There is an existing debate among economists around whether financial development causes economic growth or growth is followed by other factors. To understand this relationship many researchers have focused on the impact of banks in the financial market on economic growth. The basic idea of financial development and economic growth was raised by Schumpeter (1912) who argued that the ability of financial sector in financing the entrepreneur’s innovation will lead to growth.
Opponents of this idea argue that stock markets are not effective in promoting economic growth. Mayer (1988)
UK as market-based financial system considerable amount of need for finance is provided by the capital market.
An important factor which can affect growth is the liquidity of stock market.
It is well known that United Kingdom has one of the developed financial systems around the world with a vibrant stock market with the market capitalization of ........ in 2009. Comparatively it is higher than other countries with well developed financial market.
Financial development can trigger economic growth. Levine (1997) defines five functions for financial intermediaries. He believes that each of the functions can enhance growth through two channels: capital accumulation and technological innovation.
Pagano (1993) financial markets provide participants in the market with the ability to share risk through banks, insurance and securities market
Levine (1991) points out that stock markets enable individuals to diversify liquidity risk through portfolio formation moreover in the time of liquidity shacks they will be able to sell it in the market.
Pagano (1993) argues that development in financial markets may have dubious effect on financial development. He claims that development in financial market can discount the saving rate and consequently the growth rate will decline. At the same time as financial markets develop, investors are more likely to diversify their portfolio and protect themselves against the potential losses.
Pagano (1993) assumes an endogenous growth model in which existence of insurance in the financial market will reduce the precautionary saving. That is a case in which development of financial market may decelerate growth.
The existing argument between economists is whether financial development cause growth or vice versa, growth cause financial development or both and if it does so what the channel is.
Many studies have been done in order to measure the impact of many general variables on growth. But a more specific study is needed to analyse the impact of market specific variables on growth.
King and Levine (1992) claim that there is a significant correlation between many financial development indicators and growth.
Most of the existing studies have focused on the role of banks on growth.
Levine and Zervos (1996) claim that stock markets contribute the financial system with creating some new incentives for investment that are...