Emerging Markets Review 42 (2020) 100659

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Emerging Markets Review

journal homepage: www.elsevier.com/locate/emr

Revisiting the impact of institutional quality on post-GFC bank risk-

T
taking: Evidence from emerging countries
Ajim Uddina, Mohammad Ashraful Ferdous Chowdhuryb, Sanjay Deb Sajibc,
⁎
Mansur Masihd,
a
Martin Tuchman School of Management, New Jersey Institute of Technology, NJ, USA
b
Department of Business Administration, Shahjalal University of Science and Technology, Sylhet, Bangladesh
c
Bangladesh Bank
d
UniKL Business School, Kampung Baru, Kuala Lumpur, Malaysia

A R T IC LE I N F O ABS TRA CT

Keywords: This is the first attempt to address the impact of institutional quality on post-GFC bank risk-taking
Institutional quality behavior. This study is conducted on 730 banks from 19 emerging countries covering the period
Bank risk-taking 2011–2016. We used six indicators of good governance as a proxy for institutional quality. Both
Legal institutions static panel and Dynamic GMM estimation are used to identify the impact of these variables on
Corruption
bank risk-taking; measured by Z-score. We evidenced that increasing government effectiveness,
controlling corruption, and improving agents' confidence and adherence to the rule of law reduce
JEL classification:
banks' risk exposure and improve banks' stability. Besides supporting the Z-score model, the
G2
D73 robustness test using σ(NIM) also provides evidence of the impact of regulatory quality on re-
ducing bank risk. Surprisingly, both models tend to indicate that improving voice and account-
ability increase bank risk-taking in emerging countries. Furthermore, our study provides an in-
teresting reconciliation to the major debate on the impact of size on bank risk.

1. Introduction

The unfoldment of the 2007–2008 global financial crisis (GFC) has reshaped our understanding of financial institutions. GFC
raises several questions about the operating activities of these institutions. The major causes like bank run in the wholesale market,
excessive securitization, and unduly risky loans, all pointing towards a major flaw in the business model of the most important
financial institutions i.e., commercial banks. Scholars have identified aggressive risk-taking behavior by banks as the prime factor
behind the GFC. Bank risk-taking is referred to as the uncertainty that arises from the operating activities and decision-making
phenomena of the banks. It depends on various factors, including bank structures, competition, regulation, and corporate governance
(Agoraki et al., 2011; Anginer et al., 2016; Boyd and De Nicoló, 2005; Laeven and Levine, 2009; Wagner, 2009).
Before the GFC, fierce competition and high-profit requirements had driven banks to engage in excessive risk-taking, making both
banks and the financial system vulnerable to shocks (Rajan, 2006). In that period banks made excessive investments in mortgage
lending and securitization activities. High short-run return on mortgage and securitization influenced investors to heavily invest in
these instruments while ignoring the associated risks. To meet the demand, banks also responded by issuing more debt to creditors
and trenching risky securities. In addition to these, the prevailing notion of always appreciating house price created a false sense of
security. But once the housing bubble outburst, banks were forced to write down several hundred billion dollars in bad loans caused

⁎
Corresponding author.
E-mail addresses: au76@njit.edu (A. Uddin), mansurmasih@gmail.com (M. Masih).

https://doi.org/10.1016/j.ememar.2019.100659
Received 8 July 2018; Received in revised form 16 March 2019; Accepted 3 November 2019
Available online 07 November 2019
1566-0141/ © 2019 Elsevier B.V. All rights reserved.
A. Uddin, et al. Emerging Markets Review 42 (2020) 100659

by mortgage delinquencies. Low credit quality and highly exposed liquidity risk of banks coupled with bank run and lack of access to
the central banks' funds, instantly evaporated market liquidity and left banks with fire sales of assets as their only option. Several
major banks were compelled to write off their market capitalization in the stock market. The cost of excessive risk-taking by banks
had to be borne by the economy; the household wealth loss in the US alone was $19.2 trillion (The US Department of the Treasury,
2012).
Risk-taking behavior of banks had always been an important issue to regulators. GFC reignited the debate over the optimal level of
risk that can ensure banks' stability without hurting their profitability. After GFC, several preventive measures and regulatory re-
quirements had been implemented to overcome the crisis and prevent any such future occurrence. However, how banks are doing in
this post-crisis era is still unknown. Research is needed to answer questions like, is there any fundamental change in banks risk-taking
behavior? Are banks more responsible and vigilant in their risk-taking behavior in the post-GFC era? Are banks in all countries
showing a similar trend in their risk-taking behavior or the country's political and institutional quality has any bearing on banks' risk-
taking behavior? This study is an effort to answer the last question.
The idea of the impact of institutional quality on bank risk-taking is still novel. Although numerous studies were conducted to
determine the effect of institutional quality on the economic and financial development of a country, little attention was paid to study
the impact of these factors on the risk-taking behavior of the banking industry. Institutions greatly influence the culture and behavior
of a society. Bankers as part of the society are not free from such influence. Political science and economic literature suggest a positive
relationship between institutional quality and economic development. Sound institutions ensure efficient economic system by im-
plementing adequate financial regulatory and supervision framework (Gazdar and Cherif, 2015). Strong property rights and an
effective legal system will eventually result in the overall economic and financial development (Voghouei et al., 2011). The rule of
law and absence of corruption ensure accountability and stability in the financial sector. Higher institutional quality within a fi-
nancial system provides better financial liberalization (Chinn and Ito, 2006). From these threads of literature, we hypothesize the
existence of a relation between institution quality and bank risk-taking.
Recently Ashraf (2017) found that political institution - an element of institutional quality- has a major impact on bank risk
taking. Our study is an augmentation of his study. In addition to the political institution, we include other institutional quality
variables to explain the risk-taking behavior of banks. We analyze the impact of all institutional quality on banks risk-taking and
credit granting mentality while controlling for bank-specific, country-specific, and industry-specific factors. This paper aims to
identify how important is the institutional quality for banks risk-taking behavior. We further investigate whether more stable and
better institutional quality encourage banks to take more risk or do they work as a check and balance to reduce banks' risk exposure.
While most of the previous studies are based on pre-GFC data, our paper is mainly focused on the post-GFC data. This provides us
valuable insight into the situation of the post-GFC banking industry. This study only includes countries from the emerging market.
The exclusion of developed countries is influenced by their very much identical performance in good governance indicators. We also
have the reasons to believe that banking regulations in emerging countries are slack and therefore their decision making will be more
influenced by their institutional quality.
The rationale behind this study is twofold. First, it contributes to banking literature by addressing one very important but un-
explored area of banking business - the relationship between a country's institutional quality and its banks' risk-taking behavior. To
the best of our knowledge, no previous study comprehensively evaluates the impact of institutional quality on bank-risk taking
behavior. This study also answers some imperative questions about the post-GFC banks' business model. The role of banks' excessive
risk-taking behind GFC and the lack of related after-crisis literature warrant the need for this study. It sheds lights on current bank-
risk taking behavior in emerging countries as well as the driving forces behind such behavior. Second, the findings of this study have
significant implications for both government and regulatory authorities. Most emerging countries suffer from low institutional
quality. Widespread corruption and political instability are quite common in these countries. The findings tend to suggest that
government and regulatory authorities need to recognize and take preventive measures against the impact of institutional quality on
bank risk-taking. Besides supporting most of the established literature, as a novel contribution our study evidence strong statistical
and economical importance of institutional quality in bank risk-taking behavior. Effective government system, control of corruption,
and the rule of law all have a negative relation with bank risk-taking. The findings indicate that improving institutional quality
through better policy measures can significantly reduce bank risk.
The structure of the remainder of this paper is as follows. This introductory section is followed by a review of the literature in
section two. Section three discusses the data and variables used in this study. Section four presents the methodology and econometric
models. Section five discusses the empirical results as well as the results of the robustness test. Finally, section six includes concluding
remarks and future policy implications.

