How to Measure the Level of Financial Development

Introduction

One of the fundamental problems of the literature on financial development is about how to define and measure financial development in such a manner to enable comparisons between countries. The fact that the concept of financial development has long been held equivalent to financial size and depth has resulted in the expression of its definition over the size of the financial system. However, financial development is a multifaceted concept. The definition of financial development is required to contain all functions undertaken by the financial system. Therefore, the conventional measures of financial development (M₂/GDP, domestic credit to the private sector/GDP, etc.) that fail to go beyond the assessment of the mobilization of savings are, by themselves, insufficient to evaluate the financial system.

An accurate measurement is essential to identify correct policies regarding the development of the financial sector and its impacts. Numerous studies indicate that the analysis results vary depending on the financial development indicators used. The discrepancy of findings both make it more difficult to reach a general conclusion and hampers policy making. King and Levine (1992) claimed that there was no single precise measure that would allow the assessment of the situation of the financial system particularly in comparisons between countries and of the government activities for financial operations. Pill and Pradhan (1995) demonstrated that the conventional measures of financial development relying on real interest and monetary indicators resulted in misleading conclusions. Likewise, Lynch (1996) presented country examples to show it would be fallacious to reach conclusions on the level of financial development through the examination of a single indicator. The causes of the failure to find an appropriate indicator to measure the level of financial development are the difficulty of defining the concept of financial development, the fact that the financial system is composed of numerous financial markets, financial institutions and financial instruments the fulfilment of the functions of the financial system through various services, and the limitations regarding the potential to obtain data. The proofs showing that the level of financial development may not be represented by a single indicator led the researchers to gravitate towards the method of indexation, which enables them to deal with many indicators together.

In this context, the study has two objectives. One of them is to present in the most proper manner the definition of financial development, considering that bad definition leads to bad measurement and taking into account the discussions in the literature. The second one is to discuss how to measure the level of financial development.

In line with such objectives, the plan of the study is as follows: The introduction part will touch upon the importance of the subject and purpose of the study, and contain the problems in the relevant literature. The second section titled “Defining Financial Development” will mention the concepts of financial system, financial structure and financial market, which are frequently confused with each other, and the concept of financial development will be discussed and defined within the framework of the examples in the relevant literature. The third section titled “Measuring Financial Development” will underline the points required to be taken into account in measuring the level of financial development, and the indicators of financial development will be addressed in subsections titled financial size, financial efficiency, financial access and financial stability. Furthermore, the third section titled “Calculation of Financial Development Index” will also present examples of different sub-grouping of financial development indicators used in the literature. In the fourth section, the financial development indicators identified for 77 countries in connection with the previous section will be indexed through principal components analysis. The country rankings to be made separately in terms of the indices established and the indicators used to measure financial development in the literature will be compared, and the results will be interpreted.