Determinants of Loan Quality: Evidence from the Tunisian Banking Sector
Abstract
This paper uses probit and ordered probit methods to examine the impact of banks’ policies in terms of cost efficiency, capitalization, liquidity, activity diversification, credit growth and profitability on the loan quality in the Tunisian banking sector after controlling for the effects of firm-specific characteristics and macroeconomic conditions. Using a data set with detailed information for more than 9,000 firms comprising the portfolios of the ten largest Tunisian banks, we show that banks which are cost inefficient, low capitalized and illiquid are more likely to have a lower quality of loans. However, activity diversification, bank size and profitability do not seem to offer an important contribution in explaining the evolution of loan quality. Finally, our findings highlight the importance of taking into account firm-specific characteristics and macroeconomic developments when assessing the loan quality of banks from a financial stability perspective.
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Introduction
Exploring the determinants of problem loans is a question of substantial importance for regulatory authorities concerned with financial stability. A growing number of studies have examined the determinants of credit risk especially after the 2007-2008 financial crisis by focusing on several categories of determinants such as macroeconomic factors, bank-specific variables or firm-specific characteristics. Many studies in this field have used one of these categories of determinants ([1], [2], [3]) or two of them, simultaneously, ([4], [5]), in order to explain problem loans determinants.
The majority of studies that investigate the determinants of problem loans try to answer the question of what explains credit default at the firm level ([4]) or attempt to analyze the evolution of non-performing loans (NPLs) taken as an aggregated measure of problem loans at the bank level ([5]). However, little attention has been paid to the question of what explains that a loan has a given quality or status that lies between the two extreme statuses of safe and defaulted loan. Exploring the latter question is of great importance since it may allow banks as well as regulatory and supervisory authorities to undertake the appropriate actions and policies in order to anticipate and mitigate deterioration of the quality of banks‟ loan portfolios.
The main purpose of this paper is to empirically examine how loan quality is explained by banks-specific variables namely bank‟s cost efficiency, capitalization, liquidity, activity diversification, profitability and size while controlling for firmsspecific factors and macroeconomic conditions.
This study aims to contribute to the literature on loan quality in two ways. The first contribution comes from examining the heterogeneous impact of bank-specific factors on loan quality while controlling for firms‟ characteristics and macroeconomic conditions. The second contribution to the empirical literature on loan quality stems from considering disaggregated measure of problem loans rather than using the aggregated level of NPLs, by using detailed dataset which contains information on the quality of loans granted by banks to more than 9,000 firms for the period between 2001 and 2010.
Our results show that a high level of bank‟s cost inefficiency, low bank‟s capitalization and an increase in liquidity risk are the main factors that reduce the loan quality of banks. When macroeconomic conditions and firm-specific variables are taken into account, the results regarding the impact of bank-specific factors on loan quality improve considerably.
Conclusion
In this paper we examine the determinants of the loan quality in the Tunisian banking sector. The results provide clear evidence that loan quality in the Tunisian banking sector is positively impacted by bank‟s cost efficiency. In other words, the positive relation between cost inefficiency and problem loans relies on the fact that cost inefficient banks are managed by bad managers who do not control and monitor their operating expenses in a sufficient way, which leads to high measured cost inefficiency almost immediately. Also, bad managers have poor skills in monitoring borrowers, credit scoring and assessment of pledged collateral. These poor practices in terms of credit risk management will be reflected in an increase of the problem loans (in other words a decrease in the loan quality), but only after some time passes (after one year). The results provide also clear evidence that loan quality in the Tunisian banking sector is positively impacted by banks‟ capitalization suggesting that managers of under-capitalized banks may respond to moral hazard incentives by increasing their credits by extending loans to lower quality of borrowers at the expenses of increases in future problem loans.
The results obtained with probit and ordered probit models provide clear evidence that loan quality in the Tunisian banking sector is negatively impacted by bank liquidity risk. In other words, when banks are illiquid their debtors encounter losses due to debt rollover at higher costs. In such case, firms‟ shareholders may respond to agency problem incentives by choosing to default earlier on their commitments rather than supporting the whole losses while bankers are paid in full. The results found for the relation between bank‟s activity diversification and problem loans suggest that there is no evidence in the Tunisian banking sector for the “diversification” hypothesis. The positive relation found between activity diversification and problem loan may be explained by the fact that banks that rely on other types of banking activities may have poor skills in terms of credit risk management as they have other core business (investments, financial engineering, etc). These banks may also do not devote enough resources to improve such skills at the expenses of decreases of loan portfolios quality.
Our findings argue that loan quality is positively affected by bank‟s size. We can explain our result by the fact that large banks may have sufficient resources allowing them to improve their credit risk management unlike small banks which leads to a positive relation between bank‟s size and loan quality. The results do not seem to offer an important contribution in explaining the relation between bank‟s performance and loan quality.
When macroeconomic factors and firm-specific characteristics are taken into account, the results regarding the impact of bank-specific variables on loan quality improve considerably. These findings allow us to argue that macroeconomic and microeconomic conditions have an additional contribution in explaining the determinants of loan quality which should be examined from a financial stability perspective.
Our results have several policy implications. First, there is an evidence that bank‟s cost efficiency may serve as leading indicator for future problem loans suggesting that supervisory authorities should focus on bank‟s managerial performance in order to detect banks with potential problem loans increases. Second, regulators should place emphasis on under-capitalized banks having severe credit risk exposures in order to prevent future financial instability. Finally, policy makers should consider macro prudential regulation and supervision instead of relying only on the micro prudential perspective, when analyzing the loan quality of banks (for loan losses provisioning, stress tests, banks capitalization requirements, etc). One possible consideration, from the macro prudential regulation perspective, is to make banks‟ capital requirements countercyclical since credit risk may vary with overall macroeconomic conditions. One objective of such regulation would be to act as countervailing force to the natural decline in measured credit risk in a boom and the subsequent rise in measured credit risk during the collapse.
The study can be extended in different ways. Firstly, future studies of the loan quality determinants may focus on different types of loans (business, mortgage, consumer) rather than considering an aggregate level. Secondly, other statistical techniques may be used, such as duration models, to examine the intertemporal relations between loan quality and bankspecific variables since we have found that some relations materialize only after some time passes. Thirdly, future lines of research may examine firms‟ access to credit after default rather than only analyzing the determinants of the credit default event.