Corruption and Bank Stability

Emerging Markets Finance and Trade
ISSN: 1540-496X (Print) 1558-0938 (Online) Journal homepage: http://www.tandfonline.com/loi/mree20
Corruption and Banking Stability: Evidence from

Emerging Economies
Tudorel Toader, Mihaela Onofrei, Ada-Iuliana Popescu & Alin Marius Andrieș
To cite this article: Tudorel Toader, Mihaela Onofrei, Ada-Iuliana Popescu & Alin Marius Andrieș
(2017): Corruption and Banking Stability: Evidence from Emerging Economies, Emerging Markets
Finance and Trade, DOI: 10.1080/1540496X.2017.1411257
To link to this article: https://doi.org/10.1080/1540496X.2017.1411257
Accepted author version posted online: 15

Dec 2017.
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Download by: [Gothenburg University Library] Date: 15 December 2017, At: 19:29
Corruption and Banking Stability: Evidence from Emerging
Economies
Tudorel TOADER
Faculty of Law, Alexandru Ioan Cuza University of Iasi, 11 Carol I Boulevard, Iasi 700506,
Romania, Email: ttoader@uaic.ro
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Mihaela ONOFREI
Faculty of Economics and Business Administration, Alexandru Ioan Cuza University of Iasi, 22
Downloaded by [Gothenburg University Library] at 19:29 15 December 2017
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Carol I Boulevard, Iasi 700505, Romania, Email: onofrei@uaic.ro
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Ada-Iuliana POPESCU
Faculty of Economics and Business Administration, Alexandru Ioan Cuza University of Iasi, 22
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Carol I Boulevard, Iasi 700505, Romania, Email: ada.popescu@uaic.ro
Alin Marius ANDRIE•

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Research Center in Finance and Faculty of Economics and Business Administration, Alexandru
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Ioan Cuza University of Iasi, 22 Carol I Boulevard, Iasi 700505, Romania, Email:
alin.andries@uaic.ro. Corresponding author
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Abstract:
This paper investigates the effect of corruption on banking stability using data from banks
in emerging markets. The analysis first reveals that a lower level of corruption had a
positive impact on bank stability and is associated with fewer credit losses and with more
moderate credit growth. It then highlights the importance of bank and country
characteristics in identifying the asymmetric effects of corruption on bank stability. Our
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evidence suggests that stability of banks that are acting in a country that has not adopted
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a corporate governance code or is not a member of the European Union is affected more
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by the corruption. Also, in countries with higher levels of corruption banks could increase
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their stability if they implement rigorous corporate governance practices.
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Keywords: Bank stability, bank risk-taking, corruption, governance.
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JEL Classification: G21, D73.
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Acknowledgement:
Andrieș gratefully acknowledge the financial support from the Romanian National Authority for
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Scientific Research and Innovation, CNCS – UEFISCDI, project number PN-II-RUTE-2014-4-

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0443.
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1. Introduction
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During the last decade corruption has become a common target for international
organizations, national governments, non-governmental organisations and other entities
that recognized the great perils that it brings to political, economic and social life.
Corruption weakens political legitimacy and stability, economic development and social
welfare. Corruption manifests itself in public and private sector alike, affecting the life of
us all, but especially the lives of the poor. International organizations such as United
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Nations (1997), World Bank (2014), Organization for Economic Cooperation and
Development (2014), Council of Europe (2013), and the European Union (2013) draw
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attention on the adverse effects of corruption on economy: the increase of production cost,
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the decrease of national and foreign investment, the inefficient allocation of national
resources that generate greater social inequality and poverty.

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The negative effects of corruption on economy have been extensively analyzed by
researchers during the last 20 years in comprehensive studies. It is a well-documented fact

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that corruption triggers government inefficiency, negatively impacting on long-term

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economic growth and sustainable development1. The significance of institutional quality
on financial development and stability has long been recognized. Previous studies stress
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the importance of institutions that enforce and secure property rights for financial
development (Beck and Levine, 2008) and the probability of financial fragility being
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positively associated with weaker institutions (Demirgüç-Kunt and Detragiache, 1998).
The banking system plays a primary role in every economy as it helps to channel
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the resources from the agents that have a surplus to those that have a deficit. The recent
studies on this topic show a direct relationship between capital allocation and economic
growth (see for instance Levine, 1997; Levine, 2005; Rousseau and Yilmazkuday, 2009).
A major impediment with respect to bank capital allocation is the corruption issue and its
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This idea is sustained by many studies, e.g. Murphy et al. (1993), Mauro (1995), Wei (2000), Mo (2001),
Méon and Sekkat (2005), Podobnik et al. (2008), Johnson et al. (2011).
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impact on bank risk-taking, bank performance, and bank lending that has raised the
interest of academics. As suggested by Lien (1990), an economy may be affected by
allocation inefficiencies due to the discrimination driven by the corruption. Furthermore,
Wei (2000) finds that an increase in the corruption level has a negative impact on the
foreign direct investment amounts.
Commonly, corruption is defined as the abuse of public or corporate office for
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private gain (Bhargava, 2005). It is an endemic problem that entails a lot of undesirable
consequences, especially in emerging countries (Chen et al., 2015). These countries

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usually have undeveloped stock markets and access to finance that is usually assured by
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the banking system. Therefore, understanding how corruption affects bank activity and
what are the core roots of such behavior may help regulatory agencies to fight and to
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reduce corruption, and further to improve bank lending and economic growth.
Furthermore, a country’s regulatory culture is determined largely by inherited

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ethical norms and practices (Kane, 2012). Thus, its individual and country-wide
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institutional and governance quality affects the bank stability and bank risk-taking
behavior (Beltratti and Stulz, 2012; Klomp and de Haan, 2014). Seminal work by Barth et
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al. (2004), La Porta et al. (1998) and Levine (1998) show that countries lacking a sound
legal system and good governance might have weaker banks due to corruption or
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inefficient enforcement of law and government ineffectiveness. Fernández and González
(2005) report that the probability of a banking crisis is positively associated with weaker
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institutions, especially those related to the rule of law, the level of corruption, and contract
enforcement. The recent global crisis has highlighted the role of prudent supervision and
regulation in the financial system on both national and global scale (Özkan-Günay et al.,
2013).
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Regulation and institutional quality can be considered as a complementary,
external governance force that may be particularly relevant for banks with weak internal
governance (Beck et al., 2006). Previous studies suggest that bank risk-taking responds to
changes in domestic regulation and supervision (Barth et al., 2004; Buch and DeLong,
2008). Also, even though the existent literature has assigned precise causes to bank risk-
taking, such as bank regulation (Laeven and Levine, 2009), monetary policy (Altunbas et
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al., 2010), market competition (Beck et al., 2013), or the deposit insurance scheme
(Demirguc-Kunt and Detragiache, 2002), corruption may also determine a significant

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risk-taking level in the banking sector.
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Corruption has detrimental effects on bank risk-taking and lending activity
because it may lower the efficiency of the capital allocation mechanism from banks to the
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economy, through higher-productive investment projects (Barry et al., 2016). Also,
lending corruption is very costly for the economy because it means that banks finance less
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efficient projects of firms that pay bribes or use other types of corruption to receive a loan
(Barth et al., 2009).

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Corruption and its effects on the banking system are important to be studied in the
light of the recent financial crisis (Park, 2012) because it may help at gaining more
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insights about the determinants of such a crisis. Chen et al. (2015) argue that there is
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limited research on the impact of corruption on banking activity, especially on the
willingness of them to take risks. Also, they argue that corruption affects more less-
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developed than higher developed economies. After the financial crisis, lending by banks
suffered a severe fall (Ivashina and Scharfstein, 2009) and corruption may have an
important role in shaping the lending behavior of banks.
Furthermore, analyzing the impact of corruption on bank stability and soundness is
important because knowing the factors that influence this relationship may help central
authorities to find ways of reducing corruption. However, even bank supervisors or bank
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controlling shareholders may make abuse of their power and get involved in corrupt
actions that may negatively influence the bank stability and risk (Barth et al., 2009; Beck
et al., 2006). Moreover, the importance of the nexus between corruption and bank risk and
stability is increased in a world in which the well-functioning of the banking system
through its lending activity promotes output growth and economic stabilization (Houston
et al., 2011). Also, the negative effects of corruption are amplified in a world with very
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low interest rates, as we witnessed after the 2008 financial crisis (Chen et al., 2015).
We consider that the impact of bank lending corruption should be known by the
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regulators in order to adopt the most appropriate measures to reduce it. This is because
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they need to know the extent to which their measures will have the expected effects.
Additionally, it is of high importance to acknowledge and reduce the detrimental effects

