Economic Modelling 84 (2020) 190–202

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Economic Modelling
journal homepage: www.journals.elsevier.com/economic-modelling

Democracy, regulation and competition in emerging banking systems☆

Maria-Eleni K. Agoraki a, Georgios P. Kouretas a, b, *, Christos Triantopoulos c
a
Department of Business Administration, Athens University of Economics and Business, 76 Patission Street, GR-10434, Athens, Greece
b
IPAG Business School, 184 Boulevard Saint-Germain, FR-75006, Paris, France
c
Centre for Planning and Economic Research, 11 Amerikis Street, GR-10672, Athens, Greece

A R T I C L E I N F O A B S T R A C T

JEL classification: This paper develops a political economy framework to analyse the relations among democracy, financial regu-
G21 lation and banking competition in the emerging banking systems of Central and Eastern Europe. We develop
G28 extensive new yearly non-structural indices of bank competition instead of concentration indices as in the pre-
K23
vious literature that show its evolution over time with the level of democracy. In addition, we directly test for
Keywords: linkages between democracy, financial regulation and banking competition. Using an unbalanced panel data set
Democracy
over the period 1994–2016 for 617 banks, we show that more democratic countries with better regulatory
Regulation
Competition
framework lead to the enhancement of competition. We also find significant support for the core hypothesis that
financial regulatory framework in a “partially” democratic environment is inadequate. Given that financial reg-
ulatory framework in a “partially” democratic environment can be inadequate we find a U-shaped relation in the
sense that there is a threshold level of democracy beyond which banking systems in those countries are more
competitive.

1. Introduction
Central and Eastern Europe's (CEE) emerging banking systems pro-
vides a unique political-economic case to investigate hypothesis and
interelationships between structural factors considering the establish-
ment and the development of their financial regulatory frameworks,
especially under the spectrum of the global financial crisis.1 Delis (2012)
argued, considering the CEE countries, that underdeveloped banking
systems in less advanced political-institutional environment fail to
benefit from reforms in their early stages. This created further questions
about the level of democracy and the orientation of financial regulation
as determinants of the political-institutional environment that affect the
level of banking competition in CEE economies. In particular, democracy
is considered as the prerequisite for the financial liberalization, and, also,
for the establishment of an adequate and effective financial regulatory
framework. That adequacy and effectiveness is determined by the
regulatory framework's ability to achieve and secure its major three
goals: (a) financial stability; (b) transparency and consumer's protection;
and (c) competition. The regulatory efforts undertaken in transition
banking systems are quantitatively and qualitatively different from the
analogous ones of developed banking systems. Therefore, we construct
indices that focus on stability, transparency and consumer protection as
well as competition in order to present or capture this diversity.
However, the level of democracy and the degree of the political re-
gime's commitment to public interest differ significantly among the CEE
countries. This divergence seems to affect (a) the level of quality and
good governance of the financial regulatory and supervisory institutions
and (b) the ability of the regulatory framework to correspond to the three
aforementioned regulatory goals. Therefore, this paper is focused on
these regulatory policies because they are central in the agenda of policy
makers. Economic and public choice theory suggests that these policies
can have both a direct impact on market power, as well as an indirect

☆
The paper has benefited from valuable comments by seminar participants at the Athens University of Economics and Business. We would like to thank without
implicating Ansgar Belke, Joscha Beckman, Manthos Delis, Dimitris Georgoutsos, Francisco Nadal de Simone, George Tavlas and Chris Tsoumas for many helpful
comments and discussions. We also thank the Editor Sushanta Mallick and two anonymous referees for their valuable comments that improved the manuscript
substantially. The usual caveat applies.
* Corresponding author. Department of Business Administration, Athens University of Economics and Business, 76 Patission Street, GR-10434, Athens, Greece.
E-mail address: kouretas@aueb.gr (G.P. Kouretas).
1
The uniqueness of the situation stems from the fact that the variation in the level and type of political competition across the CEE countries is minimal and the
same can be said in terms of financial liberalization, while their banking systems were extensively reformed, since the mid-1990s, through the abolition of admin-
istrative interventions and regulations, which seriously hampered their development (Campos and Coricelli, 2002; Agoraki et al., 2011).

