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Empirical Model for Credit Risk: Implications of Results from African Countries. by Charles Augustine Abuka Director, Financial Stability Department BANK OF UGANDA Prepared for the CMI Course on Macro stress testing Wednesday 21 August , 2013 KSMS, Nairobi, Kenya Studies of Macro-financial Linkages 2 Determinants of Asset Quality • Studies Relevant to Africa – Fofack [2005] – Khemraj and Pasha [forthcoming] – Babihuga [2007] estimates a model, with the share of nonperforming loans in total loans as a function of macroeconomic variables including: • • • • • unemployment, changes in inflation, real interest rates in previous years, the business cycle, exchange rates. 3 Determinants of Asset Quality • The model controlled for the quality of banking supervision and other industry characteristics including income and financial depth. • The basic specification was as follows: npli,t = α1 + β1bcyclei,t + β2inflationi,t + β3reeri,t + β4int_ri,t + β5unratei,t + β6t_trade +β7bcpi,t +β8bcp*cyclei,t + εi,t (3) for panel data i = 1,...., 96 and t = 1998,....,2005. 4 Determinants of Asset Quality • The choice of explanatory macroeconomic variables in the model reflects the evidence provided by the large empirical literature showing that a collapse in borrowers’ credit worthiness and the subsequent deterioration in the value of collateral are the main transmission mechanisms of a macroeconomic shock to banks’ portfolios: – Thus during periods of financial distress, credit quality emerges as an important source of vulnerability and nonperforming loans deteriorate quickly before bank failures. – Therefore in order to assess the impact of macroeconomic conditions on asset quality, we focus on macroeconomic variables that potentially affect borrowers’ credit worthiness. 5 Determinants of Asset Quality 6 Determinants of Asset Quality 7 Determinants of Asset Quality – The coefficient on the business cycle variable is negative, significant and robust across all specifications, implying that economic booms are associated with improvements in asset quality. – Higher inflation, interest rates and unemployment worsen asset quality (increasing NPLs). – An improvement in the terms of trade index appears to have a positive effect on asset quality. 8 Determinants of Asset Quality – A real depreciation in the exchange rate appears to have a negative effect on asset quality. • However, the overall impact for exporters and producers of tradable goods, to which the banking system is exposed, will depend on which effect dominates, – The quality of regulatory supervision has a positive impact on asset quality. This finding is consistent with Podpiera (2004). 9 Possible variables for investigation • Explanatory Variables –The ratio of nonperforming to total loans for individual banks; –The ratio of loan loss reserves to total loans. 10 Possible variables for investigation • Macro Variables – the annual growth in real GDP at time, – the real interest rates (measured as the difference between the weighted average lending rate and the annual inflation rate), – the real effective exchange rate, – the annual inflation rate, 11 Possible variables for investigation • Macroeconomic variables – Unemployment rate, – Annual growth rate of M2, – GDP per capita, – Output gap or business cycle component of GDP – Terms of trade – Investment to GDP ratio – Real estate price inflation 12 Possible variables for investigation • Macroeconomic Variables – Growth of real fixed investment – Growth of real consumption – Growth in exports and imports – Industrial production – Oil prices – Nominal interest rates – Nominal exchange rates 13 The NPL Equation Estimation • Bank Specific Variables – Size of the ratio of the relative market share of each bank’s assets that capture the size of the institution, – the loans to total asset ratio for bank, – represents the growth in loans for each bank – the real interest rates (measured as the difference between the weighted average lending rate of each bank and the annual inflation rate), 14 The NPL Equation Estimation • Bank Specific Variables – Profit margins, – efficiency, – terms of credit (size, maturity, interest rate), – risk profile (proxied by capital/assets ratio), – Loan to asset ratio, – Equity to asset ratio, – Cost to income ratio, – Liquidity ratio, 15 REFERENCES 16 REFERENCES • Baltagi B.D., 2001 Econometric Analysis of Panel Data, John Willwy and Sons, LTD. • Eviews 6 and 7 Users Guides • Green, W.H., 2005 Econometric Analysis, Prentice Hall. • Wooldridge, J.M, 2002 Econometric Analysis of Cross Section and Panel Data, The MIT Press. 17