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of corruption on bank stability, since they may sow the seeds for a future financial crisis.
Moreover, we consider that the increased inter-connectivity between markets and banking
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systems may call for policy coordination regarding the ways of fighting and reducing
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corruption.
In recent decades, the banking sectors of Central and Eastern European (CEE)
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experienced an extraordinary credit boom and bust cycle. In the period prior to the
financial crisis (2001–2008) annual growth of private credit averaged 39 percent with a
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peak of 52 percent in 2007. The credit boom in Eastern Europe far exceeded that in other
regions but ended abruptly with the financial crisis of 2008, the crisis led to a significant
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decline in bank lending (Cull and Martínez Pería, 2013) and left a legacy of credit losses
in the region, non-performing loans in the CEE region increased to 11 percent in 2011
(Andrieș and Brown, 2017). The conditions in CEE countries created unprecedented
opportunities for researchers because, in the described setting, the strengths and
weaknesses of institutional arrangements and governmental and regulatory policies were
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exposed (Allen et al., 2017). This paper attempts to establish how corruption affects the
banks stability using data from this region. The vital role of banks in these economies
encompasses their participation in the payment system, the transmission of monetary
policy, and the provision of credit. Thus, any market failure, inefficiency, or
anticompetitive conduct among banks, is likely to impose more severe costs throughout
the economy than would similar defects in other industries (Delis, 2010).
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Given these aspects, the purpose of this paper is to give more insights on how the
level of corruption influences the bank risk-taking and thus, to enrich the existing
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literature. Our results firstly reveal that a lower level of corruption had a positive impact
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on bank stability. Also, we found evidence that corruption significantly deteriorates the
quality of bank loans and is associated with more moderate credit growth. Secondly, our
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evidence suggests that stability of banks that are acting in a country that has not adopted a
corporate governance code or is not a member of the European Union is affected more by
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the corruption. Also, in countries with higher levels of corruption banks could increase
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their stability if they implement rigorous internal corporate governance practices.
Moreover, banks benefit more from better corruption control (less corruption) during the
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crisis than during normal times.
The paper makes three contributions to the literature on corruption measures and
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their impact on banks. Firstly, in contrast to previous studies those have been focused on
non-performing loans or loan growth, we are using Z-score as a main indicator for bank
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stability. The Z-Score is by far the most widely used in the literature for estimating the
overall bank solvency (Bolton et al., 2015; Fiordelisi and Mare, 2014; Laeven and Levine,
2009). Also, the World Bank is using Z-score indicator to proxy for financial stability for
the overall banking sector (The Global Financial Development Database - World Bank).
Second, unlike previous studies, we study whether banks react differently to the
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corruption depending on some bank and country governance and regulation
characteristics. Our results reveal that in countries with higher levels of corruption banks
could increase their stability if they implement rigorous corporate governance practices.
Third, our paper analyzes the impact of corruption on bank stability for a more recent
period that allow us to check if banks benefit more from better corruption control during
crises than during normal times.
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The rest of the paper is organized as follows. Section 2 outlines key characteristics
of the corruption in Central and Eastern Europe. Section 3 provides an overview of the
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theoretical and empirical literature on the determinants of bank risk-taking and of bank
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lending corruption, and the empirical background of the nexus between corruption and
bank activity. Section 4 describes the data and econometric methodology, while Section 5
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presents the results of the empirical analysis. Finally, Section 6 summarizes our findings.
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2. Corruption in Central and Eastern Europe

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In Europe, all countries are struggling with corruption. Their vulnerability to

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corruption varies depending on a cumulus of political, economic, social and cultural

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factors. However, in comparison with Western European countries, in Central and Eastern
European countries corruption is widespread often being systemic and endemic. Illegal
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behavior such as bribery, conflicts of interest, traffic of influence, defalcation and the like
is common in Eastern European countries.
Corruption in Eastern Europe has contaminated both public and private sector.
Studies and reports show that some public sector areas are most prone to corruption than
others, such as political party and elections funding, public procurement, public
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administration, health care, training and education. Also, the private sector is weakened
by bribery given in order to secure a business advantage on a foreign market.
Over the years, efforts to globally fight corruption were concentrated in legislation
such as the United Nations Convention against Corruption (UNCAC), the Organization
for Economic Cooperation and Development Convention on Combating Bribery of
Foreign Public Officials in International Business Transactions (“OECD Convention”),
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and the Council of Europe Criminal and Civil Law Convention on Corruption. Central
and Eastern European countries reacted to these international efforts to fight corruption.
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Many have signed and ratified the United Nations, OECD and Council of Europe
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conventions against corruption, and also were and are involved in different anti-corruption
cooperation programmes that are targeting the causes and effects of corruption. As a
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result, the majority of Eastern European countries have developed multiple prong anti-
corruption strategies that focus on transparency, fairness, integrity, accountability of

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governance and a sound business environment.

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Central and Eastern European EU members have implemented the required legal
and institutional instruments to fight corruption and could lead by example the other non-
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member countries from the same geographical area. However, the positive results are not
evident due to different national impediments, the most common being the lack of
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political will, human and financial resources.
According to Transparency International, some EU members such as the Czech

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Republic, Bulgaria, Romania, Slovakia, and Slovenia stand out among countries
perceived to have increased corruption (Mulchany, 2012). Also, according to OECD,
since 2004, when the Czech Republic, Hungary, and Slovakia joined the EU, they have
been regressing in the fight against corruption because in spite of their relatively robust
legislation, its enforcement is poor (OECD, 2012).
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The anti-corruption fight in Central and Eastern European countries has produced
mixed results mostly due to old habits triggered by an inherited social mentally, poverty,
lack of education, political instability, lack of information, lack of legislation and its
inconsistent and inconsequent enforcement. According to Eurobarometer, some
respondents from Central and Eastern Europe perceive corruption as widespread in their
country: Czech Republic and Lithuania (95%), Croatia (94%), Romania (93%), Slovenia
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(91%) and Slovakia (90%). (Eurobarometer Report, 2014).
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3. Literature review
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This section presents the elements from the literature on the effects of corruption
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on bank stability and risk-taking behavior. Despite its importance, there are surprisingly
few studies, either theoretical or empirical, on the impact of corruption on banks` stability
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and risk-taking.
The existing literature is ambiguous on the effects of corruption on bank activity.