https://doi.org/10.1016/j.econmod.2019.04.009
Received 16 May 2018; Received in revised form 11 April 2019; Accepted 15 April 2019
Available online 16 April 2019
0264-9993/© 2019 Elsevier B.V. All rights reserved.
M.-E.K. Agoraki et al.
effect through democracy in CEE transition economies. In particular, the
present paper attempts to investigate the linkages and relations among
democracy, financial regulation and banking competition, based on the
political economy analytical framework of the public choice theory.
During the last decade most of the work which has been done on
measuring the competitive conditions in transition banking systems
relied on concentration indices (structural measures). The present study
departs from previous studies on the subject matter in two novel di-
rections. The first novel feature of the present paper is that we developed
extensive new yearly non-structural indices of bank competition that
show its evolution over time, therefore providing an index of industry
market power.2 A second novel feature of the present study is that to the
best of our knowledge is one of a few works that measures directly both
the regulatory reforms and the competitive conditions together with the
level of democracy as well as the quality of institutions. Finally, we
evaluate the effectiveness of financial regulations on the promotion of
well-functioning banking sectors by considering, additionally to the de-
gree of competition, other aspects of banking sectors, namely, depth,
stability and inclusiveness. The fundamental question under investiga-
tion of this paper is whether democracy is the most important objective
for the countries under consideration and whether it has a statistical
significant effect on regulation and competition in banking industry.
There are several important findings stemming from our analysis.
First, we document that the level of democracy and the degree of public
commitment to public interest differ significantly among emerging
banking systems. This divergence seems to affect, firstly, the level of
quality and good governance of the financial regulatory and supervisory
institutions, and secondly, the ability of the regulatory framework to
correspond to the major regulatory goals. Second, we provide robust
evidence that countries with better regulatory and institutional settings
tend to have lower credit risk or more stable banking system. Third, with
the development of a political economy theoretical framework we
investigate the relationship between democracy and regulation. We find
that when a “partial” democracy is in force then it is possible that major
interest groups or economic elites of the banking sector to “capture” the
regulatory framework and orient it according to their specific private
interests and against the public interest. Finally, given that in the CEE
banking systems the financial regulatory framework in a “partly” dem-
ocratic regime is inadequate, these findings have significant implications
for regulators and supervisors on modeling the appropriate regulatory
framework in order to establish a secure as well as an efficient financial
system.
The rest of the paper is structured as follows. Section 2 provides a
review of literature and develop the theoretical framework. Section 3
presents the theoretical hypotheses under consideration for the CEE
emerging banking sectors. Section 4 presents and discusses the empirical
results, with the summary and concluding remarks given in the final
section.
2. Literature review and theoretical background
The theoretical background of the democracy, financial regulation
and banking competition nexus is developed on a unified field of the
basic component's theoretical discussion: democracy and indicators of
2
Uchida and Tsutsui (2005) suggest a method that provides yearly estimates
of market power for the Japanese banking sector, thus enabling the investiga-
tion of short-term changes in the degree of competition. Accordingly, to measure
the evolution of competitive conditions over time in the banking systems of the
CEE countries, we use the methodology suggested by the latter study (see also
Jimenez et al., 2007; Agoraki et al., 2011). Most of the previous literature
employs concentration as a proxy for competition. However, it has been shown
that using market concentration measures as indicators of banking competition
has certain limitations (see for example Claessens and Laeven, 2005; among
others). Moreover, relying on concentration as a measure of bank competition
gives rise to misleading inferences and measurement problems.
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Economic Modelling 84 (2020) 190–202
the quality institutions, regulatory adequacy and market power.
During the last three decades, there is interesting work on the relation
of financial regulation (i.e. liberalization with adequate regulation and
supervision) and competition. Keeley (1990) found that the liberalization
of entry barriers in US banking contributed to lower market power and
economic profits. Deregulation –even though it is difficult to measure– is
directly measured by Salas and Saurina (2003), who employed dummy
variables that correspond to important laws. Using data on Spanish banks
for a 31-year period they discovered that deregulation measures
increased competition and eroded banks’ market power. Uchida and
Tsutsui (2005) investigated whether competition in the Japanese
banking sector has improved in the last quarter of the twentieth century
and found that competition has improved especially in the 1970s and in
the first half of the 1980s, though it became laxer after 1998. Shaffer
(1993) focuses on the Canadian banking industry, finding an already
perfectly competitive conduct prior to the reform, whilst Ribon and
Yosha (1999) find evidence of an improvement in competition in the
Israeli banking industry in the years following financial liberalization.
Neven and Roller (1999) analyzed competition in seven European
countries between 1981 and 1989 in light of the changing regulatory
frameworks to which banks are exposed and observed evidence of a more
collusive cartel-like behavior, which can be associated with the wide-
spread deregulation that took place during the 1980s. Turk-Ariss (2010)
investigates how different degrees of market power affect bank efficiency
and stability in the context of developing economies. He suggests that an
increase in the degree of market power leads to greater bank stability and
enhanced profit efficiency, despite significant cost efficiency losses. Clark
et al. (2018) analyzes the impact of bank competition on financial sta-
bility in the transition markets of the Commonwealth of Independent
States (CIS) in the context of the competing
competition-stability/competition-fragility hypotheses. Their results
verify the competition-stability hypothesis and show that competition
contributes to financial stability in these countries. In a broader context,
Nitoi et al. (2019) explores the relationship between leverage, insolvency
risk and regulation variables, as well as the temporal patterns of this
relationship, in eleven Central and Eastern Europe banking systems in the
2005–2014 period. The paper also examines whether bank ownership
structure and financial cycle strengthens the effects of prudential policies
on leverage and insolvency risk. The main finding of the analysis is that
there is a systematic link between prudential regulation and leverage,
which is time-varying. Lapteacru (2017) investigates whether CEE banks
must have greater market power to be safer. The analysis leads to the
conclusion that increased market power reduces the fragility of banking
institutions and that banking market concentration tends to make these
banks riskier.
The second strand of the literature focuses on the relation between
democracy and financial regulation. The empirical evidence is mixed
since a substantial number of studies provide evidence in favour of a
positive relationship between democracy/political freedom and growth
although a few studies have found a negative or no link between the two
variables in question (Kirmano
glu, 2003). Democracy–as is reflected in a
political system the decisions of which are attributed to the preferences
of the majority of the population– is considered to be a basic prerequisite
for the economic development and the distribution of its outcomes to the
society.3 In general, studies have suggested that the safest route to sus-
tained liberalization is enabling sustained democratization (Quinn,
2000); the positive effect of democracy goes mainly via reinforcing
economic liberalization (Fidrmuc, 2000); a democratic political regime
3
This developmental dimension of political freedom is attributed to the fact
that democracies are characterized by a moral and legal logic, because the moral
principle of avoiding arbitrarily harming others and the principle of reciprocity
are reflected to legal systems in democratic political systems where citizens'
interest and views are pictured in law and regulations that allow the competitive
function of the open market economy (Quinn, 2000).
M.-E.K. Agoraki et al.
encourages liberalization, as countries which introduced greater de-
mocracy subsequently progress further in economic liberalization too
(Fidrmuc, 2001); and finally democracy is a factor of the forwarding of
financial reforms and seems to be the best antidote against reversals
(Campos and Coricelli, 2009). However, along with financial reform and
integration with the international markets,4 the “socially rational” choice
of a democratic political system is to accompany the financial liber-
alization and reformative process with the adequate financial regulatory
framework. In terms of democracy, the social benefit of an adequate
framework overcomes either bank's benefits in terms of profitability,
innovation and efficiency from the absence of adequate and stringent
rules, or the cost of the regulations' implementation.5 So, the adequacy of
the regulatory framework is determined by its commitment to achieve
and secure the three major regulatory goals: (a) the micro- and
macro-stability of the financial system, (b) the transparency and the
consumers' protection, and (c) the market's competition (see for example
DiGiorgio and Di Noia, 2001). Therefore, during a phase of financial
liberalization, a democratic political system should implement an
adequate financial regulatory framework based on the major regulatory
goals. Recently, Benbouzid et al. (2017) investigate whether the differ-
ences in institutional frameworks are important in explaining the het-
erogeneity in the market perception about the credit quality and default
risk in developed and emerging economies. They reveal that more con-
centration of the banking sector, a stronger presence of foreign banks, a
deterioration of the banking sector health or the lack of alternative means
of finance is associated with higher CDS spreads of banks. Thus, Ben-
bouzid et al. (2017) provide strong evidence that better regulation is key
to stability in the banking system.
The relation between democracy and economic or financial liber-
alization/reform is not linear because democracy cannot be approached
as a static situation but as a process from autocracy to democracy. During
this process of political development the three main consecutive phases
can be detected: (a) the autocracy, where the decisions of the government
reflect the preferences of the dominant political elite without any moral
and legal logic; (b) “partial” where the government's choices are not
determined by the will of the majority of the citizens; and (c) “full-
fledged” democracy, where the majority of the population defines the
decisions of the government. This three-phase process of democratization
determines significantly the effect of political freedom to economic or
financial liberalization/reform as is pointed out by the U-shaped relation
(Fidrmuc, 2001; Campos and Coricelli, 2002, 2009). In the case of de-
mocracy and financial regulation, this U-shaped relation includes some
interesting issues of the political economy view.
Delis et al. (2019) examine whether democratization reduce the cost
of credit. They use global syndicated loan data from 1984 to 2014 and
they find that democratization has a significant negative effect on loan
spreads: specifically, a one-point increase in the zero-to-ten Polity IV
index of democracy reduces by at least 19 basis points the spreads. Re-
versals to autocracy hike spreads more strongly. Their findings are robust
to the comprehensive inclusion of relevant control variables, to the
instrumentation with regional waves of democratization, as well as to a
battery of other sensitivity tests. Therefore, they underline the lower cost
of loans as one relevant mechanism through which democratization can
affect economic development. Fazio et al. (2018) employ data for banks
4
Financial market's integration with the international markets strengthens
financial systems and leads them to a more intensive competition, better
exploitation of scale economies and reduction of capital costs, higher liquidity
and investment, and more efficient capital allocation (Levine, 2001, 2004;
Baldwin and Wyplosz, 2004). Triantopoulos (2010) review the advantages and
disadvantages of the integration of the EU financial markets.
5 in every dimension of the public sector and the economy. Usually, the
Particularly, the social benefits that would drive a democratic political
system to adopt an adequate financial regulatory framework are the elimination
of negative externalities, the provision of information to rational investors and
consumers, the promotion of social fair distributive goals, and the maintenance
of systemic stability.
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Economic Modelling 84 (2020) 190–202
from 66 countries for the period of 1998–2014 and compare how insti-
tutional quality as perceived by the national population, impacts financial
stability in countries that adopted inflation targeting with those that did
not. It is argued that banks from countries that adopt an inflation tar-
geting monetary policy with high quality of institutions do not have their
stability significantly enhanced by this policy. Furthermore, the authors
argue that inflation targeting and financial stability are negatively asso-
ciated in countries with low levels of institutional quality which leads to
the existence of an inverted U-shaped relationship between inflation
targeting and financial stability as a function of the institutional quality.
In particular, on the autocratic side of the political spectrum, political
elites have greater power than economic ones, and the government
represents the political elites' preferences which maximize their own
interests. These preferences are independent and different from the in-
terests of specific economic elites and power groups, reflecting the po-
litical elites' objective of staying in power. The success of this objective is
determined by the governmental elite's ability to obtain sufficient polit-
ical support. This needed support to the autocratic political systems must
be based on two pillars, the population and some economic elites. So, in
order to maintain its power, the autocratic government may promote
economic and financial reforms that enhance efficiency (Quinn, 2000;
Campos and Coricelli, 2009). The autocracy's approach for financial
regulatory framework seems to correspond to that of financial reform/-
liberalization, as the sustainability of the reform process is secured by the
regulation's effectiveness and adequacy. An authoritarian government
would equally promote the regulatory major goals: stability, trans-
parency and consumers' protection, and competition. On the other side of
the spectrum, “fully-fledged” democracy is the final stage of the
democratization process while it is the phase of this process where sig-
nificant political and economic reforms have taken place. The objective
of a “fully-fledged” democratic government is to correspond –away from
the specific preferences of economic elites, political elites and interest
groups– to the population's demand for economic efficiency and social
justice. The “socially rational” choice of “fully-fledged” democracy is to
accompany financial liberalization with an adequate financial regulatory
framework, in order to confront financial market's failures and secure the
social benefits through the equal promotion of stability, transparency,
consumers' protection, and competition. So, the government's regulatory
policies –accompanied by independent authorities, good governance and
accountability (Hupkes et al., 2005; Quintyn et al., 2007)–represent the
public demand to correct market failures and protect poorly informed
consumers, focusing on the maximization of social welfare. This
approach is characterized as “public interest theory” of regulation
(Quinn, 2000; Kroszner and Strahan, 2000; Campos and Coricelli, 2009).
The most interesting part of this democratization process is some-
where in the middle on the way from autocracy to democracy. “Partial”
democracy is the stage of the democratization process where the demo-
cratic regime is still based on weak institutions and political actors which
allow the movement of balance of power away from the political elites
towards economic elites or interest groups. During this intermediate
stage between autocracy and “fully-fledged” democracy, the economic
elites that had a privileged role in the autocratic regime or benefited the
most from the liberalization process that followed it, gain more power
than (and against) the political elites while becoming gradually able to
control governmental decisions in order to adopt policies that maximize
the interests of economic elites. Therefore, the governmental preferences
concerning the reformative process of the economy reflect the interests of
the major economic elites and do not maximize social welfare. This sit-
uation creates dynamics for economic reforms' reversals (Campos and
Coricelli, 2009). Furthermore, the first steps of the social-economic sys-
tem's democratization constitute the field of creation for interest groups
new established interest groups express private preferences that are
against the maximization of the social welfare and add pressure to the
government for reforms' reversal or block. So, the government is quite
possible to determine its decisions for economic reforms by the powerful
M.-E.K. Agoraki et al.
interest groups' preferences considering the political cost of opposing to
them. Therefore, “partial” democracy places political constraints on the
ability of the government to implement and promote economic reforms.
In parallel, rational voters may also oppose to a reform that benefits the
majority or the biggest part of the society if individual payoffs are un-
certain or long-term (Fernandez and Rodrik, 1991), affecting in an
extremely negative way the efficient allocation of public and private
resources. The economic elites and interest groups establish a network of
pressure to the government that affects its decisions and initiatives that
diverge from public interest, corresponding to the theoretical approach
of “public choice”. So, when the governmental policies in “partial” de-
mocracies reflect the preferences and the interests of the powerful eco-
nomic elites, the regime can be labelled as “captured democracy”
(Acemoglu and Robinson, 2008).
The same negative relation between “partial democracy” and eco-
nomic reforms is also observed in the financial sector. Campos and
Coricelli (2009) argued that the lowest level of financial reforms tends to
occur in intermediate regimes of democracy whilst Rajan and Zingales
(2003) underlined that the economic elites of the financial sector may
block or reverse reformative initiatives in the financial and banking
market. Braun and Raddatz (2008) suggested that the relative power of
interest groups of the financial system determines the level of financial
market's sophistication. Government's “capture” by the economic elites at
the expense of financial reforms is also presented in the financial regu-
latory framework. Banks and other credit institutions seek ways to in-
fluence and shape the regulatory framework in order to suit their
preferences (Kane, 2002). This effort for regulatory “capture” can be
direct, when the supervised institutions try and manage to define regu-
latory framework by “capturing” the regulatory authority, or indirect,
when the supervised institutions force governments who control the
regulatory authorities to promote banks' interests. In “partial” de-
mocracy, with weak financial regulatory institutions, the government
will probably give in to the economic elite's pressures considering the
benefits of “giving in”. Therefore, “captured” governments adopt laws
according to the economic elite's interest and ask pressure on regulatory
and supervisory authorities to be smooth and protect private interest (i.e.
banks). Furthermore, in a weak institutional environment, the regulatory
and supervisory authorities are also prone to a “captured” relation, as the
agents are self-interested and seek to be rewarded for their concessive
behavior with lucrative employment opportunities in the banking in-
dustry or in better governmental positions (Kroszner and Strahan, 2000).
Such a regulatory process can be labelled as “private interest theory of
financial regulation” (see for example Benmelech and Moskowitz, 2010).
Kroszner and Strahan (1999) among others identified this approach and
argued that financial regulation is partly defined by the preferences of the
economic elites. Fig. 1.
Therefore, a “captured” situation of a “partial” democracy, during
which the government does not focus on correcting banking market
failures and maximizing social welfare, is likely to lead to the blocking of
economic/financial reforms (Campos and Coricelli, 2009) and/or to the
disorientation of financial regulation. This disorientation is reflected on
the attention that the regulatory framework pays to each of the three
major regulatory goals. So, in a “captured” environment, the regulatory
framework is expected to focus more on securing the stability of the
banking system and less on promoting banking competition and safe-
guarding market transparency and consumer's protection. The regulated
institutions should clearly prefer, among the three regulatory goals, the
promotion of rules and supervisory procedures that protect domestic
market from a banking or systemic crisis, safeguarding their soundness
and potential profitability, and the sound function of real economy.
Moreover, an adequate, in terms of micro- and macro-stability, financial
regulatory framework is the fundamental prerequisite for a
new-established banking market in order to attract foreign credit in-
stitutions. Any concerns about the stability of the domestic financial
system are a crucial factor for delaying or not implementing foreign in-
vestments in it. So, banks is quite possible to ask pressure on “captured”
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Economic Modelling 84 (2020) 190–202
Fig. 1. The U-shaped relationship between democracy & financial regulation.
government to promote rules that enhance stability.
However, the same credit institutions do not push government to
implement rules and procedures for the other two regulatory goals, as
both of them oppose their objective of profitability maximization.
Particularly, powerful banks (domestic or foreign) oppose any laws and
regulations that enhance market's competition, as they want to secure
their profitability margins and their market power. Market power,
though, has a significant negative impact on social welfare as usually it is
associated with a higher cost of financial intermediation, a lower volume
of savings and investment, and therefore lower economic growth. Eco-
nomic elites of the banking system force “captured” governments and
authorities to abandon any plans for increasing competition and also, in
some cases, to accept oligopolistic practices. The same strategy of the
powerful banks has also a negative effect on regulations that increase
transparency and protect the consumers, since such legal initiatives in-
crease their functional cost and potentially shrink their profitability
margin at the expense of social welfare. However, comparing powerful
banks' negative stance against rules that enhance competition and those
that increase transparency and consumer's protection is expected to be
less intense in the latter ones because the loss in terms of potential
profitability is smaller. Furthermore, the benefits in terms of social
welfare created from the promotion of consumer protection measures are
considerably high for the population. This makes government more
resistant to pressure from the economic elites, as the political cost from
abandoning such measures may far exceed government's direct and in-
direct benefits that emerge from the “captured” regulatory process.
Summarizing the discussion of the theoretical background and the
literature review, the core hypothesis of the democracy, regulation and
competition nexus in CEE transition economies can be developed. In
particular, the under question hypothesis is that the financial regulatory
framework in a “partly” democratic regime is expected to be inadequate and
this inadequacy concerns mainly the market's competition and to a lesser
extent the transparency and the consumers' protection.
3. Model specification
We model the relationship between democracy, regulatory reform
and competition in the CEE banking systems as follows:
θt ¼ a0 þ a1 regt1 þ a2 dem þ a3 dem  regt1 þ a4 xit þ a5 mt þ uit (1)
where banking industry competition θ at year t is written as a function of
time-dependent banking sector regulatory reform, reg; a measure of de-
mocracy, dem; a vector of bank-level variables reflecting the character-
istics of each bank, x; variables that capture the macroeconomic
conditions common to all banks, m; and the error term u.
M.-E.K. Agoraki et al.
In order to measure democracy, we used the country ratings of the
“Freedom in the World” survey, which is an average index for political
rights and civil liberties ranging from 1 to 7. Even though the survey
originally categorizes the range of ratings into “free” between 1.0 and 2.5,
“partly free” between 3.0 and 5.0, and “not free” between 5.5 and 7.0, we
changed this categorization taking into consideration the special features
of a CEE case study. The political and social features of the transition
process that is taking place in the CEE countries move these countries
closer to high ratings than the other advanced countries. So, in order to
capture the “partial” democracy effect in CEE countries we categorize the
range of ratings into “free” between 1.0 and 2.5, “partly free” between 3.0
and 4.0, “becoming partly free” between 4.5 and 5.5, and “not free” be-
tween 6.0 and 7.0, moving a little closer to 7. Furthermore, we try to
check and verify our results by using the Economist Intelligence Unit's
democracy index and the Global Democracy Ranking of the quality of
democracy.6 The Economist Intelligence Unit's Democracy Index is based
on five categories: electoral process and pluralism; civil liberties; the
functioning of government; political participation; and political culture,
where higher values indicate more democratic regimes. Finally, the
Global Democracy Ranking captures the freedom and other characteris-
tics of the political system, where higher values represent increased level
of freedom. In addition, we include in eq. (1) a quadratic term of de-
mocracy variables to verify the existence of a U-shaped relation.
Furthermore, to strengthen our analysis on the key question of why
the effectiveness of financial regulations differs across countries we also
employ in our regressions three variables that reflect the quality of in-
stitutions namely; property rights, government integrity and financial
freedom. The empirical analysis also includes bank-level variables
reflecting individual strategies of banks (x), and macroeconomic country-
specific variables (m) reflecting the effect of the economic environment
in each country. The former variables include the bank size (measured by
the natural logarithm of total assets). The macroeconomic variables (m)
include the ratio of total investments over GDP (invgdp) as a proxy for the
fluctuations in economic activity, and inflation (inf), which serves as a
proxy for price stability and monetary conditions. In addition to the
macroeconomic variables, we also use foreign (for) and public (pub)
ownership as potential determinants of bank competition. Foreign
ownership is defined as the percentage of foreign owned banks in terms of
total industry assets and public ownership as the percentage of publicly
owned banks in terms of total industry assets.7
To measure the evolution of competitive conditions in the transition
banking systems over time, we use the methodology suggested by Uchida
and Tsutsui (2005). In particular, we jointly estimate the following sys-
tem of three equations that correspond to a translog cost function, to a
revenue equation obtained from the profit maximization problem of
banks, and to an inverse loan demand function:
1  2 1  2 1  2
lnCit ¼b0 þb1 lnqit þ b2 lnqit þb3 lndit þ b4 lndit þb5 lnwit þ b6 lnwit þ
2 2 2
         To evaluate the quality of banking sectors we also include in both
b7 lnqit lnwit þb8 lnqit lndit þb9 lndit lnwit þeCit
θt  
Rit ¼ Rit þrit qit þcit b1 þb2 lnqit þb7 lnwit þb8 lndit þ
ηt
qit  
Cit b3 þb4 lndit þb8 lnqit þb9 lnwit þesit
dit
lnpit ¼g0 ð1=ηt Þlnqit þg1 lngdpgþg2 lnirþeDit
(2)
6
The Global Democracy Ranking is based on the “Feasibility Study for a
Quality Ranking of Democracies” (edited by Campbell and Sük€ osd, 2002) and
the “The Basic Concept for the Democracy Ranking of the Quality of Democracy”
(Campbell, 2008).
7 9
Claessens and Laeven (2004) and Yildirim and Philippatos (2007) both
suggest that the nature of ownership matters for competition, and specifically
that foreign bank ownership improves the level of competition.
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Economic Modelling 84 (2020) 190–202
where C is the total cost of bank i at time t, q is bank output, d are de-
posits, w are the prices of inputs, R is bank revenue, r is the interest rate
on deposits, p is the price of bank output, and e are the error terms.
Variables with bars represent deviations from their cross sectional means
at each time period, so as to remove their trend. The variables gdpg and ir
are exogenous variables that affect demand. The degree of competition in
each year is given by θ, which represents the well-known conjectural
variations elasticity of total industry output with respect to the output of
the ith bank. Specifically, C is proxied by total expenses, q by total
earning assets, d by total deposits and short-term funding, w by the ratio
of total operating expenses (overheads) to total assets, R by total revenue,
r by the ratio of interest expenses to total deposits and short-term fund-
ing, p by the ratio of total revenue to total earning assets, gdpg by the
annual change of growth rate, and ir by a short-term interest rate.
The range of possible values of θ is given by [0, 1]. In the special case
of Cournot competition, θit is simply the output share of the ith bank at
each point in time. In the case of perfect competition, θit ¼ 0; under pure
monopoly, θit ¼ 1; and, finally, θit< 0, implies pricing below marginal
cost and could result, for example, from a non-optimizing behavior of
banks. As θi moves farther from zero, the conduct of bank i moves farther
from that of a perfect competitor. Therefore, the (average) conjectural
variation coefficient will reveal what kind of imperfectly competitive
behavior characterizes the market, and there is no need to impose any a
priori restriction on it. In other words, it is not necessary to assume a
certain conduct beforehand and test for its propriety.8 A merit of this
estimation method is that it provides a yearly index of industry market
power to be used in the subsequent analysis.
As discussed in section 2, the main purpose of the paper is to examine
whether financial regulatory policies are affected by democracy level and
if they have an impact on bank competition. Therefore we examine the
regulations and the supervisory procedures that promote competition,
stability, and transparency and consumer protection. To quantify the
different classes of regulation we used the approach followed by Barth
et al. (2001b, 2006, 2008) and Cihak et al. (2012). Specifically, regula-
tory indices are constructed relating to competition (comp), stability
(stab) and transparency and consumer protection (transp) (Appendix I).9
The first index (comp) shows the extent of financial regulations that
enhance competition among the actors in the banking sector as well as to
the financial system as a whole, and ranges between 0 and 11. The higher
is the level of the cumulative index the higher is the quality and the
quantity of financial regulations that promote competition. The second
index (stab) reveals the financial regulations and supervisory procedures
that secure micro- and macro-stability. This stability oriented index
ranges between 0 and 26 and higher values indicate laws that enhance
stability. The third index (transp) represents legislative initiatives and
supervisory practices that increase market's transparency and consumer's
protection. Higher indices' values indicate more and better regulations of
transparency and consumer protection and they range between 0 and 24.
static and dynamic models a set of variables such as depth, stability and
inclusiveness since these variables are important to assess the effective-
ness of financial regulations on the promotion of well-functioning
financial institutions. These variables are: Liquid liabilities to GDP, Pri-
vate credit by deposit money banks and other financial institutions to GDP,
Stock market capitalization to GDP, Bank-Z-score, Bank nonperforming loans
to gross loans and Bank capital to total assets.
8
Both θ and η, the latter representing the market demand elasticity for bank
output, are parameters to be estimated. To estimate θ we use year dummy
variables, while to estimate η we use dummy variables for every two years.
Agoraki (2009) provides a comprehensive analysis of market structure in the
European banking sector.
This approach has been also followed by Fernandez de Guevara et al. (2005),
Barth et al. (2001b, 2008), Cihak et al. (2012), Pasiouras et al. (2006), Buch and
DeLong (2008), Agoraki et al. (2011) among others.
M.-E.K. Agoraki et al.
We should note here that establishing new banking laws is unlikely to
guarantee more competitive environments in the immediate term,
especially through changes in market power. If banking-sector regulatory
reform does affect competition levels, then it is expected that there are
lags between establishing new banking laws and the time that these laws
are translated into more sound, effective and competitive banking
practices. In fact, in the estimations below, we used both the first and the
second lags of the implemented regulatory reforms as captured by all
three types of measures discussed above. As discussed above, we opt for a
non-structural measure of bank competition that shows how competitive
conditions evolve over time and variables for reg that provide explicit
proxies of the regulatory reform process.
4. Data and empirical results
We use data for 617 banks operating in the 17 transition countries in
1994–2016 shown in Table 1. We collected our data from a number of
sources. Individual bank data have been taken from Bankscope and
banks' annual reports. Data for the regulatory indices were obtained from
the World Bank database on “Bank Regulation and Supervision” devel-
oped by Barth et al. (2001a) and updated by Barth et al. (2006, 2008) and
Cihak et al. (2012). Data for democracy ratings were derived, mainly,
from Freedom House index, the Economist Intelligence Unit's democracy
index and the Global Democracy Ranking of the quality of democracy.
Data for the market structure (for, pub)10 and macroeconomic conditions
(ir, invgdp, gdpg) were collected from the EBRD's Transition Reports and
the World Bank's World Development Indicators (WDI). Data for Property
Rights, Government Integrity and Financial Freedom were retrieved from
The Heritage Organisation. Finally, the data for (a) depth; (b) stability
and (c) inclusiveness were collected from the World's Bank Database.
Naturally, the data were reviewed for reporting errors or other
inconsistencies.
The banking sector of the CEE and other emerging markets has un-
dergone substantial changes, aiming at enhancing the sector's solvency
and credibility. Table 1 provides some descriptive statistics for our
sample. It represents the structure of the banking sector over the exam-
ined period for each country. Specifically, the competition regulatory
index ranges from 5.629 in FYROM to 10.168 in Albania; the stability
regulatory index ranges from 13.048 in Latvia to 16.563 to Turkey and
finally the transparency and consumer protection index ranges from
7.119 in Ukraine to 16.985 in Turkey.
Furthermore, the democracy and quality of institutions take the
following values: Freedom House democracy index takes very low values
and ranges from 1.108 in Slovenia to 3.667 in Bosnia; the Economic
Intelligence Unit's democracy index ranges from 5.203 in Bosnia to 8.060
in Czech Republic; and the Democracy Ranking index ranges from 46.953
in Bosnia to 73.699 in Slovenia. As far as the quality of institutions we
note that the property rights index ranges from 13.320 in Bosnia to
78.119 in Estonia whereas the Government integrity index ranges from
24.073 in Ukraine to 61.482 in Estonia and the Financial freedom index
ranges from 36.743 in Ukraine to 84.794 in Czech Republic.
Over the last decade, the financial sectors of the CEE countries and
other emerging economies have converged towards a universal bank-
based system, with the presence of foreign institutions being increas-
ingly important. Buffered by banking crises that crippled their entire
economies, government have realized the importance of opening up their
banking systems to foreign capital and know-how. These privatization
programs were so extensive that in most countries the largest proportion
of banking system is already controlled by foreign banks.
Following the preliminary empirical analysis, we now turn our
attention to fully analyse the linkages among democracy and the quality
of political institutions, financial regulation and banking competition.
10
To capture the effect of public and foreign ownership we use the asset share
equivalent of public and foreign owned banks respectively.
195
Economic Modelling 84 (2020) 190–202
First we estimate the system equation (2), in order to obtain industry-
level measures of competition. Estimation is carried out for each coun-
try separately using seemingly unrelated regression and the full set of
results for θ on a country and time basis are presented in Table 2.11 The
country- and year-specific estimates derived correspond to θt in Eqs. (1)
and (3).
Some countries show fairly competitive practices (e.g., Romania,
Serbia and Ukraine), others show anticompetitive behavior (Lithuania
and Slovenia), and most lay somewhere in between. Changing patterns
over time are also different on a country-by-country basis. An interesting
pattern is observed in the more developed countries of the group
(Croatia, Poland, Bosnia), where higher values are observed in the
middle of the examined period. This may suggest that market power has
been the result of networking, owing to the weak institutional environ-
ment. However, the relatively faster (than in the other countries) process
of development and institutional/democratic reforms towards the
accession of these countries in the EU may be responsible for the
decreasing values in the last years of our sample. Finally, it is worth
noting that in some of the less developed countries (e.g., Serbia and
Romania in the first few years) banks are not behaving as optimizing
firms on average. Overall, the results do not suggest a transformation en
route towards more competitive banking sectors.
Having obtained estimates of banking-sector competition, we will
investigate whether the regulatory reform process, democracy and the
quality of institutions have a significant effect on the competition of
banks. We accomplish this task through the direct estimation of the static
specifications given by equation (1). As our estimates of the degree of
market power suggest, changes in competitive conditions in the banking
sectors of all countries examined are gradual (if any). This is quite ex-
pected as the transformation of industry structure is usually subject to
exogenous rigidities that may require time to be smoothed out, even
when transition is fast.
The choice of the estimation procedure rests on the special features of
each empirical model. Estimation of Eq. (1) is carried out using panel
data instrumental variables regression. The main reason for this choice is
that in the special CEE case it is possible that after the financial liber-
alization process begun, and taking into account the dramatic trans-
formation of the economy and the society of these countries within a
small period of time, credit risk increased significantly, which led to
increased financial instability (the banking crises of the CEE banking
sectors during the late 1990s explicitly confirmed this instability).
Therefore, the supervisory authorities attempting to smooth the turmoil
and to make domestic market more attractive for foreign investments in
the banking sector, reacted by setting new regulations and taking new
supervisory initiatives that are reflected in the regulatory indices. This in
turn led to bank failures with the remaining banks in the industry
acquiring a higher level of market power. Furthermore, the ongoing
democratization process led to the establishment of the appropriate in-
stitutions of the financial regulatory framework, the effectiveness of
which in terms of promoting competition are determined by the low or
intermediate level of democracy and the institutions inability to resist to
market pressures. The high levels of market power, as a result of a“cap-
tured” regulatory process in a “partly” democratic regime, may remain.
Therefore, it is likely that reverse causality prevails between democracy
and each of competition and regulation.
Table 3 reports the results of the estimations of three variants of eq.
(1) depending on the definition of democracy we employ as well as of the
interaction terms between the political environment prevailing in each of
the 17 countries of our sample and the alternative measures of regulatory
reform in order to examine the impact of both democracy and financial
11
Several robustness checks were performed; however, the results remained
unchanged at the 10% level of significance. In particular, we used three-stage
least squares, we included ownership variables among bank inputs in the cost
and revenue equations. All these results are available upon request.
 M.-E.K. Agoraki et al.
Table 1
Descriptive statistics (1994–2016).
Albania Bosnia Bulgaria Croatia Czech Estonia FYROM Hungary Latvia Lithuania Poland Romania Serbia Slovakia Slovenia Ukraine Turkey
Republic

