Study to Determine Impact of Credit Risk on Bank Stability Finance Essay

Abstract

Credit works as blood life of any banking institute. This research is based mainly at investigating the impact of credit risk on banking stability, in banking sector lending behavior in Pakistan using data on commercial banks and macroeconomic instability from last decade. Our results under the Co-integration of variables and Correction Modeling framework show that bank lending has a long-run relationship with macroeconomic stability. The research therefore, recommends that while banks should pay enough attention to the results of their firm exact characteristics in their credit lending activities both in the short-run and long-run, their worries about macroeconomic stability should be limited to the long-run consequences on their credit lending behavior. It is also important that proper measures be taken to curtail inflation and infrequent money supply growth making banks become adversely disposed to lending given the negative consequences of loan restriction on economic growth in the long run. In Pakistan increased lending and intermediation is a regular complement to higher real economic expansion, banks and their supervisors need to ensure that this does not compromise credit quality and weaken banks' balance sheets, especially since much of the credit growth is in areas where banks are comparatively inexperienced. The State Bank of Pakistan (SBP) has made substantial strides in strengthening its supervisory capacity and is well positioned to direct the associated risks. However, the changes are comparatively recent and yet to be tested through a complete credit cycle in the new environment. The researcher in this research will be having exploratory approach as to find out the impacts of credit risk on the stability of the banking sector of Pakistan. A quantitative (based on survey) analysis will be conducted by using questionnaire method.

Table of contents

Chapter 1

1.1 Introduction 4

1.2 Background Information & problem Statement 5

1.3 Research Questions & Objective 7

1.4 Hypothesis 7

1.5 Scope & Limitation 7

1.6 Significance of research 8

1.7 Test of Hypothesis 8

Chapter 2

Literature Review 9

Conceptual Framework 11

Chapter 3 

3.1 Research Methodology 12

3.2 Research Sampling 12

3.3 Research tools and techniques 12

Chapter 4 

Data Analysis and representation 13

Chapter 5

Conclusion, Finding and recommendations References 15

Annexure

Questionnaire (Anex-1)

CHAPTER 1

Introduction

Worldwide and in particularly in Europe the market for credit risk transfer has experienced a remarkable development in current years. This refers not only to the volume of credit risk being transferred by financial institutions but also to the total number of securitization transactions. On a micro-level, the rising popularity of credit risk securitization can be put down to the reality that banks classically use the instrument of securitization to diversify concentrated credit risk exposures and to discover an alternative source of funding by realizing regulatory arbitrage and liquidity improvements when selling securitization transactions. On a macro-level, credit risk securitization is suggested since it is expected as a reduction of the overall absorption of credit risk in the whole financial system if risks are transferred to less fragile (non-financial) institutions (BIS, 2005; ECB, 2004; IMF, 2002). In reply to the U.S. sub prime mortgage disaster from mid-2007, however, a general reassessment of risks inherent in structured finance instruments is observed diagonally the whole financial community. To date, the IMF values mark to market losses on structured finance instruments at around 1,405 billion USD (IMF, 2008). Moreover, it is assumed that about half of the amount of losses and write-downs on these instruments will explicitly shape the banking industry (IMF, 2008), perhaps constituting a serious threat of general fragility. The latter is supported by failures in valuating multifaceted securitization instruments, a weak precision in structured finance markets as well as feeble forces of market discipline, which in sum have uncovered the financial system to a serious funding and confidence crisis (BIS, 2008, 2008a; IMF, 2008, 2008a, 2007). A real-time occurrence of shocks on credit quality, exchange rate, and interest rate would have a extensive impact on the capital position of banks, mainly public sector commercial banks. A synchronous depreciation by 25 percent, a decline in the quality of 50 percent of unhedged loans in foreign currencies (100 percent provisions), and a raise in interest rates of outlying maturities (by 100, 300, and 500 basis points) would decrease the CAR of public sector commercial banks to 4.7 percent, assuming the shocks are preservative and enduring. If in addition to the above assumptions, there is a 40 percent decline of the stock market, the capital adequacy ratio of the banking sector would fall to 2.9 percent, while the capital position of public sector commercial banks would turn negative (-4.8 percent). Government injection of capital equal to 1 percent of GDP would then be required to refurbish the capital adequacy of these banks.

