly developed financial sector which ranks very high in terms of the development and sophistication of its bank and non-bank financial institutions and also of its financial markets (stocks, bonds, forex and derivatives), as well as the size, depth and access available to its financial services. The USA was ranked number 1 in 2010 and number 2 in 2011, in terms of financial development, based on the Financial Development Index rankings (World Economic Forum, 2011a).

Bank-Based Financial Development in the USA

Although the bank-based segment of the financial system in the country is relatively less developed than the market-based segment, both are quite well developed in terms of international comparisons. This section discusses the banking segment in detail and is organised as follows: Section 3.2.1.1 gives an overview of the USA’s banking sector while Section 3.2.1.2 traces the bank-based financial sector reforms. Section 3.2.1.3 traces the trends in banking sector growth as well as economic growth in the USA. Section 3.2.1.4 concludes the section by highlighting the challenges facing bank-based financial development in the USA.

Overview of the USA’s Bank-Based Financial System

Origin of the Central Bank of the USA, the Federal Reserve System
The Federal Reserve System, often known as the Federal Reserve or just « the Fed, » is the central bank of the USA. Its history dates back to as early as the late 18th Century when the first central bank known as the First Bank of the United States (BUS), was created in 1791, with its headquarters in Philadelphia (Federal Reserve
Bank of New York, “the New York Fed,” 2012).
In 1816 the second BUS took over from the first BUS until its death in 1836. The severe financial panic of 1907 resulted in bank failures, signalling the need for a central bank. Following the Glass-Willis proposal of 1912, the Federal Reserve Act was passed in 1913 establishing regional reserve banks and the Fed to control and coordinate their operations (New York Fed, 2012a).
Among its responsibilities, the Fed is responsible for supervising and regulating banks and other important financial institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers. It is also responsible for monetary policy related matters and the maintenance and stability of the financial system (Federal Reserve Bank, 2012).
Reserve Banks are responsible for supervising and examining all bank holding companies and commercial banks for soundness and safety; for providing accounts to depository institutions and for participating in setting monetary policy (Federal Reserve Bank, 2012). The Federal Reserve System consists of a Board of Governors and 12 regional Federal Reserve Banks, located in the nation’s major cities (Federal Reserve Bank, 2012).
Overview of the Banking Sector in the USA
The American banking industry is governed by, among other acts, the National Banking Acts of 1863 and 1864; the Banking Act of 1933; the Depository Institutions Deregulation Act of 1980 and the Garn-St Germain Depository Institutions Act of 1982 (Federal Reserve Bank, 2012). In addition to these Acts, Federal Reserve regulations also play a role in banking regulation. The American banks are also regulated in accordance with the principles set by the Basel Committee on Banking Supervision. Consequently, the banks comply with sound international practice.
According to the Bank of International Settlement (2003: 433), the legal framework governing payment activity, as well as the regulatory structure for financial institutions that provide payment services in the USA are complex and uneven. Most countries have only one bank regulator, but the USA’s banking system is regulated at both federal and state levels (Bank of International Settlement, 2003). Among the regulators are the Office of the Comptroller of the Currency and the Office of Thrift Supervision.
Another spectacular feature of the USA banking system is deposit insurance, known as the Federal Deposit Insurance Corporation (FDIC). Unlike most countries where only a few banks dominate the market, in the United States there are 6,291 commercial banks, 1,500 savings and loan associations, 400 mutual savings banks, and 10,000 credit unions. The total number of banks has, however, declined, falling from 14,210 in 1986 to 9,520 in 1996; and further to 7,401 in 2006, before reaching the 6,291 mark in December 2011. The fall in the number of banks during the late 2000s was mostly as a result of the late-2000s financial crisis, which many economists considered to be the worst financial crisis since the Great Depression of the 1930s (FDIC, 2012).
According to Terrell and Key (2012: 54), one of the most significant recent developments in both international banking and the structure of banking within the United States, has been the rapid growth in foreign bank operations in the United States. This growth has resulted from an expansion of the activities of banks with existing USA operations as well as de novo entry into the USA market by additional foreign banks. The USA-based offices of foreign banks currently offer a broad range of banking services to both foreign and domestic customers. Their increasing importance in USA markets has resulted in various legislative proposals to establish a uniform Federal policy concerning their activities (Terrell and Key, 2012; Federal Reserve Bank, 2012).

