credit risk in banking sectors by evaluating in nonperforming loans in european and asian countries
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Credit Risk in Banking Sectors
by Evaluating in Nonperforming Loans in European
and Asian Countries
Xiaohua Zheng
MSc International Risk Management and Finance
August 2016
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i
Abstract
The most recent financial crisis raised the public panic and raised extensive research
in the cause of a crisis. Credit risk, as a predominant risk factor in the banking crisis,
is investigated in this paper to seek the joint impact from macroeconomic movement
and banks’ internal behaviour.
This article laid emphasis on seeking for for six key systematic and unsystematic
determinants to explain the occurrence of credit risk level in ten European (Austria,
Spain, France, German, Poland) and Asian (China, Indonesia, Thailand, Philippine
and Vietnam) countries over the last decade (2005 – 2015). An econometric panel
analysis incorporating fixed-effect least square and difference General Method of
Moment was utilised in this research. The results verified a sound evidence that
unfavourable macroeconomic shocks, like economic downturns, macro
mismanagement and currency fluctuation, as well as bank disturbances, like low
bank profitability, excessive risk-taking and lending activities, challenges the
stability and credit risk level in banks across the detected regions. Changes in GDP
growth, real effective exchange rate, return on equity, loan/asset ratio and loan
growth rate depicted an inverse effect on impaired loans ratio, whereas inflation rate
displayed a positive relationship with NPLs in banking sectors.
However, the results in robustness check suggested that developing countries exist
different performance uncommon to other regions. Loan/asset ratio and loan growth
rate are found robust in both regions.
This paper found research in credit risk is substantially essential and meaningful in
predicting and evading potential banking crisis by capturing the macroeconomic
movements and institutional behaviours. Government policy makers and bank
regulators play an imperative role in providing a healthy economic and financial
environment for controlling potential crisis.
Keywords: nonperforming loans, credit risk, macroeconomic, bank-specific
ii
Acknowledgement
I would like to express my sincere gratitude to my supervisor Dr Merima Balavac,
who gave me supervision on my dissertation, as she did more than she should as a
supervisor. I appreciated as I cannot finish such a dissertation without her help.
I also sincere appreciate my family supporting me freely for my study here. Never do
I need to worry about living, the only thing I shall care is to study and live a happy
life in Bournemouth.
Lastly, thanks to my dear friends, classmates, who always be with me, always
answering and solving my endless queries and issues both in study and life. Thank
God for allowing me to meet you guys.
Special thanks to Albina Gaisina, Jay Nugent, Oluwagbenda Wise Adamolekun and
Onwuchekwa Uche that have given me great help in my dissertation.
Xiaohua Zheng (Queeni)
iii
Table of Contents
Abstract ........................................................................................................................ i
Acknowledgement ...................................................................................................... ii
Table of Contents ...................................................................................................... iii
List of Table ................................................................................................................ v
List of Figure ............................................................................................................. vi
List of Abbreviations ............................................................................................... vii
Chapter 1 Introduction ............................................................................................. 1
1.1. Background of the Study ................................................................................ 1
1.2. Research Objectives ........................................................................................ 2
1.3. Research Questions ......................................................................................... 3
1.4. Structure of the Study ..................................................................................... 4
Chapter 2 Literature Review .................................................................................... 5
2.1. Theoretical Framework .................................................................................. 5
2.2. Review of Empirical Literature ..................................................................... 6
2.2.1 Macroeconomic Indicators .......................................................................... 7
2.2.2 Bank-specific Indicators ............................................................................ 11
2.3. Research Gap ................................................................................................. 15
2.4. Hypothesis Test .............................................................................................. 16
Chapter 3 Research Methodology .......................................................................... 17
3.1. Research Design ............................................................................................. 17
3.2. Research Philosophy ..................................................................................... 18
3.3. Research Approach ....................................................................................... 18
3.4. Data Collection and Description .................................................................. 19
3.4.1 Sample Selection and Sources ................................................................... 19
3.4.2 Sample Size ............................................................................................... 20
3.4.3 Variables .................................................................................................... 20
3.5. Econometric Model and Methodology ........................................................ 22
3.5.1 Econometric Model ................................................................................... 22
3.5.2 Empirical Methodology ............................................................................. 24
3.5.3 Methodology .............................................................................................. 24
iv
Chapter 4 Empirical Findings ................................................................................ 26
4.1. Descriptive Statistics Analysis ...................................................................... 26
4.2. Main Findings ................................................................................................ 28
4.2.1 Multicollinearity ........................................................................................ 28
4.2.2 Homoscedasticity ....................................................................................... 29
4.2.3 Normal Distribution ................................................................................... 29
4.2.4 Durbin-Watson Test .................................................................................. 30
4.2.5 Empirical Results ....................................................................................... 30
4.3. Discussion of Empirical Findings ................................................................ 33
4.3.1 Inflation Rate ............................................................................................. 33
4.3.2 Growth of Real GDP ................................................................................. 34
4.3.3 Real Effective Exchange Rate ................................................................... 35
4.3.4 Return on Average Equity ......................................................................... 36
4.3.5 Growth of Gross Loan ............................................................................... 37
4.3.6 Loan to Total Asset .................................................................................... 38
4.4. Robustness Test ............................................................................................. 39
Chapter 5 Conclusion, Limitations and Recommendations ................................ 41
5.1. Conclusion ...................................................................................................... 41
5.2. Limitations ..................................................................................................... 43
5.3. Recommendations ......................................................................................... 44
5.4. Further Research ........................................................................................... 44
Reference .................................................................................................................. 45
Appendices ................................................................................................................. A
Appendix 1 Macroeconomic interlink with NPLs ........................................... A-1
Appendix 2 Normal Distribution of Independent Variables .......................... B-1
Appendix 3 Quantiles – Quantile Graph ......................................................... C-1
Appendix 4 Signs of Tested Variables .............................................................. D-1
v
List of Table Table 3.1 Observation Summary ............................................................................... 20
Table 3.2 Data Definition, Expected Signal and Sources ......................................... 22
Table 4.1 Descriptive Statistics, 2005-2015 .............................................................. 27
Table 4.2 Correlation Matrix ..................................................................................... 29
Table 4.3 NPLs: Macroeconomic and Bank-Level Determinants, 2005-2015 ......... 31
Table 4.4 Significance Period Range for Durbin-Watson Result ............................. 30
vi
List of Figure
Figure 2.1 Impact from Adverse Economic Movement ............................................. 8
Figure 2.2 Impact from Dysfunctional Management in Banks ................................. 11
Figure 2.3 Credit Risk Determinants ........................................................................ 14
Figure 3.1 Research Onion ........................................................................................ 17
Figure 3.2 Inductive and Deductive Approach ......................................................... 19
Figure 4.1 Exchange Rate Fluctuation ...................................................................... 26
Figure 4.2 Real GDP Change Performances ............................................................. 27
Figure 4.3 NPLs Ratio in Two Regions .................................................................... 28
Figure 4.4 Distribution of Logit transformed NPLs ratio ......................................... 29
vii
List of Abbreviations
NPLs Nonperforming Loans
WaMu Washington Mutual Savings Bank
IMF International Monetary Fund
OLS Ordinary Least Squares
GMM Generalized Method of Moments
GDP Gross Domestic Product
CPI Consumer Price Index
ROA Return on Asset
ROE Return on Equity
REER Real Effective Exchange Rate
ROAE Return on Average Equity
LTAR Loan-to-Asset ratio
G_LOAN Gross Loan Growth Rate
INFR Inflation Rate
Page 1 of 66
Chapter 1 Introduction
1.1. Background of the Study
The global financial crisis in 2007 – 2008 has brought a dramatic aftermath to the
world economic market, witnessed by hundreds of commercial and investment banks
destroying trillions of dollars of wealth worldwide. The crisis has brought an
enormous downgrade of credit hierarchy due to high leverage level. Meanwhile, the
exploitation of bank credit results in financial institutions failing to pay back their
massive loans and mortgages. It also brought tremendous impacts on commercial and
retail banking. For instance, Washington Mutual Savings Bank (WaMu), the biggest
saving banks in the US, was seized and sold to JP Morgan in 2008 (Sender et al.
2008). The global financial crisis has been regarded as one of the worst financial
crisis events as it gave rise to a large amount of bank failure or bankruptcy as a result
of suffering from credit risk and bad loans (Rashid et al. 2014). The aftermath of the
financial crisis caused dramatic changes in the macroeconomic environment, which
has magnified the impacts on banking sectors. Nonetheless, the internal imbalance
and mismanagement in banks were also convinced as crucial elements for financial
vulnerability. A vast amount of studies on the global financial crisis has emerged,
accompanied by research in bank profitability, credit risk exposure and loan default
probability from distinctive perspectives. Compared with other industries, it’s
apparent that banking sectors suffered immense losses during and after the global
financial crisis (El-Bannany 2015). This period makes it a worthy area to research
on in banking sectors.
Credit risk is regarded the most significant factors in banking crisis as it could
deteriorate economic environment and raise interest payments, which is commonly
found in credit risk models (Espinoza and Prasad 2010; Agnello and Sousa 2011).
Reduced credit risk management causes from a high level of speculative lending,
internal leverage and intense concentration of credit in banking sectors, accordingly,
adding up to substantial loan default probability and problems loans (El-Bannany
2015). In fact, early research found clear evidence that the level of problem loans
increases dramatically before and during the financial crisis (Gonzalez-Hermosillo
1999). Appendix 1 demonstrates the close linkage between credit quality and the
Page 2 of 66
economic downturn. The Macroeconomic factors are considered to be the
predominant factors on triggering a banking crisis. For instance, a slowdown of the
business cycle, high inflation rate, high unemployment level and huge fluctuation in
exchange rates are considerable elements for the banking crisis. Moreover, a
deterioration in bank’s financial statements can also reflect as a slowdown in the
economic conditions. Adversely, internal bank fundamentals like low profitability,
inefficiency and high leverage level also add up to potential risks on the write off in
banks’ balance sheet. Therefore, it’s essential to evaluate the credit risk exposure by
observing the macro-financial performance in banks as it plays a vital role to raise
the awareness on proper preparation to face financial vulnerability and adverse
economic movements (Castro 2013).
Nonperforming loans (NPLs), also known as impaired loans in divergent banks, is
regarded as the most common gauge to evaluate loan quality due to majority banks
have taken NPLs data as a benchmark to measure credit risk level (Ahmad and
Ariff 2007). NPLs, considered as the ‘financial pollution’, would crumble the
financial market and economic environment. Recent studies have found that failure
management of bad debts increase is the dominant cause of financial friability, which
ascertained the fact that not only did macroeconomic shocks the economic
environment but also did banks’ systematic factors matter for the credit risk. High
level of NPLs in banks exist a greater possibility for banks to face a banking crisis.
Thus, NPLs is always taken as a proxy for credit risk in measuring the financial
vulnerability of banks.
