Dynamic panel threshold analysis of the banking development–economic volatility nexus: A comparative study across income levels

Abstract

This study aims to assess the impact of banking system development on the stability of economic growth for a sample of 62 countries. This sample includes both advanced and lower-income economies from 1996 to 2016. In this context, previous research has reported inconclusive findings on this relationship. Indeed, this was largely related to obvious weaknesses concerning the indicators and methodological frameworks. To gain a more detailed insight into this subject, a dynamic panel threshold regression model is used. At this point, we chose an approach different from earlier studies, which predominantly focused on a limited set of banking size indicators and overlooked the quality aspect of the banking system. In fact, we developed a new set of banking system indicators derived through principal component analysis for each dimension. The main results indicate a nonlinear (inverted U-shaped) relationship between banking deepening and economic volatility. In this sense, statistical significance is only observed in the lower regime for low-income economies. Meanwhile, in more developed economies, improvements in banking performance led to a significant decrease in economic fluctuations, with the stabilizing impact being more evident at higher levels of banking development. Nevertheless, this relationship remains statistically insignificant among lower-income economies. The findings suggest that in high-income economies, strengthening the quality of the banking system can further maintain economic stability. For lower- and middle-income countries, a progressive strategy aimed at banking deepening is essential to avoid increased volatility.