Macro economic determinants of credit risks in the asean banking system

NGUYEN CHITHANH MASTEROFARTSINDEVELOPMENTECONOMICS HO CHIMINHCITY, DECEMBER 2016... DECLARATION...i ACKNOWLEDGEMENT...ii ABBREVIATION...iii CONTENTS...v APPENDIX...1 LIST OFTABLES...2 CH

NGUYEN CHITHANH

MASTEROFARTSINDEVELOPMENTECONOMICS

HO CHIMINHCITY, DECEMBER 2016

UNIVERSITYOFECONOMICS INSTITUTEOFSOCIAL

NETHERLANDSPROGRAMMEFOR

VIETNAM-M.AINDEVELOPMENTECONOMICS

MACROECONOMICDETERMINANTSOFC

REDITRISK INTHEASEANBANKINGSYSTEM

Athesissubmitted inpartialfulfilmentoftherequirementsforthedegreeofM A S T E R

NGUYENCHITHANH

ACKNOWLEDGEMENT

HereIwouldliketoshowmysincereexpressionofgratitudetothankmysupervisor,Dr NguyenV u H o n g T h a i f o r h i s d e d i c a te d g u i d e l i n e , u n d e r s t a n d i n ga n d supportsduringt h e makingo f t h i s t h e s i s H i s p r e c i o u s academick n o w l e d g e a n d i d e

Lastly,Iwouldliketoexpressmylovetomyfamiliesfortheirunlimitedsupportswhichh a s ledtothecompletionofthiscourseresearchproject

p e r f o r m i n g l o a n s i n c o m m e r c i a l b a n k i n g s y s t e m s o f t h e f i v e AS E

A N countriesintheperiodof2002to2015.Theresearchusesasampleof162ban k sinthesecountrieswith11variablesofmacroeconomicandbank-

specificfactorsa n d a p p l i e s t h e S y s t e m G e n e r a l i z e d M e t h o d o f Moment

se s t i m a t o r ( S G M M ) f o r dynamicpanelmodels

TheempiricalresultsinthispaperindicatethatthemovementofNPLsinthecommercialbanksofthefivestudiedcountriesisassociatedwithbothmacroeconomicv a r i a b l e s andbank-

specificfactors.Forthemacroeconomiccondition,anincreaseinu nemp lo ym ent rateandtheappreciationofdomesticcurrencyarefoundtosignificantlyincreasetheNPLs.Inaddition,bankwithhigherreturnsonassetandleverageratioandl o w ratioofequitytototalassetswillhavelowerrateofNPLs.Moreover, withtheapplicationofadditionalstatisticalanalyses,theresultsindicatethatthefindingsofthemainmodelofthispaperareconsistentandrobust

DECLARATION i

ACKNOWLEDGEMENT ii

ABBREVIATION iii

CONTENTS v

APPENDIX 1

LIST OFTABLES 2

CHAPTER1:OVERVIEW OFRESEARCH 3

1 Introduction 3

1.1 Backgrounds: 3

1.2 Problem statements: 4

1.3 Researchobjectives: 5

1.4 Researchquestions: 6

1.5 Hypothesis ofthestudy 6

1.6 Theimportanceofresearch 6

1.7 StructureofResearch 8

CHAPTER2:LITERATURE REVIEWS 9

2.1 Theoreticalreviews: 9

2.2 Empiricalreviews: 13

2.3 Conclusion 22

2.4 ResearchHypothesis: 23

CHAPTER3:DATA ANDMETHODOLOGY 27

3.1 Datacollection 27

3.2 Econometricmethodology–TheNPLsmeasurement: 28

3.3 Thevariablesdefinitionandmeasurement: 32

3.3.1 Thedependentvariable–theNon-performingloans: 32

3.3.2 Macroeconomicvariables: 32

3.3.3 Microeconomicvariables–bank-specificdeterminants 34

3.4 Econometricstrategy–Thes y s t e m GMMestimator 38

CHAPTER4:RESULTSANDDISCUSSIONs 40

4.1 Summarystatistics: 40

4.2 Unitroottests: 41

4.3 Empiricalresults: 41

CHAPTER5:OTHERANALYSISANDROBUSTNESSCHECK 51

CHAPTER6:CONCLUSION,POLICYIMPLICATIONS&LIMITATIONSOFTHER E A S E A R C H 56

6.1 Mainfindings: 56

6.2 Policyimplications: 57

6.3 Limitations: 58

6.4 Futureresearchrecommendation 58

REFERENCES 59

APPENDIX 66

n a n c i a l s e r v i c e s a s w e l l a s traditionals e r v i c e s ( t a k i n g d e p o s i t s a n d makeb

u s i n e s s l o a n s ) W h e n e v e r a l o a n i s approved,banksgainprofitsfromtheborrowersbyloaninterestrateandservicesfees.H o w e v e r , bankswouldexposetocreditriskfromthisservicebecauseborrowerscouldsuddenlylosttheirabilitiestopaytheloanintime,namelythenon-

performingloans( N P L s ) Themainreasonforthatcomesfromthemovementofthemacroeconomice n v i r o n m e n t , whichdirectlyimpactstotherevenuesandbusinessactivities ofbankb o r r o w e r s

Therefore,t h i s p a p e r w i l l c o n d u c t a n e x a m i n a t i o n a b o u t h o w t h e economicsdeterminantsa f f e c t t h e b a n k c r e d i t r i s k I n t h i s c h a p t e r , t h e b a c k g r o u n d

s , p r o b l e m statements,researchobjectives,researchquestions,significanceoftheresearchandthelayoutswillbediscussaroundthisissue

1.1 Backgrounds:

wellasfinancialliberalizationprocessind e v e l o p i n g countries,thefinancialsectorhavebeengrownwithsurprisingrate.B e s i d e s , t h e i m p r o v e m e n t s o f t e c h n o l o g y a n

d managementp r o c e d u r e s h e l p b a n k s makingdecisionstogrowinfinancialmarkets.However,theoccurrencesoftwobigeconomicrecessionsin1997and2007havesignificantlyaffectedthebankingsystemsindevelopingcountries.Itassociatedwiththedeterioratedquali

