Financial Intermediation and Stock Market Volatility in a Small Bank-Dominated Economy

Abstract

In many small developing countries, the benefits of capital market development are not realized, as banks dominate and stock markets struggle to establish a firm footing in the economy, remaining relatively illiquid and volatile. This paper examines the determinants of stock market volatility in such conditions, specifically investigating the role that banks play in engendering volatility. Although significant amounts of research have been conducted on the determinants of stock market volatility in large developed country and emerging market exchanges, the stock exchanges in small developing countries have largely been ignored, as has been the relationship between banking operations and stock market volatility. Using a Generalized Autoregressive specification, this paper investigates the conditions under which banks in conducting their core functions impact stock market volatility in a small, bank-dominated developing country. The results show that factors which affect banks’ profitability, such as inefficiency, ill-advised financial transactions and overly stringent or inconsistently applied regulations, can increase stock market volatility. They also indicate that in an economy wherein most listed real-sector firms survive through a combination of equity and credit financing, the effectiveness of financial intermediation impacts stock market volatility by affecting the profitability of such firms. We show that in small bank-dominated economies, profitable, well-functioning banks are needed if capital markets are to develop. Suggestions are provided as to how banks, regulators and policymakers can aid in the reduction of stock market volatility.