1.2. Research Objectives
Apart from the case of WaMu in the USA, several banks in Europe and Asia also
suffered from high NPLs and significant credit risks during the global regression
period, especially Italy, Indonesia and Thailand has closed down many banks. While
other banks in other countries also encountered with mergers with other banks or
injection of financial bailout from governments (Ahmad and Ariff 2007). There
exists considerable amount of studies by single countries, but they mainly
concentrate on European countries case studies (Salas and Saruina 2002; Arpa et
al. 2001; Quagliariello 2007; Cotugno et al. 2010; Zeman 2008) and regional
Page 3 of 66
analysis in Central Europe, Middle East and African countries (Williams 2004;
Mannasoo and Mayes 2009; Espinoza and Prasad 2010; Festic et al. 2011;
Castro 2013; Makri et al. 2013). Although most influenced countries in Asia are
developing countries, the aftermath and consequence in Asian countries also derive
great impacts on the global economic environment. Notably, studies in Asian
countries are comparatively less. Considerable researchers have focused on only
either the macroeconomic area (Arpa et al. 2001; Fofack 2005; Ahmad and Bashir
2013; Beck et al. 2015) or the institutional impact (Kraft and Jankov 2004; Epure
and Lafuente 2012; El-Bannany 2015), and limited studies have laid emphasis on
both perspectives including two differentiated regions.
This project intends to capture the linkage between credit risk and systematic and
unsystematic (macroeconomic-financial) aspects in ten countries that were
influenced by the global financial crisis in different levels. There include five
countries in Europe (Austria, Spain, France, German, Poland) and five countries in
Asia (China, Indonesia, Thailand, Philippine and Vietnam). This paper provides an
overview of the unfavourable macroeconomic conditions that these countries are
facing (financial crisis and economic downturns) to understand the impact from
adverse economic activities on banks’ credit risk performance, especially for the
business cycle, situations and appreciation or depreciation of local currencies. At the
same time, examinations on representative banks internal performance indicators by
tracking banks’ financial statements were also critical in this analysis. In terms of the
financial accelerator theory, it’s believed that the combination of internal institutional
mismanagement and macroeconomic disorder could magnify the impact on the asset
quality in a firm. Hence, a further study through both perspectives could be more
supportive to explain the credit risk in banking sectors. This paper also expects to
give a predictable guidance on proper policy making towards macroeconomic signals
and internal performance in financial sectors.
1.3. Research Questions
This project research explores four questions, which could assist in capturing a better
understanding of a crisis caused by negligence of credit risk in banking industry.
Page 4 of 66
How does credit risk influenced by macroeconomic shock and internal banking
dysfunctional managements in the last decade?
Is there any difference in problem loans behaviour in terms of adverse economic
activities and banking mismanagements in different regions, like Europe and Asia?
How does the impact from both perspectives magnify their effects on credit risk level
in banking sectors?
What kinds of potential measures can be taken to eliminate the impact from different
sides?
1.4. Structure of the Study
This paper intends to employ a proper econometric by a combination of panel
regression estimation, fixed-effect OLS and difference GMM estimator, to detect the
intervention across ten countries over last decades (2005 – 2015).
Five chapters structure this research. Chapter one describes the background and
objective of this study. In chapter two, it seeks a proper theoretical framework to
support the impact of macroeconomic movement and internal bank activities. At the
same time, a majority of empirical literature are reviewed to justify the
macroeconomic and financial influences on credit risk. Chapter three depicts the
methodology used in this study, accompanied by the explanation of conceived
variables, selected data, econometric models and potential problems existing in
design econometric analysis. Chapter four presents the descriptive statistics of
variables, diagnosed tests results for inherent issues, discussion on results and
findings. A robustness analysis is also carried out to underpin the results in this study.
Chapter five provides a conclusion linked with the research objectives. Limitations
and recommendations of this study are also provided for further research.
Page 5 of 66
Chapter 2 Literature Review
Studies on seeking the determinants of bank asset quality or credit risk are not new,
which has been examined by varieties of scholars through various approaches. This
chapter sheds light on the overview in the theoretical framework – the financial
accelerator and the empirical literature. The first part explains how the business cycle
magnifies the macro-financial linkage impacts on firms during the economic
downturns according to the theoretical framework. The second branch contributes to
empirical literature to identify the leading determinants of problem loans from the
macroeconomic movement as well as the bank-level fundamentals to interpret banks’
exposure to credit risk.
2.1. Theoretical Framework
The Financial Accelerator theory is the predominant and prevalent theoretical
frameworks on explaining the macro-financial linkage between macroeconomic
complementarities and financial accelerator (Bernanke and Gerlter 1989; Kiyotaki
and Moore 1997; and Bernanke et al. 1999,). Under the business cycle theoretical
framework, firm internal indicators also matter for the cyclical behaviour when
analysing the macroeconomic dynamics. As cyclical impulses in credit market
includes debt-deflationary shocks and shock to financial intermediaries.
This theory originated from the agent-principle issue, there always exists information
asymmetry, and therefore, it results in an extra cost to get the firm-level internal
information, which makes external finance costs higher than inward investment. In
this case, there occurs greater reliance on the corporate’s financial statements.
Bernanke and Gerlter (1989) identified that a firm’s financial statements are the
predominant resources of information depicting the implementation of the budget in
a corporate, which can largely influence some important decision-making like
investments and financing. That is, descent in asset price can deteriorate firms’
balance sheet and their net worth. Bernanke et al. (1999) explained that a negative
shift to the economy reduces borrowers’ net worth to different extent. Accordingly,
the initial shock on the spending and production will amplify the corresponding
effects.
Page 6 of 66
Consequently, firms’ financing ability would be destroyed to some extent, which
results in an adverse effect on their investments. Additionally, the economic
recession further downgrades the asset value, which conducts to a feedback cycle of
asset price falling, financial statements deterioration, financing conditions tightening
and economic activities declining. Vermeulen (2002) analysed the Germany, France
Italy, Spain and discovered stronger effects of the accelerator on small firms as they
have weaker balance sheets when facing the economic downturns and upturns. If
applied the financial accelerator theoretical into business cycle model, it is able to
provide a clear and precise background for NPLs modelling as they explicitly
explained the counter-cyclicality of business failure and credit risk (Williamson
1987).
Against this context, this theoretical framework is influential in the modelling of
NPL with its interaction with macroeconomic and institutional performance. Notably
in financial sectors, divergences in financial regulation and supervision affect banks’
behaviour and risk management practices and exposure, which are imperative to
explain the NPL disparities for cross countries analysis (Mensah and Adjei 2015).
Macroeconomic performance results in a direct impact on borrower’s balance sheet
and their loan capacity.
2.2. Review of Empirical Literature
Large impacts from descent or boom of global financial events on bank performance
are significant concerning asset quality and credit risk exposure through observing
the loan loss provisions, loss given default and NPLs (Beck et al. 2015). One of the
earliest studies, Keeton and Morries (1987), examined the causes of loan losses of
2470 US commercial banks and reported that commercial banks with higher risk
appetite prone to record greater loan losses. Meanwhile, they noticed that banks laid
less emphasis on the quality of borrowers during booming periods, which gave rise
to high problems loans in the banks. Their study has awakened the interests from
public and academic areas to carry out further research in credit risks regarding
problem loans in banks (Berger and DeYong 1997 and Ciccarelli et al. 2010). A
linear regression analysis was utilised by Sinkey and Greenwalt (1991) in US
banking sectors and concluded that loan losses influenced both internal and external
Page 7 of 66
factors. Similar findings have been discovered by Salas and Saurina (2002),
Fuentes and Maquieira (2003) Jimenez and Saurina (2004), Quagliariello (2007),
Cotugno et al. (2010), Louzis et al. (2012), etc.
Fernandez de Lis et al. (2000) discovered that annual growth rate of gross domestic
product (GDP) plays a vital role in explaining the NPLs fluctuation in Spanish saving
banks, ascertaining the boom of bad loans in the recession period. Vodova (2003)
investigated the banking crisis in the Czech Republic and concluded that the causes
of the banking crisis are mainly divided into macro- and microeconomic factors,
including the macroeconomic instability and inadequate preparation for financial
liberalisation, as well as non-performing loans. Quagliariello (2007) used a large
dataset of Italian intermediaries over period 1985 – 2002 and revealed that several
bank-level indicators also play a vital role in explaining the changes in the evolution
of riskiness along with macroeconomic variables. Therefore, the performance of
NPL is the most common measurement and frequently taken as the benchmark to
gauge the asset quality and banks’ credit portfolio. Overall, the empirical literature
has separated the determinants for NPLs in two categories: unsystematic conditions
and systematic bank-specific characteristics.
2.2.1 Macroeconomic Indicators
Extensive research examined the linkage between the credit risks and boom and
depression in the macroeconomic environment and discovered adverse effects of
economic conditions on NPLs. Sinkey and Greenwalt (1991) investigated the loan
loss experience of the major commercial banks in the US. They argued that the
deterioration of regional economic conditions is one of the predominant cause of
high loan loss rate in commercial banks. In addition to economic conditions, Salas
and Saurina (2002) examined the influential factors of NPLs in the Spanish
commercial and saving banks using dynamic panel model. Their results confirmed
that GDP growth shows a strong contemporaneous effect on the evolution of loan
losses in the Spanish market, which is an adverse correlation. This finding is similar
to Jesus and Gabriel’s (2006) findings on an acceleration of GDP and decline in
real interest rates brings a decrease in problem loans. At the same time, collateralised
loans are found to be a higher probability of default (Amuakwa-Mensah et al. 2015).
Hence, unfavourable macroeconomic conditions are the leading cause of problem
loans in banking sectors.
Page 8 of 66
Figure 2.1 Impact of Adverse Economic Movement
Fernandez et al. (2000) utilised panel regression analysis to examine commercial
and saving banks from macroeconomic conditions and banking indicators in Spain.
The study found a significant negative impact on the GDP annual growth rate and
bank size on NPLs. They ascertained that an enormous problem loan losses rate
increase at the time of and after the financial crisis. Arpa et al. (2001) tested credit
risk exposure by observing operation income in Austria. Their regression analysis
found that risk provisions are negatively correlated with real interest rate and real
GDP growth, while real estate inflation and consumer price index (CPI) have
positive impacts. Ahmad (2003) stated that real GDP growth negatively affects the
credit risk exposure in Malaysia banking sectors. Gerlach et al. (2005) studied the
Hong Kong commercial and saving banks and find that economic growth, CPI and
property price inflation erodes the NPLs ratio. Adversely, they believe that deflation
in economy delays the economic growth, and decrease the profitability and affecting
the debt paying ability of borrowers. A direct measure of banks’ write-off to loan
ratio is used by Hoggarth et al. (2005) to estimate the influence of adverse
macroeconomic shocks on aggregate losses in the UK banking system. They found
that loan quality and financial fragility cannot directly be impacted by dynamics of
interest rate and inflation rate. Blavy and Souto (2009) measured the credit risk and
frequencies of default rate by analysing the macro-financial linkages in Mexican
banking systems. They found that domestic and external macro-financial variables
have a strong intervention on banking soundness. Louzis et al. (2012) studied the
impact of macroeconomic fundamentals on business loan default by using dynamic
panel data methods. They found real GDP growth, unemployment rate and interest
rate have the strongest effects on NPLs volatility. Ahmad and Bashir (2013) used
nine macroeconomic variables to investigate the determinants of NPLs in Pakistani
banking sectors. The results show GDP growth, inflation rate, interest rate and
•GDP decrease
Business Cycle
•High Infation Rate
Macro-Mismanagement
•Change of Exchange Rate
Currency Fluction
•High Problem Loans
Credit Risk
Page 9 of 66
industrial production are negatively associated with NPLs, while CPI is positively
associated, which is same to Arpa et al. (2001), and no impact was found from the
unemployment rate, real effective exchange rate and foreign direct investment.