Whenborrowersareunabletofulfilltheirobligationstotheloans,itwouldbecomec

r e d i t riskofbanks,whichisoneofthesignificantrisksamongmanykindsofrisksthatmostofthecommercialbanksareexposed.Creditriskisdistinguishedbyt w o componentswhicharesystematicandunsystematiccreditrisk(Castro,2013)andinf a c t , itisveryhardtosetanefficientcreditriskmanagementpolicyandprocedureforthebankingsystem.Thisisbecauseoftheunpredictablenaturesofeconomic

environmentthathavetheimpactstobanking-specificfactorsaswellasrisksinbankingindustry.Therefore,thisimpacthasraisedmanyseriousconcernstoresearchersandp o l i c y makerstounderstandtherelationbetweencreditriskandthebusinesscycleino r d e r toensurethestabilityofabankingsystem

1.2 Problemstatements:

largestU.S.investmentbank.Itisbecauseofthesubprimemortgagecrisis,manyl o a n d e f a u l t s makest h e b a n k i l l i q u i d i t y t o p r e v e n t fromt h e c r i s i s M o r e o v e r , t h e d e p o

ThebeginningofrecentcrisisexplodedsincethecollapseoftheLehmanBrothers,thefourth-s i t o r ThebeginningofrecentcrisisexplodedsincethecollapseoftheLehmanBrothers,thefourth-s d o a maThebeginningofrecentcrisisexplodedsincethecollapseoftheLehmanBrothers,thefourth-sThebeginningofrecentcrisisexplodedsincethecollapseoftheLehmanBrothers,thefourth-sivew i t h d r a w t h e i r m o n e y o u t o f t h e b a n k a ThebeginningofrecentcrisisexplodedsincethecollapseoftheLehmanBrothers,thefourth-s theyl o ThebeginningofrecentcrisisexplodedsincethecollapseoftheLehmanBrothers,thefourth-s t t h e

i r co n f id en c e inthebanks.Asaresult,thebankdonothaveenoughmoneytodobusinessa n d indirectlycausetheWashingtonMutualbankruptcy.SincetheLehmanBrotherdobusinessaroundtheworld,italsoleadsbanksinmanycountriesfacethecreditrisk

Makingloanisthetraditionalfunctionprovidedbythebankbutitalsocausesthecreditri sk , whichcomefromtheborrowerswhoareinabilitytopaybacktheloansastheypromised.FollowingtoCastro(2013),theincreaseofbadloansinbanks’balancesheetl e a d s totheproblemofliquidityandinsolvency,whichisthesignalforbankingcrisis.I n thecaseofilliquidityandinsolvency,bankswilllosetheirabilitiestopaytotheirdebtor s andfailtomeettheirobligations.Asashockhavehappened,bankswillbeconsideredaslossandcouldbeforcedtoshutdown.From

there,bothbanksandtheird e b t o r s willbestruggledbylossanditwilleffecttoeconomy.Therefore,itiscrucialt o raiseawarenesstothecreditriskinordertodeterminethecauseofrisksandpreventb a n k s fromilliquidityandinsolvencyproblems

Consequently,ifbanksneedtocontrolthecreditriskefficiently,theymustunderstandth efactorsthatcausethecreditrisk.However,assuggestionofGarr(2013),thenatureofmacroeconomice

n v i r o n m e n t i s u nf or et ol da nd a l s o a ss o c i a te s wi th v a r i o u s m i c r o e c o n o m i

c factors,whichmakesbanks’creditriskmanagementbecomeaverycomplicatedandtoughobjectiveinordertomanagethecreditrisk.Lackofknowledgea n d e x p e r i e n c e i n

c r e d i t r i s k managementc a n l e a d s b a n k s t o m o r e s e r i o u s r i s k s B e s i d e

s , Ratnovski(2013)pointsaviewthatcreditriskmanagementmaybecomeab u r d e

n r a t h e r t h a n a s o l u t i o n f o r b a n k s b e c a u s e itc o u l d d r a i n a c e r t a i n a m o u n t of

resourcesandtimeofbanks.Formorespecific,themanagersalsohavetoputmanye f f

o r t inknowledgeandexperiencestodealwithitanditcouldraisetheadministrativeco stwhilealowreturnonhighlyliquidassetscannotbecompensatedthecost.Acreditriskprogramrequirestimetotakeeffectandresources(suchascapitalandlabors)tob e employedandmanagedforalongtimeinordertopreventbanksfromasuddena t t a c k ofcreditrisk.Therefore,ifthecreditriskpolicyandprocedurearenotbasedontherealsituationofthefactorsthatimpacttocreditrisk,theywillbelossbecausetheirm o n e y a n d t i m e f o r t h e c o s t l y p r o g r a m a r

e w a s t e d , b u t a l s o theyw i l l

s u f f e r s a s i g n i f i c a n t raiseofthecreditriskproblems

Asaresult,ithasledtomanyinterestsof

researchersandpolicymakersinfindingthef a c to r s thatcanleadtothebankcreditrisk,sothattheycanunderstandthesefactorsand buildaneffectivecreditriskmanagementtolimittheprobabilityofcreditrisk

1.3 Researchobjectives:

Thepaperwillexaminetheinfluenceofmacroeconomicenvironmentfactorstothen o n -

p e r f o r m i n g loansratio(NPLs)inthefivecountriesofASEAN(Indonesia,Malaysia,Philippine,ThailandandVietnam)coveringa13-

yearperiodoftimefrom2 0 0 2 to2015,whichareinthesamedevelopmentrateinthearea.However,duetothel a c k ofNPLsdataatcountrieslevel,theNPLsratioofindividualcommercialbankwillb eexaminedandinordertopreventfrombiasandtoensurethemodelconsistent,otherb a n k -

s p e c i f i c factorswillbeadoptedinthispaper,thereare162commercialbanks’information collected.ThedataformacrodeterminantsiscollectedfromtheWorldB a n k datawhilebank-specificonesisfromtheBankScope-

Fitch’sInternationalBankD a t a b a s e Finally,theobjectivesofthispaperareasfollows:

- ToexaminetheimpactsofmacroeconomicdeterminantstotheNPLsratioofthecommercialbanksinthefivecountriesofASEAN

- Tostudythenatureofthecommercialbanks’specific

factorstowardtheNPLsinthefivecountriesofASEAN

- Tof i n d a n a p p r o p r i a t e d methodt o

measuret h e r e l a t i o n s h i p b e t w e e n m a c r o e c o n o m i c factorsandtheNPLsratio

ditriskinthefivestudiedASEANcountries

H2:InterestratehasasignificantpositiveeffectonbankcreditriskinthefivestudiedASEANcountries

