2010The FinancialDevelopment Report

The Financial Development Report 2010

World Economic ForumGeneva, Switzerland

World Economic Forum USA Inc.New York, USA

The terms country and nation as used in this report do not in all cases refer to a territorial entity that is a state as understoodby international law and practice. The termscover well-defined, geographically self-contained economic areas that may not be states but for which statistical data aremaintained on a separate and independentbasis.

World Economic Forum USA Inc.

Copyright 2010by the World Economic Forum USA Inc.

All rights reserved. No reproduction, copy ortransmission of this publication may be madewithout written permission.

No paragraph of this publication may bereproduced, stored in a retrieval system, ortransmitted, in any form or by any means,electronic, mechanical, photocopying, or otherwise without the prior permission of the World Economic Forum.

ISBN-10: 92-95044-93-2ISBN-13: 978-92-95044-93-7

This book is printed on paper suitable forrecycling and made from fully managed andsustained forest sources.

A catalogue record for this book is availablefrom the British Library.

A catalogue record for this book is availablefrom the Library of Congress.

Contents

Contributors v

Academic Advisors vii

Preface ixby Klaus Schwab

Foreword xiby Kevin Steinberg

Executive Summary xiii

Part 1: Findings from the Financial 1Development Index 2010

1.1: The Financial Development Index 2010: 3Unifying the Narratives of Reformby James Bilodeau and Ibiye Harry

1.2: Financial Development, Capital Flows, 31and Capital Controlsby Howard Davies and Michael Drexler

1.3: SME Finance: What Have We Learned 49and What Do We Need to Learn?by Thorsten Beck

Part 2: Country/Economy Profiles 57How to Read the Country/Economy Profiles ..............................59

List of Countries/Economies........................................................61

Country/Economy Profiles............................................................62

Part 3: Data Tables 291How to Read the Data Tables ....................................................293

Index of Data Tables ...................................................................295

Data Tables .................................................................................297

Technical Notes and Sources 369

About the Authors 379

Partner Institutes 381

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EDITOR

James BilodeauAssociate Director and Head of Emerging Markets FinanceWorld Economic Forum USA

PROJECT TEAM

Ibiye HarryProject Manager, World Economic Forum USA

Lawrence ChuangAssociate, World Economic Forum USA

PROJECT ADVISORS

Margareta Drzeniek HanouzDirector, Senior EconomistWorld Economic Forum

Thierry GeigerAssociate Director, EconomistWorld Economic Forum

CONTRIBUTORS

Thorsten BeckProfessor of Economics and Chairman of the European Banking Center, Tilburg University

Howard DaviesManaging Director, The London School of Economics and Political Science

Michael DrexlerGlobal Head of Strategy, Commercial Investment Banking andWealth Management, Barclays

EXPERT COMMITTEE*

Chris ColesPartner, Actis

Howard DaviesManaging Director, The London School of Economics and Political Science

Michael DrexlerGlobal Head of Strategy, Commercial Investment Banking andWealth Management, Barclays

Nick ODonohoeGlobal Head of Research, JPMorgan Chase

Gerard LyonsChief Economist and Group Head of Research, Standard Chartered

Raghuram RajanProfessor of Finance, University of Chicago

Nouriel RoubiniProfessor of Economics and International Business, New York University and Chairman, Roubini Global Economics

Andrei SharonovManaging Director, Troika Dialog

Kevin SteinbergChief Operating Officer, World Economic Forum USA

Augusto de la TorreChief Economist for Latin America and the Caribbean, The World Bank

We would like to thank Dealogic and Thomson Reuters for theirgenerous contribution of data for this Report.

FROM THE WORLD ECONOMIC FORUM

Kevin Steinberg, Chief Operating Officer, World Economic ForumUSA

Max von Bismarck, Director and Head of Investors Industry

Giancarlo Bruno, Director and Head of Financial ServicesIndustry

Anuradha Gurung, Associate Director

Trudy Di Pippo, Associate Director

Abel Lee, Associate Director

Kerry Wellman, Senior Community Manager

Lisa Donegan, Community Manager

Irwin Mendelssohn, Community Manager

Tom Watson, Project Manager

Isabella Reuttner, Project Manager

Nadia Guillot, Senior CoordinatorAlexandra Hawes, Coordinator

Takae Ishizuka, Coordinator

Elisabeth Bremer, Coordinator

Centre for Global Competitiveness and PerformanceJennifer Blanke, Director, Lead Economist, Head of the Centre for Global Competitiveness and Performance

Irene Mia, Director, Senior EconomistCiara Browne, Associate DirectorPearl Samandari, Community ManagerRoberto Crotti, Junior Quantitative Economist

We thank Hope Steele for her superb editing work and Neil Weinberg for his excellent graphic design and layout. We would also like to thank Chris Ryan for his assistance inassembling data for this Report.

Contributors

*The Forum is grateful for the support of the Industry Partners who served on the Expert Committee. Any findings contained in the Report aresolely the view of the Reports authors and do not reflect the opinions of the Expert Committee members.Employees of the World Economic Forum USA.

The Forum is grateful for the support of the Academic Advisors who contributed to the Report. Any findings contained in the Report aresolely the views of the Reports authors and do not reflect the opinions of the Academic Advisors.

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Martin BailyBrookings Institution

Thorsten BeckTilburg University

Richard CooperHarvard University

Erik FeyenThe World Bank

Luc LaevenInternational Monetary Fund

Subir LallInternational Monetary Fund

Maria Soledad Martinez PeriaThe World Bank

Sergio SchmuklerThe World Bank

Luigi ZingalesUniversity of Chicago

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Academic Advisors

ix

Pref

ace

When the Forums first Financial Development Reportwas published in 2008, the world was in the midst of a financial crisis that posed one of the single greatestthreats to global prosperity we had seen in over 70years. Two years later, with the publication of this thirdedition of The Financial Development Report, the globalcommunity can look back with an appreciation thatconcerted global action may have averted the worst ofan immediate crisis. This work is far from complete,however, and the immediate dangers of financial insta-bility are still present. Perhaps the most immediate con-cern is that many developed economies must confrontsevere fiscal constraints without jeopardizing a fragileeconomic recovery.The financial risks confronting the global economy

are both broader in scope and longer in term than justthose stemming from the recent crisis. The robustgrowth and relative stability of emerging marketeconomies have been bright spots shining through the turmoil of recent years. It is expected that the global economy will rely on these economies to be the primary engine of global economic growth in theyears ahead. Yet these economies in turn must rely onfinancial systems that, in many instances, are less devel-oped. It is imperative that development areas withinthese financial systems be addressed to ensure that future economic growth is not undermined: newsources of long-term capital must be tapped to fundmuch-needed infrastructure; local capital markets mustbe developed to meet the expanding credit needs of all economic sectors; and access to retail financial ser -vices must be extended to help stimulate consumerdemand in these markets, which in turn can offset global imbalances.The aftermath of the financial crisis has brought a

ferment of ideas about how to respond to the crisis andestablish new models for financial systems going for-ward. The Forum itself has hosted much of this dialoguethrough its various stakeholder communities, its regionaland annual events, and its Network of Global AgendaCouncils. While it is important that these ideas be heardand vetted, it is also increasingly important that stake -holders move to unite around a coordinated reformagenda that addresses all of the financial risks that couldthreaten long-term economic growth. It is in this spiritthat we offer this years Financial Development Report, as acomprehensive yet accessible reference tool with which

to focus priorities on the most-needed areas of financialreform.

In the tradition of the Forums multi-stakeholderapproach to global issues, the creation of this Reportinvolved an extended program of outreach and dialoguewith members of the academic community, public fig-ures, representatives of nongovernmental organizations,and business leaders from across the world. This workincluded numerous interviews and collaborative sessionsto discuss the findings, and their implications, of theIndex as well as possible modifications to its design.Other complementary publications from the WorldEconomic Forum include The Global CompetitivenessReport, The Global Enabling Trade Report, The GlobalGender Gap Report, The Global Information TechnologyReport, and The Travel & Tourism Competitiveness Report.We would like to express our gratitude to our

industry partners and the academic experts who servedon the projects Expert Committee: Chris Coles,Partner, Actis; Michael Drexler, Global Head of Strategy, Commercial Investment Banking and WealthManagement, Barclays; Nick ODonohoe, Global Head of Research, JPMorgan Chase; Howard Davies,Managing Director, London School of Economics;Gerard Lyons, Chief Economist and Group Head ofResearch, Standard Chartered; Professor RaghuramRajan, University of Chicago; Andrei Sharonov,Managing Director, Troika Dialog; Kevin Steinberg,Chief Operating Officer, World Economic Forum USA;and Augusto de la Torre, Chief Economist for LatinAmerica and the Caribbean, The World Bank. We areappreciative of our other academic advisors who gener-ously contributed their time and ideas in helping shapethis Report.We would also like to thank James Bilodeauat the World Economic Forum USA, editor of theReport, for his energy and commitment to the project, aswell as the other members of the project team, includ-ing Ibiye Harry and Lawrence Chuang. We are gratefulto Margareta Drzeniek Hanouz and Thierry Geiger fortheir guidance as Project Advisors. Appreciation alsogoes to the Centre for Global Competitiveness andPerformance Team, including Jennifer Blanke, CiaraBrowne, Roberto Crotti, Irene Mia, and Pearl Samandari.Finally, we would like to thank our network of PartnerInstitutes, without whose enthusiasm and hard work theannual administration of the Executive Opinion Surveyand this Report would not be possible.