θ 0.564 0.650 0.401 (0.162) 0.625 0.588 0.603 0.456 0.758 1.041 0.476 0.701 0.246 0.038 0.315 0.872 0.265 0.529
(0.131) (0.183) (0.096) (0.100) (0.179) (0.098) (0.114) (0.119) (0.207) (0.073) (0.101) (0.106) (0.090) (0.161) (0.054) (0.091)
Size 5.833 5.331 6.308 (1.604) 6.416 8.363 6.223 7.553 6.093 6.599 5.027 8.319 7.123 6.609 7.216 7.321 5.983 8.466
(1.557) (1.378) (1.698) (1.808) (2.058) (1.731) (1.626) (1.714) (1.425) (1.643) (1.743) (1.581) (1.426) (1.155) (1.753) (1.874)
inf 3.073 2.186 36.320 (64.26) 5.808 3.309 8.227 9.557 8.325 6.959 5.727 7.470 23.571 20.921 5.332 5.784 30.755 32.999
(3.606) (2.737) (16.023) (3.516) (10.379) (27.859) (6.942) (9.438) (10.298) (8.305) (31.984) (25.228) (4.091) (5.001) (26.55) (36.223)
pub 17.222 7.465 10.859 11.997 15.301 1.970 2.073 8.834 5.873 18.748 23.948 23.995 25.160 20.178 20.033 7.050 20.518
(21.58) (15.412) (17.251) (15.006) (24.153) (5.551) (1.534) (12.906) (2.967) (18.579) (21.115) (23.693) (29.183) (22.638) (15.451) (3.136) (5.222)
for 82.660 82.278 76.002 71.646 75.066 84.220 50.486 72.722 63.497 69.068 65.970 34.531 62.496 69.245 27.420 37.488 13.049
(20.592) (19.493) (10.043) (30.675) (26.529) (30.215) (25.287) (18.972) (11.813) (21.316) (27.518) (14.794) (32.742) (26.426) (23.354) (19.701) (1.330)
invgdp 29.317 20.191 23.415 (6.210) 23.886 28.036 28.391 21.364 22.356 25.351 21.646 21.328 24.907 25.058 26.308 22.976 20.654 20.377
(5.078) (3.206) (4.794) (2.217) (4.625) (3.855) (1.747) (7.162) (3.869) (2.183) (3.449) (5.196) (4.816) (3.309) (3.572) (2.537)
comp 10.168 6.719 8.430 (0.790) 7.178 7.8407 8.286 5.629 7.821 6.895 6.437 6.701 7.705 6.234 8.191 8.358 5.735 6.420
(1.269) (0.779) (1.461) (1.993) (0.904) (0.930) (1.131) (1.427) (0.497) (0.800) (1.231) (1.554) (1.809) (0.768) (0.739) (1.488)
stab 16.398 15.201 16.571 (0.495) 13.127 15.827 14.418 14.413 16.069 13.048 15.733 15.892 14.775 13.228 13.804 16.017 14.559 16.563
(1.297) (0.401) (0.993) (0.844) (0.495) (1.813) (0.665) (1.263) (0.825) (0.954) (0.847) (0.975) (0.982) (1.001) (0.497) (0.496)
transp 16.702 13.403 12.331 (1.208) 14.028 14.088 13.245 11.795 16.036 12.734 14.241 12.486 13.839 11.530 13.036 16.000 7.119 16.985
(0.458) (1.293) (0.95) (0.998) (0.432) (1.319) (1.248) (1.061) (0.428) (0.500) (0.823) (0.499) (1.204) (0.001) (0.993) (1.001)
demFREEDOM 3.166 3.667 1.886 (0.343) 2.139 1.150 1.169 2.913 1.429 1.413 1.242 1.173 2.033 2.131 1.179 1.108 3.231 3.431
(0.453) (0.572) (0.860) (0.229) (0.237) (0.593) (0.374) (0.299) (0.293) (0.238) (0.125) (0.221) (0.240) (0.206) (0.592) (0.551)
demECON 5.791 5.203 6.904 (0.154) 6.900 8.060 7.706 6.469 7.257 7.298 6.779 7.158 6.672 6.526 7.339 7.759 6.074 5.550
(0.107) (0.342) (0.103) (0.137) (0.091) (0.336) (0.201) (0.216) (0.571) (0.165) (0.178) (0.166) (0.029) (0.158) (0.462) (0.273)
demRANK 54.290 46.953 62.708 (4.454) 64.166 69.871 70.789 52.393 68.256 68.540 65.068 68.619 60.416 58.269 66.323 73.669 50.923 50.281
(4.603) (4.788) (5.718) (2.388) (3.281) (8.474) (2.095) (2.889) (7.036) (3.142) (4.367) (4.131) (2.971) (2.149) (5.281) (6.057)
Property rights 31.385 13.320 35.897 (9.131) 34.276 70.114 78.119 67.920 50.809 53.059 32.769 44.988 34.201 38.914 50.942 56.926 29.732 55.011
196

