Nabamita Dutta
Deepraj Mukherjee
Abstract
In recent years there has been a plethora of studies on economic-institution relationship (See, Rodrik et. al. 2004; Acemoglu et. al. 2001, 2002; de Soto 2000; North 1990) but there are still important gaps in our understanding of its sources and consequences. These institutions can be formal or informal in nature. We follow the extant literature and define the formal institutions as rules and regulations that are well documented and are determined or executed through formal position of authority and ownership (Glaeser et al. 2004; Beck at al. 2001) and informal institutions as values and norms that are derived socially and therefore not well documented or necessarily sanctioned by the formal authority (see, for example Tabellini, 2008). The interaction between the formal institutions and informal institutions can be of two types: complements or substitutes. There exists literature that studies these two types of association and has come up with mixed evidence (see, for instance Sheng et al. 2005; Poppo and Zenger, 2002, Lazzarini, Miller & Zenger, 2004; Uzzi, 1996; Gulati, 1995; North, 1990; Sitkin and Roth ,1993)
Our paper is an attempt to investigate the substitution and complementary effects between formal and informal institutions. In this paper, we focus on the impact of these two types of institutions on financial development. Previous studies have stressed the need for good formal institutions for financial development of a nation (Huang, 2010; Clague, Keefer, Knack and Olson, 1996; Olson, 1993). Recent studies have shown that while formal institutions are necessary, informal institutions captured by aspects like trust, control are also important for financial development (See, for instance, Dutta and Mukherjee, 2011). We examine the following questions in the paper - do formal and informal institutions affect financial development of country jointly? If yes, do they act as complements or as substitutes?
To test our hypothesis, we consider a simple theory model followed by rigorous empirical analysis. As a measure of informal institution, we have considered the aggregate index of culture (Tabellini, 2008) based on the first principal component of the 4 traits – Trust, Control, Respect and Obedience. We have used various measures of formal institutions from Polity IV database, DPI database and Freedom House database. Considering a panel of 121 countries over a period of almost three decades and using 5 year average panel data, we find that these two types of institutions do have a joint impact on financial development. Further, they act as complement to each other. In the presence of efficient levels of formal institutions, informal institutions enhance financial development. We use fixed effect specifications for our benchmark analysis. The endogeneity concerns have been addressed by considering the independent variables in lagged form. To further control for the endogeneity, we have considered system GMM specifications as part of the robustness analysis. Our results are robust to inclusion of controls and sub-sample of developing countries.