1.2 Problem Statement

"Credit to the private sector in Pakistan has been increasing very speedily. While this reflects the floating economy, if continued, it may threaten future credit quality problems. In addition, the extensively expected increase in interest rates and tighter liquidity circumstances may unfavorably impact banks' balance sheets and their stability"

1.3 Background Information

The researcher is intended to do research on the impact of credit risk on the instability because in recent decade it has been observed that credit lending has caused Global Recession , specially in world wide financial market and banks leading them to solvency. The researcher wants to know to how much extent the financial institutions of Pakistan under the credit risk impact and what should be done to control this. The Group's principal activities are to provide commercial banking and other financial services. The Group offers personal banking, cash management, retail loans and other financial services. These services comprise deposits, savings/current bank account, vehicle loans, personal loans, retail trade finance, global banking, lending to priority sector and small scale sector, foreign exchange and export finance, corporate loans and equipment loans. The Group operates throughout 1078 branches within Pakistan and 17 branches outside Pakistan. Credit Rating by JCR - VIS Credit Rating Company Limited - June 26, 09

Long Term Rating: 'AA +'

United Bank Limited is one of the largest Commercial Bank in Pakistan. The Bank's long term rating is AA +, which denotes good credit quality. Protection factors are strong. Risk is modest but may vary vaguely from time to time because of economic conditions.

Short Term Rating 'A-1+'

The short-term rating is A-1+, which denotes the highest certainty of timely payment. Short-term liquidity, including internal operating factors and / or access to alternative sources of funds, is outstanding and safety is just below risk free Government of Pakistan's short-term obligations. UBL was set up in 1959 and is today one of Pakistan's major banks in terms of deposits and advances with a huge domestic and international network. Its salient features are:

Company Description:

UBL is a Banking Company, which is engaged in Commercial & Retail Banking and related services domestically and overseas.

History of the Company:

UBL was established in 1959 and is one of the major commercial banks of Pakistan. The Bank is making every effort to meet the up-coming challenges through strategic planning and making the best use of the resources at its command. A professional team was appointed in mid 1997 to restructure the bank and to commence rightsizing. The management is also in the process of rationalizing the branch network and identifying and recovering its doubtful and classified portfolio. It has planned to institute major improvements in customer services and internal systems to improve efficiency. It also intends to launch innovative products. The bank is increasing resource mobilization through regular deposit campaigns and accelerating the process of recovery of outstanding advances and non-performing assets.

Operational Structure:

UBL operates 1375 domestic and a subsidiary viz. United Executors and Trustees Company Ltd. as on 30.06.2000. It has 20 overseas branches situated in the UK, USA, UAE, Yemen, Bahrain and Qatar. It also operates one offshore branch in the Export Processing Zone, Karachi and it has representative offices in Cairo-Egypt and Tehran-Iran. It also has a joint venture - Oman United Exchange Co., Oman Muscat and a subsidiary - United Bank A.G. Zurich, Switzerland set up in 1968. It has 21 ATMs with 8 in the UAE, 3 in Bahrain, 1 in Doha, 7 in Islamabad and 2 in Karachi.

1.4 Research Questions & Research Objective

1.4.1 Research Questions:

Q1: What are different macroeconomic factors which generate credit risk Impact? Q2: How can a bank expose to the credit risk? Q3: How a bank's stability is correlated with the unsecured lending risks?

1.4.2 Research Objective

To find out different macro-economic factors on which the credit risk is based. To find out the relationship of credit risk factor and bank stability.

1.5 Hypothesis

H0: There is no significant relationship between bank stability and credit risk factors. H1: There is significant relationship between bank stability and credit risk factors.

1.6 Scope and Limitations of Study

1.6.1 Scope of the research:

The scope of the research will be limited as the base organization for the research is United Bank Limited Pakistan, and the researcher is the employee of the bank. A total number of 400 employee as well as customers will be based as population of the research. And out of this population 120 will be taken as sample.

