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Effect of Banking Regulation on

Performance: Evidence from Turkey
a b b
Serdar Ozkan , Cagnur Kaytmaz Balsari & Secil Varan
a
Izmir University of Economics, Izmir, Turkey
b
Dokuz Eylul University, Izmir, Turkey
Published online: 10 Dec 2014.

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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

Effect of Banking Regulation on Performance:

Evidence from Turkey
Serdar Ozkan, Cagnur Kaytmaz Balsari, and Secil Varan

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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the global financial crisis of 2008.

KEY WORDS: banking sector, corporate governance, financial crises, regulation, Turkey.

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

Serdar Ozkan (serdar.ozkan@ieu.edu.tr) is a professor of accounting and finance at Izmir University

of Economics, Izmir, Turkey. Cagnur Kaytmaz Balsari (cagnur.kaytmaz@deu.edu.tr), correspond-
ing author, is an associate professor of accounting and finance at Dokuz Eylul University, Izmir,
Turkey. Secil Varan (secil.varan@deu.edu.tr) is an assistant professor of accounting and finance
at Dokuz Eylul University, Izmir, Turkey.

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).

Financial Crises Led to Banking Regulations in Turkey

Following rapid economic growth in the 1980s, Turkey’s economy was put under global
pressure in the early 1990s. This resulted in an increase in exchange rates, interest rates,
and inflation in the country. Following the failure of three banks in 1994, the government
launched an economic stability program, which included a full deposit insurance system
and placed weakened banks on the treasury’s surveillance list for poor financial status
instead of closing them (Kibritcioglu 2005).
The period 1997–2000 represents a new era of both expansion and consolidation in
Turkey’s banking sector. New small-scale banks were established; some state banks were
privatized; and insolvent banks were taken over by the Savings Deposit Insurance Fund
(SDIF). In 1999, Banking Law no. 4389 was introduced; as its major contribution, the
public units responsible for the surveillance and supervision of the banking sector were
united under the title “Banking Regulation and Supervision Agency” (BRSA) (for the
pros and cons of Banking Law no. 4389, see Neyapti and Dinçer 2000).
In spite of these developments, due to the crisis wave beginning in East Asia in 1997, the
banking sector crisis in Turkey became more pronounced in late 2000. Thus, the BRSA had
taken full control of bank supervision by September 2000 and addressed new regulations
on risk management and capital adequacy. Additional insolvent banks were transferred
to the SDIF until the BRSA undertook the Banking Sector Restructuring Program (the
Program) in 2002. The Program aimed to counter the deterioration in Turkey caused by
the 2000–2001 crisis. These developments were consistent with the helping-hand view of
banking regulation. The helping-hand view argues that, in weak institutional environments,
 198  Emerging Markets Finance & Trade

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.

Literature Review and Hypotheses Development

Macey and O’Hara (2003) state that what distinguishes banks from other firms is their
capital structure, liquidity production function, moral hazard problems, conflict between
fixed claimants and shareholders, and asset structure. They also stress that regulation is
necessary for the banking industry, considering the multiplier effect that banking activi-
ties have on the rest of the economy. Barth et al. (2001) classify banking regulations and
examine the implications of a number of factors for banking sector performance and
fragility. These factors are (1) regulations on bank activities and the mixing of banking
and commerce; (2) regulations on domestic and foreign bank entry; (3) regulations on
capital adequacy; (4) deposit insurance system design features; (5) supervisory power,
independence, resources, loan classification stringency, provisioning standards, diversi-
fication guidelines; (6) regulations fostering information disclosure and monitoring of
banks; and (7) government ownership of banks.
The regulations applied to the Turkish banking sector can be described as a process with
the following four stages: (1) clearance of the weak banks from the system, (2) regulation
of capital adequacy and external reporting, (3) implementation of a design for a deposit
insurance system, and (4) corporate governance–related regulations.
Fama and Jensen (1983) use agency theory as an approach to understanding corporate
governance. They indicate that, due to the greater complexity of agency problems, corpo-
rate governance for the banking sector functions differently from that for other sectors.
The literature suggests that moral hazard problems may arise in the relationship between
banks and their stakeholders due to the greater complexity of agency problems related
to the additional information asymmetries among depositors, borrowers, and regulators.
Therefore, “regulations for banks” are primarily instruments aimed at resolving agency
problems (Dewatripont and Tirole 1993). From this perspective, “banking regulations”
are seen as representatives and protectors of the interests of minority shareholders and
thus serve as a corporate governance mechanism in reducing moral hazard problems.
Representation hypothesis, however, provides a different perspective on the necessity
of regulation, establishing “regulations on capital standards” as a tool for the transfer of
control from shareholders to regulators and indirectly to depositors and minority share-
 July–August 2014  199

