Macroeconomic instability has stunted growth in many developing economies in the past two decades. As a result, the governments of these economies are looking for ways to better manage the economic factors that contribute to instability. Encouraging the creation of diverse financial markets, characterized by a wide range of financial institutions, may be one such option for better macroeconomic risk management. Greater institutional diversity could broaden the reach of financial markets, thus reducing liquidity constraints. And diversity may offer some insurance against the fallout from boom-and-bust cycles in each institutional type since each institutional type only covers a limited market segment.
But greater institutional diversity could contribute to instability. Many institutions may not fully capture economies of scale, driving up costs and fees for customers and exacerbating liquidity constraints. This may especially be the case if governments try to incentivize the creation of institutions in otherwise underserved markets through regulatory preferences and subsidies. Institutions may also compete for a limited number of creditworthy projects, potentially funding an increasing number of speculative projects. Liquidity constraints and speculation could raise economic instability. And financial market contagion may limit the insurance value of diversified financial markets.
We study the link between financial market diversity and economic instability in developing economies for the past few decades, using aggregate data from the Fraser Institute’s Economic Freedom database, the International Monetary Fund’s International Financial Statistics, the World Bank’s Global Financial Development database, the Bank for International Settlements’ international banking statistics and the BankScope database. We find that financial market diversity matters for economic stability for most subperiods during the past two decades as well as for most regions. Our research particularly suggests that greater diversity is associated with faster growth, larger credit markets, a broader deposit base, and a smaller chance of asset bubbles, all of which could contribute to more stability.
