Institutional quality and risk in the banking system.
| Autor | Canh, Nguyen Phuc |
Introduction
Generally speaking, the banking credit risk is defined as the risk that loans are not repaid partially or totally (Liao et al, 2009; Lopez et al, 2014), such risk can lead to the bank default. Since 2008 and the banks' failure leading to the global financial crisis, the determinants of the banks default\credit risk became an important topic (Jaloudi Mutasem, 2019; Ngo Tra et al, 2019). There is a growing literature focusing on the determinants of credit risk and bank default risk including microeconomic factors such as bank liquidity, bank capital, bank size, bank competition, credit derivatives, internal rating systems, collateral, the relationship between lender and customer (Imbierowicz and Rauch, 2014; Agarwal et al, 2016; Mandala et al, 2012) and macroeconomic factors such as inflation, unemployment, house price, credit cycles, business cycle and economic growth (Hoque et al, 2015; Tajik et al, 2015).
The literature has pointed out that an analysis of macroeconomics factors contributing to the credit risk of the banking system is essential for policymakers to prevent a potential financial crisis (Agnello et al, 2011; Beltratti and Stulz, 2012). However, the existing literature dealing with macroeconomics determinants under-investigates the influence of the institutional quality on the credit risk and default risk of the banking system. Meanwhile, the literature on the impacts of macro institutional quality on credit risk in the banking system is scary. Notably, there are likely no studies on the association between institutional quality with other determinants of bank risk such as economic conditions or banking system characteristics. Roughly speaking, institutions refer to government effectiveness, regulatory quality and the rule of law. The literature has documented that better institutions can actually reduce asymmetric information and transaction cost, and therefore, they improve resource allocation (Williamson, 1981; Ho and Michaely, 1988). That is, the improvement in institutional quality may have important impacts on credit risk in the banking system. More importantly, the bank managers' behaviours may be different under different contexts of their bank's situation and economic conditions (Vo and Nguyen, 2014). Therefore, the impacts of institutional quality on bank risk may be heteroscedastic across economic conditions and bank conditions.
Our study finds that better institutions indexed by the mean of six institutional quality (including control of corruption, government effectiveness, regulatory quality, rule of law, political stability and voice and accountability) reduce the default risk, especially the credit risk of the banking systems. This is the major contribution of this research because the current literature does not offer yet an econometric analysis of the combined effect of institutional and economic factors on the risk in the national banking system. In doing so, this study is innovative because the impact of the institutional quality on the banking system's risk is examined in association with the characteristics of the banking system (i.e. capitalization, liquidity, profitability, competition) and the economic conditions (i.e. economic growth, foreign direct investment (FDI) flows, trade openness). Second, the study examines further the influence of institutions and their combination with some economic and banking system specific characteristics (i.e. liquidity, capitalization, profitability and concentration as the drivers of bank credit supply, economic growth and FDI inflow and trade openness) on the credit risk and default risk of the banking system. Our findings indicate that the influence of institutions in reducing the default risk is weaker in well-capitalized/profitable banking systems and high-growth economies. Our analysis suggests that institutional quality can act as a useful tool to reduce the default risk in highly liquid and concentrated banking systems, especially in high-growth economies with high economic integration. We explain our study in the following section.
The remaining of the paper is structured as follows. The second section provides the literature review and hypotheses development. In the third section, the methodology and data are introduced, while the fourth section presents and discusses our empirical findings, whereas the fifth section concludes the study with some policy implications \recommendations.