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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Hypothesis 1: Banking reforms in Turkey are positively related to bank

performance.
Research implies a positive relationship between sound corporate governance and
bank performance (e.g., Berger et al. 2005; Choi and Hasan 2005). In an analysis of
bank regulation and supervision in 107 countries, Barth et al. (2001) report that bank
performance is improved by both banking regulations on information disclosure and
regulations that enhance private-sector monitoring of banks. They also show that legal
and regulatory reforms designed to promote private monitoring of financial institutions
are an effective financial reform strategy. In addition to financial information disclosure
and audit requirements of banks, a distinctive feature of Banking Law no. 5411 is the
prohibition on CEO duality. To investigate whether the corporate governance–related
banking sector regulations have significant effects on the performance of Turkish banks,
we have developed a second hypothesis:
Hypothesis 2: Banking Law no. 5411, which includes the prohibition of CEO dual-
ity, has a positive effect on bank performance.

Data and Methodology

We use annual bank-level data for all deposit banks in Turkey. Development and invest-
ment banks and the branches of foreign banks are excluded from the sample because of
their different structural characteristics. Table 1 presents the sample information. Data for
the total number of banks that were in operation over the period 1998–2009 are provided
by the Bank Association of Turkey (BAT). The bank-level data of financial and gover-
nance variables are obtained from the annual reports of the BAT and the web pages of
the BAT, BRSA, and Borsa Istanbul. Unfortunately, as shown in Table 1, data for eleven
bank-year observations are not publicly available from these sources; thus, we provide
an unbalanced panel data set consisting of 382 bank-year observations as the remaining
sample. The period 1998–2009 is particularly relevant as it includes Banking Law no.
4389 in 1999, the foundation of BRSA in 2000, the 2000–2001 banking crisis, and the
2008 financial crisis. The expropriations of twenty-one banks during the 2000–2001 crisis
led to a decrease in the number of banks in our sample after 2000.
The dependent variable of this study is bank performance. For the effect of banking
reforms on bank performance, the model evaluates the banking reform indicators with
bank- and industry-specific control variables based on the models of Choi and Hasan
(2005) and Lin and Zhang (2009). The basic regression model is as follows:
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Table 1. Sample information

Filter 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Banking system in Turkey 75 81 79 61 54 50 48 47 46 46 45 45

Foreign bank branches 12 14 13 12 11 9 7 7 7 7 6 6
200  Emerging Markets Finance & Trade

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)

Source: Banks Association of Turkey (www.tbb.org.tr/modules/banka-bilgileri/banka_sube_bilgileri.asp?tarih=31/12/1998-31/12/2009/).

 July–August 2014  201

Bank Performance Measure = α + β1(Banking Reform Indicators)

+ β2(Bank-Specific Control Variables) + β3(Industry-Specific Control Variables)
+ β4(Macroeconomic Control Variables) + β5(Year Fixed Effects) + error term.

Bank Performance Measures

Lin and Zhang (2009) investigate the effect of banking sector ownership reforms on
performances of banks in China. Lin and Zhang (2009) use nonperforming loans (NPL)
to analyze asset quality across banks. Since we investigate the role of regulation and
corporate governance principles on bank performance, we follow Lin and Zhang (2009)
and use return on assets (ROA) and NPL as bank performance measures.1 We use ROA
for investigating whether the regulation process has an effect on the profitability of banks.
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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.