2. Literature review

Bank risk-taking behavior is a well-studied phenomenon. Academicians find it as an important policy issue for the overall banking
sector stability. Over the years many theoretical and empirical studies examined the risk-taking behavior of banks. Our paper builds
on the strand of literature examining bank risk-taking behavior in an international setting. Historically, to identify factors affecting
bank risk-taking researchers were mainly concerned about two sets of factors; banks' internal factors such as size (González, 2005;
Saunders et al., 1990), loan-loss provision, bank capitalization (Laeven and Levine, 2009), and environmental factors such as,
competition (Beck et al., 2013; Boyd and De Nicoló, 2005), bank regulation (Klomp and de Haan, 2012), deposit insurance
(Demirgüç-Kunt and Detragiache, 2002) and activity restriction (Barth et al., 2004) etc.
Saunders et al. (1990) assessed the relationship between bank size and bank risk-taking behavior and found a negative correlation

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A. Uddin, et al. Emerging Markets Review 42 (2020) 100659

between bank size and bank risk-taking. In contrast, González (2005) in his assessment shows a significant positive relationship
between these two. Laeven et al. (2016) examined the relationship during GFC and found risk-taking behavior of banks increases
proportionally with bank size (Laeven et al., 2016). Besides these key theoretical aspects, several empirical studies were also con-
ducted on this topic. Demsetz and Strahan (1997) used data from 150 publicly traded bank holding companies from 1980–1993 to
examine the impact of bank size on bank risk-taking and found undiversifiable risk increase with bank size. Iannotta et al. (2007)
analyzed risk-taking data of 180 large banks of European countries and found large banks are generally better capitalized. In contrast,
in a study inovolving 270 commercial banks across 48 countries, Laeven and Levine (2009) found large banks are exposed to higher
risk as they possess low capital ratio than smaller banks. Capital requirements is another crucial determinant for bank risk-taking.
Previous literature shows a mixed conclusion about its influence. Bolt and Tieman (2004) found strict capital requirement lead banks
to adopt stricter credit policy. Laeven and Levine (2009) also supported their idea and argued stringent capital requirement enhances
bank stability. In contrast, Delis and Staikouras (2011) showed a negative relationship between bank capitalization and bank risk-
taking.
Several empirical literatures conclude that banks with large market power have a lower probability of default. More competition
in the banking industry enhance financial stability and decrease borrower credit risk (Boyd and De Nicoló, 2005). Some found a
positive linear relationship between higher competition and banking sector stability (Barth et al., 2004; Schaeck et al., 2009) while
others proposed a nonlinear relationship between competition and bank risk-taking (Martinez-Miera and Repullo, 2010). Deposit
insurance is a regulatory measure to protect bank depositors. While deposite insurance plays a significant role in maintaining public
confidence in the financial system, it comes with an unintended consequence. It encourages banks to take excessive risks. Most of the
studies found a negative relationship between explicit deposit insurance and bank risk-taking (Anginer et al., 2016; Demirgüç-Kunt
and Detragiache, 2002; Hoque et al., 2015). Explicit deposit insurance reduces market discipline and eventually encourages banks to
take excessive risks (Angkinand and Wihlborg, 2010).
Klomp and de Haan (2012), assessed the impact of bank regulation and supervision on bank risk-taking behavior. They found that
stricter regulation and oversight reduces banking risk. Measures like capital regulation, supervisory control, liquidity regulation, and
activity restrictions reduce bank risk level (Klomp and de Haan, 2012). Few studies examine the effect of Basel core principles (BCPs)
for effective bank supervision implemented by the Basel Committee on Banking Supervision (BCBS). Demirgüç-Kunt et al. (2008)
initially found a positive relationship between overall financial soundness of banks and BCPs compliance. But in a follow-up study in
2011 with 3000 banks from 86 countries, they found better compliance with BCPs not always result in financial soundness. This
result is consistent with the study of Marston (2014) who uses a sample of 25 countries to examine the relationship between the
overall index of BCPs compliance with non-performing loans (NPLs) and loan spreads. The result from these studies indicates that
BCPs compliance is not a significant determinant of financial soundness of a bank.
Mixed findings also exist regarding the relationship between activity restrictions and bank risk-taking. Barth et al. (2004) argued
there is a negative relation between activity restrictions and bank stability. Lower activity restrictions and allowing banks to diversify
their income across several sources enhance stability and eventually reduce bank risk level (Barth et al., 2004). In contrast, Klomp
and de Haan (2012) shows a positive relationship between activity restrictions and bank stability. They argued higher activity
restrictions reduces banks liquidity risk and market risk which in turn enhance banks stability.
Apart from these bank-specific and macroeconomic variables, Ashraf (2017) tried to evaluate the impact of political institutions
on bank risk-taking in a recent study. According to him, sound political institutions stimulate bank risk-taking behavior. This is
consistent with the hypotheses that better political institutions increase banks risk by boosting the credit market competition from
alternative sources of finance. In addition, Houston et al. (2010) found bank risk-taking is higher in countries with strong creditor
rights. Chen et al. (2015) assessed the impact of corruption on bank risk-taking. They collected data from 1200 banks from 35
emerging countries for the period of 2000–2012. They found bank risk-taking behavior is positively related to corruption; the higher
the level of corruption in a country is, the higher level of risk banks are taking in that country. In addition, they also examined the
interactive effect of corruption on the monetary policy's risk-taking channel and found that there is a notable impact of monetary
policy on bank risk-taking with a high level of corruption (Chen et al., 2015). Studies also found that corruption impact banking
stability of a country. A higher level of corruption disrupts the lending and investment decision of banks which eventually destabilize
the total banking industry (Barry et al., 2016; Toader et al., 2018).
To the best of our knowledge except for these selected studies, no other study tried to evaluate the impact of institutional quality
or good governance on bank risk-taking behavior. However, literature in economics and other areas of finance strongly suggest
Institutional quality plays a pivotal role in the development of an efficient and effective financial system. Socio-economic factors like
corruption, property rights, and political stability influence the financial development of a country (Uddin et al., 2017a). Gazdar and
Cherif (2015) argued institutions play a vital role in the overall performance of a financial market. They examined the relationship
between institutional quality and financial development and found a positive correlation between these two factors. Besides,
Voghouei et al. (2011) argued that institutional quality and political stability stimulate the development of the financial sector.
Politically connected firms can obtain more loans from banks but end up with a higher default rate (Khwaja and Mian, 2005). Firms
with a connection to politicians have better access to long-term bank loans and require less collateral (Charumilind et al., 2006). Park
(2012) found nonperforming loans are higher in countries with high corruption. Likewise, Barth et al. (2009) found illegal practices
of the lending process through financing less efficient project is very costly for the economy. The practice of extortion and bribery can
increase the volatility of the economy and hinder the entrepreneurship development of the country (Barth et al., 2009).
A financial system becomes efficient when its institutions become sound and effective. The efficiency of a financial system, in
turn, influences the risk-taking behavior of the organizations that operate in that system. The proven significant influence of various
institutional quality variables on financial system encouraged us to believe the existence of a relationship between institutional