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Based on the law and finance theory pioneered by La Porta et al. (1997), we would expect
corruption to reduce bank credit. In their seminal paper, Beck et al. (2006) make a firm-
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level study to analyze the extent to which bank supervisory policies influence the degree
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to which corruption of bank officials prevents firms from receiving external finance. Their
results support the “supervisory power view” because they find that supervisory power
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increases corruption in bank lending activity. These results are also consistent with Barth
et al. (2009). Also, Beck et al. (2006) support the “private empowerment view” because
private monitoring of banks has a positive impact on bank lending activity, especially in
countries with stable and strong legal systems. Barth et al. (2009) find that bank
competition and information sharing have a positive impact on lending corruption, since
they help reducing it. Also, they find that lending corruption is lower in case of
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government-owned banks and these results are in contrast to the Barry et al. (2016)`s
results. Also, Barth et al. (2009) find that strong legislation and stable legal systems have
a beneficial impact on lending corruption by reducing its amount.
Weill (2011a) proxy corruption by using two composite indices based on the data
provided by Transparency International and the Information for Democracy Foundation.
Their two indices capture the perceived level of corruption and the amount of corruption
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related to the existing bribes in bank lending activity. Weill (2011a) finds that corruption
decrease bank lending activity and the result is not dependent on the degree of bank risk
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aversion. Similarly, Weill (2011b) performs country-level and bank-level estimations to
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investigate the effect of corruption in bank lending and shows that corruption reduces
bank lending.
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Park (2012) investigates the influence of corruption on bank lending activity and
economic growth using data for 70 countries, for the period 2002-2004. They focus on the
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quality of loans and, thus, proxy the financial soundness of banks using the share of non-
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performing loans and use the Corruptions Perceptions Index to proxy the country’
corruption level. Their results suggest that corruption increases bank non-performing
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loans and deteriorates the bank financial soundness. Also, the poor quality of bank loans
reduces economic growth and the author argues that this may be a new channel through
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which corruption affects economic growth. Similarly, Goel and Hasan (2011) investigates
the effects of economy-wide corruption on bad loans across a large sample of countries
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and their evidence reveals that greater corruption is associated with more bad loans.
Chen et al. (2015) make a micro-level study to analyze the impact of corruption on
the bank risk-taking of banks in emerging economics for the period 2000-2012. Their
results show that corruption increases bank risk-taking and it amplifies the impact of
monetary policy on risk-taking behavior of banks. Their results are in favor of the “sand
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the wheel” view on corruption. Bougatef (2015) estimates the impact of corruption on the
bank soundness of 69 Islamic banks for the period 2008-2010 and his results are in line
with Park (2012): higher level of corruption means lower bank stability and financial
soundness. Also, Bougatef (2016) analyzes the impact of corruption on the non-
performing loans of 22 emerging economies for the period 2008-2012 and his results
demonstrate that corruption deteriorates the loan quality. Moreover, Bougatef (2016)
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shows that the beneficial role of higher accessibility to credit information on bank
financial soundness may be seen only in countries with low levels of corruption.
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Atkins et al. (2017) study the relation between early loan loss provisions and
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lending corruption and argue that lending corruption is lower in the presence of loan loss
provisions. However, this beneficial effect of timely loan loss provisions is altered in the
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presence of deposit insurance schemes and in countries with higher state-ownership in the
banking system. Barry et al. (2016) examine whether the corruption in bank lending is
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influenced by the type of bank ownership and, if so, whether external stakeholders help
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reducing this negative influence. Also, they investigate whether the economic
development of a country influences the relation between corruption and lending, since
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developed economies may have more ways to combat corruption, but also more
possibilities of making use of it. Their results show that corruption in bank lending
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activity is higher for countries with more state-owned banks or with more family-owned
banks and the results hold for both developed and emerging economies. Also, they find
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that strong supervisory policies reduce the lending corruption in case of family-owned
banks, but the result does not hold for state-owned or industrial-owned banks.
In contrast to these studies we use the Z-score, an overall indicator of bank
soundness, which is inversely related to the probability of bank insolvency (see Laeven
and Levine, 2009). The Z-score became rather popular in the literature (Mercieca et al.
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2007). This ratio combines together information on performance (for instance, return on
assets indicator), leverage (equity to assets indicator) and risk (for instance, standard
deviation of return on assets). It can be shown that the Z-score measures the number of
standard deviations a return realization has to fall in order to deplete equity. A higher Z-
score implies a lower probability of insolvency, providing a direct measure of soundness
that is superior to, e.g., analyzing leverage (Schaeck and Cihák, 2014). A bank can
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therefore be classified as being less stable, or closer to insolvency, if it shows lower
performance, it is less capitalised or it has a higher degree of variation in returns (Mare et

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al., 2017).
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To sum up, we can conclude that empirical evidence on the effects of corruption
on bank activity suggest that higher level of corruption is associated with a deterioration
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of bank stability and this relation is influenced by different factors that may amplify or
dampen this effect. Furthermore, the negative impact of corruption is transmitted through
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the banking system to the whole economy, since corruption may miss-allocate bank
finance from productive investments projects to less efficient and unproductive ones.
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Also, by increasing bank risk-taking and lowering bank stability, corruption may favor the
accumulation of risks that could lead to a future economic and financial crisis. All these
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arguments support the view that studying the nexus between corruption and bank stability
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is important for the proper decisions of regulator and central authorities regarding the
appropriate measures to fight corruption and prevent it from happening.

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4. Data and Methodology
The study aims at analysing the relation between the level of corruption and bank
stability and risk-taking behavior and the role of some bank- and macro-specific
characteristics in the relation between corruption and bank risk. The research investigates
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whether the impact of corruption differs across banks from Central and Eastern European
countries depending on the bank governance and macroeconomic environment. We
conduct a panel, bank-level, analysis of the relation between corruption on the one hand
and banking stability and credit risk on the other hand.
The sample includes 144 commercial banks from 17 countries in Central and
Eastern Europe2, analyzed within an eight-year period from 2005 to 2012. Bank-level
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annual data is used since the aim of the study is to carry out an analysis on the impact of
the corruption on individual bank stability. The source for bank-level data is the
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BankScope database. We follow Andrie• and Brown (2017) sampling methodology and
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collect data for all commercial active banks in CEE countries. Following Claessens and
van Horen (2012), we account for mergers and acquisitions, and entry and exit during the
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analyzed period. We include only commercial banks in the dataset to minimize any
possible bias due to the different nature and business scope among banks that have
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different objectives and conduct businesses in different specializations. One concern
related to the empirical analysis is the potential heterogeneity among different financial
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institutions. The impact of the corruption arguably might differ across commercial banks,
cooperative banks, investment banks and real estate and mortgage banks. To make sure
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that there is consistency across the sample, we restricted the investigation to the
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commercial banking sector, which comprises one of the largest segments of depository
institutions in Eastern Europe (Chortareas et al., 2013). Our sample accounts for approx.
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75% of the total assets of the CEE banking systems in 2012.
After the 2008 financial crisis, the governance and regulation of banking systems
became a very important topic for both the academia and the central authorities because
the crisis brought to the front line the importance of designing a regulatory and
supervisory framework that could insure financial stability and prevent future crises.
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Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania,
Macedonia, Montenegro, Poland, Romania, Serbia, Slovakia, Slovenia and Ukraine.
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Firstly, we investigate whether the strength of corruption control influences the
bank stability and risk-taking behavior. Since the dataset used is panel form over the
period 2005–2012, the panel ordinary least squares estimator is used to examine the
impact of the strength of corruption control on bank stability and risk-taking after
including related control variables. Use of panel estimator offers two advantages here:
first, this estimator assesses the impact of existing level of the corruption on bank stability
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and risk-taking proxies and thus takes into account cross-country variation in the strength
of corruption control; second, this estimator also helps to shed light on how the
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probability of bank default changes over time if changes, although slow, occur in the
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strength of corruption control (Ashraf, 2017). Specifically, we estimate the following
model:
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, , = + × , + × , , + + + , , (1)
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In this equation, , represents bank i risk from country j, in the year t.

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, is the level of corruption in country j, in year t, and , is a vector of yearly bank-

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level variables that we control for in our model; - year fixed effect; - country fixed
effect and , - error term.

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The benchmark models are estimated by using the fixed-effects estimator, which is
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chosen based on the Hausman test that suggests the fixed-effects estimator is preferable to
the random-effects estimator because the regressors are shown correlated with the time-
invariant bank-specific variables. We use heteroskedasticity and within-panel serial
correlation robust standard errors in our estimations, all estimated models include country
and year fixed effects and allow for clustering of standard errors at the country level. To
check the robustness of our main results, we also employ various alternative econometric
methodologies later.
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The main dependent variable is the bank Z-score (Laeven and Levine, 2009),
which is computed as the ratio between the sum of return on assets and level of
capitalization for each bank (equity/total assets) and the standard deviation of return on
assets for every three years as below. It represents the number of standard deviations
below the mean by which profits would have to fall so as to deplete the bank’s equity
capital (Houston, et al., 2010). In this way, the Z-score measures the distance from
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insolvency (Laeven and Levine, 2009). A high level of Z-score denotes the fact that the
bank is more stable.

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,,
,,
,,
Z − score , , = (2)
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,,
where: Z − score , , – Financial stability of bank i, country j, in year t; ROA , , - return on

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,,
assets of bank i, country j, in year t; – denotes ratio of equity over total assets of bank
,,
i, country j, in year t; σ – standard deviation of return on assets of bank i, country j,

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,,
in year t.
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We follow Schaeck and Cihák (2014) by using a three-consecutive-year rolling
window to calculate σ ,,
. Similar to Wu et al. (2017), we also experiment using a five-
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year rolling window to calculate Z-scores and find that our main results do not change and
remain statistically significant. However, using a five-year rolling time will cause a
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considerable reduction in the number of our observations. Due to the 3-year overlapping
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window used for the calculation of Z-scores measures, the effective sample period for
empirical analysis starts from the year 2007.
The Z-score has been widely used in the recent literature for measuring bank risk
(Delis et al, 2014; Demirgüç-Kunt, and Huizinga, 2010; Houston et al., 2010; Köhler,
2015; Laeven and Levine 2009). Previous research showed that the Z-score's ability to
identify distress events, both in the whole period and during the crisis years, is at least as
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good as the CAMELS variables, but with the advantage of being less data demanding
(Chiaramonte et al., 2015; Poghosyan and ihák, 2011). Also, the Z-score proves to be
more effective when bank business models may be more sophisticated as it is the case for
large and commercial banks (Chiaramonte et al., 2015).
Because of the high skewness of the Z-scores, following Demirgüç-Kunt et al.
(2008), in the regressions we use as the dependent variable ln (1 + − ) to smooth
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out higher values of the Z score and to avoid truncating the dependent variable at zero.
For brevity, we use the label ‘‘Z-score’’ in referring to the logged Z-score in the
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remainder of the paper.
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In order to assess the impact of corruption on bank stability and risk-taking
behavior, we use as two alternative risk measures: Credit losses and Excessive credit
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growth. We use the non-performing loans to gross loan ratio as a measure for Credit
losses. Non-performing loans represent a major obstacle to the development of banking