H3:InflationratehasasignificantimpactonbankcreditriskinthefivestudiedASEANcountries

H4:Exchangerateappreciationhasasignificantrelationshipwithbankcredi

tr i s k inthefivestudiedASEANcountries

H5:UnemploymentratehasasignificantlypositiveimpactonbankcreditriskinthefivestudiedASEANcountries

1.6 Theimportanceofresearch:

Numerousexistingpapersareconductedtoexaminethecreditriskdeterminantswithina countryoracategoryofcountries(suchasinEurope,OECDordevelopedcountries)o r alimitofdeterminantcategory.Inthis study,t he potential determinants of ban kc r e d i t r i s k ,

w h i c h a r e

a p p l i e d i n t h e model,a r e 11f a c t o r s ( i n c l u d i n g f i v e main

macroeconomicdeterminantsandsixadditionalbank-specificfactors).Thisisalsothef i r s t paperthatexaminestheimpactsofthesevariabl

es ontheNPLsofcommercialb an ksinfiveASEANcountries(Indonesia,Malaysia,Philippine,ThailandandVietnam)from2002to2015.Inaddition,duetothenatureofthedatasampleinthisp a p e r and thelimitof relatedresearchpapers,theresearchmethodologicaldesignwillf o l l o w anextensiveapproachthroughthedynamicpaneldataeconometrictechniquest h a t serveasarobustcross-

validationoftheresultsaswellasseveraladditionalanalysisandrobustnesstests

Theresultsoftheresearchwillassistabetterunderstandingintothekeyfactorsofcreditr i sk inthecommercialbanksofstudiedcountries.Inaddition,thepaperwillproposeusef ul informationinexplainingwhatcausethebankcreditriskandinevaluatingtheperformanceofthebankstowardtheNPLs.AccordingtoDemirguc-

KuntandD e t r a g i a c h e (1998),bankingsystemofacountry

withhighinflationrate,u n e m p l o y m e n t andinterestrateseemtohavehigherbankcreditriskandbankingcrisisw o u l d b e e a s i l y o c c u r T h e r e f o r e , t h i s s t u d y w i l l g i v e moreu n d e r s t a n d i n g i n t h e connectionoftheeconomicdevelopmentsandthecreditriskaswellastheinformationo n howthebanks’operationandtheeconomicconditionwithinthesecountriesis

Formores p e c i f i c , t h e i n v e s t o r a n d d e p o s i t o r w i l l k n o w h o w a n d w h e

n t h e b a n k p er f o r m an c es a r e i n t h e s t a b l e a n d s o u n d c o n d i t i o n t h r o u g h k n

o w i n g n a t u r e o f t h e economicandbankspecificfactors.Withthisknowledge,theirbankingactivitiesaremucheasiertomakeexactdecisionstousetheirfundandpreventfrombadinvestments.I n addition,theresultwillprovidetobankmanagersanefficientloanandcreditriskmanagementpolicywiththeinformationofwhicheconomicandbankspecificd e t

e r m i n a n t s o f t h e b a n k i n f l u e n c e c r e d i t r i s k T h e r e f o r e , w i t h i n f o r m a t i o n

s u c h a s increaseint h e i n f l a t i o n r a te , i n t e r e s t r a t e o r domesticc u r r e n c y ap pr ec i

a ti on, b a n k s c o u l d issueanappropriated approachtomonitor,evaluateandcontrolforbankriske x p o s u r e s withamorepreciseway.Consequently,anefficientcreditriskmanagementp o l i c y w i l l helpbankmanagementmoreeffectiveincapitalallocation,bankingperformance,operatingcostandprofitability

1.7 StructureofResearch:

Thisr e s e a r c h p a p e r i s o r g a n i z e d i n s i x c h a p t e r s C h a p t e r 1 i s t h e i n t r o d u c

t i o n a n d overviewthegeneralideaofthestudycontext.Chapter2givestheliteraturereviewsofthepreviousstudiesinboththeoreticalandempiricalframeworksfortheeffectofthemacroeconomicf a c t o r s o n t h e b a n k c r e d i t r i s k a n d i t a l s o d e s c r i b e s t h e p r o

p o s e d hypothesesd e v e l o p m e n t f o r t h e study.C h a p t e r 3 consistso f t h e d a t a a n

d r e s e a r c h m e t h o d o l o g y whichincludestheresearchmethodology,datacollectionmethods,themodeldescriptionandvariabledescription

Chapter4willpresentandinterprettheresultsoftheeconometricanalysiswithrespecttotheresearch’stheoreticalandempiricalanalyses,whicharelinkedtothehypotheseso f theresearchpaper.ItwillshowtherelationshipoftheeconomicfactorsandtheNPLsr at i o ofbanks.Furthermore,chapter5conductsadditionalanalysisandrobustnesstesti n ordertoexaminetheconsistentoftheestimatorandfinallychapter6willsuggestsomepolicyimplications,thelimitationsandthefinalconclusionofthisthesis

2.1 Theoreticalreviews:

Creditriskisdefinedastheriskfromborrowerswhohavelosttheirabilitytopayloansbacktolenderspartiallyortotally.Inrecentyears,manybanksintheworldexperiencedsubstantiallossesandreductionofcapitalprovisionduetorapiddeteriorationinassets’quality.Thisnotonlyincreasedbanks’exposuretoeconomiccrisisbutalsorestrictedb a n k lendingabilitywithbothdirectandindirectconsequencestothefinancialstabilitya n d e c o n o m i c a c t i v i t i e s T h e r e f o r e , t h e needf o

r t h e c r e d i t r i s k a n a l y s i s i s c r u c i a l becauseitisnot onlytoensureastablebanking systemforaprosperous economic growthb u t a l s o c a n r a i s e t h e a w a

r e n e s s t o t h e r e g u l a t o r y a u t h o r i t i e s t o p r e v e n t a p ossi ble crisisinthefuture.Castro(2013)identifiesfactorsaffectingsystematicandu n s y s t e m a t i c creditriskseparately.Thefactorsinfluencingthesystematiccreditriska r e : m a c r o e c o n o m

