Banking Sector Stability and Economic Growth in Ethiopia: The Two-Step System GMM Analysis

Abstract

This study investigates the relationship between banking sector stability and economic growth in Ethiopia, employing a dynamic panel data approach with the Two-Step System Generalized Method of Moments (GMM). The analysis uses a balanced dataset from 13 Ethiopian commercial banks covering 2014 to 2023, gathered from the World Bank database, the National Bank of Ethiopia, and audited financial statements. Banking sector stability is assessed using indicators such as Z-score, non-performing loan (NPL) ratio, capital adequacy ratio (CAR), liquidity ratio (LR), return on assets (ROA), and loan-to-deposit ratio (LDR), along with key macroeconomic and institutional factors. The results show that banking stability, as indicated by Z-score, liquidity ratios, and profitability, has a positive and significant effect on economic growth, confirming the sector’s role in promoting development. Surprisingly, a positive correlation between NPLs and economic growth suggests unique structural features in the Ethiopian banking system that warrant further investigation. Other variables, such as inflation rates, government expenditure, and gross domestic savings, positively influence economic growth, whereas foreign direct investment is negatively associated with it. The study highlights the importance of enhancing the stability of the banking sector by implementing robust regulatory frameworks, prudent risk management practices, and improved profitability to support sustainable economic development in Ethiopia, while calling for additional research into the unexpected effects of NPLs and FDI amid ongoing financial reforms.