Inflation targeting and bank risk: The interacting effect of institutional quality

Louati, Salma; Boujelbene, Younes Article Inflation targeting and bank risk: The interacting effect of institutional quality Cogent Business & Management Provided in Cooperation with: Taylor & Francis Group Suggested Citation: Louati, Salma; Boujelbene, Younes (2020) : Inflation targeting and bank risk: The interacting effect of institutional quality, Cogent Business & Management, ISSN 2331-1975, Taylor & Francis, Abingdon, Vol. 7, Iss. 1, pp. 1-15, https://doi.org/10.1080/23311975.2020.1847889 This Version is available at: https://hdl.handle.net/10419/245007 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Full Terms & Conditions of access and use can be found at https://www.tandfonline.com/action/journalInformation?journalCode=oabm20 Cogent Business & Management ISSN: (Print) (Online) Journal homepage: https://www.tandfonline.com/loi/oabm20 Inflation targeting and bank risk: The interacting effect of institutional quality Salma Louati & Younes Boujelbene | To cite this article: Salma Louati & Younes Boujelbene | (2020) Inflation targeting and bank risk: The interacting effect of institutional quality, Cogent Business & Management, 7:1, 1847889, DOI: 10.1080/23311975.2020.1847889 To link to this article: https://doi.org/10.1080/23311975.2020.1847889 © 2020 The Author(s). This open access article is distributed under a Creative Commons Attribution (CC-BY) 4.0 license. Published online: 26 Nov 2020. Submit your article to this journal Article views: 445 View related articles View Crossmark data BANKING & FINANCE | RESEARCH ARTICLE Inflation targeting and bank risk: The interacting effect of institutional quality Salma Louati 1 * and Younes Boujelbene 1 Abstract: This paper investigates whether institutional quality determines the effect of inflation targeting (IT) on the banking risk of Islamic versus conventional banks, using an unbalanced panel data over the period 2007–2016. However, the use of the generalized method of moments (GMM) and two measures of institutional quality, namely the Corruption Perception Index and the Government Effectiveness Index, show that the institutional quality failures strengthens the negative impact of IT on conventional banking risk. For the Islamic banking business model, results suggest that corruption impair the good functioning of the price stability channel of financial stability. While IT have different impact on Islamic and conventional banking stability, the operation of these two types of banks in the same corrupt environment reduces the positive effects expected from such a monetary policy. Subjects: Social Sciences; Economics, Finance, Business & Industry; Finance; Corporate Finance; Banking; Business, Management and Accounting; Risk Management Keywords: Islamic banks; financial stability; IT; quality of institutions 1. Introduction Since the early 90s, IT has become the most suitable strategy for fighting inflationary pressures and therefore ensuring the proper conduct of monetary and exchange rate policies. This practice has been adopted by a large number of central banks around the world, particularly in emerging economies (Lucotte, 2015). ABOUT THE AUTHORS Salma Louati holds a PhD in Finance and now she a student researcher in Applied Economics at the Research Unit of the Faculty of Economics and Management of Sfax, Tunisia. She is also a corresponding author, whose skills and expertise are developing around corporate finance and, more particularly, banking and finance, banking risk management and financial crises. Younes Boujelbene is a Professor at the Faculty of Economics and Management of Sfax, Tunisia. He is specialized in financial economics, econometrics, risk management and insurance. PUBLIC INTEREST STATEMENT To stabilize the inflation rate close to the target value, the central bank uses its instruments, such the interest rates, to regulate the monetary aggregates, which are considered to be the main determinants of inflation in the long term. In fact the adjustment of the interest rate can have an impact on the stability of the banking system. Within this framework, our study focuses on the impact of an inflation-targeting monetary (IT) policy on the stability of both conventional and Islamic banks by stressing the role of the institutional quality. Our results also show that implementing an IT system in an economic environment characterized by the spread of corruption and government inefficiency can destroy the stability of the banking system. Moreover, although Islamic banks are immune from the interest rate risk, a fallen institutional quality impedes the positive effects of IT. Louati & Boujelbene, Cogent Business & Management (2020), 7: 1847889 https://doi.org/10.1080/23311975.2020.1847889 Page 1 of 15 Received: 29 May 2020 Accepted: 01 November 2020 *Corresponding author: Salma Louati, Faculty of Economics and Management, University of Sfax, 3042 Sfax, Tunisia E-mail: [email protected] Reviewing editor: David McMillan, University of Stirling, Stirling, UK