Whereas the insignificant effects from unemployment rate is opposite to Louzis et al.
(2012). However, Poposka (2015) observed the problem loans in selected developed
and developing countries and failed to find a significant relationship between GDP
growth and NPLs in Macedonia between 2004 and 2014, which is the opposite to the
other empirical literature.
Fofack (2005) used an unbalanced dataset in sixteen sub-Saharan Africa countries to
discover the impacts on NPLs. They introduced a new factor, real exchange rate
appreciation, and found that exchange rate movement, economic growth and real
interest rate played a significant role over period 1990 - 2003. Baboucek and
Jancar (2005) assessed the linkage between macroeconomic shocks and loan quality
in Czech banks from 1993-2004. They found appreciation in real effective exchange
rate has significant impact on the quality of loans as well as a significant positive
impact on the inflation rate and unemployment rate. Their study is in consensus with
Jakubik’s (2007) research on Czech Republic banking as he used a regression
analysis and found that bad loans in banking portfolio deteriorate as a result of
shocks in a form of changes in real GDP growth, interest rate and inflation rate.
Zeman and Jurea (2008) used multivariate regression analysis and demonstrated
slowdowns on the nominal interest rate and exchange rate are the most important
factors for NPLs dynamics, however, they ascertained that GDP does not have a
substantial impact on the banking performance. More recent studies like Dash and
Kabra (2010) used panel data regression and suggested that real exchange rate is a
major factor to impact NPLs performance. Khemraj and Pasha (2009) used a panel
data set and a fixed effect model in six Guyanese banks by observing real GDP,
annual inflation and real effective exchange rate. Their results showed a strong
inverse relationship between NPLs and GDP while real effective exchange rate
positively impacts the NPLs, which indicated local currency appreciation would give
rise to a higher loan portfolio in commercial banks.
Though, there is a quite common argument that economic downturn significantly
determinants credit risk because bank assets are more likely to deteriorate during
Page 10 of 66
economic downturns, which adding to default risks (Fischer et al. 2001, Ahmad
2003). A studied in commercial banks in Canada and the U.S. was carried out by
Fischer et al. (2001). They identified similar adverse effects from GDP growth on
credit risk, which is same as in Ariff and Marisetty (2001). Mannasoo and Maves
(2009) studied Central Eastern European countries using a panel logit model with a
set of explanatory variables and estimated that decline in GDP growth and changes in
banks’ internal and external environment result in deterioration of banking sectors’
performance and stability. Babihuga (2007) examined the 96 countries in Asian,
European and Sub-Saharan African regions. He found that inflation rate and real
GDP growth have an opposite impact on NPLs and capital adequacy. Meanwhile,
inflation and the real exchange rate emerge to different degrees as important
determinants. Nkusu (2011) quantified the impact of macro-financial vulnerabilities
on banks’ loan portfolio quality. His result identified that slowdown of GDP growth
and high unemployment rate are the key indicators in producing more bad loans.
Because these two variables are the leading drive of banking system distress and
deterioration in economic activity. De Bock and Demyanets (2012) studied 25
emerging countries and discovered huge impacts from GDP growth rate and
exchange rate on NPLs over their observed countries. A most recent research did by
Beck et al. (2015) has ascertained that real GDP growth is the prime drive of NPL
ratios over the past decades. They applied dynamic panel analysis and estimated
some significant determinants of asset quality over last ten years in 75 countries
worldwide. Moreover, exchange rate depreciations are found to result in an
ascendant of NPLs in countries with high level of lending in foreign currencies to
unhedged borrowers.
The review of the empirical literature demonstrated the substantial significance of
macroeconomic factors, such as GDP growth, interest rate, exchange rate,
unemployment rate, inflation rate, CPI and etc., on credit risk level and firm fragility.
In single countries studies, the results are even more distinguished between
developed and developing countries. It can be seen by different signals on the
macroeconomic factors across numerous countries. Combined with some panel
countries studies, it is more convincible to conclude that deterioration of economic
environment is the essential drive of business downturns, which significantly result
in higher level of loan losses in banking systems.
Page 11 of 66
2.2.2 Bank-specific Indicators
In addition to impacts from macroeconomic conditions, many empirical studies
suggest that fundamentals inside banks’ financial statements as well as risk profile
can explain the loan loss in banking sectors. Bercoff et al. (2002) used an
accelerated failure time model to test Argentinean banks and confirmed that bank-
level fundamentals play an essential role in interpreting the fluctuations in banks’
riskiness evolution in addition to macroeconomic indicators. Waeibrorheem and
Suriani (2015) used pooled model to study the determinants of credit risks in Islamic
Banks and Conventional Banks from macroeconomic factors and banks particular
factors, and find some indicators from both aspects have a significant effect on two
different kinds of banks, confirming Keeton and Morrie’s (1987) early research.
Therefore, efficiency, profitability (Return on Asset, ROA, and Return on Equity,
ROE), bank’s risk-taking ability (proxy by loan to total asset ratio) and lending
activities (loan growth) are identified to have significant on credit risk in banks by
using a proxy of NPLs (Figure 2.2).
Figure 2.2 Impact of Dysfunctional Management in Banks
Determinants of nonperforming loans associated with bank efficiency and
profitability can lead to efficiency problems in banking sectors. Fuentes and
Maquieira (2003) analysed banks in Chile and stated that asset growth, operation
efficiency and exposure to loan losses help explain NPLs. Godlewski (2004) took
ROA as a principal indicator to evaluate bank performance and find a negative
impact on bank’s profitability on NPLs level. While some researchers identified
some contradictory results that high levels of ROE are contributed to a greater future
risk (Garcia-Marco and Robles-Fernandez 2008), they argued that the policy of
profit maximisation is accompanied with a high level of risks. Therefore, more new
research regarding an interaction between bank profitability and bank risks were
•Low ROE or ROA
Bank Profitability
•High Loan/asset ratio
Exessive Risk-taking
•High Gross Loan Growth
Lending Activities
•High Problem Loans
Credit Risk
Page 12 of 66
conducted. Cotugno et al. (2010) used a sample of 1,927 observations in Italian
banks over the financial crisis period (2006 – 2008) and demonstrated a substantial
negative relationship with bank profitability. That is, Banks with high ROA are
associated with lower level of impaired loan losses. Similar outcomes have been
recognised by Epure and Lafuente’s (2012) study in Costa-Rico over period 1998-
2007. Louzis et al. (2012) test Greek bank-specific factors and find that bank
performance and inefficiency indicators serve as leading interpreting power in
explaining loan losses in banks. They used ROE, inefficiency index, as a proxy of
bank management and conclude a negative and statistically significance for all NPLs
catalogues. In addition to the macroeconomic perspective, Makri et al. (2013) also
recognised ROE and capital ratio appear to exert a powerful influence on bank’s loan
losses rate in their study of a panel of 14 countries in the Eurozone. Fredrick (2012)
studied the financial performance of commercial banks in Kenya and realised a
strong relationship between ROE and asset quality. Bank profitability is always
serving as a proxy of bank’s management. Hence, the previous results are consensus
to Berger and DeYong’s (1997) early ‘bad management’ hypothesis. However,
results found by Vatansever and Hepsen (2013) are contradictory to previous
research. They detected eight systematic and unsystematic fundamentals in Turkey
and reported that NPLs ratio appears to be positively influenced by ROE.
Economic boom times usually witness rapid loan growth over the world, while such
lending soars have been identified as a substantial factor in increasing the risk and
raising financial crisis (Caprio and Klingebiel, 1996). Williams (2004) studied
European banks from 1990 – 1998 and found a stable relationship between loan
quality and cost efficiency, so does recent research by De Bock and Demyanets
(2012), who analysed 25 emerging countries over period 1996-2010 and addressed
that credit indicators like loan growth are the core determinants of problem loans.
Bikker and Metzemakers (2004) investigated the intervention from business cycle
to bank provision behaviour and described that loan growth, loan to total asset and
capital to total assets significantly determinate the loan loss provision. Kraft and
Jankov (2005) also discovered that rapid loan growth increased the probability of
credit quality deterioration. However, they argued loan growth rate is not the sole
predictor of banking failure as other bad business policies combined with loan
growth rate could magnify the loan losses and result in a deadly bank failure. This
Page 13 of 66
conclusion is agreed by Espinoza and Prasad (2010) although they also found
similar positive effects from loan growth on NPLs by dynamic panel analysis on 80
banks in GCC over 1995 – 2008. They were aware that there still exists a number of
factors affect banks’ risk-taking ability, like ownership structure, agency problem
and regulatory action. Mannasoo and Mayes (2009) used a discrete-time survival
model and found it possible to take advantage of the bank-specific variable to
forecast the financial vulnerabilities in banking sectors in Europe. Their results
indicated variations in bank earning, efficiency, and relative size of credit portfolio
are one of the warning indicators. In Cotugno et al.’s (2010) study, a positive
correlation between default rate and gross loan growth rate was found in Italian
banking sectors. However, negative relationship between loan growth and impaired
loans was also found in several studies. Cavallo and Majnoni (2002) found a
negative sign for loan growth rate as they regard the increase of new loans and the
loosening of monitor tend to reinforce the risk exposure of banks portfolio, which
would decrease the loan losses rate. A similar negative signal of loan growth on
bank’s NPLs ratio was discovered by Laeven and Majnoni (2003) as well. More
recently, Bonfim (2009) also found an analogous negative sign for loan growth rate
and ascertained the firms’ financial situation has a central role in explaining default
probabilities.
Bikker and Metzemakers (2005) studied the relationship between bank loan
provision behaviour and business cycle by observing 29 OECD countries over the
past decade. They found that loan as a share of total asset ratio various across
countries, as positive significance effects are found in US, Italy and the UK, while
impacts of loan/total asset ratio in Japan, France and Luxembourg turn out to be
insignificant. However, Mannasoo and Mayes (2009) found an interesting result
that fluctuation in banks internal and external environments destroy the performance
and stability in banking sectors, loan asset ratio is negative with respect to bank
distress with respect to early warning models, which is opposite to early dominant
evidence. Cotugno et al. (2010) analysed the loan default rate and bank’s production
specialisation in lending (Loan to total asset ratio) and found a substantial weakness
of the relations. They confirmed that the deterioration of loan quality is closely
linked with bank’s lending activities. Festic et al. (2011) studied five European
countries (Bulgaria, Romania, Estonia, Latvia and Lithuania) by utilising both panel
Page 14 of 66
regression fix- and random-effects. Loan to asset ratio is demonstrated to stimulate
the growth of NPLs due to the soft loans given by the banks. However, in
Vatansever and Hepsen’s (2013) findings in Turkey, their result showed that debt
ratio, loan to asset ratio does not have a significant effect in explanation of loan
default rate on multivariate perspective, which is partly consensus with Bikker and
Metzemakers (2005). El-Bannany (2015) discovered the similar outcome of the
relationship between bank profitability and problem loans. He employed a multiple
regression analysis in UAE banks over the global financial crisis period and
identified a significant impact on the level of credit risk disclosure from foreign
ownership, bank age and bank profitability variables.