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sector. Emerging countries have had a long-standing problem with non-performing loans
as a major obstacle to the development of domestic banks (Zhang et al., 2016). Previous
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work has identified that non-performing loans signal future financial problems for banks
(Demirguc-Kunt, 1989) and point out that NPLs can be used to mark the onset of a
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banking crisis (Reinhart and Rogoff, 2011). The quality of bank loans plays an essential
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role in the overall bank soundness since one of the core activities of banking institutions is
to make loans, even though its importance has been gradually decreasing over the past
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decades (Park, 2012).
The global financial crisis have shown that excessive credit growth often leads to
the build-up of systemic risks to financial stability, which may materialize in the form of
systemic banking crises. Recent contributions, such as Alessi and Detken (2017), Jordà et
al. (2010) and Schularick and Taylor (2012), present evidence, based on more than a
century’s worth of data, that credit growth is a good predictor of financial crises, and
17
banking crises in particular. Also, previous studies show that rapid credit growth is an
early indicator of build-up of credit risk (Maechler et al., 2010). Results by Foos et al.
(2010) suggest that excessive loan growth represents an important driver of the riskiness
of banks, and Dell’Ariccia et al. (2012) present evidence that fast credit growth can be
linked to a decline in lending standards.
Following previous studies, e.g. Detragiache et al. (2008), Park (2012) and Chen
t
ip
et al. (2015), we use the level of corruption in a country as independent variable in our
analysis, which is proxied by Corruption Perception and Control of Corruption indices.

cr
The database was built using data on corruption measures provided by the Transparency
us
International and World Bank. Information on all 17 countries for the period between
2005 and 2012 was collected from their databases. The main indicator of corruption that
an
we use is Transparency International's Corruption Perception Index, which is frequently
employed in prior works such as Weill (2011a) and Chen et al. (2015). The Corruption
M
Perception Index, essentially a poll of polls, is an average of the results of surveys of
business people and the assessment of country analysts from various sources regarding
ed
prevailing levels of corruption. Scaled from 0 to 100, a higher value in the Corruption
pt
Perception Index indicates less corruption perceived in the country.
As an alternative measure of corruption, we use Control of Corruption index

ce
calculated by the World Bank. This index is also part of the Worldwide Governance
Indicators. Control of corruption captures perceptions of the extent to which public power
Ac
is exercised for private gain, including both petty and grand forms of corruption, as well
as "capture" of the state by elites and private interests (Kaufmann et al., 2009).
We thus have the following hypotheses:
Hypothesis 1.1. Better corruption control (less corruption) is associated with more
bank stability.
18
Hypothesis 1.2. Better corruption control (less corruption) is associated with less
credit losses.
Hypothesis 1.3. Better corruption control (less corruption) is associated with less
excessive credit growth.
We included in our analysis a number of variables in order to control for bank or
country characteristics that may have an impact on banking stability. Prior studies suggest
t
ip
a significant relationship between bank size, bank business-models and bank risk taking
(Altunbas et al., 2011). Similar to Andrie• and Brown (2017), to control for differences in
cr
size and business models across our sample, we employ following bank-level control
us
variables: (1) Bank size measures (log) total assets of the bank in the pre-crisis period; (2)
as in Beltratti and Stulz (2012) we use the Loans to total assets ratio that captures the
an
banks’ investment strategy; (3) following Demirguc-Kunt et al. (2013) we use Capital
structure (Equity/Total assets) defined as regulatory capital divided by total assets; (4) in
M
order to assess the impact of bank’s funding strategy on bank’s performance and risk, we
use as measure the Funding structure, defined as share of Deposits in Total assets
ed
(Demirgüç-Kunt and Huizinga, 2010); (5) Foreign ownership dummy that takes the value
1 for foreign owned banks and 0 otherwise. Laidroo (2016) shows that bank ownership is
pt
associated with significant differences in CEE banks’ risk taking behavior. We winsorize
ce
the bank-level explanatory variables at the 1 percent and 99 percent levels.
In order to test the robustness of our results, we provide a number of alternative

Ac
specifications of the base results.
, , = + × , + × , , + × , + × , + + ,
(3)
19
In Models 3-4 we add to the baseline specification banking market controls
( , ) - Financial intermediation level; Return on assets; and Bank concentration; and
country-level controls ( , ) − GDP growth and Inflation. Definition and data sources
for all variables used in our analysis are presented in Appendix 1. In Model 5, we report
estimates with panel-corrected standard errors (Beck and Katz, 1995). This correction
controls for bank-level heteroscedasticity and an AR(1) process in the error structure. In
t
ip
Model 6, we apply the difference generalized method-of-moments (GMM) estimators. We
conclude that the specification under Model 2 is robust to the variance considerations
cr
captured by the GMM approach. The results on the impact of corruption on bank stability
us
and risk continue to hold.
Secondly, we study whether banks react differently to the corruption depending on

an
some bank and country governance and regulation characteristics. The following
equations are used:

M
= + × + × ∗ + × + × + ×
ed
, , , , , ,
, + + , (4.1)
pt
, = + × , + × , ∗ , + × , + × , + ×
+ + (4.2)
ce
, ,
Ac
We add to our baseline equation an interaction term between the corruption and
the following dummy variables: (1) Corporate Governance Code – a dummy taking the
value of 1 for all banks which are acting in a country that have adopted and implemented
a Corporate Governance Code. (2) High Rule of Law – a dummy taking the value of 1 if
the value of Rule of Law index for that country is lower than the median value of Rule of
Law index for entire sample of countries. Rule of law captures perceptions of the extent to
20
which agents have confidence in and abide by the rules of society, and in particular the
quality of contract enforcement, property rights, the police, and the courts, as well as the
likelihood of crime and violence. (3) Tight Corporate Governance – a dummy taking the
value of 1 if the value of Corporate Governance Index for that bank is higher than the
median value of Corporate Governance Index for entire sample of banks. Similar to
Andrieș and Nistor (2016), in order to assess the corporate governance mechanisms we
t
ip
create a composite index as an unweighted average index based on the following eight
indicators: CRO Present, CRO Executive, Risk committee, Risk committee reports to
cr
board, Board size, Board expertise, Board independence and Board foreign. (4) Member
us
of European Union – a dummy taking the value of 1 for all banks which are acting in a
country that is member of the European Union. (5) State ownership – a dummy taking the
an
value of 1 if the bank has more than 50% of state ownership. Allen et al. (2017) show that
the behavior of banks during a crisis depends on the structure of the ownership. (6)
M
Finally, since changes can occur in bank risk-taking behavior during financial crisis
ed
situation, we create a dummy variable, Crisis, that equals to 1 if a country is categorized
as under financial crisis in a year by the Laeven and Valencia (2013)’s financial crisis
pt
database and 0 otherwise.
Hence, six alternative hypotheses that condition on country and bank

ce
characteristics are stated in terms of bank responses to the corruption:
Hypothesis 2.1.Banks that are acting in a country that has adopted and
Ac
implemented a Corporate Governance Code benefit less from better corruption control
(less corruption) than do banks from countries that have not adopted and implemented a
Corporate Governance Code.
21
Hypothesis 2.2.Banks that are acting in a country with a lower value of Rule of
Law index benefit more from better corruption control (less corruption) than do banks
from countries with a higher value of Rule of Law index.
Hypothesis 2.3.Banks with tight corporate governance benefit less from better
corruption control (less corruption) than do banks with lax corporate governance.
Hypothesis 2.4.Banks that are acting in a country member of the European Union
t
ip
benefit less from better corruption control (less corruption) than do banks from countries
that are members of the European Union.

cr
Hypothesis 2.5.State banks benefit more from better corruption control (less
us
corruption) than do private banks.
Hypothesis 2.6.Banks benefit more from better corruption control (less corruption)
an
during crises than during normal times.
A detailed description of all variables included in the study is presented in