(2.661) (4.718) (5.390) (2.367) (8.826) (5.026) (1.845) (4.706) (2.495) (9.959) (4.687) (4.761) (3.776) (9.072) (3.292) (8.963)
Government 26.795 25.305 36.905 (3.976) 40.942 46.595 61.482 50.001 40.854 43.667 35.198 60.491 33.797 30.720 43.797 57.712 24.073 37.573
Integrity (7.374) (11.015) (6.250) (4.542) (5.965) (2.946) (7.786) (8.441) (5.828) (8.330) (6.299) (10.376) (5.446) (7.998) (3.563) (8.691)
Financial 62.973 55.019 58.943(96.885) 57.639 84.794 80.342 68.654 61.549 70.373 62.846 48.201 48.197 46.228 66.962 53.191 36.743 55.791
Freedom (13.374) (14.464) (6.361) (5.007) (7.535) (4.636) (9.458) (17.273) (4.529) (9.959) (6.491) (7.845) (13.254) (7.337) (9.056) (9.882)
Liquid liabilities 67.466 49.244 56.999 56.100 66.403 56.355 48.877 37.495 34.301 34.908 60.807 31.453 31.925 57.576 51.922 31.817 36.436
to GDP (4.987) (11.493) (16.614) (17.542) (6.905) (11.907) (7.099) (12.221) (12.496) (16.497) (8.651) (5.804) (13.297) (4.236) (11.434) (9.017) (7.330)
Private credit by 14.319 45.534 43.249 51.793 45.463 56.045 38.065 45.093 30.428 31.379 44.988 26.792 34.072 42.504 51.275 48.596 31.037
deposit money (13.672) (9.910) (20.778) (16.881) (10.003) (24.861) (14.740) (27.158) (16.811) (12.303) (10.395) (15.148) (11.159) (7.209) (22.156) (28.729) (17.516)
banks and
other financial
institutions to
GDP
Stock market 8.434 20.116 12.436 32.801 18.855 23.403 19.468 7.022 15.629 5.603 34.139 7.651 21.724 4.692 18.213 19.003 23.714
capitalization (2.526) (7.248) (10.564) (19.282) (5.549) (10.364) (8.196) (2.983) (7.276) (5.813) (13.069) (4.855) (16.663) (2.755) (9.651) (13.639) (6.463)
to GDP
Bank Z-score 14.587 15.747 8.475 (1.724) 4.457 11.716 6.370 5.335 5.741 5.939 5.728 22.885 6.843 13.729 15.082 2.644 5.573 8.007
(2.998) (2.670) (0.654) (2.566) (1.878) (0.786) (1.389) (1.456) (1.377) (11.737) (2.068) (2.729) (3.007) (0.897) (1.583) (2.025)