PrefaceKLAUS SCHWAB

Executive Chairman, World Economic Forum

The World Economic Forum is pleased to release TheFinancial Development Report 2010, the third editionsince its inaugural publication in 2008. Initiatives such asthis Report aim to enrich and focus the dialogue, amongmultiple global stakeholders, that the Forum has pro-moted through its events, Global Agenda CouncilNetwork, and Industry Partnership Programme. TheReport represents a key ongoing initiative undertaken aspart of the Forums Industry Partnership Programme.The Programme provides a platform for CEOs and senior executives to collaborate with their peers and an extended community of academics, leaders from government, and experts from civil society to tackle key issues of concern to the global community.

Unifying the narratives of reformFinancial reform continues to occupy a central place onthe global agenda. In some respects, because the urgencyof the response to the immediate financial crisis hasmoderated, there is now more room for debate aboutpriorities for long-term reform and preferred models forfinancial development in the years to come. We believethis Financial Development Report provides an importanttool with which to ground this debate in actual meas-ures of progress at the country level.At the global level, while progress has been made in

many areassuch as the new capital requirements underBasel IIImany questions remain in areas such as coun-tercyclical capital buffers and the best way to treat system-ically important institutions. Even as multilateral rulesare drafted and agreed upon, it is vital that institutionalreform at the country level be undertaken to ensure thatnew rules can be enforced and regulatory arbitrage pre-vented. The variables in this Report help provide guid-ance on measuring progress at the country level.As reforms are proposed and some enacted, there is

a diversity of opinion around how they may affect theavailability and cost of capital and how this impact couldaffect economic growth. The business environment indifferent economies, including the tax regime, avail -ability of talent, and cost of doing business, could alsoimpinge on the availability of capital. This Report includesassessments of the business environment and availabilityof different forms of capital for corporate end-users.The G-20 and various multilateral organizations

have identified financial inclusion as a central issue ontheir agenda. The ability of a financial system to provide

basic financial servicessuch as loans, savings accounts,and insurance to consumersis one of its most impor-tant functions. A number of measures with which toassess progress in the provision of retail financial servicesare provided within the Report.

The Financial Development Report 2010In light of the ongoing richness of debate, we offer thisyears Report as a way to unify these different narrativesand enable stakeholders to collectively prioritize, imple-ment, and assess reforms. Part 1 of the Report summa-rizes this years Index results and related findings inthree sections. Chapter 1.1 outlines the methodology forthe Index, the academic theory and assumptions sup-porting it, and some of the key findings from the Indexresults. Chapter 1.2 provides an example of how theIndex can be used to help countries prioritize reformefforts, focusing on the development of defenses againstvolatile capital flows and a code of practice for use ofcapital controls. Chapter 1.3 highlights the issue ofsmall- and medium-sized enterprise (SME) finance, anexample of a critical issue that must be included withinan expanded narrative of reform that addresses financialdevelopment more broadly.We encourage readers to delve into the detail of

Part 2: Country/Economy Profiles and Part 3: DataTables of the Report.The richness and breadth of thedata paint a balanced picture of the challenges andopportunities faced by different countries.By design, this Report must rely on data that are

available for all the economies it covers, to proxy for keyelements of financial development. This year, as everyyear, it is with a degree of humility that we put forthour findings given some of the inherent limitations ofthese data, the rapidly changing environment, and theunique circumstances of some the economies covered.Yet, in the Reports attempt to establish a comprehensiveframework and a means for benchmarking, we feel itprovides a useful common vantage point to unify prior-ities and frame action. We welcome your feedback andsuggestions for how we may develop and utilize thisReport to promote the potential of financial systems asenablers of growth and individual prosperity.On behalf of the World Economic Forum, we

wish to particularly thank the members of the ExpertCommittee, the Academic Advisors, and James Bilodeauand Ibiye Harry for their boundless support.

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ForewordKEVIN STEINBERG

Chief Operating Officer, World Economic Forum USA

The Financial Development Report 2010 and the FinancialDevelopment Index (FDI) on which it is based providea score and rank for 57 of the worlds leading financialsystems and capital markets. They analyze the drivers offinancial system development that support economicgrowth in advanced and emerging economies to serve asa tool for countries to benchmark themselves and prior-itize areas for reform.The Report defines financial development as the factors,

policies, and institutions that lead to effective financial interme-diation and markets, as well as deep and broad access to capitaland financial services. In accordance with this definition,measures of financial development are captured acrossseven pillars:

1. Institutional environment2. Business environment3. Financial stability4. Banking financial services5. Non-banking financial services6. Financial markets7. Financial access

The FDI thus takes a comprehensive view in assess-ing the factors that contribute to the long-term devel-opment of financial systems; it includes but is muchbroader than just measures of immediate financial stability.Because of this broad definition, for the top scorers

in the Index, the United States (1st) and the UnitedKingdom (2nd), the very low scores in financial stabilityare counterbalanced by incumbent strengths in financialintermediation that buoy their positions in the rankings.The two countries both show advantages in non-banking financial services and financial markets, and the United Kingdom also demonstrates strength inbanking financial services (based on measures of size and efficiencyfinancial stability is captured elsewhere).The business environments in both countries displaysigns of deterioration, particularly in the area of taxation.As in last years Index, the economies in the top 10

are predominantly smaller (by GDP) than the membersof the G-8; this is true for 6 out of the top 10 in overallrank (see Table 1). These smaller economies includeHong Kong SAR (3rd), Singapore (4th), Australia (5th),

the Netherlands (7th), Switzerland (8th), and Belgium(10th). Both Canada (6th) and Japan (9th) maintainedtheir overall rank from last year.An important finding from this years Index results

can be seen in the context of the current economicenvironment: emerging market economies are now theprimary driver of global economic growth and, at cur-rent rates, could generate the majority of absolute GDPgrowth over the next five years. Although this finding isencouraging in many respects, it also points towardsome risks: the financial systems in many of these countries are less developed than those in advancedeconomies. On average, emerging market economiesscored 1.3 points lower than advanced economies in theIndex (see Figure 1, a comparison of GDP growth andthis years Index scores.)Although financial stability has been a relative

advantage for many emerging market economies overthe last several years, their performance in other areas ofthe Index may increasingly constrain economic growthat the country and global level. The risks to economicgrowth posed by these development areas can be seen in the following critical areas:

Long-term financing for infrastructure. Banks maybe increasingly limited in their ability to providethe tenor and amount of financing needed to fundsignificant infrastructure needs. The development ofcapital markets in many emerging markets may benecessary to fill this gap. Additionally, weaknesses in

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Table 1: Top 10 in overall Index ranking

2010 2009 2010 Change rank rank score in score

Economy (1 to 57) (1 to 55) (1 to 7) (2010 vs. 2009)

United States 1 3 5.12 0.01

United Kingdom 2 1 5.06 0.22

Hong Kong SAR 3 5 5.04 +0.06

Singapore 4 4 5.03 +0.01

Australia 5 2 5.01 0.12

Canada 6 6 4.98 +0.02

Netherlands 7 8 4.73 0.12

Switzerland 8 7 4.71 0.21

Japan 9 9 4.67 +0.03

Belgium 10 13 4.65 +0.15

the institutional environments of many economieswill need to be addressed to increase the willingnessof investors to commit long-term capital.

Deep and accessible local bond markets.The localbond markets in many Asian and Latin Americancountries are not as developed as other parts oftheir financial systems. This can limit the availabilityof capital for important sectors, such as small- andmedium-sized enterprises (SMEs) (Chapter 1.3 discusses some of the obstacles to SME financing).Additionally, strong local bond markets can be animportant defense against the harmful effects ofvolatile capital flows (please see Chapter 1.2 for adiscussion of capital flows, capital controls, andfinancial development).

The extension of retail financial access. As seen inmany Asian and some Latin American countries,poor access to retail financial services for consumersmay hinder efforts to stimulate local demand thatcould help offset global economic imbalances.Savings, credit (including mortgages), and insurancecan help increase and smooth the spending of con-sumers who will be increasingly critical to sustain-ing economic growth.

The recent financial crisis has underscored theinterconnected nature of financial systems. If weaknesses

in the institutional environments or financial stability of global financial centers such as United States andUnited Kingdom persist or worsen, this will only add to the urgency of developing financial systems in othercountries to promote sustained economic growthworldwide.

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Figure 1: Absolute GDP growth vs. FinancialDevelopment Index 2010 score

Source: GDP data taken from IMF, World Economic Outlook Database, April2010.

$5

$6

$7

$8$7.7 trillion

3.16$6.5 trillion

4.45

Emergingmarkets

Advancedeconomies

5

4

3

2

1

Absolute GDP grow

th(20102014, US$ trillions)

Overall FDI score

l Average FDI score n Absolute GDP growth

Part 1 Findings from the FinancialDevelopment Index 2010

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CHAPTER 1.1

The Financial DevelopmentIndex 2010: Unifying theNarratives of ReformJAMES BILODEAU, World Economic Forum USA

IBIYE HARRY, World Economic Forum USA

Continued global financial uncertainty has underscoredthe complexity and interconnectedness of financial sys-tems. Financial instability originally emanating primarilyfrom the US mortgage markets several years ago hasproceeded to manifest itself in a number of other assetclasses and regions, most recently in sovereign debt inthe euro zone.1 Economies continue to grapple withquestions of financial reform that must be considered intandem with other fundamental questions, such as howto drive sustained economic growth and promote fiscalresponsibility.

