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Purpose
The purpose of this paper is to empirically examine the impact of financial development on poverty reduction in developing countries. The paper also investigates whether financial development affects poverty via institutional quality and GDP growth.


Design/methodology/approach
To take into account the dynamics nature of panel data and country-specific effects, the authors use a two-step system GMM estimator. The authors also employ a large array of measures of financial development in order to check the robustness of the results. The analysis is carried out for a sample of developing countries using an unbalanced panel data set covering the period 1985-2008.


Findings
The authors find that financial development plays a significant role in reducing absolute poverty. However, the authors do not find any pro-poor impact of financial development when poverty is measured in relative terms. The authors show that the impact of financial development on poverty alleviation is statistically significant when liquid liabilities and credit granted to the private sector are used as a proxy of financial development. The results on the indirect effect of financial development indicate that financial sector development has larger effects on poverty reduction when institutional arrangements are sound or/and when economic growth is high.


Practical implications
The findings suggest that the inference for a pro-poor effect of financial development depends primarily on the measure of poverty and the choice of the proxy for financial development. Banking sector reforms may be an effective instrument to tackle absolute levels poverty. However, the policy makers should not rely only on financial reforms, regardless of whether they are based on banks or stock markets, to narrow the gap between the poorest quintile of the population and the richer quintiles. Rather, they should also utilize fiscal policies, such as progressive taxation and public-expenditure projects, to redistribute resources.


Originality/value
The paper differs from the previous studies in several ways. First, it studies the financial development-poverty nexus using three alternative indices of poverty. Second, this study focusses on a sample of developing countries only. As the structure and development level of the financial sector in poor and rich countries could differ significantly, focussing on developing countries helps mitigate the problem of heterogeneity arising from using a pooled sample of rich and poor countries. Third, robust estimation methods are applied that take into account the dynamic nature of empirical models and country-specific effects.