Analysis of the key factors influencing credit risk of banks in Afghanistan

Sayed Khusrow
Mohammad Naim
Yaqub Ali
Students of Master of Finance and Accounting at Balkh University
Abstract
The issue of credit risk is one of the most sensitive issues of the banking industry, which can be
considered as a main cause of bankruptcy of banks. The 2008 economic crisis in United States of
America, which was rooted in rising credit risk, highlighted the importance of paying attention to
credit risk. In recent years, the rise in inflation in Afghanistan has led to an increase in deferred bank
claims that could put the country's banking system in serious troubles. Therefore, this research
determines the factors affecting credit risk in the banking system of the country. For this purpose, an
econometric analysis method has been used. The data of this research are collected from 14 active
banks in Afghanistan and the study period is from 2008 to 2017.
The results of this study, which examines the impact of macroeconomic factors and interbank factors
on credit risk, have shown that the variables of liquidity risk, the ratio of facilities to deposits, return
on assets, the ratio of capital to assets and bank size to the probability of 100% and variables with
97% efficiency ratio are the most effective factors in the credit risk model of banks in Afghanistan.
The probability of including other variables such as profit margin, financing structure, deposit ratio
and macroeconomic variables in the model is less than 25%, and therefore there is no strong evidence
that they are effective on credit risk. It seems that these variables, especially macroeconomic
variables, can only affect the credit risk by the channel of the variables included in the model or the
same internal factors.
Keywords: Credit risk, Banking system, Bayesian Model Average (BMA),
Weighted Average Least Squares (WALS). 2
Introduction
Banking is one of the most important activities of the economy. By organizing and directing receipts
and payments, banks can facilitate trade and promote markets and cause growth and prosperity in the
economy. Banks, as the main actors of the money market, in line with the policies of the central
bank, with the bill and expansion of bank credits and directing funds from one party to another, affect
the performance of macroeconomic variables. On the other hand, the correct relationship between
financial and productive systems in each country is considered as one of the most important factors
in the economic growth of the countries. Equipping and allocating investment resources to economic
activities through the financial market are carried out by the market of credit loans as a part of this
market. In fact, they act as a channel of communication between savers and investors for the efficient
use of the capital factor. In Afghanistan, due to the economic structure of the country and due to the
lack of capital markets and other non-bank and contract markets, the financing of real economic
sectors is borne by the banking systems and the proper functioning of this system depends on the
proper use of the collection resources. This requires an accurate assessment of the risks ahead and
identifying ways to deal with these risks. Due to its specific features, the financial and banking
system is faced with a variety of risks including credit risk, liquidity risk, and market risk. Therefore,
it is very important to identify and control the level and extent of each of these risks in their place for
the financial sectors and the banks. Credit risk is important in monetary and credit institutions. It is
important that the resources used to allocate can undermine credibility and the ability to repay the
debt of a monetary entity and make it a bankrupt. Given the importance of banks, this risk is an
integral part of the banking industry. The purpose of this study was to determine the effective factors
and determine the risk of credit in banks.
In this paper, we intend to examine the factors affecting credit risk by Bayesian Model Average
(BMA) and Weighted Average Least Squares (WALS).The first part of the article is dedicated to
explaining the theoretical foundations of the research. In the second part, empirical studies are
presented about the issue of credit risk and its effective factors. The third part is devoted to the
methodology of research. The fourth section analysis the data and estimates the model, and in the
end, in the final section, the summary and conclusion of the discussion is presented. 3
1- Subject Literature
1-1-Types of Risks Faced By a Bank
A bank faces many types of risks and these must be managed carefully. If the bank is not able to take
its money back from a company or from a person then gradually the stake of the bank will go down
and the bank will be in a financially weak position, as a result depositors will withdraw money from
the bank.
There are eight types of risks. These eight risks are divided into 3 categories.
Major Risks
1.Credit Risk
2.Market Risk
3.Operation Risk

