1 معهــد الـدرا�صـات امل�صرفيــة )متوز 2012(Institute of Banking Studies (July 2012)

Bank Concentration, Institutional Quality, and Economic

Growth: Empirical Evidence from MENA Emerging Markets

Nedal A. Al-Fayoumi

Professor of Banking and Finance

The University of Jordan

The economic and finance literature provides evidence indicating that banking sector development enhances economic growth and that a banking development is related to its institutional framework (La Porta et al. 1997, 1998; Levine 1997, 2005; Rajan and Zingales, 1998). It also has been shown theoretically that the degree of market power in the banking sector can influence the ability of firms to receive external financing and consequently on economic growth.

Two opposing arguments regard the effect of market power on economic growth through its effect on the access of firms to external financing (Cetorelli and Gambera, 2001): In highly concentrated markets, banks with monopoly power would impose higher loan rates and a smaller quantity of loanable funds. This behaviour would affect negatively on firms’ access to credit, thus reducing economic growth. On the other hand, banks with monopoly power have a greater incentive to establish long-run lending relationships with their client firms, thus facilitating their access to credit. Therefore, more banking concentration and/or less banking competition leads to more credit access for firms and boost economic growth.

Moreover, Rajan and Zingales (1998) argue that in the low quality institutional environment, bank based system survives and concentration is more effective in this case, because banks can use their power to protect their benefits in the absence of effective institutions and legal provision. Bank concentration could help banks in solving the asymmetric information problem through long-run relationships with borrowers in emerging markets that have law quality institutional environment. Consequently, bank concentration in these markets may be preferable because it has a positive effect on economic growth (Ferndndez et al., 2010).

The aim of our study is to extend previous literature by examining empirically the simultaneous effect of banking concentration and quality of institutions on economic growth using data from Meddle East and North Africa (MENA) less developed countries during the period (1996-2010). In particular, two questions are addressed:

-Do both bank concentration and institutional quality matter for economic growth?-Does the quality of institutions have an influence in shaping the relationship between bank concentration and economic growth?

We can consider MENA countries as an interesting sample from which to draw some inferences about the relationship between concentration, institutions quality, and economic growth, because the banking sectors in these countries are highly concentrated and institutional and legal systems quality are at early stage of development. This argument is supported by González-Rodríguez (2007) who indicated if countries have weak institutional environments, are more bank-based and are financially less developed, bank concentration structure can be most thoroughly verified in these countries.

معهــد الـدرا�صـات امل�صرفيــة )متوز 2012(2Institute of Banking Studies (July 2012)

- Data

Our data set consists of 15 MENA countries and covers the period 1996-2010. These countries are: Algeria, Bahrain, Egypt, Iran, Jordan, Kuwait, Lebanon Morocco, Oman, Saudi Arabia, Syria, Tunisia, Quarter, UAE, and Yemen. The major variables that we use in this study are taken from the World Development Economic Indicators database (2011), Beck and Demirgüç-Kunt (2009) database Financial Institutions Structure, Bankscope, Heritage Foundation, and Polity TM IV Project.

- The Model

The present study will investigate whether institutions quality plays any important role in shaping the relationship between bank concentration and economic growth in MENA countries by estimating the following two models:

GDPGjt = f( CONCjt, INSTjt, CONCjt X INSTjt,CONTjt)

GDPGjt = f( CONC2jt, INSTjt, CONC2

jt X INSTjt,CONTjt) Where,

- GDPG: Growth in real GDP per capita- CONC: Bank concentration- CONC2: Squared bank concentration- INST: Institution quality (Economic freedom index or Polity2 index)- CONC X INST: Interaction effect - CONC2 X INST: Non-linear interaction effect

- CONT: Control variables (Domestic Credit to private sector, General government final consumption expenditure, Gross capital formation, School enrollment, Financial crisis dummy variable)

The Generalized Method of Moments (GMM) methodology is employed here to control for endogeneity in our growth equations. The GMM estimator has been widely employed in recent empirical works, particularly in macroeconomics and finance (Liang, 2007)

The Results

Tables 1 and 2 present the results of this study. They indicate that bank concentration has an overall positive effect on economic growth, where the coefficient of concentration variable is significant in all models. This result is in the line of the argument that indicates monopoly power gives banks incentive to establish lending relationships with their client firms, thus facilitating their access to credit. Moreover, the coefficient of interaction effect is negative and significant in all models, which means that the lower the quality of institutions in MENA countries leads to greater positive effect of bank concentration on economic growth. These results are consistent with Fernández et al. (2010) results which indicate higher value of close relationships between banks and firms in countries where a poor-quality institutional environment does not favor the development of markets.