Studies in the bank-specific fundamentals cover larger ranges in the selection of
independent variables. The bank efficiency, profitability, excessive risk-taking ability,
regulatory, bank management and loan portfolio are regarded as predominant factors
in the research on credit risk level. Whereas, the results also various across countries
like the divergent sign of ROE, loan growth rate and loan to total assets. Panel
countries studies give a more precise interpretation on institutional performance’s
impact on the credit risk level from three perspectives. Hence, it can be summarised
that unsystematic factors, bank-specific variables, are able to predict vulnerabilities
in banking sectors in addition to economic activities.
Figure 2.3 Credit Risk Determinants
Credit Risk
BusinessCycle
MacroMismanage-
ment
CurrencyFluctuations
Bank Profitability
Lending Activities
Risk-taking Ability
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To sum up, the aftermath of bank credit performance from the volatility of global
economic shakes and banking internal weakness in different countries is quite
uneven (Figure 2.3). The empirical literature has proved extensive effects from
unsystematic conditions and systematic bank specific characteristics on loan losses in
banking sectors. In accordance with the financial accelerator theory, the effect on
firm performance, especially credit risk would be magnified as there exists a robust
interlink between economic downturns and upturns as well as companies’ internal
behaviour. Therefore, further studies in the credit risk behaviour in banking sectors
are necessary as it also reflects the maturity of the local economic conditions and
firm growth. This paper contributes to empirical literature to discover relative macro-
financial indicators to review their impacts in the most recent period.
2.3. Research Gap
Early research mainly concentrated on single countries studies like the U.S., Spain,
Italy, Austria, Australian, Mexican, Greek, Malaysia, etc., most of the studies
primarily focus on advanced western countries. With the evolution of research
methods and results, more literature emphasised their study in one region, like
European or part of European Countries (CESEE, CEE, SEE), the Gulf Cooperative
Council (GCC), NAFTA, Middle East and North Africa (MENA) or Sub-Saharan
African. Analysis of determinants diversified from either macroeconomic or bank
specific perspective, some of them studied both sides but in only one region. Beck et
al. (2015) covered the largest amount of countries (75), however, the study only
focuses on macroeconomic performances. As discussed above, it is clear to witness
an increasing tendency on cross countries studies instead of single countries, internal
and external indicators exposures other than only one direction in research. However,
limited studies are covering both perspectives in differentiated regions to compare
the difference. This project will shed light on five developing countries in Asia and
seek another five similar countries in European regions according to the GDP figure
in accordance to the IMF GDP ranking to debate the significance from financial
stability and institutional performance on credit risks level in banking sectors.
Page 16 of 66
2.4. Hypothesis Test
Hypothesis Test 1:
H0: Inflation rate is insignificant to NPLs ratio.
H1: Inflation rate is significant to NPLs ratio.
Hypothesis Test 2:
H0: GDP growth rate is insignificant to NPLs ratio.
H1: GDP growth rate is significant to NPLs ratio.
Hypothesis Test 3:
H0: Real effective exchange rate is insignificant to NPLs ratio.
H1: Real effective exchange rate is significant to NPLs ratio.
Hypothesis Test 4:
H0: Return on average equity is insignificant to NPLs ratio.
H1: Return on average equity is significant to NPLs ratio.
Hypothesis Test 5:
H0: Gross loan growth rate is insignificant to NPLs ratio.
H1: Gross loan growth rate is significant to NPLs ratio.
Hypothesis Test 6:
H0: Loan to total asset ratio is insignificant to NPLs ratio.
H1: Loan to total asset ratio is significant to NPLs ratio.
Page 17 of 66
Chapter 3 Research Methodology
This chapter paid attention to the research design and the implementation of this
study, which is a guideline to accomplish this research systematically. The function
of this section is to outline the methodology and related techniques or tools used in
this project, including the research design, research approach, research philosophies.
At the same time, it describes the logic behind of what data is selected, how the data
is collected, possible diagnose test for the panel data sets in econometric analysis and
how data would be analysed. By way of the purpose to detect the interference
between credit risk and bank loan portfolio, this paper would mainly overview the
macroeconomic and microeconomic perspectives under the empirical research
background and current economic performance.
3.1. Research Design
Research Design contains clear research objectives, derived from research questions,
and specify the research approach and philosophy. The research design is a
comprehensive plan for data collection and analysis in empirical research projects
(Bhattacherjee 2012), which can be depicted in the research design onion (Figure
3.1).
Figure 3.1 Research Onion
Source: Research Method of Business Students (Saunders et al. 2009)
Page 18 of 66
3.2. Research Philosophy
Four main paradigms of research methods are well known as research philosophy,
while positivism and social constructionism paradigm are more associated with
quantitative studies.
The philosophy of positivism is mainly adopted the philosophical of a stance of
natural science, which belongs to the ‘resources’ researcher. Basically, it’s to
generate a research strategy to collect relevant and credible data. Hypotheses will be
developed based on the existing theory. The whole procedure is to test and confirm,
or refute, the whole or part of the hypotheses, leading to a potential evolution of the
existing theory which may then be examined by further research (Saunders et al.
2009). This study applies the positivism paradigm as it observe six variables by
collecting a large amount of credible data from Datastream and Bankscope. In
addition, it develop six hypotheses to discuss their impacts on the credit risk in
banking sectors.
3.3. Research Approach
In the research methodology, there are two main research approaches according to
the research onion above, inductive and deductive approach. The inductive approach
is naturally interpretative as it begins with detailed observations and theories are
proposed towards the end of the research process as a result of observation. No
theories and hypothesis would have applied in inductive studies. By contrast, the
deductive strategy is associated with ‘developing a hypothesis based on existing
theory, and then designing a research strategy to test the hypothesis Silverman
(2011). Summary of inductive and deductive approach is displayed in Figure 3.2.
Page 19 of 66
Figure 3.2 Inductive and Deductive Approaches
Source: The Ultimate Guide to Writing a Dissertation in business studies: a step by step assistance (Dudovskiy 2016)
Research methodology in this paper follows the deductive strategy, which can be
justified by testing the macroeconomic and bank-level indicator by hypothesis tests
based on the theoretical framework.
3.4. Data Collection and Description
3.4.1 Sample Selection and Sources
This paper used a panel data set over ten countries in Europe and Asia over the
period 2005-2015. All analytical databases are obtained from Bankscope and
Datastream databases. In terms of the fundamental purpose of this project, the author
selected separately five countries (Austria, Germany, Spain, France and Poland) in
Europe and another five countries (China, Indonesia, Philippine, Thailand and
Vietnam) in Asia. According to the latest worldwide GDP Ranking (2015) from IMF
World Economic Outlook (International Money Fund 2016), this paper randomly
selected three countries from the top ten list over Asia and Europe. Thus, they are
China, Germany and France. Regarding the selection of the rest countries, author
targeted the countries which are ranked close to each other across the ranking
difference. Therefore, the selected samples are believed to be capable of capturing
the deficiency and gap between developed and emerging market as banks in these
countries operate under divergent banking systems, regulations and market structures.
Deductive Approach
Inductive Approach
Page 20 of 66
Consequently, cross-sectional data for the whole model is selected, comprising of
bank profitability, efficiency, and leverage rate in commercial and saving banks’
financial statements and countries specific macroeconomic performance among
selected countries. The corresponding data are collected at an annual frequency from
2005-2015 as the financial database is available annually only. Hence, the macro
data is also collected respectively in an annual regularity.
3.4.2 Sample Size
Selected sample includes ten countries in Europe and Asia. The paper initially
planned to gather around 15 banks for each country. The dataset is panel as it
comprised several banks in observed countries for the decade 2005 – 2015. However,
some countries don’t have sufficient data for commercial and saving banks over the
past ten years. Thus, there exists divergence on bank numbers across the selected
countries. Overall, 92 banks are chosen and the number of banks from each country
is displayed in Table 3.1. The sample in this paper is cross-section time-series data.
Table 3.1 Observation Summary
Country Number of Banks
Asia
China 13
Indonesia 6
Philippine 8
Thailand 12
Vietnam 3
Europe
Austria 6
France 21
Germany 5
Spain 10
Poland 8
Total 92
Source: Datastream and Bankscope
3.4.3 Variables
Credit risk was utilised as the dependent variable in this paper depicted by the
performance of NPLs ratios, while the raw data demonstrated high volatility across
the countries. Therefore, a logit transformation is utilised on NPLs ratio, which logit
ensures the applied value (𝑥), here refers to the dependent variable, to span over the
Page 21 of 66
time interval and distributed proportionally. Logit is a common transformation for
linearizing sigmoid distributions of proportions (Armitage et al. 2001), which is
defined as below:
𝑙𝑜𝑔𝑖𝑡(𝑥) = ln( +,-+
)
The definition of nonperforming loan witnesses slight difference over the world, the
majority of countries defined the NPLs as impaired loans (or problem loans) which
have high potential being unable to be fulfilled within 90 days. Though, ‘Impaired
loans’ is a common concept in accounting, which reveals the probable cases in when
the creditor would fail to gather the full amount that it is specified in the loan
agreement from the debtor. Hence, the impaired loans are quite different from the
official classification of non-performing loans. Aiming to provide a fair and clear
justification regarding the research purpose, this project selected the dependent
variable from Bankscope unitedly under the name of ‘impaired loan/gross loan’,
which helps to eliminate the difference in varies countries.
The independent variables are divided into macroeconomic indicators and bank-
specific explanatory factors, three variables for each group. With regard to the
macroeconomic fundamentals indicators, it includes real GDP growth, inflation rate
and real effective exchange rate (REER), which mainly is collected from Datastream.
This paper calculated the change of REER to represent the appreciation and
depreciation of the local currency. An increase in the real effective exchange rate
represents an appreciation of the local currency, making the good and services
produced getting comparatively expensive (Castro 2013). US dollar is taken as the
intermediate currency, thus, the exchange rate for all currency is based upon USD.
On the other hand, bank-level indicators, such as efficiency and profitability ratio
(Return on Average Equity, ROAE), and excessive lending performance, Loan-to-
Asset ratio (LTAR) and Gross Loan Growth Rate, are selected as key financial
determinants to examine the risk-taking level and credit risk. All internal bank data
come from the Bankscope. Table 3.2 summarises symbol, definition, expected signal
and sources of dependent and independent variables in this research.