M
Appendix 1.
ed
INSERT TABLE 1
pt
In order to gain some insights into our data, the computed descriptive statistics and
correlation matrix are presented in Table 1. Our stability variables indicate banks with
ce
high stability levels, but also banks with high probability of insolvency. The highest level
Ac
of bank stability recorded in the sample is highlighted by a Z-score of 1345 and 0.12%
share of non-performing loans in gross loans. The probability of default is increased for
banks with negative Z-score and high levels of non-performing loans (the maximum value
in our sample is 58.86%). Emerging Europe’s banking system has, on average, a 415.19
level of stability based on Z-score and a 10.03% share of non-performing loans in gross
loans.
22
Table 1, Panel B shows that stability indicators differ strongly across countries,
with banks in Estonia displaying the lowest level of stability (51,82) while banks in
Croatia are displaying the highest level (1139,85). Also, the risk-taking behavior as
measured by Credit Losses and Excessive credit growth differs strongly across countries
during the 2005 - 2012 period. Our results show that banks in Ukraine display the highest
level of risk-taking, while banks in Estonia display the lowest level. Table 1 Panel C
t
ip
shows that the annual variation in bank stability indicator across our sample is substantial,
with annual rates varying from 213 in 2009 to 584 in 2011.

cr
The level of corruption at the country level, which is proxied by Corruption
us
Perception and Control of Corruption indices, differs strongly across countries. Table 1,
Panel C shows that there is substantial variation in the level of corruption during the
an
analysed period.
The banking system in emerging Europe is also characterized by an 11.14% level

M
of capital adequacy. Banks earnings are, predominantly, from traditional activities (loans
ed
represents 62.40% in total assets). In terms of ownership, 76% of banks from Central and
Eastern European are foreign banks.

pt
There are also differences between the financial and economic development level
for the countries considered. There are systems where only three banks dominate the
ce
entire national banking sector (bank concentration mean is over 59%) and systems where
domestic credit to private sector by banks is less than 14% from the national GDP. The
Ac
economic development recorded in the 2005-2012 period for the analyzed region
represents, on average, 2.59%, with economies that suffered economic contraction of over
17%. The most developed country has an annual GDP growth of 12.23%.
The correlation matrix presented in Table 1, Panel D helps to understand the
relation between the alternative proxies for corruption and for bank stability and risk-
23
taking behavior. Results show a strong positive correlation between the Corruption
Perceptions Index and Control of Corruption. Also, the results show a positive correlation
between the control of corruption indices and bank stability, suggesting that tighter
control of corruption means more bank stability. However, the corruption indices are
negatively related to the level of Credit losses and Excessive credit growth and this
highlights that stronger control of corruption means less non-performing loans and
t
ip
excessive credit growth (lower bank risk).
cr
us
5. Results
an
This section presents the empirical estimates of the regression specifications presented in
Section 4. The baseline specification is presented in Eq. (1) outlining the response of
M
banks’ distance to default, credit losses and excessive credit growth to changes in: (i)
Corruption Perceptions Index and (ii) Control of Corruption Index. Models (1)-(4) of
ed
Tables 2-7 are estimated using Panel FE OLS, model (5) via PCSE, while model (6) via
First Difference GMM. Model 1 of Tables 2-7 shows the effects of corruption on bank
pt
stability and risk-taking behavior using a simple regression with country and year fixed
effects. In Model 2 of Tables 2-7 we insert bank level characteristics as control variables.
ce
In columns (1), (2),(5) and (6) we include year and country fixed effects, while in
Ac
columns (3)-(4) we drop the country fixed and insert various banking market conditions
(column 3) and macroeconomic control variables (column 4).
Table 2 displays the impact of Corruption Perceptions Index on banks’ stability
measured by Z-score. A positive coefficient is linked with an improved banking stability,
while a negative coefficient corresponds to lower distance to default (or higher probability
24
of insolvency).3 Empirical results indicate that the relationship between perceptions of
corruption and banks’ distance to default is positive and statistically significant. The
coefficient presented in column (1) shows that one unit increase in Corruption Perceptions
Index is associated with 0,1 units increase in banks’ Z-score. Considering the mean Z-
score of our emerging markets` sample that is about 415 units, the estimate implies
associated semi-elasticity of 0.03 %. The results of estimations using bank, banking
t
ip
system and macroeconomic level controls are presented in Columns (2)-(4). The results of
these regressions show that the corruption indicators are still positively and statistically
cr
significantly associated with the Z-score.
us
Moreover, we still find that the estimates of the coefficient on corruption using the
panel-corrected standard errors and the difference generalized method-of-moments

an
estimators are statistically significant and produce consistent results with the regressions
using the fixed-effects estimator.

M
INSERT TABLE 2
ed
Analyzing the impact of Control of Corruption Index as main determinant,

pt
empirical results confirm the positive link between lower levels of corruption and
ce
solvency (Table 3). A one unit increase of the index is linked with 3.58 units increase in
banks’ distance to default, as shown by the coefficient presented in column (1). The
Ac
associated semi-elasticity is about 1.1 percent. Our finding from alternative estimations,
Table 3 Columns (2)-(6), is that the results are still consistent with the benchmark
estimation results. Our results are in line with previous studies, e.g. Chen et al. (2015),
and reveal that banks' stability decreases as the severity of corruption increases.
3
Higher Z-score values are associated with greater stability and a lower default.
25
INSERT TABLE 3
Further, we investigate the impact of Corruption Perceptions Index on banks’
Credit losses measured by the non-performing loans to gross loan ratio. A positive
coefficient is linked with higher credit losses, while a negative coefficient corresponds to
a lower impaired loans ratio. Results presented in Table 4 highlight a negative and
t
significant relationship between corruption and banks’ credit losses during crisis. We find
ip
that the estimates obtained by using alternative estimation methods are still highly
cr
significant.
us
INSERT TABLE 4
an
Similarly, the empirical output presented in Table 5 provides evidence of a
M
negative relationship between Control of Corruption Index and banks’ non-performing
loans ratio during crisis that is statistically significant. The coefficient presented in
ed
column (1) indicates that an increase of Control of Corruption Index by 1 percent
generates a decrease of banks’ credit losses by about 14 percent. Similar to Park (2012),
pt
our results stress that corruption significantly aggravates the problems with bad loans in
ce
the banking sector. Using alternative estimation methods, Columns (2)-(6), it renders
qualitatively consistent and statistically significant results.

Ac
INSERT TABLE 5
In a next step, we explore the association between the perceptions on corruption
and banks’ excessive credit growth that is defined as the difference between banks’ gross
loans growth and the country average level of gross loans growth. A positive indicates
26
higher excessive credit growth rates, while a negative coefficient corresponds to lower
excessive credit growth rates. Results depicted in Table 6 highlight a negative relationship
between perception of corruption and banks’ excessive lending growth.
INSERT TABLE 6
Analyzing the impact of Control of Corruption Index as main determinant,
t
empirical results confirm the negative relationship between lower levels of corruption and
ip
excessive credit growth (Table 7). A one percent increase in the index is linked with 16.79
cr
percent decrease in banks’ excessive lending growth, as shown by the coefficient
us
presented in column (1). Similar to Weill (2011a), our results reveal that banks are
engaged in more risky lending activities in more corrupt economies, so they significantly
an
decrease the lending standards and are consequently more vulnerable.
All these results strongly support our Hypotheses 1.1., 1.2. and 1.3. that better
M
corruption control (less corruption) is associated with more stable banks, less credit losses
and less excessive credit growth.