2.1.1 BusinessCycleandRisk:

Ther e l a t i o n s h i p b e t w e e n t h e e c o n o m y a n d f i n a n c i a l s y s t e m h a s b e e n

a r g u e d i n a numberoftheories.Withintheframeworkofbusinesscycles,theconnectionbetweenm a c r o e c o n o m i c factorsandloanqualityisemphasizedbylinkingtothemovementofb u s i n e s s c y c l e w i t h f i n a n c i a l v u l n e r a b i l i t y a n d b a n k i n g p e r f o r

m a n c e.S p e c i f i c a l l y , M e s s a i andJouini(2013)offersatheoreticalmodelsfromWilliamson(1987),whichemphasizesthenatureofcreditriskandproposestheimpactofbusinesscycletothef i na n ci al sectorofacountry.Inaddition,MessaiandJouini(2013)alsosummarizedtheoreticalreviewforthisrelation, thephasesofthebusinesscyclerelatingtobankingperformancehavebeens t u d i e d i n ordertoexpresstherelationshipb e t w e e n

t h e m a c r o e c o n o m i c environment(suchastheyearlyGDPgrowth,therealinterestrate,the

a n n u a l inflationrate,the exchange rateandthe unemploymentrate)and thequalityof

Page| 10

loans.Duringtheeconomicexpansionphase,thereareonlyarelativelysmallproportionofbadloans,borrowersareconfidenttohaveadequateincomeormorecashheldtorepayfortheirloansintimeofdeadlines.Therefore,lendersmaynotpaymuchattentionstothecreditstandardsandallowmorerisk(KochandMcDonald,2003)orthei n c r e a s e d a b i l i t y ofc r e d i t

o r s t o r e p a y l o a ns l e a d s t o r e d u c i n g o f c r e d i t r i s k f o r lenders(SalasandSaurina,2002).However,wheneconomicconditionsworsen,thestudiesofJiménezandSaurina(2006)forSpanishbanksandBohachova(2008)formembersofOrganizationForEconomicCooperationAndDevelopment(OECD)reacht h e conclusionthatbanksarevulnerabletoadverseselectionintheirfinancialdecisionsa n d moralhazardbehavioroftheircreditorssothatthiscausesanincreaseinriskofloans

2.1.2 InterestRateandRisk:

Itisalsoarguedthathigherinterestrate,mostlyinducedbymonetarypolicy,associatesh i g h l y withdebtburdenduetohigherinterestpayment,whichleadstohighrateofN P L s Forinstances,followingthetheoryofasymmetricinformation,borrowersarea b l

e t o f a c e a d v e r s e s e l e c t i o n p r o b l e m a s i n t e r e s t r a t e s u r g e s ,i t i s c a l l “ b

a d r i s k ” (Bohachova, 2008),theresultofloanapplicantsisprobablyadversewiththeborrowers’selection.Inordertopayfortheirloans,insteadofusingtheloansonsafeprojectswithl o w returns,creditorstendtohavestrongmotivetoriskierprojectswithmuchmoreh i g h e r income.Inaddition,wheninterestrateincreases,bankswillearnmorereturnsfromnewloansandfloatinginterestloanswhileborrowershavetostandwithhigherpaymentsan dt h e n t

h e p r o b a b i l i t y ofi n c r e a s e inc red it r i s k w o u l d o c c u r o n ba nk s’ b a l a n c e sheets(Demirguc-

KuntandDetragiache,1998).However,fromtheviewoftheb a n k s i d e , b a n k s d i v e r s i f y t

h e i r f i n a n c i a l r o l e s i n t h e market,theyc o n d u c t a s s e t t r a n s f o r m a t i o nandtheylendtoalargenumberofborrowersaswellasborrowfrom

alar ge n u m b e r o f d e p o s i t o r s ( W i l l i a m s o n , 1 9 8 7 ) M o r e o v e r , insomec o u

n t r i e s w i t h interestrateliberalization,becauseofrisesinthecostsoffundsandthecultureofhigh-r i s k behaviors;higherratesarechargedtohigh-

riskborrowersinordertomitigaterisks,h e n c e banksoverallriskexposureincreasesmore(Fofack,2005)

Whentheeconomywentdown,thereturnonbankassetsdeterioratesmorethantheratet h a t mustbepaidondepositorsandbankswouldreduceprofitsorfacelosses.Asbank’sa s s e t s arecomposedoflong-termfixedinterestrateloans,thusbankscannothandleforthe

returnonassetsquicklyenough.Asaresult, banks termlendinginterestrateinordertodealwiththeirliabilitypayments(Mishkin,1996)1.Inaddition,w h e n borrowersarelikelytobeexposedtodebtburden,banksalsofacetoalargeriskyl o a n portfolio,thusahighernetinterestmarginisrequiredtocompensatethehigherr i s k ofdefault(AhmadandAriff,2007),whichleadstoasystematicbankingsectorsproblems

o rr o w er s therebymakingthequalityofpreviouslyextendedloansworseandresultingt o creditrationing(Bohachova,2008).Inaddition,ifvariableloanratesareapplied,highinflationleadsborrowerstoadverseselectionsbecausebankswillprefertoadjustt helendingratestokeeptheirrealreturnsstableorthegovernmentconductsmonetarypolicytof i g h t aga ins t i

n f l a t i o n ( Nk us u, 2 01 1) Ont h e o th er han d, d i s i n f l a t i o n a lso a f f e c t s loanqualitybecauseinapreviouslyhigh-

inflationeconomy,therearehighrealinterestrate, which m a k e s the e a r n i n g s ofb o r r o

w e r s d e c l i n e d an d e n c o u r a ge s ri sks similartoariseinnominalinterestrate(Mishkin,1996)

2.1.4 ExchangeRateandRisk:

Exchangerate,whichindicatesthevalueofdomesticcurrencyintermsofanother,isal so

o n e o f m a c r o e c o n o m i c s o u r c e s o f e c o n o m i c i n s t a b i l i t y a s w e l l

a s b a n k r i s k

1 MostoftheUnitedStatesbankingpanicsfollowanincreaseinshort-termlendinginterestrates.

exposure.Becauseofnocurrencymatchingbetweentheincomeofborrowersandtheirl o a n debts,forloansnominatedinforeigncurrency,depreciationofdomesticcurrencyincreasesdebtsanddebtors’incapacitytopaytheloansandthenbankswouldfacetol o a n d e f a u l t s ( C u r a k eta l , 2 0 1 3 ) Whend o m e s t i c c u r r e n c y depreciates, t h e r a t e o f impairedl o a n s w o u l

