The Impact of Countries' Institutional Characteristics on Bank Performance

This study examines the relationship between national institutional quality and banking sector performance using a comprehensive panel dataset of 448 bank-year observations across 28 countries during 2010-2020. Employing multiple econometric approaches, including fixed effects, random effects, and instrumental variable estimation, we investigate how six dimensions of institutional quality from the World Governance Indicators influence key banking performance measures, including profitability, efficiency, stability, and risk management. The empirical results demonstrate robust positive relationships between institutional quality and banking performance across all specifications. Rule of Law emerges as the most influential institutional dimension, with a one standard improvement corresponding to 0.52 percentage point increases in Return on Assets and 2.84 percentage point reductions in Non-Performing Loans Ratios. The analysis reveals that institutional effects operate through distinct transmission mechanisms, with Rule of Law primarily affecting credit risk outcomes, Government Effectiveness influencing capital adequacy measures, and Control of Corruption enhancing operational efficiency. Institutional effects exhibit significant heterogeneity across development levels and periods. Developing countries demonstrate institutional effect magnitudes approximately four times larger than developed economies, while crisis periods show effects 40 percent stronger than normal periods. Moving from the 25th to the 75th percentile of institutional quality corresponds to nearly one percentage point improvement in Return on Assets, representing economically meaningful enhancements in the banking sector performance. The findings have important policy implications for financial sector development strategies. The results suggest that institutional development should constitute a primary priority for countries seeking to strengthen their banking sectors, with legal framework improvements yielding particularly high returns. The differential effects across development contexts indicate that governance reforms may provide especially valuable benefits in developing countries, where institutional constraints bind more tightly on financial sector performance.