ed
pt
INSERT TABLE 7
ce
To investigate possible channels that could shape the impact of corruption on bank
stability, we further assess the impact of bank and country characteristics on the nexus
Ac
between corruption perception and banks stability (Table 8). The interaction between
corruption perception and the dummy corresponding to banks that are acting in a country
that has adopted and implemented a corporate governance code reveals a negative and
significant relationship as suggested by the coefficient on the interaction term Corruption
Perceptions Index × Corporate Governance Code (-0.1875**, Column 1). On the other
hand, banks from countries with a low corruption level and a high rule of law level
27
manage to increase more their stability in comparison with banks from countries with
higher corruption and lower rule of law. The coefficient on the interaction term
Corruption Perceptions Index × High Rule of Law shows a positive link (i.e., 0.0892*).
The internal corporate governance mechanisms have also a significant impact on the
nexus between corruption perception and banks’ stability. In countries with higher levels
of corruption (or a lower Corruption Perceptions Index) banks could increase their
t
ip
distance to default if they implement rigorous corporate governance practices, as
suggested by the interaction term Corruption Perceptions Index × Tight Corporate

cr
Governance (-0.0630**).
us
Column (4) shows that the positive effect of a low level of corruption on banks’
stability diminishes for banks from EU countries in comparison with non-EU members.
an
The coefficient on the interaction term Corruption Perceptions Index × Member of the EU
is negative and statistical significant (-0.1540***). Moreover, our results in Column (6)
M
show that the positive effect of a low level of corruption on banks stability is augmented
ed
during the crisis period in comparison with the non-crisis period. The coefficient on the
interaction term Corruption Perceptions Index × Crisis is positive and statistical

pt
significant and confirm the Hypothesis 2.6., which states that banks benefit more from
better corruption control (less corruption) during the crisis than during normal times.
ce
Ac
INSERT TABLE 8
Finally, the evidence provided in Table 9 confirms the significant impact of bank
and country characteristics on the nexus between corruption and banks’ stability, when
using the Control of Corruption Index as proxy for corruption. In the case of banks from
the EU countries, a better control of corruption improve less the banks’ stability in
comparison with banks from non-EU countries, the coefficient on the interaction term
28
Control of Corruption × Member of EU being negative and statistical significant (-
3.3700***). The same is true for banks from countries with better corruption control that
implemented a corporate governance code in comparison with banks from countries that
have not adopted such practices (the coefficient of the interaction Control of Corruption ×
Corporate Governance Code is – 6.2165***).
t
ip
INSERT TABLE 9
cr
A similar effect is obtained for banks activating in countries with lower corruption
us
that implemented tight internal governance structure, as suggested by coefficient of the
interaction Control of Corruption × Tight Corporate Governance (-0.3817**). On the

an
other hand, a better control of corruption linked with a better rule of low can significantly
improve banks’ stability. The coefficient on the interaction term Control of Corruption ×
M
High Rule of Law shows a positive and highly significant impact (2.8221***).
Overall, the results support our Hypotheses 2.1. - 2.3., that banks with tight
ed
corporate governance or which are acting in a country that has adopted and implemented a
Corporate Governance Code or in a country with a higher value of Rule of Law index
pt
benefit less from better corruption control (less corruption).

ce
Regarding the ownership structure, our results reveal that state owned banks
record, in average, a lower level of stability, but the impact of corruption on bank stability
Ac
is not affected by the ownership type.
Conclusions
29
In this paper we use a dataset covering 144 banks in Central and Eastern Europe
from 2005 through 2012, to examine the relationship between the level of corruption and
bank stability and the role of some bank- and macro-specific characteristics in the nexus
between corruption and bank risk.
The analysis first reveals that a lower level of corruption has a positive impact on
bank stability. Also, we found evidence that corruption significantly deteriorates the
t
ip
quality of bank loans and it is associated with more moderate credit growth.
Second, the research investigates whether the impact of corruption differs across
cr
banks from Central and Eastern European countries depending on the bank governance
us
and macroeconomic environment. Our evidence suggests that stability of banks that are
acting in a country that has not adopted a corporate governance code or is not a members
an
of the EU is affected more by the corruption. Also, in countries with higher levels of
corruption banks could increase their stability if they implement rigorous corporate
M
governance practices.
ed
The results of our paper regarding the harmful impact of corruption on financial
stability and risk-taking behavior of banks justify the importance of the anti-corruption
pt
regulations and their prompt enforcement in emerging countries, especially during the
crisis period.
ce
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Ac
ce
pt
ed
39
M
an
us
cr
ip
t
Table 1 Descriptive statistics and correlation matrix
Panel A - Descriptive statistics

Variable Obs. Mean Std. Dev. Min Max
Z-score 843 415.1894 1345.7880 -0.0504 10443.61
Credit Losses 844 10.0379 10.5818 0.12 58.86
Excessive credit growth 1105 -2.0257 28.4148 -53.3707 146.3497
Corruption Perceptions Index 1152 42.4223 10.8964 22 67
Control of Corruption 1152 0.0495 0.4687 -1.03 1.02
Bank size 1133 14.5610 1.3647 10.6164 17.3732
Asset structure 1133 11.1492 5.0596 3.4390 35.7280
t
Capital structure 1133 0.6240 0.1433 0.1682 0.8946
ip
Funding structure 1126 0.6004 0.1876 0.0706 0.9329
Foreign ownership 1152 0.7612 0.4264 0 1
Financial intermediation level 1112 55.5238 19.1213 14.7801 105.08
cr
Return on assets 1008 0.8890 1.4143 -8.1428 4.3910
Bank concentration 1008 59.5548 14.9149 26.1626 99.6443
GDP growth 1152 2.5918 5.0456 -17.9549 12.2332
us
Inflation 1152 4.7011 3.7263 -2.1670 22.3110
an
M
ed
pt
ce
Ac
40
Panel B - Country level
Excessive Corruption
Credit credit Perceptions Control of
Country Z-score Losses growth Index Corruption
Albania 962.1870 12.0775 13.5104 30.1875 -0.6400
Bosnia and Herzegovina 387.0605 7.9460 -6.4579 32.3875 -0.3162
Bulgaria 356.6706 7.6276 3.6788 38.1625 -0.1862
Croatia 2442.2850 10.3039 -11.7762 40.1625 0.0137
Czech Republic 5763.2610 4.5969 -8.9091 47.8375 0.2975
Estonia 51.8287 3.7200 -13.7840 65.0625 0.9237
Hungary 280.0236 10.0416 -16.4470 50.5750 0.4200
t
Latvia 85.4487 13.8221 -2.9356 45.7375 0.1987
ip
Lithuania 118.1565 14.1283 -4.4745 48.8125 0.1637
Macedonia (FYROM) 2871.8510 12.5790 -3.4541 35.5500 -0.1887
Montenegro 101.1857 14.6146 10.2810 35.2125 -0.2512
cr
Poland 279.0130 7.2464 -5.5678 46.8500 0.3487
Romania 142.7291 12.4491 9.3152 36.3875 -0.2050
Serbia 201.2882 11.6620 7.0195 33.5125 -0.3087
us
Slovakia 1015.7320 5.7471 -7.3643 45.3375 0.2837
Slovenia 266.8606 8.3515 -12.587 63.4625 0.9225
Ukraine 67.3261
an 17.0785 18.3649 25.1250 -0.8650
Panel C - Year level

Credit credit Perceptions Control of
Year Z-score Losses growth Index Corruption
M
2005 . 4.7872 -3.6364 38.2083 0.1037
2006 . 4.4201 -3.4475 40.3541 0.0806
2007 564.8437 3.8856 -1.0896 43.3055 0.0432
2008 655.1956 5.5836 -1.2142 43.8750 0.0370
ed
2009 225.4276 11.6500 -2.6514 43.1666 0.0270

2010 375.5769 13.8724 -2.5257 42.6666 0.0282
2011 3470.339 14.9834 -0.5985 41.1631 0.0536
2012 307.3242 16.4336 -1.2394 46.6388 0.0229
pt
Panel D - Correlation matrix

Credit Control of
Z-score credit Perceptions
Losses Corruption
ce
growth Index
Z-score 1.0000
Credit Losses -0.4181 1.0000
Excessive credit growth -0.2546 0.3862 1.0000
Ac
Corruption Perceptions Index 0.2126 -0.3027 -0.1329 1.0000

Control of Corruption 0.2142 -0.3578 -0.1282 0.9741 1.0000
41
Table 2 Corruption Perceptions Index and Banking Stability
Dependent: Z-score Model 1 Model 2 Model 3 Model 4 Model 5 Model 6

