Riks modeling of banking industry

Submitted to: Dr. Shahid Mansoor Hashimi

Submitted by: Sumra Abbas
Roll no: 04
Subject: Risk Management
Class: M.Phil
Semester: second






Economics Department of PIDE

TABLE OF CONTENTS:
1-Introduction
2- industry profile
3- Risk identification and measurement
4- Methodology
5- Variable construction and data source
6- Estimation and results
7- Conclusion
References
Tables
1- Table 1 of fixed effect
2- Table 2 of random effect
3- Table 3 of heteroscedasticity Breusch pagan Godfrey test
4- Table 4 of Hausman Test
Graphs
















Risk modeling of banking industry
Introduction
Bank is a financial institution that is licensed as a receiver of deposit. It accepts
and safeguards money and then lends this money to earn some profit. It also
provides other financial services as well to their customers. Banking system
provide services such as cash management, reporting about the account
transactions as well. Functions of banking system vary from one bank to
another. Common functions of banks highlighting need of bank as well include:
Safeguard money and valuable
receive deposits and make collection
offer loans and credits
Other payment services i.e. account checking, money orders etc.
Offer security to customers saving accounts
Banks working in many of countries must have to obey heavy rules and
regulations imposed by State and Federal agencies. These regulations are
regarding their services and operation that how they facilitate their customers.
The banker has to perform all function by remaining within the designed
regulation to maintain the public interest. Regulations are necessary for safety
of saving, control of credit and money for getting economic goals, promote
confidence of public in financial system etc. These are also important for helping
different sector of economy like small business, housing schemes and
agricultural loans etc.

Banking Sector in Pakistan
There is a wide spectrum of financial institutes in Pakistan such as specialized
banks, commercial banks, insurance companies, micro-finance banks and
Islamic banks. Banking sector that was dominated by national commercial banks
few years ago has been privatized. Islamic banking has also been introduced.
SBP has been issued licenses to Islamic banks and Al-Meezan Bank licensed by
SBP. Meezan had been functioning as an Islamic Investment Bank and has
become the first Islamic bank of country. The capacity of state bank of Pakistan
has improved due to acquisition of new skills, improved quality of existing
human resource base, updated technology etc. as banking supervision and
regulation are risk based so they are managed through international standard
and codes prescribed by Basel Committee.

Objective

Proper soundness of economy is obtained through the stability of macro-
economic indicators that obtained through the proper utilization of resources
such as physical resources human resources etc. banking sector is one of most
important financial sectors part that plays role in proper utilization of financial
resources. So the objective here is to capture the different types of risk faced to
banking sector and their effect on banks performance or returns. To some
extent try is made to capture market risk as well and risks due to
macroeconomic environment too.

Hypothesis:

Ho: credit risk, liquidity risk and market risk effect the banking performance
H1: credit risk, liquidity risk and market risk doesnt affect the banking
performance
The purpose of this study is to examine that how different types of risk such as
credit risk and liquidity risk effect banks performance or st ability.
2) industry profile:

A financial institution licensed as a receiver of deposits is definition thats
generally used for bank. Basically banks are categorized into two types
1) Commercial or retain bank
2) investment banks.
Banks are mostly regulated by their respective central bank or national
government in most of countries. Commercial banks are mostly concerned
with management of deposits and withdrawals as well as they are conscious
about providing short-term loans to individuals.
Basic issues that are faced to banking sector are wide in nature. There are a
lot of risks that are faced by banking sector. Major risk or issue that is faced
by banking industry are defined under risk identification.
Pakistan banking sector can be classified into following categories
State bank of Pakistan:- main central bank in Pakistan that is regulator of all
banking operations in Pakistan.
Nationalized Scheduled Banks:- these deals with capital market and banking
industries. They offer a lot of services and products such as loans, saving,
credit cards and consumer banking.
Private scheduled banks: their primary objective is to get profit i. e. bank
spread. They engage in channeling funds from deposits to lenders.
Foreign Banks:- concentrate on plastic money and international trade finance
Specialized banks: banks with specific interest thus catering to specific
sector.