Additional information is available at the end of the article © 2020 The Author(s). This open access article is distributed under a Creative Commons Attribution (CC-BY) 4.0 license. In fact, the growing enthusiasm of central banks in the emerging economies for IT is mainly explained by the difficulties encountered by the monetary authorities of these countries in conducting their monetary and exchange rate policies during periods of high inflation. In this sense, Lucotte (2015) indicates that, for a central bank, an IT strategy does not consist only in announcing a target rate but also in implementing a whole framework based on three main characteristics. First, the central bank must assign a numerical inflation target and a precise horizon for achieving this target. Second, it must adjust its instruments on the basis of a set of macroeconomic and financial indicators (Bordes & Clerc, 2007). Finally, it must make vigorous efforts to improve transparency and communication with financial market participants. 1 The traditional view of IT (the Schwartz, 1995 hypothesis) argues that price instability may lead to incorrect lending/borrowing decisions, increasing loan defaults, compromising the banking system loan portfolio, and increasing bankruptcies. In this context, De Guimarães e Souza et al. (2016) confirm that the adoption of IT implies gains in economic growth. Moreover, in the case of developing economies, De Mendonça and De Guimarães e Souza (2012) suggest that the IT is an effective monetary regime in reducing the volatility of inflation to internationally acceptable levels. Despite the development of the IT strategy and the successful experiences of industrialized economies that have already adopted it, the global financial crisis has proven that this prospective is not always true. Indeed, the relatively low and stable inflation of the early 2000s did not prevent the global economy from experiencing a housing price bubble that burst in 2008. In this framework, Ftiti et al. (2017) tested the efficiency of the IT regime in terms of economic performance. Their results showed that in some emerging countries where inflation is a topical challenge, this monetary policy ensures price stability with a sustainable growth (Ayres et al., 2014; Ftiti & Hichri, 2014; De Mendonça & De Guimarães e Souza, 2012; Öztürk et al., 2014). However, in the case of the industrialized countries, their results revealed that the monetary policy sacrifices economic growth despite price stability. This last result is important because it justifies the criticisms of Stiglitz (2008) and Blanchard et al. (2010) who pointed out that this monetary regime contributed to the Great Depression following the subprime crisis. Among others, analysts showed that the commitment to low inflation levels makes the economic policy too loose in normal times. Thus, the policy rate approaches the zero lower-bound, reducing the margin for any adjustment of the interest policy rates should any economic downturn arise. Moreover, it is widely argued that central banks in the IT-countries have been less concerned with the development in the financial markets and therefore did not respond to financial imbalances. For their part, Giavazzi and Giovannini (2010) illustrate this debate by noting that “[. . .] the crisis has taught to us that central banks, when they set interest rates, should also be concerned about the fragility of the financial system”. On the other hand, in a study of 70 countries over the 1998–2012 period, Fazio et al. (2015) showed that the greater strength of banks operating in countries where inflation is a target is not essentially due to the implementation of such a monetary policy. In fact, the authors explain this finding by the pre-crisis dichotomy between the monetary policy and financial stability that led the authorities to conduct these two policies separately. Referring to the work of Mishkin (2011), Fazio et al. (2015) stated that central banks are not accustomed to including financial vulnerability in their general equilibrium models, which means that they do not believe that financial stability is a condition for the promotion of price stability. In the same context, Castro (2011) studied the extent to which the Central Bank of England, the Fed, and the European Central Bank focus on the financial imbalance when adopting the IT strategy. His findings showed that only the European Central Bank seems to tighten its policy stance in the presence of increasing financial imbalances Notwithstanding this criticism, the adoption of IT raises a number of questions, particularly in the emerging economies, among which is the institutional framework of these countries. Indeed, the emerging economies are generally characterized by relatively marked institutional weaknesses which can interfere with the conduct of the monetary policy. For this reason, the need for an institutional framework in line with the objective of price stability is crucial under penalty of tarnishing the credibility of the monetary policy, and therefore its