Corruption Perceptions Index 0.1005*** 0.0939*** 0.0272* 0.0270* 0.0739*** 0.0760**
(0.0268) (0.0259) (0.0141) (0.0141) (0.0232) (0.0318)
Bank size 0.4521*** 0.2956*** 0.2893*** 0.4367*** 1.5151***
(0.0990) (0.1004) (0.1025) (0.0936) (0.4949)
Capital structure 0.0430* 0.0179 0.0183 0.0605*** 0.0764
(0.0246) (0.0273) (0.0271) (0.0196) (0.0505)
Asset structure 2.8860*** 3.2651*** 3.2537*** 2.1092*** 4.8820***
(0.7589) (0.8220) (0.8211) (0.6926) (1.2156)
Funding structure 1.1251** 1.3797** 1.4870** 1.3285*** -1.1533
t
(0.5030) (0.5857) (0.6007) (0.5003) (1.2904)
ip
Foreign ownership 0.0354 0.3790 0.4085 0.1717 -4.3770***
(0.2404) (0.2533) (0.2560) (0.2286) (0.2522)
Financial intermediation level -0.0058 -0.0073
cr
(0.0084) (0.0085)
Return on assets (%) 0.1665*** 0.1605**
(0.0503) (0.0693)
us
Bank concentration -0.0094 -0.0090
(0.0101) (0.0102)
GDP growth -0.0068
(0.0227)
Inflation 0.0327
an
(0.0256)
Method Panel FE Panel FE Panel FE Panel FE PCSE FD - GMM
Year Fixed Effect Yes Yes Yes Yes Yes Yes
Country Fixed Effect Yes Yes No No Yes Yes
M
R-squared 0.2857 0.3406 0.1823 0.1814 0.3629
Number of banks 144 144 144 144 144 144
Number of obs. 843 840 673 673 840 553
ed
pt
ce
Ac
Table 3 Control of Corruption and Banking Stability
Dependent: Z-score Model 1 Model 2 Model 3 Model 4 Model 5 Model 6

Control of Corruption 3.5840** 3.2455** 2.4914**
* * 0.7150** 0.7381** * 2.3892**
(0.9206) (0.9184) (0.3553) (0.3545) (0.7591) (1.1439)
Bank size 0.4644** 0.2853** 0.2750** 0.4435**
* * * * 0.9634
(0.1003) (0.1021) (0.1049) (0.0955) (0.6074)
Capital structure 0.0620** 0.1009**
0.0456* 0.0183 0.0188 * *
(0.0251) (0.0273) (0.0271) (0.0197) (0.0366)
Asset structure 2.6600** 3.2785** 3.2681** 1.9710**
t
* * * * 2.1858*
ip
(0.7578) (0.8211) (0.8209) (0.6881) (1.2563)
Funding structure 1.0032** 1.3448** 1.4612** 1.2521** 1.5931
(0.5115) (0.5852) (0.5996) (0.5028) (1.3261)
cr
Foreign ownership -
3.7083**
0.0391 0.3596 0.3918 0.1686 *
us
(0.2408) (0.2521) (0.2548) (0.2326) (0.4308)
Financial intermediation -0.0071 -0.0091
level (0.0085) (0.0087)
Return on assets (%) 0.1612**
an * 0.1561**
(0.0501) (0.0684)
(0.0102) (0.0103)
GDP growth -0.0090
M
(0.0226)
Inflation 0.0346
(0.0255)
Panel FE Panel FE Panel FE FD -
ed
Method Panel FE PCSE GMM

R-squared 0.2865 0.3405 0.1854 0.1850 0.3639
Number of banks 144 144 144 144 144 144
pt
Number of obs. 843 840 673 673 840 553

ce
Ac
43
Table 4 Corruption Perceptions Index and Credit Losses
Dependent:
Model 1 Model 2 Model 3 Model 4 Model 5 Model 6
Non-Performing Loans
Corruption Perceptions -
Index 0.4312** - - - -
* 0.3705*** 0.1837*** 0.1824*** 0.3236*** 0.2401
(0.1081) (0.1057) (0.0646) (0.0642) (0.0848) (0.7467)
Bank size -
-1.9142* -0.8919 -0.8742 2.3914*** -15.4890
(1.0556) (0.6683) (0.6767) (0.6646) (30.4702)
Capital structure 0.1016 0.1070 0.1083 0.0205 -1.3777
(0.2060) (0.1772) (0.1766) (0.1330) (3.3736)
t
Asset structure - - - -
ip
19.7746** 13.9089** 13.7749** 13.6608**
* * * * 85.6757
(167.150
cr
(4.8312) (5.0568) (5.0678) (3.9077) 6)
Funding structure -0.6365 -1.9314 -1.9794 1.5973 -69.3483
(147.692
us
(4.9815) (4.4444) (4.4316) (3.0853) 4)
Foreign ownership 1.5573 -0.2820 -0.3392 1.0705 -29.3286
(1.9958) (1.7168) (1.7059) (1.4281) (72.3693)
level
an (0.0439) (0.0443)
Return on assets (%) - -
1.6902*** 1.7431***
(0.2731) (0.4061)
Bank concentration 0.0293 0.0303
M
(0.0404) (0.0403)
GDP growth 0.0323
(0.1179)
Inflation -0.0056
ed
(0.1002)
pt
R-squared 0.3428 0.3687 0.3483 0.3495 0.2146

Number of banks 144 144 144 144 144 144
Number of obs. 844 843 702 702 843 569
ce
Ac
44
Table 5 Control of Corruption and Credit Losses
Dependent:
Non-Performing Loans
Control of Corruption - - -
14.9681** 12.5410** - 11.4500*
* * -3.2148* -3.2315* 9.0597*** *
(4.4603) (4.3263) (1.8318) (1.8378) (2.6184) (4.8390)
Bank size - -
-2.0025* -0.9165 -0.8943 2.3626*** 6.1187**
(1.0410) (0.7030) (0.7147) (0.6661) (2.5480)
Capital structure 0.0884 0.1227 0.1237 0.0177 -0.1470
(0.2025) (0.1755) (0.1745) (0.1338) (0.2406)
t
Asset structure - - - -
ip
18.9725** 14.4788** 14.3238** 13.5936**
* * * * -2.4303
(4.8341) (5.0397) (5.0514) (3.9406) (10.6939)
cr
Funding structure 0.1921 -1.5476 -1.6028 1.4521 -1.5396
(4.8146) (4.3992) (4.3963) (3.0867) (6.8908)
Foreign ownership 1.6917 -0.0561 -0.1206 1.1217 3.5903
us
(1.9809) (1.7029) (1.6912) (1.4176) (3.5266)
level (0.0442) (0.0454)
Return on assets (%) - -
an 1.7644*** 1.8262***
(0.2704) (0.3990)
Bank concentration 0.0272 0.0284
(0.0424) (0.0423)
GDP growth 0.0395
M
(0.1212)
Inflation -0.0070
(0.1009)
ed

R-squared 0.3414 0.3665 0.3492 0.3502 0.2128
Number of banks 144 144 144 144 144 144
pt
Number of obs. 844 843 702 702 843 569

ce
Ac
45
Table 6 Corruption Perceptions Index and Excessive Credit Growth
Dependent:
Excessive credit growth
Corruption Perceptions - -
Index 0.6750** - - 0.7206** -
* 0.6951*** 0.7108*** * 0.7182*** -0.4027*
(0.0912) (0.0943) (0.1350) (0.1299) (0.1003) (0.2315)
Bank size -
- - 2.8128** -
2.0723*** 3.2358*** * 2.0753*** 4.6381
(0.6233) (0.7990) (0.7840) (0.7891) (3.5933)
Capital structure - -
t
-0.4342** 0.5905*** 0.5406** -0.5432** 0.0288
ip
(0.2058) (0.2280) (0.2292) (0.2486) (0.7852)
Asset structure 23.8521** 22.8051** 20.8906* 28.6742**
* * * * 38.1039
cr
(32.9266
(7.9801) (8.6739) (8.5749) (8.5029) )
Funding structure -5.3547 -9.5088 -10.7155 -5.1078 -3.6466
us
(20.4103
(7.2686) (7.9254) (7.6944) (6.3890) )
Foreign ownership -4.2700 -5.0633 -5.5987* -4.3792* 3.3899
(11.8907
an
(2.6522) (3.2199) (3.0465) (2.4383) )
Financial intermediation level -0.0169 0.0401
(0.0817) (0.0833)
Return on assets (%) 2.4327**
3.9234*** *
M
(0.7520) (0.9397)
Bank concentration -0.1489* -0.1359
(0.0840) (0.0839)
GDP growth 1.3121**
ed
*
(0.3339)
Inflation -
0.8355**
*
pt
(0.3015)
ce