Economic Modelling 84 (2020) 190–202

Bank 26.794 9.793 9.055 (7.101) 10.341 7.710 1.648 6.356 5.647 9.592 15.914 7.782 14.918 19.091 8.015 7.595 17.271 6.029
nonperforming (7.836) (4.406) (3.732) (6.78) (1.552) (4.965) (4.843) (7.473) (9.917) (1.672) (3.685) (4.006) (7.384) (3.981) (8.812) (5.593)
loans to gross
loans
Bank capital to 8.434 13.949 11.009 (2.261) 12.730 6.256 10.656 8.655 8.572 10.141 11.905 9.091 8.178 20.196 9.358 8.489 13.688 11.275
total assets (1.403) (3.131) (2.354) (0.821) (2.104) (0.725) (1.957) (1.986) (1.913) (5.934) (0.494) (1.696) (1.954) (0.541) (2.343) (2.299)

Note:θ: competition; Size: ln(total assets); inf: the inflation rate (cpi); pub: % of publicly owned banks in terms of total industry assets; for: % of foreign owned banks in terms of total industry assets; invgdp: total investments/
GDP; comp: competition regulatory index; stab: stability regulatory index; transp: transparency and consumer protection regulatory index; demFREEDOM: Freedom House democracy index; demECON: Economist Intelligence
Unit's democracy index; demRANK: Global Democracy Ranking index. Figures other than ratios and indices are expressed in thousand euros.
 M.-E.K. Agoraki et al.
Table 2
Evolution of competitive conditions in transition banking systems (θt).
Albania Bosnia Bulgaria Croatia Czech Republic Estonia FYROM Hungary Latvia Lithuania Poland Romania Serbia Slovakia Slovenia Ukraine Turkey

1994 0.192 0.412 0.181 0.551 0.591 0.731 0.224 0.413 1.158** 0.762 0.044* 0.167 0.534 1.097** 0.191 0.478
1995 0.181 0.428 0.245 0.599 0.601 0.589 0.382 0.416 0.900** 0.775 0.031* 0.083* 0.498 1.005** 0.258 0.513
1996 0.178 0.615 0.169 0.515 0.500 0.670 0.317 0.713 1.147** 0.888 0.153 0.107 0.445 0.901 0.268 0.496
1997 0.473 0.689 0.187 0.502 0.366 0.703 0.328 0.846 1.114** 0.742 0.236 0.117 0.396 0.970** 0.294 0.482
1998 0.408 0.701 0.183 0.514 0.437 0.684 0.779 0.450 0.683 1.134** 0.754 0.279 0.073* 0.412 0.977** 0.193 0.517
1999 0.352 0.811 0.259 0.570 0.414 0.801 0.652 0.366 0.756 1.138** 0.723 0.381 0.115 0.419 1.077** 0.269 0.477
2000 0.791 0.829 0.293 0.524 0.577 0.861 0.614 0.419 0.671 1.099** 0.742 0.328 0.059* 0.373 1.067** 0.273 0.588
2001 0.897 0.870 0.349 0.537 0.369 0.887 0.714 0.377 0.629 1.134** 0.742 0.236 0.121 0.321 1.008** 0.249 0.596
2002 0.360 0.811 0.210 0.711 0.651 0.936 0.628 0.473 0.832 1.163** 0.771 0.293 0.041* 0.284 1.012** 0.213 0.612
2003 0.544 0.849 0.347 0.807 0.653 0.853 0.773 0.482 0.773 1.101** 0.800 0.382 0.001* 0.322 0.996** 0.247 0.652
2004 0.589 0.812 0.378 0.793 0.676 0.700 0.639 0.563 0.839 1.161** 0.675 0.322 0.080* 0.356 1.083** 0.278 0.647
2005 0.610 0.804 0.340 0.813 0.617 0.646 0.620 0.549 0.830 1.107** 0.636 0.293 0.035* 0.287 0.991** 0.240 0.654
197