Bank-Based Financial Reforms in the USA

In 1913, the Federal Reserve Act was passed, creating the country’s central bank, the Federal Reserve System (the Fed) in order to promote an even safer banking system. However, although the Fed enhanced financial stability, it did not do much to prevent the failure of many US banks during the 1930 – 1933 financial crisis (Tregenna, 2009).
In the wake of the Depression of the early 1930s, a number of important banking reforms were ushered in. Among the reforms was the Banking Act of June 1933, which led to the establishment of the federal deposit insurance and federal regulation of interest rates on deposits (FDIC, 2012). The federal insurance for deposits was, and is still, administered by the Federal Deposit Insurance Corporation (FDIC) which guarantees a standard insurance amount per depositor, per insured bank. Funding for the FDIC comes from premiums paid by member institutions. The United States was the first country to officially enact deposit insurance to protect depositors from losses by insolvent banks (FDIC, 2012).
Two years later, the Banking Act of 1935 was passed. The Act created the Fed and strengthened the central banks’ powers by making them less decentralised than they had been.
Between 2008 and 2010, the FDIC insurance was expanded when Congress temporarily increased the Insurance limit to $250,000 but this later became permanent. Historically, insurance limits were $2,500 in 1934; $5,000 in 1935; $10,000 in 1950; $15,000 in 1966; $20,000 in 1969; $40,000 in 1974; $100,000 in 1980; and $250,000 in 2008 (FDIC, 2012). The Depositors’ Insurance Fund (DIF) insures deposits in excess of the FDIC limits at state-chartered savings banks.
In 2010, the 111th United States Congress passed the Dodd – Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203), signed into federal law by the President on July 21, 2010; and which became effective instantly (United States Government Printing Office, 2012).

Banking Sector Growth and Economic Growth in the USA

There were about 20,000 banks in 1907, and about 30,000 by the early 1920s. In the early 2000s, cheap credit led to a housing and commercial real estate boom, which later led to the global financial crisis during the late 2000s. This crisis saw further reduction in the total number of banks in the United States as many large banks collapsed (FDIC, 2012). Table 3.1 shows the number of FDIC-insured commercial banks, branches and total number of offices in the United States during the period 1935-2011.
The development of the American banking sector is also reflected by growth in private sector credit extension. The period from 1975 to 1981 was characterised by an almost constant degree of credit provided by the financial institutions to the private sector, averaging 120% of GDP. Thereafter, private sector lending increased to 150% until 1987 when it became constant again, only to improve three years later. From 1991 to 2011, private sector lending maintained an upward trend, despite minor fluctuations between 1999 and 2003 and also between 2007 and 2009. Historically, between 1975 and 2011, private sector lending reached an all-time low, of 115.2% in 1981; and an all-time high of almost 250% in 2007 (World Bank, 2012a).
Non-performing loans, though generally low, have been on the increase since 2008. Credit information is easily available to both consumers and banking institutions. Both consumers and institutions have strong legal rights. Table 3.2 depicts some of the banking indicators showing the development of the USA’s banking sector.
The growth of the American banking sector can also be indicated by the increasing number of Automated Teller Machines (ATMs) which has risen steadily over the years, from 352,000 ATMs in 2002 to 396,000 in 2005, to 425,010 in 2008; and slightly down to 403,000 in 2009 (United States Department of State, 2012).
From an economic growth perspective, the economy of the United States is the world’s largest national economy and the world’s second largest overall economy, after that of the European Union (IMF, 2012c).
Per capita GDP in the United States averaged US$26954.92 between 1975 and 2010. Historically, from 1975 until 2010, GDP per capita reached an all-time high of US$48442.00 in 2011 and a record low of US$7516.68 in 1975 (World Bank, 2012a). Between 1975 and 2010, GDP per capita exhibited an upward trend in general. Figure 3.1 shows the trends in banking sector growth, as indicated by credit extension to the private sector, and economic growth in the United States during the period 1975-2012.