Banking Reform Indicators

For measuring the effect of banking reforms on performance, we follow Choi and Hasan
(2005) in using dummy variables for the postreform periods, indicating a substantial
change in the banking regulatory structure. We use four dummy variables—REHAB,
DEPOSIT, REGUL, and CEO—to measure the effects of three major banking reforms
and the prohibition of CEO duality for banks in Turkey (see Table 3 for descriptions of
the variables).
Since we hypothesize that banking reforms are positively related to bank perfor-
mance, we expect positive coefficients on banking reform indicators. We hypothesize
that CEO duality has a negative effect on bank performance; therefore, we expect a
negative coefficient on CEO. Finally, regarding the regulations on capital adequacy,
CAPAD is used.

Bank-Specific Control Variables

ASSET is used as a proxy for controlling the differences in bank size and the market share.
We also control for bank age. The variable LOGAGE is defined as the natural logarithm
of bank age. If longer-established banks have experience and performance advantages
over relatively new banks, the coefficient will be positive for LOGAGE.
LIQUID controls for the differences in bank assets. Compared to banks with lower
levels of liquid assets, banks with high levels of liquid assets may receive lower interest
income, and liquidity will tend to be negatively associated with profitability (Demirgüç-
Kunt et al. 2003). Thus, high liquidity infers lower lending by banks.
NPL is also used as an independent variable in ROA and LOAN models as a risk
control measure and is expected to be negatively associated with performance. LOAN is
 202  Emerging Markets Finance & Trade

Table 2. Descriptive statistics of bank performance indicators

Standard
Variable Observations Mean deviation Minimum Maximum

1998 ROA 47 0.5744682 20.53378 –123.7 17.4

LOAN 47 34.28723 12.43322 9 62.3
NPL 47 54.17021 44.10724 2 133
1999 ROA 48 –9.34375 39.34378 –168.7 13.8
LOAN 48 26.50417 13.00759 0 57.6
NPL 48 52.58333 40.78372 2 129
2000 ROA 48 –15.67083 35.2699 –169.2 7
LOAN 48 26.48542 15.04435 0.4 59.1
NPL 48 58.875 40.96684 2 135
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2001 ROA 24 –6.012083 9.492012 –41.5 4.7

LOAN 24 18.15958 8.929136 0.4 30.83
NPL 24 55.83333 40.2521 2 128
2002 ROA 26 1.521538 3.855726 –12.3 10.9
LOAN 26 24.94923 12.15242 0.5 45
NPL 26 37.88462 41.74238 2 132
2003 ROA 26 1.007692 6.066361 –17.7 12.8
LOAN 26 28.37885 14.88798 1.9 51.2
NPL 26 27.84615 37.04127 2 134
2004 ROA 28 0.4860714 13.33576 –63.2 19.9
LOAN 28 33.86143 17.9533 1.4 66.7
NPL 28 16.03571 24.52887 2 104
2005 ROA 27 0.8103704 7.091543 –28.3 14
LOAN 27 40.81259 17.93784 0 65.2
NPL 27 17.11111 29.58083 1 115
2006 ROA 26 2.846154 6.167219 –2.7 32.2
LOAN 26 44.51538 20.34783 0 73.2
NPL 26 9.230769 21.33412 1 111
2007 ROA 25 2.424 2.429897 –0.3 12.4
LOAN 25 48.18 20.92736 0 71.8
NPL 26 10.65385 22.1521 1 116
2008 ROA 26 1.930769 2.005746 0.1 9.6
LOAN 26 48.95 19.67641 0 73.3
NPL 26 20.96154 27.67885 1 121
2009 ROA 26 1.992308 1.634117 –1.7 6.8
LOAN 26 47.99615 21.91541 0 75.1
NPL 26 34.30769 35.6996 1 136

also used as an independent variable. If LOAN is negatively associated with NPL, then
the coefficient is expected to be positive for ROA.

Industry-Specific Control Variables

STATE and FOREIGN are the proportions of equity ownership by state and foreign
investors, respectively. We control for foreign ownership since the regulatory develop-
ments in the banking sector led foreign banks to strengthen their investments in Turkey
 July–August 2014  203

Table 3. Descriptions of variables

Category Notation Description/calculation
Bank performance ROA Ratio of net profits to assets
LOAN Total loans as a percentage of total assets
NPL Nonperforming loans over total loans
Banking reform REHAB Dummy variable for the continuous banking sector restructuring
indicators program that became effective as of 2002: REHAB = 1 for
years 2002 and onward; otherwise, REHAB = 0
DEPOSIT Reflects the changes of the deposit insurance system in
Turkey by 2004: DEPOSIT = 1 for years 2004 and onward;
otherwise, DEPOSIT = 0
REGUL Dummy variable showing the effect of Banking Law no. 5411:
REGUL = 1 for 2006 and onward; otherwise, REGUL = 0
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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.

