The impact of changes in Interest rate on Non performing loans in Pakistan

Yasir Ayub latent

Comsats Institute of Information Technology ,Lahore Email:MC09103@gmail.com Introduction
Lending and borrowing are the two main operations of the financial intermediries and financial intermedieries are the major component of the financial system of any country.Theory of financial intermedieries aurged that banks and other financial institutions mainly take the funds from the surplus units of the system and lend it to the deficit units(Allen & Sontemero).In lieu of it the surplus units demand compensation for the deffered use of the funds and the deficit unit ,who now have the funds from the surplus units would pay compensation for the redily use of these funds.This compensation is actually the opputunity cost of the money and this cost is known to be a intrest rate (Faboozi & Peterson).This cost is considered to have the severe effect on the economic shifts.The variation in the lending rate would definitely increase the cost of debt thus increase the chances of default as proposed in quantitative theory by (Chatterjee, Corbae, Nakajima.According to Obamuyi the loans is considered to be a performing if the borrower repay all the intrest and principle payment according to the contractual terms between the borrower and the lender otherwise it is considered to be a non performing loan(NPL).Non performing loans are the major causes of the the banks facing financial crises and consequently its faliure.Non performing loans not only hurts the financial sector badly but also economic growth of the country in its aftershocks(Hou 2007).In the last few decades no of banks have failed and among these several have been closed by the regulatory

authority(Brownbridge1998).The faliure of banks will have to major implications in the future.Firstly , These banks faliure causes the banking crises by harming the banking sector.secondly, It will ultimately restrict the credit flow in the economy hence effecting the development of business units in the country(Chijoriga, 1997; Brownbridge)

In the context of Pakistan the definition of NPL comes from the State Bank Of Pakistan Prudential regulations.according to the recently issued circular no 2 dated june,2010.the loan is considered to be a substandered if its interest payment and principle payment is overduefor 90 days. After being overdue for 180 days, loan is classified as Doubtful and after 01 year it is reported as loss.Pakistani banking sector hampered by enormous amount of Non performing loans present in the sector (Masood2009) The volume of non-performing loan is rising every year as we can see that non-performing loans of Pakistani banking sector were Rs. 176.77 billion and having infection ratio of 7.28 percent and these have risen to Rs. 608.748 billion in march 2012 having infection ratio of 17.75 percent (State Bank of Pakistan, 2012). In order to reduce non-performing loans it is necessary to find the root causes of these loans.

Literature Review
The previous literature is highly saturated with the topic under concern i.e Non performing loan and it relationship with the lending/intrest rate.Many people tried to find determinants of the non performing loans in banking sector of several countries.Some uses macroeconomic variables andd tried to predict the non performiong loan on the basis of intrest rate,Exchange rate,Inflation , GDP growth rate while other uses banks credit risk assesment as a tool for prediction. As explained earlier non performing loans is the main reason for banks financial crises that ultimately leads to the Banks faliureThe thing that leads bank towards financial crises is not only the amount that has been classified as NPL and has been strucked in the market but also the bank having NPL in the Balance sheet should maintain provision for it which further pushes the bank into state of financial disturbance.(Bars&Siems,SBP Report) (Adebola, Wan Yusoff, & Dahalan, 2011) further proposed that non performing loans are not only dangerous for the economy of the country but it is destructive for the whole world as in the case of Sub-Saharan and East asian countries.So it is the need of the hour to determine the main resaons for the Non performance of loans and thus help policy makers while they are having decisions. Also the increase in the trend of the non performance loan in a country is an indication of the financial crises in the economy.there is not a strong impact of non performing loan on the economice performance but the impact is there(Kaminsky and Reinhart (1999)

The first portion of the litearature is related to the aftershocks of the Non performing loans in the economy.The second portion enlightens the litearatue that uses different fators as a predictors to predict the non performance of the loans mainly intrest rate and other macroeconomics variables. There is positive relationship between intrest rate and the Non performing loans as evidenced by (Ongweso Alfridah) the study was conducted in Kenya and the data period is ranges from 2000 to 2004.Regression model were developed by using intrest rate as independent variable and non performing loan as dependent variable.The non performance of loans declined with the relative decline in the intrest rate between 2000 to 2004.A recent study shows relating to Pakistan has been conducted by the(Saad saddique,Kamran shahzad Malik 2012) has indicated the weak relationship between the intrest rate and the non performance of the loan.They use the big data set ranging from the 1996 to 2011.Opening up ways for future research as intrest rate is not proved to be the sole factor that effect Non performance of loan. Another study has been conducted recently that encompass all macroeconomic variable as a independent variables.This study is different in a sense that it uses primary data instead of secondary data.The respondents are loan providing and approving authorities of Pakistani banking industry , 201 bankers have been selected and a questionniare is floated among them.Regression and Correlation Anlaysis has been carried out on this data.Outcomes include Interest Rate, Energy Crisis, Unemployment, Inflation, and Exchange Rate has a significant positive relationship with the non-performing loans of Pakistani banking sector while GDP growth has significant negative relationship with the non-performing loans of Pakistani banking sector(Muhammad Farhan&Ammara Sattar) Louzis, Vouldis and Metaxas (2010) conducted their research on 9 large banks of Greece , their study is somewhat different from others because they classify the loans in three categories i.e Business , Consumer & Mortgages.Then he tried to explain the movement in NPL of these categories with the help of management quality and macroeconmoics as independent variables.He founds positive relationship of intrest rate and the Non performing Loan,Further he found that NPL arising from mortgage loan are least effective.The results are in line with the Espinosa and Prasad (2010).

The most comprehensive and most recent study to the date is conducted by (ECB 2013,Roland Petr).It includes data set from 75 countries of the world and try to predict the NPL on the basis of the GDP growth rate , Lending interest rate , Share prices and the Exchange rate.Panel regression shows significant positive Relationship between the All of the above Independent variables.While the direction and amount of impact is contigent in case of exchange rate and the share prices. The studies in the past have tried to relate the Macroeconomic factor such as GDP, Interest rate,Inflation rate,Exchange rate and Share prices with the variable of concern i.e Non performing loan.Most of the studies have been conducted in abroad as well as Pakistan that relates Interest rate with NPL.In this article we examines the relationship between interest rate and the Non performing loan and try to draw some solid conclusion.

Research Methodology
The methodology use in this study is a two way methodolgy .irst of all we use GARCH models to test for the variance among the weighted average interst rate and weighted averege non performing loans.In the first step we use the ADF test to determine the stationarity of data.In other words ADF test validate the presence of unit root in the series of concern.if it would not be stionary at unit root we will go for further differences until we get the stationarity property in our series. In the second step we use the simple regression and the variables of concern are being regressed with simple regression tool.WANPL(Wieghted average non performing loan) is the weighted average of the Non performing loans based upon different banks.Bank having greater.Weights are assigned on the basis of market captialization.WANPL is our dependent variable in this study.Our second variable is the VWALIR(Volatility in weighted average lending interest rate) this is the independent variable and the data on this variable is obtained from the State bank of Pakistan Monthly report on interest rate.

Where,

References
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