effectiveness. Louati & Boujelbene, Cogent Business & Management (2020), 7: 1847889 https://doi.org/10.1080/23311975.2020.1847889 Page 2 of 15 In this paper, we aim at revisiting the effect of IT and bank’s stability by highlighting the role of the quality of the institution and distinguishing between Islamic and conventional banks. More particularly, we seek to address the following fundamental questions; (i) to what extent is institutional quality involved in the relationship between IT and banking fragility? (ii) are Islamic banks immune from the harmful effects of IT? In fact, this paper, which is built upon these two issues, has to receive substantial attention in the academic literature, as it can fill the gap in the Islamic banking literature by examining whether IT affects the banking system stability and if so, is this effect caused by the quality of institutions. To the best of our knowledge, this is the first survey to consider this pattern in the Islamic banking industry. Indeed, if both Islamic and conventional banks are part of the same financial system, then any instrument of monetary policy is expected to affect both types of banking systems (Raza, Shah et al., 2019). Therefore, our choice of the Islamic banking industry was not arbitrary since Islamic banks are commonly synonymous with interest-free banks operating in an interest-free system, which is one of the important things differentiate them from the conventional banks or the interest-based ones. Therefore, the Central Bank uses its instruments, such as the interest rates, to regulate the monetary aggregates, which are considered to be the main determinants of long-term inflation. In fact, the control of the monetary aggregates should help stabilize the inflation rate at the target value. However, such practices may have repercussions on the state of health of conventional banks, which is something still ambiguous in the case of Islamic banks. Therefore, using a sample of two different types of commercial banks, Islamic and conventional banks, this paper is intended to find out if IT has an eventual effect on Islamic bank’s financial stability, to examine whether the quality of institutions has any effect on the IT-stability nexus. According to the banking literature, financial stability and bank risk-taking are assessed through a variety of indicators. In fact, some studies, such as those of Pessarossi et al. (2020), Cole and White (2012) and Betz et al. (2014), used profitability as a determinant variable of financial distress. In another study, Liang et al. (2020) tested the theory of Wagner (2010) to explore the impact of diversification on banking risk. For all what has been previously said, we included in our regression a set of bank and country-specific control variables to account for the characteristics that affect banking risk-taking behavior. To achieve our purpose, we have employed two institutional quality measures, namely the corruption perception index of the international transparency, and the government effectiveness index of the World Bank’s Governance Indicators (WGI). Moreover, we specify an interaction term between these variables with dummies to check whether a specific country has adopted IT. Additionally, we used a split sample analysis to explore the differences between the two banking business models. Thus, our results show that the implementation of a monetary policy based on IT can threaten the stability of conventional banks. This result can be explained by the credibility paradox according to which unsustainable booms take longer to be discovered by central banks that have adopted this strategy. Nevertheless, in the case of Islamic banks, IT can promote banking stability provided that institutional quality is strengthened. The remainder of this paper proceeds as follows. Section 2 reviews the relevant literature, Section 3 describes the data and the methodological framework then, Section 4 discusses the results and finally, Section 5 concludes the paper. 2. Literature review The literature offers a great number of studies that compared the financial characteristics of Islamic banks to those of their conventional peers, especially in terms of stability (Anginer et al., 2014; Beck et al., 2013; Berger et al., 2009; Ghosh, 2016; Louati et al., 2016), profitability (Alexakis Louati & Boujelbene, Cogent Business & Management (2020), 7: 1847889 https://doi.org/10.1080/23311975.2020.1847889 Page 3 of 15 et al., 2019; Kusumastuti & Alam, 2019; Mimouni et al., 2019; Rashid & Jabeen, 2016), efficiency (S. A. Srairi, 2010; Alqahtani et al., 2017; Bitar et al., 2017; Johnes et al., 2014, 2014; Saeed & Izzeldin, 2016) and credit risk (Ghenimi et al., 2017; Louhichi et al., 2019). For instance, Beck et al. (2013) used an array of different variables to compare Islamic and conventional banks’ soundness. More particularly, they employed an indicator of maturity matching the ratio of liquid assets to deposit and short-term funding to assess the sensitivity to bank runs. In fact, they found that Islamic banks are more stable