Macroeconomic Control Variables

Although it is a difficult task to control for macroeconomic policies as the other possible
drivers of loan growth and bank performance, we use three different macroeconomic
control variables following Demirgüç-Kunt et al. (2003), Huybens and Smith (1999),
and Wu et al. (2007).
GDP is the growth rate of gross domestic product per capita. The rising trend of GDP
growth was reversed after 2004 and continued to fall due to the global financial crisis in the
years 2008 and 2009, changing –1 percent and –6 percent, respectively. Demirgüç-Kunt et
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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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Table 4. Regression results with ROA as the dependent variable

Coefficient estimates

Variables Pred. Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8

Banking reform indicators

REHAB + 5.22 — 5.62 — 3.21 9.99* — 1.91
DEPOSIT + –4.55 — — –6.03* –4.85 –3.63 — –2.43
REGUL + –3.95 –5.19 — — –1.02 –3.73 — 1.59
CEO – –21.77*** –21.56*** –20.77*** –21.01*** — –20.02*** –11.7*** –11.45***
CAPAD + — — — — — — 0.11*** 0.14***
Bank-specific control variables
ASSET 1.35 1.23 1.23 1.18 0.78 1.38 0.75 0.59
LOGAGE + –3.83 –4.45 –5.59 –4.46 –3.96 –1.42 –0.57 –2.13*
LIQUID – 0.063 0.042 0.019 0.061 0.106 0.082 0.04 0.16**
LOAN + 0.511*** 0.48*** 0.39*** 0.512*** 0.503*** 0.453*** 0.23*** 0.31***
NPL – 0.01 0.011 0.02 0.005 –0.034 0.007 0.006 0.008
Industry-specific control variables
STATE – 0.545* 0.549* 0.62** 0.61** 0.21 0.49* 0.21 0.13*
FOREIGN + –0.055 –0.058 –0.097 –0.089 –0.065 –0.05 –0.03 0.028
HHI – –0.031* –0.023** –0.039** –0.015 –0.023 –0.007 –0.02*** 0.006
Macroeconomic control variables
GDP + — — — — — –0.12 — –0.19
CPI + — — — — — 0.35*** — 0.14
M2 + — — — — — — –0.11 –0.19
Constant 3.74 4.03 17.59 –1.31 2.12 –37.38* 6.40 –20.96
Number of observations 361 361 361 361 371 361 316 316
R    2 0.59 0.58 0.58 0.58 0.53 0.60 0.66 —
Adj. R  2 0.50 0.49 0.49 0.49 0.43 0.51 0.57 —
Hausman test Prob > χ2 0.00 0.00 0.03 0.01 0.01 0.01 0.00 0.11
R  2: between 0.59

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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Table 5. Regression results with LOAN as the dependent variable

Coefficient estimates

Variables Pred. Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8

Banking reform indicators

REHAB + 9.14*** — 10.97*** — 9.03*** 6.97** — –5.49
DEPOSIT + 12.34*** — — 14.97*** 12.27*** 15.12*** — 12.02***
REGUL + 5.18*** 10.29*** — — 4.88*** 8.85*** — 9.07***
CEO – 1.73 2.16 0.04 1.23 — 1.97 –3.25 0.80
CAPAD — — — — — — –0.039** –0.03*
Bank-specific control variables
ASSET –0.33 –0.55 –0.15 –0.45 –0.27 0.01 –3.25 –0.48
LOGAGE + 3.53 6.37*** 9.43*** 4.77** 3.78* 0.97 –0.04 4.65**
LIQUID – –0.414*** –0.42*** –0.42*** –0.43*** –0.42*** –0.45*** –3.25*** –0.41***
206  Emerging Markets Finance & Trade

