The Relationship Between Financial Stability and Credit Supply: Evidence from Iraq

Abstract

Objective: The study aims to investigate the impact of bank credit on financial stability in the Iraqi economy and to reveal trends in bank credit in the Iraqi economy.   Method: We use the Vector Error Correction Model (VECM) and the Granger causality to assess the role of bank credit in strengthening financial stability in the Iraqi economy for the period 2006 to 2021.   Result: We provide evidence on the presence of a long-term relationship between bank supply and all indicators of financial stability. In the short term, a positive association is documented between bank credit and capital adequacy ratio.   Conclusion: Several conclusions could be drawn from our analysis of the evolution of bank credit and financial stability indicators, as well as from our empirical investigation of the relationship between them. The bank credit has been steadily increasing from 2006 to 2021. The capital adequacy ratio (CAR) was very high over the period 2006-2021, exceeding the standard ratio set by the Central Bank of Iraq, which is 12%. This reflects the soundness of the banking system in Iraq.  However, the return on equity declined from 27.1% in 2010 to 5.15% at the end of the study period in 2021. Using the VECM model and Granger causality, we provide evidence that bank credit affects financial stability through multiple channels. Thus, the Iraqi central bank should use the tool of credit supply to enhance financial stability.