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Effets of Banking Regulationson Performnce PDF
Effets of Banking Regulationson Performnce PDF
To cite this article: Serdar Ozkan , Cagnur Kaytmaz Balsari & Secil Varan (2014) Effect of Banking
Regulation on Performance: Evidence from Turkey, Emerging Markets Finance and Trade, 50:4,
196-211
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196 Emerging Markets Finance & Trade
ABSTRACT: In this study, we investigate the effect of regulation on banking sector per-
formance in an emerging country context. Consecutive crises in the early 2000s led to
three waves of reformist banking regulations in Turkey: (1) the banking sector restructuring
program in 2002, (2) limitation of the full deposit insurance system in 2004, and (3) a
corporate governance–related banking law in 2005. Results show that these actions had
a positive effect on bank lending, asset quality, and profitability. Findings also support the
view that the sequence and timing of banking reforms in Turkey acted as a shield against
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Theory suggests that, in the banking sector, regulation is essential due to complex moral
hazard problems and the necessity of protecting depositors and minority shareholders
(Dewatripont and Tirole 1993; Santos 2000). However, there is no clear evidence about
which regulatory and supervisory policies work best to promote bank performance in any
particular economy since the effect of regulation in resolving these issues is highly affected
by cultural factors, economic conditions, and legal structures of the countries (Laeven and
Levine 2009; La Porta et al. 1998). Thus, each country sets the composition, as well as
the timing, of banking regulations within the range of government’s strong helping-hand
and grabbing-hand approaches. One of the major motivators of banking regulations is
a financial crisis; crises often trigger a series of regulations (Dinçer and Neyapti 2008).
Abiad and Mody (2005) and Shehzad and de Haan (2010) point out the “learning effect,”
which may be explained as the tendency of the previous reform processes to foster further
reforms in a way that minimizes disruption, thus leading to financial stability.
The financial crises in the past two decades caused three important consecutive regu-
latory actions to be brought into force in Turkey: (1) the banking sector restructuring
program in 2002, (2) limitation of the full deposit insurance system in May 2004, and
(3) Banking Law no. 5411, which set corporate governance standards for Turkish banks
in late 2005.
In comparison with prior crises, and relative to the other emerging countries, the nega-
tive effect of the 2008 global financial crisis was limited in Turkey (Kilinç et al. 2012).
According to Neyapti and Dinçer (2014), bank regulation and supervision help banks
channel funds into efficient investment projects through monitoring and increase the
ratio of loans returned to banks. Consistent with this view, Bredenkamp et al. (2009) and
Emerging Markets Finance & Trade / July–August 2014, Vol. 50, No. 4, pp. 196–211.
© 2014 M.E. Sharpe, Inc. All rights reserved. Permissions: www.copyright.com
ISSN 1540–496X (print) /ISSN 1558–0938 (online)
DOI: 10.2753/REE1540-496X500412
July–August 2014 197
Rawdanowicz (2010) point out that the underlying cause of the global financial crisis’s
limited effect was the positive performance of the banking sector, which is attributable
to the recent banking reforms in Turkey.
Therefore, we aim to provide empirical evidence for the role of regulation and corpo-
rate governance principles in banking sector performance, as well as in the prevention
of future financial crises. To the best of our knowledge, this paper is a pioneering study
in the area as it provides important empirical evidence capturing the recent economic
crises from the perspective of an emerging country.
In this study, we use three different bank performance measures; profitability, sup-
port to the contribution of the banking sector in financing of economic activities, and
asset quality. We analyze all deposit banks in the Turkish banking system for the period
1998–2009. Findings suggest a significant positive effect on profitability resulting from
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the corporate governance–related banking sector regulation on bank lending and asset
quality and, specifically, from the abolition of chief executive officer (CEO) duality. We
also find that all three regulatory actions have had a positive effect on bank lending, which
shows the contribution of Turkish banks to the financing of economic activity. Results
show that the corporate governance–related banking sector regulation positively affected
asset quality. These findings are robust to the changes in bank-specific, industry-specific,
and macroeconomic control variables, and to sensitivity tests. The results of this study
also provide support for the benefits of regulation favoring a grabbing-hand approach
(Shleifer and Vishny 1998) for the banking sector of an emerging economy, especially
during the 2008 financial crisis, since the grabbing-hand view encourages legal and
regulatory reforms that promote and facilitate private monitoring of financial institutions
(Barth et al. 2001).
increased reliance on private monitoring leads to exploitation of small savers and hence
much lower levels of bank development (Barth et al. 2001, p. 13).