Literature review
The literature on institutional quality usually claims that institutions facilitate the efficient allocation of resources contributing therefore to economic activities (Tran Nam and Dat Le, 2019) and economic growth (Nguyen et al., 2018). For instance, Beekman et al. (2014) find that corruption reduces incentives for individuals in both voluntary contributions and investments in Liberia creating therefore an impact on the economic growth. There are reasons to expect links between institutional quality and bank risk. First, a good institutional environment is also very important to reduce problems related to information asymmetry (Cohen et al., 1983; Ho and Michaely, 1988) and transaction cost (Jude and Levieuge, 2015). This issue directly affects credit activities (Qu et al., 2018) because the asymmetric information problem often presented as a major obstacle in channelling funds from savers to borrowers (Neyer, 2004; Lindset et al., 2014; Miller, 2015). For instance, Nguyen et al. (2018) documented that the better institutional quality induces higher credit level in the banking system in emerging economies over the period 2002-2013 as the reduction impacts of institutional quality on asymmetric information and transaction cost. In this context (low asymmetric information and the transaction cost), if the problem of asymmetric information including adverse selection and moral hazards becomes less serious, commercial banks will be less likely to supply loans to poor credit-worthiness borrowers and borrowers will also less likely to be involved in risky projects. Second, there is concrete literature pointing out that the better institutional quality induces a more effective macroeconomic policy (Nguyen, 2018; Nguyen et al., 2018; Su et al., 2019), which includes the banking regulations. As a result, the bank managers would be more careful in supplying credit to better credit-worthiness borrowers to meet the regulations. Third, better institutional quality is argued with less uncertainty in the macroeconomic systems as more prudential macroeconomic policies, while high uncertainty is argued to link with a higher risk in economic activities (Strobel et al., 2018). For instance, much evidence is showing that governments in advanced countries (mostly with high institutional quality) usually implement a counter-cyclical fiscal policy, while governments in developing countries are observed with pro-cyclical fiscal policy (Nguyen and Thong, 2016). That is, better institutional quality may be expected with lower macroeconomic uncertainty. In summary, we can expect that better institution quality will reduce the credit risk and the overall default risk of the banking system.
The originality of our research is to investigate this aspect through different characteristics, such as banking liquidity, capitalization, profitability and concentration. The association between institutions and economic growth is also examined as well as the influence of the association between institutions, and economic integration (including FDI inflow and trade openness) on the bank risk. This combined analysis has not been proposed by the existing literature that usually deals with classical statistical analysis by individual factors. Banking systems with a high level of diversification, high capital adequacy and high profitability are healthier and hence have a lower external cost to raise funds in response to financial distress (Kashyap and Stein, 1995; Kashyap and Stein, 2000; Gambacorta, 2005). The stability of a banking system might be directly related to the institutional environment. Park (2012) found that corruption distorts the bank fund allocation leading to poor project management in 76 countries. It has been well reported that information asymmetry in the form of moral hazard is one of the key roots of banks' risk-taking behaviours, such as the search for yield (Rajan and Dhal, 2003) and too big to fail (O'hara and Shaw, 1990; Papachristos, 2011). We expect that a reduced information asymmetry thanks to the improvement in the institutional quality (Cohen et al, 1983; Ho and Michaely, 1988) can restrain moral hazards and reduce risky behaviours of commercial banks. In this context, one can expect a reduction of the credit risk in the banking systems and then a decrease in the overall bank default risk. Despite some theoretical works, the topic is still under-investigated. Our study aims at filling this gap. Larsson (2006), Cao and Birchenall (2013); Driffield et al. (2013); and Ghosh (2013) showed that institutional quality can have an important role in the stability of the banking system. However, highly concentrated banking systems (dominated by few large banks covering large market shares) create a situation in which banks can leverage their size in managing credit information. In other words, we might expect that any improvement in the institutional quality will have a marginal effect on the reduction of the credit and default risks. Meanwhile, many recent studies have found that banking systems with higher liquidity would have riskier activities in their activities (Nguyen and Boateng, 2013; Nguyen and Boateng, 2015; Nguyen et al, 2015). Related to that, we can expect that a higher institutional quality could limit such risky activities.
The default risk of the banking system can result from various activities. Higher liquidity and a well-capitalized banking system could invite banks to take more risks (Nguyen and...
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