Financial Development and Banking Risk: International Evidence for the Role of Financial Institutions and Markets

ABSTRACT This study investigates the effects of financial development on banking risk using a panel of 125 countries (2000–2019), of which 92 are developing economies. However, financial development consists of advances in both financial institutions and financial markets, which may have distinct effects on banking risk. Distinguishing between these two dimensions of financial development allows us to identify which channel is more effective in affecting banking risk, thereby providing valuable insights for policymakers as well as for banking professionals. The findings indicate that financial development consistently reduces banking risk, with stronger effects in developing countries. Disaggregating financial development into financial institution and financial market development reveals that the development of financial institutions plays a stabilizing role, whereas financial markets exhibit more context‐dependent effects. The evidence underscores the importance of policies aimed at strengthening financial institutions, particularly in developing economies.