**2. Literature review**

The theory governing the intertemporal causal relationship among bank capital, risk, and efficiency is initialized by Berger & De Young [8] with four hypotheses,

### *Causal Relationship Among Bank Capitalization, Efficiency, and Risk-Taking in ASEAN… DOI: http://dx.doi.org/10.5772/intechopen.109120*

namely "bad luck," "bad management," "skimping," and "moral hazard." Berger and De Young posit that the four hypotheses can occur concurrently, and they imply the different behavior of banks. Under "bad luck" hypothesis, external shock might cause non-performing loans to increase. Thereby banks react by incurring additional costs to monitor and work out with delinquent loans resulting in decrease in cost efficiency. Bad management hypothesis assumes that low cost efficiency is the result of poor management practices. Inadequate credit scoring, loan monitoring and controlling are caused by bad managers, leading to mounting problem loans. Both bad luck and bad management hypotheses predict negative association of non-performing loans and cost efficiency. Skimping hypothesis refers to the trade-off between short-term operating costs for long-term loan performance. A bank may increase cost efficiency through declining cost of credit appraisal, monitoring and controlling loans but at the expense of long-term problem loan portfolio. Skimping hypothesis predicts positive relationship between efficiency and problem loans. Moral hazard hypothesis does not imply the direct association of problem loans and efficiency. Bank managers, particularly weakly capitalized banks, can take excessive risk, given risk can be borne by creditors, thereby increasing the level of bad loans. Moral hazard can have impact on the above three hypotheses.

Berger & De Young [8] analyze US commercial bank data and find evidence that supports bad luck and bad management hypotheses. The interrelationship between efficiency and loan quality is two ways: increase in nonperforming loans followed by the decrease in cost efficiency and vice versa. Evidence for skimping hypothesis is observed for only a subset of banks, which are efficient over time. The studies from European banks of Fiordelisi et al. [6] and Williams [9] as well as the work of Prakash et al. [14] in India, support evidence of bad management behavior. Several other studies investigate the intertwinning of capital, risk, and efficiency and find mixed evidences. Kwan and Eisenbeis [3] find that less efficient US banks appear to have low risk, whereas Altunbas et al. [1] find the contrasting evidence in European banks where inefficient banks have higher capital and lower risk level. Negative association of risk and efficiency found in the studies of Bitar et al., Louati et al., Nguyen and Nghiem [11, 12, 15], and Isnurhadi in Islamic banks [16], whereas a positive relationship existed in the work of Tan and Floros [17], Tahir and Mongid [13], and Manta and Badircea [18]. Those studies do not explore in detail the direction of causation. Moral hazard behavior is found in various studies [8, 13, 19–21].

Another strand of literature pays attention on the causation in nexus between capital and efficiency. Berger and Bonaccorsi [10] examine the interactions between capital and efficiency and hypothesize that a reduction in capital ratio can improve efficiency because of the decrease in agency cost of external equity financing. This hypothesis is named "agency costs shareholders-managers" by Lešanovská and Weill [22]. Beside, another assumption is proposed that an increase in capital ratio can cause an improvement in efficiency because agency cost helps reduce the conflict between shareholders and debtholders. The assumption is called "agency cost shareholdersdebtholders" hypothesis. Empirical evidences of Berger and Bonaccorsi [10], Skopljak and Luo [23], Pessarossi and Weill [24] support agency cost hypothesis where higher capital ratio is associated with improved efficiency.

Berger and Bonaccorsi [10] also look at reverse causality running from efficiency to risk. They suggest the two hypotheses that are "efficiency risk hypothesis" where more efficient banks cause lower level of capital because higher returns can substitute for financial distress risk and "franchise value hypothesis," where efficient banks maintain high capital to preserve their economic rents. The results from studies of

Berger and Bonaccorsi [10], Williams [9], and Kwan and Eisenbeis [3] show dominant substitution effect of the efficiency risk hypothesis, whereas the franchise value hypothesis is found in small banks. The result of Bagntarasian and Mamatzakis [25] finds evidence of structural breakpoint in the relationship between capital and efficiency. Evidence that supports franchise value hypothesis is found in low-efficiency banks, whereas evidence from high-efficiency banks supports the efficiency risk hypothesis.

Koutsomanoli and Filippaki [7] adopt a panel VAR framework to closely investigate the complex causal relationship of risk and efficiency. For a sample of European banks, they observe that the impact of inefficiency on risk is small and short-lived, whereas the reverse effect is negative and significant. Other study by Jouida [26] also adopts the same panel VAR framework to examine the causality of bank capital and systemic risk in French market. The study finds a negative bidirectional relationship of capital and systemic risk. Further study of Bagntarasian and Mamatzakis [25] explores the nexus of capital buffer, Zscore, and performance using dynamic panel threshold analysis. They focus on testing the efficiency risk hypothesis and franchise value hypothesis and find the evidence of efficiency's impact on capital buffer and risk.

Yet, no study so far has addressed the combined causality and directional interactions among the three factors of capital, credit risk, and efficiency and explained the different behavior among banks within this nexus. Therefore, further investigation can provide evidence on the underlying nature of the directional impact of one component on another. This chapter reveals the dynamic interactions among risk, efficiency, and capital through investigating primary shocks that cause the variability in each of the three variables. This type of comprehensive assessment of dynamic relationships can provide evidence that explains the different results in literature, particularly in ASEAN region where behavior of banks is not thoroughly studied in order to provide useful implication for management and regulators.
