Institutions and Bank Intermediation: The Joint Role of State Capacity and Civil Liberties

Abstract

We examine the effects of state capacity and civil liberties on bank intermediation, measured by banks' ability to generate liquidity in the economy. Theory suggests that a strong state that upholds civil liberties can create institutions that promote economic activity, including the development of its banking sector. We investigate this hypothesis by testing a possible channel: confidence in the banking system. Democracies tend to increase trust in the banking system by reforming institutions, while autocracies frequently rely on cronyism. Over the long run, trust in the banking system promotes banking development and intermediation in democracies, whereas cronyism and the risk of expropriation by autocrats undermine the potential for banking sector advancement in autocracies, despite having a trustworthy banking system. Our findings provide evidence in support of this channel, offering new insights into the role of political institutions in the banking sector.