Institutions and credit risk in banking system the case of emerging economies

Policies and Sustainable Economic Development | Institutions and Credit Risk in Banking System: The Case of Emerging Economies SU DINH THANH University of Economics HCMC - dinhthanh@ueh.edu.vn NGUYEN PHUC CANH University of Economics HCMC canhnguyen@ueh.edu.vn Abstract The extant literature has documented the determinants of bank credit risk, but does not pay much attention to institutions This study fills this gap by investigating the effects of institutions on bank credit risk Our data covers 33 emerging economies over the period of 2002 - 2013 Applying system GMM estimator for unbalanced panel data, the study finds intriguing findings Given credit supply, the effects of bank liquidity and bank profitability are negative, while the effects of bank capital and bank size and bank concentration are significantly positive On the other hand, in terms of credit demand the effect of real GDP growth rate is negative Our main finding is that institutions have negative effects on bank credit risk Particularly, in the present of institutions, the interaction effects of bank liquidity, bank capital and bank size, bank profitability, and real GDP growth rate are strengthened These results imply that improvements in institutions are significant for control over bank credit risk in emerging countries Keywords: institution; banking system; credit risk; emerging economies Introduction There has been a growing literature on determinants of bank credit risk in the recent years, especially since the 2008 global financial crisis Several studies blame the crisis on excessive risk taking of banking system (Agnello & Sousa, 2012; Hoque, Andriosopoulos, Andriosopoulos, & Douady, 2015) A deep understanding of credit risk determinants is crucial importance for the proper evaluation of banking system risk and has a direct link with the development of suitable regulation and prudential tools In fact, there are numerous works focusing on the determinants of credit risk in banking system including microeconomic factors such as bank liquidity, bank capital, bank size, bank competition, credit derivatives, internal rating systems, collateral, relationship between lender and customer (e.g., Imbierowicz & Rauch, 2014; Agarwal et al., 2016; De Lis et al., 2001; Mandala et al., 2012); and macroeconomic factors such as inflation, unemployment, house price, credit cycles, business cycle, and economic growth (e.g., Hoque et al., 2015; Castro, 2013; Chen, 2007; Jiménez et al., 2005; Tajik et al., 2015; Marcucci & Quagliariello, 2009; Jiménez et al., 2005) The credit activities of banking system are the function of the asymmetric information problem (Lindset et al., 2014; Miller, 2015; Neyer, 2004) This problem may be reduced if the institution of a country is improved The quality of institution and financial regulation are definitely determinants of bank credit risk since the improvements in institution and financial regulation reduce the asymmetric information problems, thus induce banking system to provide bank loans with better quality On the other hand, financial insurance regulation may stimulate banks in taking more risks Indeed, the role of public institutions or public governance in reducing the overall risk in the economy is explored in several studies (Cohen et al., 1983; Dal Bó & Rossi, 2007; Dutta et al., 2013; Ho & Michaely, 1988; Williamson, 1981) However, not much is known about public institutions in determining credit risk in banking system in emerging countries In addition, the associations between public institutions and other determinants of credit risk such as bank capital, bank liquidity, bank size, bank competition, and economic growth are ignored Therefore, this study goes to fill this gap by investigating the effects of public institutions and the associations between them with bank characteristics including bank capital, bank liquidity, bank size, and bank competition, which reflect the determinants of bank credit supply, on bank credit risk This paper is not the first to explore the determinants of credit risk in banking system, but it is innovative in several ways First, this is the first study using three dimensions of public institutions including government effectiveness, regulatory quality, and rule of law to investigate the effects of institutional quality on credit risk in banking system in emerging countries Second, we use interaction terms between each institutional indicator and bank credit supply factors in order to examine the effect of credit supply’s determinants on bank credit risk when institutions are present In addition, we use interaction terms between each institutional indicator and real economic growth in order to examine the effect of bank credit demand factors when institutions are present These methodologies ensure that our model catches all the main drivers of credit activities relating to credit risk in banking system With these strategies, we believe that our study has significant contribution to both scholar and practice In fact, our empirical results show that institutional quality has significant negative effect on credit risk in banking system, indicating that improvements in institutions (such as government effectiveness, rule of law, and regulatory quality) have good effects on banking system stability and reducing systematic risk This result has strong contribution to the literature of institution, where the institutional quality impacts not only on economic growth (e.g., Acemoglu & Robinson, 2008; Dollar & Kraay, 2003; Fatás & Mihov, 2005), but also on the stabilization of financial market Most notably, we find that improvements in government effectiveness and rule of law in line with the higher of liquidity, capital, size, competition, and lower of profitability in banking system increase bank credit risk The interaction terms between regulatory quality with bank credit supply characteristics have same