Page 22 of 66
Table 3.2 Data Definition, Expected Signal and Sources
Symbol Explanation Expected Signal Source
Dep
. NPLs Aggregate non-performing loans to total gross loans
Bankscope
Mac
roec
onom
ic
G_GDP Annual growth rate of Gross Domestic Product
(-) Datastream
REER Real effective exchange rate each country to the US dollars
(-) Datastream
INFR Annual average inflation rate (+)/(-) Datastream
Ban
k –
leve
l
ROAE Return on Average Equity (-) Bankscope
G_LOAN The growth rate of gross loans in annual frequency
(+) Bankscope
LTAR The Loan to Total Asset Ratio (+) Bankscope
3.5. Econometric Model and Methodology
3.5.1 Econometric Model
In order to detect the credit risk level and identify the impact on bank credit risk, this
paper mainly seeks for predominant determinants of NPLs through macroeconomic
and bank-specific perspectives by using panel regression analysis. Panel data
controls individual heterogeneity, at the same time, it provides more informative data,
more variability, less collinearity among the variables, more degree of freedom and
more efficiency (Baltagi 2012). Meanwhile, regression analysis is commonly
regarded as a useful way to predict an outcome variable from predictor variables in
multiple regression. Thus, the following Ordinary Least Square (OLS) econometric
function applied with correspondent variables is as below:
𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3 = 𝛽6 + 𝛽,𝑅𝑂𝐴𝐸1,3 + 𝛽<𝐺_𝐿𝑂𝐴𝑁1,3 + 𝛽?𝐿𝑇𝐴𝑅1,3 + 𝛽A𝐺_𝐺𝐷𝑃1,3+ 𝛽C𝑅𝐸𝐸𝑅1,3 + 𝛽D𝐼𝑁𝐹𝑅1,3 + 𝜀1,3
The dependent variable (𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3) is the indicator of credit risk for country 𝒾 and
time 𝑡 . Where 𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3-, is the lag of 𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3 . 𝑅𝑂𝐴𝐸 correspond to the
Return on Average Equity, 𝐺_𝐿𝑂𝐴𝑁 refer to the Gross Loan Growth Rate, 𝐿𝑇𝐴𝑅
Page 23 of 66
demotes Loan-to-Asset ratio; 𝐺_𝐺𝐷𝑃 represents real GDP growth, 𝑅𝐸𝐸𝑅 means real
effective exchange rate and 𝐼𝑁𝐹𝑅 is inflation rate.
In order to capture the persistence of the dependent variable, the dynamic panel data
model – econometric specification is chartered by the presence of dependent variable
with a one-year lag, 𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3-,, included as an explanatory variable on the right-
hand side. Thus, the regression equation is displayed as follow:
𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3 = 𝛽6 + 𝛽,𝑅𝑂𝐴𝐸1,3 + 𝛽<𝐺_𝐿𝑂𝐴𝑁1,3 + 𝛽?𝐿𝑇𝐴𝑅1,3 + 𝛽A𝐺_𝐺𝐷𝑃1,3+ 𝛽C𝑅𝐸𝐸𝑅1,3 + 𝛽D𝐼𝑁𝐹𝑅1,3 + 𝛽I𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3-, + 𝜀1,3
The dependent variable is explained by its lag, 𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3-,, together with other
macroeconomic and bank-specific variables. In OLS estimation, the added lagged
dependent variable will cause the OLS estimator biased and inconsistent if the error
term is not serially correlated (Baltagi 2012). In addition, the fixed-effects model is
consistent only when the model applied a very large T (Agung 2013). In this model
is applied with large N and a comparatively short T as the data is collected yearly
and ten years only, thus, which could result in the within estimator to be inconsistent
and suffer from Nickell biases (Baltagi 2012). Generalised method of moments is
more efficient in dynamic panel data analysis (Arellano and Bond 1991). Therefore,
Difference GMM is applied to transform the data to first differences by using the
lagged levels of the right-hand side variables as instruments, which eliminates the
individual effects. Further, time dummy is added in this dynamic panel regression
model, which is introduced to minimise the potential bias of estimates that could
arise from cross-section correlation of the residuals (Balavac 2012).
Regarding expected signs summarised from the empirical literature on table 2,
nonperforming loans are expected to have a negative relationship with the economic
boom, such as GDP growth, real effective exchange rate appreciation, and strengthen
in internal bankability, for example, higher profitability. On the other hand, the
impact from bank loan portfolio on NPLs is estimated to be positive, as an increase
in banking loan tends to add up the risk of bad loans in banks. However, the impact
on inflation rate is unpredictable as its empirical results various across countries and
uncertain in multi-countries analysis.
Page 24 of 66
3.5.2 Empirical Methodology
This paper incorporates two econometric specifications in panel regression analysis;
they are panel OLS and difference GMM estimation by Eviews (Griffiths et al.
2011).
Makri et al. (2014) utilised a dynamic panel regression model to investigate the
effect of banking and macroeconomic factors on NPLs. Further, they implemented
the difference GMM estimation to provide consistent and unbiased results, and in
first and second period lagged variables were employed as instruments in their GMM
estimation. Similar dynamic panel model is implemented by Espinoza and Prasad
(2010), additionally, their methodology also includes OLS, fixed effects and system
GMM. They applied the logit transformation of the NPL ratio as well to allow the
dependent variable to distribute symmetrically. This paper mainly follows empirical
methodology as above on estimating the determinants of credit risks through
dynamic panel regression model.
3.5.3 Methodology
Before starting the estimation of the panel LS regression model, several essential pre-
tests are applied to ensure there is no related issues causing endogeneity problems. In
this model, two groups of variables, Loan to Total Asset and Gross Loan Growth
(Bonfim 2009), GDP growth rate and exchange rate (Beck et al. 2015) are estimated
to suffer from endogeneity.
Multicollinearity, this would be carried out by generating the correlation matrix and
observing independence behaviour. If the correlation level between each variable is
less than 0.8, meaning that the model would not serve from severe multicollinearity
issue.
Homoscedasticity – In the fixed-effect model, this would be carried out by doing a
heteroscedasticity test under the unstructured data. If the p-value for the test is less
than 0.5%, indicating the model don’t exist homoscedasticity issue. In the GMM
estimation, the heteroscedasticity is not considered as a problem in this method as
GMM estimation is consistent to heteroscedasticity.
Page 25 of 66
Autocorrelation, this issue would be verified by the Durbin-Watson result. The
figure should be dropped into the area that is not significant to represent the result
and model.
Normality, all observed variables will be dealt with a histogram graph individually
to see whether they distribute normally.
After the tests, this project began with the econometric estimation of bank credit risk
performance by including different macroeconomic indicators and bank-specific
variables through the Panel Least Squares estimator overall observed countries. The
methodology aims to consider the time-constant unobserved values across countries
and gain an overall view of whole observations. Additionally, under the limitation of
the precise set of countries and the entire time-varying variables, the model could
encounter with omitted or unobserved variables biases, accordingly endogeneity
problem. Thus, the related external instruments variable method would be employed
in the estimation. As the whole sample contains a large set of firms, the fixed-effect
model is a more appropriate specification (Baltagi 2012). Therefore, a Hausman
Test is utilised to identify the more suitable model in a statistical sense for a panel
dataset regression analysis, namely fixed- and random-effects model (Agung 2013).
In this case, fixed-effects (FE) estimation is in favour of due to the Hausman Test
suggest to reject the null hypothesis that random effect is suitable. The
implementation of fix-effect is utilised to eliminate the endogeneity problem as much
as possible.
With regard to capturing the persistence of NPLs ratio performance, this chapter
extends the investigation by use dynamic specification. It includes a lagged of logit
transformed dependent variable as an independent variable on the right-hand side as
well as adding the time dummy variables. The difference GMM method is necessary
and well suit to be applied here to evade unbiased and endogenous estimations issues
(Salas and Saurina 2002). For GMM estimator, using instruments in levels, i.e.
𝑦1,3-< has no singularities and much smaller variance, which is recommended as
instrument variable in GMM estimation (Baltagi 2012). Hence, LogitNPL1,3-< is
implemented as internal instruments for the explanatory variables to eliminate the
endogeneity issue and make this model more consistent.
Page 26 of 66
Chapter 4 Empirical Findings
This chapter summarised the trait of the dataset by observing the diagnostics tests of
multi-correlation, homoscedasticity test, Durbin-Watson test, normal distribution,
etc., which helps to identify the problems and modified the model into a proper one.
Moreover, this section further discussed empirical findings of this research by
focusing on the influence of each independent variables, linking with the empirical
literature to explain their signs and influences on the dependent variable. Lastly, a
robustness test is implied to capture the robustness of each independent variables
further.
4.1. Descriptive Statistics Analysis
Table 4.1 depicted the observing variables over Europe and Asia over last decade.
Overall, each variable incorporates 1011 observations, which are unevenly
distributed over the observed period. The macroeconomic variables from each
country, compared with NPLs ratio, is flat but still shows high variability across
times and countries, especially the real effective exchange rate. The exchange rate in
the observation countries witnessed a gentle appreciation tendency in general (Figure
4.1). Fluctuation of exchange rate changes in Poland experience the highest boom
during the financial crisis, it went from -12% to approximately 30% but dropped
sharply and still unsteady afterwards. Similar fluctuation happened in other countries
while these fluctuations are at a lower level.
Figure 4.1 Exchange Rate Fluctuation
-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Austria
German
Spain
France
Poland
China
Philippine
Indonesia
Thailand
Vietnam
Page 27 of 66
-8-6-4-202468
1012141618
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
China Indonesdia Phillippine ThailandVietnam Austria German SpainFrance Poland
Matching with the real GDP changing performance (Figure 4.2) over 2005 – 2015,
there is a noticeable depreciation of exchange rate in ten countries at different levels
after the financial crisis. The recovery of local currency appreciation varies across
the observing economics in accordance with their economy situations, which resulted
in divergent levels of impaired loans ratio. The standard deviation in the descriptive
statistics stands for the volatility of each data for difference variables.
Figure 4.2 Real GDP Change Performances
Table 4.1 Descriptive Statistics, 2005-2015
Variable Obs. Mean Median Max Min Std. Dev.
Dep
. NPLs 1011 4.92 3.44 86.49 0.04 6.27 LogitNPLs 1011 -1.48 -1.45 0.81 -3.40 0.46
Mac
ro. INFR 1011 2.80 2.19 23.12 -0.95 2.68
G_GDP 1011 4.04 3.70 16.29 -5.57 3.81 REER 1011 0.47 -0.89 29.49 -13.81 7.81
Ban
k–le
vel LTAR 1011 56.44 59.18 93.22 0.10 17.96
ROAE 1011 5.90 1.40 44.25 -277.36 12.87 G_LOAN 1011 14.49 10.46 820.62 -96.80 35.67
Table 4.1 indicates that NPLs ratios varied significantly across countries and banks
over 2005 – 2015 as its standard derivation reaches 6.27. The bank-internal data
records a higher variability in all variables, even the lowest standard derivation
Page 28 of 66
(ROAE) is approximately two times (12.87) higher than NPLs. The bank
fundamentals have demonstrated the worsening of banks’ asset quality and loan
portfolio since the burst of global financial crisis, which is clearly proven in the
financial statements in all banks. However, if it’s separated into two regions, it can
be seen that the NPLs ratio in Asia witnessed a decrease while the Europe
experienced an increasing tendency after the financial crisis. The figure 4.3 showed a
significantly improvement on banks’ NPLs ratio in 2007 for European countries,
with a downfall at the year 2010 and went back remained at a high level afterwards.
Whilst, the situation in Asia is experiencing a falling tendency over the period.
