Financial Development and Economic Recession: Nonlinear and Causal Evidence from Advanced and Emerging Economies

Abstract

We investigate how financial development, proxied primarily by private credit, bank deposits, and bank profitability, influences economic recession. We employ a logistic regression model with both country and time fixed effects, thereby controlling for unobserved heterogeneity across countries and global shocks over time. We found that financial development plays an important role in shaping macroeconomic stability, though its effects vary across country groups. In advanced economies, higher levels of private credit, stronger bank deposit bases, and higher bank profitability reduce the probability of recession, indicating that well-developed financial systems enhance economic resilience. Whereas the effects in emerging economies are less consistent, suggesting that rapid financial expansion may increase vulnerability to recession, reflecting weaker institutional frameworks and less mature financial systems. We also found a nonlinear relationship between financial development and the risk of an economic recession. While initial improvement in the financial system may not immediately reduce the severity of a recession, the stabilizing effects become more pronounced as financial systems deepen and become more efficient. However, the results from the 2SLS model indicate that the direct causal effect of financial development is limited once endogeneity is addressed, which underscores the importance of institutional factors. Moreover, our robustness checks addressing endogeneity suggest that the effectiveness of financial development depends heavily on institutional quality, governance, and the strength of the banking sector. These findings provide important policy insights for designing financial systems that support long-term economic stability and resilience.