The effect of Non-performing Loans Some Evidence.doc

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1、The Non-performing Loans: Some Bank-level EvidencesYixin Hou Corresponding author Department of Economics, University of Birmingham Edgbaston Birmingham B15 2TT UK Email address: yxh375bham.ac.uk AbstractThis paper looks into the non-performing loan problem in commercial banks. Using the threshold r

2、egression technique, we found some evidences that non-performing loans have non-linear negative effect on banks lending behaviour.JEL Codes: G21 E44Key Words: non-performing loan, credit crunch, threshold effect, capital ratioI. IntroductionA simple definition of non-performing is: A loan that is no

3、t earning income and: (1) full payment of principal and interest is no longer anticipated, (2) principal or interest is 90 days or more delinquent, or (3) the maturity date has passed and payment in full has not been made.The issue of non-performing loans (NPLs) has gained increasing attentions in t

4、he last few decades. The immediate consequence of large amount of NPLs in the banking system is bank failure. Many researches on the cause of bank failures find that asset quality is a statistically significant predictor of insolvency (e.g. Dermirgue-Kunt 1989, Barr and Siems 1994), and that failing

5、 banking institutions always have high level of non-performing loans prior to failure. It is argued that the non-performing loans are one of the major causes of the economic stagnation problems. Each non-performing loan in the financial sector is viewed as an obverse mirror image of an ailing unprof

6、itable enterprise. From this point of view, the eradiation of non-performing loans is a necessary condition to improve the economic status. If the non-performing loans are kept existing and continuously rolled over, the resources are locked up in unprofitable sectors; thus, hindering the economic gr

7、owth and impairing the economic efficiency.In this paper, we focus on the impacts of non-performing loans on microeconomics, specifically, at the bank level to empirically evaluate how non-performing loans affect commercial banks lending behaviour. The rest of the article is organised as follows. Se

8、ction 2 provides the definitions of non-performing loans. Section 3 discusses some consequences of non-performing loans on the economies. Section 4 explains the methodology for our empirical studies. Section 5 describes the data. Section 6 gives out the empirical results. And section 7 gives out the

9、 conclusion.II. Non-performing LoansThere is no global standard to define non-performing loans at the practical level. Variations exist in terms of the classification system, the scope, and contents. Such problem potentially adds to disorder and uncertainty in the NPL issues. For example, as describ

10、ed by Se-Hark Park (2003), during 1990s, there were three different methods of defining non-performing loans in Japan: the 1993 method based on banking laws; the “Banks Self-Valuation” in March 1996; and the “Financial Revival Laws-Based Debt Disclosure” in 1999. These measurements have gradually br

11、oadened the scope and scales of the risk-management method. Similar to the trend in Japan, more countries, regulators, and banks are moving towards adopting and adapting better and more consensus practices. For example, in the U.S., federal regulated banks are required to use the five-tier non-perfo

12、rming loan classification system according to BIS: Pass, Special Mention, Substandard, Doubtful, and Loss. Presently, the five-tier system is the most popular risk classification method, or, in some cases, a dual system of reporting according to their domestic policy guidelines as well as the five-t

13、ier system. According to BIS, the standard loan classifications are defined as follows:(1) Passed: Solvent loans;(2) Special Mention: Loans to enterprises which may pose some collection difficulties, for instance, because of continuing business losses;(3) Substandard: Loans whose interest or princip

14、al payments are longer than three months in arrears of lending conditions are eased. The banks make 10% provision for the unsecured portion of the loans classified as substandard;(4) Doubtful: Full liquidation of outstanding debts appears doubtful and the accounts suggest that there will be a loss,

15、the exact amount of which cannot be determined as yet. Banks make 50% provision for doubtful loans;(5) Virtual Loss and Loss (Unrecoverable): Outstanding debts are regarded as not collectable, usually loans to firms which applied for legal resolution and protection under bankruptcy laws. Banks make

16、100% provision for loss loans. The details of the loan classifications are collected from various BIS documents.Non-performing loans comprise the loans in the latter three categories, and are further differentiated according to the degree of collection difficulties.In addition to the standardised sy