This complexity is also illustrated by the degree towhich the actions of different stakeholders have im -pacted the functioning of financial systems. The indebt-edness of both individuals and sovereign entities, riskmanagement by financial institutions, the originate-and-distribute model facilitated by the shadow bankingsystem, oversight by regulators, and the promotion ofexports through exchange rate policy by lawmakershave all been cited as factors influencing the develop-ment of financial systems in the last several years. Somerecent research also traces the root cause of current finan-cial instability to broader societal and economic ques-tions such as the failure to address income inequalitythrough investments in human capital and education.2

As countries move from an immediate response tofinancial crisis to the implementation of longer-termpolicies that will influence the shape of financial systemsfor years to come, it is important to view these actionswhile keeping in mind this complexity of financial sys-tems and the factors and stakeholders that influencethem. This includes objectively assessing which measureswill most improve overall financial development overthe long term; how they will affect the different stake-holders within financial systems; and, ultimately, howthey will further economic prosperity for all participantsin the global economy. Empirical studies concerningfinancial development and growth have generally foundthat cross-country differences in levels of financial devel-opment explain a considerable portion of the cross-country differences in growth rates of economies.3

It is in this context that the third annual FinancialDevelopment Report aims to provide policymakers with a common framework to identify and discuss the range of factors that are central to the development of globalfinancial systems and markets. It provides the FinancialDevelopment Index (FDI), which ranks 57 of theworlds leading financial systems and can be used bycountries to benchmark themselves and establish pri -orities for financial system improvement. The FinancialDevelopment Report is published annually so that coun-tries can continue to benchmark themselves against theirpeers and track their progress over time.

In recognition of the diversity of economies cov-ered in the FDI and the variety of financial activitiesthat are vital to economic growth, the FDI provides aholistic view of financial systems. For the purposes of

this Report and the FDI, we have defined financial devel-opment as the factors, policies, and institutions that lead toeffective financial intermediation and markets, as well as deepand broad access to capital and financial services.This defini-tion thus spans the foundational supports of a financialsystem, including the institutional and business environ-ments; the financial intermediaries and markets throughwhich efficient risk diversification and capital allocationoccur; and the results of this financial intermediationprocess, which include the availability of, and access to,capital.

The FDI relies upon current academic research inboth selecting the factors that are included and in deter-mining its overall structure. This encompasses a varietyof measures intended to capture different dimensions offinancial stability that have been highlighted in the cur-rent crisis. However, consistent with its purpose of sup-porting the long-term development of financial systemsand their central role in economic growth, it alsoencourages a broad analysis over a theoretical focus on a few specific areas. With this holistic view, decisionmakers can develop a balanced perspective as to whichaspects of their countrys financial system are mostimportant and empirically calibrate this view relative to other countries.

Financial development and economic growthA large body of economic literature supports the prem-ise that, in addition to many other important factors, theperformance and long-run economic growth and wel-fare of a country are related to its degree of financialdevelopment. Financial development is measured by fac-tors such as size, depth, access, and the efficiency andstability of a financial system, which includes its markets,intermediaries, range of assets, institutions, and regula-tions. The higher the degree of financial development,the wider the availability of financial services that allowthe diversification of risks. This increases the long-rungrowth trajectory of a country and ultimately improvesthe welfare and prosperity of producers and consumersthat have access to financial services. The link betweenfinancial development and economic growth can betraced back to the work of Joseph Schumpeter in theearly 20th century,4 and more recently to RonaldMcKinnon and Edward Shaw. This link is now wellestablished in terms of empirical evidence.5

The slow economic recovery for many countriessince the onset of the recent crisis has underscored the negative impacts that financial systems can have oneconomic growth; in general, economic recoveries afterfinancial crises have been shown to be much slowerthan those that occur after recessions not associated withfinancial crises.6 However, it is important to consider thepositive impact that broader financial development andmore dynamic financial systems can have on longer-term economic growth as well. Research supports the

idea that countries that have experienced occasionalfinancial crises have, on average, demonstrated highereconomic growth than countries that have exhibitedmore stable financial conditions.7 Financial innovation,when undertaken prudently, can also be important toeffectively screen and allocate funds to new and pro -ductive enterprises, particularly as technology evolves.8

Thus, although it is important to mitigate the short-term impact of crises, it is also important to view financial development in terms inclusive of, but broader than, financial stability.

Economic theory suggests that financial marketsand intermediaries exist mainly because of two types ofmarket frictions: information costs and transaction costs.These frictions lead to the development of financialintermediaries and financial markets, which performmultiple functions. Among these are facilitating the trad-ing, hedging, diversification, and pooling of risk; provid-ing insurance services; allocating savings and resources tothe appropriate investment projects; monitoring man-agers and promoting corporate control and governance;mobilizing savings efficiently; and facilitating theexchange of goods and services.

Financial intermediation and financial markets contribute directly to increased economic growth andaggregate economic welfare through their effect on cap-ital accumulation (the rate of investment) and on tech-nological innovation. First, greater financial developmentleads to greater mobilization of savings and its allocationto the highest-return investment projects. This increasedaccumulation of capital enhances economic growth.Second, by appropriately allocating capital to the rightinvestment projects and promoting sound corporategovernance, financial development increases the rate oftechnological innovation and productivity growth, fur-ther enhancing economic growth and welfare.

Financial markets and intermediation also benefitconsumers and firms in many other ways that are notdirectly related to economic growth. Access to financialmarkets for consumers and producers can reduce pover-ty, such as when the poor have access to banking ser -vices and credit. The importance of microfinance can be seen in this context. This access allows consumers tosmooth consumption over time by borrowing and/orlending and stabilizes consumer welfare in the presenceof temporary shocks to wages and income. By con-tributing to the diversification of savings and of port -folio choices, it can also increase the return on savingsand ensure higher income and consumption opportuni-ties. Insurance services can help mitigate a variety ofrisks that individuals and firms face, thus allowing betterrisk sharing of individual or even macroeconomic risks.9

The seven pillars of financial developmentTo understand and measure the degree of financialdevelopment, one must consider all of the different

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factors that together contribute to the degree of depthand efficiency of the provision of financial services.Conceptually, in thinking about an index that measuresthe degree of financial development, the various aspectsof development can be seen as seven pillars groupedinto three broad categories, as indicated in Figure 1:

1. Factors, policies, and institutions: the foundationalcharacteristics that allow the development of finan-cial intermediaries, markets, instruments, and services.

2. Financial intermediation: the variety, size, depth,and efficiency of the financial intermediaries andmarkets that provide financial services.

3. Financial access: access by individuals and busi -nesses to different forms of capital and financial services.

The seven pillars are organized and described belowaccording to these three categories. (See Appendix A for the detailed structure of the FDI and a list of allindicators.)

Factors, policies, and institutionsThis first category covers those foundational featuresthat support financial intermediation and the optimalprovision of financial services and includes the first three

of the seven pillars: the institutional environment, thebusiness environment, and the degree of financial stability.

First pillar: Institutional environmentThe institutional environment encompasses the laws andregulations that allow the development of deep and effi-cient financial intermediaries, markets, and services aswell as the macroprudential oversight of financial sys-tems. This includes the overall laws, regulations, andsupervision of the financial sector, as well as the qualityof contract enforcement and corporate governance.

Economic theory proposes that a strong institution-al environment exists to alleviate information and trans-action costs.10 Much empirical work has tackled issuesrelated to the importance of institutions and theirimpact on economic activity in general. The presence oflegal institutions that safeguard the interests of investorsis an integral part of financial development.11 Reformsthat bolster a countrys legal environment and investorprotection are likely to contribute to a more efficientfinancial sector.12 Accordingly, we have included vari-ables related to the degree of judicial independence andjudicial efficiency.

The recent crisis has clearly emphasized the impor-tance of regulation at the institutional level as it relatesto financial stability and corresponding effects on thereal economy. As highlighted in the recent financial cri-sis, central banks play a critical role in the functioning of financial systems and this year we have included

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Figure 1: Composition of the Financial Development Index

Source: World Economic Forum.

Factors, policies, and institutions

1. Institutional environment

2. Business environment

3. Financial stability

Policymakers

Financial intermediation

4. Banking financial services

5. Non-banking financial services

6. Financial markets

Financial intermediaries

Financial access

7. Financial access

End users of capital

Financial Development Index

measures related to central bank transparency.13 A meas-ure of the effectiveness of regulation of securitiesexchanges is also included. The degree to which coun-tries coordinate or harmonize their regulatory regimesinternationally is also an important consideration.However, since there is little in the way of cross-countrydata that captures this in a uniform way, we are unableto include a specific indicator for thisat least until fur-ther research becomes available.

Better corporate governance is believed to encour-age financial development, which in turn has a positiveimpact on growth.14 Contract enforcement is alsoimportant because it limits the scope for default amongdebtors, which in turn promotes compliance. Variablescapturing these measures as they relate to the formaltransfer of funds from savers to investors are included inthe pillar.15 Inadequate investor protection leads to anumber of adverse effects, which can be detrimental toexternal financing and ultimately to the development ofwell-functioning capital markets.16 In general, inade-quate enforcement of financial contracts has been foundto augment the process of credit rationing, thus hinder-ing the overall process of growth.17

Other important aspects of the institutional environ-ment are a countrys capital account openness and domes-tic financial sector liberalization. Financial liberalizationgenerally permits a greater degree of financial depth,which translates into greater financial intermediation

among savers and investors. This in turn increases themonetization of an economy, resulting in a more effi-cient flow of resources.18 Empirically, however, theimpact of capital account liberalization delivers mixedevidence. Several studies have asserted that capitalaccount liberalization has no impact on growth, whileothers have found a positive, and statistically significant,impact.19 At the same time, other work asserts that therelationship is undetermined.

