FINANCIAL INTEGRATION AND FINANCIAL DEVELOPEMNT: THEORY AND EVIDENCE

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CHAPTER THREE FINANCIAL DEVELOPMENT, INSTITUTIONAL QUALITY AND SOCIAL CAPITAL: THEORY AND EVIDENCE

Introduction

This chapter explores literature on financial development and its link with levels of institutional quality and social capital available in a country. Financial literature has shown that financial integration has a positive effect on financial development and economic growth. Further theoretical and empirical propositions have been made to suggest that such positive development can only occur within certain thresholds of general legal systems, institutional quality and social capital. This chapter discusses theoretical and empirical evidence relating to these variables, showing how they are assumed to enhance financial development after financial integration has occurred.

Financial development and institutional quality: Early views

As shown in the previous chapter, financial literature has over the years placed great focus on the impact financial integration has on economic growth and financial development. However, not much focus has been placed on the disparities that occur in terms of financial development and economic growth after financial integration has been firmly established within a region or an economic bloc. Thus, inadequate attention has been placed on other important elements that might affect the financial development process that should occur after financial integration. However, literature shows that one of those elements is the legal structuring of financial systems across countries herein referred to as institutional quality. Early works on law and finance by Stigler (1964) centre on the effects of regulation of the securities market on buyers of securities offered on the market. Stigler examines the returns of buyers‟ pre and post implementation of the United States securities act of 1933. His study finds no difference in terms of returns between the two sets of buyers, giving the hint that regulation of the markets has no effects. Jensen and Meckling (1976) bring a new perspective with regards to the legal structure of institutions through their theory of the firm, which combines elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. Their theory of property rights suggests that specification of rights is affected through the legal act of contracting and the behavior of managers in institutions depends on the nature of these contracts (Jensen and Meckling, 1976, p.4). The agency theory specifies the contractual relationship between shareholders and managers of institutions. According to the theory, managers of institutions are agents under contract, offered incentives to act in the best interest of institutions (Jensen and Meckling, 1976, p.5). Through the nature of these contracts, the theory claims that shareholder value of institutions is maximized. However, the theory takes biased view in that it assumes all managers at institutions are more motivated by personal gain, and without incentives would not act in the best interests of institutions nor increase shareholder value. It ignores the fact that there are managers motivated to act responsibly in the best interests of institutions and not necessarily through incentives. In addition, the early works on law and finance fail to show explain the role of law in terms of aspects such as rules for investors, investor protection, contract enforcement and how these are then used to create wealth in financial markets, leading to financial development.
Easterbrook and Fischel (1991) attempt to overcome this limitation and shed further light on the law finance relationship, touching on rules pertaining to insider trading and fiduciary duties, disclosure requirements for securities, corporate control rules and how these are applied to maximize wealth in financial markets and vice versa. The analysis by Easterbrook and Fischel (1991) takes more of a verbal logic approach and does not in any way attempt to provide proof of any relationship between establishment of any specific law and corresponding changes in wealth across financial markets. On the other hand, Hart (1995) adopts a modern view of the agency theory applicable mainly to financial institutions. Hart (1995) argues that traditional approaches such as the neoclassical, principal‐agent, and transaction costs theories cannot by themselves explain firm boundaries. The study attributes the aspect of the agent having power in institutions to incomplete contracts and says if contracts are complete, agents have no power and can only act in the best interests of institutions they serve. In addition, Hart`s (1995) theory views the financial system as being made up of contracts which in turn determine how it operates and develops. However, these early works do not go on to explain why there are variations in the levels of financial development amongst countries. They do not give empirical evidence on how differences in the nature of legal rules applied across countries have gone on to shape the quality of institutions and financial landscape of those countries. They do not explain why some countries have greater depth in terms of their financial markets or why there are differences in terms of stock market valuations across equity markets, or why some countries have more sophisticated banking markets. These shortcomings have led to empirical studies being carried out in later years to try to find out if there is any link between financial development and institutional quality across countries.

