This paper investigates the relationship between the liquidity roles of banks, financial fragility and economic growth. It integrates the analysis of liquidity crises into the analysis of the long run growth effects of financial intermediation.
The development of a banking system to pool liquidity risk allows economies to achieve higher growth rates and higher long run level of wealth and consumption. We show that financial development is particularly important for the growth performance of middle-income economies.
However, a banking system may be vulnerable to liquidity crises with potentially large output and welfare consequences in the short run. We show that sufficiently rich economies can afford the cost of full coverage against the risk of liquidity crises, while middle income economies may find optimal to remain vulnerable in exchange for higher returns and welfare. This explains why middle income countries exhibit on average higher growth and higher frequency of banking crises.
A large number of empirical studies support the existence of a positive relationship between financial intermediation and growth. King and Levine [1995] and Beck, Levine and Loayza [2000] find a positive effect of the relative size of the banking sector, and several measures of financial development on per capita output growth. On the other hand, the banking crisis literature has pointed out the role of financial liberalization and the rapid increase in financial depth as good predictors of financial crisis. Loayza and Ranciere [2001] attempt to reconcile the apparent contradiction between those two strands of the literature. They show that a long-run positive relationship between financial intermediation and output growth can coexist for some countries with a negative short-run relationship, specially for those countries that have suffered financial crises episodes.