2006 0.661 0.799 0.771 0.744 0.674 0.589 0.602 0.541 0.840 1.102** 0.587 0.371 0.142 0.274 0.982** 0.371 0.658
2007 0.607 0.724 0.687 0.716 0.689 0.562 0.465 0.523 0.842 1.010** 0.596 0.345 0.154 0.215 0.812 0.378 0.671
2008 0.655 0.701 0.596 0.685 0.708 0.542 0.352 0.510 0.896 1.020** 0.571 0.352 0.143 0.219 0.802 0.396 0.653
2009 0.671 0.674 0.637 0.751 0.632 0.522 0.410 0.532 0.821 1.120** 0.612 0.312 0.152 0.231 0.824 0.291 0.510
2010 0.540 0.422 0.372 0.572 0.600 0.351 0.221 0.675 0.883 1.012** 0.642 0.175 0.020 0.245 0.687 0.223 0.520
2011 0.523 0.327 0.330 0.612 0.611 0.412 0.225 0.542 0.831 0.878 0.712 0.126 0.092* 0.237 0.642 0.217 0.412
2012 0.514 0.410 0.292 0.580 0.583 0.380 0.251 0.522 0.800 0.825 0.728 0.129 0.084* 0.245 0.670 0.231 0.482
2013 0.567 0.532 0.355 0.582 0.672 0.426 0.257 0.518 0.788 0.925 0.691 0.290 0.157 0.272 0.715 0.245 0.479
2014 0.598 0.418 0.386 0.524 0.719 0.458 0.245 0.502 0.763 0.911 0.677 0.246 0.128 0.229 0.662 0.268 0.422
2015 0.317 0.546 0.425 0.612 0.511 0.41 0.462 0.699 0.802 0.375 0.672 0.114 0.152 0.212 0.671 0.238 0.476
2016 0.418 0.592 0.328 0.578 0.528 0.389 0.486 0.682 0.795 0.572 0.655 0.168 0.231 0.271 0.675 0.235 0.322

Note: The table presents estimates of competition (θ) for 17 transition countries over the period 1994–2016. A value of θ statistically equal to one implies monopoly practices. While a value equal to zero implies competitive
conditions. Lower values suggest increased competition and higher values increased market power. * indicates that the hypothesis of perfect competition is not rejected at the 5 per cent level of statistical significance and **
indicate that monopolistic conditions are not rejected at the 5 per cent level.

Economic Modelling 84 (2020) 190–202

M.-E.K. Agoraki et al. Economic Modelling 84 (2020) 190–202

Table 3
Reform, competition and democracy in transition banking systems (dep. variable: θ).
Static models (Eq. (1)) Dynamic models (Eq. (3))

I II III IV V VI

lagged dep. 0.501 (10.76)*** 0.004 (0.15) 0.445 (9.29)***

comp 0.018 (1.98)** 0.140 (6.05)*** 0.098 (1.37) 0.034 (2.91)*** 0.546 (9.12)*** 0.061 (1.94)**
stab 0.007 (1.07) 0.202 (11.50)*** 0.265 (3.79)*** 0.019 (2.27)** 0.344 (4.84)*** 0.009 (0.43)
transp 0.058 (14.06)*** 0.003 (0.42) 0.111 (3.81)*** 0.034 (5.74)*** 0.129 (5.72)*** 0.008 (0.58)
demoFREEDOM 0.161 (3.23)*** 0.003 (4.042)***
demECON 0.641 (3.82)*** 0.216 (3.20)***
demRANK 0.029 (8.35)*** 0.015 (2.68)***
demoFREEDOM^2 0.031 (7.95)*** 0.003 (3.58)***
demECON^2 0.034 (3.39)*** 0.021 (3.53)***
demRANK^2 0.001 (3.14)*** 0.001 (2.83)***
comp* demFREEDOM 0.024 (6.27)*** 0.006 (4.09)***
comp*demECON 0.013 (3.45)*** 0.076 (8.89)***
comp *demRANK 0.002 (4.52)*** 0.001 (3.19)***
stab * demFREEDOM 0.015 (6.22)*** 0.031 (3.12)***
stab *demECON 0.042 (1.98)** 0.059 (2.02)**
stab *demRANK 0.003 (1.50) 0.001 (0.19)
transp * demFREEDOM 0.007 (1.99)** 0.004 (2.10)**
transp *demECON 0.021 (1.68)* 0.030 (3.72)***
transp *demRANK 0.001 (1.01) 0.001 (1.27)
Property rights 0.001 (3.62)*** 0.001 (2.36)*** 0.001 (0.97) 0.001 (2.58)*** 0.002 (4.04)*** 0.000 (0.08)
Government Integrity 0.004 (8.76)*** 0.005 (9.34)*** 0.004 (5.01)*** 0.003 (5.11)*** 0.004 (5.53)*** 0.004 (6.56)***
Financial Freedom 0.001 (1.88)* 0.001 (1.42) 0.002 (3.08)*** 0.001 (2.91)*** 0.004 (5.73)*** 0.002 (5.51)***
Liquid liabilities to GDP 0.001 (3.01)*** 0.001 (2.68)*** 0.003 (5.08)*** 0.001 (0.39) 0.004 (4.61)*** 0.001 (2.22)**
Private credit by deposit money 0.001 (1.72)* 0.001 (0.89) 0.001 (0.32) 0.001 (4.45)*** 0.002 (4.15)*** 0.002 (5.27)***
banks and other financial
institutions to GDP
Stock market capitalization 0.001 (1.60) 0.001 (3.92)*** 0.004 (10.61)*** 0.001 (2.05)** 0.001 (3.86)*** 0.001 (4.13)***
to GDP
Bank Z-score 0.010 (8.07)*** 0.012 (8.66)*** 0.012 (5.11)*** 0.001 (0.87) 0.009 (3.47)*** 0.009 (4.93)***
Bank nonperforming loans 0.002 (3.63)*** 0.002 (4.18)*** 0.005 (4.86)*** 0.001 (1.18) 0.020 (10.23)*** 0.001 (0.69)
to gross loans
Bank capital to total assets 0.003 (2.31)** 0.005 (3.35)*** 0.017 (6.48)*** 0.003 (2.06)** 0.042 (14.51)*** 0.007 (3.39)***
size 0.001 (2.02)** 0.001 (2.30)** 0.001 (1.75)* 0.001 (1.57) 0.002 (4.58)*** 0.001 (0.68)
for 0.044 (3.50)*** 0.046 (3.70)*** 0.035 (2.95)*** 0.233 (4.37)*** 0.202 (6.53)*** 0.204 (4.00)***
pub 0.039 (1.23) 0.039 (1.19) 0.057 (1.45) 0.272 (0.99) 0.502 (8.57)*** 0.856 (2.90)***
inf 0.001 (0.17) 0.002 (3.84)*** 0.006 (5.15)*** 0.004 (6.43)*** 0.001 (0.44) 0.005 (8.94)***
invgdp 0.006 (9.58)*** 0.006 (9.33)*** 0.001 (0.77) 0.006 (7.54)*** 0.018 (8.12)*** 0.006 (7.55)***
crisis 0.157 (7.77)*** 0.128 (13.51)*** 0.163 (11.35)*** 0.054 (5.25)*** 0.105 (4.91)*** 0.044 (4.02)***
EU membership 0.056 (4.31)*** 0.039 (3.09)*** 0.015 (0.79) 0.087 (0.34) 0.099 (5.95)*** 0.056 (2.27)**
cons 0.195 (4.22)*** 0.981 (9.77)*** 0.620 (5.69)*** 0.294 (1.89)* 0.209 (2.12)** 0.756 (2.41)***
No of observations 2937 2722 1253 2585 2400 2325
Wald (p-value) 0.000 0.000 0.000 0.000 0.000 0.000
R-squared 0.422 0.419 0.594
Sargan (p-value) 0.523 0.647 0.520

Note:θ: banking industry competition; comp: competition regulatory index; stab: stability regulatory index; transp: transparency and consumer protection regulatory
index; demFREEDOM: Freedom House democracy index; demECON: Economist Intelligence Unit's democracy index; demRANK: Democracy Ranking index; size: logarithm of
total assets; inclusiveness is proxied by private credit money banks and other financial institutions to GDP; for: % of foreign-owned banks in terms of total industry assets;
pub: % of publicly-owned banks in terms of total industry assets; inf: the inflation rate (cpi); invgdp: total investments/GDP; crisis: dummy variable that takes value 1 for
the years 2008–2016; EU membership: dummy variable that takes value 1 if the country is a member of the eurozone; cons: the constant term. Wald is a test indicating
goodness of fit of the regression. Sargan is a test for overidentifying restrictions. All models include country dummy variables. The table reports coefficients and t-
statistics in parentheses. ***, **, and * indicate 1, 5 and 10% significance levels, respectively.