17、stem, efforts have been made to improve the classification of loans. For example, more countries are shortening the period when unpaid loans become past due, intending to put loans on lenders timetable sooner and require them to address these loans before losses start to escalate. The International

18、Accounting Standard 39 revised in 2003 focuses on recognition and measurement of financial instruments and, most importantly, defines and establishes the measurement and evaluation of impaired loans. As lenders usually make little or no loss provision for impaired loans, they are at risk to be sudde

19、nly forced to reclassify such loans as a loss and take a full write-down if the borrowers go bankrupt. The initiation of this standard is to prevent lenders from being caught off-guard. In addition, many global economists, rating agencies, and organisations such as the World Bank and the Asian Devel

20、opment Bank have begun to evaluate the effects of NPLs on GDP growth. They reduce growth estimates to reflect the time and cost of resolving large non-performing loan issues.In this paper, we use the standard BIS definition of NPLs, i.e., the last three categories of the BIS classification. First, t

21、he standard definition makes it possible to compare the non-performing loan problem across countries and banks. Second, the BIS definition is a prudential definition for NPLs, which includes loans with uncertainty in addition to the virtual loss, thus, it enable banks to address the NPL problems bef

22、ore it cause disasters.III. The Effects of NPLs on EconomicsNon-performing loans can lead to efficiency problem for banking sector. It is found by a number of economists that failing banks tend to be located far from the most-efficient frontier (Berger and Humphrey (1992), Barr and Siems (1994), DeY

23、oung and Whalen (1994), Wheelock and Wilson (1994), because banks dont optimise their portfolio decisions by lending less than demanded. Whats more, there are evidences that even among banks that do not fail, there is a negative relationship between the non-performing loans and performance efficienc

24、y (Kwan and Eisenbeis (1994), Hughes and Moon (1995), Resti (1995). The phenomena that banks are reluctant to take new risks and commit new loans is described as the ”credit crunch” problem. According to the United States Council of Economic Advisors (1991), credit crunch is “a situation in which th

25、e supply of credit is restricted below the range usually identified with prevailing market interest rates and the profitability of investment projects”. A “credit crunch” is a disequilibrium phenomenon. It is present when banks are unwilling to lend, especially when a firm with profitable projects c

26、annot obtain credit in spite of low interest rates (lower than the expected marginal products). Credit crunch results in excess demand for credit and hence credit rationing, where loans are allocated via non-price mechanism. Eventually, it imposes additional pressure on the performance of the moneta

27、ry policy. The idea of credit crunch has drawn attention when the traditional view failed to satisfactorily explain the economy state for those countries that suffered from the South-East Asian financial crisis in 1997. Under the traditional view, the link between the interest rate change and the re

28、al economic activity occurs through investment and consumer durable expenditure. In response to the currency crisis in 1997, the interest rate was raised. It was strongly believed by IMF that the hike would help stabilise the foreign currency market and eventually induce banking reform by crowding o

29、ut low-profit projects. However, the persistent fall in economic growth rate and the lasting economic recession cast doubt on the true benefits of the policy and the effectiveness of the traditional view of the transmission mechanism. The idea of credit crunch addresses an alternative explanation fo

30、r the transmission mechanism.During a crisis, in order to restore the credibility among creditors and depositors, failing financial institutions not only try to expand their equity bases, but also reduce their risky assets or change the composition of the assets portfolio. As a result of such defens

31、ive action, the corporate debtors are always targeted, thus stalling the overall economic growth. Specially, the reluctance of banks to lend can be caused by several reasons, such as the increased capital adequacy requirement imposed by Basel Accords; impaired debt-servicing capacity, especially sma

32、ll-to-medium enterprises (SMEs); risks of a further fall in collateral value, etc., which make the interest rate not to serve as the main determinant by banks in credit approval. Non-performing loans have been viewed to constitute one of the most important factors causing reluctance for the banks to