In May 2004, BRSA tightened the limits of loan exposure and limited the full insur-
ance system, which can be considered as representing the first step in a change in direc-
tion from the strong helping-hand approach of the government toward a grabbing-hand
approach.
The continuous regulation process was finalized by Banking Law no. 5411 in Novem-
ber 2005. The major original contribution of Banking Law No. 5411 to the system was
its corporate governance–related requirements, such as the new regulations on financial
information disclosure, the auditing of banks, the restructured responsibilities of the
board of directors, and the prohibition of CEO duality. Thus, these developments can be
considered as a second step toward a grabbing-hand approach.
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There can be no doubt that each of the above-mentioned waves of banking regulation
contributed individually to the establishment of a sound banking system in the country.
Furthermore, as each incorporated the requirements of the previous reform(s), these
waves can be seen as complementary.
holders (Santos 2000). This type of regulation can also be viewed as having the same
role as deposit insurance, which is provided to depositors by governments. Government-
controlled deposit insurance may be a source of moral hazard by encouraging excessive
risk taking, potentially leading to bank failures and systemic crises (Demirgüç-Kunt and
Kane 2002). Barth et al. point out that “countries with more generous deposit insurance
schemes have a much higher likelihood of suffering a major banking crisis” (2001, p. 35).
Since the purpose of the deposit insurance system is to protect depositors and create
competition opportunities for smaller banks (Demirgüç-Kunt and Kane 2002), regulation
may substitute for deposit insurance, without the associated negative side effects.
Considering the previous arguments and in accordance with agency theory and rep-
resentation hypothesis, for the necessity of regulation in the banking sector, we have
developed the following hypothesis:
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Investment banks 15 19 18 15 14 14 13 13 13 13 13 13
Banks with missing data 1 0 0 7 2 1 0 0 0 0 0 0
Remaining sample (state, 47 48 48 27 27 26 28 27 26 26 26 26
private, and foreign
deposit banks)
It is also important to analyze how banks respond to the regulation process in terms of
asset quality and whether loan performance problems appear in the periods following
the reforms. Therefore, NPL is used as a performance measure indicating asset quality.
We also use loan ratio (LOAN) to measure the contribution of the banking sector to the
Turkish economy. Table 2 presents the descriptive statistics of the dependent variables.
ROA shows a stable trend after 2006. LOAN continues increasing after the 2000–2001
banking crisis, while NPL decreases. However, the downward trend of NPL is reversed
after 2007, with the onset of the recent global financial crisis. Descriptions for all vari-
ables are presented in Table 3.
also used as an independent variable. If LOAN is negatively associated with NPL, then
the coefficient is expected to be positive for ROA.
CEO Dummy variable showing whether the CEO and chairman of the
board are the same person
CAPAD Capital adequacy ratio: equity divided by the sum of amounts
subject to credit risk, market risk, and operational risk
Bank-specific ASSET The sector shares in terms of assets
control variables LOGAGE The natural logarithm of bank age, defined as the bank’s
activity period from the foundation date, in years
LIQUID Liquidity ratio, calculated as the liquid assets (cash and
balances with the Central Bank of Turkey + trading securities
[net] + deposits in banks and other financial institutions +
money market securities + investment securities available for
sale [net] + reserve deposits) as a percentage of total assets
NPL Nonperforming loans over total loans
LOAN Total loans as a percentage of total assets
Industry-specific STATE The proportion of equity ownership by state
control variables FOREIGN The proportion of equity ownership by foreign investors
HHI Market concentration, measured as the sum of the squares of
the five largest banks’ market share in total industry assets
Macroeconomic GDP Annual growth rate of gross domestic product per capita
control variables CPI Annual percentage change in the consumer price index
M2 Money and quasi money (the sum of currency outside banks,
demand deposits other than those of the central government,
and the time, savings, and foreign currency deposits of
resident sectors other than the central government) as
percentage of GDP
by increasing their shares in the system. Mian (2003) finds that state banks perform
significantly less well than foreign banks in terms of profitability; however, there is no
significant difference between the average profitability of private domestic banks and
that of foreign banks in emerging economies. Therefore, we predict negative coefficients
for STATE and positive coefficients for FOREIGN.
