The Institutional Environment and the Banking – Growth Nexus: Theory and Investigation for MENA

This paper seeks to provide some theoretical and empirical answers to the following question: Does the institutional environment affect the causality relationship between banking development and economic growth? In the theoretical part, we develop an endogenous growth model where the institutional environment is captured through two indicators: the judicial system efficiency and the easiness of informal trade. We show that an improvement of the institutional environment has two effects. First, it intensifies the causality direction from banking to economic growth through a reduction of defaulting loans. Second, it reduces the interest rate spread. In the empirical part, considering twenty-two MENA countries over the period 1984-2004, we find a bi-directional causality. The first one, which runs from banking development to economic growth, is more intense in countries with a more developed institutional environment. The second causality runs from economic growth to banking and indicates that a more developed economy has a more developed banking system.