d i n c r e a s e , e s p e c i a l l y forl o a n s nominatedi n f o r e i g n c u r r e n c y C r e d i t riskforbankloansislikelytoincreasetoimportersanddecreasetoexporters,t h u s bank’soverallriskexposurewillbedeterminedbyitsnetvulnerabilitytoexportingo r importingborrowers.Astheforeigncurrencyappreciates,itcostsmoretopurchasef o r e i g n goodsandservices,therebymoreunitsofdomesticcurrencyarerequiredtos e c u r e thesamequantityofimportedgoodsandservicesthanbefore.Accordingly,thedemandoffinancialsupportforbankcreditwillincreasetocovertheraisingcostsandi t wouldreducethefirm’sprofitability,thenfirmwillencountertheproblemtoserveinterestandprincipalofloans(Poudel,2013).Ontheotherside,Bochahova(2008)alsoe x p r e s s e s twotheoreticalinteractionsofexchangeratemovementonbanks’creditrisk.F o r mores p e c i f i c , b a n k s ’ v o l a t i l i t y c o u l d i n c r e a s e d

u e tot h e d o m e s t i c c u r r e n c y d e p r e c i a t i o n whenbanksliabilitiesdenominatedinforeigncurrenciesarehigherthantheirforeignexchangeassets.Inaddition,agreatrateofdomesticcurrencydepreciationc o u l d leadtodisintermediationasdepositorsdecidetowithdrawtheirfundsfrombankstoinvestdirectlytoother“hardcurrencyassets”withhigherreturns,thusbankswillf a c e capitalshortageandbankcreditriskswillincrease

Specifically,therelationbetweenunemploymentandNPLsareproposedbyLawrence( 1 9 9 5 ), whoconductedatheoreticalmodelaboutlife-

cycleconsumption.Inthismodel,t h e p r o b a b i l i t y o f loan defaultise x p l i c i t l y

e x p l a i n e d t h a t d u e toa n i n c r e a s e inu n e m p l o y m e n t , itwillinducelowerlevelofincomefromborrowers andtheirdebt-

servicingcapacity,thustheprobabilityofcreditriskishigher.Furthermore,inordertol i m i t theriskandensurethecapitalforbanks,higherinterestrateloanwillbeofferedto clientswithhigherriskrates.Fromthe model,Rinaldi andSanchis-Arellano(2006)haveextendedtheirstudyandsuggestedthatthepossibilitiesofNPLsalsoreliedontheunemploymentrate,whichreflectsthecurrentincomeandtheuncertaintyregardingtothefutureincomeofborrowersaswellasthelendingratesappliedbybank.Besides,th ismodelalsoimpliesthatthevolumeofloantaken,theamountofinvestmentandthetimepreferenceratealsoimpacttheprobabilityofdefault

BergeandBoye(2007) proposethat duringperiodsofcyclicaleconomicrecession,asunemploymentr i s e s a n d co rp or at e e a r n i n g s a r e d i m i n i s h i n g , b o

t h N P L s an d b a n k s ' l o s s e s maysurge.Higherunemploymentratealsomakeborrowerssufferfromdebt-

servicingcostsan do t h e r co sts wh ile b a n k s h a v e to determinet h e i r l o a n p ro vi si o

ns f o l l o w i n g totheborrowers’expectedfutureflowsofincomeandexpenditure.Itwilld e t e r i o r a t e t h e b o r r o w e r ’ s d e b t -servicingc a p a c i t y a s movementsof

thesef a c t o r s diversefromexpecteddevelopments,thusthecreditriskwillincrease

2.2 Empiricalreviews:

2.2.1 GrossDomesticProduct(GDP):

GrossDomesticProduct(GDP)canbedefinedasthemonetaryvalueofallthefinishedg o o d s andservicesproducedwithinaparticular country'sbordersinaspecifictimep e ri o d Followingformerresearches,thispaperwilluseannualgrowthrateofrealGDPat constantpricesasanindicatorforbothofeconomicactivitiesandbusinesscycles,w h i c h mayhavedirectlyimpactonthebankingsysteminregardtobankrisks.MostofliteraturesfindasignificantinfluenceandanegativerelationshipbetweenGDPgrowtha n d NPLs.Specifically,Shu(2002)executesstresstesti

ngfortheHongKong’sbankings e c t o r tocalculatethevolatilitiesofloanqualitybetween1995and2002.Borrowers’abilitytoloanrepaymentandthebanks’portfoliopositionareinfluencedbychangesin

macroeconomicdeterminants,whichareconsideredastheriskfactorsinthepaper.Theau t h o r concludesthathighereconomicgrowthoreconomicexpansionhighlyassociatesw i t h higherprofitabilityforcorporatesector,reducingthedefaultrateswhilebanks’exp o su r e tor i s k r e d

u c e s a n d t h e n o p e n m o r e c h a n c e s t o l e n d r a p i d l y M o r e o v e r , applyingMerton

´smethodologytoanalyzetherelationshipbetweenCzechbankcreditr i s k a n d macroeconomi

cf a c t o r s , J a k u b i k ( 2 0 0 7 ) findst h a t d e c r e a s e s i n r e a l G D P g r o w t h deterioratesthebanks’loanportfolioqualityduetochangesinthecorporateea r n i ng s ,wagegrowth

andhighunemploymentrate,whichleadstohigherbankcreditrisk.InthecaseinTunisiabankingsystem,ZribiandBoujelbène(2011)examineap an el modeloftencommercialbanksfrom1995to2008anduseGDPgrowthasthemacroeconomic variableinordertoascertainthebankcreditrisk.TheyalsoindicatethenegativeoveralleffectofGDPgrowthonthebankcreditrisk

Louzisetal

(2012)conductresearchwithdynamicpanelapproachonawiderrangeofl o an s (consumerloans,businessloans,andmortgages)inGreekbankingsystemovertheperiod2003–

2009.Theyconcludethattheborrowers’capacityofloanrepaymentsd e p e n d s onthephaseoftheeconomiccycle.InaneconomicdownturnorlowerGDPg r o w t h , theNPLs willin c

r ease forallloantypeswhile intheeconomicexpansion, borrowerswillhavesufficientandenoughincomestorepaytheirloan.Therefore,itcanb eexpectedthatNPLsiscorrelatednegativelywiththeeconomiccycle,risingattimesw h e n economicactivityslowdownanddeterioratesthequalityallloantypes

