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Workers' remittances to developing countries have become the second largest type of flows after foreign direct investment. This paper uses data on remittance flows to 109 developing countries during 1975–2007 to study the link between remittances and financial sector development. In particular, we examine the association between remittances and the aggregate level of deposits and credit intermediated by the local banking sector. This is an important question considering the extensive literature that has documented the growth-enhancing and poverty-reducing effects of financial development. We provide evidence of a positive, significant, and robust link between remittances and financial development in developing countries.

Remittances, funds received from migrants working abroad, to developing countries have grown dramatically in recent years from U.S. $3.3 billion in 1975 to U.S. $289.4 billion in 2007 (World Bank, 2009). They have become the second largest source of external finance for developing countries after foreign direct investment (FDI) and represent about twice the amount of official aid received, both in absolute terms and as a proportion of GDP (Fig. 1 and Fig. 2).

While the development potential of remittance flows has increasingly been recognized, the effect of remittances on financial development had remained largely unexplored. Better understanding the impact of remittances on financial development is important given the evidence on the growth-enhancing and poverty-reducing effects of financial development. This paper tries to fill the gap in the literature. Using balance of payments data on remittance flows to 109 countries for the period 1975–2007, we investigate the link between remittances and financial development, focusing on the ratio of bank deposits and credit to GDP. We find a positive and significant association between remittances and financial sector development. This result is robust to using different estimation techniques and accounting for endogeneity biases arising from omitted factors, reverse causation, and measurement error. Overall, by finding that remittances are positively associated with bank deposits and credit, this paper highlights another potential channel through which remittances may have a positive influence on recipient countries' development. However, because concerns about the endogenity of remittances remain, more research on the link between remittances and financial development is warranted.