regulatory reforms on market power. The empirical results are obtained
from random effects panel data estimation of eq. (1). We apply the least
squares methods of fixed effect (FE) and random effect (RE). Based on the
Haussman test we are unable to reject the null hypothesis that our
specification follows a RE model. In addition, we include in the set of
exogenous variables. We include in all three specifications, six variables
which provide a better understanding of the quality of banking sectors,
namely depth, stability and inclusiveness. In this static setting it is shown
that besides the variable private credit by deposit money banks and other
financial institutions to GDP, these variables are statistically significant and
they have the correct sign. Furthermore, in all three specifications we
included three variables that reflect the quality of institutions in each
country which along with the level of democracy that prevails in each
country is expected to improve the effectiveness of financial regulatory
framework. The coefficients of democracy captured by three different
indices are statistically significant. Furthermore, the coefficient for
demoFREEDOM is positive as expected implying that a smaller value of this
index corresponds to more democracy and increased competition given
the theoretical values that this index and the competition variable can
obtain. Moreover, the coefficients demECON and demRANK have the ex-
pected negative sign. Opposite to the first index these two indices imply
that when their value rises we move to more democratic regimes and this
results to higher competitive banking sectors. The overall conclusion
implies that more democratic countries have better regulatory frame-
work which leads to increased competition in the banking sector. This
finding is further reinforced by the statistical significance of property
rights, government integrity and financial freedom indices. The estimated
coefficients also have negative sign since a higher level of property rights,
government integrity and financial freedom implies a higher level of
competition. Therefore, we argue that not only the level of democracy
but also the quality of institutions has a favourable impact on improved
regulatory reform framework and a higher level of competition in the

198
M.-E.K. Agoraki et al.
respective banking industry. Overall based on the Wald tests and R-
squared values exhibit good fit. The R2-adjusted measure is reasonably
high on all estimated models providing substantial evidence of good
explanatory power.12
Given that endogeneity issues might be present in the form of reverse
causality we re-estimate our benchmark model using a dynamic specifi-
cation by including a lagged dependent variable among the regressors.
We instrument against all regulation and macroeconomic variables as
well as their first lags and country dummies in eq. (1). Therefore, we
augment the static models given by eq. (1) with lagged dependent vari-
ables as follows:
θt ¼ a0 þ δ1 θt1 þ a1 democracy þ a2 democracyit  regt1 þ a3 xit þ a4 mt
þ uit
(3)
A value of δs between 0 and 1 implies that the dependent variables of
the above equations persist, but they will eventually return to their
normal (average) level. Values close to 0 mean that the speed of
adjustment is high, while values close to 1 imply very slow adjustment.13
With respect to the dynamic model formulation the estimation of Eq.
(3) is conducted the GMM estimator proposed by Blundell and Bond
(1998). To determine whether our instruments are valid in the system
GMM approach, we used the specification tests proposed by Arellano and
Bond (1991) and Arellano and Bover (1995). We applied the
Sargan-Hansen test of over-identifying restrictions to determine any
correlation between instruments and errors. In order for an instrument to
be valid, no correlation should be attested between the instrument and
the error terms. The null hypothesis is that the instruments and the error
terms are independent. Therefore, failure to reject the null hypothesis
could provide evidence that valid instruments are used. We find no evi-
dence of over-identifying restrictions. Also we examine whether there is a
second order serial correlation with the first differenced errors. The GMM
estimator is consistent if there is no second order serial correlation in the
error term of the first-differenced equation. The null hypothesis in this
case is that the errors are serially uncorrelated. Therefore, failure to reject
the null hypothesis could supply evidence that valid orthogonality con-
ditions and instruments are used. A final practical issue in estimating Eq.
(3) is that the interaction terms are highly collinear with their compo-
nents. An easy way to reduce multicollinearity is by “centering” the
variables. We do this by subtracting the mean from each observation and
we observe that correlation of all independent variables is decreased.
An overall comment is that the dynamic models were found to be
more suitable to describe the relationships in hand. The coefficient on the
lagged dependent variable is highly significant and negative in models IV
and VI indicating a considerable level of persistence. The coefficients of
the main results are statistically significant and with the correct sign.
Specifically, the coefficient of the competition index is negative and
statistically significant in specifications IV and V implying that when the
value of the index increase then the market power declines and the
banking sector becomes more competitive. The stability index has a
statistically significant coefficient with a positive sign in all dynamic
specifications implying that as expected a more stable banking system
leads to higher market power. Finally, when transparency of the banking
sector increases the market power decreases given that the coefficient is
statistically significant and negative in specifications IV and V. In a
12
The coefficients of the time and country dummies have been omitted from
the regression output but are available upon request.
13
The coefficients on the lagged values take implausible values (e.g., negative
or very small) for panels with a very small time dimension, and are highly
dependent on the robustness of the estimation method (see Nerlove, 2002). Note
that as suggested above we also used the second lags of the reform/regulatory
variables to identify whether the impact of these variables is delayed for more
than one year. However, such evidence has not been found and given space
considerations the results are not reported.
199
Economic Modelling 84 (2020) 190–202
similar vein with the static models the coefficient of demoFREEDOM is
statically significant and positive which confirms that as the level of
democracy increases (low values of the index) competition increase
whereas the coefficients of demECON and demRANK have a coefficient
which is statistically significant and negative implying that as the level of
democracy increases (higher values of each index) depending on the
democracy definition applied in this group of the emerging markets the
banking sector becomes more competitive.
Furthermore, the joint relationship between financial regulations, the
level of democracy, and market power of banks is negative. In particular,
the specifications with interaction terms allow us to examine whether the
total effect of financial regulations can change sign depending on the
level of democracy. This finding is intriguing as far as the impact of de-
mocracy on market power is considered where a negative and significant
coefficient is found on the interaction term of this variable with the
regulatory variables, competition, stability and transparency. In order to
calculate the value of democracy where the impact of regulatory variables
turns negative we take the derivative with respect to the regulatory
variables of the estimated equations presented in Table 3 and set it equal
to 0. Thus, for a given level of the competition index an increase in the level
of democracy decreases market power. Similarly, for a given level of the
stability index higher level of democracy leads to a more competitive
banking industry. Finally, for a given level of the transparency index when
the level of democracy increases the market power falls. Therefore, our
findings reveal that for higher levels of democracy, considering all the
three indexes of democracy, the impact of financial regulations and su-
pervisory procedures to bank's market power turns negative, verifying
the positive impact of both high levels of democracy and high quality of
financial regulation in the enhancement of competition. Overall, ac-
cording to all three democracy indicators, that as the level of democracy
increases the financial regulatory reform process is getting stronger,
verifying our hypothesis of a general positive relation between political
freedom and financial regulation.
We also discuss the effects of the variables that reflect quality of in-
stitutions in each of the emerging economies. It is shown that property rights,
government integrity and financial freedom have coefficients that are statisti-
cally significant. For all three models (IV-VI) the coefficients of property
rights, government integrity and financial freedom are negative and
therefore the argument that when the value of these variables increase bank
competition in the CEE emerging economies rises also holds under dynamic
specifications. When we turn to the coefficients of the variables that further
reflect other aspects of banking sectors we underline the statistical signifi-
cance of the bank Z-score variable, the ratio of bank non-performing loans to
gross loans and the ration of bank capital to total assets.
With respect to the control variables, bank ownership appears to be
another important parameter, with a higher presence of foreign banks in
the market resulting increased competition.14 This finding, is in line with
the widely held view that selling to strategic foreign investors is the
desirable form of privatization to promote competitive conditions. This
may imply regardless whether the institution is domestic or foreign,
declining banks’ market power could lead successful restructuring much
more likely.15 Furthermore, this effect confirms that the reduction of
market power owing to the privatization of publicly-owned institutions,
which is reflected on the positive correlation between θ and pub.16
14
For example, it has been argued by Bonin et al. (2005) that until recently the
information technology in transition countries was only basic. However, these
conditions were obviously improved since enhancement of quality and avail-
ability of financial services, adoption of modern banking skills, and increase in
the quality of human capital are among the major benefits of foreign banks entry
in emerging markets (Levine, 1996; Lensink and Hermes, 2004).
15
For more on this issue, see Delis (2012).
16
We estimated several different versions of the equations presented, adding
or excluding some of the control variables. Changes in the results were
negligible.
M.-E.K. Agoraki et al.
A more in-depth analysis using the three specific regulatory indices
shows that more advanced democracy levels have a favourable and to the
right direction and statistically significant impact on financial regulations
that focus separately on competition, stability, and transparency and
consumer protection in both static and dynamic specifications. Hence,
our results presented in Table 3 verify our basic hypothesis about “par-
tial” democracy's impact on the quality of financial regulation. A U-
shaped relation between democracy and financial regulation with sig-
nificant impacts to banking competition, which is strengthened by the
enhancement of the specific regulations and procedures that promote
competition. Specifically, to confirm the existence of a U-shaped relation
we include a quadratic term of democracy variables. Our estimates re-
ported in Table 3 confirm the existence of a U-shaped relation since the
quadratic term for demoFREEDOM is statistically significant and negative
and the quadratic term for demECON and demRANK are statistically sig-
nificant and positive.
Furthermore, it is also likely that initial stringency requirements17
impose increased costs to potential entrants, having an adverse effect on
competition. Therefore, contrary to standard accounts, the results of
Table 3 indicate that the reform process has not contributed positively to
competitive conditions of the CEE banking systems, as seen in measures
of θ (Table 2). However, an overview of the estimations in columns I-VI,
taking in consideration the social and political environment of the region,
allow us to give alternate interpretations to the relation between regu-
latory reform and competition in the CEE banking systems, which in fact
may not be restricted to economic phenomena. Such interpretations may
include informational opacity, partisan politics, domestic alliances and
institutional capacity (see Delis, 2012), as regulations and supervisory
procedures, apart from those that focus on enhancing competition,
cannot by themselves reduce banks’ market power, as their effectiveness
is determined by the quality of the institutional and political environ-
ment in which the financial regulatory framework operates. Therefore,
we have to examine the effect of both financial regulations and political
freedom to banking competition. Finally, as it revealed by the inclusion
of variables that reflect the quality of institutions and capture other
important aspects of banking sectors the results in both static and dy-
namic models show that the enhancement of regulations and procedures
that promote competition decrease, as it was expected, market power of
banks.
5. Summary and concluding remarks
In this paper we developed a political economy theoretical frame-
work, based on the well-known public choice approach, in order to
analyse the interrelationships of the democracy, financial regulation and
banking competition nexus. In particular, we extended the approach of
the U-shaped relation between democracy and financial/economic re-
form to the relationship between democracy and financial regulation,
and we investigated the impact of this relation to the competition in the
banking market. We argue that during a period of “partial” democracy it
is quite possible for the major interest groups or economic elites of the
banking sector (no matter local or foreign) to “capture” the government
or the regulatory authorities in order to shape and orient the financial
regulatory framework according to their specific private interest and
against the public interest. Such a disorientation of financial regulation is
reflected on the emphasis that the regulatory framework holds for each of
the three major regulatory goals. So, a “captured” regulatory framework
is expected to focus more on securing the stability of the banking system
and less in promoting banking competition and safeguarding market
17
As can be seen in Appendix I these include: verification of the sources of
funds to be used as capital by regulatory/supervisory authorities, not allowing
the initial or subsequent injections of capital be done with assets other than cash
or government securities, not allowing the use of borrowed funds as initial
disbursement of capital.
200
Economic Modelling 84 (2020) 190–202
transparency and consumer's protection, underlying the emphasis on the
banks' margin of profitability.
Our empirical specification on CEE banking systems supports our
basic hypothesis, that the financial regulatory framework in a “partly”
democratic regime is inadequate and this inadequacy concerns mainly
the market's competition and to a lesser extent the transparency and the
consumers' protection, as both affect negatively banks' margin of profit-
ability. The results suggest (a) a general positive relation between po-
litical freedom and adequate financial regulation, as the higher the level
of democracy is, the stronger the gets the financial regulatory reform; (b)
more democratic countries have better regulatory framework; (c) coun-
tries with better regulatory and institutional settings tend to have lower
credit risk or more stable banking system; (d) a wider trend for powerful
banks, no matter they are local or foreign, to develop pressure networks
in order to increase market power and make successful restructuring
much less likely, creating questions concerning the widely held view that
strategic foreign investments in the CEE banking markets is the desirable
practice to promote competitive conditions, (e) a tendency of the
financial regulations and supervisory procedures to increase competition
of the banking system as the level of democracy is getting higher, and (f)
a U-shaped relation between democracy and financial regulation with
significant impacts to banking competition, which is strengthened by the
enhancement of the specific regulations and procedures that promote
competition. Specifically, we tested for the existence of a U-shaped
relation with the inclusion of a quadratic term of democracy variables
which were found to be statistically significant and with the correct sign
providing evidence of a U-shaped relation.
In particular, the U-shaped relation, a “becoming partial free” demo-
cratic regime affects significantly negative financial regulations and su-
pervisory procedures that enhance banking competition, market's
transparency and consumer's protection. Whilst this regime has a positive
impact on regulations that strengthens financial stability, verifying the
expectation that in the early intermediate stages of democratization
(where institutions and political culture are very weak) the characteris-
tics of financial regulatory reform may correspond to the preferences of
the powerful banks. We also argue that better regulation is key to sta-
bility in the banking system.
Furthermore, we observe that the financial regulation's orientation
changes as the democratization process continues. Therefore, a “partial
free” democratic regime affects increasingly all the three types of finan-
cial regulations and supervisory procedures. This result is in line with the
expectation of a regulatory bias towards characteristics that correspond
to the preferences of powerful banks during the intermediate period of
the democratization process. However, this regulatory bias tends to run
down as democratic institutions are getting stronger. Therefore, as the
enhancement of democracy increases it is more difficult for economic
elites to capture the regulatory framework. The “captured” opportunities
for powerful banks are minimized when the democratization process
reaches “full-fledged” democracy. Thus, a “free” democratic regime af-
fects positively and equal increasingly all three types of financial regu-
lation, as the decisions of the government and the regulatory authorities
reflect the public interest for social welfare and enhanced market
competition (against private interest) more than during the intermediate
periods of democratization.
Our approach and results provide an analytical tool for the explana-
tion of the low levels of banking competition in CEE economies and the
regulatory inadequacy in many of the region's financial systems,
contributing also to the ongoing debate about democracy and economic
prosperity from a political economy view for the function of the financial
system and its regulatory framework. Our findings are of importance
significance to central banks, policy makers and portfolio managers since
as it is explicitly shown there are a very strong interrelationship between
quality of political institutions, financial regulation and banking
competition.
M.-E.K. Agoraki et al. Economic Modelling 84 (2020) 190–202