3)Risk identification and measurement

There are a lot of risks faced by banking sector. However, Risk faced by banking
sector can be categorized majorly into six categories. Systematic risk or market
risk, liquidity risk, operational risk, counterparty risk, credit risk and legal risk.
Credit risk
It arises due to non-performance of the borrower. Its when the borrower fails
or is un-willing to pay its obligation. Credit risk is the most important cause of
banks problem. Credit risk is diversifiable, but it s not possible to be
eliminated. The reason is because its also related with market risk. Due to
its importance, there is need to analyze financial condition of borrower and
its the value of collateral.
Market risk or systematic risk
This risk arises due to change in market rates i.e. ER, interest rate, equity
prices etc. because all these effect the value of on and off balance sheet
position.
Liquidity risk
It is the risk that a given security or asset cannot be traded quickly
enough in the market to prevent a loss. There are two types of liquidity
risk.
Market liquidityAn asset cannot be sold due to lack of liquidity in the
market essentially a sub-set of market risk. This can be accounted for
by:
Funding liquidityRisk that liabilities:
Cannot be met when they fall due
Can only be met at an uneconomic price
Can be name-specific or systemic

Legal risk
Its the risk that unenforceable contracts, lawsuits or adverse judgments
can disrupt or can negatively affect the condition.
Operational risk
It arises due to lose control on operations, inadequacy of information,
fraud and unforeseeable events resulting to unexpected loss.
Counterparty risk
It occurs due to non-performance of trading partner. This nonperformance
can be due to systematic factor or due to other political or legal factors. In
this diversification is main tool for controlling the non-systematic
counterparty risk.

Risk management modeling

Risk management is essential item to be considered especially in activities
related to banking and finance. Risk Management is the process of measuring
the actual or prospective dangers of a specific situation. For measurement of
risk faced to banking industry, its modeled in a way that, there are three
categories defined of variables that are bank specific indicator, industry specific
indicator and macroeconomic indicators.

First of all, bank specific factor are derived by Camel Rating system. CAMEL
stands for Capital adequacy, Asset quality, Management and Earning and finally
L for Liquidity. Sometime CAMEL is termed as CAMELS as well where S is
defined as sensitivity to market risk.
Capital adequacy shows the relationship between equity and the risk weighted
assets it tells that how to rise equity and measure the ability to which the
organization observes the loan losses.
Asset quality evaluates the portfolio risk and shows productivity of LT assets.
Management is about knowing the functions of BOD i.e. either they or
performing well or not well. It also takes into account their ability to make
decision.
Earning processes performance of institution like earning through operations
etc. Liquidity Management basically examines fund availability to institutions for
meeting their credit demand and CF necessities as well.
GDP is taken as industry variable while Real interest rate (RINT) and Real
effective exchange rate is take as macroeconomic indicator.
4) Methodology
A linear regression is calculated by using a un-balanced panel of 38 banks
operating in Pakistan from 2007-2011. Measurement of risk faced to banking
industry, its modeled in a way that, there are three categories defined of
variables that are bank specific indicator, industry specific indicator and
macroeconomic indicators.

RET
it
= f(BSF
i,t
, ISI
t
, MEI
t
) +
it


where RET
it
is dependent variable calculated as NPL to gross advances by bank
I at time t. BSFi,t stand for bank specific indicator of bank i at time t; ISI industry
specific indicator in time t, MEIt stands for macro indicator in time t. the
subscripts shows that bank specific indicator are allowed to vary over time and
across entities while industry specific indicator and macro-economic indicators
are allowed to vary over time only but not across entities or banks.

In mathematical way, its can be expanded as

RET
it
= o +
1
SETA+
2
RETA+
3
ROE+
4
ROA+
5
WCTA+
6
GDP+
7

REER+
8
RINT+
it

The list of explanatory variables aims to include wide variety of the possible
risks thats are faced by banking risk. Effect of various risks and the risk
minimizing factor on banking stability is estimated through method of stepwise
least square with Breusch Pagan Godfrey test.First of all stationarity of data is
checked through unit root test with Augumented Dickey Fuller Test and then
Hausman test is applied to see either fixed effect should be suitable or random
effect.
As specification of this model i s with purpose to identify the statistically
significant correlations between the variables rather than examining causal
relationship between bank stability and different risks.