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A. Uddin, et al. Emerging Markets Review 42 (2020) 100659

quality and bank risk-taking. Although there are a few studies about the relationship between bank risk-taking and some stand-alone
institutional quality variables, there is no comprehensive study that tests the impact of all the institutional variables on bank risk-
taking. In this study, we include all the indicator of good governance along with the bank-specific and country-specific control
variables and identify how these institutional quality variables affect bank risk-taking in emerging countries.

3. Data and variables

The dataset consists of the annual data of 730 banks from 19 countries. In addition to bank-level data, the country-specific data of
each country also been collected and used in this study. We gathered the bank-specific data from the Orbis Bank Focus of Bureau Van
Dijk database. The country-level data used in this study can divide into two groups: macroeconomic variables and institutional
quality variables. We collected Macroeconomic data from the World Bank and FRED Saint Louis database (Fed, 2018). The worldwide
governess indicators (WGI) variables are used as a proxy to measure institution quality. WGI report on six broad dimensions of
governance; voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rules
of law, and control of corruption. We collected WGI data from the World WGI database (World Bank, 2018).

3.1. Sample

The study consists of bank holding companies and commercial banks from 19 emerging countries. The countries are selected
based on the International Monetary Fund (IMF) emerging countries list as of 2015. As we believe the market was still recovering in
2010, we include data from the time period of 2011 to 2016. From 23 countries on the list, some countries are excluded based on the
missing institutional quality data or unavailability of other country-specific or industry level data. We collect the income statement
and balance sheet data for each bank from Orbis Bank Focus database.
Not all banks from these 19 countries are included in our study. The sample selection involves removing small banks and banks
with missing necessary accounting data. From all banks, first banks with asset less than 500 million USD are removed. Later bank
with less than four years of valid data is also removed. Finally, to avoid the outlier effect, we conduct a 99% winsorization for all
remaining bank-level data. Table 1 reports the countries included in our study, as well as the number of banks, mean Z-score, mean
σ(NIM), and the mean of institutional quality variables for each country.

3.2. Measurement of bank risk-taking

Following established literature (Ashraf et al., 2016; Beck et al., 2013; Houston et al., 2010; Laeven and Levine, 2009) bank risk-
taking is measured by Z-score. Z-score is calculated as the return on asset (ROA) plus annual equity to total asset ratio (CAR) divided
by the standard deviation of return on asset before loan loss provision. That is, Z-score = (ROA + CAR)/σ(ROA). Z-score indicates the
number of standard deviations a banks return must fall from its mean value to deplete all shareholders' equity. It is also a measure of
banks stability. The higher the Z-score of a bank the more stable the bank is and therefore less probability of that bank to go bankrupt
(Uddin et al., 2017b)
As Z-score is a highly skewed measure (Beck et al., 2013), we use natural logarithm of 1 + Z-score to smooth the value. From now
on, for the rest of the paper Z-score refer to the ln(1 + Z). The use of logged value also avoids truncation of the Z-score to zero. As

Table 1
Number of banks and mean statistics of each country.
Country name No. of σ(NIM) Z-score Government Political Regulatory Rule of law Voice and Control of
banks effectiveness stability quality accountability corruption

Argentina 30 2.281 3.224 −0.116 0.093 −0.844 −0.658 0.366 −0.441

Bangladesh 24 0.598 3.212 −0.755 −1.293 −0.885 −0.775 −0.444 −0.887
Brazil 46 3.016 3.244 −0.139 −0.199 −0.024 −0.065 0.468 −0.189
China 153 0.553 4.007 0.201 −0.546 −0.264 −0.430 −1.633 −0.363
Egypt, AR. 26 0.770 3.085 −0.748 −1.509 −0.663 −0.537 −1.091 −0.637
India 64 0.376 3.487 −0.058 −1.124 −0.405 −0.066 0.421 −0.441
Indonesia 61 0.946 3.618 −0.166 −0.548 −0.212 −0.469 0.096 −0.561
Iran, IR. 7 2.400 2.315 −0.413 −1.090 −1.406 −0.928 −1.545 −0.715
Iraq 6 1.570 3.456 −1.159 −2.135 −1.199 −1.469 −1.081 −1.294
Kazakhstan 27 1.419 2.592 −0.259 −0.184 −0.228 −0.567 −1.196 −0.887
Malaysia 53 0.375 3.907 0.981 0.125 0.682 0.501 −0.397 0.229
Nigeria 19 1.025 2.650 −1.054 −1.999 −0.773 −1.084 −0.559 −1.160
Pakistan 21 0.731 3.539 −0.741 −2.573 −0.667 −0.833 −0.766 −0.933
Philippines 23 0.417 3.576 0.102 −1.089 −0.074 −0.416 0.068 −0.505
Qatar 12 0.407 4.09 0.899 1.075 0.666 0.82 −1.76 0.996
Russian F. 97 1.452 2.464 −0.296 −0.903 −0.394 −0.772 −1.038 −0.975
Saudi Arabia 15 0.534 4.467 0.076 −0.464 0.052 0.179 −1.858 0.002
South Africa 19 0.915 4.265 0.344 −0.089 0.331 0.128 0.619 −0.017
Thailand 27 0.397 4.014 0.286 −1.082 0.234 −0.134 −0.683 −0.397

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A. Uddin, et al. Emerging Markets Review 42 (2020) 100659

logged Z-score is widely accepted and unproblematic bank insolvency risk measure (Lepetit and Strobel, 2015) we used this as the
dependent variable in our study. In addition to Z-score for robustness test, we also use the volatility of net interest income σ(NIM) as
the dependent variable. σ(NIM) equal the standard deviation of net interest margin of a bank and is also a widely accepted and used
measure of bank insolvency risk (Ashraf et al., 2016; Ashraf, 2017). A higher value of σ(NIM) indicates increasing banks earnings
volatility and therefore higher bank risk.