3 معهــد الـدرا�صـات امل�صرفيــة )متوز 2012(Institute of Banking Studies (July 2012)

Based on these results, we can conclude that Policy makers and regulators in MENA countries should improve institutional quality in order to support the role played by the banking sector in enhancing economic growth.

Table 1: Economic Growth, Concentration, and Institutional Quality

(Linear Institutional Quality)

Dependent variable GDP Growth

Institutional Quality 1 Polity Institutional Quality 2 Economic Freedom

Explanatory VariablesLag Dep .5936*

(.3356) .4209

(.3564) .30881 .35241

Lag Dep .5864 * (.3378)

.51847* (.3087)

Concentration 1.5842*** (.3111)

1.5505*** (.31969)

-1.4326* (.7989)

Concentration 1.584826 *** (.3122)

24.9102 *** (3.0478)

Polity -2.12983 (2.2401)

-1.3925 (2.2158)

Economic Free .2682 ( .9854)

.0442 (.9009)

Con*polity -.4350*** (.1070)

Econ*conc -.3868*** (.0503)

General Government

1.5693 (1.4115)

1.297184 (1.4297)

1.0753 (1.4105)

General Government

1.5473 (1.4187)

1.6204 (1.2964)

Gross Cap -.0416 (.7924)

.1153 (.8234)

-.0369 ( .8125)

Gross Cap -.0263( .7971)

-.1010 (.7284)

Domestic Credit

2.1002*** (.4732)

2.5167*** (.5423)

2.7406*** (.5375)

Domestic Credit

2.1002 *** (.4748)

2.1956*** (.4341)

School 1.7745 *** (.6318)

2.00871*** (.6376)

1.8678*** (.6294)

School 1.7728*** (.6341)

1.5889 *** (.5799)

Dummy -20.4727**(8.8340)

-20.67348** (9.24703)

-18.1390** (9.1373)

Dummy -20.9251 ** (9.0194)

-18.6219** (8.2471)

Wald Test 89.64*** 87.90*** 106.96*** Wald Test 89.08*** 165.2***

Sargan 243.9369*** 230.1926*** 220.3451*** Sargan 242.1558*** 230.9283***

معهــد الـدرا�صـات امل�صرفيــة )متوز 2012(4Institute of Banking Studies (July 2012)

Dependent variable GDP Growth Institutional Quality 1 Polity Institutional Quality 2 Economic Freedom

Explanatory VariablesLag Dep .5835*

.3330.4259 .3539

.3076 (.3473)

Lag Dep .57783* (.3351)

.5691 * (.3376)

Concentration^2 .0208*** .0038

.0205 *** .0040

.0242** .0104

Concentratio^2 .0208*** .0039

.06582 *** .01466

Polity -1.5662 2.2429

-1.0596 2.1978

Economic Free .0208.0038

.0534 .9551

Con^2*polity -.0064*** .00139

Econ*concentration^2 -.06184*** .01947

General Government 1.6612 1.4013

1.4169 1.4213

1.1777 1.3920

General Government 1.6435 1.4083

1.7787 1.3746

Gross Cap .06028 .78841

.1741307 .818453

-.05244 .80249

Gross Cap .07195.7929

.10078 .7735

Domestic Credit 2.0575*** .4691

2.4382*** .53797

2.6707*** .5289

Domestic Credit 2.0575*** .47068

1.9540*** .46036

School 1.8265*** .6246

2.049378 *** .63112

1.8926*** .61859

School 1.8253*** .62671

2.0117*** .6142

Dummy -20.9479** 8.74613

-21.2803** 9.1677

-18.4725** 8.9928

Dummy -21.3019** 8.9235

-19.0268** 8.7352

Wald Test 94.13*** 91.77*** 117.06*** Wald Test 93.55*** 108.38***

Sargan 244.6726*** 230.6551*** 219.5739 Sargan 242.9901*** 245.2154***

Table 2: Economic Growth, Concentration, and Institutional Quality

(Non-Linear Institutional Quality)

• This article is based on the work under processing titled: Bank Concentration, Institutional Quality, and Economic Growth: Empirical Evidence from MENA Emerging Markets.

Nedal A. Al-Fayoumi (Professor)Professor of Banking and Finance and the director general of financial funds at the University of Jordan. He has

received his Ph.D from the University of Wales, UK in 1999.Professor Al-Fayoumi is specialized in presenting training programs at local, regional and international levels. The area of his specialization is Financial and Credit Analysis, Corporate Governance, and Bank Management. He has been cooperated with a number of prestigious institutions like: International Finance Corporation (IFC), The European Union, EJABI, Bank-Scope, Belgium, Gulf Stock Exchanges, NENARACA, Institute of Banking Studies/Jordan, TAG-organization, and Jordanian Businessmen Association / JBA. More recently, professor al-Fayoumi has participated in developing a number of professional training programs for brokers and dealers.