Center for Research on Economic Development

The paper, motivated by the extent of government involvement in the financial sectors of many countries, presents a model of a link between financial intermediation and economic growth. The model conceptualises a financial leverage coefficient, a construct which is the outcome of aggravated moral hazard generated by a combination of government involvement in financial intermediation and the presence of institutional rigidities and distortions (like the absence of effective bankruptcy procedures). These two characteristics gradually dilute the weakened co-financing norms and systematically undermine investment efficiency. The leverage coefficient undergoes a regime switch when the density of government involvement in the financial sector exceeds a threshold, thereupon reversing the rate of capital formation in the economy. Indices that capture changes in density of government involvement and effective co-financing are consequently investigated and applied to India. JEL Classification: D82, E44, G21, O16.