Challenges Facing Bank-Based Financial Development in the USA

Although the US banking sector is recovering from the financial crisis of the late 2000s, it is far from fully recovered. On the contrary, it still faces a number of challenges that include: a shrinking mortgage market, increasing non-performing asset levels, weak economic growth, and the threat of contagion from Europe.
Although the incidence of non-performing loans in the USA banking sector is low compared to those in the emerging economies, an upward trend is evident in the last few years when viewed against the country’s historical statistics.
According to IMF (2012c), weak economic growth in the US poses a challenge to the country’s banking sector. During such times when economy recovery is patchy and growth is below its potential, banks have difficulties in coming up with cutting edge strategies for survival. Capital is also a challenge as banks will need more capital to support additional lending as part of the on-going economic recovery, and to both meet stiffer regulatory requirements in the future and withstand any future shocks to their balance sheets (IMF, 2012c).
Since the USA is among the world leading economies, its banking system is open to the international world, making it prone to the not so favourable/harsh conditions prevailing in other economies. Currently, the US banking sector is threatened by the contagion from Europe – the European sovereign debt crisis. Natural Disasters have also become a threat to the USA banking industry which is affected by disasters such as tropical cyclones, like Hurricane Sandy. Banking infrastructure and, to some extent, bank personnel, may be lost.
Another challenge facing the USA banking system, in the view of the New York Fed (2012b is the “too-big-to-fail (TBTF)” challenge since there are some very big banks whose failure, if allowed, is catastrophic. The New York Fed (2012b) further states that, the market’s belief that a TBTF firm is more likely to be rescued in the event of distress than other firms weakens the degree of market discipline exerted by capital providers and counterparties. Although a number of policy measures that alter incentives and reduce the probability of distress have been put in place, they only help to reduce the chances of TBTF occurring, but do not completely eliminate the problem (New York Fed, 2012b).

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Stock Market Development in the USA

Although the USA bank-based and market-based financial segments are both well developed by international standards, the latter segment is relatively more developed than its bank-based counterpart. Consequently, the USA economy is generally referred to as market-based (Demirguc-Kunt and Levine, 2001).
According to Sylla (1998), the precocity of USA banking development was duplicated in the development of the stock market. Following the debt refinancing of 1790 and the launching of the BUS a year later, securities markets sprang up virtually overnight in the major cities of Philadelphia, New York, Boston and Baltimore so as to provide regularised trading opportunities for the new claims (Sylla, 1998). The national market securities, which then included the USA debt issues and Bank stock, traded in each city and were joined by steadily growing lists of local securities. Sylla (1998) further points out that even a securities’ market crash in early 1792 could not for long arrest
the rapid deepening of these markets. This leap in asset liquidity allowed investors, both domestic and foreign, to overcome their reluctance to hold USA securities. By 1803 more than half of the government’s debt and the stock of the Bank, and half of all American securities issued to that date, were held by European investors (Sylla, 1998). Thus, for the United States, capital market globalisation arrived early in the nation’s history, long before the more celebrated capital market globalisations of the late 19th and late 20th centuries (Sylla, 1998).
To date, the United States has the most highly developed capital markets in the world and the size of the USA stock market is one of many examples that indicate this (World Federation of Exchanges, 2012). The combined market capitalisation (total dollar value of all stocks) of the NASDAQ OMX and NYSE Euronext is over $17.5 trillion – more than the next six largest exchanges combined (World Federation of Exchanges, 2012).
The following section covers the stock market in the USA in more depth and is organised as follows: Section 3.2.2.1 covers the origin of the stock market in the USA while Section 3.2.2.2 presents stock market reforms. Section 3.2.2.3 traces the trends in stock market growth and economic growth in the USA. Section 3.2.2.4 concludes the section by highlighting the challenges facing stock market development in the USA.