than their conventional counterparts. The authors also showed that the good quality of Islamic bank’s assets and their well funding is behind this result. In addition, Abedifar et al. (2015) indicated that small Islamic banks, as opposed to conventional banks, have higher stability rates. Similarly, in a recent survey, Alqahtani and Mayes (2018) have added evidence that, during an economic downturn period, small Islamic banks can efficiently manage their insolvency. Within the same context, and using the E-GARCH and GJR-GARCH estimation techniques, Caby and Boumedienne (2013) reported that Islamic banks’ stock returns are less volatile than those of conventional banks, suggesting that Islamic banks are more stable. Moreover, the study of Louhichi et al. (2019) is along this line on this research as it combines the regulatory factors and market competition to explain Islamic and conventional banks’ stability. However, other studies, namely the one of Bourkhis and Nabi (2013), have examined the financial soundness of Islamic and conventional banks. In addition to the measures related to banks’ capitalization, a number of indicators related to the asset quality and profitability provide complementary information about the health of the bank. However, the authors reported no significant differences between the two banking business models. Furthermore, Another strand of the literature considers competitiveness as an important indicator of banking stability. According to a comparative approach of Islamic and conventional banks, Kabir and Worthington (2017) as well as Louhichi et al. (2019) analyzed the trade-off between competition and financial stability. In fact, the authors supported the competition– fragility hypothesis by providing empirical evidence of a positive link between banking market concentration and bank’s risk taking incentives for both business models. In the context of a comparative study opposing Islamic banks to conventional ones, and in another strand in the literature, among others, Abedifar et al. (2013), Bitar et al. (2016), Alqahtani et al. (2017), Johnes et al. (2014), S. Srairi (2013, 2019)raised questions about efficiency using the cost to income ratio and efficiency scores. While prior studies in the field of Islamic banking have been primarily concerned with identifying their risk, efficiency, and profitability, profiles and comparing them to those of conventional banks, little research has been conducted to examine whether IT has any effect on the banking system stability and risk and whether this relationship is affected by countries’ institutional quality. In fact, from a theoretical perspective, the adoption of IT driven by action on the interest rate cannot pass without effect on banking stability. In fact, raising the key rate risks eliminating the most solvent part of the customer’s base, which implies the deterioration of the banking portfolio quality and, consequently, the increase of risk. In the context of Islamic banks, Bitar et al. (2017) investigated whether and how political systems affect the financial soundness of the two banking system models. Their findings revealed that Islamic banks underperform their conventional counterparts in more democratic political systems but outperform them in hybrid and Sharia’a-based legal systems. In addition, Shah and Rashid (2019) investigated the impact of monetary policy on the credit supply of Islamic versus conventional banks of Malaysia. The authors provide strong evidence on the existence of the credit channel of monetary policy transmission mechanism. They also suggested that Islamic banks are less vulnerable to changes in monetary policy instruments compared to their conventional counterparts. In fact, an examination of the existing relevant literature clearly revealed that the research studies that dealt with the IT–financial stability nexus are very rare. To our knowledge, the study of Louati & Boujelbene, Cogent Business & Management (2020), 7: 1847889 https://doi.org/10.1080/23311975.2020.1847889 Page 4 of 15 Frappa and Mésonnier (2010) is the only existing study that comparatively investigated the state of the financial system in targeting versus non-targeting countries. Relying on a sample of 17 advanced economies, their empirical analysis showed that IT is associated with higher real house prices and price-to-rent ratio. Considering the latter as indicators of financial instability implies that the financial sector is relatively less stable in countries implementing the IT regime Actually, the closest paper to ours is the one of Fazio et al. (2018). Using bank-level data from 66 countries over the 1998/2014 period, the authors showed that IT is found to have a stabilizing effect, especially for banks operating in countries where institutions are perceived to have average levels of quality. Within this context, Fouejieu (2017) investigated whether in the emerging markets inflation targeters are more financially vulnerable than their non-targeting peers. In fact, based on a sample of 26 emerging countries including 