What’s the connection between financial development, volatility, and growth?

Understanding macroeconomic volatility part 3
Read parts 1 & 2

There’s good evidence that a country’s level of financial development affects the impact of volatility on economic growth, particularly so in less developed countries, as the charts below demonstrate
 
In Chart 1, the “X” axis tracks a financial “deepening” index developed by the IMF to measure the sophistication of a country’s banking system, while the “Y” axis reflects growth. As financial depth increases, we can see, growth trends up. However, very high levels of financial development (note where the United States stands, at the end of the curve) can start to have the opposite effect. In Chart 2, which examines financial deepening against volatility, we see a mirror image of Chart 1: as financial development rises from low levels, it tends to reduce volatility, but at very high levels higher volatility can be the result. In economics, by the way, this is known as a “non-linear” relationship.

A deep banking system helps—but only up to a point
 

Source: Authors’ own calculations using the financial deepening index developed by the IMF in Sahay and others (2015a). Note: The curve in Panel A shows the predicted effect of financial deepening on growth for each level of the index, holding fixed other controls. The curve in Panel B shows the predicted effect of financial deepening on growth volatility, holding fixed other controls. Growth volatility is measures as the standard deviation of GDP growth rates over a five-year moving average.

But why does a deeper banking wellhave this effect in less-developed economies?  In a 2010 study, Aghion et al. identified a “transmission channel”—credit. If people and companies have ample access to credit due to a well-developed financial system, then long-term investment is counter-cyclical, because costs are lower during recessions.
 
Moreover, Carneiro and Hnatkovska argue in a 2016 paper that when domestic financial markets are under-developed, people and companies face tighter-than-usual financial constraints in bad times, and this in turn amplifies the effects of interest-rate rises on domestic economic activity. When higher volatility leads to lower rates of investment, output and consumption, the result will be lower economic growth and lower levels of welfare for society at large.
 
But with regards financial development, there can be too much of a good thing: Recent studies suggest that beyond a certain level, financial development generates decreasing returns to growth and stability ( Arcand, Berkes, and Panizza (2012); Sahay et al. (2015a)). There are three arguments for why this is so:

• Too much access to finance may increase the frequency of booms and busts, thus increasing volatility and driving down economic growth.
• Excessive finance can divert talent and human capital away from productive sectors and toward the financial sector without a clear positive impact on growth.
• Excessive leverage and risk taking can feed economic and financial volatility, with negative consequences for long-term growth, especially if regulation and supervision are inadequate.