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Financial Intermediation, Corruption, and Economic Growth: Evidence from the European Union

We estimate the effect of financial intermediation by banks, corruption, as well as their interaction, on economic growth. Previous empirical research does not give clear answers on the importance of financial intermediation or control of corruption for economic growth. Regarding financial intermediation, a general conclusion which could be made from the existing literature is that there is a broadly positive correlation between financial development (i.e. financial deepening) and economic growth but there is still no consensus on the direction of causality. However, papers with recent data show that the impact of financial deepening on growth is not as strong. In fact, the effect disappears or is even negative after a certain threshold level. The effect of corruption on growth is usually negative or statistically insignificant. We separately analyse old and new EU member states in the period 1996-2009 and apply System GMM procedure. The main finding is that in the observed period economic growth in the EU is negatively influenced by financial depth (proxied by share of private credit by deposit money banks in GDP) and, in the case of new EU member states, by financial efficiency (proxied by bank net interest margin) as well. Bank crises have a negative effect on the real GDP p.c. growth rates in the latter economies. As concerns corruption, some results are unexpected. Primarily, better control of corruption (Worldwide Governance Indicators variable) is associated with lower economic growth rates in new EU member states. This is probably due to the fact that institutions improved in the observed period, and economic growth rates were even negative. Institutional improvements were largely motivated by the EU association process. In countries with less institutional volatility, such as old EU member countries (on average), there is a strong positive relationship between institutions and growth. It is possible that in new EU economies the negative effect of corruption is hidden behind the bank crisis. Namely, our results show that the negative effect of a bank crisis on economic growth is six times larger at low (first quartile) than at high (third quartile) control of corruption. In addition, it is possible that corruption contributed to high levels of public investment, which spurred economic growth despite of a misallocation of resources. The results also show that the effect of financial intermediation on economic growth differs depending on corruption. Interaction terms between financial depth/efficiency and corruption are not statistically or economically significant, but splitting all the countries in the sample (with addition of seven other transition economies and 10 Latin American economies) into two groups based on low/high control of corruption, gives evidence that the effect of financial intermediation on economic growth in countries with high incentives for rent-seeking is negative. In addition, corruption enhances the negative effect of financial intermediation on economic growth.

Financial intermediation; corruption; economic growth; European Union

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