Origin of the Stock Market in the USA

In the USA, the history of stock market activities dates back to as early as 1792 when an agreement that established the rules for buying and selling bonds and shares was signed. Nonetheless, the first USA stock exchange was inaugurated in 1817, today the New York Stock Exchange Euronext (NYSE:NYX/NYSE Euronext). The USA had several stock exchanges, which gradually acquired one another and/or merged over the years to form three big stock exchanges – the biggest one being the NYSE Euronext, followed by the NASDAQ OMX, which is two-thirds the size of the NYSE Euronext by market capitalisation, followed by the Chicago Stock Exchange (CHX) (see World Stock Exchanges, 2011; NYSE:NYX, 2012; NASDAQ OMX, 2012; and Chicago Stock Exchange, 2012).
Although these three are the most visible stock exchanges in the USA, there are other exchanges that specialise in financial instruments, other than stocks. These include: i) the Chicago Mercantile Exchange (CME) (often called « the Chicago Merc, » or « the Merc »), which is an American financial and commodity derivative exchange based in Chicago and founded in 1898 as the “Chicago Butter and Egg Board” (CME Group, 2014) ; ii) the International Securities Exchange (ISE), which operates a leading USA options exchange and offers options trading for over 2,000 underlying equity, ETF, index, and FX products (International Securities Exchange, 2014); iii) the Boston Options Exchange (BOX), which is an electronic equity options market co-owned by seven broker-dealers and the TMX Group (Boston Options Exchange, 2014); and iv) the Chicago Board Options Exchange (CBOE), which is the largest options exchange in the world (Chicago Board Options Exchange, 2014). In addition to exchange-traded funds, index and equity options, the CBOE also features proprietary options offerings, including the CBOE Volatility Index (VIX), a global benchmark for market volatility, and also the S&P 500 (SPX), an American index producing the highest volume of trades (Chicago Board Options Exchange, 2014).
In the history of the USA stock market, there are some USA stock exchanges that did not survive. These include: i) the US Futures Exchange (USFE), which was an electronic futures market that barely survived a few years of operation (Stock Exchanges around the World, 2014). Although approval for the exchange was awarded in 2004, USFE did not launch until first-quarter 2007, and subsequently terminated all operations in December 2008; and ii) the Boston Equities Exchange (BeX), which was a short-lived regional exchange launched by the Boston Stock Exchange with backing from Wall Street (Stock Exchanges Around the World, 2014). Below is a detailed account of the origin and expansion of the three major stock exchanges in the USA.
New York Stock Exchange Euronext (NYSE:NYX)
The biggest stock exchange in the USA and the world’s largest equities platform is the New York Stock Exchange Euronext, Inc. (NYSE:NYX). The aggregate market capitalisation of its listed issuers is greater than that of issuers listed on the next four largest exchanges combined (New York Stock Exchange Euronext “NYSE:NYX”, 2012). NYSE:NYX is a Euro-American multinational financial services corporation, (with headquarters in New York, USA and Paris, France). It operates multiple securities exchanges that include New York Stock Exchange, the world’s largest cash equities market; NYSE Euronext, the Eurozone’s largest cash equities market; NYSE Arca (formerly known as ArcaEx), a fully electronic exchange for growth-oriented enterprises; and NYSE Alternext, a Pan-European market designed specifically for emerging companies (NYSE:NYX, 2012).
NYSE:NYX has its origin in the Buttonwood Agreement that was signed on 17 May 1792 (NYSE:NYX, 2012). In 2007, the NYSE Group, Inc. merged with Euronext N.V. to form the New York Stock Exchange Euronext, headquartered in New York. According to NYSE:NYX (2012), the historic combination of NYSE Group and Euronext in 2007 marked a milestone for global financial markets as it brought together major market places across Europe and the United States with histories stretching back more than four centuries. The combination was by far the largest of its kind and the first to create a truly global marketplace group (NYSE:NYX, 2012). The other NYSE Euronext New York Exchanges are NYSE Arca, NYSE Amex and ArcaEdge. NYSE Euronext is fully computerised (NYSE:NYX, 2012).
The NASDAQ OMX Group, Inc. (NASDAQ: NDAQ)
The NASDAQ OMX Group, Inc. (NASDAQ: NDAQ) is an American multinational financial services corporation that owns and operates the NASDAQ stock market in the USA. It has its headquarters in New York.
In 2006, NASDAQ completed its separation from the NASD and began to operate as a national securities exchange. In 2007, NASDAQ combined with the Scandinavian exchange group, OMX, and officially became the NASDAQ OMX Group, further demonstrating commitment to technology and innovation across global markets (NASDAQ OMX, 2012). In the same year, NASDAQ OMX acquired the Boston Stock Exchange (NASDAQ OMX, 2012). In 2008, NASDAQ OMX acquired: i) the Philadelphia Stock Exchange; ii) the Philadelphia Board of Trade, known today as NASDAQ OMX Futures Exchange; and iii) Chicago-based Bloom Partners, a leading market intelligence firm. In the same year, it also created NASDAQ Last Sale, the first USA stock exchange to facilitate free, universal access to real-time stock data (NASDAQ OMX, 2012).
In 2010 NASDAQ OMX acquired the SMARTS Group, the world-leading technology provider of market surveillance solutions to exchanges and regulators. It also acquired FTEN, which is a leading provider of Real-Time Risk Management solutions for the financial securities market, thereby enabling broker-dealers to manage risk and improve the investment process (NASDAQ OMX, 2012).
According to NASDAQ OMX (2012), the NASDAQ OMX Group currently owns and operates 24 markets, 3 clearing houses, and 5 central securities depositories, spanning six continents. Eighteen of the 24 markets trade equities. The other six trade options, derivatives, fixed income, and commodities. NASDAQ OMX is a public company listed on the NASDAQ Global Select Market (NDAQ) and has been part of the S&P 500 since 2008 (NASDAQ OMX, 2012).
Chicago Stock Exchange (CHX)
The Chicago Stock Exchange (CHX) was established in the city of Chicago (Chicago Stock Exchange, 2012). In 1949, the CHX merged with the exchanges of Cleveland, St. Louis and Minneapolis to form an exchange called the Midwest Stock Exchange (Chicago Stock Exchange, 2012). In 1959, the New Orleans Stock Exchange joined the Midwest Stock Exchange (Chicago Stock Exchange, 2012). In the 1990s, the Exchange underwent a transformation which included a name change to Chicago Stock Exchange in 1993 (Chicago Stock Exchange, 2012).
All the stock exchanges in the USA are regulated by the US Securities and Exchange Commission, the SEC. The SEC has its origins in the Securities Act of 1933 which was passed after the Great Crash of 1929 (USA SEC, 2012).