effects as government effectiveness and rule of law excluding the profitability and competition in banking system, which have opposite impacts on bank credit risk More precisely, we find that the interaction terms between improvements in institutions with economic growth increase bank credit risk This results show the risk-taking activities of banking system with higher liquidity, capital, size, competition, and lower profitability in emerging economies in the case of better government effectiveness and rule of law Better regulations also simulate banks taking more risks excluding banking system with lower profitability and higher competition, which means that better regulations help banking system more stabilization and more safety The rest of the paper proceeds as following manner Section reviews related bank credit risk determinants through the drivers of credit demand and credit supply Section introduces methodology and data Section presents our empirical evidences from three dimensions of institutions including government effectiveness, rule of law, and regulatory quality Final section concludes Literature review Many previous empirical studies analyze determinants of bank credit risk or nonperforming loans, including macroeconomic factors and specific banking sector characteristics (Castro, 2013) The bank credit risk is generally defined as the risk that a loan is not being paid by borrowers to bank partially or totally The analysis of bank credit risk determinants in banking system is essential for policy makers since it provides early alarms for macroeconomic management in front of shocks and preventing financial system from a possible crisis (Agnello et al., 2011; Agnello & Sousa, 2012; Beltratti & Stulz, 2012) In the literature, bank credit risk is divided into systematic credit risk and unsystematic credit risk (e.g., Ahmad & Ariff, 2007; Aver, 2008; Frye et al., 2000; Dietsch & Petey, 2002) The drivers of systematic credit risk include: (i) macroeconomic factors such as unemployment, economic growth, inflation, and exchange rate; (ii) changes in economic policies such as monetary policy, fiscal policy, economic legislation changes, or trade policy, (iii) and political changes These factors may influence the probability of borrowers paying their loans For instance, Aver (2008) finds that employment, long-term interest rates, and the value of stock market have important impacts on credit risk of the Slovenian banking loan portfolio Kattai (2010) and Fainstein and Novikov (2011) show that banking systems highlight the importance of economic growth in Estonia, Latvia, and Lithuania Salas and Saurina (2002) and Jakubík (2007) also point out that GDP growth and interest rates are the main macroeconomic factors affecting bank credit risk for the Spanish and Czech, respectively The divers of unsystematic credit risk includes: (i) the factors related to borrowers such as personality, financial solvency, and capital of individuals; (ii) management, financial position, sources of funds, and financial reporting, and specific factors of the industry sector of firms (Castro, 2013) Zribi and Boujelbène (2011) studies ten commercial banks in Tunisia over the period 1995- 2008 by estimating a panel model controlling for random effects find that ownership structure, prudential regulation of capital, profitability are main drivers of bank credit risk Furthermore, Ahmad and Ariff (2007) point out the importance of micro characteristics from commercial banks of some emerging and developed economies on the bank credit risk including regulatory capital and management quality Meanwhile, Jiménez and Saurina (2004) use data from several Spanish credit institutions to investigate the role of collateral, type of lender, bank-borrower relationship, and the effects of characteristics of the borrowers and of the loan on bank credit risk They find that collateralized loans have a higher probability of default, and that while loans granted by savings banks are riskier, a close bankborrower relationship increases the willingness for risk-taking behavior of banks Nevertheless, there is a multitude of empirical studies looking at main drivers of bank credit risk and highlighting that macroeconomic and microeconomic variables should be included into the analysis due to their considerable influence The vast majority of these empirical works consider the macroeconomic and microeconomic factors as the most important drivers in the determinants of bank credit risk based on a single country analysis Some provide a multi-country comparative analysis without concerning to the effects of institution and its associations with microeconomic factors and macroeconomic factors In this study, we inspect the determinants of credit risk in banking system under the aspects of credit supply and credit demand factors to better understanding the influence of institution on credit function and risk-taking behavior of overall banking system The institution of a country which is defined as the rules of the game in a society (North, 1990), includes three features: (i) “humanly devised” which contrasts with other economic fundamentals; (ii) “the rules of the game” to set “constraints” on human behavior; and (iii) their major effect will be through incentives (see North, 1981; Acemoglu & Robinson, 2008) Several works have studies the effects of institution, which is named as the new institutional economics, but the effects of institution on credit risk in banking system are still ignored Therefore, we try to build our arguments to explain for this issue by four directions First, better institutional quality induces higher economic growth, and then reduces credit risk in banking system In the literature of economic growth, institution is considered the differences in residuals of economic growth Previous studies agree that better institutional quality is positively and significantly correlated with economic growth (Young & Sheehan, 2014) For instance, Djankov