The impact of banking development and stock market liquidity on economic growth is well documented in the “finance and growth” literature (Levine and Zervos, 1998; Beck and Levine, 2003; Rajan and Zingales, 1998). However, the results are inconclusive with regard to which is more important, if the impact of one subsumes the other, and the relevance of banks and stock markets in the context of legal and institutional development of different countries.
In this paper, we examine and provide new evidence on the interdependence between stock market liquidity and banking development; how the institutional details of an economy such as legal origin and stock market efficiency affect stock market liquidity and banking development; and finally how banking development and stock market liquidity impact economic growth in several developed and emerging markets with varied institutional developments.
There are two reasons for stock market and banking development to be interdependent. First, existing literature documents a positive impact of banking and financial intermediation on stock market development (King and Levine, 1993; Levine and Zervos, 1998; Clayton, et al., 2000). This “financial services” view as argued by Levine (1999) sees banking and stock market activities as “complements” and implies that both banking development and stock market liquidity will have a positive impact on each other and also on economic growth. Conversely, Beck et al (2000) suggest that the growth in stock markets is due to the increasing preference of firms to obtain external financing from the equity markets rather than banks.
This implies banks and stock markets are substitutes and the competition among banks and stock markets in providing external financing to corporations will result in an inverse relation between banking development stock market liquidity. In either case, an argument exists for a simultaneous relation between banking development and stock market liquidity and its resultant effect on economic growth.