13 targeters, the author stated that the monetary policy in these targeting countries is relatively more sensitive to financial risks while Fazio et al. (2015) compared the risk-taking behavior of banks in IT countries to that of their counterparts from non-IT countries. Their results revealed that banks operating in IT countries have an enhanced stability, which enables them protect themselves during global liquidity shortages Periods. Simultaneously, Hove et al. (2017) included other institutional quality variables, such as central banks’ independence, fiscal discipline and financial sector development, to investigate the extent to which these variables can influence the ability to achieve inflation target bands. They added that the improvement of institutional quality can bring about some important elements in favor of inflation target bands. Regarding the relationship between institutional quality and banking stability, Bermpei et al. (2018) showed that regulatory instruments (with the exception of the supervisory power) can efficiently act on banking stability only if they are of good institutional quality. As for Houa and Wang (2016), they investigated the relationship between banking marketization and banking stability across different levels of institutional quality in China. Their results showed that an improvement of the institutional quality can reduce the adverse influence of banking marketization on banking stability. On a panel of 37 emerging markets and 21 advanced economies over the 2000/2015 period, Bui and Bui (2019) argued that financial openness can force domestic banks to behave more prudently only when legal systems, market discipline, and transparency are reliable. In other words, the impact of financial openness on banks’ risk-taking behavior depends on the development of institutions. 3. Empirical approach 3.1. Data and variables description The empirical analysis in this paper, which is based on a sample of 42 conventional banks and 15 Islamic ones, covers the 2007/2016 period. Therefore, since our main objective is to test the impact of IT on banking risk, we selected data from a cross-country sample that adopted IT and of which banking system includes both Islamic and conventional banks. A detailed description of these banks’ distribution per country and type is provided in the Appendix A (Table A1). Moreover, the data related to financial information are extracted from DataStream while the information about the quality of institutions and the macroeconomic variables, which indicated in Table 1, are extracted from several sources. 3.2. Applied methodology In this section, we explain the main empirical model, the employed variables and their sources. To scrutinize the “ITBanking risk” nexus, we used a dynamic panel data. This approach enabled us to examine the joint endogeneity of the explanatory variables through the use of internal instruments, namely the Arellano and Bover (1995), Blundell and Bond (1998) system, the GMM estimator (Cooray & Schneider, 2016). With reference to previous literature (Belkhir et al., 2019; Fazio et al., 2018; Shah & Rashid, 2019), we constructed the following equation: Louati & Boujelbene, Cogent Business & Management (2020), 7: 1847889 https://doi.org/10.1080/23311975.2020.1847889 Page 5 of 15 Zscore=Riskikt ¼α0þαiþαtþβ1Zscore=Riskikt1þβ2ITkt þβ3Quality Instkt þβ4Quality Instkt2þβ4ITkt �Quality Inst þ�δzXz;ikt þeikt where Zscore=Riskikt is the stability or risk-taking proxy for the specific bank i that operates in country k at period t. ITkt is a dummy variable that takes the value of one if the country k is an inflation targeter during period tand zero otherwise; QualityInstkt is a measure of the quality of institutions, then QualityInstkt2 is the quadratic term for the quality of institution measure which is introduced to capture a possible non linear relationship between this latter and the depended variable. While Xz;ikt is a vector of countryand bank-specific controls. And finally, αi and αt are bank and time fixed effects, respectively (Fazio et al., 2018). Table 1. Variables description and data sources Variable Description Source Z-score a Zscoreit ¼ROAit þCARit σROAit Where ROAit is the return on assets for bank i at time t. CARit is the amount of equity to assets ratio of bank i at time σROAit is computed as the standard deviation of return on assets within each individual bank time t. Author calculation σROA The standard deviation of return on assets Datastream IT A dummy variable which takes the value of one if the bank operates in an IT country k during year t IMF website, Roger (2010) Authors’ own research. Quality of government institutions Corruption The Corruption Perception Index provide a measure of the corruption perceived level in several countries on a scale ranging from 10 to zero. In particular, higher index values imply the more a country’s citizens perceive their government as transparent and accountable. The transparency International Government effectiveness This measure used in several empirical studies to assess the