et al (2002) finds that the lower cost of opening a medium-size business in the United States in comparison with Nigeria, Kenya, Ecuador, and Dominican Republic is highly correlated with economic growth Meanwhile, Beekman et al (2014) find that corruption reduces incentives of individuals in both voluntary contributions and investments in Liberia, and thus impacts on economic growth Therefore, better institutional quality will be in line with higher economic growth and hence improving the financial situation of borrowers and reducing credit risk in banking system Second, better institutional quality reduces asymmetric information problems (Cohen et al., 1983; Ho & Michaely, 1988; Williamson, 1981); hence, banks will be less probability of making wrong decisions in lending to bad borrowers Third, better institutional quality reduces overall risk in the economy (Cohen et al., 1983; Ho & Michaely, 1988; Williamson, 1981), thereby inducing a lower systematic risk and reducing credit risk of bank credit portfolio In fact, better institutional quality helps economic agents more trustable in business transactions Thus, institutional quality positively impacts the efficiency of businesses (Dal Bó & Rossi, 2007), and mitigates systematic risk in overall economy Dutta et al (2013) find that worse corruption situation leads to high inequality, poverty, and employment and thus undermines the effectiveness of economic growth in India Four, better institutional quality reduces transaction cost in economic activities in general and credit activities in particularly As a result, better institutional quality induces higher efficiency of credit activities and better control of credit risk in banking system Although the views of systematic and unsystematic credit risk dominate in the literature of bank credit risk, we can examine the determinants of credit risk in banking system under the basic determinants on demand and supply sides of credit function The approach of the systematic and unsystematic credit risk is suitable for bank level studies due to defining factors relating to systematic or unsystematic risk, but the approach of determining the drivers of credit risk from the views of supply and demand side in credit function is better at the banking system level or country level, since it is easy to define the drivers of credit risk in the overall banking system In the literature, the function of credit is impacted by supply and demand side factors On the demand side, income level and growth rate of GDP per capita are main determinants of credit demand (Backé & Wójcik, 2008) For instance, Duprey (2012) uses real GDP growth in explaining the different pattern of bank behaviors over macroeconomic fluctuations at 459 public banks in 93 countries Similarly, Elekdag and Han (2015) find that domestic factors such as economic growth and monetary policy shocks are more dominant than external factors in driving rapid credit growth in emerging Asia Policies and Sustainable Economic Development | Indeed, economic growth increases the expected income and profit in line with better financial conditions of private sector, thus allowing for higher levels of indebtedness (Kiss, et al., 2006), while households may want to increase debt levels to smooth consumption in current time since they expect higher income in the future (Backé & Wójcik, 2008) In addition, higher economic growth increases the disposable income of people and thus stimulates them in consumption and investment Firms are also induced to expand their operations to catch up with increasing demand, thereby stimulating the increased credit demand Even though the profit of firms may be higher due to economic growth, thus stimulating them to rely more on internal funds instead of bank loans (Kiss et al., 2006), this effect may be not strong as the positive effects of economic growth on credit demand in developing or emerging economies since high economic growth needs a bundle of capital Accordingly, fluctuations in economic growth definitely change credit demand and then, in turn, impact on credit risk in banking system, which explains the relation between credit risk and business cycle (Marcucci & Quagliariello, 2009) For example, using lagged percentage change in GDP to explain for the banking crisis in the Nordic countries in the period of 1980s-1990s, Pesola (2001) finds that the shortfalls of GDP growth below forecast contribute to their banking crises Salas and Saurina (2002) finds that the GDP growth rate in line with other microeconomic factors such as firms, and family indebtedness, rapid past credit or branch expansion, inefficiency, portfolio composition, size, net interest margin, capital ratio, and market power are drivers of credit risk in Spanish commercial and savings banks in the period 1985-1997 Meyer and Yeager (2001) and Gambera (2000) find that macroeconomic variables are good predictors for the non-performing loans in the US Marcucci and Quagliariello (2008) use data from Italian banks and find that the credit risk is increased in economic downturns Similarly, Hoggarth et al (2005) provide the same evidence for the case of the UK There are some possible explanations to the cyclicality of credit risk such as disaster myopia, over- optimism, herd behaviors, and insufficient market disciplines (Marcucci & Quagliariello, 2008) Marcucci and Quagliariello (2008) verify the cyclicality of credit risk from the following perspectives: (i) economic growth increases the profit of firm, which raises asset prices rise and customers’ expectations at the beginning of expansionary phase and then increases aggregate demand As a result, the increasing of aggregate demand induces a rapid growth in bank credit portfolio and in economy's indebtedness, where banks usually underestimate their risk exposure and relax their credit standards due to over-optimism in the increasing of credit demand, which causes the deterioration of borrowers’ creditworthiness; and (ii) customers’ profitability will be worsened when an exogenous shock occurs The overoptimism is likely to become over-pessimism that can trigger the pitfall of asset prices and worsens customers’ financial wealth depressing deeper, while the downturn in asset prices worsens the value of collaterals of banking system Therefore, non- performing assets emerge, while firms’ financial distress increases, causing losses in banks’ balance sheets, and 510 | Policies and Sustainable Economic Development thus both banks’ profitability consequently as cyclicality and capital adequacy deteriorate 520 | Policies and Sustainable Economic Development 0.0249*** 0.0077** (Reguqua*Ban 0.0120*** kliq) (-1) 0.0096*** 0.0105*** 0.0116*** Crerisk (Reguqua*Bankc ap) (-1) (Reguqua*Banka sset) (-1) No institutio nal effect The effects of Regulatory quality 0.2566*** 0.1993*** 0.2929** 0.3179*** 0.1714*** 0.0112** 0.0138*** 0.0150*** 0.0205*** (Reguqua*Bankroa) (-1) 0.4403*** 0.5032*** 0.3359*** (Reguqua*Ban kcon) (-1) 0.0138 * 0.0186* * (Reguqua*Gdpg) (-1) N 273 No of countries 33 244 33 247 33 247 33 247 33 241 33 241 33 244 33 No of IVs 24 25 26 27 27 28 30 24 0.0407 AR(2) test (p0.248 0.228 0.125 0.177 0.164 0.479 0.500 value) Hansen test (p- 0.297 0.239 0.537 0.331 0.368 0.238 0.299 value) Notes: *, **, and *** denote significance levels at 10%, 5%, 1% respectively 0.858 0.144 The estimated results in Table show that the effects of rule of law are same as those of government effectiveness Table shows that interaction results of regulatory quality and bank profitability and bank concentration are different from those of government effectiveness First, the interaction effect of regulatory quality and bank profitability is positive, suggesting that the impacts of bank profitability on credit risk in banking system are strengthened when regulatory quality is present This result shows that banking system with higher profitability in line with better regulation increases credit risk in banking system Second, the interaction effect of regulatory quality and bank concentration is positive, suggesting that the impacts of bank concentration on credit risk in banking system are strengthened when regulatory quality is present This result shows that banking system with higher concentration or lower competition in line with better regulation increases credit risk in banking system This result implies that the lower competitive banking system will take more risk if the regulatory quality is improved in emerging economies This result is consistent with the theory of “too big to fail,” which means that banking system with lower competition stimulates banks taking risks if the regulation is improved such as deregulation or freely market Conclusion and policy implications This paper’ aim is to contribute to the existing literature on the relationship between institutions and credit risk in banking system It is conducted based on data of 33 emerging economies over the period of 2002 - 2013 In this study, determinants of credit risk in banking system are explored on credit demand credit supply and institutions such as government effectiveness, rule of law and regulatory quality are employed respectively to estimate This study has interesting findings 522 | Policies and Sustainable Economic Development Regarding credit supply side, first, the effect of bank liquidity is significantly negative, suggesting that higher liquidity reduces the credit risk in banking system in emerging economies Second, the effect of bank profitability on credit risk in banking system is significantly negative, suggesting that higher profitability helps banks reduce credit risk due to lower risk-taking activities Third, the effect of bank capital and bank size on credit risk in banking system is significantly positive, suggesting that banks with larger size and capital are taking more risk than smaller one Fourth, the effect of bank concentration on credit risk is significantly positive, suggesting that higher concentration or lower competition in banking system stimulates higher credit risk Regarding the side of credit demand, the effect of real GDP growth rate on credit risk is significantly negative, suggesting that high economic growth reduces credit risk in banking system Considering institutions, the effect of government effectiveness is significantly negative, suggesting that high effectiveness of government reduces credit risk in banking system The interaction effects of government effectiveness are interesting First, the impact of bank liquidity on credit risk is strengthened in the present of government effectiveness because better institution produces better information and then reduces transaction cost and overall risk in order to lower credit risk in banking system Second, the impacts of bank capital and bank size on credit risk in banking system are strengthened when government effectiveness is present because the better of government in implementing sound policies make banking system with higher capital and larger size taking riskier credit activities Third, the negative impact of bank profitability on credit risk in banking system is strengthened when government effectiveness is present because better institutions limit banks taking risk in their credit activities Fourth, the impact of bank concentration on credit risk is reduced when government effectiveness is present Thus, banking sector with lower competition in line with improvements in institution reduces risk-taking activities in bank credit market Fifth, the impact of real GDP growth rate on credit risk in banking system is strengthened when government effectiveness is present because better institutional quality in line with higher economic growth will enhance over-optimism in banking system and real sectors When replacing government effectiveness by rule of law and regulatory quality, the interaction effect signs are rather consistent There are only two 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