Figure 4.3 NPLs Ratio in Two Regions
4.2. Main Findings
4.2.1 Multicollinearity
Table 4.2 depicts the correlation level among different variables with each other for
the whole observed data, which is an alternative way to detect multicollinearity issue.
A correlation coefficient of 1 (-1) indicates the value is positively (negatively)
correlated with the other variable. There is a common measure of the size of the
effect that value of ±0.1 means a low-level correlation, while any value over ± 0.75
demonstrates that any estimated variables are strongly correlated with each other
(Field 2012). Obviously, all of the variables are entirely independent of each other as
the highest correlation result is 0.368, indicating that the variables don’t suffer from
multicollinearity issue.
1.52.02.53.03.54.04.55.05.56.06.57.0
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
NPl
s/G
ross
Loa
ns
Year
Europe
Asia
Page 29 of 66
Table 4.2 Correlation Matrix
LogitNPLs REER G_GDP INFR G_LOAN LTAR ROAE LogitNPLs 1.000 REER 0.067 1.000 G_GDP -0.227 -0.254 1.000 INFR -0.100 -0.109 0.368 1.000 G_LOAN -0.106 -0.107 0.150 0.137 1.000 LTAR 0.088 0.075 0.002 0.004 -0.088 1.000 ROAE -0.206 -0.019 0.325 0.273 0.118 0.015 1.000
4.2.2 Homoscedasticity
All dataset was set as unstructured data on the Eviews to allow for the standard OLS
regression. The heteroscedasticity test outcomes confirmed that OLS model doesn’t
suffer from homoscedasticity issue. In the GMM estimation provides consistent and
efficient estimates of the parameters in White weighing matrix (Arellano and Bond
1991), accordingly, the selected variables are consistent to heteroscedasticity as the
model automatically selected with the White-weighing matrix and white coefficient,
which keeps the model away from the heteroscedasticity problem.
4.2.3 Normal Distribution
It’s clear that the logit transformation of NPLs demonstrated a comparatively less
volatile distribution (Figure 4.4). It can also be identified by a relatively small
disparity on the value range from -3.40% to 0.81%.
Figure 4.4 Distribution of Logit transformed NPLs ratio
-3.5
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
-4 -3 -2 -1 0 1
Quantiles of LOGITNPL
Qua
ntile
s of
Nor
mal
0
50
100
150
200
250
-3.5 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0
Frequency
LOGITNPL
Page 30 of 66
Figure 4.4 displayed a normal distribution of the dependent variable, whose value
range is within -3.5 to 1.0. Most of the variable are normally distributed, except for
real GDP growth rate and exchange rate. Compared with other variables, real GDP
growth and exchange rate are more volatile, and their frequency is quite uneven
(Appendix 2 and 3).
4.2.4 Durbin-Watson Test
According to the Hausman Test, the first model is run under fixed-effect panel
regression. The initial R square is relatively small (64.0%), which mean the overall
goodness of the original model is comparatively small, the results of independent
variables only explain 64% of NPLs (Field 2009). Meanwhile, the Durbin-Watson
result was only 0.984, which dropped in the significant positive autocorrelation
period, which means the model suffers from Autocorrelation issue.
Table 4.3 Significance Period Range for Durbin-Watson Result
Significant Positive
Autocorrelation
No Decision
No Significant Autocorrelation
No Decision
Significant Negative
Autocorrelation
0
1.613 (1.735 2.265) 2.387 4
Therefore, a lag of the dependent variable is utilised to resolve the autocorrelation
issue, and the new result is displayed in model 1 (Table 4.3). Apparently, the new
Durbin-Watson result went up to 2.107, falling in the No Significant Autocorrelation
period range (Table 4.4). The result indicates that new model does not have the
Autocorrelation problem. At the same time, the R-square reaches 82.5%, which
means the output of Model 1 suggests that the variability of NPLs is well explained
by both macroeconomic and financial variables at 82.5%.
4.2.5 Empirical Results
Table 4.3 reports the estimated coefficients and their p-values of the fixed-effect
panel LS and dynamic panel regression by difference GMM. Overall, the designed
models are capable of interpreting the NPLs ratios fluctuation across observing
countries in Europe and Asia well. Both the fixed effect panel LS and difference
GMM reveal that real GDP growth, Inflation Rate, Loan/Asset Ratio, Return on
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Average Equity and Growth Gross Loan have an significant impact on NPLs while
the evidence on the Real Effective Exchange Rate is quite mixed (Appendix 4).
Table 4.4 NPLs: Macroeconomic and Bank-Level Determinants, 2005-2015 Fixed-Effect Panel LS Difference GMM Model 1 Model 2 LogitNPLs (-1) 0.703***
-0.024
INFR 0.010*** 0.023*** -0.004 -0.006 G_GDP -0.016*** -0.016*** -0.003 -0.004 REER 0.002*** -0.008*** 0.000 -0.001 LTAR -0.239*** -1.215*** -0.115 -0.253 ROAE -0.286*** -0.020* -0.067 -0.148 G_LOAN -0.104*** -0.116*** -0.019 -0.022 Constant -0.314***
-0.067
time dummy no yes Number of Obs. 918 826 R-square 0.824975
Adjusted R-square 0.804031
Durbin-Watson stat 2.107175 Number of banks 92 92
Number of instruments 54 NOTES: Significance level: *, **, *** denotes significance at10%, 5% and 1% respectively. The standard error of each variable is put in the bracket. An increase in REER reflects an appreciation. Dependent variable: LogitNPLs
The standard error measures the uncertainty of each estimated parameter, the larger
the standard error, the greater the uncertainty about the estimated parameter value
(Ryan 2009). Thus, ROAE and LTAR have higher risk level compared with other
variables. Therefore, the model of fixed-effect panel OLS can be interpreted as
below:
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𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3 = −0.314 + (−0.286𝑅𝑂𝐴𝐸1,3) + (−0.019𝐺]^_`1,3)
+ (−0.239𝐿𝑇𝐴𝑅1,3) + (−0.016𝐺abc1,3) + 0.002𝑁𝐸𝐸𝑅1,3
+ 0.01𝐼𝑁𝐹𝑅1,3
Where 𝐿𝑜𝑔𝑖𝑡𝑁𝑃𝐿1,3 is the indicator of credit risk for country 𝒾 and time 𝑡.
𝑅𝑂𝐴𝐸 is the Return on Average Equity,
𝐺_𝐿𝑂𝐴𝑁 refers to the Gross Loan Growth Rate,
𝐿𝑇𝐴𝑅 denotes Loan-to-Asset ratio,
𝐺_𝐺𝐷𝑃 represents real GDP growth,
𝑅𝐸𝐸𝑅 means real effective exchange rate and
𝐼𝑁𝐹𝑅 is inflation rate.
The results in Model 1 demonstrated that all independent variables have significant
impacts on problem loans, and all the significant level is at 1%. They are in line with
the majority of the empirical studies while in contradictory with minorities, which
would be explained later in the discussion part.
In dynamic panel estimation, the first period lagged dependent variable is added into
Model 2 to capture the persistence of dependent variable. As discussed before, GMM
is the most effective and efficient estimator in dynamic panel data analysis. Thus,
first difference GMM was taken in Model 2. Added the period dummy variable, the
duration in model 2 automatically excluded some periods and started from 2007-
2015. The internal instrument, LogitNPL1,3-<, was confirmed by the Sargan test to be
a valid instrument in this model.
Overall, the evidence in Table 4.3 demonstrates that both macroeconomic shocks and
bank fundamental indicators are significantly associated with problem loans in
Europe and Asia. The general outcomes indicated that nonperforming loan worsens
significantly when GDP decrease, inflation rate grows and appreciation in the real
exchange rate as well as a descendant in bank profitability (ROE) and a slowdown in
gross loan growth rate. However, the performance of Loan/Asset ratio is not in line
with the majority of empirical studies, which would be deeply analysed later.
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Observed the results in a comprehensive perspective, it can reach a common
conclusion that worsening in the economic environment and descendent in bank
performance could lead to ascendance in credit risk in banking sectors. The majority
result is in line with findings from Bercoff et al. (2002), Cotugno et al. 2010, Festi
et al. (2011), Louzis et al. (2012), Vatansever and Hepsen (2013) and Beck et al.
(2015).
4.3. Discussion of Empirical Findings
4.3.1 Inflation Rate
The inflation rate is commonly regarded as a signal of macroeconomic
mismanagement and a source of uncertainty (Quagliariello, 2003). High inflation
rate is considered to be associated with wider exposure to risky loans. The coefficient
in two models displayed a significant positive linkage between inflation rate and loan
quality, and inflation rate is significant at 1% confidence interval. In FE estimation,
an increase of one unit change in inflation rate emerges to an ascendance in NPLs
ratio of about 0.01 unit changes, ceteris paribus. The result is in consensus with Arpa
et al. (2001); Babihuga (2007) and Ahamd and Bashir (2013), although it’s not
similar with Castro’s (2013) finding that inflation is not relevant to credit risk. It is
because he included both real value of outstanding loans and borrower’s actual
income, the another one could cancel the effect. While in our case, there is no other
variable to eliminate the effect of inflation. Therefore, the impact of inflation rate on
the dependent variable in model 2 become stronger after added the time dummy in
difference GMM estimation. It’s clear that one unit increase in inflation conduct to
0.023 units increase in credit risk. It can be justified that the inflation rate is stable
and leads to less impact on the NPL before the financial crisis. When splitting away
the pre-crisis period, inflation rate was found to affect the loan losses in banks
substantially. As inflation usually increase risks and uncertainties for market
participants in general, which lead to higher problem loans, which is always a proxy
of macroeconomic mismanagement (Arpa et al. 2001). Moreover, Derbali (2011)
also reported a positive association between inflation and bank profitability, which
demonstrated that the dynamics of inflation rate and bank profitability affected
directly bank loan portfolio, which supports the financial accelerator theory that
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deterioration of bank assets value could be magnified by the combination of both
factors.
The outcome of inflation rate matches the initial prediction of its expected sign, thus,
in hypothesis test 1, the models failed to reject that null hypothesis that inflation rate
is insignificant to NPLs ratio.
4.3.2 Growth of Real GDP
As expected, a decrease in real GDP growth is associated with a rise in non-
performing loan ratios in both models as expected. The real GDP growth is
significant at 1% confidence interval. Both outputs in fixed-effect LS (Model 1) and
difference GMM estimation (Model 2), reached the same negative significant level.
The result is consistent with the majority of current studies (Fernandez et al. 2000;
Ahmad 2003; Quagliariello 2007; Khemraj and Pasha (2009); Ahmad and
Bashir (2013); Beck et al. 2015). Although some single country studies failed to
find a significant relationship with GDP growth rate, which is not representative. The
results in both models show that if other independent variables are kept fixed, one
unit change in real GDP growth is associated with 0.016 unit changes in NPLs. A
deterioration in the real economy always results in an increase in potential loan
losses in banking sectors’ loan portfolio. An increase in GDP is usually assisted in
the individual income growth, which is typically linked with a rise in profitability
(Messai and Jouini 2013). It can be proven from the later result that bank
profitability is negatively significant with problem loans. GDP growth is a signal of
economic boom, which plays an imperative role in individuals and firms’ debt-
paying ability as higher personal income and profitability add to their capability to
fulfil their financial obligations and help to decline problem loan accumulation. The
findings reveal the fact that booming periods adversely improves the loan losses,
which point out the importance of economic policies give rise to the economic
growth and avoid serious problems of credit default and banking crisis (Castro
2013).
