Do Banks suffer from Moral Hazard?

An empirical threshold model of the impact of nonperforming loans on bank lending

Yixin Hou and David Dickinson Department of Economics Birmingham Business School University of Birmingham

Preliminary draft. Please do not quote without the authors permission This Draft March 2010

Corresponding author David Dickinson Department of Economics Birmingham Business School University of Birmingham Edgbaston Birmingham B15 2TT UK Tel +44 (0)121 414 8093 Fax +44 (0)121 414 7380 Email: d.g.dickinson@bham.ac.uk

Abstract
This paper examines how non-performing loans (NPLs) affect bank lending behaviour. It uses a large multi-country data set of banks and investigates the influence of NPLs on the amount of credit which banks grant. We use a threshold model to investigate this issue and find that lending behaviour is significantly different below and above a critical threshold level of NPLs. We find that lending is dependent also on the capital ratio. The thresholds are different across developed and less-developed financial markets. The paper identifies that the results obtained provide evidence on whether banks are subject to moral hazard in lending. The impact of capital regulations also influences the risk-taking behaviour of banks. JEL Codes G21, G18, G11

1. Introduction Given the recent turbulence in banking and the rise in non-performing loans (NPLs) there is renewed interest in the impact of NPLs on banks and their behaviour. Of particular interest is the extent to which deterioration in bank performance leads to moral hazard in that there is an incentive for banks to take more risk. We investigate this issue by examining the relationship between bank lending and NPLs. Specifically we use a threshold approach to identify if and how bank lending behaviour changes as the level of NPLs rises above a threshold value (which is determined endogenously). By carefully specifying the implications of the moral hazard hypothesis we are able to use our empirical findings to understand whether it is an issue. We also control for capital adequacy in order to consider the impact of regulatory controls on our results. Our study is multi-country and hence we have a number of alterative regulatory regimes in which to consider our findings and to explain their significance. Much of the research on NPLs to this time has been directed at their implications for bank failure and the findings that asset quality is a statistically significant predictor of insolvency and that banking institutions always have large non-performing loans prior to failure (e.g. DermirgueKunt 1989, Barr and Siems 1994). Literature focusing on the causes of the NPLs problems provides a number of explanations for the phenomenon. At the microeconomic level, asymmetric information and adverse selection, risk preference, risk measurement, corporate governance, have been put forward to try to explain the causes of non-performing loans. From the macroeconomic view, the non-performing loans problem is seen to be the consequence of macroeconomic inefficiency. For example, the long lasting Japanese bad-loan problem since the bubble burst in 1990 is viewed as the consequence of a deflationary slump. The experience of Japan, as well as that of the 1930s has been the major impetus for the policy responses to the current banking crisis. It has been argued that the general impact of NPL is to induce reductions in lending and a flight to quality (e.g. Bernanke and Gertler, 1994). Hence enterprises, which are financially sound, suffer liquidity problems and financial distress resulting in bankruptcy, as a result of the dryingup of bank credit channels. Furthermore the need of banks to re-build capital means that they cut back more generally on extending credit, causing reduced demand and hence further falls in economic activity. Alternatively there is the argument that banks engage in more risky lending as

a result of moral hazard when NPLs rise. In other words, there is an incentive for banks to take more risks if their financial position is worsening as a result of increased NPLs. This problem becomes even more acute if there is a perception that banks will be bailed out if they become insolvent (e.g. Boyd et. al, 1998, Nier and Baumann, 2006). Examining the relationship between bank lending and their NPLs will provide insights into the potential for credit crunches or moral hazard problems to appear since we will be able to identify the extent to which banks increase lending as NPLs increase or reduce. We start from the premise that the impact of NPLs on bank lending is non-linear. It is quite normal for banks to experience bad loans as a normal part of their business and hence we would not expect to observe effects on bank behaviour at normal levels. However once NPLs rise above this normal operational level banks will need to take action to stabilise their business, by building capital and adjusting their credit policies to increase loan quality, or take more risk in order to build funds as a way out of potential insolvency problems. This approach leads us naturally to adopt a threshold regression technique to model the empirical relationship between NPLs and bank lending. We find that such an approach has some empirical success and that there is interesting variation in the threshold level across different regions. Since we also apply thresholds for bank capital ratios we indentify some interesting interactions between banks behaviour and regulatory requirements. The rest of this paper is organised as follows. Section 2 explains our definition of non-performing loans and highlights why non performing loans can impact on lending behaviour as well as discussing consequences of non-performing loans on the economy more generally. Section 3 uses the empirical version of the threshold model to test how the non-performing loan affects banks loan decision. And section 4 provides interpretation of our results and concluding comments.