Other Significant Risk

1.Liquidity Risk
2.Business Risk
3.Reputational Risk

Unrelated Risks
1.Systemic risk
2.Moral hazard

Credit Risk
If a borrower does not repay a loan, the lender may lose the principle of the loan or the interest
associated with it. It arises because the borrower expects to use future cash flows to pay current
debts.
A credit risk is the danger of default on an obligation that may emerge from a borrower neglecting to
make required installments.
Credit risk is most likely caused by loans, acceptances, interbank transactions, trade financing etc.
Market Risk
Market risk arises due to the factors affecting the overall performance of the financial market, it is
also known as the systematic risk.
Operational Risk
Operational risk is the risk not arising from financial, systematic or market-wide risk. It is the risk
remaining after determining systematic and financing risk and includes risk resulting from
breakdowns in internal procedures. 4
Liquidity Risk:
Liquidity risk is the risk due to the lack of marketability of an investment that cannot be bought or
sold quickly. This means the inability of a bank to provide cash.
Business Risk:
Business hazard is the likelihood of an organization to have lower than foreseen benefits or
experience a misfortune instead of taking a benefit. Business hazard is impacted by various
components, including deals volume, per-unit value, input costs, rivalry, the general monetary
atmosphere and government controls
Reputational Risk:
Reputational risk is a threat or danger to the good name of a business. It occurs through a number of
ways, directly as the result of the actions of the company itself, due to the actions of an employee. To
avoid reputational risk a company also needs to be socially responsible and environmentally
conscious. Reputational risk is the major hidden risk than can pose a threat to the survival of the large
companies. The reputational risk arises from the actions of errant employees.
Systematic Risk:
Systematic Risk is the ups and downs of returns caused by macroeconomic factors that affect all
risky assets. Systematic risk consists of day to day fluctuations in a stock’s price.
Moral Hazard:
Moral hazard is a circumstance in which one party gets included in a dangerous situation realizing
that it is secured against the hazard and the other party will acquire the cost. It emerges when both
the parties have inadequate data about each other. 5
1-2. Factors Affecting Credit Risk in the Banking System
One of the problems facing the banking system of various countries, including Afghanistan, is the
increase in non-current and deferred facilities in the banking network. This increase reflects the credit
risk of the banks, which results a decline in the value of the banking network assets and a decline in
the value of banks and, consequently, potential financial instability in the future. There are various
reasons for the formation and expansion of non-current facilities. After reviewing the above
mentioned factors, the above factors are expressed in two general categories of outsourcing
(macroeconomic and internal factors).
We will study the macroeconomic (external) factors affecting the emergence of credit risk. To
illustrate the relationship between macroeconomic factors and credit risk, we refer to business cycle
models. Trading cycles are fluctuations that are defined as successive cycles of boom and stagnation.
In a period of economic prosperity, with increasing national production, households and firms have
an income stream and sufficient power to repay their obligations. Therefore, credit risk is reduced.
But in the recession, with the rise in unemployment, household income is reduced and, as a result,
their ability to repay the bank decreases. On the other hand, during this period, the total production
and prices of goods and, consequently, corporate income will be reduced, and the ability of
companies to repay their debts to creditors will decrease, and during this time the volume of banking
activities will also decrease. Therefore, with a recession and a sharp decline in economic activity, the
banking crisis also begins and expands.
In addition to macroeconomic conditions, the characteristics and structure of a bank for loan
repayment and competition conditions in the banking industry as internal factors can also affect the
credit risk of a bank. 6
2-Literature Review
Many studies have been carried out on risk management and credit risk of banks in different
countries and here are some of these studies and their results:
Audil Khaki (2011) studied the “Factors influencing credit risk of Egypt banks ", which compared