quality of public services, of civil services, and of policy formulation and implementation, as well as the extent of the government’s commitment to these policies. This indicator ranges from −2.5 (weak effectiveness) to 2.5 (strong effectiveness). The World Bank’s Governance Indicators (WGI). Bank-specific variables Bank Size (size) Natural logarithm of total assets Datastream Liquidity ratio Liquid assets/Total assets Datastream Cost performance Costs/Total assets Datastream Diversification Non-interest income/total income Datastream HHI The Herfindahl–Hirschman Index is a traditional measures of concentration which is calculated by adding up the squares of the market shares of all banks using total assets (Ariss, 2010; Louhichi et al., 2019). Datastream Macroeconomic variables Prop.righ Property rights Heritage Foundation Fin.free Financial freedom index Heritage Foundation GDPgr Annual Gross domestic product growth rate World Bank CPI The consumer price index World Bank a Zscoreit which is is computed referring to Louhichi et al. (2019), provides a measure of banking soundness where a higher value implies a high degree of bank solvency and vice versa (Clark et al., 2018). Referring to Louhichi et al. (2020), σROAit is calculated over the full sample period. Louati & Boujelbene, Cogent Business & Management (2020), 7: 1847889 https://doi.org/10.1080/23311975.2020.1847889 Page 6 of 15 4. Empirical analysis 4.1. Summary statistics First, we present the scatter plots of Islamic and conventional bank’s average stability measures against the average corruption perception index for IT and non-IT countries, which are presented in Figures 1 and 2, respectively. In fact, in both figures, we notice that the format of the scatter plots for both types of banking business models appears to suggest an inverse U-shaped relationship between banking stability and the quality of institutions. Furthermore, since the corruption perception index is inversely related to the level of the quality of institutions, we can conclude that low and high values of the corruption perception index usually have a lower Z-score, that is, a higher fragility. Moreover, we notice that the average financial stability of the conventional banks appears to be higher than that of their Islamic counterparts, but only in IT countries. 4.2. Empirical results This paper investigates the extent to which the quality of institutions can alter the IT-banking stability nexus. Since IT coincides in the two banking business models, we mainly intend to test if one solution fits both of them. Therefore, to determine whether IT has an indirect effect on banking soundness, as channeled through institutional quality, we incorporate interaction terms Figure 1. Scatter plots of the Islamic and conventional banks’ average stability measures against the average corruption perception index for IT countries. Figure 2. Scatter plots of the Islamic and conventional banks’ average stability measures against the average corruption perception index for non-IT countries. 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Journal of Financial Intermediation, 19(3), 373–386. https://doi.org/10. 1016/j.jfi.2009.07.002 Louati & Boujelbene, Cogent Business & Management (2020), 7: 1847889 https://doi.org/10.1080/23311975.2020.1847889 Page 14 of 15 Appendix A. © 2020 The Author(s). This open access article is distributed under a Creative Commons Attribution (CC-BY) 4.0 license. You are free to: Share — copy and redistribute the material in any medium or format. Adapt — remix, transform, and build upon the material for any purpose, even commercially. The licensor cannot revoke these freedoms as long as you follow the license terms. Under the following terms: Attribution — You must give appropriate credit, provide a link to the license, and indicate if changes were made. You may do so in any reasonable manner, but not in any way that suggests the licensor endorses you or your use. No additional restrictions You may not apply legal terms or technological measures that legally restrict others from doing anything the license permits. Cogent Business & Management (ISSN: 2331-1975) is published by Cogent OA, part of Taylor & Francis Group. Publishing with Cogent OA ensures: • Immediate, universal access to your article on publication • High visibility and discoverability via the Cogent OA website as well as Taylor & Francis Online • Download and citation statistics for your article • Rapid online publication • Input from, and dialog with, expert editors and editorial boards • Retention of full copyright of your article • Guaranteed legacy preservation of your article • Discounts and waivers for authors in developing regions Submit your manuscript to a Cogent OA journal at www.CogentOA.com Table A1. Sample banks distributed by IT country and bank type Country IT Adoption CB IB Turkey Yes 2006 14 3 Bangladesh 9 2 Indonesia Yes 2005 6 3 Malaysia 13 7 Sum 42 15 Louati & Boujelbene, Cogent Business & Management (2020), 7: 1847889 https://doi.org/10.1080/23311975.2020.1847889 Page 15 of 15