Financial development is a prerequisite for economic development. Given the very low levels of both domestic and national savings, and together with rapid population growth, Bangladesh has the need to mobilize its financial resources more effectively to make resources available for investment.

The Manikin-Shaw model (1973) of financial development states that development of a country’s financial structure is a precondition for economic growth, but the two authors provide alternative theories of the transmission mechanism by which financial conditions affects savings and investment. According to professor McKinnon (1973) economic units must accumulate money prior to investment. McKinnon’s hypothesis emphasizes the importance of money broadly defined as the primary vehicle through which saving (investment) occurs. Complementarily hypothesis implies that domestic savings share a positive relationship with the demand for real broad money. According to Shaw (1973), economic units must not necessarily accumulate money prior to investment. The financial deepening hypothesis asserts that saving and investment may occur through the accumulation of non-money assets.  This hypothesis implies a negative relationship between domestic savings and demand for real broad money, suggesting a substitution from money to other non-money financial assets as the primacy repository of domestic savings.
The importance of financial institutions for rapid growth is undisputed. A comprehensive study by King and Ross (1992) from across 119 developed and developing countries over the1960-1989 period provides compelling evidence that economic growth is dramatically dependent on financial sector size, private sector banks, credit to private enterprises and interest rates. The larger the financial sector in the context of the overall economy, the greater the share of lending by depository rather than central banks, and the greater the share of credit to the private rather than public sector, the greater is the rate of economic growth. These factors increase growth by rising to the amount and efficiency of investment.

We also investigate the relationship between the volume of demand deposits and economic output in developing economies. Many authors have accepted the theory that financial development is a prerequisite for economic growth in underdeveloped and developing nations, and have emphasized the important role assumed by the commercial banking system as and intermediary between savers and investors. Although much empirical analysis has been presented which supports the financial development theory, most has been indirect in nature. We employed data obtained from the International Financial Statistics Yearbook (1992) to produce significant evidence supporting the hypothesis that growth in the commercial banking sector significance explains growth in economic outpour.

We observed examine the determinants of income velocity of money in Bangladesh, and find that determinants of income velocity of money in Bangladesh, and find that proxy for financial development(demand deposits over time deposits) affects velocity negatively, implying that the development of financial institutions in Bangladesh remains at a primitive stage. More recently, we got evidence for McKinnon’s complementary hypothesis for Bangladesh, suggesting that Bangladesh’s financial system has not yet achieved a level of development whereby alternative non-monetary assets have replaced money as the primary repository for domestic savings. Private sector banks are more efficient than NCBs in Bangladesh on a risk-return criterion over 1984-85 period. One important policy implication from these studies is that the efficiency of existing commercial banks in Bangladesh should be improved so that these banks can accelerate the pace of economic development by focusing the domestic savings and guiding these savings to productive ventures.

This research contributes to our understanding of the relative merit of private banking vis-a-vis NCBs and its role in the development of Bangladesh in the following ways. First, private sector banks are viable alternatives to inefficient NCBs. At present, potential investors are fully aware of the overvaluation of NCB loan portfolio and hence overstated net worth, and have little interest in purchasing shares. For privatization to occur, the NCBs need to be restructured so as to attain a reasonable ability to function as business-like operations. The sale of equity shares in the NCBs to the public through the capital market will yield positive benefits both for the government and for the equities market itself, The government will gain revenue from the sales(and  the BB will no longer have to use its limited resources to subsidize NCB operating costs). The offering of NCB equity shares will increase the volume and variety of shares available for trading thereby broadening the securities market.

Second, funds are mobilized primarily through the banking system in the formal financial sector. There is no secondary market for government securities, no market for corporate debt and the equity market is small. Hence there is a preponderance of debt financing relative o equity financing. The banking system cannot provide large-scale long-term funds. Most deposits in the banks are short term, banks are limited in their ability to provide long-lending because of the large risk factors associates with short-term borrowing and long-tem lending. Furthermore, banks have a tendency to make loans based on collateral and/or personal relationships, not on projected cash flows. As a resell, most companies are highly leveraged and small and medium scale enterprises are virtually unable to obtain financing. Equity markets are in a rudimentary state and have yet to fulfill their potential to foster efficiency in the mobilization and allocation of long-term finance. Increases in log-term interest rates will provide increased incentive for the capital market to play an expanded role in financial investment to augment commercial bank lending.

Third, a risk adverse investor wold expects a positive relationship between risk and return from a financial investment in a capital market. Varley (1992) finds that this positive risk-return relationship does not exist for Bangladesh. The low-risk, low maturity National Savings Certificates offer a yield (16.6% APR) which is higher than the yield offered on high risk equity investment (16.0%), and this difference is larger on an after-tax basis because NSC yields enjoy tax subsidies while equity returns do not. Given a negative relationship between risk and return, it is paradoxical to observe that most businesses in Bangladesh have higher leverage ratios. This paradox exists because of regulatory laxity on the punishment of loan defaulters. It is expected that with a proper enforcement of a loan recovery act, the inverted risk-return relationship will become direct, and will encourage businesses to float their shares in the capital market.

Fourth, reform of the financial system and of the NCBs is a crucial aspect in the development of the Bangladesh equity capital market. system reform will increase the supply of loanable funds and , as the securities of privatized NCBs become available for trading, increase the  scope of equity financing as well. Privatization of NCBs will help alleviate the current problem of  a lack of securities which , in turn, will foster further financial market development. Deregulation will also help convince the private sector of the government’s commitment to developing financial markets and increase investors’ confidence in the equity markets. Over time, it is expected that private business will be able to finance expansion by publicly selling debt and equity securities. However, Development of the equity market is dependent on financial market reform and expansion of private banking. Fifth, the establishment of flexible interest rates will give both the private banks and the NCBs greater scope to  improve and expand their operations. The ability to adjust interest to take into account such aspects of the banking industry as cost of funds, credit risks, and local competitive pressures will provide both opportunity and risk to the institutions involved. it is anticipated that private banking will expand as a result of private bankers’ sharper competitive instincts and superior experience. This competitive opportunity should make the issuing of additional private bank charters more attractive, thus increasing the financial and political strength of the private banking sector, The likely expansion of private banking should not be mistaken, however, for a guarantee of security and continued existence of all banks, private or nationalized. In a competitive environment where auks are required to meet financial soundness requirements such as capital adequacy, some banks, private of NCB, may fail and go out of business. Just as refits are the reward for efficiency, so is the failure the penalty for inefficiency. Reward and penalties are inseparable from a well-functioning competitive market environment.

Sixth, without a substantial improvement in the NCB’s operations and financial soundness it would be difficult to sell tem to private investors. Improved supervision is also necessary to lessen the risk of bank failure or losses to depositors. Privatization of the banking system and its consequent increase in the number and soundness of loans made to private entrepreneurs will increase the relative size of the private economy per se. In particular, it will increase the size of that portion of the private economy, comparing publicly traded companies, that is accessible to prospective individual investors, not simply members of families or closed groups.

Seventh, a rivet banking system is also essential to the development of private enterprise firms as fully independent entities, since government-owned commercial banks are generally able to and frequently do, exert excessive control over enterprises to which they lend.