the effects of these factors on banks' credit risk in the conventional banking system. The factors were
studied for the six active banks in this system. The variables studied in this study are: Productivity
Management, Risky Loan Exposure, Risk Mortgages, Legal Capital, Salary Claims, Financial Risk,
Risky Assets, Total Natural Margin, and Loan-to-Deposit Ratio for the period of 2001-2008. The
results of the research indicate that there is a significant difference between the risk factors of the
Islamic banks and the conventional ones. Based on the results of Regression, three variables in the
Islamic banks include: management efficiency, high risky assets and total assets of the bank; and in
conventional banks, four variables: exposures of risky loans, risky capital, legal capital, reserve ratio
of suspicious claims and high-risky assets have a significant impact on credit risk. The coefficient of
determination of 75.6% in conventional banking and 34% in Islamic banking shows that these
variables generally have a stronger impact on the credit risk of conventional banks than Islamic
banks' credit risk.
Saad Darwish (2013) in a study titled “The factors influencing bank credit risk” examined the factors
affecting credit risk in Qatar. In this research, an example of the ten commercial banks of Qatar from
2001 to 2009 has been used and examined macroeconomic factors and microeconomic variables
affecting credit risk. The results indicate that the main factors affecting the credit risk of banks in
Qatar are property structure, precautionary capital rules, profitability, and macroeconomic indicators.
This study shows that public ownership increases bank credit risk. In addition, prudent capital rules
reduce credit risk. The ratio of return on assets has a positive and significant effect and the ratio of
capital adequacy has a negative effect on credit risk. Also, the results indicate that macroeconomic
indicators such as GDP growth, exchange rate are among the determinants of credit risk in banks and
affect the credit decisions of banks in Qatar.
Other research investigates comparative analysis for several chosen countries. Ahmad (2007) in a
study titled “Multi-country study of bank credit risk determinants “examined the effect of the
macroeconomic situation on the credit risk of banks. In this study, gross domestic product, GDP
growth, facility growth, imports of goods and services, inflation and credit risk in previous periods as
explanatory variables and credit risk with the ratio of facilities reached the past and deferred banks,
and the total assets of the bank are considered as a dependent variable in the model. The results of
this research indicate that GDP growth, the import of goods and services, the growth of facilities and
credit, and credit risk with a period of interruption have a positive and significant effect on banks'
credit risk. It also confirms the negative and significant effect of GDP and inflation on credit risk of
banks. 7
3-1-BMA
3-An Overview of Model Average Estimators 8 9
3-2- WALS 10 11 12
4-Model Estimation
4-1 - Describing the variables
Since we are investigating the effects of fourteen explanatory variables on credit risk in the banking
system, we have used the method of BMA and the WALS. For this purpose by using STATA
software we are considering to examine the factors affecting credit risk in two groups of internal
bank factors and macroeconomic factors.
The explanatory variables of the factors within the banks are: liquidity risk, efficiency ratio, deposit
ratio, profit margin, asset return, bank size, facility / deposit ratio, ratio of capital to total assets and
financing structure. And the macroeconomic factors include economic growth rate, exchange rate
and inflation rate.
In this research, the statistical population includes all the banks in Afghanistan, and the sample of the
investigation consists of fourteen private and public banks established before 2008. As it is seen in
the table 1, the data used in this study is unbalanced panel for the years 2008-2017. In addition, data
on macroeconomic factors has been gathered from information sources and statistical data from the
Central Bank of Afghanistan time series.
Table 1: Series Name of The Bank Input Information
Year
1 Afghanistan 2017
International Bank
2 Afghanistan Commercial 2016
Bank
3 Ghazanfar Bank 2013
4 Maiwand Bank 2016
5 Afghan United Bank 2015
6 Azizi Bank 2017
7 Bank-e-Millie Afghan 2014
8 First MicroFinance 2013
Bank-Afghanistan
9 New Kabul Bank 2017
10 Pashtany Bank 2014
11 Bakhter Bank 2013
12 Arian Bank 2009
13 Barak Bank 2010
14 Pakistan National Bank 2008