Knut Wicksell Working Paper Series,
Lund University, Knut Wicksell Centre for Financial Studies

Abstract: This paper explores the relation between institutional quality, trust and stock market participation. In our theoretical motivation, agents update their beliefs in a Bayesian manner based on their historical observations on frauds and they choose to invest in the stock market if their subjective probability of fraud is sufficiently low. In accordance with this theoretical motivation, we develop an empirical model, which tests the hypothesis that higher institutional quality is likely to lead to a higher level of trust, together with the hypothesis that when the level of trust is sufficiently high, agents choose to invest in the stock market. We use a large sample of European (SHARE survey) data on households residing in fourteen European countries that have a large variation in institutional quality. We find that institutional quality has a significant effect on trust and that trust (particularly the part that is explained by institutional quality) in turn significantly affects stock market participation. Moreover, our model takes into account the learning process of immigrants, who experience a dramatic change in institutional quality. We find that the probability that an immigrant participates in the stock market increases both with the institutional quality of the country of residence and that of the country of origin. However, on average, the former is more influential than the latter. We also find that immigrants with a higher level of education adapt their level of trust faster to the institutional environment of the country of residence than those with a lower level of education. The impact of the institutional quality of the immigrants’ country of residence on stock market participation, relative to that of their country of origin, tends to increase with education.

Keywords: institutional quality; learning; trust; limited participation puzzle

JEL-codes: C13; G11

53 pages, April 10, 2014

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