Thus, this paper rejects H0 in hypothesis test 2 that GDP is not significant for
nonperforming loans. On the contrary, real GDP growth rate appears to have a
significant negative impact on loan losses.
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4.3.3 Real Effective Exchange Rate
The REER appears to be highly significant in the nonperforming loan ratio, which is
in line with some empirical literature reviewed in chapter two (Arpa et al. 2001;
Castro 2013 and Khemrai and Pasha 2009). A real exchange rate appreciation was
correlated with a worsening in the current account because the goods and service
become more expensive in that country. Thus, countries with currencies appreciation
experienced a larger deterioration in their local economic environment (Corsetti et
al. 1998). REER is significant at 1% confidence interval and matches the expected
positive signal. One unite increase in REER leads to 0.002 units increase in problem
loans, ceteris paribus.
However, in difference GMM estimation, the coefficient direction changed from
positive to negative. Meanwhile, one unit change in NPLs is associated with 0.008
units decrease in REER, ceteris paribus. It could be explained by the countries that
we are observed that Poland, Thailand, Philippine, and Vietnam they have substantial
fluctuation in their currency exchanges over the observed period, as the economy in
South East Asia are more fragile after the Asian financial crisis in 1997. Indonesia,
Thailand and Philippine are most affected by the crisis, they experienced a quite high
exchange rate appreciation (Corsetti et al. 1998), which is associated with a
worsening economy. Hence, when excluding the pre-crisis period (2005-2006) in the
GMM estimation, these Asian countries reflects a high volatile in their local
currencies. Beck et al. (2015) got the negative relationship between nominal
effective exchange rate and asset quality, tested with countries dummy variables and
various level of international claims. As appreciation in local currency makes the
products get higher prices than its initial value. While, massive depreciation of local
currency causes an increase in the amount of money to buy the same products,
especially foreign merchandises, which add up to the burden of the local economy.
Consequently, it’s explainable that a vast depreciation in the local currency increase
the bank loan losses. Noticeably, it can provide a more precise estimation on the
impact of exchange rate if other factors like export or foreign trading indicators could
be added in economic model. As the result in difference GMM estimation is more
robust. This paper concludes a negative relationship with regard to outputs in Model
2.
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This project rejects H0 in hypothesis test 3 that REER is insignificant for NPLs. On
the contrary, REER emerges to have a significant impact on credit risk.
4.3.4 Return on Average Equity
Economic activities are not able to fully explain the evaluation of non-performing
loans. Thus, beyond macroeconomic indicators, impressive results also appear in
bank-specific variables as well.
As far as ROAE is concerned, it is regarded as the proxy for bank profitability. The
ROAE in fixed-effect panel LS is recorded a significant negative relationship to
NPLs, which is a consensus with Godlewski (2004); Cotugno et al. (2010); Louzis
et al. (2012), Makri et al. (2013). Model 1 tells that ROAE is significant at 1% if
keep other variable consistent, one percentage increase in ROAE can result in 0.286
percentage decrease in the nonperforming loan. The negative relationship is
supported by previous studies on the bank profitability. Outputs in GMM estimation
emerges a less level significance (10% confidence interval) effect for ROAE over
NPLs. One unit change in NPLs is associated with 0.02 unit changes in ROAE,
ceteris paribus. The negative relationship proves that high bank profitability evades
the risk of liquidity and solvency issues in banks as it introduces continuous cash
flow into banks, which could reduce the bank’s problem loan ratio.
However, some studies proved an opposite relationship between ROE and NPLs
ratio, for instance, Vatansever and Hepsen (2013), which makes the signal for ROE
as profitability to determinant NPLs a bit confusing. Therefore, relevant information
was found in Sundararajan et al.’s (2002) study that an analysis of profitability by
using ROE encountered with a greater risk of ignoring high leverage level. As bank’s
leverage is often determined by regulation, while regulation is not easy to detect,
hence, ROA tends to be more representative when measuring bank profitability
(Babihuga 2010). Nevertheless, results in two models are capable of representing the
bank profitability when evaluating bank performance. As discussed in inflation rate
and GDP growth sections, dynamic of GDP growth, inflation rate and bank
profitability is related with performance of individuals and corporate’s debt payback
ability, consequently, credit risk level in banks. Hence, the finding confirmed that
high profitability is less pressured to revenue creation and, accordingly, less
constrained to engage in credit risk offerings (Haneef et al. 2012).
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Thus, hypothesis test 5 rejected the H0 as ROAE appears to be insignificant to NPLs
in difference GMM estimation.
4.3.5 Growth of Gross Loan
In accordance with the result in Table 3, Growth of Gross Loan in both models
displays a negative relationship with problem loan and significant at 1% confidence
interval. One unit change in loan growth rate is associated with -0.116 units change
in loan default ratio, ceteris paribus. Loan growth is expected to have a high potential
to bring excessive problem loans (Salas and Saruina 2002; Bikker and
Metzemakers 2005; Cotugno et al. 2010). Rapid loan growth has been regarded as
an imperative factor that increases the risk of a crisis as it takes place during
economic boom times and such lending booms (Caprio and Klingebiel, 1996).
However, the result in this paper turns out to be contradictory with the initial
expectation.
Salas and Saurina (2002) failed to find a significant relationship with loan quality.
Moreover, there still exist some current research emerge an opposite relationship
between problem loan and loan growth, such as Bonfim (2009), Cavallo and
Majnoni (2002) and Laeven and Majnoni (2003). In early research, Keeton (1990)
explained that loan growth is driven by the nature demand by individual or
corporates, that is, increasing in lending may not necessary lead to loan losses. Kraft
and Jankov (2005) found that rapid loan growth increased the probability of credit
quality deterioration. However, they pointed out that it is too simple to reply purely
on rapid loan growth rate to explain the problems loans in banks because it’s difficult
to capture the correlation between lending growth rate and default probabilities. If
combined with other destructive business policies, like heavy reliance on paying
above-average interest rates on deposits or interbank funding, rapid loan growth can
contribute to a deadly consequence for banks. The negative sign of loan growth rate
in this paper implies that there may exist a real natural demand of loans unrelated to
the creditworthiness of borrowers or potential good monitoring in place. Their
existence is to control the quality of lending among examined countries and observed
periods, which conducted to an increase in loan growth resulting in a decrease in
nonperforming loans.
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This paper rejects H0 in hypothesis test 5 that G_LOAN is insignificant to NPLs. By
contract, G_LOAN emerges to have significantly impact credit risk.
4.3.6 Loan to Total Asset
Bank’s excessive lending and banks risk-taking ability are usually proxy by
loan/total asset ratio. The impact of loan/total asset ratio decreases the NPLs
significantly at 1% confidence interval in two models. In the difference GMM
estimation, the effects is stronger. However, the results are contradictory to the main
empirical findings (Cavallo and Majnoni 2002; Männasoo and Mayes 2009;
Cotugno et al. 2010; Festic et al. 2011) as the empirical test on loan/asset ratio is
expected to have a positive correlation with problem loans in banks. The share of
banks’ loans to total banking assets counts as a proxy of excessive-risks taken in the
banks. The higher the ratio indicated, the riskier a bank would be to encounter with
higher defaults. Accordingly, loan/asset ratio is usually correlated with banking
problems and increase the NPL ratio, which could cause solvency issue due to
mismanagement in banks. However, a negative relationship between loan/asset ratio
and bank distress was found in early warning models, which means lending activities
is underdeveloped (Männasoo and Mayes 2009).
As the loan to total asset ratio measures the gross loans outstanding as a percentage
of total asset, the negative relationship indicates one-unit change occurs in loan/asset
ratio the change in the NPLs is 1.215, ceteris paribus. It can firstly be seen by the
negative sign of gross loan growth as discussed before, the loans growth in the
observed banks didn’t necessarily cause an increase in bad loans. If the increasing
speed in the total asset is larger than or no growth in the gross loan, it will result in a
decrease in bad loans ratio although the general performance in loan/asset ratio is
increasing over the period. Moreover, it can also be concluded that lending activities
is immature in some countries and is a marginal part of banks activities in developing
markets, like Thailand, Indonesia, Philippine and Vietnam. Thus, it exists the
situation that the increase in loan/Asset ratio also demonstrates an adverse movement
for the problem loans in this project.
This paper rejects H0 in hypothesis test 6 that LTAR is insignificant to NPLs. On
contradictory, LTAR emerges to have significantly opposed impact credit risk.
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Overall, the results in FE panel LS and difference GMM estimation indicated that
both the macroeconomic conditions and financial fundamentals are significant
determinant variables on banks’ credit risk, proxy by impaired loan ratio. The
dynamic of GDP growth, inflation rate and exchange rate are proven to have a
statistical significance with credit risk level in banks, though the performance of
exchange rate appears to have a different sign on determining NPLs in two models.
In the examination of REER, related foreign trading indicators are suggested to be
added in future studies. Macroeconomic deterioration only lacks a strong voice to
explain the bank loan losses. Hence, some bank-level factors also demonstrated a
substantial effect on the explanation of bad loans in banks, like ROAE, loan growth
rate and loan/asset ratio. Two variables conduct to an adverse sign, which is out of
expectation and majority of empirical studies. It also requires other factors adding
into the model so as to provide a better evaluation of bank default rate. The
combination of macroeconomic and bank internal factors is able to magnify the
deterioration of the asset value, which supported by the financial accelerator theory.
4.4. Robustness Test
A further robustness test is implied in this paper by separate the analysis into two
regions, Europe and Asia, within the observed period (2005 – 2015). In the
robustness check, this research only applied one of the specifications used before,
difference GMM estimation, to test the robustness of the coefficients among
macroeconomic and bank internal factors.
Comparing with the dynamic panel specification results in Table 4.3, the results in
Europe appears to be stronger. Six determinants demonstrated significant impacts on
the problems loans in banks. However, four factors displayed an opposite sign
towards dependent variable, like INFR, GDP growth, REER and ROAE, which is
different from the main findings. Only loan/asset ratio and loan growth rate remain
the adverse relationship with loan losses although the coefficient is smaller, as it
takes away the impact from Asian countries. The results show that loan performances
are more robustness in determining the credit risk in banks.
