Diversity matters in the world of finance: does ethnic and religious diversity hinder financial development in developing countries

This paper investigates the relationship between ethnic and religious diversity and financial development by using the data for 102 developing countries. It is widely accepted that financial depth, and the more ready availability of finance, has a central role to play in fostering economic growth. We hypothesize that financial development in developing countries, especially those at the early stages of economic development, may be retarded by pre-existing ethnic and religious diversity, which may produce conflict. However, we believe that this risk can be moderated by sound institutional functioning – including good governance and democracy. Financial depth is measured by M2 and private credit (as a percentage of GDP); the Alesina fragmentation index is used for measuring ethnic and religious diversity, varieties of democracy (VDEM) and the quality of governance datasets. Our results are supportive of our hypothesis that ethnic and religious diversity can indeed hamper financial development; these risks, however, are mitigated by well-functioning institutional arrangements