Besides,forcross-countrylevel,accordingto

astudywithdynamicpaneldatamethodo f Castro(2013),intheperiod1997q1–

2011q3,regardtobanksofGreece,Ireland, Portugal,Spain,andItaly,thepaperdemonstratesthesignificantinteractionofGDPdevelopment andtherecentfinancialcrisistothemovementofthebankcreditrisk.T h e i r resultsshowthatGDPgrowthisnegativelyrelatedtotheNPLs,thehigherlevelofGDPgrowthcausesahigherlevelofincomeforborrowers,leadstogreatercashflows.ThisalsoraisestheprofitabilityofthebankandlowerstheNPLsandbaddebts.T h e sameconclusionisfoundedinthepapersofNkusu(2

011)incaseof26advancedco un t r i e s from1998to2009;orMessaiandJouini(2013)incaseofItaly,GreeceandS p ai n forthe per io d of2 00 4-

2 00 8; o r K lei n ( 2 0 1 3 ) i n case o f Ce nt ra l, Eastern and

2011;orChaibiandFtiti(2015)incaseofcomparisonbetweenFrenchandGermaneconomy.Ontheotherhand,thereareseveralresearchersfoundoutnosignificantrelationshipbetweenGDPgrowthandbankcreditrisk.Forexample,Poudel(2013)indicatesnos

i g n i f i c a n t relationshipbetweenGDPandNPLsin31Nepalesecommercialbanksoverth eperiodfrom2001-

2011.Itcanbeexplainedthatduringeconomydownturn,whenmakingn e w l o a n s , b a n k

s t e n d toc a r e f u l l y q u a l i f y t h e i r b o r r o w e r s b a s e d o n c r e d i t w o r t h i n e s s andcreditconditionofborrowers.Besides,banksarewellpreparedandwillcategorizetheirclientsanddebtorsinordertocontroltheamountofNPLsandcreditrisk.Therefore,thevolumeo

incomesecuritiesyields( B o h a c h o v a , 2008)

Fofack(2005)findspositiverelationshipbetweenrealinterestrate andcreditriski

nS u b

-S a r a h a n Africa.Thepapersuggeststhathigherinterestrateleadstoanincreaseincostofborrowingthatborrowerswouldpaytoobtainloan,aswellasanincreaseincostofdepositsthatmakethecommercialbanks’profitdecrease.Therefore,thedefaultratewillincrease.Inaddition,JiménezandSaurin a(2006)withthehelpofGeneralizedM e t h o d ofMoments(GMM)estimatorfordynamicpanelmodelsalsousedtherealinterestratetoi n v e s t i g a t e t h e i

m p a c t o f i n t e r e s t r a t e o n l o a n l o s s Theyf o u n d a significantandpositiverelationshipbetweeninterestrateandloanslossesinSpanish

commercialorsavingsbankbetweenDecember1984andDecember2002.Alsowiths t u

d y applyingtheGMMestimatorforbankingsystemsinSoutheasternEurope,Curake t al

(2013)pointoutthatthehigherrealinterestrateis,thehigherpossibilityoftheN P L s ofvariablerateloanare.Theexplanationisthatastherealinterestrateincreases,itcreatesanadditionalburdenfordebtorstoservetheirpaymentobligations

Fromtheresearch conductedbyCastro(2013)inGIPSIcountries,thepaper

uselong-t e r m i n uselong-t e r e s uselong-t r a uselong-t e i n i uselong-t s r e g r e s s i o n a s b e n c h m a r k f o r analysisandi uselong-t

i s t h e m o s t appropriatemeasurementsbecausebanksnormallyandmostlydolendinglong-

termloans.Thestudyfindsasignificantpositiverelationshipbetweeninterestrateandcreditrisk.Alsointheresearch,forrobustnesscheckofthemodel,thelong-

terminterestratei s replacedinturnbytherealinterestrateandtheinterestratespreads,theresultsofthese v a r i a b l e s a r e i n samed i r e c t i o n , I n a d d i t i o n , l o n g -

t e r m i n t e r e s t r a t e i s moreimportanttomeasuretheeffectofcreditriskwhenloaninterestiseitherhigherorlowera n d higherinterestratewillleadtoincreasetheobligationforcorporateborrowersandindividuals,thusitinducesthebanks’creditrisk.Thesimilarresultsarefoundinther e s e a r c h ofQuagliariello(2007) betweenthelong-terminterestrate,measuredbyten-

yearItalianTreasurybond,andtheproxyforcreditrisk,theloanlossprovision I

n addition,thef i n d i n g s o f S o l a r i n e t a l

( 2 0 1 1 ) , w h i c h c o m p l y o n t h e b a s i s o f A u t o r e g r e s s i v e distributedlag(ARDL)approachonIslamicbanksofMalaysiaandinterestrat e, indicatesasignificantpositivelong-runimpactonNPLs.AlsoinMalaysia,withat e s t oncommercialbanksduring2006till2010,Asarietal

(2011)applythevectore r r o r correctionmodeltodiscovertheeffectofinterestedrateonNPLs.Theyfindastronglong-

runrelationshipbetweeninterestrateandNPLswhileinshortrun,interestr at e donotinfluenceNPLs

ThepaperofAliandDaly(2010)employscreditrisklogitregressionforbothbankingsysteminUSAandAustraliafor14yearsfrom1995Q1to2009Q2anddoesnotfindanysignificantrel

month)andcreditriskinbothUSAandAustralia.

ationshipbetweennominalinterestrateorshort-terminterestrate(6-2.2.3 Inflationrate:

Inflationratedecreasesthepurchasingpowerofcurrency,whenthegeneralpricelevelo f goodsandservicesisrisinginaneconomyuntilacertainextent.Inflationratesareg en er all y associatedwiththeinterestrateofloanandaffecttheefficiencyofbankings e c t o r aswellasthedebtobligationofborrowers.Throughliteraturereviews,theimpacto f inflationonNPLscanbepositiveornegative.Ononehand,asinflationrateincrease,th e realvalueofloansinnominalratesorvariablerates(asadjustedaccordingtothei n f l at i o n) deteriorates, deb to rs caneasilyrepaytheirloans.O ntheo th er hand,h i g h i n f l at io n r e d u c e s r e a l v a l u e o f t h e p r o f i

t a b i l i t y w h i l e r i s e s c o s t o f c a p i t a l a n d t h u s w eak en s thedebtors'abilitytotheloan(Curaketal.,2013)

