Abstract
The paper analyzes the determinants of the loan loss provision (LLP) of 22 commercial banks in Pakistan from 2010 to 2017. The motive of the research is that LLP is a measure of credit risk as a proxy for bank risk-taking behavior profits and banks’ sustainability. Especially after the occurrence of a global financial crisis. The quantitative research method of data collection from Bureau Van Dijk’s BankFocus portal and the World Bank’s World Development Indicators. Other than considering specific bank variables such as capital adequacy ratio, return on average equity, and government securities, the effects of macroeconomic variable inflation and lending interest rates are explicitly studied. The model of pooled ordinary least squares (POLS), fixed effect (FE), panel corrected standard error (PCSE), and panel data estimation in the form of a general method of moments (GMM) two-step system is used to find the risk-taking behavior of banks in Pakistan. The results obtained by the use of inflation (INF) as an instrumental variable of LLP are highly dependable with a negative impact on loan loss provision. Lending interest rate (LIR) has a positive and significant relationship with LLP and contribute in the study of macroeconomic variables for bank risk-taking, excessive amount of interest rate was not beneficial for banks to earn profits especially during the economic crises. Return on average equity (ROAE) significantly moderates LLP with a negative interaction and helped the bank with profitable operations and save bank from solvency. Capital adequacy ratio (CAR) and government securities (GOV) are insignificant to LLP. The result is robust by measure of endogeneity, and highlights the important role of commercial banks’ sustainability to explain risk-taking behavior in Pakistan with the intention to increase profits after the occurrence of financial crises. The study further contributes to future research on managerial policy and decision making. In summary, the paper on loan loss provision has the capacity to forecast commercial banks’ credit risk for risk-taking in an emerging country.
Highlights
The global financial crisis raised questions about the sustainability of bank models and operating activities that retain loan loss provision to earn profits
loan loss provision (LLP) has a vital role to play in the banking sector, this study was carried out to examine the impact of LLP use by Pakistani commercial banks as an example to measure bank risk-taking
LLPit–1 is lagged loan loss provision, where LLP is proxy for credit risk; Capital adequacy ratio (CAR) is capital adequacy ratio; Return on average equity (ROAE) is return on average equity; GOV is government securities; the control variable vector denoted by INF and Lending interest rate (LIR); ∂ is used to know the time trend; Φ, β, and ∂, are parameters; the number of cross-sections is denoted by i (= 1, 2, ..., 22); t is the number of time series (= 2010, 2011, . . . , 2017); and e is the error term
Summary
The global financial crisis raised questions about the sustainability of bank models and operating activities that retain loan loss provision to earn profits. The banking sector favors economic growth by loan loss provision (LLP), and the recent global financial crisis proves that banks with a level of stability can increase or decrease the impact of financial shocks on the economy of a country or can harm bank system sustainability [1]. An increasing number of studies show that loan loss provision positively and significantly impacts risk-taking behavior of a bank. The research is intended to answer the following questions: (1) Does loan loss provision in the Pakistani economy fully measure credit risk in commercial banks? The State Bank of Pakistan dictates that commercial banks in the country must set loan loss provisions and increase the ratio requirements for LLP for commercial-based banks at 1.25% of credit risk-weighted assets in standard methods. The rest of the paper is as follows: Section 2 consists of a literature review; Section 3 specifies the characteristics of commercial banks in Pakistan; Section 4 elaborates statistical tools used to run the specified model; Section 5 is based on the results; and Section 6 is the conclusion, with policy suggestions and recommendations for managers regarding beneficial risk management in the banking sector of Pakistan
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