3.3. Measurement of institutional quality

Institutional changes determine the way society evolves and the direction of economic performance (Lott and North, 2006). In
recent years, in addition to fundamental macroeconomic variables, institutional quality variables received increasing attention as a
contributor to long-run economic development. Several studies have provided conclusive evidence of the impact of institutional
factors on the economic growth of a country (Acemoglu et al., 2002; Eicher and Leukert, 2009; Knack and Keefer, 1995). Being the
heart of the economic system banking sector is yet to receive its due attention for the impact of institutions on its performance.
Institution, as North defined “rules of the game in a society, or, more formally…the humanly devised constraints that shape
human interaction. In consequence, they structure incentives in human exchange, whether political, social or economic”(Lott and
North, 2006). Institution significantly influence the culture and behavior of a society, and the behavior of the banking industry is no
way out of this influence. Although many studies are conducted to determine the impact of institutional quality on the economic and
financial development of a country, little attention has been paid to analyze the impact of these factors on the performance of the
banking industry and how they shape the participants' behavior of this industry. Recently Ashraf (2017) analyzed the impact of
political institutions on bank risk-taking behavior. By capturing government constraint, he concludes that better political institutions
encourage banks to take more risk. Our study tries to augment his study to include other institutional quality variables in addition to
government and political constraint.
World Bank WGI is used to measure the institutional quality of a country. WGI summarizes the views on the governance quality of
a country from a large number of enterprises, citizen, and experts. WGI captures six key dimensions of governance. These are voice
and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law, and control
of corruption. It combines data from 30 different data sources and updates annually (World Bank, 2018).
Voice and accountability reflect the ability of people of a country to select their government, express their opinion, freedom of
association, and free media. Political stability and absence of violence measure the likelihood of no violence, terrorism, and stability
of the government within a country. Government effectiveness reflects the quality of public services, quality of policy formulation
and implementation and the extent by which these are free from political pressure. Regulatory quality indicates the ability of a
country's government to formulate and implement sound regulatory policies to effectively regulate and promote private sector
development. The rule of law reflects the confidence of agents on the law and the degree by which they abide by the law. It also
includes a country's quality of contract enforcement, property right, level of crime and violence, and effectiveness of its law en-
forcement agencies. Finally, the control of corruption reflects the level of corruption in a country. All these institutional quality
variables range from approximately −2.5 (weak) to 2.5 (strong) governance performance (World Bank, 2018).

3.4. Bank level control variables

To control the bank-specific characteristics three bank-level variables are used in this study. These include total assets (TA), loan
loss provision divided by total asset (LLPTA), and noninterest income divided by total income (NITI). The logarithm of the total asset
(LTA) is used as the proxy measure of size. The logarithm is used to account the skewness of the variable. Literature suggests size
either can have a positive or a negative effect on bank stability. The LLPTA measure the credit risk of the bank and it is expected to
have a negative impact on bank Z-score. Final bank-specific variable i.e., NITI reflects the percentage of total income that is generated
by non-interest related activities. It also expected to have a negative relation with Z-score.

3.5. Country level control variables

Six country-level control variables are used in this study to account the impact of a country's macroeconomic development and
banking industry structure. Among these GDP per capita, inflation, and real interest rate are used to account the broader macro-
economic environment, and bank concentration, deposit insurance, and capital to asset ratio are used to control the overall banking
industry characteristic of a country. For GDP we use natural logarithm of annual gross domestic product per capita measured in
current US dollars. Inflation denotes the percentage change in the annual average consumer price index. Real interest rate removes
the inflationary expectation from the interest rate. Real interest rate is used to measure cross country and over time variation in
macroeconomic condition. Data for these variables are collected from the World Bank database.
Bank Concentration refers to the total asset of the three largest banks operating in a country divided by total assets of all banks
operating in that country and calculated annually for each country. It analyzes the impact of industry structure on bank risk-taking.
Deposit insurance is a dummy variable, and it equals to 1 if a country has implemented explicit deposit insurance and 0 otherwise.
While excessive depositor insurance is expected to prevent depositor runs it is also a source of moral hazard. It makes banks relax in
their lending procedures. The expected coefficient of deposit insurance is negative. Capital to asset ratio measures a country's bank
capital and reserves to its total assets. Capital and reserve include all owners' funds, retained earnings, general and special reserves,
provisions, and valuation adjustment. It is used as a proxy for regulatory capital requirements for the banking industry of a country.

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A. Uddin, et al. Emerging Markets Review 42 (2020) 100659

4. Methodology

4.1. Pooled panel

Since the dataset consists of a panel data from 2011–2016, following the commonly established methodology pooled panel
method is applied to this study as a base model. The pooled panel OLS considers the cross-country variation in institutional quality
variables. By estimating the impact of institutional quality on bank risk-taking it helps us understand the change in the probability of
bank default over time for every change in institutional quality variables (Ashraf, 2017).
K L M
Z ­scorei, j, t = ai + ∑ βk Xik,j,t + ∑ βl X jl,t + ∑ βm X jm,t + εi,j,t
k=1 l=1 m=1 (1)

Here, i, j and t subscripts represent bank, country and year, respectively. ai is the constant term. The dependent variable, Z-score, is
used as a proxy for bank risk-taking, where higher values of Z-score represent a lower probability of bank default and vice versa. Xi, j, tk
are the bank-level control variables. These include LTA, LLPTA, and NITI. Xj, tl is the country-level control variables. These include
banking industry level variables- bank concentration, capital to asset ratio, and explicit deposit insurance as well as macroeconomic
variables -log of GDP per capita, real interest rate, and inflation. Finally, the main focus of this study, the institutional quality
variables are denoted by Xj, tm. These include voice and accountability, political stability and no violence, government effectiveness,
regulatory quality, rule of law, and control of corruption. εi, j, t is the error term. Heteroskedastic-robust standard errors are used to
estimate p-values in regressions.

