Institutions and the financial development–economic growth nexus in sub‐Saharan Africa

Abstract Using a sample splitting approach that does not impose an exogenous quadratic term, we examine the effect of financial development on economic growth in sub‐Saharan Africa by allowing the link to be mediated by the level of institutions. Our findings reveal a disproportionate growth‐enhancing effect of finance, given countries’ distinct level of institutional quality. More specifically, when the International Country Risk Guide‐based measure of institutions is used as the threshold variable, below the optimal level of institutional quality, financial development does not significantly promote economic growth. For countries with institutional quality above the threshold, higher finance is associated with growth. However, when institutions are measured by World Governance Indicators proxy, we find a significant effect of financial development, irrespective of whether a country is below or above the threshold. Interestingly, the growth‐enhancing effect of finance is greater for low‐institution countries relative to high‐institution countries. Thus, through its ability to provide some crucial roles, the well‐developed financial sector may also perform the function of sound institutions in influencing economic growth.