A Study on the Role of Institutional Quality in Financial Development of Selected OIC Countries

One of the effective factors in economic growth and development is financial development. Indeed, today, the level of economic development is determined by the level of financial development in the countries. Economists emphasize on the importance of financial market and its key role in economic development (e.g., Schumpeter, 1912; Hicks, 1969; McKinnon, 1973; King, 1993; Beck & Levine, 2003). Therefore, identifying the determinant factors of financial development is really crucial. Many studies have been done to identify effective factors in financial development. However, most of them focus on the role of economic factors in financial development. Among all effective factors in financial development in countries, less attention has been given to the role of institutional quality. Hence, the aim of this paper is to study the effect of institutional quality on financial development with emphasis on banking sector in selected countries of Organization of Islamic Cooperation (OIC).
There are two popular theories that explain the role of institutions in financial development. According to Law and Finance Theory introduced by Laporta, Lopez-de-silabes, Shleifer, and Vishny (1997; 1998), differences in the legal protections of investor and creditors and the quality of contract enforcement can explain the different level of financial development between countries. Endowment Theory introduced by Acemoglu, Johnson, and Robinson (2001) explains the relationship between different formation of colonization and institutions during 17-19 centuries. Acemoglu et al. (2001) found that the origin of colonization has a permanent effect on formation of institutions. Beck & Levine (2003) apply both theories for explanting financial development and found that legal origin matters for financial development because legal traditions differ in their ability to adapt efficiently to evolving economic conditions. In addition, some other studies have been done on political economics of financial development (e.g., Pagano & Volpin, 2000; Rajan & Zingales, 2003; Girma & shortland, 2008; Singh, Kpodar & Chura, 2009; Anayitos & Toroyan, 2009; Hung, 2010). All studies in this area have found that quality of institutions play a key role in financial development.
In this study, using panel data method for selected countries of the Organization of Islamic Cooperation (OIC) over 1996-2010, the effect of institutional quality on financial development is examined. This paper investigates the effect of seven institutional quality indicators (i.e., voice & accountability, control of corruption, political stability, rule of law, government effectiveness, regulatory quality and weighed average of six institutional quality indicators) on two financial development indicators, namely, private credit by deposit money banks and other financial institutions/GDP. Information of governance indicators has taken from World Governance Indicators. Based on World Bank definitions, voice & accountability reflects perceptions of the extent to which a country's citizens are able to participate in selecting their government as well as freedom of expression, freedom of association, and a free media. Control of corruption reflects perceptions of the extent to which public power is exercised for private gain, including both petty and grand forms of corruption as well as capturing of the state by elites and private interests. Political Stability measures perceptions of the likelihood of political instability and politically-motivated violence, including terrorism. Rule of law reflects perceptions of the extent to which agents have confidence in and abide by the rules of society, and, in particular, the quality of contract enforcement, property rights, the police, and the courts as well as the likelihood of crime and violence. Government effectiveness reflects perceptions of the quality of public services, the quality of the civil service, and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies. Regulatory quality reflects perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development.
Data of two financial development indicators have been taken from World Bank and International Financial Statistics dataset. In this study, the overall governance indicator (weighed average of six institutional quality indicators) is calculated by principal component analysis approach. The results of poolabilty test and Chaw test indicate that panel approach should be applied in all models. In addition, the results obtained from Breusch-Pagn and Hausman tests show that using fixed effect model is appropriate for all seven models.
Among these seven models whose dependent variables are Private credit by deposit money banks and other financial institutions/GDP, two models are selected based on , namely, Akaike Info Criterion and Schwarz Criterion. The results of estimation suggest that overall governance indicators (weighted average of six indicators of institutional quality) and control of corruption have a significant and positive effect on Private credit by deposit money banks and other financial institutions/GDP. From these seven models whose dependent variable is M2/GDP, one model is selected based on related criteria, as the best model. In this model, government effectiveness indicator has a significant and positive effect on M2/GDP. Hence, improving institutional quality is a necessary and essential factor for enhancing financial development and policymakers should apply appropriate policies to improve government's position in these countries. Through this way, one of the barriers of economic development would be removed.