Severalstudieshavefoundinflationispositivelyaffectingthebankscreditrisk.The

r e s u l t s o f D e m i r g u c

-K u n t a n d D e t r a g i a c h e ( 1 9 9 8 ) , u s i n g a multivariatel o g i t econometricmodelwithalargesampleofdevelopedanddevelopingcountriesin1980-

9 4 , in di cat et hat h i g h r a t e o f i n f l a t i o n is o n e of t h e co nse que nces e x a c e r b a

t i n g r i s k problemsofbankingsector.Highinflationmayassociatewiththehighnominalinterestr a t

e andbankswouldfinditdifficulttoperformamaturitytransformation.Inaddition,a s

t h e paper‘sempiricalevidenceshows,whenrestrictivemonetaryp o l i c i e s arei m p l e

m e n t e d tocontrolinflationandkeepbankingsectorstability,theyleadtoasharpincreaseinrealinterestrate;highrealratestendtoincreasethelikelihoodofabankingc r i s i s Utilizingapaneldataatbanklevelforbothpublicandprivatecommercialbanksi n India,Thiagarajanetal

(2011)conductaninvestigationintherelationshipbetweencurr ent inflationandoneyearlaginflationwithbankcreditrisk.Inthepublicsectorb a nk s , theauthorsfind

apositiverelationshipbetweencurrent inflationand creditriskb u t noanyrelationshipwithoneyearinflationlag.However,incaseofprivatesectorbanks,therelationshipbetweeninflationandcreditriskisnotsignificant.Furthermore,t h e researchofBadar&Javid(2013)alsosuggeststhesignificantlypositiverelationshipb e t w e e n inflationandbankcreditrisk,whichexaminestheimpactofmacroeconomico n NPLsof36Pakistanicommercialbanksduringtheperiod2002to2011.The

studystatesthatinflationwillaffecttheprofitabilityofcommercialbanksandincreas

etheb a n k credit risk Becausethe contractionary fiscalpolicy fromgovernmentis

establishedtoincreasetheinterestrateinordertocontrolinflationwhentheConsumerp r i c e index(CPI)increases.Thus,increaseininterestratewillleadtoanincreaseinthec o s t ofborrowingaswellasreducetheborrower'srealincomeandtheirabilitytorepayt h e loan.Consequently,NPLsincreasewhiletheprofitabilityofbanksdecreases,attheend b a n k s c r e d i t r i s k w i l l i n c r e a s e S

i m i l a r l y b a s e d o n sampleo f 6 9 b a n k s i n 1 0 S o u t h e a st e r n Europeancountries

(2013)concludesthattheinflationvariableispositiveandsignificant.Theauthorsexplainst h a t becauseofcurrencyinstabilityandvariableinterestrateloanadjustedforinflation,r e

d u c e t h e volumeo f l o a n s a n d o n l y establisht h e i r lendingactivitiesi n a s s u r e d s e

2.2.4 Exchangerate:

Exchangerateisdefinedasthevalueofonenation’scurrencyinrelationtothevalueofothernations’currenciesandvolatilityofexchangerateisoneofthemainsourceso f economicinstability,w h i c h c o u l d s t r o n g l y a f f e c t t h e l o a n q u a l i t y n o m i n a t e d i n f o r

e i g n currencyaswellasbankcreditrisk.Inthisresearch,therealeffectiveexchanger a t e (REER)2,willbeaddedtocontrolforexternalcompetitivenessofstudiedASEANcountries.ThelocalcurrencyisappreciatedasincreasesinREER,whichleadstotheg o o d s a n d s e r v i c e s p r o d

u c e d i n t h a t c o u n t r y r e l a t i v e l y m o r e e x p e n s i v e a n d a f f e c t s a d v e r s e l y

t h e

competitivenessofexport-orientedfirmsaswellastheirabilitiestopayd e b t (Nkusu,2011).Consequently,theratioofNPLsincreases

Consideringthenominaleffectiveexchangerate,Shu(2002)examinestheexposureofH o n g Kongbanks’lending portfolio(loansdenominatedin foreigncurrenciesorusedabroad)totheMainlandChinaandthenominaleffectiveexchangerate.Theauthorpointsoutthebankingsector’sexposuretotheMainlandandtheappreciationofthenominaleffectiveexchangeratedeterioratebanks’portfoliosandassetqualityduringt h e Asianfinancialcrisis.Formorespecific,appreciatedexchangerateincreasesthebu r d en onforeignborrowers torepaydebts.Inaddition,higherimportpricescausehigherproductioncostandthenleadbusinessfailures Thesefactorscouldresulttomoreforeignloandefaults

Fofack(2005)conductsaresearchtoinvestigatethecorrelationbetweenNPLsandther e a l exchangerateappreciationintheSub-

SaharanAfricacountriesduringthe1990s.T h e authoralsomakesa comparisonbetweenCFAandnon-

CFAco un tr ie s34.Asisshowninthewholecountriesstudy,therealexchangerateappreciationmaydiminishthee c o n o m i c g r o w t h o f c o u n t r i e s w h i c h a r e h i g h l y d e p e n

d e n t o n e x p o r t s (sucha s

CameroonandCôted’Ivoire,theworld-topcoffeeandcocoaexporters),andinducedt h e bankingcrisis.Forcountriesinthe

CFA,Fofack(2005)pointsoutthatbankcredit

2 Itisdefinedastheweightedaverageofacountry'scurrencyisdeterminedbycomparingtherelativetradebalancewithani n d e x orbasketofothermajorcurrencies,whiletheeffectsofinflationisadjusted.

3 The

CFAisabbreviatedfor“FrancofAfricanFinancialCommunity”,whichincludes14Sub-SaharanAfricancountries,mostofthemaretheformercoloniesofFrance.

4 Thefixedexchange rateregimesisemployedbytheCFAcountries,theirdomesticcurrencyvalueisfollowedtothe

Frenchfranc,whiletheflexibleexchangeregimesis appliedin non-CFAcountries.