Appendix I. Information on regulatory variables

Variable Category Description

comp Competition This variable is determined by adding 1 if the answer is yes to questions 1–7 and 0 otherwise, while the opposite occurs in the case of
questions 8–11 (i.e. yes ¼ 0, no ¼ 1). (1) Is it legally required that applicants submit information on the source of funds to be used as
capital? (2) Are the sources of funds to be used as capital verified by the regulatory/supervisory authorities? (3) Is there a maximum
percentage of bank capital that can be owned by a single owner? (4) Are accounting practices for banks in accordance with International
Accounting Standards (IAS)? (5) Are accounting practices for banks in accordance with U.S. Generally Accepted Accounting Principles
(GAAP)? (6) Are auditing practices for banks in accordance with international auditing standards? (7) Are banks limited in their sectoral
concentration? (8) Is there more than one body/agency that grants licenses to banks? (9) Is more than one license required (e.g., one for
each banking activity, such as commercial banking, securities operations, insurance, etc.)? (10) Are banks limited in their lending to
single or related borrowers? (11) Do regulations require credit ratings for commercial banks?
stab Stability This variable is determined by adding 1 if the answer is yes to questions 1–23 and 0 otherwise, while the opposite occurs in the case of
questions 24–26 (i.e. yes ¼ 0, no ¼ 1). (1) Is this ratio risk weighted in line with the 1988 Basle guidelines? (2) Does the minimum ratio
vary as a function of an individual bank's credit risk? (3) Does the minimum ratio vary as a function of market risk? (4) Does the
minimum ratio vary as a function of operational risk? (5) Is there a simple leverage ratio that is required? (6) Is an external audit a
compulsory obligation for banks? (7) Are auditors licensed or certified? (8) Do supervisors get a copy of the auditor's report? (9) Does the
supervisory agency have the right to meet with external auditors to discuss their report without the approval of the bank? (10) Are
auditors required by law to communicate directly to the supervisory agency any presumed involvement of bank directors or senior
managers in illicit activities, fraud, or insider abuse? (11) Are external auditors legally required to report to the supervisory agency any
other information discovered in an audit that could jeopardize the health of a bank? (12) Can supervisors take legal action against
external auditors for negligence? (13) Has legal action been taken against an auditor in the last 5 years? (14) Can the supervisory
authority force a bank to change its internal organizational structure? (15) Has this power been utilized in the last 5 years? (16) Are
banks required to hold either liquidity reserves or any deposits at the Central Bank? (17) Are interbank deposits covered? (18) Is there a
formal definition of a “nonperforming loan” ? (19) Are financial institutions required to produce consolidated accounts covering all bank
and any nonk-bank financial subsidiaries (including affiliates of common holding companies)? (20) Are off-balance sheet items disclosed
to supervisors? (21) Are there any mechanisms of cease and desist type orders, whose infraction leads to the automatic imposition of civil
and penal sanctions on the banks directors and managers? (22) Can the supervisory agency order the bank's directors or management to
constitute provisions to cover actual or potential losses? (23) Is there a separate bank insolvency law? (24) Are banks allowed to hold
reserves in foreign denominated currencies or other foreign denominated instruments? (25) Are banks required to hold reserves in
foreign denominated currencies or other foreign denominated instruments? (26) Can initial disbursement of capital be done with
borrowed funds?
transp Transparency and investors' This variable is determined by adding 1 if the answer is yes to questions 1–22 and 0 otherwise, while the opposite occurs in the case of
protection questions 23 and 24 (i.e. yes ¼ 0, no ¼ 1). (1)Are accounting practices for banks in accordance with International Accounting Standards
(IAS)? (2)Are accounting practices for banks in accordance with U.S. Generally Accepted Accounting Principles (GAAP)? (3)Is it
required by the regulators that bank audits be publicly disclosed? (4) Are specific requirements for the extent or nature of the audit
spelled out?(5) Is there an explicit deposit insurance protection system? (6) Are premia collected regularly (ex ante)? (7) Do deposit
insurance fees charged to banks vary based on some assessment of risk? (8) Does the deposit insurance scheme also cover foreign
currency deposits? (9) Does the deposit insurance authority by itself have the legal power to cancel or revoke deposit insurance for any
participating bank? (10) Were insured depositors wholly compensated (to the extent of legal protection) the last time a bank failed? (11)
Can the deposit insurance agency/fund take legal action for violations against laws, regulations, and bylaws (of the deposit insurance
agency) against bank directors or other bank officials? (12) Has the deposit insurance agency/fund ever taken legal action for violations
against laws, regulations, and bylaws (of the deposit insurance agency) against bank directors or other bank officials? (13) Is
participation in the deposit insurance system compulsory for all banks? (14) Are off-balance sheet items disclosed to the public? (15)
Must banks disclose their risk management procedures to the public? (16) Are bank directors legally liable if information disclosed is
erroneous or misleading? (17) Have they been enforced in the last 5 years? (18) Are there any mechanisms of cease orders, whose
infraction leads to the automatic imposition of civil and penal sanctions on the banks directors and managers? (19) If an infraction of any
prudential regulation is found in the course of supervision, must it be reported? (20) Are there mandatory actions that the supervisor
must take in these cases? (21) Can individual supervisory staff be held personally liable for damages to a bank caused by their actions or
omissions committed in the good faith exercise of their duties? (22) Can the supervisory agency be held liable for damages to a bank
caused by its actions? (23) Were any deposits not explicitly covered by deposit insurance at the time of the failure compensated when the
bank failed (excluding funds later paid out in liquidation procedures)? (24) If a customer has multiple loans and one loan is classified as
non-performing, are the other loans automatically classified as non-performing?
Note: The individual questions and answers were obtained from the World Bank database developed by Barth et al. (2001a, 2006, 2008) and Cihak et al. (2012).

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