NPL – –0.005 –0.038** –0.036** –0.017 –0.005 –0.003 –0.04 0.02

Industry-specific control variables
STATE – –0.46*** –0.54*** –0.77*** –0.56*** –0.44*** –0.16*** –0.18*** –0.51***
FOREIGN + 0.09** 0.101** 0.21*** 0.13*** 0.09** 0.05* 0.13*** 0.09**
HHI – –0.042*** 0.00004 –0.027*** –0.019*** –0.043*** –0.02 0.01** 0.03*
Macroeconomic control variables
GDP + — — — — — 0.24* — –0.08
CPI + — — — — — 0.18*** — 0.11*
M2 — — — — — — 0.15 –0.49***
Constant 60.49*** 35.49*** 39.67*** 48.96*** 60.45*** 40.42*** 35.09*** 33.99**
Number of observations 361 361 361 361 371 361 316 316
R  2 0.85 0.81 0.80 0.83 0.85 — — 0.89
Adj. R  2 0.82 0.77 0.75 0.80 0.81 — — 0.85
Hausman test Prob. > χ2 0.02 0.00 0.00 0.01 0.00 0.75 0.29 0.00
R  2: between 0.64 0.44

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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Table 6. Regression results with NPL as the dependent variable

Coefficient Estimates

Variables Pred. Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8

Banking reform indicators

REHAB – –25.67*** — –25.18*** — –24.92*** –17.83 — –28.07*
DEPOSIT – –18.15*** — — –18.11*** –18.49*** –14.79* — –7.86**
REGUL – –0.90 –5.65 — — –3.1 –4.65 — –18.05
CEO + 20.45*** 21.20*** 22.38*** 20.5*** — 20.52*** 26.86*** 22.5***
CAPAD — — — — — — –0.038 –0.035
Bank-specific control variables
ASSET –2.87 –2.59 –3.14* –2.46 –2.8 –2.67 –2.76 –2.62
LOGAGE – 25.52*** 24.42*** 22.49*** 26.07*** 23.82*** 25.15*** 17.46** 21.74***
LIQUID + –0.28 –0.42** –0.41** –0.31* –0.28 –0.26 –0.56*** –0.39**
LOAN + –0.07 –0.43** –0.37** –0.21 –0.07 –0.06 –0.18 0.24
Industry-specific control variables
STATE + –0.15 –0.22 –0.088 –0.18 0.22 –0.11 0.16 0.094
FOREIGN – 0.10 0.13 0.059 0.12 0.13 0.09 0.02 0.09
HHI – –0.021 –0.12*** –0.052* –0.09*** –0.02 –0.04 –0.14*** –0.006
Macroeconomic control variables
GDP – — — — — — –0.53 — 0.82
CPI – — — — — — 0.02 — 0.31
M2 — — — — — — 0.39 1.30*
Constant 14.07 81.35*** 52.75** 51.51** 17.52 19.57 91.79*** –53.86
Number of observations 361 361 361 361 371 361 316 316
R  2 0.56 0.54 0.55 0.55 0.54 0.57 0.61 0.64
Adj. R  2 0.47 0.44 0.46 0.46 0.44 0.47 0.52 0.54
Hausman test Prob. > χ2 0.01 0.01 0.01 0.00 0.00 0.01 0.01 0.00

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.

Conclusions and Implications

In this study, we aim to analyze the role of regulation and corporate governance on banking
sector performance. We analyze the effects of three important reformist actions occur-
 July–August 2014  209

Table 7. Results for the stepwise regression of ROA, LOAN, and NPL models on
banking reform indicators and controls
ROA LOAN NPL

Coefficient Coefficient Coefficient

Variables estimates Variables estimates Variables estimates

CAPAD 0.13*** LIQUID –0.55*** HHI –0.08***

CEO –11.75*** DEPOSIT 12.72*** CEO 24.39***
LOAN 0.31*** STATE –0.13*** FOREIGN –0.15**
STATE 0.09** CAPAD –0.06*** M2 –1.17***
CPI 0.21*** REGUL 9.00*** DEPOSIT –11.19**
LIQUID 0.15** M2 –0.5*** ASSET –0.69
REHAB 7.17* NPL –0.04** LOAN –0.15
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LOGAGE –2.15** LOGAGE –1.23** Constant 55.45***

ASSET 0.56** GDP –0.32
FOREIGN 0.04 Constant 79.67***
Constant –28.30****
Adj. R  2 0.31 0.62 0.23

* 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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