Financial Development, Institutions, Democracy, Political Competition: A test of two tales

This paper examines the relationship between political competition and financial development across a global sample of 127 countries, with a particular focus on developed and democratic OECD countries. Building on the theoretical frameworks of Acemoglu and Robinson (2006) and Besley et al. (2010), we explore whether political competition impacts financial development in a non-monotonic or monotonic manner. Using robust measures of financial development that capture both the depth and efficiency of the financial sector, we find a U-shaped relationship between political competition and financial development in the full sample, consistent with the political replacement effect of Acemoglu and Robinson. This result suggests that financial development is promoted when political competition is either very low or very high, but hindered at intermediate levels of competition. In contrast, we observe an S-shaped relationship in OECD countries, indicating that political competition at intermediate levels is particularly conducive to financial development in developed democracies. These findings provide new insights into the nuanced role political competition plays in shaping financial systems, challenging the assumption that more political competition always leads to greater financial development. Our results are robust to a range of estimation techniques and alternative measures of political competition and financial development.