Improvement in governance and availability of foreign aid are generally claimed to have welfare enhancing effects on economies of developing nations. The ambiguity of relationship between the two, however, calls for further research in this respect. Most of the developing countries are suffering from low quality of governance hence there is a need to investigate the underlying factors that deteriorate the governance quality and in turn hinder the process of economic growth. Economic literature is resplendent with controversies regarding the inter-linkage between the foreign aid and institutional quality. Foreign aid can be used to improve the quality of governance by releasing the recipient government from binding earned revenue constraints. However, foreign aid may deteriorate the governance quality, government not being accountable to the general public may indulge in unproductive activities like rent seeking and moral hazard etc, that reduce the welfare of the society. Countries that are receiving foreign aid and experiencing conflicts, internal or external, are facing low quality governance. Conflicts, whether internal or external, have an adverse impact on the institutions. Cross border tensions, civil wars, coup threats, political violence, terrorisms and foreign pressures leave the government unstable and deteriorate the institutional quality.