Financial development and institutional quality: Empirical evidence

La Porta et al. (1996) originate the argument that differences in financial development could be a result of differences in nature of legal rules across countries. Their initial study examines investor protection rules for corporate shareholders and creditors across 49 countries and quality of enforcement of those rules. They also examine the origin of these rules in terms of whether they originate from civil law or common law. Their study finds out that countries whose legal rules originate in the common law tradition tend to protect investors considerably better than countries whose laws originate in the civil law (La Porta et al., 1996, p.40). In terms of protection of shareholders, the study finds out that concentration of ownership of shares in the largest public companies is negatively related to investor protections, giving an indirect indication that small investors do not get the same protection as big investors. The study does not go on to show how the differences in investor protection rules and enforcement go on to affect development of financial markets across countries. In response to this empirical question, La Porta et al. (1997) carry out further study using the same sample of 49 countries. This study finds out that countries with poorer investor protection rules have narrower debt and equity markets. The study also finds a link between origin of legal rules and financial development. Countries with civil laws are shown to be having narrower financial market than countries with common law (La Porta et al., 1997, p.19). These findings throw light on the mystery of the link between finance and institutional quality. They provide evidence that good investor protection rules can entice investors to provide investments funds towards specific countries, at the same time, from the findings; one can also note that weak investor protection rules can result in investors shunning countries with such, leading to lower levels of financial development.
Though the findings attest to the link between the two, the study does not answer the question as to the whether high institutional quality levels are the only condition necessary for financial development to take place. In the same vein, it does not show whether institutional quality really is a condition for financial development given a situation where countries open up their capital accounts through financial integration, leading to a rise in depth and breadth of financial markets, without any changes taking place to the rules of investor protection. The study does not also explain situations where countries which evidently have weaker financial regulation frameworks, can still attain higher levels of financial development in (in terms of depth and breadth) than countries with stronger financial regulation frameworks. Another study by La Porta et al. (2000) identifies the legal approach as the best way of understanding governance of institutions and again supports the view that differences in terms of breadth and depth of capital markets, in dividend policies, and in the access of firms to external finance are attributable to differences in legal approach.
In support of the significance of institutions in facilitating financial development, Beck and Levine (2003, p.1), note “in countries where legal systems enforce private property rights, support private contractual arrangements, and protect the legal rights of investors, savers are more willing to finance firms and financial markets flourish”. Their review of the relationship between law and finance across European countries again shows differences in terms of financial development across countries can be explained by the different legal systems adopted by those countries. Weill (2010) takes a different approach and examines how institutional quality in the form of corruption affects financial development. Findings of the study show a negative relationship between corruption and financial development, measured by the ability of banks to lend to households and firms. However, the study is based on sample data from one country. Unlike Weill, Huang (2010) looks at institutional quality from a political perspective. He argues that democratic rather than autocratic political institutions have a positive effect on financial development across countries. In agreement with La Porta et al. (1997), Huang (2010) notes democracies better facilitate property rights protection and contract enforcement, encouraging investment. In addition, Huang identifies the link between institutional quality and financial integration, indicating that institutional quality improvement can be a way under which financial integration can lead to financial development and economic growth. Huang`s study is based on extensive data from 90 countries over a 40 year period. His study does not conduct any tests to provide evidence that indeed financial development which occurred is a result of democratization. It is just based on observations on levels of financial development pre and post democratization. Minea and Villieu (2010) look at institutional quality from a growth perspective and conclude that governments can only stimulate economic growth under given threshold levels of institutional quality and financial development. Cherif and Dreger (2014, p.9) note that institutional conditions are important for the development of the banking sector and stock markets. In their study, Cherif and Drager (2014) find that corruption and law and order are the most prominent factors stifling financial markets development and recommend better law enforcement and anti-corruption practices as strategies to support the financial development process. However, the study by Cherif and Drager (2014) left out data from countries which were in conflict at the time of the study. As a result, there were gaps in the data, with unbalanced panels in some of the data. In spite of that, the findings concur with previous studies on institutional quality. In addition, Levine (2001) examines the legal origins of financial development in terms of their emphasis on the rights of private property owners‟ vis-à-vis the state and their ability to adapt to changing commercial and financial conditions in financial development. The study findings assert that legal origins adopted centuries back explain the differences in the level of financial development between countries. Furthermore, Rachdi and Mensi (2012) assess whether institutional quality matters for financial development and economic growth from a Middle Eastern and North African perspective. Their study again shows that institutional quality is an important factor for both financial development and economic growth. The findings of this study are significant in that unlike other studies, the study uses different measures of institutional quality which include law and order, corruption, external conflicts, socioeconomic conditions, and democratic accountability. These measures give much broader view of institutional quality. The study findings are also based on econometric tests carried out in the study rather than on verbal logic as in other previous studies. Another significant study by Chinn and Ito (2006) looks at aspects that matter for financial development from a financial integration point of view. The findings of this study are significant in that it becomes one of the first to emphasize the importance of institutions for financial development to take place after financial integration has occurred. According to Chinn and Ito (2006, p.187) the general level of legal development on aspects such as law and order, corruption, quality of bureaucratic system, creditor and shareholder protection matters for financial integration and development. However, the perspective on legal development as an important aspect for financial development cannot be applied holistically as Chinn and Ito base their findings on data from the least developed countries and not from the industrialized countries. It might be that legal development might not be important if a country has reached a certain level of industrialization. Beck et al. (2001, p.2-3) assess four theories regarding the determinants of financial development across countries. Their study focuses on four areas:
1. The traditional law and finance theory which attributes financial development to legal origin.
2. The dynamic law and finance theory, which looks at adaptability of legal origin to changes.
3. The politics and finance theory, which emphasizes the importance of politics as the main determinant of financial development and takes law as secondary.
4. The endowment view, which looks takes the pre-existing conditions prior to
establishment of any laws as the main determinants of financial development. In agreement with La Porta et al. (1997), Beck et al. (2001) find that differences in legal origin help in explaining differences in financial development across countries. The study also finds out that countries with common law have stronger institutions while civil law limits the level of financial development (Beck et al., 2001, p.39-40). In addition, there is evidence in support of the dynamic law and finance theory as the study also shows that countries like Germany which have allowed their laws to adapt to changing times have had higher levels of financial development than those which have remained stagnant (Beck et al., 2001, p.39-40. However, the Beck et al. (2001) study is not done in the context of developing countries. For instance, Beck et al. (2001) base their findings on institutional laws adopted from developed countries such as German, France and Scandinavian countries. They ignore the institutional laws found in mostly developing countries like the pre-colonial centralized African setup of institutions which according to Gennaioli and Rainer (2005), reduce corruption and foster the rule of law or the Islamic laws and systems found in many Middle Eastern and West African countries whose presence has an impact on levels of financial development as observed by Kuran (2004). Unlike Beck et al. (2001), Rajan and Zingales (2000) argue that the law does not influence finance. Their view is closer to the politics and finance theory as they claim that the level of financial development depends on those with political power. From their viewpoint, incumbents oppose financial development because it breeds competition hence they will not allow laws which will seek to promote financial development. However, recent studies by Law and Azman-Saini (2008, 2012) oppose the political view and maintain the viewpoint that institutional quality is important for financial development.
Law and Azman-Saini (2008, p.16) note that institutional quality significantly enhances financial development, especially for the banking sector, at the same time, in terms of stock market development , the relationship is assumed to be U shaped, indicating that there is a limit to the extent to which institutional quality enhances stock market development. The rule of law, political stability and government effectiveness are identified as important institutional elements in the financial development process (Law and Azman-Saini, 2008, p.16). In support of these findings, Law and Demitriades (2006) also provide evidence that openness and institutions are important determinants of financial development. Compton and Giedman (2007) subscribe to the view that institutional quality significantly enhances financial development. In concurrence with Law and Azman-Saini (2008, 2012), their study also finds strong links between banking sector development and well-functioning institutions. Again in agreement with Law and Azman-Saini (2008, 2012), the study also finds no robust link between institutional quality and stock market development. Having reviewed literature on law and finance, one can note that there is a large body of work which attests to a positive relationship between institutional quality and finance. However, there is also financial literature which views the role of law in the financial development process with uncertainty or with an element of doubt, especially advocates of the political viewpoint. Perotti and Haber (2008, p.2) argue that legal factors alone cannot spur financial development, but also have to be complemented by political institutions. They also claim that legal enforcement requires support by the executive branch and state that the time invariant nature of legal origin implies that it cannot be used to explain changes in financial development over time. Another study by Perotti (2014) again supports the political viewpoint and identifies political accountability as the driving force behind financial development instead of the legal viewpoint. In relation to this, Perotti (2014, p.25) observes that as the need for political accountability increases, politicians are left with no option than to allow increased access to credit and to allow for greater entry into financial markets. Having taken into account the time variant nature of political accountability and time invariant nature of legal origin, Perotti (2014) identifies evolution in political institutions as the main determinant of evolution of the financial sector.
Rajan and Ramcharan (2011) try to investigate the relationship between land and access to banking sector credit for the United States in the 20th century. Their study also confirms the political view that elites may restrict financial development in order to limit access to finance. In addition, Benmelech and Moskowitz (2008) examine laws for financial regulation in the Unites States and find that strictness of financial regulation is correlated with strictness of other economic and political restrictions that exclude certain groups. They also argue that usury laws used in regulation reflect the outcome of personal interests of certain groups which have coercive power. Therefore, according to Benmelech and Moskowitz (2008) political interests instead of legal enforcement drive financial development. Similar viewpoints are expressed in other studies by Acemoglu et al. (2005), Pagano and Volpin (2005) and Roe (2003). However, advocates of the political viewpoint do not examine the direct impact on financial development of political influence across countries. Conclusions of these studies, for example Benmelech and Moskowitz (2008), Rajan and Ramcharan (2011), Perotti (2014) are based on single country evidence, which may not be applicable to other parts of the world. In addition, critics of the political viewpoint also argue that it is not always the case that the political elite will achieve what they desire in terms of restricting or allowing financial development, as a result of inefficiency or disorganization in the political organizations (see Blanchard and Shleifer, 2000). Besides advocates of the political viewpoint, there are others who also doubt the positive impact of improvements in the legal system. For instance, while acknowledging that improvements in the legal system are associated with broader equity markets, Lombardo and Pagano (2000), also agree that this can have different effects on equity returns, depending on the nature of changes that would have taken place, so the effects are not necessarily always positive. On the other hand, Engermann and Sokoloff (2000) attribute the development of institutions to initial resource endowments which countries had access to. For example, they claim that in countries where land ownership was highly concentrated, inequality in the society persisted for longer periods than in countries where it was easy to access land. Such inequalities resulted in those countries following different paths in terms of economic and institutional development, leading to differences in the levels of financial development.