4.2. Dynamic generalized method of moments (GMM)

For the analysis of banking sector panel data, fixed and random effects models are generally used. However, there is a probability
that the impact of one-year performance can affect the subsequent year's performance (Athanasoglou et al., 2008). This impact of
lagged dependent variable also resulted in a difficulty in the models especially when the time period (T) is shorter than the number of
observations (N) (Beggs and Nerlove, 1988). To address this issue, Arellano and Bond (2006) proposed the Difference Generalized
Methods of Moments (GMM) by differencing all regressors when employing GMM.
The difference GMM includes both lagged levels as well as lagged differences. GMM is based on the assumption that the first
differences of instrumental variables are uncorrelated with the fixed effects. Therefore it allows the model to introduce more in-
struments and improve its efficiency (Arellano and Bover, 1995). For panel data with small 'T' and large 'N' both Difference GMM and
System GMM are suitable if independent variables are not strictly exogenous; and heteroscedasticity and autocorrelation exist among
individual samples, in this study, banks (Roodman, 2009). However, the problem of serious finite sample biases might arise with
difference GMM if the instruments used have near unit root properties. To overcome this, Bond (2003) suggests for System GMM as it
has notably smaller finite sample bias and much greater precision when estimating autoregressive parameters using persistent series.
In addition, the system GMM controls for unobserved heterogeneity and the persistence of the dependent variable. Considering the
above-mentioned reasones we used the System GMM for this study. To conduct the empirical analysis following formula for GMM
proposed by Athanasoglou et al. (2008) is used:
K L M
Z ­scorei, j, t = ai + δZ ­scorei, j, t − 1 + ∑ βk Xik,j,t + ∑ βl X jl,t + ∑ βm X jm,t + vi,j,t
k=1 l=1 m=1 (2)

and
vi, j, t = ui, j + εi, j, t (3)

Here, Z-scorei, j, t−1 is the lag value of dependent variable. vi, j, t is the disturbance term, with ui, j is the unobserved bank-specific effect
and the εi, j, t idiosyncratic error. This is a one-way component regression model, where ui, j ~ IIN (0, ϭv2) and independent of εi, j, t ~
(0, ϭu2).

4.3. Robustness test

Although Z-score is the most acceptable and widely used measure of bank risk, an alternative measure will further corroborate the
findings from Z-score. Therefore, for robustness test, we use σ(NIM) as a second measure of bank risk-taking. σ(NIM) equals the
standard deviation of annual net interest margin. It helps to measure the lending risk of a bank. It is also directly associated with the
loan quality and earning capacity of a bank. For this, some viewed it as a better measure than Z-score for lower quality loans (Ashraf,
2017). The base model for Pooled Panel analysis using σ(NIM) is -
K L M
σ (NIM )i, j, t = ai + ∑ βk Xik,j,t + ∑ βl X jl,t + ∑ βm X jm,t + εi,j,t
k=1 l=1 m=1 (4)

For robustness test, we also use σ(NIM) model in dynamic GMM too.

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Table 2
Descriptive statistics.
Variables N Mean Median Std. dev Minimum Maximum Lower quartile Upper quartile

ROAA 4380 1.234 1.122 2.125 −19.721 21.722 0.684 1.770

ROE 4380 11.201 11.980 11.447 −42.153 40.322 6.470 17.066
Z-Score 4254 3.469 3.564 1.021 −2.734 6.483 2.872 4.138
NIM 4380 4.058 3.215 4.043 −15.362 71.272 2.266 4.996
σ(NIM) 4380 0.978 0.548 1.353 0.047 14.699 0.310 1.069
LTA 4192 15.688 15.677 2.013 4.550 21.718 14.474 16.847
LLPTA 4254 0.011 0.005 0.029 −0.036 1.042 0.002 0.011
NITI 4185 1.418 0.826 3.098 −14.797 23.633 0.395 1.584
Capital to asset ratio 4254 9.265 8.921 2.319 5.317 14.798 7.156 11.091
Bank concentration 4380 45.760 43.660 12.226 26.751 94.982 41.111 47.863
Log GDP 4380 8.707 8.920 0.855 6.728 11.392 8.154 9.295
Inflation 4287 5.735 5.411 3.773 −0.900 39.266 2.628 7.690
Real interest 4371 4.856 3.918 8.186 −17.374 53.543 2.218 6.375
Control of corruption 4380 −0.474 −0.450 0.411 −1.396 1.111 −0.808 −0.304
Govt. effectiveness 4380 −0.036 −0.043 0.471 −1.264 1.115 −0.259 0.243
Political stability 4380 −0.697 −0.593 0.639 −2.817 1.224 −0.998 −0.378
Regulatory quality 4380 −0.239 −0.283 0.418 −1.521 0.838 −0.416 −0.100
Rule of law 4380 −0.363 −0.422 0.421 −1.701 0.959 −0.692 −0.080
Voice and accountability 4380 −0.643 −0.765 0.793 −1.907 0.654 −1.266 0.154

K L M
σ (NIM )i, j, t = ai + δσ (NIM )i, j, t − 1 + ∑ βk Xik,j,t + ∑ βl X jl,t + ∑ βm X jm,t + vi,j,t
k=1 l=1 m=1 (5)

and
vi, j, t = ui, j + εi, j, t (6)

5. Empirical results and discussions

5.1. Summary statistics

Table 1 reports country-level mean statistics and Table 2 reports global statistics. Table 1 includes mean Z-score, mean σ(NIM),
and the mean of institutional quality variables for each country. The country-level mean statistics signify the cross-country variation
in our sample group. It also reveals the close relationship between our two measures of bank risk. A closer look will reveal that
countries with higher σ(NIM) also demonstrate lower Z-score e.g., Iran, Kazakhstan, Russian Federation. On average most emerging
countries have a Z-score above 3 with the lowest in Iran (2.315) and the highest in Saudi Arabia (4.467). Although the mean scores of
institutional quality variables vary across countries and among variables, an easily discernable pattern also exists. Countries like
Egypt, Iraq, Pakistan have a consistent low score, indicating the adverse impact of ongoing war and political instability on these
countries over the last decade. Overall, Qatar, South Africa, and Saudi Arabia outperform other emerging countries in institutional
quality measures, indicating the presence of political stability and the rule of law in these countries.

5.2. Institutional quality and bank risk-taking

The impact of institutional quality variables along with bank-specific and macro-environmental control variables on Z-score are
reported in Table 3. The second and third column of the table report the regression output from pooled panel analysis; pooled OLS
and random effects model respectively. We analyzed both fixed effects and random effects model but based on the Hausman test we
only report the random effects result. Hausman test results are also consistent with our primary objective as we wanted to identify the
effect of variables on bank risk-taking both over time and across countries. Column four reports the result from dynamic GMM
analysis. Following Arellano and Bond (2006) we only report system GMM, for its increased efficiency when the panel units (number
of banks) are large and time periods are moderately small. System GMM corrects any bias for standard GMM by using additional
moment restriction and makes lagged first differences as instruments in the level equation (Arellano and Bover, 1995; Roodman,
2009). Both first order and second order autocorrelation follow the Arellano and Bond (2006) specification for GMM consistency as
we have autocorrelation in the first order [AR(1)] but no autocorrelation in the levels [AR(2)]. Both the Sargan test and Hansen test
results are insignificant implying that the instruments as a group are exogenous. Therefore, we believe our dynamic GMM model is
consistent and robust for the analysis.
The finding of previous literature about the impact of bank-specific variables on bank-risk also holds for the banks in emerging
countries. As expected, we found size and loan loss provision have a negative effect, and net interest income has a positive effect on
bank risk-taking. Loan loss to total asset ratio is found statistically and economically significant to bank risk in all three models.
Although the magnitude varies, the large negative coefficients indicate a substantial increase in bank risk for an increase in the loan

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Table 3
Institutional quality and bank risk taking.
Variables Pooled OLS Random effects Dynamic GMM