The Herfindahl–Hirschman index (HHI) measures market concentration. Although the
Turkish banking industry comprises a relatively small number of banks, it is dominated
by a few, thus the value of HHI is high. The rise in HHI in the Turkish banking sector
after 2000 reflects the decrease in the number of banks after the 2000–2001 crisis. The
increase of HHI after the 2000–2001 crisis caused the banking industry to move to a
less competitive structure. Although the “market value hypothesis” states that increased
market power yields monopoly profits, concentration is usually negatively related to
204 Emerging Markets Finance & Trade
profitability once other effects are controlled (Berger et al. 2005). We therefore expect
negative coefficients for HHI.
al. (2003) point out a positive relationship between business opportunities for banks and
the growth rate of the economy; therefore, we expect positive coefficients for GDP. CPI is
the annual percentage change in the consumer price index. Although Turkey has a history
of high inflation, after the 2000–2001 crisis, “price stability” became the primary objective
of the Central Bank, and the floating exchange regime was adopted. Due to the efforts of
the Central Bank, the annual percentage change in CPI declined to 10.6 percent in 2004,
from 54.9 percent in 2000. We therefore control for inflation in our model. According to
the theoretical model of Huybens and Smith (1999), bank performance and lending activity
will tend to rise in the presence of inflation; however, certain thresholds exist. Thus we
expect a positive coefficient of CPI. M2, as an indicator of financial system development,
refers to money and quasi money (the sum of currency outside banks; demand deposits
other than those of the central government; and the time, savings, and foreign currency
deposits of resident sectors other than the central government) as a percentage of GDP.
Higher levels of M2 imply better performance of the banking sector, indicating that the
banks are playing an important role in the allocation of funds; thus, efficient fund alloca-
tion is expected to boost ROA performance of banks (Wu et al. 2007).
Due to the structure of our data, we conduct a panel data analysis to control for bank-
specific heterogeneity. We perform the Hausman test to determine which model should
be stressed. If the Hausman test is significant, we apply the fixed effects model; if it is
insignificant, we apply the random effects model. The assumption of the fixed effects
model is that bank-specific effects are fixed parameters to be estimated; the assumption
of the random effects model is that banks constitute a random sample (Bortolotti et al.
2004). According to the Hausman tests as reported in Tables 4, 5, and 6, we use fixed
effects models for all models, with the exceptions of Model 8 in Table 4 and Models 6
and 7 in Table 5. Hence, for the fixed effects regression used in the analysis, the model is
depicted in Equations (1) and (2):
yit = Xit β + εit (1)
εit = ηi + υit, (2)
where ηi is the individual-specific effect that is constant over time; υit is the error term;
and yit is one of the performance variables (ROA, LOAN, or NPL).
Results
The findings of the analysis for profitability, bank lending, and asset quality are shown in
Tables 4, 5, and 6. In terms of profitability, the overall effect of regulation is insignificant
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Variables Pred. Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8
Notes: We use random effects generalized least square (GLS) regression for Model 8. Fixed effects regression is used for all other models. * 0.10 significance level for a
two-tailed test; ** 0.05 significance level for a two-tailed test; *** 0.01 significance level for a two-tailed test.
July–August 2014 205
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Variables Pred. Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8
Notes: We use random effects GLS regression for Models 6 and 7. Fixed effects regression is used for all other models. * 0.10 significance level for a two-tailed test;
** 0.05 significance level for a two-tailed test; *** 0.01 significance level for a two-tailed test.
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Variables Pred. Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8
Notes: Fixed effects regression is used for all models. * 0.10 significance level for a two-tailed test; ** 0.05 significance level for a two-tailed test; *** 0.01 significance
level for a two-tailed test.
July–August 2014 207
208 Emerging Markets Finance & Trade
for the first three models, as shown in Table 4. This is an expected result since the objec-
tive of regulation was not to increase bank profitability but to safeguard the stability of the
sector. However, CAPAD and CEO have significant coefficients. The significant negative
effect of CEO duality on profitability is reported for all models, which can be interpreted
as showing a benefit of corporate governance–related regulation, resulting in better man-
agement practices for those banks that had CEO duality prior to regulation. This result is
consistent with De Jonghe et al. (2012), who find that CEO nonduality helps banks achieve
higher risk/return efficiency. The positive significant coefficient of CAPAD suggests that
regulation to improve capital adequacy of banks has a positive effect on bank performance.
As a bank-specific control variable, LOAN is positively related to profitability as expected,
indicating that higher bank lending leads to better performance.