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TABLE OF CONTENTS
ABSTRACT
ACKNOWLEDGEMENTS
DEDICATION
DECLARATION
TABLE OF CONTENTS
LIST OF TABLES
LIST OF FIGURES
LIST OF ABBREVIATIONS
CHAPTER ONE INTRODUCTION AND BACKGROUND
1.1 Introduction
1.2 An overview of regional integration amongst SADC countries
1.3 Overview of the financial sector of SADC
1.4 Statement of the problem
1.5 Hypotheses
1.6 Objectives of the study
1.7 Justification of the study
1.8 Structure of the thesis
CHAPTER TWO FINANCIAL INTEGRATION AND FINANCIAL DEVELOPEMNT: THEORY AND EVIDENCE
2.1 Introduction
2.2 Forms of financial integration
2.3 Financial integration and financial development: Theoretical perspectives
2.4 Financial development and economic growth: Empirical evidence
2.5 Financial integration, economic growth and financial development: Empirical evidence
2.6 Conclusion
CHAPTER THREE FINANCIAL DEVELOPMENT, INSTITUTIONAL QUALITY AND SOCIAL CAPITAL: THEORY AND EVIDENCE
3.1 Introduction
3.2 Financial development and institutional quality: Early views
3.3 Financial development and institutional quality: Empirical evidence
3.4 Financial development and social capital
3.5 Summary of contribution of the study
CHAPTER FOUR REVIEW OF METHODOLOGICAL APPROACHES
4.1 Introduction
4.2 Methodological approaches in previous studies
4.3 Conclusion
RESEARCH METHODOLOGY
5.1 Introduction
5.2 Research design
5.3 Data collection
5.4 Data analysis
5.5 Conclusion
CHAPTER SIX PRESENTATION, ANALYSIS AND DISCUSSION OF FINDINGS
6.1 Introduction
6.2 Trend analysis for SADC global financial integration
6.3 Trends in financial development in the SADC region
6.4 Trends in institutional quality and social capital
6.5 Descriptive statistics
6.6 Correlation analysis
6.7 Unit root tests
6.8 Panel cointegration tests
6.9 Endogeneity tests
6.10 Trade Protocol impact on banking development
6.11 Trade Protocol Impact on Stock Market Development
6.12 Summary of the Trade Protocol Impact on Financial Development
6.13 Finance and Investment Protocol impact on Banking Development
6.14 Finance and Investment Protocol impact on Stock Market Development
6.15 Summary of Finance Protocol impact on Financial Development
6.16 Combined effect of the trade and finance protocols on Banking Development
6.17 Combined effect of the trade and finance protocols on Stock Market Development
6.18 Summary of the effects of the combined protocols on Financial Development
6.19 Conclusion
CHAPTER SEVEN DISCUSSION OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS
7.1 Introduction
7.2 Discussion of empirical findings
7.3 Contribution to the body of knowledge
7.4 Conclusion
7.5 Limitations of the study
7.6 Recommendations of the study
7.7 Suggestions for further study
Bibliography
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