375 16 Macroeconomic shocks and Islamic bank behavior in Turkey Ahmet Faruk Aysan, Mustafa Disli, Adam Ng and Huseyin Ozturk 1 INTRODUCTION Events such as the ‘credit crunch’, ‘bank run’, ‘financial contagion’, ‘flight to quality’ and ‘systemic risks’ have widely transpired in recent times. One important dimension permeat- ing these events is the dynamic link between macroeconomic shocks and banks’ behavior. Economic crises experienced by five East Asian countries in the late 1990s were accompa- nied by financial sector problems. The Great Recession of the late 2000s also corresponded to heightened solvency risks affecting over-leveraged banks and financial institutions in many developed countries. 1 In a world of imperfect information, adverse macroeconomic shocks could weaken firms’ balance sheets, diminish bank capital and trigger financial disintermediation. Positive shocks, on the contrary, could increase firms’ net worth and prompt additional bank lending. Understanding the nature of this interaction offers regu- lators, supervisors, firms and households valuable insights into the process of policymak- ing, financial intermediation and responding to boom and bust cycles in the economy. The credit and deposit behaviors of banks can be affected by several types of macro- economic shocks. These include shocks to the business cycle, domestic monetary policy and external risk perception. Prolonged prosperity, according to the financial instability hypothesis of Minsky (1986), may induce speculative euphoria and excessive borrowing that pushes the economy to the brink of a meltdown. Perceived risk of loans may be underestimated by the banks during lending boom periods. Loan quality characteristi- cally weakens as a result of optimistic risk assessments based on the higher expected value of collateral and the current strong economy (Başçı, 2006). This view has been a fertile ground for both theoretical and empirical inquiries. For example, Bucher et al. (2013) present a model that focuses on the role of business cycle volatility as a potential cause for internal and external funding problems of banks. In a downturn, the internal and external funding sources are depleted by virtue of low cash flows from existing loans and low funding liquidity of new loans. This prompts banks to fuel excessive credit growth in good times to strengthen internal funding later during bad times. Banks could also fail if loans become too toxic in an economic downturn. Implications from the model suggest that the performance of banks can be improved only if there is a stabilization of the real economy. Empirically, Asea and Blomberg (1998) showed that the market for bank loans experiences systematic cycles of over and under-lending based on a dataset of 580 US banks between 1977and 1993. In contractionary phases of the cycle, risk premiums on loans and the probability of collateralization increase, although loan size remains unaf- fected. During the expansionary phases of the cycle, the premium and the probability of collateralization decrease; while loan size increases. M4091 HASSAN_9781784710729_t.indd 375 14/10/2016 15:41