This paper investigates the relationship between banking and growth in the presence of an inefficient judicial system. With regards to banks, the legal framework is particularly important. For example, in case of borrower's default the bank often has the right to seize collateral. However, in practice the enforcement of this right depends on the efficiency of the judicial system. A number of empirical studies (Stulz, 2001; Levine, 1998 and Beck et al., 2001) have shown that the legal framework is crucial for the development of a financial system. Figure 1 shows two financial depth indicators (Private Credit/GDP and Liquid liability/GDP) in the period 2000-04 versus the judicial efficiency (JE) for 76 countries divided in quartiles according to their "level" of judicial efficiency. It is clear that the two indicators of financial development increase with the judicial efficiency. This positive relationship suggests that the emergence of a banking system at the early stage of economic development may be influenced by the level of judicial efficiency.
The existence of a banking system is expected to lead to higher economic growth by providing more finance for productive projects. However, the judicial efficiency may in turn affect the intensity of this positive relationship. That is, when the judicial system is weak, banks will finance only those entrepreneurs providing sufficient collateral. Figure 2 outlines the entrepreneurship density in the period between 2002-04 versus the judicial efficiency for 56 countries . The solid curve traces the regression line which has a positive and highly significant coefficient (t-statistic, 5.18) and an R2 of 0.20. An increase of the judicial efficiency of 1 is associated, on average, with 18.83 percent increase in the entrepreneurship density. This is a large quantitative effect which suggests that even if a banking system has already emerged, an economy may suffer from low entrepreneurship due to the weakness of its judicial system.
Motivated by these empirical facts this paper proposes a theoretical model that focuses on two issues. First, the model seeks to provide a new explanation of the emergence of banking based on capital accumulation and credit market imperfection (judicial inefficiency). This is an issue that is rarely analyzed in the theoretical literature. To our knowledge the only exception is Tressel (2003), whose model analyses the emergence of banks after a first stage of development where the economy is endowed with an informal credit market. However, his analysis does not include the role of the credit market imperfection. In our model, credit market imperfection (judicial inefficency) is defined as in Matsuyama (2000, 2004) in relation to an enforcement problem: the borrowers are willing to honor their payment obligations vis-à-vis the bank only if they are inferior to the cost of default. This cost of default increases with the judicial inefficiency. Also, contrary to Tressel (2003), in our model the economy develops due to self-financed projects before the emergence of the banking system. This model shows that the banking system emerges once the economy reaches a particular stage of development. The higher the credit market imperfection (judicial inefficiency) the later this emergence occurs.
The second issue concerns the evolution of the effect of banking on growth when the credit market is imperfect. It is related to the theoretical studies analyzing the relationship between financial development and economic growth which began with Gurley and Shaw (1955), Goldsmith (1969) and McKinnon (1973). After the emergence of the endogenous growth theory more convincing models were constructed (Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1993; Boyd and Smith, 1996; Blackburn and Hung, 1998). Their common approach consists in the integration of a micro-economic model of financial contract theory in a dynamics general equilibrium model. These studies demonstrate the importance of financial development for economic growth. However, few theoretical models were developed to explain the weak impact of the banking system on growth in many countries where although a modern banking system has always emerged, it is far from playing its role in enhancing economic growth (Demetriades and Hussein, 1996). Nabi and Suliman (2009) showed that the intensity of causal effect from banking to economic growth is higher when the institutional environment improves. This is due to the reduction in the defaulting loans and the diminishing of the interest rate spread.
In this paper we propose a model which explains the countries' discrepancies in terms of the banking effect on economic growth by their different credit market imperfections’ levels. Indeed, its shows that after the banking emergence, the economy develops more quickly but remains under its growth potential level along a second stage of development. This is due to a credit rationing brake caused by the credit market imperfection. This credit rationing loosens progressively as the economy develops and disappears in the third stage of development. The lower the credit market imperfection is the faster the economy reaches the third stage of development. Hence, the removal of credit market imperfection should be a part of financial reforms since it increases the enforceability of credit contracts and reduces the credit rationing phase.
