The Rule of Banking System Development in Economic Growth: The Case of Iran

This paper empirically investigates the relationship between banks and economic growth emphasizing the transmission channels from financial development to growth in Iran using time series methodologies, namely Johansen’s co-integration and Granger causality methods in the context of error correction models (ECM). The results show that in our case study banks affect economic growth mainly through the capital accumulation channel. Because of financial backwards and market imperfections, agents face many borrowing constraints, which may hinder their ability to invest at optimal levels. In this situation, the role of banking system in increasing investment through capital accumulation is expected to be strong. In our study, we do not find an evidence for productivity channel, perhaps reflecting inefficiency of the Iranian banking system, which imposes many restrictions on bank choices such as credit rationing and directed finance under financial repression. Our results strongly support the supply-leading hypothesis. The main policy message of the paper is that banking system development matters for investment and economic growth in Iran. Therefore, policies that affect financial system are also likely to influence investment and economic growth.