Abstract
The instinct of bankers is to keep the borrowers alive through recycling and renewals of bad loans into loans, a window dressing exercise; or worse yet, advancing additional fresh loans to effectively insolvent borrowers to tide over what is perceived as cash flow problems and forthcoming illiquidity, thereby getting deeper into financial distress. In this sense, insolvency occurs first, illiquidity follows later. Increase in the intermediation costs lead to increase in Non-performing Loans (NPLs). The intermediation cost reflects the operating efficiency of banks. If credit risk is not managed properly it eventually shows up in NPLs, or the concentration of banking credit in a few sectors of the economy, or in a few segment of borrowers, or a rising proportion of riskier loans in its portfolio during times of rapid expansion of banking credit. This paper studies intermediation costs in credit markets within a dynamic Stiglitz and Weiss (1981) framework. The theoretical predictions of our model gains support by Pakistani banks’ quarterly data for the period 2007-09. Data suggests that an increase in intermediation costs results in an increase in NPLs. Analyses show that, if intermediation cost is administered properly, it ultimately lowers NPLs. We argue that minimization of intermediation costs improves financial soundness.
Highlights
It is but natural for bankers to keep the borrowers alive through recycling and renewals of bad loans into loans which in essence is a window dressing exercise; or worse still, advancing additional fresh loans to effectively insolvent borrowers to tide over what is perceived as cash flow problems and imminent illiquidity, thereby getting deeper into financial distress
As the intermediation cost reflects the operating efficiency of banks and increase in the intermediation costs leading to increase in Non-Performing Financings (NPFs) of banks, we are motivated to study the impact of intermediation costs on NPFs in credit markets with special focus on Islamic banks operating in Pakistan
This paper examined the impact of intermediation cost on the NPFs of Islamic banks operating in Pakistan during January 2007 to June 2009
Summary
It is but natural for bankers to keep the borrowers alive through recycling and renewals of bad loans into loans which in essence is a window dressing exercise; or worse still, advancing additional fresh loans to effectively insolvent borrowers to tide over what is perceived as cash flow problems and imminent illiquidity, thereby getting deeper into financial distress. BSR estimates show that intermediation costs during the late 1990s was about 3.5%, and began to decline and is currently around 2.7% This suggests that banking efficiency improved at least on the funding side over the late reform period, but still it is above the cost range prevailing in comparator countries at around 2.0%, and is much higher than the range of 1.5 to 2.0% observed in leading countries. The concern that banking spreads are high is valid, but in a deregulated system there is hardly much that the monetary authority (SBP) can do to help reduce the spread since it is embedded into the bank funding structure on the one side, and into lending operations and investments on the other
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