Abstract:

Empirical literature on growth and democracy gives no clear indication as to how political regime impacts growth; there is evidence of positive, negative and no direct effect of democracy and financial development nexus. This paper attempts to resolve this controversy by putting this question in an institutional framework. Particularly, it raises the question of whether effects of democracy on financial development are influenced by the quality of economic and political institutions. Looking at a large sample of developed and developing countries over the period 1984-2007, we confirm the evidence that democracy enhances the FD in countries with strong institutional framework. Most importantly, our findings reveal that democracy will rather hamper the development of the financial sector when the country’s institutional quality is poor. Indeed, low regulatory quality, weak rules of law, less control of corruption and a heavy bureaucracy are reported to undermine benefits of democracy in stimulating the FD. Moreover, results indicate that parliamentary democracies tend to outperform presidential democracies in promoting the development of the financial sector. Finally, further results indicate that to take full benefits from democracy, democratizing counties should promote economic institutions; otherwise transition to a democratic government will not affect their financial development.