An Empirical Analysis of the Relationship Between Institutional Quality and Financial Development

Abstract

Although the effects of institutional quality and its indicators on economic growth have been extensively examined, studies focusing on the institutional quality-financial sector development link remain limited. Therefore, this study concentrates on the institutional quality-financial development link, while also incorporating fixed capital, trade openness, and foreign direct investment as additional independent variables in the financial development model. The study employs panel data techniques, including CADF, Pedroni, Westerlund, AMG, FMOLS, and Dumitrescu–Hurlin approaches. The empirical findings indicate that the series are stationary at first differences and that a cointegration relationship exists among them. In the long run, institutional quality enhances financial sector development, while fixed capital and trade openness also play supportive roles in promoting financial development. However, no significant link is determined between foreign direct investment and financial sector development. Bidirectional causality is identified between institutional quality, fixed capital, trade openness, and financial development, whereas no causality is detected between foreign direct investment and financial development. These findings provide important implications for policy orientation.