Financial development and governance: A panel data analysis incorporating cross-sectional dependence

Abstract

This study investigates bidirectional causality between governance and financial development using panel data of 101 countries from 1984 to 2013. The financial development–governance nexus is explored using econometric methods robust to cross-sectional dependence, and the relationship between different levels of development and openness is analyzed. Long-run equation estimates show clear evidence that financial development positively affects governance, and this positive impact is found to be robust to three different measures of governance. Further analysis shows that improving governance quality has a positive effect on financial development, while Granger causality tests demonstrate bidirectional causality between financial development and the governance measures. Finally, the impact of financial development on governance is dependent on a country’s level of development and openness. These findings underscore the crucial role of financial development in bringing about good governance reforms and economic growth that, in turn, can further develop the financial sector. As such, a symbiotic and synergistic relationship can persist between good governance, growth, and financial development. The findings provide significant motivation for policymakers to encourage openness and financial sector development to lift the standard of living, especially in emerging economies.