1.6.2 Limitations:

There will be some limitation of the study which are as follows: As the credit risk impact tends to be not much applicable in Pakistan, so the scope of research will be specific. Researcher will be unable to approach all the branches of UBL due to time and gender constraint. Being a female and social constraint, it will be difficult to approach physically each and every respondent of the research. The scale of the research is limited to 400 respondents only. Insufficient time given for the research may be a constraint to complete the research within a specific time interval and researcher in this state may pass over some useful information. Data will be collected by the researcher herself by means of questionnaire. Researcher may be biased to some extent on giving the final recommendations. Due to limited access to the confidential data of banks, researcher will be restricted to the available information.

1.7 Significance of Research

This research has a great importance especially with reference to the stability of the financial institutions. As in this research, the research will be explaining different factors of credit risk which create significant impact on the stability of the banking sector. The research will figure out the relationship between the macro-economic factors of lending risk identification and its impact on financial institutions. This study will also help the financial policy makers and bank supervisors to figure out the risks currently associated with the prevailing credit system of the banking sector and they will be able to control the risk factors to some extent.

1.8 Test of Hypothesis:

Both hypothesis will be tested after using some statistical analysis of correlation between the variables.

CHAPTER 2

Literature Review

Economic theory provides countervailing forecast of the relationship between credit risk securitization and banking stability (Shin, 2009; Krahnen and Wilde, 2008; Jiangli et al., 2007). This may be due to the fact that the relationship depends on both a direct and indirect impact. The straight impact of credit risk on banking stability depends on how much credit risk is in fact transferred to outside investors. This relationship however is not different. While the "credit risk stability" view points out that the bank's overall risk experience is likely to be reduced if the tail risk of senior trenches being transferred to external investors exceeds the sum of default risks of the first-loss position which is normally retained by the bank (Jiangli et al., 2007), the "credit risk weakness" view replies that the major part of default risks normally remains within the bank's first loss position acting as a quality signal towards external investors (DeMarzo, 2005; Instefjord, 2005; Riddiough, 1997; Greenbaum and Thakor, 1987). In this context, it is in addition emphasized that former Basel I regulations have provided an encouragement to keep the larger part of risks within the bank. Thus, as corporate and retail loans were not risk-adjusted but internationally backed up with regulatory capital under Basel I regulations, keeping the main part of default risks within the first loss piece naturally provoked profits from regulatory arbitrage (Allen and Gale, 2006). The indirect effect of credit risk securitization on financial permanence is determined by the bank's strategy to use credit risk as a basis of additional funding to finance new assets with liquid capital that has become accessible from selling credit risk transactions.

Thus, the indirect effect of credit risk is not clear but rather depends on a wide range of investment policies and can more probably be defined by the way the bank's overall asset portfolio risk is restructured (Krahnen and Wilde, 2008). In this context the "credit risk-stability" view points out that reinvesting liquid capital into new assets may inflame a better diversification of the bank's asset portfolio if remaining total assets are less correlated after credit risk (Cebenoyan and Strahan, 2004; Demsetz, 2000). In contrast, the "credit risk-fragility" view suggests that the real effect on a bank's financial soundness may depend on the risk-level of new assets being taken in, which again is determined by the present level of contest in the respective asset market (Instefjord, 2005). Moreover, using liquid capital to expand the amount of total assets or to repurchase shares and pay high dividends to shareholders may in addition lead to an increase in the bank's leverage (Shin, 2009; Leland, 2007). Empirical evidence on the relationship between credit risk and banking strength is ambiguous as well. To start with, applying event study methodology Uhde and Michalak (2009), Hänsel and Krahnen (2007), Franke and Krahnen (2006) as well as Lockwood et al. (1996) provide empirical proof that credit risk securitization has a positive impact on the increase of a bank's systematic risk. This consequence holds even when controlling for the banks' pre-event level of systematic risk, the type of credit risk transaction, the regulatory framework as well as the underlying reference portfolio (Uhde and Michalak, 2009). Turning to panel data analysis, using balance sheet data from commercial banks in Canada for the period from 1988 to 1998, Dionne and Harchaoui (2003) discover that credit risk transfer is inversely correlated to a bank's regulatory capital supporting the capital arbitrage theory. Moreover, they offer empirical evidence that an increase in the volume of credit risk transfer has a harmful impact on the banks' asset quality and hence financial soundness. Similarly, Uzun and Webb (2007) look at the impact of credit risk securitization on banking stability using data from a sample of 112 financial institutions in the U.S. for the period from 2001 to 2005.

