I. Introduction A well functioning system can play an important role in economic development by facilitating capital formation, which in turn promotes economic growth.(1) A higher rate of growth is, in turn, a necessary condition for alleviating poverty in a market economy where major wealth or income redistribution may be difficult to achieve (Jain and Tendulkar 1990). Financial sector development or involves the design and implementation of policies to intensify the degree of monetization of the economy through increased access to institutions, their transparent and efficient functioning, and ensuring reasonable rates of return in real terms. The banking sector tends to dominate the system in most developing countries and is, therefore, the focus of this article. Until the early 1970s, it was generally believed that low interest rates on bank loans and deposits would promote investment spending and growth -- a notion consistent with the Keynesian and neoclassical analyses where the interest rate is part of the cost of capital (see Keynes 1936 and Jorgenson 1967, respectively). McKinnon (1973) and Shaw (1973) challenged this conventional wisdom. They argued that higher interest rates increased the amount people are willing to hold as assets by decreasing the holdings of non-financial assets such as cash, gold, commodities, and land. An additional channel through which the same effect might materialize would be by increasing the holdings of domestic assets relative to foreign assets. The domestic system would consequently be able to extend more loans to investors, hence raising the equilibrium rate of investment.(2) This is further enhanced if the cost of intermediation by banks is kept low by having a competitive banking structure and minimal taxation on intermediation. Thus, McKinnon-Shaw argued strongly in favour of financial Motivated at least partly by their work, many developing countries have undertaken liberalization, though the timing, pace and sequencing have varied quite significantly. The outcome of these reforms has been mixed at best. While liberalization produced improved economic performance in some countries, it also led to distress and crises in many others.(3) This mixed outcome has led to a reassessment of the case for liberalization. The neo-structuralist economists have argued that higher bank interest rates lead to higher bank deposits simply due to the transfer of funds away from alternative asset holdings (Taylor 1983), such as the informal credit markets (Edwards 1988; van Wijnbergen 1982) or share markets. They also argued that some of these, such as the informal credit markets, might be a more efficient means of financing investment since institutions in these markets are essentially unregulated and do not need to hold reserves (as banks do). Thus, according to the neo-structuralists, raising interest rates on bank deposits would decrease, rather than increase, the rate of capital formation in the economy. However, Kapur (1992) and Bencivenga and Smith (1992) have shown that the argument about the greater efficiency of the informal sector due to the lack of a formal reserve requirement is not valid if the central bank makes proper use of the banks' reserves, thereby ensuring that the reserves do not bear a social cost. This implies that as long as a part of the additional assets entering the banking sector are from non-financial or foreign assets, raising bank interest rates (to market clearing level) would be desirable.(4) In this article we estimate econometrically the main factors affecting the deepening in four Asian economies, namely, South Korea, Malaysia, Thailand, and Indonesia. The choice of the countries was based on: their exemplary investment and growth rates from the mid-sixties to the mid-nineties that has evoked considerable interest in their development experiences, and the crisis of 1997-98 which has evoked interest in them for somewhat different reasons; and their having experienced a wide range of real interest rates and real exchange rate variations, which makes it possible to analyse the impact of these variables. …