The results for the six models of bank lending are presented in Table 5. The overall
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effect of regulation in terms of three banking reform variables, REHAB, DEPOSIT, and
REGUL, is significant for most models and positively related to bank lending. This result
implies that, as intended by the authorities, the three regulation waves had positive effects
on bank lending. As a bank-specific control variable, LIQUID is negatively related to
bank lending as expected for all models; banks that provide more capital to the real sector
have less in liquid assets. The effects of the industry-specific control variables STATE and
FOREIGN are significant for all models. Foreign ownership is positively related to bank
lending in Turkey; state ownership has a negative effect, indicating that foreign banks
provided more capital to the Turkish economy during the period of this study. This result
may indicate that foreign banks desire to gain a significant market share in the Turkish
market. As an industry-specific factor, HHI is found to have a negative effect on bank
lending. This is an expected result since the increase in market concentration in the sector
leads to less lending by banks.
Results for asset quality show that both the rehabilitation process and the new deposit
insurance system have negative and significant effects on the NPL ratio, as presented in
Table 6. This result can be interpreted as showing the success of both regulation and the
changed deposit insurance system on improving the asset quality of banks. The posi-
tive significant effect of CEO duality can be seen in regard to the NPL ratio, suggesting
the positive effect of the prohibition of CEO duality as a corporate governance–related
regulation on asset quality. Since LOGAGE is positively related to NPL for all models, it
can be said that in terms of asset quality, the longer-established banks have no experience
or performance advantages over relatively new banks in Turkey.
Sensitivity Analysis
When using a dummy variable for any particular reform, it is debatable whether the
effect will be felt in the same year or in the following years. Considering this, a sensitiv-
ity analysis is performed. New dummy variables are created for one year ahead of the
regulations. These variables do not provide different results compared to the initial year
dummies. To eliminate possible biases arising from multicollinearity, a stepwise regres-
sion is performed for all models. The results are reported in Table 7. The results show
that the prior findings on banking reform indicator variables are robust.
Table 7. Results for the stepwise regression of ROA, LOAN, and NPL models on
banking reform indicators and controls
ROA LOAN NPL
* 0.10 significance level for a two-tailed test; ** 0.05 significance level for a two-tailed test; *** 0.01
significance level for a two-tailed test.
ring during the period 2002–5 in Turkey: (1) the banking sector restructuring program
in 2002, (2) the change of the full deposit insurance system in 2004, and (3) Banking
Law no. 5411 of 2005, which set corporate governance standards on the performance of
Turkish banks as measured by profitability, bank lending, and asset quality.
We find that these three reformist actions had a significant effect on bank lending;
this, in turn, allowed Turkish banks to make a greater contribution to the financing of
economic activity. The asset quality of banks improved after the first two reformist actions.
The restructuring program positively affected asset quality by strengthening the legal
and regulatory environment and thus improved private banking in Turkey. The change
in the deposit insurance system forced banks to decrease risk taking, which increased
their asset quality.
The positive effect on asset quality and profitability enabled by the abolition of CEO
duality provides support for the benefits of corporate governance–related regulation for
the banking sector. Finally, as expected, regulation to improve capital adequacy of banks
has a positive effect on bank performance.
It should be noted that the restructuring program and regulations on capital adequacy—
that is, the first wave of reforms—can be viewed as part of the helping-hand approach,
whereas the limitation of the full deposit insurance system and Banking Law no. 5411
are stages toward the grabbing-hand approach of the government. Our results imply
that, as an exit strategy, the helping-hand approach may be effective in improving bank
performance in financial crises. However, to secure the overall success of the system,
a step toward the grabbing-hand approach is needed, in accordance with international
practice. Our results show that deposit insurance change, as the second stage of the
process, strengthened the improvement in asset quality and bank lending and prepared
the way for corporate governance–related regulation to increase bank profitability and
secure asset quality as the final stage.
210 Emerging Markets Finance & Trade
Our findings support the view that the sequence and timing of regulatory actions acted
as a shield for Turkey against the recent global crisis. However, it should be noted that,
as Shehzad and de Haan (2010) argue, although the financial reforms reduce the likeli-
hood of systemic crises, the increase in competition that these reforms bring actually
increases the likelihood of nonsystemic crises; that is, crises limited to a small number
of banks. In emerging markets, increase in foreign ownership in the banking industry
may therefore elevate the possibility of nonsystemic crisis by eliminating the potential/
future small domestic banks after financial reforms. This indication provides a potentially
flourishing area of future research in the stability of the banking sector following the
implementation of banking reforms.
Note
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1. Gunay (2012) uses “efficiency” as another bank performance indicator and finds significant
improvement in the restructuring period in Turkey.
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