Lak Lak Nazhat El Hasanah

Type of the article: Research Article

Abstract
Institutional quality is a cornerstone for developing a financial system at the country level, including financial soundness in the banking sector. Hence, this study examines the impact of institutional quality on banks’ default risk in a dual banking system, with an in-depth analysis of the differential influence on Islamic and conventional banks. Applying the Two-Step System Generalized Method of Moments (2-Step SGMM), the study comprises 2,232 bank-year observations from 248 banks across eight countries, spanning the period from 2013 to 2021, which utilize dual banking systems. The findings of the study document that the aggregate score of institutional quality and its elements reduces banks’ default risk in all observed countries, comprising Saudi Arabia, Bangladesh, the United Arab Emirates (UAE), Kuwait, Bahrain, Malaysia, Indonesia, and Pakistan. Moreover, Islamic banks are better than conventional banks in terms of their marginal effect on default risk when there is a change in institutional quality. Islamic banks are also found to have less default risk than conventional banks when higher institutional quality is present in the elements of control of corruption and voice and accountability. The results emphasize the pivotal role of institutional quality, as the level of the banking system’s stability depends on the development of institutional quality.