TABLE OF CONTENTS
DECLARATION
ABSTRACT
KEY WORDS
DEDICATION
ACKNOWLEDGEMENTS
TABLE OF CONTENTS
LIST OF TABLES
LIST OF FIGURES
ACRONYMS
CHAPTER 1 INTRODUCTION TO THE STUDY
1.1 Background to the Study
1.2 Statement of the Problem
1.3 Objectives and Hypotheses of the Study
1.4 Significance of the Study
1.5 Organisation of the study
CHAPTER 2 FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN DEVELOPING COUNTRIES
2.1 Introduction
2.2 Financial Development in South Africa
2.3 Financial Development in Brazil
2.4 Financial Development in Kenya
2.5 Concluding Remarks
CHAPTER 3  FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN DEVELOPED COUNTRIES
3.1 Introduction
3.2 Financial Development in the United States of America (USA)
3.4 Financial Development in Australia
3.5 Concluding Remarks
CHAPTER 4  FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: THEORETICAL AND EMPIRICAL LITERATURE REVIEW
4.1 Introduction
4.2 Financial Development and Economic Growth: A Theoretical Framework
4.3 Bank-Based Financial Development and Economic Growth: Empirical
4.4 Market-Based Financial Development and Economic Growth: Empirical Evidence
4.5 Conclusion
CHAPTER 5  ESTIMATION TECHNIQUES AND EMPIRICAL MODEL SPECIFICATION
5.1 Introduction
5.2 Empirical Model Specification
5.3 Estimation Techniques
5.4 Data Source and Definition of Variables
5.5 Conclusion
CHAPTER 6 ECONOMETRIC ANALYSIS AND EMPIRICAL FINDINGS
6.1 Introduction
6.2 Empirical Findings and Analysis for Developing Countries
6.3 Empirical Findings and Analysis for Developed Countries
6.4 Summary of Results (All Study Countries)
6.5 Conclusion
CHAPTER 7 CONCLUSION AND POLICY IMPLICATIONS
7.1 Introduction
7.2 Summary of the Study
7.3 Summary of Empirical Findings
7.4 Conclusions and Policy Implications
7.5 Limitations of the Study and Areas for Further Research
BIBLIOGRAPHY
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