R-squared 0.0680 0.0882 0.1175 0.1392 0.0643
Number of banks 144 144 144 144 144 144
Ac
Number of obs. 1105 1098 932 932 1098 802
46
Table 7 Control of Corruption and Excessive Credit Growth
Dependent:
Excessive credit growth
Control of Corruption - - - - -
16.7922** 16.9295** 20.0284** 20.3600** 17.1547**
* * * * * -3.5233
(1.9479) (1.9484) (2.8984) (2.8028) (2.4797) (10.0353)
Bank size - - - 10.0279*
1.8305*** 2.6340*** 2.2063*** -1.8322** *
(0.6088) (0.7841) (0.7740) (0.8032) (4.8242)
Capital structure -
-0.4412** 0.5789*** -0.5303** -0.5690** 0.2069
t
(0.2010) (0.2244) (0.2254) (0.2515) (0.9515)
ip
Asset structure 21.5925** 27.9835**
* 19.4352** 17.3799** * 45.1177
(7.6922) (8.4494) (8.3357) (8.5605) (39.3990)
cr
Funding structure -4.7539 -9.8516 -11.0865 -4.5079 -3.0011
(7.0439) (7.6781) (7.4356) (6.4252) (24.8189)
Foreign ownership -3.6269 -4.4049 -4.9232* -3.6864 3.9883
us
(2.5246) (3.0765) (2.9058) (2.4387) (10.7958)
Financial intermediation 0.0292 0.0899
level (0.0799) (0.0812)
Return on assets (%) 4.2398*** 2.7987***
an (0.7326) (0.9174)
(0.0792) (0.0791)
GDP growth 1.3039***
(0.3299)
M
Inflation -
0.9124***
(0.2936)
ed

R-squared 0.0793 0.0960 0.1316 0.1537 0.0674
Number of banks 144 144 144 144 144 144
pt
Number of obs. 1105 1098 932 932 1098 802

ce
Ac
47
Table 8 Impact of Bank and Country Characteristics on the Nexus between Corruption
Perceptions Index and Banks Stability
Dependent variable: Banks Stability

0.2092 0.041 0.0306 0.1790* 0.0294 0.0316
** 8* * ** ** **
Corruption Perceptions Index
(0.088 (0.021 (0.017 (0.0410 (0.014 (0.015
7) 9) 5) ) 7) 2)
7.4963
**
Corporate Governance Code
(3.549
8)
t
-
0.1875
ip
Corruption Perceptions Index × Corporate
**
Governance Code
(0.087
0)
cr
-
2.263
High Rule of Law 0
us
(1.898
1)
0.089
Corruption Perceptions Index × High Rule of 2*
Law
an (0.046
9)
0.0773
Tight Corporate governance (0.907
9)
M
-
0.0630
Corruption Perceptions Index × Tight
**
Corporate Governance
(0.019
ed
5)
4.4087*
**
Member of EU
(1.6284
)
pt
-
0.1540*
Corruption Perceptions Index × Member of EU **
ce
(0.0431
)
-
0.0493
State ownership
Ac
(0.953
9)
-
Corruption Perceptions Index × State 0.0225
ownership (0.025
0)
-
0.8206
Crisis *
(0.461
9)
0.0077
Corruption Perceptions Index × Crisis *
(0.003
48
7)
Bank Controls Yes Yes Yes Yes Yes Yes
Banking System Controls Yes Yes Yes Yes Yes Yes
Macroeconomic Controls Yes Yes Yes Yes Yes Yes
Panel Panel Panel Panel Panel Panel
Method
FE FE FE FE FE FE
R-squared 0.221
0.1987 9 0.1794 0.2517 0.1827 0.1823
Number of obs. 673 673 673 673 673 673
t
ip
cr
us
an
M
ed
pt
ce
Ac
49
Table 9 Impact of Bank and Country Characteristics on the Nexus between Control of
Corruption and Banks Stability
Dependent variable: Banks Stability

6.8625* 0.6603* 0.9086 3.8409* 0.8283 0.8061*
** ** ** ** ** *
Control of Corruption
(0.442 (0.370 (0.3653)
(2.0254) (0.2184) 1) (0.7618) 3)
-0.6006
Corporate Governance Code
(0.4231)
-
Control of Corruption × Corporate 6.2165*
t
Governance Code **
(1.9846)
ip
1.4939*
High Rule of Law **
(0.4389)
cr
2.8221*
Control of Corruption × High Rule of Law **
(1.0030)
us
-
0.1703
Tight Corporate Governance
(0.243
5)
an -
0.3817
Control of Corruption × Tight Corporate
**
Governance
(0.075
1)
M
-
1.9757*
Member of the EU
**
(0.3603)
ed
-
Control of Corruption × Member of the 3.3700*
EU **
(0.8754)
pt
-
1.0113
State ownership **
(0.452
ce
1)
-
0.7194
Control of Corruption × State ownership
(0.541
Ac
8)
-
1.1508*
Crisis
**
(0.2552)
0.1380
Control of Corruption × Crisis
(0.2186)
Bank Controls Yes Yes Yes Yes Yes Yes
Banking System Controls Yes Yes Yes Yes Yes Yes
Macroeconomic Controls Yes Yes Yes Yes Yes Yes
Panel Panel Panel Panel Panel Panel
Method
FE FE FE FE FE FE
50
R-squared
Ac Number of obs.
ce
pt
ed
673
0.2131
51
M
0.2301
673
an
0.1820
673
us
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Corruption and Bank Stability

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Corruption and Bank Stability

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Emerging Markets Finance and Trade

ISSN: 1540-496X (Print) 1558-0938 (Online) Journal homepage: http://www.tandfonline.com/loi/mree20

Corruption and Banking Stability: Evidence from

To link to this article: https://doi.org/10.1080/1540496X.2017.1411257

Accepted author version posted online: 15

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Alin Marius ANDRIE•

characteristics in identifying the asymmetric effects of corruption on bank stability. Our

Scientific Research and Innovation, CNCS – UEFISCDI, project number PN-II-RUTE-2014-4-

organizations, national governments, non-governmental organisations and other entities

resources that generate greater social inequality and poverty.

researchers during the last 20 years in comprehensive studies. It is a well-documented fact

that corruption triggers government inefficiency, negatively impacting on long-term

economic growth and sustainable development1. The significance of institutional quality

positively associated with weaker institutions (Demirgüç-Kunt and Detragiache, 1998).

interest of academics. As suggested by Lien (1990), an economy may be affected by

allocation inefficiencies due to the discrimination driven by the corruption. Furthermore,

foreign direct investment amounts.

Commonly, corruption is defined as the abuse of public or corporate office for

consequences, especially in emerging countries (Chen et al., 2015). These countries

Furthermore, a country’s regulatory culture is determined largely by inherited

inefficient enforcement of law and government ineffectiveness. Fernández and González

(Demirguc-Kunt and Detragiache, 2002), corruption may also determine a significant

(Barth et al., 2009).

limited research on the impact of corruption on banking activity, especially on the

important role in shaping the lending behavior of banks.

Furthermore, analyzing the impact of corruption on bank stability and soundness is

stability is increased in a world in which the well-functioning of the banking system

Additionally, it is of high importance to acknowledge and reduce the detrimental effects

weaknesses of institutional arrangements and governmental and regulatory policies were

encompasses their participation in the payment system, the transmission of monetary

their stability if they implement rigorous internal corporate governance practices.

crisis than during normal times.

crises than during normal times.

2. Corruption in Central and Eastern Europe

In Europe, all countries are struggling with corruption. Their vulnerability to

corruption varies depending on a cumulus of political, economic, social and cultural

is common in Eastern European countries.

by bribery given in order to secure a business advantage on a foreign market.

for Economic Cooperation and Development Convention on Combating Bribery of

Foreign Public Officials in International Business Transactions (“OECD Convention”),

corruption strategies that focus on transparency, fairness, integrity, accountability of

governance and a sound business environment.

political will, human and financial resources.

According to Transparency International, some EU members such as the Czech

perceived to have increased corruption (Mulchany, 2012). Also, according to OECD,

legislation, its enforcement is poor (OECD, 2012).

inconsistent and inconsequent enforcement. According to Eurobarometer, some

The existing literature is ambiguous on the effects of corruption on bank activity.

a beneficial impact on lending corruption by reducing its amount.

provided by Transparency International and the Information for Democracy Foundation.

In contrast to these studies we use the Z-score, an overall indicator of bank

score implies a lower probability of insolvency, providing a direct measure of soundness

performance, it is less capitalised or it has a higher degree of variation in returns (Mare et

appropriate measures to fight corruption and prevent it from happening.

4. Data and Methodology

countries depending on the bank governance and macroeconomic environment. We

and banking stability and credit risk on the other hand.

different objectives and conduct businesses in different specializations. One concern

75% of the total assets of the CEE banking systems in 2012.

In this equation, , represents bank i risk from country j, in the year t.