5) Variable construction and data source
Explanatory variables

One of Camel Ratio is termed as capital adequacy ratio that is calculated as
shareholders equity divided by total assets (SETA). Its basically the level of
equity to maintain balance with risks faced by banks such as market risk, credit
risk and liquidity risk. This ratio shows the financial soundness of industry. In
CAMEL ratio sometime tier 1 capital and tier ii capital is divided by risk weighted
average of total assets. Risk weighted average of total asset is defined by
BASEL II specified risk portfol io. As risk of each bank vary from each other so
for each class different level of risk is defined.

Second one termed as asset management ratio that is defined as retained
earning divided by total asset (RETA). As retained earnings are net earnings
percentage that are not paid as dividend. These are retained for the purpose of
reinvestment. This ratio helps to measure the extent to which a company depend
on leverage or debt. The lower the ratio implies that company is funding assets
by source of borrowing rather than through retained earnings. And it leads to
increase in risk of bankruptcy if the firm is unable to meet its debt obligations.

In management and earnings ratio, two ratios have been used ROE and ROA.
Return on equity (ROE) is the quantity of net income returned in terms of
percentage of shareholders equity. It tells how much profit a company has
earned as compared with the total amount of shareholder equity. This ratio
states about capacity of earning profit to bank on its total assets employed
or how profitable it is for owner.ROA shows the banks profit that it earned
in relation to other resources that are employed in percentage form. It is
one of management ratio because it shows that how well is management of
bank to employ resources to earn profit.


And finally liquidity ratio is calculated as working capital divided by total asset.
Working capital is calculated as current asset mi nus current liabilities. This ratio
is useful for measuring companys efficiency and its short term financial health
as well. Positive value of working capital implies that bank is able to meet its ST
obligations and vice versa. Hence its perfectly useful in measuring liquidity risk.
Because banks with positive working capital has no problem regarding payment
of depositors amount. It implies bank faces low level of liquidity that has
positive influence on stability. And excessive liquidity leads to structural problem
to bank as its results in instability of industry.

RET is taken as dependent variable calculated as NPL divided by gross
advances. This ratio tells about quality of loan portfolio of bank. It shows
percentage of NPLs as gross advances made by a bank and evaluates assets
quality based on loan portfolio.

Data on variables that are used in analysis so far is take from Banking statistics
of Pakistan. The data on three macro variable GDP, real interest rate and real
effective exchange rate is taken from annual report of SBP.

Estimation and Results

First of all data of 38 banks is imported to Eviews and then the stationarity of all
variables is checked through unit root test. Test type taken was ADF and
automatic selection was taken as Akaike info Criterion. Because data is Panel
so unit root test is applied on each variable one by one. These are results of
variables that are stationary at level except real effective exchange rate and
GDP.


ADF-Fisher Chi-Squared STATISTICS PROB.
RET
109.562
0.0010
RETA 94.0845 0.0414
SETA 110.191 0.0025
ROE 126.873 0.0001
ROA 121.690 0.0002
WCTA 95.5090 0.0334
RINT 175.694 0.0000

Then equation is estimated with effect specification taken as fixed (table 1) and
then random (table 2) and the results were taken. Then after estimating equation
with random effect, Hausman test is applied.

Hausman test is useful in making decision about making choice that either fixed
effect should be taken or random effect. Under panel data its observed that
either regressors are correlated with individual effect or not while making choice
between fixed and random effects. The hypothesis is taken as

Ho: random effects are efficient and consistent
H1: random effects are inconsistent.

Small value of Hausman statistics implies acceptance of Ho mean random
effects estimator is good. While large value implies acceptance of H1 means
fixed effect model is consistent. In this case chi squared statistics is
14.507402 (table 4). This large value which is larger than critical or tabulated
value implies rejection of null hypothesis and acceptance of alternative
hypothesis. Hence this panel estimation will be with fixed effect.
For checking heteroskedasticity Breusch-Pagan-Godfrey test was applied as
shown in table 3. As
Ho: there is no heteroscedasticity
H1: there is heteroscedasticity
As can be seen in table 3 that value of P value is 0.242237 greater than 0.05. it
implies acceptance of Ho imply that there is no heteroskedasticity.

