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This paper aims to offer an empirical study of the impact of institutional quality on the banking system risk and credit risk.

Applying cross-sectional dependent tests and stationary tests to check the property of our sample, the panel corrected standard errors model is recruited as the main estimator, while feasible generalized least squares, pool ordinary least squares (OLS), robust pool OLS and other estimators are used as a robustness check for an unbalanced panel data for 56 economies divided into three subsamples between 2002 and 2015.

The empirical results show several significant contributions. First, an improvement in institutional quality is an important factor to reduce the banking system risk. This effect of the institutions is less important in well-capitalized, highly profitable and in high-economic growth countries. This effect is also stronger in highly liquid banking systems. Notably, a better institutional quality helps to reduce the banking system risk in the highly concentrated banking system. Second, institutional quality has a significant negative relationship with the banking credit risk, especially in highly concentrated banking systems and in high-growth countries. This influence is weaker in highly liquid and well-capitalized banking systems. Finally, better institutions reduce the positive effect of trade openness, but it induces a higher credit risk for the banking system from the trade openness. Notably, a better institutional quality enhances the negative effect of foreign direct investment (FDI) inflow on both banking system risk and credit risk. These findings are documented for a global sample and three subsamples: low and lower-middle-income economies, upper-middle-income economies and high-income economies.

This study provides some recommendations, for policymakers, on the roles of institutions in the banking system and financial stability.