Critically examine whether legal institutions matter for financial Essay

Critically examine whether legal institutions matter for financial development with further implications for economic growth - Essay Example The greater the levels of financial development in the country, the wider are the provisions of financial services that allow risk diversifications, and this in turn boosts the economic growth curve of a nation. Joseph Schumpeter first proposed the link between economic growth and financial development in the early 20th century, where he claimed that the financial intermediaries advocated technological modifications by providing economic resources for the invention of new products (Schumpeter, 1912). Levine and Zervos (1998) in their papers show that development within the stock market and banking sectors of a nation are reasonably reliable indicators of the economic growth. For industrial expansions at the microeconomic level, Rajan and Zingales (1998) and Demirguc-Kunt and Maksimovic (1998) feel that financial institutions are an essential component. Despite contentions, a majority of the research papers suggest that there is indeed a strong connection between the financial develop ment and economic growth. ... al intermediation and markets, as well as deep and broad access to capital and financial services† (The Financial Development Report 2010, 2010, 4). Here institutions chiefly refer to laws that control and monitor the financial sector, contractual enforcement and the quality of corporate governance. The word â€Å"institution† as defined by Douglas North (1991) states that these are man-devised constraints that shape a nation’s socio-economic and political interaction. These constraints maybe informal like social taboos, sanctions, trust, social traditions and customs, social capital, and social codes of conduct; or they may also be formal like legal system, constitutions, property rights, etc. Institutions have been devised in to create an order in the society, and decrease the chances of uncertainty in various transactions and exchanges. As per economic theories, a strong and stable institutional environment is essential for decreasing the transaction and inform ation charges (Levine, 2004).There are also a significant number of research papers that establish the close relation between financial development and a country’s institutional characteristics, especially its legal framework (Arestis, Demetriades, and Luintel, 2001). Thus, from a study of papers one can conclude that legal institutions from an essential part of the financial development of a nation, since it works towards protecting the investor interests (Barth, J., Caprio, G., and Levine, R., 1999). The law and finance theory centres on the part played by the legal institutions in analysing global differences perceived in financial development (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2000). The law and finance theory suggests that in countries that have strong legal institutions and effective