Given such ambiguity over the impact of capitalaccount openness, it is best examined within the context of the legal environment. The better a countryslegal and regulatory environment, the greater the bene-fits from capital account opennessand vice versa.Accordingly, within the FDI we try to capture the rela-tionship between capital account openness and the levelof legal and regulatory development, and have interactedthe variables used to measure each (see Appendix A).The presence of both a robust legal and regulatory sys-tem and capital account openness provides a positiveindication of the financial development of a country. Wehave also interacted the capital account openness vari-able with the level of bond market development becauseof research that asserts the importance of developingdomestic bond markets in advance of full liberalizationof the capital accounts.20 (Please see Box 1 for furtherdiscussion of capital flows and capital controls in thecontext of financial development.) Assessments of

According to classic economic theory, capital flows from devel-oped economies, which have a capital surplus, to developingmarkets, which have a surplus of investment opportunities.However, this orthodox economic view has been challenged by a number of events. Research has also found that capital has recently flowed from emerging economies, such as Chinaand the Middle East, to developed markets, such as the UnitedStates.

Capital flows are a feature of globalization and offer a number of worthwhile benefits. These include enablinginvestors to promote the long-term allocation of resources andproviding liquidity and financing where needed. The question isone of how to harness these benefits while mitigating potentialrisks. Such risks are of particular concern for smallereconomies that are still in development. Capital flows that arelarge relative to a local economy generally bring three dangers:(1) inflation of bubbles, (2) currency mismatches, and (3) maturi-ty or liquidity mismatches. Categories of resilience againstthese risks include (1) deep local asset markets, (2) deep localcurrency markets, and (3) well-developed local debt markets.

The Financial Development Index (FDI) can helpeconomies assess their resilience to episodes of excessive

capital flow. An economys FDI scores in the three aforemen-tioned resilience categories can be aggregated into a defensivescore and mapped against its GDP (see Figure 4, Chapter 1.2). Ifthe GDP is small and the defensive score is also small, an econ-omy can be potentially at risk from speculative flows. As a second step, it can also be insightful to map the relationshipbetween an economys defensive score and its advanced mar-ket score, which aggregates selected variables from the FDIrelated to the development of more advanced asset markets.Despite the importance of the resilience measures previouslydescribed, they might not prevent a capital flow episode thatthreatens the systemic stability of a local economy.Consequently, there can be circumstances where measures ofcapital control are required. Historical episodes show that fivetypes of capital controls have been employed most frequently:(1) unremunerated reserve requirements, (2) time requirements,(3) quantitative limits, (4) direct tax on financial transactions,and (5) the regulation of trade between residents and non- residents. The efficacy of a capital control will depend on themotivation of the speculators it is supposed to deter and also on the state of the economy in which it is implemented.

Box 1: Financial development, capital flows, and capital controls

(Please see Chapter 1.2 by Howard Davies and Michael Drexler for a full discussion of this topic.)

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commitment to WTO trade agreements as they relate tofinancial services have also been included and interactedin a similar manner.

A similar analysis can be extended to the degree ofliberalization of the domestic financial sector. Thisdegree of liberalization is based on whether a countryexerts interest rate controls (either ceilings or floors),whether credit ceilings exist, and whether foreign cur-rency deposits are allowed. In general, the better a coun-trys legal and regulatory environment, the greater theimpact of domestic financial sector liberalization on acountrys economic growth. Variables representing eachof these characteristics have been interacted to representthis result. Recent research supports the importance ofadvanced legal systems and institutions in this respect,holding that the presence of such institutions is as vitalas having both a developed banking sector and equitymarkets.21

Second pillar: Business environmentThe second pillar focuses on the business environmentand considers:

the availability of human capitalthat is, skilledworkers who can be employed by the financial sector and thus provide efficient financial services;

the state of physical capitalthat is, the physicaland technological infrastructure; and

other aspects of the business environment, includingtaxation policy and the costs of doing business forfinancial intermediaries.

The creation and improvement of human capitalhave been found to assist the process of economicgrowth.22 Empirical evidence supports this observationand shows positive correlations between human capitaland the degree of financial development.23 Our proxiesfor the quality of human capital are related to theenrollment levels of tertiary education. We also includemeasures that reflect the quality of human capital, suchas the degree of staff training, the quality of manage-ment schools and math and science education, and theavailability of research and training services.

Another key area is infrastructure. We capture abasic measure of the quality of physical infrastructure,which is important given its role in enhancing theprocess of private capital accumulation and financialdepth in countries by increasing the profitability ofinvestment.24 However, our analysis of infrastructureemphasizes measures of information and communicationtechnologies, which are particularly important to thosefirms operating within a financial context because oftheir data-intensive nature.

Another integral aspect of the business environmentis the cost of doing business in a country. Specifically,

research has shown that the cost of doing business is avital feature of the efficiency of financial institutions.The different costs of doing business are fundamental toassessing a countrys business environment as well as thetype of constraints that businesses may be facing.25 Assuch, the better the business environment, the better theperformance of financial institutions and the higher thedegree of financial development. Variables that capturesuch costs include the World Banks measures of the costof starting a business, the cost of registering property,and the cost of closing a business. Indirect or transactioncosts are captured in variables such as time to start abusiness, time to register property, and time to close abusiness.

Our analysis also considers taxes as another keyconstraint that businesses in the financial sector can face.The variables in this subpillar focus on issues related todistortionary and burdensome tax policies, reflectingclearer consensus around the importance of these issues.High marginal tax rates have been found to have distor-tionary effects, so we have included a variable to capturethis. Because there is less clarity in the academic litera-ture around the effects of absolute rates of taxation andissues of data comparability, we have not included meas-ures related to overall tax rates.

Third pillar: Financial stabilityThe third pillar addresses the stability of the financialsystem. The severe negative impacts of financial instabil -ity on economic growth can be profoundly seen in therecent financial crisis as well as in past financial crises.This instability can lead to significant losses to investors,resulting in systemic banking crises, systemic corporatecrises, currency crises, and sovereign debt crises.

This pillar captures the risk of three types of crises:currency crises, systemic banking crises, and sovereigndebt crises. For the risk of currency crises, we includethe change in real effective exchange rate, the currentaccount balance, a dollarization vulnerability indicator,an external vulnerability indicator, external debt toGDP, and net international investment position. Theexternal debt to GDP and net international investmentposition variables are specifically applied to developingand developed countries, respectively.

The systemic banking crises subpillar combinesmeasures of historic banking system instability, an assess-ment of aggregate balance sheet strength, and measuresof the presence of bubbles. Historic instability is cap-tured in a measure of the frequency of banking crisessince the 1970s; more recent banking crises are givengreater weight. Empirical research has shown that coun-tries that have gone through systemic banking crises orendured a high degree of financial volatility are moresusceptible to profound short-term negative impacts onthe degree of financial intermediation.26We also capturethe degree of economic output loss associated withcrises (weighting output loss from more recent crises

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more heavily.) A Financial Stress Index also captures theincidence of financial stress in countries that do notreach the proportions of a full-blown crisis.27 It isimportant that prudential regulation include the estab-lishment of uniform capital adequacy requirements, andaccordingly we have included a measurement of Tier 1capital in this subpillar.28 Some research indicates thatquantitative capital adequacy measures are not alwaysaccurate measures of the financial strength of banks indeveloping countries.29 Accordingly, we have included afinancial strength indicator that balances quantitativemeasures of balance-sheet strength with qualitativeassessments of banks abilities to meet their obligationsto depositors and creditors.

The last type of crisis captured within the financialstability pillar is sovereign debt crisis. The manageabilityof public debt defined as total public debt as a percent-age of GDP is included in this pillar. The ability ofcountries to pay this debt in full and in a timely manneris captured in sovereign credit ratings, an importantproxy for the risk of such a crisis; these data were cal -culated as an average of both local currency sovereigncredit ratings and foreign currency sovereign credit rat-ings. A high sovereign credit rating signifies less likeli-hood of default occasioned by a sovereign debt crisis.Credit default swaps provide a quantitative, market-based indicator of the ability of a country to repay itsdebt. Macroprudential measures such as inflation andGDP growth are also included, as these also influencethe ability of countries to service their debt.

The greater the risk of these crises, the greater thelikelihood that the different processes of financial inter-mediation will be hampered, precipitating lower eco-nomic growth rates. However, these effects of financialstability on economic growth can be considered interms of a tradeoff between risk and innovation/return.For example, a financial system that is very heavilysupervised and regulated may be very stable and neverspark a financial crisis. However, such a controlled sys-tem would hamper the financial development and inno-vation that increases returns, diversifies risks, and betterallocates resources to the highest-return investments.Conversely, a financial system that is very free and inno-vative and is very lightly regulated and supervised mayeventually become unstable and trigger credit boomsand asset bubbles that can severely affect growth,returns, and welfare. Although there is some tradeoffbetween the stability of the financial system and itsdegree of innovation and sophistication, financial stabili-ty remains an important input in the process of financialdevelopment.

