Loan Loss Provision and Risk-Taking Behavior of Commercial Banks in Pakistan: A Dynamic GMM Approach

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.

Bank-Specific and Macroeconomic Determinants of Profitability: A Revisit of Pakistani Banking Sector under Dynamic Panel Data Approach

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Nexus of Risk-taking Behavior, Capitalization, and Profitability of Chinese Banks: Evidence from Panel Threshold Regression

“…Bank activities with no interest cause harm to diversified banks, as of volatile nature and fewer profits from lending. Loan loss provision and liquidity are inversely proportional to return on assets and return on equity (Zheng, Changjun et al, 2019). According to (Dang, 2011), banks maintain statutory liquidity requirement as customer DEPO is cheap methods to fund as the margin is high between DEPO and rate of lending which a bank use to create income.…”

“…return on assets has an inverse correlation with asset quality and suggests that a diversified bank with excellent performance restricts loan loss provision. Loan loss provision has an important and moderate effect on return on equity as interaction is harmful to the profitable running of business and safety net from solvency risk (Zheng, Changjun et al, 2019). As banks increase loans than profitability decrease as the lending ability of bank is poor and suggest an increase in loan loss provision (Louzis et al, 2012).…”

Determinants of Banks’ Credit Risk: Evidence from Jordanian Banks Listed on Amman Stock Exchange

“…We measure the quality of the loans given by the bank by the loan loss provision ratio calculated by dividing total loan loss provision on total loans given (Zheng et al, 2019;Kasana and Naveed, 2016;and Al-Abedallat and AL-Shubiri, 2013). Higher loan loss provision ratio suggests bad loan quality.…”