Results
as finally selection through Hausman test that either to use panel data with fixed
effect or random effect. And it was conclusion after estimation that to use panel
data with fixed effect. As in table 1 regression has been estimated for panel data
with fixed effect. So result of regression are as follow:
RET
it
= o +
1
SETA+
2
RETA+
3
ROE+
4
ROA+
5
WCTA+
6
GDP+
7

REER+
8
RINT+
it

RET
it
= -0.831100 + -0.014123 SETA+ -0.129120 RETA+ -0.001632 ROE+ -1.391837
ROA+ -0.071250 WCTA+ -5.07E-06 GDP+ 0.009779 REER+-0.002628RINT+
it

Conclusion
As it can be interpreted through table 1 that no one result is significant. As all
are going to be insignificant and each of variables is negatively related with RET
except real effective exchange rate then it implies that there is some problem
with independent problem. As the data set that is used for analysis is just of 5
years then in case of panel estimation with fixed effects this can lead to
insignificant results because panel year observation arent too sufficient.
References:
Angbazo, L. (1997). Commercial Bank Net Interest Margins, Default Risk,
Interest Rate Risk, and off-Balance Sheet Banking. Journal of Banking and
Finance, 21: 55-87.

Khawaja, M. and M. Din (2007). Determinants of Interest Spread in Pakistan.
The Pakistan Development Review, 46: 129-143.

Khan, B. and M. Hasan (2010). What Derives Interest Rate Spread of
Commercial Banks in Pakistan? Empirical evidence Based on Panel Data SBP
Research Bulletin, vol 6.

Altman, E. I. and Saunders, A. 1998. Credit risk measurement: Developments
over the last 20 years. Journal of Banking and Finance 21: 1721-1742.

Caprio, G. and Klingebiel, D. 1996. Dealing with bank insolvencies: Cross
countryexperience, The World Bank, Washington, D.C.







Tables

Panel data estimation while in case of taking specification test as fixed results are as follow:
Table 1
Dependent Variable: RET
Method: Panel Least Squares
Date: 06/26/13 Time: 09:59
Sample: 2007 2011
Periods included: 5
Cross-sections included: 38
Total panel (unbalanced) observations: 178


Variable Coefficient Std. Error t-Statistic Prob.


C -0.831100 0.583314 -1.424789 0.1566
WCTA -0.071250 0.156725 -0.454618 0.6501
RETA -0.129120 0.160327 -0.805352 0.4221
SETA -0.014123 0.011680 -1.209210 0.2287
ROA -1.391837 0.549415 -2.533310 0.0125
ROE -0.001632 0.007099 -0.229852 0.8186
REER 0.009779 0.008102 1.206895 0.2296
GDP -5.07E-06 0.000269 -0.018849 0.9850
RINT -0.002628 0.006643 -0.395614 0.6930


Effects Specification


Cross-section fixed (dummy variables)


R-squared 0.784352 Mean dependent var 0.158853
Adjusted R-squared 0.710836 S.D. dependent var 0.194400
S.E. of regression 0.104537 Akaike info criterion -1.460682
Sum squared resid 1.442489 Schwarz criterion -0.638423
Log likelihood 176.0007 Hannan-Quinn criter. -1.127234
F-statistic 10.66908 Durbin-Watson stat 2.787062
Prob(F-statistic) 0.000000














Table 2
while in case of taking specification test as random results are as follow:

Dependent Variable: RET
Method: Panel EGLS (Cross-section random effects)
Date: 06/26/13 Time: 10:16
Sample: 2007 2011
Periods included: 5
Cross-sections included: 38
Total panel (unbalanced) observations: 178
Swamy and Arora estimator of component variances


Variable Coefficient Std. Error t-Statistic Prob.


C -0.752628 0.576922 -1.304558 0.1938
RETA -0.172830 0.099372 -1.739226 0.0838
SETA -0.000258 0.005624 -0.045801 0.9635
WCTA 0.020693 0.096504 0.214430 0.8305
ROA -1.033868 0.406136 -2.545620 0.0118
ROE -0.006567 0.006755 -0.972243 0.3323
RINT -0.002408 0.006616 -0.363942 0.7164
REER 0.008658 0.008057 1.074668 0.2841
GDP 2.04E-06 0.000268 0.007612 0.9939


Effects Specification
S.D. Rho


Cross-section random 0.114838 0.5469
Idiosyncratic random 0.104537 0.4531


Weighted Statistics


R-squared 0.260561 Mean dependent var 0.059975
Adjusted R-squared 0.225558 S.D. dependent var 0.120308
S.E. of regression 0.106351 Sum squared resid 1.911466
F-statistic 7.443974 Durbin-Watson stat 2.123309
Prob(F-statistic) 0.000000