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riskc o u l d i n c r e a s e w i t h t h e a s s o c i a t i o n o f t h e a g g r e g a t e s t o c k o f m o n

e y a n d r e a l effective exchangerateappreciation.Thesecontributionsdeterioratebanks’loanpo rtfo li os inthesecountriesbecauseitispossiblythatexchangerateappreciationoccurstogetherwiththechangesintermsoftrade.Banksmakeloanstosupporttheexportactivitiesintheagriculturalsectorbutthedecreaseinexportratecausesbanksen c o u n t er e d apressurefromhighlyaccumulatedproblemsloans.H o w e v e r , non-

CFAc o u n t r i e s arenotstronglycorrelatedwiththerealexchangerate,theprobablyexplanationf o r i t i s t h a t t h e s e c o u n t r i e s h a v e c o n d u c t e d a f l e x i b l e e x c h a

n g e r a t e s regimes,thustherewouldappearanautomaticadjustmentprocesstolimittherisk.Bymeansofacomparativeanalysis,theexaminationthedeterminantsofNPLsofcommercial

b a n k s i n F r a n c e a n d G e r m a n y , C h a i b i a n d F t i t i ( 2 0 1 5 ) c o n c l u d e t h

a t increaseinrealeffectiveexchangerateisasignificantpositivedeterminantofNPLsinF r a n c

e ,

amarket-basedeconomy,andcontributestoanincreaseincreditrisk.However,a n exchangerateappreciationsignificantlycontributestolowerNPLsinGermany,ab a n k -

b a s e d economy,becauseitwouldhaveimprovedtheabilityofthoseGermansw h

o borrowforeigncurrencytoservicetheirdebtsandtheNPLsratiodecreases

RefertothestudyofCastro(2012)inGIPSIcountries,whichshareasinglecurrency–

t h e Euro,from1997to2011andfoundnegativerelationshipbetweenrealeffectivee x c h a n g e rateandcreditrisk.ThepaperincludesthelagofREER,withreferencetothe27EUmembers,intheequationtocontrolforexternalcompetitivenessandpointsoutt o thefactthatanincreaseinthisvariablecontributestoanincreaseinthecreditrisk.F u r t h e r m o r e , i n t h

e r e s e a r c h inC E S E E c o u n t r i e s byK l e i n ( 2 0 1 3 ) , e x c h a n g e r a t e d e p r e

c i a t i o n againsttheeuro,comingalongwithhigherinflation,contributetohigherNP L s intheperiodof1998–

2011.ThesameresultsarealsofoundedbyGunsel(2012)forNorthCyprus,byVogiazas&Nikolaidou(2011)forBulgaria

However,Hoggarthetal

(2005)applystresstestsofUKbanksusingaVARapproachincludingchangesintherealeffectiveexchangerateandfindalittleimpactonthe N P L s AlsoAver(2008)inSloveniahasnotfoundanyrelationshipinforeignexchangef l u ct u a t i o n andcreditrisk

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2.2.5 Unemploymentrate:

Theunemploymentrateisanadditionalinformationregardingtheimpactofeconomicconditionstobankcreditrisk.Asanincreaseintheunemploymentrateshouldinfluencen e g a t i v e l y totheincomeofindividualsaswellascorporatesectorsandincreasethedebtburden.Therefore,anincrease intheunemploymentrateisexpectedtoleadtoanincreaseinthebankingcreditrisk.ToforecastbanksperformancesaswellastoobtainrelativelyearlywarningsofunusualperformancebasedonmacroeconomicindicatorsintheU.S.,Gambera(2000)conductsa s t u d y w i t h q u a r t e r l y d a

t a f r o m 1 9 8 7 - 1 9 9 9 t o i n v e s t i g a t e t h e i n f l u e n c e o f

macro-economicvariablesonloanlosses;theresultsindicatethatincomesofhouseholdsalongw i t h unemployment r ate sar esi gn if ic an t factorsaswe lla sg oo dp red ic to rs fo rl oa n l osses intheU.S.Inaddition,MessaiandJouini(2013),forasampleof85banksinItaly,GreeceandSpainfortheperiodof2004-

2008,alsocometotheresultthatNPLsi s p o s i t i v e l y c o n n e c t e d w i t h t h e u n e m p l

o y m e n t r a t e T h e samef i n d i n g s a b o u t t h e po si tiv e correlationofunemploymenttoNPLsarecorroboratedwiththestudyofNkusu(2 01 1)in26AdvancedEconomies,Farhanetal.(2012)inPakistan,bothVogiazasandN i k o l a i d o u (2013)andBucurandDragomirescu(2014)inRomanyandMakrie t al(2014)in14countriesofEurozone

Furthermore,fortheNordicbankingsystemintheperiodfrom1993to2005,BergeandBoye(2007)findapositivelysignificantimpactofunemploymentonNPLsinbothh o u s e h o l

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higheru n e m p l o y m e n t w i l l r a i s e p r o b l e m l o a n s T h e samer e s u l t i s f o u n d by

K e l l y ( 2 0 1 2 ) , t h e d e f a u l t probabilitieso f t h e r e s i d e n t i a l mortgageb o o k o f I r i

s h f i n a n c i a l institutionsdependonchangesinunemploymentrate,whichhavestrongerinfluenceont h o s e comparedtohousepricemovements.Throughanunemploymentshockin2006to2007,theincomefallsthatlimitindividualstorepayburdenofthemortgage

MorerecentlyintheresearchofChaibiandFtiti(2015),asthecomparisonbetweenthetwodifferenteconomyFranceandGermany,theresultrevealsthatthecreditriskinFrench banksaremoresensitivetotheeconomicenvironment(thegrowthofGDPandu n em p l o y m en t) thanthoseinGermany,althoughtheNPLratiosforbothFranceandG e r m an y risesignificantlywhentheunemploymentrateincreases.Thiscanbee x p l a i n e d bythefactthatmostlyloansofGermanbanksareallottedtoprivatesectorwith high-

skilledworkerswhoarelesslikelytobecomeunemployed

However,refertoacomparativestudyof3typesofloansinGreekbanksconductedbyLouzisetal.(2013),allNPLcategoriesaresignificantlynegativeimpactedbyu n e m p l o y m e n t Amongothertypesofloans,thebusinessNPLsisthemostsensitivebecausefirmsseemtocuttheirlaborcostbeforetheyfacedebtservicingproblems.WhileindicatorofconsumerNPLsimpliesthatanincreaseinunemploymentpreventsh o u s e h o l d s ’ a b i l i t y f

r o m s e r v i c e t h e i r d e b t s Furthermore,m o r t g a g e s a r e t h e l e a s t sensitiveNPLtype.TheexplanationforthisdifferenceissimilartoChaibiandFtiti( 2 0 1 5 ) , itcouldbethatthatmortgageloansaremostlyprovidedtocivilservantsandh i g h -