The paper examines the causality relationship between banking sector development (BSD) and economic growth (GDP) by using panel VAR model. Using data from selected 34 OECD countries, the study finds Granger causality between BSD and GDP. The paper suggests that banking sector indicators can be considered as the policy variable to accelerate economic growth in OECD countries. The policy implication of this study is that the economic policies should recognize the differences in the banking sector development-growth nexus in order to maintain sustainable economic growth in the region.

Throughout the years, the major focus in the development literature has been to identify empirically alternative schemes to promote economic growth. A majority of these financial analysts believe that banking sector development is a key to economic growth. Influenced to a large extent by the rapid and spectacular development in the scale and complexity of the banking sector, the policy makers have now made strengthening of banking sector a priority, with the expectation that this will contribute significantly to economic growth (Eng and Habibullah, 2011).
Historically, there are two important empirical questions: First, Robinson’s (1953) causal nexus between financial development and economic growth; second, Schumpeter’s (1911) strong belief that bank credit, and hence financial intermediation, is the main source and encouragement for innovative entrepreneurs to promote economic growth. No doubt, research on the direct impact of research and development is important; but nowadays this is mainly financed through internal sources. This, however, does not mean that on a more general level financial development in particular, countries or regions do not have a direct impact on economic growth (Fase and Abma, 2003).

The relationship between banking sector development and economic growth is not something new. It has generated a considerable amount of attention from academicians and policy makers. Several studies have explored both theoretical foundations (Levine, 2005; and Cole et al., 2008) and empirical evidence (La Porta et al., 2002; Micco et al., 2007; Naceur and Ghazouani, 2007; Cornett et al., 2010; Pradhan, 2011; and Moshirian and Wu, 2012) regarding the impact of banking sector development on economic growth. The claim is that a well functioning banking system significantly promotes a country’s growth, while a banking crisis, resulting from malfunctioning of the banking system, exerts an independent negative real effect (Dell’Aricca et al., 2008; and Campello et al., 2010), and causes serious disruptions of a country’s economic activities (Hoggarth et al., 2002; Boyd et al., 2005; Hutchison and Noy, 2005; and Serwa, 2012).