Financial intermediaries and marketsThe second category of pillars measures the degree ofdevelopment of the financial sector as seen in the dif -ferent types of intermediaries. These three pillars are

banking financial services, non-banking financial ser -vices (e.g., investment banks and insurance firms), andfinancial markets.

Consensus exists on the relationship between thesize and depth of the financial system and the supplyand robustness of financial services that are importantcontributors to economic growth.30 This relationshipoccurs because the size of financial markets is viewed asan important determinant of savings and investment.31

The size (total financial assets within a country) of thefinancial system also matters because the larger it is, thegreater its ability to benefit from economies of scale,given the significant fixed costs prevailing in financialintermediaries activities. A larger financial system tendsto relieve existing credit constraints. This facilitates bor-rowing by firms and further improves the process of savings mobilization and the channeling of savings toinvestors. Given that a large financial system should allo-cate capital efficiently and better monitor the use offunds, improved accessibility to financing will tend toamplify the resilience of an economy to shocks.

Thus, a deeper (total financial assets as a percentageof GDP) financial system is an important component offinancial development as it contributes to economicgrowth rates across countries.32 Measures of size anddepth have been included in each of the three financialintermediation pillars to capture this factor.

Fourth pillar: Banking financial servicesAlthough the previous pillar captures some of the nega-tive impacts that an unstable banking system can haveon an economy, banks also play a vital role in supportingeconomic growth. This role is captured in the fourthpillar. Bank-based financial systems emerge to improveacquisition of financial information and to lower trans-action costs, as well as to allocate credit more effi -ciently. This role is especially important in developingeconomies.

The efficient allocation of capital in a financial sys-tem generally occurs through bank-based systems ormarket-based financial systems.33 Some research assertsthat banks finance growth more effectively and effi -ciently than market-based systems, particularly in under-developed economies where non-bank financial inter-mediaries are generally less sophisticated.34 Research also shows that, compared with other forms of financialintermediation, well-established banks form strong tieswith the private sector, a relationship that enables themto acquire information about firms more efficiently andto persuade firms to pay their debts in a timely man-ner.35 Advocates of bank-based systems argue that banksthat are unimpeded by regulatory restrictions tend tobenefit from economies of scale in the process of col-lecting information and can thus enhance industrialgrowth. Banks are also seen as key players in eradicatingliquidity risk, which causes them to increase investments

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in high-return, illiquid assets and speed up the processof economic growth.36

One of the key measures of the efficacy of thebanking system captured in this pillar is size. The largerthe banking system, the more capital can be channeledfrom savers to investors. This enhances the process offinancial development, which in turn leads to greatereconomic growth. These measures of size span depositmoney bank assets to GDP, M2 to GDP, and privatecredit to GDP. Another key aspect of the banking sys-tem is its efficiency. Direct measures of efficiency cap-tured in the Index are aggregate operating ratios, such as bank operating cost to assets and the ratio of non- performing loans to total loans. An indirect measure ofefficiency is public ownership. Publicly owned bankstend to be less efficient, impeding the processes of creditallocation and channeling capital, which in turn slowsthe process of financial intermediation.

Measures of operating efficiency may provide anincomplete picture of the efficacy of the banking systemif it is not profitable. We have thus also included anaggregate measure of bank profitability. Conversely, ifbanks are highly profitable while performing poorly inthe operating measures, then this may indicate a lack ofcompetition along with undue and high inefficiency.

A third key aspect of the efficacy of the bankingsystem captured by this pillar is the role of financialinformation disclosure within the operation of banks.Policies that induce correct information disclosure andthat authorize private-sector corporate control of banks,as well as motivate private agents to exercise corporatecontrol, tend to encourage bank development, opera-tion, and stability.37 This has a positive effect on theoverall economy.

Fifth pillar: Non-banking financial servicesNon-bank financial intermediariessuch as brokerdealers, traditional asset managers, alternative asset man-agers, and insurance companiescan be both an impor-tant complement to banks and a potential substitute forthem. Their complementary role lies in their efforts tofill any vacuum created by commercial banks. Theircompetition with banks allows both parties to operatemore efficiently in meeting market needs. Activities ofnon-bank financial intermediaries include their partici-pation in securities markets as well as the mobilizationand allocation of financial resources of a longer-termnaturefor example, in insurance activities. Because of inadequate regulation and oversight, certain non- banking financial services, such as securitization, played a detrimental role in the current financial crisis as partof the so-called shadow banking system. However, within the context of a sound legal and regulatoryframework, they fulfill unique and vital roles as financialintermediaries.

The degree of development of non-bank financialintermediaries in general has been found to be a good

proxy of a countrys overall level of financial develop-ment.38 Empirical research has found that banks as wellas non-bank financial intermediaries are larger, moreactive, and more efficient in advanced economies.39

Advocates of the market-based system (i.e., non-banks)point to the fact that it is able to finance innovative andhigh-risk projects.40 There are three main areas of non-bank financing activity that we capture in the Index:initial public offering (IPO), merger and acquisitions(M&A) activity, and securitization activity.

Additionally, we include a number of variables onthe insurance sector, which can facilitate trade and com-merce by providing ample liability coverage. Insurancealso creates liquidity and facilitates the process of build-ing economies of scale in investment, thereby improvingoverall financial efficiency.41 And insurance has beenfound to mobilize illiquid savings to positively affectgrowth.42

Sixth pillar: Financial marketsThe four major types of financial markets include bondmarkets (both for government and corporate bonds),stock markets where equities are traded, foreignexchange markets, and derivatives markets.

Stock market liquidity is statistically significant interms of its positive impact on capital accumulation,productivity growth, and current and future rates ofeconomic growth.43 More generally, economic theorysuggests that stock markets encourage long-run growthby promoting specialization, acquiring and disseminatinginformation, and mobilizing savings in a more efficientway to promote investment.44 Research also shows thatas countries become richer, stock markets become moreactive and efficient relative to banks.45 Bond marketshave received little empirical attention, but recentresearch has shown that bond markets play an importantrole in financial development and the effective allocationof capital.46

Derivatives markets are an important aspect of thispillar because they can significantly improve risk man-agement and risk diversification. The development ofderivatives markets can enhance the confidence of inter-national investors and financial institutions and encour-age these agents to participate in them. Derivatives markets generally are small in emerging markets. Thestrengthening of the legal and regulatory environmentcan enhance the development of such markets.47

Financial accessThis third and final category is comprised of one pillarthat represents measures of access to capital and financialservices.

Seventh pillar: Financial accessThe measures represented in this last pillar span meas-ures of access to capital through both commercial and

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retail channels. Empirically, greater access to financialservices has been associated with the usual proxies forfinancial development and the resulting economicgrowth.48 The presence of financial services per se asreflected by size and depth does not imply their accessi-bility by the different types of users within an economy.Thus, the presence of access becomes integral to ouranalysis.

We separate our access measures within this pillarinto retail and commercial access measures in light of

the different channels (and issues) associated with each.Commercial access includes measures such as access toventure capital, commercial loans, and the local equitymarkets. Retail access includes measures such as thepenetration of bank accounts and ATMs and access tomicrofinance; these data were provided by theConsultative Group to Assist the Poor and theMicrofinance Information Exchange.

Given the importance of small- and medium-sizedenterprises (SMEs) in driving economic growth inmany countries, the importance of financial access forSMEs has recently been highlighted by organizationssuch as the G-20. Please see Box 2 and the subsequentchapter by Thorsten Beck for a full discussion of someof the financial access issues faced by SMEs. Dependingon how they are defined (and they are defined differ -ently across many countries), SMEs can have financialneeds that can be viewed from the perspective of bothretail and commercial access. There is a shortage ofglobal data related to SME finance, but the G-20 andother multilateral organizations have highlighted thisneed; when new data become available we will incorpo-rate them into the Index.

Performance in the other pillars contributes to per-formance in this pillar and to the extent of access tofinancial services by end users. Accessibility, along withthe size and depth of the financial system as a wholecaptured in the previous pillars, has a significant effecton a countrys real activity, economic growth, and over-all welfare.

Adjustments to the Financial Development Index this yearThe overall structure of the Financial DevelopmentIndex remains the same as that used in last years Report.There are still seven pillars in the Index with the sameassociated subpillars in each. Each of these subpillarscontains the constituent variables that make up theIndex. Appendix A lays out the complete structure andmethodological detail for the Index.

We have made some minor improvements to theIndex this year at the variable level. We have added threeindicators to enhance the banking system stability sub-pillar. A measure of output loss during banking crisesprovides an indication of the depth of past crises interms of their effect on overall economic output. AFinancial Stress Index indicates the degree to which afinancial system is under strain irrespective of the exis-tence of a full-blown crisis. The inclusion of the Tier 1capital ratio provides a measure of capital adequacywithin the banking system. We removed the manage -ability of private debt variable from last years Report asit was based on securitized debt, which did not providea sufficiently consistent measure of debt across all coun-tries in our sample.

Box 2: SME finance: What have we learned andwhat do we need to learn?

(Please see Chapter 1.3 by Thorsten Beck for a full discussion of thistopic.)

The availability of financing to small- and medium-sized en -terprises (SMEs) has recently gained prominence in policy-makers debates. The rising profile of this topic has beenreflected in a number of realms including discussions onfinancial sector reform and the G-20s establishment of anSME finance committee.