Lag Z-score 0.689***

(0.071)
LTA −0.110*** −0.184*** −0.138***
(0.005) (0.015) (0.010)
LLPTA −6.812*** −8.322*** −9.601***
(0.954) (0.427) (1.312)
NITI 0.005* 0.006*** 0.002***
(0.003) (0.002) (0.000)
Bank concentration 0.002 0.001 0.001
(0.002) (0.001) (0.000)
Deposits insurance −0.564*** ‐−0.919*** −0.159**
(0.072) (0.084) (0.061)
Capital to asset ratio 0.036*** 0.044*** 0.053***
(0.009) (0.005) (0.010)
Log GDP −0.171*** −0.048*** −0.093***
(0.039) (0.014) (0.000)
Inflation −0.040*** −0.011*** −0.003***
(0.007) (0.002) (0.000)
Real interest 0.006** 0.002** 0.007***
(0.002) (0.001) (0.001)
Voice and accountability −0.083* −0.137*** −0.069**
(0.042) (0.037) (0.031)
Political stability 0.050 0.036 0.013
(0.052) (0.028) (0.037)
Govt. effectiveness 0.249*** 0.105** 0.120**
(0.095) (0.045) (0.062)
Regulatory quality −0.014 0.073 0.097**
(0.122) (0.057) (0.046)
Control of corruption 0.244*** 0.348*** 0.198**
(0.051) (0.054) (0.080)
Rule of law 0.212*** 0.212*** 0.090***
(0.027) (0.063) (0.022)
Constant 5.601*** 5.658*** 1.757***
(0.356) (0.364) (0.464)
R-squared 0.337
Arellano-bond: AR(1) 0.000
Arellano-bond: AR(2) 0.924
Sargan test (p-value) 0.211
Hansen test (p-value) 0.854

Values in parentheses indicate standard deviation.

A higher value of Z-score indicates higher stability and lower bank risk.
***, **, * denotes statistical significance at 1%, 5%, and 10% level, respectively.
The Hausman test statistics: Prob > chi2 = 0.563

loss provision ratio. The impact of size on bank risk-taking is found significant in the random effects model (0.11), pooled panel
(0.18), and GMM model (0.13) at 1% level of significance. Supporting the findings of Laeven et al. (2016) and Laeven and Levine
(2009), the negative coefficient indicates that larger banks take a higher level of risk. Non-interest income ratio on bank risk-taking
also found statistically significant. Although the size of the coefficient is small, the sign indicates that in emerging countries bank Z-
score improves as non-interest income ratio increases. In addition to that, the dynamic GMM model also proved the lagged impact of
Z-score on current Z-score. The lag coefficient is 0.7 at 1% significant level. This indicates that a substantial portion of the current
year's bank risk comes from the previous year's bank risk.
Except for bank concentration, all country-level control variables affect bank risk-taking in some magnitude. Having no significant
relation between bank concentration and bank risk Indicates that the structure of the banking industry does not influence banks' risk-
taking mentality. The dummy variable explicit deposit insurance has a very significant relation with bank risk. According to the
random effect model, the presence of deposit insurance can increase banks Z-score of that country by approximately 1 point. The
findings support our initial hypothesis plus previous literature on this topic. Government explicit deposit insurance encourages banks
to take more risk by giving them a sense of assurance that the government will bail them out during distress. The regulatory capital
requirement measured by capital to asset ratio has a significant positive relation with bank Z-score. The result is consistent in all
three-model implying that bank stability increases with a country's overall capital to asset ratio requirement. GDP and inflation have
a negative relation with bank stability. Aggressive loan distribution is one possible reason for a growing economy to increase bank
risk. When the economy is growing banks will find more projects to be financially feasible for loan approval, and therefore engage
themselves in aggressive loan disbursement. The subprime mortgages before GFC is a prime example of this behavior. The final
control variable, the real interest rate also has a positive impact on bank risk-taking. However, the magnitude is small, for dynamic

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GMM it is 0.007 at 1% significant level. The positive relation indicates that, along with real interest rate banks asking interest rate
also goes up, resulting in a lesser number of financially feasible projects to accept. In such a situation banks become conservative and
therefore take less risk.
Our study provides significant insight into the primary concern of our research, the impact of institutional quality variables on
bank-risk taking. We found conclusive evidence about the effects of voice and accountability, government effectiveness, corruption,
and rule of law on bank risk. According to the pooled panel, an effective government system (0.25), a reduction in corruption (0.24),
and the existence of rule of law (0.21) can increase bank stability by improving bank Z-score. The result is also consistent in the
random effects and system GMM model. Although in GMM the coefficient estimation is smaller than pooled panel estimation, all
three variables, government effectiveness (0.12), control of corruption (0.20) and rule of law (0.09) are still significant at 1% level of
significance. The impact of these three institutional quality variables on reducing bank risk is consistent with our initial assumptions.
An effective government system and the rule of law not only ensure individual rights and institutional sovereignty but also facilitate
fair and efficient distribution of wealth - a prime notion behind an efficient economic system. Banks as a central piece of any country's
economic system, therefore, are very much affected by that country's government system and the rule of law. In addition, corruption
can significantly jeopardize the banking operation of a country. In countries with rampant corruption, bankers are more likely to be
influenced by unethical means and accept loans that have a high probability of default. Similar results are also evident in Toader et al.
(2018) and Barry et al. (2016). In both studies, the authors argued a higher level of corruption disrupts the lending and investment
decision of the banks which eventually destabilized the total banking industry. Such corrupt and illegal practices on the lending
process through financing less efficient project is also very costly for the economy (Barth et al., 2009). This significant positive impact
of these institutional quality variables also has some important implications. Banks maintain a lower level of risk in countries with
better governance. Governance and rule of law ensure check and balance in the banking system. It promotes accountability in
bankers' actions as there is no way of getting out of an imprudent decision, resulting in less aggressive lending and lower risk-taking.
With reference to voice and accountability, it is expected that a higher level of information availability through media in-
dependence can reduce bank cost and increases the performance of the overall industry. However, too much transparency may be
harmful as well. Interestingly we found that voice and accountability has a substantial negative impact on bank risk-taking. The
coefficient is 0.14 for random effects and 0.07 for dynamic GMM at 1% and 5% significant level respectively. Similar to our findings,
Horváth and Vaško (2016) found higher transparency about financial imbalances and accompanying risks escalated the crisis in the
last economic downturn in 2007–2008. Nevertheless, further explorative studies are necessary to develop proper understanding
behind this eccentric behavior.
Although our study provides conclusive evidence of the impact of government effectiveness, corruption, rule of law, and voice and
accountability on bank risk-taking we do not find any relationship between political stability and bank risk-taking in our initial
model. The insignificant impact of political stability is partially caused by the inclusion of GDP in our model. Political stability
ensures positive GDP growth of a country (Aisen and Veiga, 2013; Feng, 1997). To test the second order impact, we conducted an
additional test removing GDP and find the evidence of a negative relationship between political stability and bank Z-score. At 1%
level of significance, both the random effects model (0.41) and Dynamic GMM (0.28) showed that a stable political situation increases
bank-risk taking behavior. This result is also consistent with the findings of Ashraf (2017), who found sound political institutions
stimulate bank risk-taking behavior. This excessive risk-taking is the result of higher credit market competition and aggressive loan
distribution during a sound political environment or a booming economy. Finally, the impact of regulatory quality only found
significant in dynamic GMM model (0.09) at 5% level of significance. Although GMM is the most sophisticated model in our study
because of the insignificant relation in pooled panel and random effect model, we are unable to make a strong claim about the
existence of a substantial relationship between a country's government ability to formulate and implement effective regulatory policy
and the risk-taking behavior of the banks of that country. Our results clearly find that the overall impact of institutional development
is positive for the stability of the banking sector. The possible implication of this outcome is that institutional quality can strengthen
the bank regulation and supervision, efficient lending practices, lowering moral hazard, and improved loan repayment system.

