Financial Development

A well developed financial system is very essential for the smooth functioning of any economy. One set of important statistical indicators that is used to look at the financial development of a country is financial development ratios.

An economy can be broadly divided into financial and non-financial sectors. Financial sector consists of banks and other financial institutions. Business of the financial sector is financial intermediation, that is channeling resources from surplus sectors (savers) in the economy to the deficit sectors (borrowers) in the economy.

Non-financial sector consists of household sector, private corporate business, government and the rest of the world. In the non-financial sector there are surplus spenders (savers) and deficit spenders (borrowers). Within household sector some households may have savings and someone else may have to borrow. On the whole the household sector may have net savings which can be lent to others sectors like corporate or government which is in need of funds. This way there are intra and inter-sectoral flows of funds in an economy.

Flow of funds can take place in two forms. One is that the surplus and deficit spenders can interact directly. That is deficit spenders directly borrow from surplus spenders by issuing claims on themselves. The other form is through financial intermediation. Here financial intermediaries mobilize the funds from surplus spenders and lend them to deficit spenders.

The claims issued in an economy can be classified into primary or secondary issues. Primary issues are claims issued by deficit spenders directly to the surplus spenders. Primary issues are also called new issues. Secondary issues are claims issued by financial sector. Total issues in an economy consist of both primary and secondary issues.

Volumes of these financial flows can be used to define various ratios of financial development. These ratios are (i) Finance Ratio, (ii) Financial Interrelations Ratio, (iii) New Issue Ratio and (iv) Intermediation ratio.

Finance Ratio (FR): It is defined as the ratio of total financial claims issued during the year to national income of that year. This captures the relation between financial development and overall economic development and indicates the financial deepening.

Financial Interrelations Ratio (FIR): FIR is the ratio of financial claims issued to net physical capital formation. This captures the relation between financial development and the growth of physical investment. Sometimes it is calculated as the ratio of the total stock of financial assets to the stock of physical assets at a point of time.

New Issue Ratio (NIR): NIR is the ratio of primary (new) issues by the non-financial sector to the net physical capital formation. This is a measure of 'financial disintermediation'. This indicates the extent to which non-financial sectors are financing their investment by borrowing directly from the ultimate savers rather than through the financial intermediaries.

Intermediation Ratio (IR): This is the ratio of secondary issues to primary issues i.e. claims issued by financial institutions to issues of non-financial sectors. This indicates the degree of financial intermediation.