The Quality of Institutions and Financial Development

Using banking sector and stock market development indicators, we explore the importance of a wide range of institutional quality variables as sources of financial development. The empirical results based on the dynamic panel system GMM estimations demonstrate that a high-quality institutional environment has positive effect on financial development. However, some institutional aspects matter more than others do. Particularly, the rule of law, political stability and government effectiveness play a vital role in influencing banking sector development. The findings also suggest that regulatory quality does contribute to financial development but only when a threshold level of regulatory quality development has been attained, a condition which is more prevalent among low-income countries, than among the entire set of countries. In terms of policy implication, the findings suggest that improving institutional infrastructure and identifying the beneficial aspects of particular institutions, would encourage the development of financial markets.