Empirical Model for Credit Risk: Implications of Results from African Countries.

byCharles Augustine Abuka

Director, Financial Stability DepartmentBANK OF UGANDA

Prepared for the CMI Course on Macro stress testing

Wednesday 21 August , 2013

KSMS, Nairobi, Kenya

Studies of Macro-financial Linkages

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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.

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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 = 1 + 1bcyclei,t + 2inflationi,t + 3reeri,t + α β β β

4int_ri,t + 5unratei,t + 6t_trade + 7bcpi,t β β β β+ 8bcp*cyclei,t + i,t β ε (3)

for panel data i = 1,...., 96 and t = 1998,....,2005.

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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 non-performing 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.

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Determinants of Asset Quality

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Determinants of Asset Quality

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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.

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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).

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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.

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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,

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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

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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

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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),

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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,

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REFERENCES

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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.

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