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Table 4.5 Robustness Test Difference GMM Europe Asia Model 2 LogitNPLs (-1) 0.623*** 0.540*** 0.703*** 0.014 0.055 -0.024 INFR -0.051*** -0.006 0.023*** 0.008 0.008 -0.006 G_GDP 0.008*** -0.000 -0.016*** 0.002 0.004 -0.004 REER 0.013*** -0.003* -0.008*** 0.002 0.002 -0.001 LTAR -0.011*** -0.005*** -1.215*** 0.001 0.002 -0.253 ROAE 0.014*** 0.004*** -0.020* 0.001 0.001 -0.148 G_LOAN -0.001*** -0.007*** -0.116*** 0.000 0.001 -0.022 Period 2007-2015 2007-2015 2007-2015 Number of Obs. 448 375 826 Number of instruments 50 42 54 Time dummy yes yes yes Number of banks 50 42 92
NOTES: Significance level: *, **, *** denotes significance at10%, 5% and 1% respectively. The standard error of each variable is put in the bracket. An increase in REER reflects an appreciation. Dependent variable: LogitNPLs By contrast, the inflation rate and GDP growth in Asia emerge to have no significant
impact on credit risk in banks as the results show an insignificant impact towards
dependent variable. As the GDP growth in China witnessed a significant growth
while other countries show different levels of fluctuation and decrease, which could
cancel the effects from GDP growth to nonperforming loans over the period.
Analogous to European countries, loan/asset ratio and loan growth rate significantly
determine loan default rate in Asian banks and keep the same sign as the initial
expectation as well. Moreover, REER appears to be a robust factor in determining
the NPLs in Asia. ROAE indicated a positive relationship with NPLs, which is the
same as that in Europe while opposite to the main findings in this paper.
In general, loan/asset ratio and loan growth rate is concluded to be more robust in
both Europe and Asia over the last ten years. Some other factors turn out to be
different from the initial findings in this paper (Appendix 4), which suggestes the
economic situations in two regions proved to be a large difference, particularly in
emerging markets.
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Chapter 5 Conclusion, Limitations and Recommendations
This chapter presents a summary of the main findings of this project research, aiming
to gain achievements matching with the initial incentives and research objectives of
this study. Apart from that, limitations are discussed in this chapter. Accordingly,
recommendation for the policy makers and potential future research based on this
study are also provided in this section.
5.1. Conclusion
The recent financial crisis has revitalised the public passion for exploring the features
triggering a banking crisis and impact of the crisis on the economy. Nonetheless,
some attentions should be given to the credit risk in banks before laying full
emphasis on the analysis of banking crisis. In fact, liquidity issue caused by problem
loans in banks’ financial statement can lead to banks solvency and consequently
resulting in a banking crisis. Hence, it’s necessary to consider the factor that
warming up credit risk as an origin of understanding the banking and financial crisis.
By using econometric panel analysis, this project incorporated six core determinants
to evaluate their impacts on banks’ credit risk behaviour through studying systematic
shocks and internal unsystematic functions among ten countries in Europe and Asia
over last decade. In order to capture a better understanding of credit risk, this paper
applied both fixed-effected and difference GMM estimation and compared results
from both sides by benchmarking the nonperforming loan ratio. The credit quality of
the portfolio has been modelled using the NPL ratio. The results in this project
proved strong evidence that adverse macroeconomic activities and dysfunctional
management significantly affect the credit risk level in banks.
Consistent with the theory as well as some earlier studies, business cycle (proxy by
GDP growth) has a significant opposite relationship with problem loan. Descent in
economic growth lowers down borrowers’ ability to pay back their debts as a worse
economy cuts income and profitability of debtors, conducting to a boom in NPLs.
The negative relation implies that control actions should be reinforced at the rest
signs of changes in the economic cycle (Salas and Saruina 2002). On the other side,
the inflation rate is positively connected with latent loan losses. Inflation is always
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accompanied by risk and uncertainty which is also associated with bank profitability.
High inflation could expand the possibility of higher loan losses. Likewise, Real
effective exchange rate also displayed a significant a positive relation in the fixed-
effect model and a negative relationship in difference GMM estimation with default
loan profitability. As the case in this project included some developing countries like
Thailand, Philippine and Indonesia who witnessed massive currency depreciation
after the Asian financial crisis (Corsetti et al. 1998). Depreciation in local currency
adds to the burden in purchasing the same products especially commodities overseas.
Hence, additional factors, like export or import, are plausible to be included to
explain the credit risk model more soundly.
In addition to adverse macroeconomic shocks, this paper also shed light on the
insight of impact from bank-specific characteristics on banking sectors by observing
bank profitability, excessive lending and risk-taking ability. Within expectation, bank
profitability verified a significant negative linkage with NPLs ratio as high
profitability assist banks escaping from severe liquidity and solvency issues.
Excessive risk-taking (proxy by loan/asset ratio and loan growth rate) was found to
be significant, but adversely, relevant to credit risk in banks in European and Asian
countries. Two coefficient of these two variables ranked top two among six variables,
confirming a substantial impact on the lending activities and loan quality on bad
loans. One unit changes in loan growth rate is associated with -0.116 unit changes in
loan default ratio, and one-unit fluctuation in loan/asset ratio are connected with -
1.215 unit changes in impaired loan ratio, ceteris paribus. The results are
contradictory to a majority of studies as lending activities only are too simple to
capture its impact on NPLs. Thus, it’s compulsory to pay extra attention to the real
demand for the loans and some bad business policies in different countries as a
combination of these factors could result in unpredictable effects on banks. Banks
with higher loan-to-assets ratios stand out as more advanced in these markets
(Männasoo and Mayes 2009).
A robustness check is implied to check the coefficient for the impact macroeconomic
and bank-level fundamentals separately in Europe and Asia. The outcomes in two
different regions depicted quite distinguished consequences. INFR, GDP growth,
REER and ROAE exhibited opposite sign from the main findings in Europe. GDP
and inflation rate turn out to be insignificant to NPLs in Asia. REER is still a
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robustness determinant in Asia. ROAE in both countries appears to be positively
associated with NPLs. Nonetheless, loan/asset ratio and gross loan growth rate are
the two most robustness factors negatively determining the problem loans both
Europe and Asia.
Findings above ascertained the fact the research by observing the factors above is
quite meaningful in predicting and controlling potential banking crisis in different
countries. Adverse business cycles contribute to banking frangibility and in return,
the dysfunctional behaviour of banks adversatively affects the economic cycle.
5.2. Limitations
As discussed in previous chapters, there exist several boundaries in this research
project, which explained some results in the main findings is not persistent in the
robustness check and contradictory to empirical studies.
1. As discussed in chapter four, usage of ROAE as a proxy for bank profitability
would exist the risk of negligence of high leverage level in banks (Sundararajan et al.
2002). Babihuga (2010) also suggested that ROA is more suitable in representing
banks’ profitability.
2. In the examination of real exchange rate, the factor itself exists limitation on
analysing its impact on loan losses as currency appreciation or depreciation has a
stronger effect on the countries who has larger or smaller foreign exchange reserves,
imports and exports, and hedging performance in currency performance. It’s
plausible to incorporate foreign trading indicators to better capture their impact on
exchange rate appreciation and depreciation.
3. Rapid loan growth rate alone is unable to explain the problems loans in banks fully.
If combined with some other devastated business policies, like heavy reliance on
paying above-average interest rates on deposits or interbank funding can magnify a
deadly consequence for banks.
4. The observation in countries and variable is insufficient, a larger range of
countries and more variable would help to interpret the credit risk more precisely.
Page 44 of 66
5.3. Recommendations
Findings in this paper on the influence of macroeconomic variables and bank-
specific factors have implications for the conduct of macroeconomic policy as well
as internal bank regulations establishment. Policymaking in both sides plays an
essential role in justifying a proper solution in economic and financial imbalance.
For an economic perspective, steady growth, without deep recessions that put the
survival of risk, and without too-rapid growth that is based on a robust expansion of
bank loans, is the best macroeconomic policy for keeping a low level of problem
loans. A pro-cyclical business circle provides a healthier economic environment for
banking sectors. Hence, the role of government in reducing NPLs level in banks is
crucial. As government can open their market to attract foreign investment to inject
cash flow into the local economy, which could also create more job and production
in the market. Free trade agreement with the neighbour countries would also assist
the export and import trading to enhance the increase of local economy.
On the other side, it has got more explicit that bank regulators should lay more
explicit emphasis on the control and scrutiny associated with loans quality to
eliminate bad loans. Lending activities are still immature in some developing
countries, while a strong focus on prudential regulation, particularly through proper
liquidity provisions and buffers, could help mitigate the impact of macroeconomic
risk on the banking system and create a stable banking system in all countries.
5.4. Further Research
The current study has used panel OLS and difference GMM estimator to test six key
macroeconomic and bank-specific variables, whereas future studies can use other
systematic, i.e. unemployment rate, lending interest rate, housing price, and
unsystematic variables, capital adequacy ratio, return on asset, to investigate the
NPLs behaviour in depth. As discussed in the limitation section, larger time span and
a wider range of countries could add in so as to capture a more precise understanding
of the cause of the credit risk in banks. Other aspects like proxies of regulations,
policies and mechanisms can also be examined to gain a deeper research on its
intervention on loan default rate as well as its potential effect on a banking crisis.
Page 45 of 66
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A-1
Appendices Appendix 1 Macroeconomic interlink with NPLs
-20
0
20
40
60
80
100
120
2,004 2,006 2,008 2,010 2,012 2,014 2,016
year
INFR GDP EXR NPL
B-1
Appendix 2 Normal Distribution of Independent Variables
0
100
200
300
400
500
600
700
-300 -250 -200 -150 -100 -50 0 50
Fre
quency
ROAE
0
20
40
60
80
100
0 10 20 30 40 50 60 70 80 90 100
Fre
quency
LTAR
0
40
80
120
160
200
240
-4 0 4 8 12 16 20 24
Frequency
INFR
0
40
80
120
160
200
-8 -4 0 4 8 12 16 20
Frequency
GDP
0
100
200
300
400
500
600
700
-100 0 100 200 300 400 500 600 700 800 900
Fre
quency
G_LOAN
0
50
100
150
200
250
-15 -10 -5 0 5 10 15 20 25 30
Fre
quency
EXR
C-1
Appendix 3 Quantiles – Quantile Graph
-40
-20
0
20
40
60
-300 -200 -100 0 100
Quantiles of ROAE
Quantile
s o
f Norm
al
ROAE
-20
0
20
40
60
80
100
120
0 20 40 60 80 100
Quantiles of LTAR
Quantile
s o
f Norm
al
LTAR
-4
0
4
8
12
-5 0 5 10 15 20 25
Quantiles of INFR
Quantile
s o
f Norm
al
INFR
-10
-5
0
5
10
15
20
-10 -5 0 5 10 15 20
Quantiles of GDP
Quantile
s o
f Norm
al
GDP
-150
-100
-50
0
50
100
150
-200 0 200 400 600 800 1,000
Quantiles of G_LOAN
Quantiles
of Norm
al
G_LOAN
-20
-10
0
10
20
30
-20 -10 0 10 20 30
Quantiles of EXR
Quantiles
of Norm
al
EXR
D-1
Appendix 4 Signs of Tested Variables
Symbol Expected Empirical Robustness Test
(GMM) FE GMM Europe Asia
Dep
.
NPLs
Mac
roec
onom
ic
G_GDP (-) (-) (-) (+) (-)
REER (-) (+) (-) (+) (-)
INFR (+)/(-) (-) (+) (-) (-)
Ban
k –
leve
l ROAE (-) (-) (-) (+) (+)
G_LOAN (+) (-) (-) (-) (-)
LTAR (+) (-) (-) (-) (-)
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