Financial Development and Financial Liberalization: Can Social Capital Substitute for Formal Institutions? Luuk Elkhuizen, Niels Hermes, Jan Jacobs and Aljar Meesters University of Groningen, the Netherlands ESRC project meeting, London, UK March 2017 Ackowledgement: Niels Hermes would like to acknowledge, without any implication, support by the ESRC and DFID under ESRC Reference: ES/N013344/1 on “Delivering Inclusive Financial Development and Growth”. 7-10-2016

Introduction Financial development and economic growth Determinants of financial development Especially relevant for countries with less developed financial sector Financial liberalization and financial development Conditions that make financial liberalization work This paper: social capital 7-10-2016

Research question Does social capital influence the relationship between financial liberalization policies and financial development? Work-stream 1.1 ESRC programme 7-10-2016

Financial development and financial liberalization Financial liberalization: competition, entry, interest rates, capital account (McKinnon, 1973; Shaw, 1973; Claessens et al, 2001; Chinn and Ito, 2006) Critics: asymmetric information, relationship lending, risk taking, speculative capital, sudden stops (Stiglitz, 2000, Boot, 2000; Hellmann et al., 2000; Kaminsky and Schmukler, 2008) 7-10-2016

Empirical evidence Mixed results Large heterogeneity between countries and time periods (Huang, 2011) Institutional quality: rule of law, bureaucratic efficiency, corruption (Demirguc-Kunt and Detragiache, 1998; Klein and Olivei, 2008) Financial regulation and supervision (IMF, 2015; Hermes and Meesters, 2015) 7-10-2016

Social capital Resource – next to physical and human capital – that enhances production and trade (Coleman, 1988) Interpersonal trust, information sharing, shared social norms Associated with higher growth (La Porta et al., 1997; Knack and Keefer, 1997) Substitute for failing formal institutions (Ahlerup et al., 2008; Boix and Posner, 1998) 7-10-2016

Social capital and financial development Direct relationship High-trust countries have larger financial sectors (Calderon et al., 2002) Households/firms in high-trust areas save more and have better access to credit (Guiso et al., 2004) Microloan repayment and social capital (Cassar et al., 2007; Karlan, 2007; Feigenberg et al., 2013) 7-10-2016

Financial development, financial liberalization and social capital Indirect relationship Social capital as a substitute for weak formal institutions Financial liberalization positively affects financial development – even though formal institutions are weak – when social capital is strong 7-10-2016

Methodology and data Data 1973-2008 for 82 countries Financial development (GFDD) Financial liberalization (Abiad et al., 2010) Social capital (WVS; Knack and Keefer, 1997) 7-10-2016

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Robustness checks Cluster-mean centering (Dieleman and Templin, 2014) Within-between estimation: ρ1 captures within-country variation over time ρ2 captures between effects of time-variant averages 7-10-2016

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Robustness checks Five- instead of four-year averages growth rates of financial development Analysis using individual components of financial liberalization Strongest results for removing bank entry barriers No results for reducing government involvement in banks Sub-sample analysis, leaving out Asian countries hit by the 1997 crisis 7-10-2016

Conclusions Strong social capital positively affects the relationship between financial liberalization and financial development... …Especially when formal institutions are weak So, the impact of financial liberalization on financial development appears to be conditional on both formal and informal institutions Financial liberalization policies should therefore be made context-dependent 7-10-2016

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