A Theoretical Framework for Understanding the Relationship Between Financial Sector Development, Institutional Quality, and Long-Run Economic Growth in Nigeria

The theoretical nexus between financial sector development, institutional quality, and long-run economic growth in sub-Saharan African economies is characterised by endogeneity, threshold effects, and institutional heterogeneity that conventional finance-growth models fail to adequately capture. This study develops and empirically validates an original theoretical framework for the finance-institutions-growth relationship in Nigeria, integrating institutional economics, endogenous growth theory, and the financial accelerator hypothesis into a unified analytical model. The framework proposes that the growth effect of financial sector development is contingent on institutional quality, implying non-linear and threshold-dependent relationships. Bayesian threshold vector autoregression methodology was employed using annual data from 1985 to 2022, with institutional quality measured by a composite index derived from World Governance Indicators. Financial development was measured by six indicators synthesised into a principal component index. The empirical results confirm two institutional quality thresholds below and above which the finance-growth relationship is qualitatively different. Below a governance threshold of 0.41 (on a normalised scale), financial development has a negligible or even negative growth effect, consistent with the financial misallocation hypothesis. Above this threshold, the finance-growth effect is strongly positive. The study makes original theoretical contributions by formally modelling the governance-contingency of financial development effects, providing an empirical taxonomy of Nigerian financial development regimes, and proposing a governance-adjusted financial development index as a policy monitoring tool. These contributions address significant gaps in the Nigerian finance-growth theoretical and empirical literature.

Keywords: financial sector development, institutional quality, economic growth, threshold effects, Bayesian VAR