Empirical research shows that SMEs are more con-strained by financing and other institutional obstacles thanare large enterprises. These constraints are exacerbated byweaknesses in the financial systems of many developingcountries. An access possibilities frontier can be used toexplain how difficulties in managing risk and transactioncosts involved in SME lending make financial institutions andmarkets very reluctant to reach out to this group of enterpris-es, especially in developing countries. The frontier is definedas the maximum share of SMEs that can be served by finan-cial institutions in a commercially viable way. The location ofthe frontier in a particular economy, and thus the share ofbankable SMEs, is determined by technology as well as bythe institutional framework within which financial institutionsoperate.

A number of different business models and lendingtechniques, as well as policies and reforms, can enticefinancial institutions and markets to lend to SMEs. Despite atraditional focus on relationship lending, research has foundthat both relationship- and transaction-based lending tech-niques are appropriate for SME lending. With respect topolicy making, three policy categories exist in expandingSMEs access to external finance. Market-developing poli-cies can help push out the frontier, market-enabling policiespush incumbent and new financial institutions toward theexisting frontier, while market-harnessing policies preventthe financial system from moving beyond the frontier towarda point of financial fragility.

The access possibilities frontier allows for a more rigor-ous analysis of obstacles to SME finance in a specific coun-try. However, this analysis must also take into account thediffering size and nature of SMEs across countries.

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We have enhanced the non-banking financial serv-ices pillar by adding some insurance-related variables.Two variables provide better measurement of the non-life insurance market in terms of both density and coverage. We have also added a variable related to lifeinsurance coverage. Given the importance of local bondmarkets as a source of capital within economies, we also added a measure of local currency corporate bondissuance to GDP within the bond markets subpillar.

We removed two variables related to the corporategovernance subpillar within the institutional environ-ment pillarofficial supervisory power and privatemonitoring of the banking industrybecause of a lack of updated data.

We have also added two countries to the Index:Morocco and Romania. This raises the total number of countries covered in the Index from 55 to 57.Accordingly, this will lower the year-on-year ranks ofcountries that score below either of these countries.

The Financial Development Index 2010 rankingsThe overall ranking for this years Financial DevelopmentReport can be seen in Table 1, along with the 2009 rank-ing, the Index score, and the change in score from lastyear. Looking broadly across the results for the 57 coun-tries covered in the Index, there are some overall trendsthat emerge.

Overall trends in 2010 rankingsIn comparing Index scores from 2009 and 2010, we seea fairly even split between countries that have advancedand those that have declined. The top-ranked countrieswithin the Index do not change significantly, althoughthe United States does take the top spot from theUnited Kingdom (2nd); the US score remains essentiallyunchanged from last year, while the United Kingdomsdrops the most of any country within the top 10. It isonly very minor score differentials that separate theUnited Kingdom from the next five countries that scorebelow itHong Kong, Singapore, Australia, Canada, andthe Netherlands.

In terms of the rest of the top 20, Denmark showsthe biggest decline, falling from 10th to 16th place.Malaysia achieves a significant increase, moving from22nd to 17th place, earning its place as the only emerg-ing market in the top 20 of the Index.

All of the BRIC country rankings either improveslightly or stay the same. China shows the biggestadvance, moving up four spots to 22nd place. Brazil(34th) moves up two spots, India (37th) one spot, andRussia stays the same at 40th place.

As with past years, there can be considerable varia-tion across the seven pillars for specific countries, as canbe seen in the pillar results in Table 2. For instance,Sweden, Norway, and Denmark all achieve top ranks inthe Institutional environment pillar (2nd, 3rd, and 4th

Table 1: The Financial Development Index 2010 rankings: Comparison with 2009

20102010 2009 score Change

Country/Economy rank rank (17) in score

United States 1 3 5.12 0.01

United Kingdom 2 1 5.06 0.22

Hong Kong SAR 3 5 5.04 +0.06

Singapore 4 4 5.03 +0.01

Australia 5 2 5.01 0.12

Canada 6 6 4.98 +0.02

Netherlands 7 8 4.73 0.12

Switzerland 8 7 4.71 0.21

Japan 9 9 4.67 +0.03

Belgium 10 13 4.65 +0.15

France 11 11 4.63 +0.06

Sweden 12 14 4.60 +0.11

Germany 13 12 4.49 0.05

Spain 14 15 4.42 +0.02

Norway 15 17 4.31 0.06

Denmark 16 10 4.30 0.34

Malaysia 17 22 4.20 +0.23

Ireland 18 16 4.20 0.19

Austria 19 18 4.20 0.09

Finland 20 19 4.12 0.12

United Arab Emirates 21 20 4.03 0.18

China 22 26 4.03 +0.16

Bahrain 23 27 4.00 +0.15

Korea, Rep. 24 23 4.00 +0.09

Italy 25 21 3.95 0.03

Saudi Arabia 26 24 3.87 0.02

Israel 27 28 3.85 +0.16

Kuwait 28 30 3.69 +0.07

Jordan 29 25 3.65 0.24

Chile 30 31 3.53 0.06

South Africa 31 32 3.53 +0.05

Brazil 32 34 3.53 +0.06

Czech Republic 33 33 3.46 0.02

Thailand 34 35 3.37 +0.03

Poland 35 39 3.33 +0.06

Slovak Republic 36 37 3.30 0.00

India 37 38 3.24 0.05

Egypt 38 36 3.24 0.09

Panama 39 29 3.22 0.41

Russian Federation 40 40 3.21 +0.05

Morocco 41 n/a 3.20 n/a

Turkey 42 44 3.18 +0.15

Mexico 43 43 3.07 +0.01

Romania 44 n/a 3.05 n/a

Hungary 45 41 3.04 0.04

Vietnam 46 45 3.03 +0.04

Colombia 47 46 3.02 +0.08

Peru 48 42 3.01 0.06

Kazakhstan 49 47 2.98 +0.05

Philippines 50 50 2.97 +0.14

Indonesia 51 48 2.90 0.00

Argentina 52 51 2.78 +0.01

Ukraine 53 53 2.76 +0.05

Pakistan 54 49 2.62 0.23

Bangladesh 55 54 2.55 0.02

Venezuela 56 55 2.55 +0.03

Nigeria 57 52 2.43 0.29

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Country/Economy Rank Score

United States 1 5.12United Kingdom 2 5.06Hong Kong SAR 3 5.04Singapore 4 5.03Australia 5 5.01Canada 6 4.98Netherlands 7 4.73Switzerland 8 4.71Japan 9 4.67Belgium 10 4.65France 11 4.63Sweden 12 4.60Germany 13 4.49Spain 14 4.42Norway 15 4.31Denmark 16 4.30Malaysia 17 4.20Ireland 18 4.20Austria 19 4.20Finland 20 4.12United Arab Emirates 21 4.03China 22 4.03Bahrain 23 4.00Korea, Rep. 24 4.00Italy 25 3.95Saudi Arabia 26 3.87Israel 27 3.85Kuwait 28 3.69Jordan 29 3.65Chile 30 3.53South Africa 31 3.53Brazil 32 3.53Czech Republic 33 3.46Thailand 34 3.37Poland 35 3.33Slovak Republic 36 3.30India 37 3.24Egypt 38 3.24Panama 39 3.22Russian Federation 40 3.21Morocco 41 3.20Turkey 42 3.18Mexico 43 3.07Romania 44 3.05Hungary 45 3.04Vietnam 46 3.03Colombia 47 3.02Peru 48 3.01Kazakhstan 49 2.98Philippines 50 2.97Indonesia 51 2.90Argentina 52 2.78Ukraine 53 2.76Pakistan 54 2.62Bangladesh 55 2.55Venezuela 56 2.55Nigeria 57 2.43

1st pillar: Institutional environment

Country/Economy Rank Score

Singapore 1 6.08Sweden 2 6.05Norway 3 5.88Denmark 4 5.88Canada 5 5.87United Kingdom 6 5.79Finland 7 5.78Germany 8 5.78Netherlands 9 5.76Hong Kong SAR 10 5.70Switzerland 11 5.66Austria 12 5.66Belgium 13 5.59United States 14 5.58Ireland 15 5.55Japan 16 5.54France 17 5.51Australia 18 5.47Israel 19 5.13Malaysia 20 5.05Bahrain 21 5.01Spain 22 4.96United Arab Emirates 23 4.78Hungary 24 4.59Jordan 25 4.47Romania 26 4.47Chile 27 4.46South Africa 28 4.42Saudi Arabia 29 4.36Italy 30 4.32Thailand 31 4.32Panama 32 4.28Czech Republic 33 4.20Korea, Rep. 34 4.11China 35 4.08Poland 36 4.04Kuwait 37 3.87Egypt 38 3.85Turkey 39 3.82Slovak Republic 40 3.81Peru 41 3.67Philippines 42 3.64Nigeria 43 3.63Brazil 44 3.61Vietnam 45 3.58Indonesia 46 3.54Colombia 47 3.52Mexico 48 3.51Morocco 49 3.37Kazakhstan 50 3.23India 51 3.21Argentina 52 3.21Russian Federation 53 3.15Pakistan 54 2.94Ukraine 55 2.83Bangladesh 56 2.53Venezuela 57 2.34