33、 provide credit. In a high NPL condition, banks increasingly tend to carry out internal consolidation to improve the asset quality rather than distributing credit. Also, the high level of NPLs requires banks to raise provision for loan loss that decreases the banks revenue and reduces the funds for

34、new lending. The cutback of loans impairs the corporate sector as they have difficulties in expanding their working capital, blocking their chances of resuming normal operation or growing. Unavailability of credit to finance firms working capitals and investments might trigger the second round busin

35、ess failure which in turn exacerbates the quality of bank loans, resulting in a re-emerging of banking or financial failure. In a worse case, it triggers an endless vicious liquidity spiral: As a result of poor economic condition and the depressed economic growth, the level of NPLs increases the wea

36、ker corporate sector makes banks more reluctant to provide additional credits with insufficient capital, the production sector is further weakened, resulting in decreases in aggregate demand again, even worse borrowers condition creates more NPLsKrueger and Tornell (1999) support the credit crunch v

37、iew and attribute the credit crunch in Mexico after the 1995 crisis partially to the bad loans. They point out that banks were burdened with credits of negative real value, thereby reducing the capacity of the banks in providing fresh fund for new projects. Agung et. al. (2001) using the macro and m

38、icro panel data analyses to study the existence of a credit crunch in Indonesia after the crisis. Both the macro and micro evidences show that there was a credit crunch, characterised by an excess demand for loans, starting to emerge in August 1997, one month after the contagion effects of the excha

39、nge rate turmoil in Thailand spreading to Indonesia. They investigate the relationship between the loan supply and real lending capacity, lending rates, real out put, banks capital ratio, and non-performing loan. The results show that the coefficients on NPLs are negative and significant, which indi

40、cate that bank credit supply declines with the worsening of the NPLs problem. Westermann (2003) compares the cases of Germany after the credit boom of the late 1990s and Japan aftermath the bubble burst in early 1990s. He argues that even though the German banks were in a better condition than Japan

41、ese banks were, as the path of Germans aggregate credit looks so similar to that of Japan, it is at least unlikely that the German credit slowdown was entirely driven by demand, while that of Japan was mostly caused by a lack of supply. There must at least be some supply side changes that affect the

42、 aggregate credit, and differences only exist in the magnitude of the problem. He further points out that the one of the main reasons in Germany for the credit crunch is the increased risk of non-performing loans after the credit boom.IV. Empirical SpecificationEmpirical Methodology forTesting the E

43、ffect of Non-Performing LonasOne implication from the Credit Crunch view is that increased non-performing loans can cause the decline in commercial bank credits, as banks with high level of non-performing loans in their portfolio may become increasingly reluctant to take up new risks and commit new

44、loans.In this paper, we use panel data from individual banks balance sheet to empirical assess whether non-performing loans will negatively affect banks lending behaviour. The empirical model is specified to capture the credit supply side factors. Normally, the supply of loans is determined by banks

45、 lending capacity and factors that influence banks willingness to provide credits. In this paper, non-performing loans are also taken into consideration. Based on Credit Crunch view, the NPLs should have a negative effect on loans, implying that the higher NPLs in a banks portfolio, the less credit

46、that the bank can and is willing to supply.For a simple commercial bank balance sheet, assets are mainly composed of commercial loans and other earning assets; while on the liability side, deposits and capital are the main components. Thus, we can conjecture that the loan growth is affect by deposit

47、 growth, capital growth and other earning assets growth. In addition, we take the non-performing loan growth into consideration. The basic model is as follows: (1)where the index is the index for individual banks and is the index for time period. is the loan growth rate, is the deposit growth rate i

48、n each time period , is the capital growth rate, is the other assets growth rate, and is non-performing loan growth rate of the pervious year.As financial intermediations, commercial banks main function is to receive deposits and make loans to facilitate the flow of capitals. For most of the commerc

49、ial banks, deposits are the main funding sources for commercial banks assets. And loans take up the biggest proportion in the asset portfolio. With the expansion of the asset size, banks will expand the volume of the loans to re-balance the asset portfolio. Under the normal situation, loan growth rate is expected to move in the same direction as the growth of deposits. The sign in front of, thus, is expecte