Unweighted Statistics


R-squared 0.363463 Mean dependent var 0.158853
Sum squared resid 4.257858 Durbin-Watson stat 0.953210








Table 3
Heteroskedasticity Test: Breusch-Pagan-Godfrey


F-statistic 1.308603 Prob. F(8,169) 0.2422
Obs*R-squared 10.38314 Prob. Chi -Square(8) 0.2392
Scaled explained SS 43.59745 Prob. Chi -Square(8) 0.0000



Test Equation:
Dependent Variable: RESID^2
Method: Least Squares
Date: 06/26/13 Time: 13:53
Sample: 2007 2011
Included observations: 178


Variable Coefficient Std. Error t-Statistic Prob.


C 0.383929 0.382339 1.004160 0.3167
RETA -0.080214 0.032576 -2.462361 0.0148
WCTA 0.066737 0.031561 2.114541 0.0359
RINT 0.005270 0.004398 1.198231 0.2325
REER -0.005460 0.005356 -1.019492 0.3094
GDP 0.000184 0.000178 1.034463 0.3024
SETA -0.000776 0.001587 -0.489065 0.6254
ROA 0.045980 0.147625 0.311462 0.7558
ROE -0.000452 0.003881 -0.116382 0.9075


R-squared 0.058332 Mean dependent var 0.022987
Adjusted R-squared 0.013756 S.D. dependent var 0.070359
S.E. of regression 0.069874 Akaike info criterion -2.435021
Sum squared resid 0.825110 Schwarz criterion -2.274144
Log likelihood 225.7169 Hannan-Quinn criter. -2.369781
F-statistic 1.308603 Durbin-Watson stat 1.557729
Prob(F-statistic) 0.242237













Table 4

Correlated Random Effects - Hausman Test
Equation: Untitled
Test cross-section random effects


Test Summary Chi-Sq. Statistic Chi-Sq. d.f. Prob.


Cross-section random 14.507402 8 0.0695



Cross-section random effects test comparisons:

Variable Fixed Random Var(Diff.) Prob.


RETA -0.129120 -0.172830 0.015830 0.7283
SETA -0.014123 -0.000258 0.000105 0.1756
WCTA -0.071250 0.020693 0.015250 0.4565
ROA -1.391837 -1.033868 0.136910 0.3333
ROE -0.001632 -0.006567 0.000005 0.0240
GDP -0.000005 0.000002 0.000000 0.7522
REER 0.009779 0.008658 0.000001 0.1922
RINT -0.002628 -0.002408 0.000000 0.7123



Cross-section random effects test equation:
Dependent Variable: RET
Method: Panel Least Squares
Date: 06/26/13 Time: 10:24
Sample: 2007 2011
Periods included: 5
Cross-sections included: 38
Total panel (unbalanced) observations: 178


Variable Coefficient Std. Error t-Statistic Prob.


C -0.831100 0.583314 -1.424789 0.1566
RETA -0.129120 0.160327 -0.805352 0.4221
SETA -0.014123 0.011680 -1.209210 0.2287
WCTA -0.071250 0.156725 -0.454618 0.6501
ROA -1.391837 0.549415 -2.533310 0.0125
ROE -0.001632 0.007099 -0.229852 0.8186
GDP -5.07E-06 0.000269 -0.018849 0.9850
REER 0.009779 0.008102 1.206895 0.2296
RINT -0.002628 0.006643 -0.395614 0.6930


Effects Specification


Cross-section fixed (dummy variables)


R-squared 0.784352 Mean dependent var 0.158853
Adjusted R-squared 0.710836 S.D. dependent var 0.194400
S.E. of regression 0.104537 Akaike info criterion -1.460682
Sum squared resid 1.442489 Schwarz criterion -0.638423
Log likelihood 176.0007 Hannan-Quinn criter. -1.127234
F-statistic 10.66908 Durbin-Watson stat 2.787062
Prob(F-statistic) 0.000000



Graphs



This shows that ROA is stationary at level and same thing is being
depicted in graph. And same in case RET and GDP at first difference.
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