2nd pillar: Business environment

Country/Economy Rank Score

Sweden 1 5.99Singapore 2 5.91Hong Kong SAR 3 5.89Finland 4 5.87Switzerland 5 5.80Denmark 6 5.79Canada 7 5.72Netherlands 8 5.66Norway 9 5.62France 10 5.56Belgium 11 5.54Germany 12 5.51Australia 13 5.48Bahrain 14 5.45United Kingdom 15 5.45Austria 16 5.37United States 17 5.37Ireland 18 5.36Korea, Rep. 19 5.33Japan 20 5.13United Arab Emirates 21 5.11Saudi Arabia 22 5.02Spain 23 4.87Italy 24 4.76Hungary 25 4.75Romania 26 4.74Slovak Republic 27 4.68Czech Republic 28 4.67Turkey 29 4.62Malaysia 30 4.59Chile 31 4.53Kuwait 32 4.51Israel 33 4.45Russian Federation 34 4.43Poland 35 4.42Colombia 36 4.33Thailand 37 4.29China 38 4.26Kazakhstan 39 4.16Panama 40 4.14Morocco 41 4.02Argentina 42 4.02Jordan 43 3.96Ukraine 44 3.94South Africa 45 3.92Mexico 46 3.90Peru 47 3.83Egypt 48 3.81Brazil 49 3.80Pakistan 50 3.60Vietnam 51 3.47India 52 3.35Philippines 53 3.34Indonesia 54 3.22Venezuela 55 3.07Nigeria 56 2.83Bangladesh 57 2.80

3rd pillar: Financial stability

Country/Economy Rank Score

Saudi Arabia 1 6.11Hong Kong SAR 2 5.75Malaysia 3 5.68Singapore 4 5.66Switzerland 5 5.64United Arab Emirates 6 5.48Chile 7 5.38Norway 8 5.37Australia 9 5.21Brazil 10 5.15France 11 5.13Finland 12 5.09Canada 13 5.03Slovak Republic 14 4.98Mexico 15 4.98Morocco 16 4.95China 17 4.93Kuwait 18 4.91Belgium 19 4.83Peru 20 4.82Austria 21 4.80Czech Republic 22 4.79Bahrain 23 4.73Germany 24 4.72Thailand 25 4.71Denmark 26 4.67Sweden 27 4.62South Africa 28 4.56Poland 29 4.55Bangladesh 30 4.52Netherlands 31 4.51Israel 32 4.47Japan 33 4.46Colombia 34 4.44Egypt 35 4.39Indonesia 36 4.39Philippines 37 4.38Italy 38 4.29United States 39 4.26Venezuela 40 4.25Jordan 41 4.20Russian Federation 42 4.17Korea, Rep. 43 4.15Panama 44 4.09India 45 4.03United Kingdom 46 3.99Spain 47 3.94Vietnam 48 3.87Kazakhstan 49 3.82Romania 50 3.77Turkey 51 3.70Pakistan 52 3.65Ireland 53 3.60Argentina 54 3.24Ukraine 55 3.13Nigeria 56 3.07Hungary 57 2.89

Table 2: Financial Development Index 2010

FACTORS, POLICIES, AND INSTITUTIONSOVERALL INDEX

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4th pillar: Banking financial services

Country/Economy Rank Score

United Kingdom 1 5.36Netherlands 2 5.34Hong Kong SAR 3 5.33Spain 4 5.24Japan 5 5.17Ireland 6 5.07Australia 7 5.06China 8 4.91Belgium 9 4.88Sweden 10 4.81Canada 11 4.76Malaysia 12 4.70Singapore 13 4.64Bahrain 14 4.61Switzerland 15 4.52Norway 16 4.33Germany 17 4.33Austria 18 4.21Denmark 19 4.19United Arab Emirates 20 4.17Israel 21 4.15Italy 22 4.13France 23 4.09Finland 24 4.08Panama 25 4.03Jordan 26 4.03United States 27 4.01Korea, Rep. 28 3.96Czech Republic 29 3.88Kuwait 30 3.73South Africa 31 3.68Morocco 32 3.63Thailand 33 3.55Saudi Arabia 34 3.53Vietnam 35 3.49Slovak Republic 36 3.41Chile 37 3.24Brazil 38 3.22Poland 39 3.13Turkey 40 3.07India 41 3.06Egypt 42 3.03Argentina 43 2.93Kazakhstan 44 2.86Bangladesh 45 2.77Philippines 46 2.75Peru 47 2.73Pakistan 48 2.69Colombia 49 2.65Ukraine 50 2.62Indonesia 51 2.61Mexico 52 2.59Nigeria 53 2.43Venezuela 54 2.40Hungary 55 2.21Romania 56 2.11Russian Federation 57 2.05

5th pillar: Non-banking financial services

Country/Economy Rank Score

United States 1 6.07United Kingdom 2 5.51Canada 3 4.49China 4 4.45Russian Federation 5 4.28Korea, Rep. 6 4.15Japan 7 4.14Australia 8 3.96Netherlands 9 3.65Spain 10 3.64Singapore 11 3.61Brazil 12 3.56India 13 3.53Germany 14 3.43France 15 3.39Ireland 16 3.18Hong Kong SAR 17 3.18Malaysia 18 3.17South Africa 19 2.76Switzerland 20 2.75Italy 21 2.70Kazakhstan 22 2.55Belgium 23 2.55Ukraine 24 2.48Argentina 25 2.48Sweden 26 2.40Poland 27 2.37United Arab Emirates 28 2.32Jordan 29 2.30Denmark 30 2.27Israel 31 2.21Philippines 32 2.17Egypt 33 2.14Norway 34 2.13Finland 35 2.12Indonesia 36 2.07Colombia 37 2.06Bahrain 38 1.99Mexico 39 1.98Austria 40 1.96Turkey 41 1.90Morocco 42 1.89Chile 43 1.86Czech Republic 44 1.73Venezuela 45 1.70Panama 46 1.65Vietnam 47 1.65Peru 48 1.63Thailand 49 1.60Hungary 50 1.52Slovak Republic 51 1.46Kuwait 52 1.44Romania 53 1.44Saudi Arabia 54 1.40Nigeria 55 1.25Pakistan 56 1.25Bangladesh 57 1.12

6th pillar: Financial markets

Country/Economy Rank Score

United States 1 5.83Singapore 2 5.08Switzerland 3 5.02United Kingdom 4 5.02Japan 5 4.84Australia 6 4.68France 7 4.56Netherlands 8 4.51Kuwait 9 4.41Germany 10 4.31Hong Kong SAR 11 4.31Canada 12 4.30Belgium 13 4.07Spain 14 4.00Italy 15 3.90Denmark 16 3.78Sweden 17 3.64Korea, Rep. 18 3.46Jordan 19 3.34Finland 20 3.32Austria 21 2.88Israel 22 2.82Ireland 23 2.82India 24 2.81Malaysia 25 2.61Norway 26 2.60South Africa 27 2.45United Arab Emirates 28 2.30Hungary 29 2.24China 30 2.14Venezuela 31 2.13Thailand 32 2.05Russian Federation 33 2.05Brazil 34 1.93Saudi Arabia 35 1.91Pakistan 36 1.90Philippines 37 1.88Egypt 38 1.87Turkey 39 1.87Romania 40 1.85Poland 41 1.76Bahrain 42 1.74Kazakhstan 43 1.71Chile 44 1.71Morocco 45 1.63Czech Republic 46 1.62Mexico 47 1.59Ukraine 48 1.56Slovak Republic 49 1.51Vietnam 50 1.45Peru 51 1.45Indonesia 52 1.44Argentina 53 1.40Colombia 54 1.35Nigeria 55 1.21Panama 56 1.11Bangladesh 57 1.01

7th Pillar: Financial access

Country/Economy Rank Score

Australia 1 5.22Hong Kong SAR 2 5.11Belgium 3 5.07Saudi Arabia 4 4.73United States 5 4.70Canada 6 4.67Sweden 7 4.65Austria 8 4.51Bahrain 9 4.48United Kingdom 10 4.30Norway 11 4.27Spain 12 4.27Singapore 13 4.26France 14 4.19United Arab Emirates 15 4.08Ireland 16 3.82Israel 17 3.74Vietnam 18 3.72Netherlands 19 3.69Malaysia 20 3.63Egypt 21 3.61Italy 22 3.59Chile 23 3.56Switzerland 24 3.56Denmark 25 3.52China 26 3.44Brazil 27 3.42Japan 28 3.38Germany 29 3.34Czech Republic 30 3.31Turkey 31 3.29Panama 32 3.27Slovak Republic 33 3.24Jordan 34 3.22Bangladesh 35 3.12Thailand 36 3.11Hungary 37 3.05Poland 38 3.05Indonesia 39 3.02Romania 40 3.01Kuwait 41 2.99Mexico 42 2.95South Africa 43 2.95Peru 44 2.93Morocco 45 2.90Korea, Rep. 46 2.86Colombia 47 2.81Ukraine 48 2.77India 49 2.72Philippines 50 2.65Finland 51 2.58Nigeria 52 2.55Kazakhstan 53 2.55Russian Federation 54 2.37Pakistan 55 2.32Argentina 56 2.19Venezuela 57 1.97

Table 2: Financial Development Index 2010 (contd.)

FINANCIAL INTERMEDIATION FINANCIAL ACCESS

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places, respectively) but do not make the top 10 ineither the non-banking financial services pillar or thefinancial markets pillar. Similarly, some emerging-marketeconomies achieve high scores in financial stability. InTable 3 one sees that 8 of the top 20 economies in thefinancial stability pillar are emerging markets.