5.3. Robustness test

Table 4 reports the result of the robustness test using σ(NIM) as a measure of bank risk. We conducted all three pooled OLS,
random effects, and dynamic GMM for σ(NIM) and like Table 3 the results are reported in column two, three, and four respectively.
The rationale behind using σ(NIM) model is that it is a more direct measure of a bank's lending risk. Through robustness analysis,
σ(NIM) model provides additional support to the findings of our Z-score model. In bank-specific control variables σ(NIM) model also
proves that loan loss provision increases bank risk whereas net non-interest income ratio decreases bank risk. The results are eco-
nomically and statistically significant across models. However, like the ongoing controversy in established literature, we found
conflicting result about the impact of bank size on bank risk-taking. Where the Z-score model (section 5.2) indicates that bank-risk
falls as bank size increases, the σ(NIM) model shows the opposite. Following the findings of Saunders et al. (1990) and Iannotta et al.
(2007) in σ(NIM) model, we found that bank risk increases with bank size. The result is consistent in all three analysis at 1% level of
significance.
Although the results might seem inconsistent at first, our finding provides a useful reconciliation for this controversial topic. This
seemingly contradictory result occurs mainly for two reasons: non-diversifiable risk and off-balance sheet activities. Large banks have
more diversification opportunities. Through diversification large banks can stabilize their earnings over the years, resulting in a lower
σ(NIM). Therefore, when we measure bank risk via σ(NIM), we can see larger banks have a lower risk. However, undiversifiable risk
increases with bank size (Demsetz and Strahan, 1997). But σ(NIM) is unable to reflect those undiversified risk. Luckily those

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Table 4
Robustness test using σ(NIM).
Variables Pooled OLS Random effects Dynamic GMM

Lag σ(NIM) 0.660***

(0.193)
LTA −0.132*** −0.182*** −0.123***

(0.033) (0.059) (0.031)

LLPTA 4.471*** 2.250*** 3.883**
(1.119) (0.804) (1.681)
NITI −0.127*** −0.071*** −0.077***

(0.020) (0.010) (0.032)

Bank concentration 0.019* 0.010* 0.065***
(0.010) (0.005) (0.012)
Deposits insurance 0.814*** 0.606*** 0.340**
(0.287) (0.157) (0.164)
Capital to asset ratio 0.177*** 0.147*** 0.082*
(0.035) (0.029) (0.056)
Log GDP 1.153*** 1.007*** 0.153***
(0.159) (0.155) (0.021)
Inflation 0.036 0.019 0.071***
(0.029) (0.015) (0.022)
Real interest 0.032*** 0.023*** 0.069***
(0.010) (0.007) (0.025)
Voice and accountability 1.835*** 1.539*** 0.280
(0.168) (0.188) (0.026)
Political stability 0.135 0.587*** 0.447***
(0.201) (0.198) (0.131)
Govt. effectiveness −0.875** −0.667*** −0.545**
(0.378) (0.266) (0.272)
Regulatory quality −1.055** −0.662** −0.408
(0.491) (0.322) (0.492)
Control of corruption 0.249 −0.757** −0.780**
(0.599) (0.328) (0.361)
Rule of law −1.845*** −1.389*** −0.565***
(0.507) (0.366) (0.101)
Constant −5.548*** −2.844* 1.551
(1.413) (1.725) (1.482)
R-squared 0.257
Arellano-bond: AR(1) 0.000
Arellano-bond: AR(2) 0.318
Sargan test (p-value) 0.033
Hansen test (p-value) 0.108

Values in parentheses indicate standard deviation.

A higher value of σ(NIM) indicates increasing banks earnings volatility and therefore higher bank risk.
***, **, * denotes statistical significance at 1%, 5%, and 10% level, respectively.

undiversified risk and their impact can be captured by σ(ROA). The second reason for this opposing result is banks' increasing use of
off-balance sheet activities and their associated risk (Angbazo, 1997). Today banks are involved in a number of highly risky off-
balance sheet activities e.g., securitized loans, operating lease. These off-balance sheet activities are a major source of revenue for
large banks. But for small banks, the opportunities for involving in such off-balance sheet activities are limited (Hassan et al., 1994;
Hou et al., 2014). As the name suggests, off-balance sheet items do not appear in the balance sheet, while σ(NIM) only considers net
interest income from the balance sheet. As a result, σ(NIM) is unable to reflect these off-balance sheet activities and their associated
risk. However, as a holistic measure, Z-score reflects both balance sheet and off-balance sheet items and their associated risk.
Therefore, when we measure bank risk via Z-score, we can see bank-risk increases with size reflecting both undiversifiable risk and the
risk associated with off-balance sheet activities.
In country-level control variables σ(NIM) model corroborates the findings of the Z-score model for deposit insurance rate, GDP,
and inflation; further confirming our claim that explicit deposit insurance and fast-growing economy encourage banks to take higher
risk. However, we observe interesting result about the impact of bank concentration and bank capital requirement ratio on bank-risk.
Though using the Z-score model we were unable to find any relation between bank concentration and bank risk-taking, here in σ(NIM)
model we found bank concentration has a positive impact on bank risk. Low profitability of smaller banks in concentrated banking
industry might be a reason for this. The more direct relation of profitability with NIM makes this relation visible in σ(NIM) model. We
also found contradictory evidence about the impact of capital to asset ratio and real interest rate. Unlike Z-score (section 5.2), here we
found an increase in regulatory capital requirement or an increase in real interest rate increases bank-risk. The finding is justified, as
net interest margin is more of an indicator of bank income variability rather than the capital requirement. As regulators impose more

