1. 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”.

2. 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

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

4. 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)

5. 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)

6. 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. 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)

8. 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

9. 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)

21. 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

23. 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

24. 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