Financial development, foreign banks and quality of governance: Preventing the worsening of income inequality

Despite the recent advances in the burgeoning literature on financial development and income inequality, the expectation that foreign banks have the ability to transfer institutional quality in addition to funding, in order to combat income inequality, is an open empirical issue. We use a sample of 114 countries for the period 1995-2013. We create four subsamples on the basis of per capita income, and we investigate two basic hypotheses: first, whether the presence of foreign banks, controlling for other aspects of financial development, affects income inequality; second, if the various tenants of the quality of institutions and governance have a preponderance. We find that, while overall the presence of foreign banks is an insignificant determinant of income inequality, it has a negative relationship with inequality for the group of countries in the second quartile from the bottom (credit to the private sector being the other significant negatively related variable for the same group). Rule of Law and government effectiveness are consistently negatively related to inequality for the bottom two quartiles. Finally, we find unemployment, controlling for endogeneity, to have a positive effect on inequality for two of the subgroups. Not surprisingly, the presence of foreign banks does not play a role in highly developed countries. However for this group, governance quality indicators, such as control of corruption, do have an impact on income inequality. Our results have straightforward policy implications. Lower income countries need both more financial development with more presence of foreign banks and additionally significant improvements in the quality of institutions and governance. Higher income countries can do better vis a vis income inequality, if they improve the quality of system controls in place.