Many developing economies entered the recentdownturn with much stronger macroeconomic andfinancial fundamentals than they had in previous finan-cial crises. This included lower liability dollarization,lower fiscal and private debt, and a better aggregate balance sheet for the financial services sector. For manycountries, such as Brazil, this was the result of effectivemacroeconomic and financial policy in the wake of pastcrises, as well as generally favorable economic conditionsthat included higher commodity prices and strong capi-tal inflows in the period preceding the crisis.

However, it is important not to confuse financialstability as measured in the third pillar of the Index withbroader financial system development as measured in theoverall Index. The broader Index looks at many differentand often complex factors that support the long-termdevelopment of the financial systems it assesses. Financialstability is only part of the assessment of how wellfinancial systems in these countries contribute to overalleconomic growth by diversifying risks and efficientlyallocating capital to those who most need it. Thus, wesee that many of those economies that do perform wellin the financial stability pillar do not perform nearly aswell in other pillars in the Index.

For some developing countries, which perform relatively well in this pillar but poorly in others, thisresult may represent the relative lack of integration anddevelopment of their financial intermediaries, which

limit their exposure to the global financial turmoil. Asdescribed previously in this chapter, in some instancesfinancial stability may imply a tradeoff with healthy risk-taking or the efficient allocation of capital to thehighest-return investments. Also, notably, the risks thatcan stem from a lack of financial development arebroader in scope than financial crises or immediatefinancial instability. To illustrate this point further, wewill look at the relationship between economic growthand financial development.

Financial development and economic growthIn Figure 2, one sees a fairly strong correlation betweenfinancial development and GDP per capita. As discussedearlier in this chapter, the link between economicgrowth and financial development is well established in the academic literature.

A potentially more surprising finding can beobserved when one considers the current global eco-nomic environment. In the wake of the recent financialcrisis, many emerging-market economies have demon-strated highly resilient and robust economic growth,particularly when compared with that of developedcountries. The implication of this finding as it relates tofinancial development can be seen in Figure 3. We haveplotted the 57 countries covered by the Index in termsof the compound annual growth rate (CAGR) of theirGDP and their overall Index score. While the correla-tion is not as tight as it is with GDP per capita, the basicconclusion is still obvious: many of the highest-growtheconomies also have the least-developed financial systems.

The implication of this finding for individual coun-tries is clear, and is one that this Report has aimed toaddress since its inception: countries must take a holisticapproach in the assessment and improvement of theirfinancial systems so they can continue to support eco-nomic growth. Yet there are also broader implications forthe global economy in light of the current fragile eco-nomic recovery. In Figure 4 we have used IMF forecastsof nominal GDP from 2010 to 2014 to create an esti-mate of the absolute amount of GDP growth in emerg-ing markets (US$7.7 trillion) vs. advanced economies(US$6.5 trillion) over the next five years. By this roughestimate, approximately 54 percent of global economicgrowth in the next five years could come from emergingmarkets. By contrast, the average FDI score for emerg-ing markets is 3.16 vs. 4.45 for advanced economies.

Thus, in broadest terms the global economic recov-ery will be disproportionately affected by the perform-ance of less-developed financial systems in emerging-market economies. Although many of these economiesdemonstrated a high degree of financial stability throughthe recent financial crisis, there could be other potentialrisks for other aspects of their financial systems. Areview of regional results of this years FDI suggestswhat some of these risks might be.

Table 3: Financial stability: Top 20 economies

2010 rank Economy Score

1 Saudi Arabia 6.112 Hong Kong SAR 5.753 Malaysia 5.684 Singapore 5.665 Switzerland 5.646 United Arab Emirates 5.487 Chile 5.388 Norway 5.379 Australia 5.2110 Brazil 5.1511 France 5.1312 Finland 5.0913 Canada 5.0314 Slovak Republic 4.9815 Mexico 4.9816 Morocco 4.9517 China 4.9318 Kuwait 4.9119 Belgium 4.8320 Peru 4.82

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Figure 2: GDP per capita vs. Financial Development Index 2010

Source: GDP data taken from IMF, World Economic Outlook Database, April 2010.

0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000

2

3

4

5

6

R2 = 0.63

FDI 2010 score

GDP per capita 2009 (US dollars)

Figure 3: 200509 GDP CAGR vs. Financial Development Index 2010 score

Source: GDP data taken from IMF, World Economic Outlook Database, April 2010.Note: CAGR = compound annual growth rate.

2 3 4 5 6

2

0

2

4

6

8

10

R2 = 0.26200509 GDP CAGR

Overall FDI score

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Asian financial development and economic growthFigure 5 shows a summary of the performance of Asianeconomies (excluding Japan) across the seven pillars ofthe FDI. China, India, and Hong Kong are broken outseparately, while the remaining Asian countries are aver-aged together, weighted by GDP. As a well-establishedglobal financial center, Hong Kong generally performssignificantly better than other countries. Financial sta -bility is commonly a relative strength for all theseeconomies.

Some of the weaker pillar scores, however, begin toreveal some potential risks that these financial systemsmight pose for economic growth, both in the regionand globally. Relatively weak scores in the financial mar-kets pillar and non-banking financial services pillar mayindicate an inability of capital markets to serve criticalfinancing needs in the future. In particular, scores in thebond market subpillar were low in many of these coun-tries. As the credit needs of companies in the regioncontinue to expand, the ability to tap local bond mar-kets may become critically important. As described inChapter 1.2, deep local bond markets can also providean important bulwark against volatile cross-border capital flows.

Many Asian countries have highlighted the critical -ity of investing in infrastructure to support continuedeconomic growth. In many of these economies, the abil-ity of banks to provide the tenor of financing needed tosupport long-term investments in infrastructure is lim -ited in the face of expanding need. Public investment in infrastructure may also diminish as the provisions of

stimulus packages begin to subside. A lack of deep localbond markets could mean the absence of a criticalsource of long-term financing.

Some of these weaknesses appear to translate intolow scores for financial access in some Asian countries,because corporations indicate difficulty obtainingfinancing through the capital markets relative to loans orprivate credit. Retail financial access for consumers isalso an area of weakness for many of these economies.The ability of Asian economies to stimulate domesticdemand could be hindered by limited access to savingsand demand accounts, consumer credit, mortgages, andinsurance. This in turn could affect the potential forAsian consumer demand to offset global economicimbalances that could threaten economic growth.

Latin American financial development and economicgrowthA summary of the performance of Latin Americancountries across the seven pillars can be seen in Figure 6.Brazil and Mexico are broken out separately, while theother Latin American countries are averaged together,weighted by GDP. There appears to be a relatively highdegree of uniformity in the performance of countriesacross the pillars. As with the Asian economies, financialstability is a clear strength.

By contrast, performance in the financial marketsand non-banking financial services pillars is relativelylow. (Brazil scored higher than other countries in thenon-banking financial services pillar because of a veryhigh level of IPO activity.) The development of deep

Figure 4: Absolute GDP growth vs. Financial Development Index 2010 score

Source: GDP data taken from IMF, World Economic Outlook Database, April 2010.

$5

$6

$7

$8

$7.7 trillion

3.16$6.5 trillion

4.45

Emerging markets Advanced economies

5

4

3

2

1

Absolute GDP growth (20102014, US$ trillions)

Overall FDI score

l Average FDI score n Absolute GDP growth

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Figure 5: Asian performance across pillars

Note: Summary of results for Asian countries, excluding Japan. Rest of Asia consists of Bangladesh, Indonesia, Kazakhstan, Korea, Rep., Malaysia, Pakistan, thePhilippines, Singapore, and Vietnam, with results weighted by GDP.

0

1

2

3

4

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6

7

Pillar 1Institutionalenvironment

Pillar 2Business

environment

Pillar 3Financialstability

Pillar 4Bankingfinancialservices

Pillar 5Non-banking

financialservices

Pillar 6Financialmarkets

Pillar 7Financialaccess

FDI 2010 score

n Chinan Indian Hong Kong SARn Rest of Asia

Figure 6: Latin American performance across pillars

Note: Rest of Latin America consists of Argentina, Chile, Colombia, Panama, Peru, and Venezuela, with results weighted by GDP.

0

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Pillar 1Institutionalenvironment

Pillar 2Business

environment

Pillar 3Financialstability

Pillar 4Bankingfinancialservices

Pillar 5Non-banking

financialservices

Pillar 6Financialmarkets

Pillar 7Financialaccess

FDI 2010 score

n Braziln Mexicon Rest of Latin America

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local markets can be important to ensure that all sectorswithin these economies are served. Research has shownthat in the absence of deep local markets, there are seg-ments of the economy, particularly SMEs, that may notbe able to access capital as easily as larger corporations.49

Given that on average SMEs contribute 29 percent toformal GDP in emerging markets, this could be a keyconstraint to economic growth in the region.50

Similar to Asia, investment in infrastructure will beessential to support the continued pace of economicgrowth in Latin America. Local bond markets can pro-vide an important source of disciplined long-term capital to augment funding by banks and national development banks such as BNDES (BrazilianDevelopment Bank).

Unlike Asian economies, Latin American economieswere not as weak in financial access as in the other pil-lars. This was in part because of stronger scores withrespect to retail finance. However, access to commercialfinance proved weaker, particularly in Mexico wheresevere constraints to many forms of capitalincludingventure capital, private