DP1127 | Banking and Development

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This paper reformulates the well known financial development conjecture (FDC) and supplies some new empirical evidence in its favour. The financial development conjecture, namely, that there exist strong feedback effects between real and financial development, is described in this paper by use of the cost of financial intermediation. The theoretical part of the paper describes how specialization of banks can lead to such feedback effects, which work through the cost of financial intermediation. In the empirical part of the paper we use US cross-state data from banks' income statements to show that the cost of banking is negatively related with the level of real economic development.