They find that credit risk is negatively related to a bank's capital environment. Controlling for basic assets they provide further empirical evidence that the reduction in financial soundness is predominately linked with credit risks of credit card receivables whereas securitizations of mortgage loans and home equity lines of credits have a optimistic impact on banking stability. Finally, Jiangli and Pritsker (2008) examine the impact of mortgage loan securitizations on bank stability, profitability and leverage using data from U.S. bank holding companies for the period from 2001 to 2007. In line with Uzun and Webb (2007) they discover that mortgage securitizations tend to decrease a bank's financial fragility. In contrast, however, they also offer empirical evidence for a positive relationship between credit risk and a bank's leverage whereas profitability tends to increase due to securitization. Talavera , Tsapin and Zholud (2006) investigated the macroeconomic insecurity and bank lending in Ukraine. They found a negative association between bank loan to capital ratio and macroeconomic uncertainty and its component (demand and time deposit) with banks increasing their lending ratios when macroeconomic uncertainty decreases. The reaction of banks to changes in uncertainty is not consistent and depends on bank-specific characteristics mainly bank size and profitability. For the bank-specific factors, changes in monetary aggregates which can be related to macroeconomic policies are relatively more significant for large banks than for small banks counterparts. This shows that small banks are less able to change their behavior over time in response to changes in monetary policy and their lending depends to a much greater extent on capital. Also, monetary policy uncertainty factor is important for bank lending behavior in the case of more profitable banks but less significant for the less profitable.

• Conceptual Framework of Research
• Bank's Obligator Asset Values
• Bank's Total Assets
• Bank Loan to asset ratio
• Ratio of bank deposits to capital
• Economic Indices

Monitory Policy Inflation Rate Exchange rate Interest Rate Bank Stability (Dependent variable) Credit Risk Driving factors (Independent Variables)

Bank Credit policies

Short Term loans Long Term Loans

CHAPTER 3

Methods and Procedures. Methodology of Study

To respond to the research questions mentioned in chapter 1, researchers will explain here the different choices of methodology that have been adopted in this research. The goal of thesis is exploratory as to find out the impacts of credit risk on the stability of the banking sector of Pakistan. A quantitative (based on survey) analysis will be conducted by using questionnaire method.

Survey Instrument used

Questionnaire to be used in the research which contains Likert scale to collect and evaluate the data on this instrument to evaluate the relationship between the variables.

Sampling Technique

The sample size out of the 400 population is 120 employees taken as respondents. Convenient sampling method will be used in this regards because of limited approach and scope of the research.

Data Collection

As mentioned above the data will be collected by using questionnaire method and from the previous studies available on the same topic of research. Then the data will be analysed to explain the researcher point of view on the subject of the research. The data for the research are time series figures for the quoted commercial banks operating in Pakistan from 1988 to 2010 and the corresponding variables as obtained from the publications of the Central Bank of Pakistan Statistical Bulletin. The data on bank lending activities and other bank characteristics are obtained from the annual published financial statements of the banks and the Fact book published by the Karachi Stock Exchange

Research Tools

The tools that will be used in the research for the data analysis is SPSS software to calculate Mean, Standard deviation, correlation.

CHAPTER 4

Data Analysis and Representation

In his chapter information related to data analysis with proper explanation of processed data in the SPSS, containing data tables and graphical representation.

CHAPTER 5

Conclusion, Findings & Recommendations

In this section final conclusions of the study, researcher's own findings out of the research and closing recommendations will be mentioned.

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