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capital requirement, banks need to free up more assets to accommodate the additional capital requirement, resulting in less fund for
loan and investment and less profit opportunities. Similarly, an increase in the real interest rate means an increase in both the
discount rate and prime rate, resulting in a higher cost of funds as well as fewer investment opportunities.
The robustness test using σ(NIM) as a measure of bank risk strongly supports our original hypothesis- low institutional quality
increases bank risk-taking behavior. In addition to supporting most of the findings of Z-score, σ(NIM) provides additional evidence
about the effect of political stability and rule of law on bank risk. Previously in section 5.2, we were unable to make conclusive
evidence of the effect of these two. Here, the random effects analysis supports that effective government system (−0.667), rule of law
(−1.389), and control of corruption (−0.757) decrease bank risk. This finding is also true for GMM. The negative impact of voice and
accountability also holds in robustness test in pooled panel estimation.
Interestingly, unlike Z-score, we found evidence of the impact of both political stability and regulatory quality on bank risk-taking.
In both pooled panel and dynamic GMM, we found political stability is significant at 1% significant level. This finding is also
consistent with the second order impact of political stability on Z-score when we remove GDP from the model. Finally, at 5%
significant level, regulatory quality is also found significant in pooled panel analysis. The negative coefficient indicates that better
regulatory quality increases the risk-taking approach of the banking industry of a country. However, no relation in dynamic GMM
limits us to qualify our claim by some degree.
Both Z-score and σ(NIM) are acceptable and widely used measures of bank risk. Z-score measures ROA and CAR in relation to the
variability on ROA, whereas σ(NIM) measures earning variability. Some visible contradictory findings may be the result of the
inherent difference between the two measures. However, these contradictions do not affect the broad reliability of our findings. From
our original analysis and confirmed by the robustness test, we found that institutional quality of a country significantly affects the risk
level of banks operating in that country. We found strong evidence that government effectiveness, control of corruption, and rule of
law reduce bank risk. Further analysis proved better regulatory quality also helps to reduce bank risk. Among good governance
measures, political stability and voice and accountability somehow encourage bank risk. This is the result of aggressive business
practices by banks during a stable political environment (Ashraf, 2017; Houston et al., 2010). Although voice and accountability have
a different estimation, overall this study suggest that better institutional quality influences banks in taking lower risk. Institutional
quality works as a check and balance for a country's banking sector. Therefore, improving institutional quality can reduce bank risk,
ensure stability in the banking sector and overall economy, resulting in a more robust economy and a lower probability of financial
crisis like GFC.

6. Conclusions and policy implications

Bank-risk taking behavior is a well-studied phenomenon. The 2007–2009 GFC has challenged our conventional knowledge about
bank risk-taking behavior and urged the importance of new research in this area. As a response to this newfound need, this study
analyzed the post-GFC risk-taking behavior of 730 banks from 19 emerging countries. This study provides some significant insight
into one relatively untouched area of banking literature, the effect of institutional quality on bank risk-taking behavior. From the
established literature, it is proven that bank-specific factors coupled with some industry and country level factors significantly affect a
bank's risk exposure at a given time. In addition to that, the effect of culture and institutional quality on a country's social and
economic development is also well established. This study tries to combine these two areas of literature and intends to find how
institutional quality affects the behavior of micro-level financial institutions— more precisely the risk-taking behavior of banks.
The empirical analysis of this study supports most of the earlier literature in bank risk-taking. Bank-specific variables - total asset,
loan loss provision to total asset ratio, and net income to total income- are found most important determinants of bank risk-taking.
Our study also provides valuable insights to reconcile the ongoing dispute about the effect of bank size on bank risk-taking. Because
of undiversified risk and off-balance sheet items, when risk is measured by Z-score, increasing bank size increases bank risk and when
risk is measured by σ(NIM), increasing bank size reduces bank risk. Country-level variables like GDP, real interest rate, and explicit
deposit insurance also significantly influence bank risk-taking behavior. However, unlike other studies, we do not see any conclusive
evidence to support the idea that banking industry concentration affects bank risk-taking behavior of a country.
While this study supports most of the established literature about bank risk-taking, the novel contribution of this study is the role
played by the institutional quality. Our study found strong statistical and economical significance of most institutional quality
variables in bank risk-taking decision. Both pooled panel and dynamic GMM analysis proved that government effectiveness, cor-
ruption, and the rule of law of a country significantly influence the risk-taking behavior of that country's banks. The results of our
original Z-score model were also mostly corroborated by a robustness test using a second measure of bank risk, σ(NIM). High cor-
ruption, ineffective government, and absence of law and order, encourage banks to engage in highly aggressive loan disbursement
activity. Low institutional quality increases credit market competition, create adverse selection problems, and induce moral hazards
in the banking sector. Corruption induced by bribery and unethical influence provide incentives for bankers to approve loans without
much credit evaluation. Poor law enforcement and insufficient regulation reduce the cost of default for debtors. Insufficient legal
actions also provide bankers and debtors jail-free pass by assuring the ways to get out from fraud charges. It also creates the
expectation of government bailouts. Therefore, in countries with low institutional qualities, bankers are more prone to accepting a
high and sometimes unjustified risk.
The findings of this study have significant implications for the governments, regulators as well as individual banks. Firstly,
regulators and banks need to recognize the impact of political institutions on banks' operating activities. Initiatives should be taken to
detach banks' decision-making system from the influence of the country's institutional culture. Given the interdependency of a
country's culture, socio-economic structure, institutional quality, and banks' operating environment, this won't be easy. Most

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emerging countries suffer from widespread corruption and political instability. Corruption also leads to low regulatory quality and
poor law enforcement system. Therefore, the most implementable strategy will be following more robust risk measurement criteria
for countries with weak institutional quality. The regulatory authorities, especially central banks, need to play the most crucial role.
They need to recognize the differences of operating environments between developed and emerging countries and modify the in-
ternational requirements (e.g., BASEL requirement's, CAMEL rating) as necessary and where appropriate develop their own risk
measures and penalty procedures. Secondly, by ensuring the rule of law and regulatory quality government can not only improve the
risk-taking behavior of banks but also provide stability and integrity to the overall economy. Explicit deposit insurance initially
developed to safeguard the depositors and the economy during a financial crisis proved to induce moral hazards. Therefore, higher
capital requirements or regulation to control bank risk-taking would be a better solution than deposit insurance. Finally, banks as an
institution also need to come forward to maintain a balanced risk profile. Identifying the risk tolerance level, prioritizing stability
over profitability, and aligning the idea of wealth maximization in the corporate mission can reduce a bank's overall risk. Effective
Internal control system and periodic internal audit can work as a check and balance that governance system in the first place failed to
provide. It will ensure accountability and responsibility for the bankers' activities.
Although this study found a significant and substantial impact of institutional quality on bank-risk taking, the first-order effect of
political stability is not conclusive. Additional study is required to explain the second-order effect we evidenced in our study. In
addition, the positive impact of voice and accountability on increasing bank risk also warrants further investigation. This study only
considers 19 emerging countries; therefore, the next step will be testing whether these findings also hold for other developing and
even developed countries.

Acknowledgments

The authors are grateful to the editor (Prof. Jonathan Batten) and the anonymous reviewers for their learned comments which
enhanced the quality of the paper greatly.

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