This article investigates the role of institutional quality in shaping the link between financial development and income inequality across a sample of 52 developing countries over 1990–2015 using a system Generalized Method of Moments (GMM) estimator.
The study uses system GMM dynamic panel analysis for its empirical analysis. System GMM, developed by Blundell and Bond (1998), is a more robust technique to control for omitted variable bias, endogeneity and cross-sectional heterogeneity. Sargan test of overidentifying restrictions is used to check the validity of the variables used as instruments in the regression analysis. Additionally, serial correlation among the differenced error terms is tested using AR(1) and AR(2) specification tests.
The empirical estimates revealed a negative impact of financial development on income inequality, suggesting that a deeper, stronger financial system contributes to a more equitable distribution of income. Similarly, the coefficient of institutional quality displays a negative and statistically significant sign, which indicates that a reduction in income inequality can be achieved by improving the quality of the institutions. Further, the coefficient for the interaction effect between financial development and institutions exhibited a positive and significant sign, which suggests that beneficial effects of financial development on income inequality dampen as the quality of institutions improves.
The empirical findings of this study are contingent upon the countries selected, data period chosen and the methodology used. However, the results cannot be generalized for individual countries under consideration.
The study contends that as institutional quality enhances, financial systems and institutions assume complementing functions instead of substitutive ones. In economies marked by weak institutions, financial intermediaries often undertake quasi-institutional roles (substitutive). They facilitate trust, diminish transaction costs and provide credit to marginalized people who may otherwise be excluded from economic engagement. However, as the institutional quality improves, institutions begin to play complementary rather than substitutive roles. Financial intermediaries are no longer required to execute governance functions independently; instead, they function well inside a strong institutional framework that mitigates knowledge asymmetries and moral hazard.
This research uniquely explores the moderating role of institutional quality in the finance–inequality nexus, providing fresh insights into how governance structures shape development outcomes.
