There has been a longstanding interest among development analysts and practitioners in the contribution that finance can make to the development process. In an early contribution, Arthur Lewis (1955) suggested a two-way relationship between financial development and economic growth, where financial markets develop as a consequence of economic growth, and in turn act as a stimulus to the growth of the real economy. Subsequent analysis and empirical research have built on these early ideas, by developing a further understanding of the various functions performed by the financial system in the development process (Levine, 1997), and by testing empirically for the causal relationship between finance and development (Levine et al., 2000; World Bank, 2001b).
More recently, attention has switched to the role of finance in poverty reduction in developing countries. A fundamental cause of poverty is market failure, and financial market imperfections often prevent the poor from borrowing (Stiglitz, 1994). Improving the access of the poor to financial services, particularly to credit and risk-insurance services, strengthens the productive assets of the poor, enhances their productivity, and increases the opportunities for achieving a sustainable livelihood (World Bank, 2001a).
There is a growing body of empirical evidence to support the view that financial development can reduce income inequality and poverty levels in the developing world, both directly through widening access of the poor to financial services, and indirectly through the impact of financial development-led growth on poverty reduction (Jalilian and Kirkpatrick, 2001; Westley, 2001).
A closely related issue concerns the stability of the financial system. As the recent East Asian crisis demonstrated, a stable financial system is vital for economic growth, and a financial crisis can dramatically worsen poverty (World Bank, 2001a: 165; World Bank, 2001b: 76). Weak financial regulation, often as a consequence of over-hasty financial liberalisation, has contributed directly to economic instability and decline (Caprio and