2).

A Threshold model of the effect of NPLs on Bank Lending

In order to understand the relationship between bank lending and NPLs we need to consider why it is that NPLs occur. There are both a demand and supply side factors. Clearly not all firms that borrow will succeed and defaults and bankruptcy are natural economic selection processes. Banks

will typically lend on the basis of information gathered about the borrower, setting the interest rate to reflect the risks of lending and any collateral requirements, and managing the risk in a proactive way. Clearly if banks dont operate their business well then we would expect to see a higher proportion of NPLs. It has been observed that failing banks (those with high NPLs) tend to be located far from the efficient frontier (Berger and Humphrey (1992), Barr and Siems (1994), DeYoung and Whalen (1994), Wheelock and Wilson (1994)). There is evidence that even among banks that do not fail, there is a negative relationship between the non-performing loans and performance efficiency (Kwan and Eisenbeis (1994), Hughes and Moon (1995), Resti (1995)). Other empirical studies using supervisory data have supported such a negative relationship. For example, Peristiani (1996) finds a positive relationship between the cost efficiency and the examiners ratings of bank management quality. DeYoung (1997) observes a stronger link between the banks management ratings and their assets quality ratings. Some direct measures of bank cost and production also show a negative relationships between the NPLs and bank performance (Berg, Forsund and Jansen (1992), Hughes and Mester(1993)). So we may observe that banks with high NPLs are likely to be low efficiency banks and that NPLs may be associated with poor risk management. The relationship between NPLs and banks lending decisions is likely to be driven by macro as well as micro factors. Thus changes in NPLs may reflect the economic environment. For example, an increase in NPLs may signal unanticipated economic deterioration which causes an upward revision in the probability of loan default. There may be a natural inclination to tighten credit allocation procedures which has the effect of reducing the amount of credit extended and an improvement in the quality of assets as bad loans are cleared. Additionally the negative effect of NPLs on future lending is often associated with the need of banks to build up capital to protect against loan losses. Finally bank managers may be rewarded according to their relative performance. If the expectation is that the NPL problem is economy-wide then there will be an incentive to avoid further losses in order to be seen to be doing better than the market as a whole. So we would expect to see a relationship between NPLs and bank lending decisions driven by both market and economy wide factors as well as bank level problems.

The particular feature of this paper is to consider the interaction between NPLs and bank lending decisions but in the context of a threshold model. Our rationale for using the threshold approach is that banks typically make provisions for NPLs up to a specific (normal) level and may also cut back on lending in response to increases in NPLs but that when they rise above this point the bank begins to respond more aggressively and indeed to start to take more risk. Such a threshold will reflect historical factors such as the observed distribution of NPLs (for example banks may use a particular confidence interval which implies that they infer a small probability (e.g. 5%) of NPLs rising above this level). Alternatively regulations and the actions of the regulatory agencies may imply that NPLs up to a certain level require no specific action while beyond the authorities start to look more closely at the activities of the particular bank. Of course the appropriateness of the threshold model is an empirical matter which we shall take up in the next section. The existence of a threshold approach to managing lending may also have implications for the credit crunch view of the loans market. If there is a substantial increase in the negative impact of NPLs on new lending after a particular level of NPLs are reached then we would expect to see credit crunches occurring once this critical level had been reached across the banking sector. In other words whilst NPLs are at a level considered normal the possibility of a credit crunch would be rather low but once they went generally above this level the chances are significantly increased. We now turn to the framework in which we shall set up our threshold model. We wish to examine the impact of increasing non-performing loans on credit supplies of commercial banks, controlling for other factors that affect credit representing demand and supply conditions. For a simple commercial bank balance sheet, assets are commercial loans and other earning assets and in addition there is cash and other non-earning assets which typically absorb short-term shocks; on the liability side, deposits and other short-term funding along with capital are the main components. Thus, we can conjecture that the loan growth is affected by deposit growth, capital growth and other earning assets growth. Thus the supply of loans (Lt) is determined by banks lending capacity, given by deposit growth rate and factors that influence banks willingness to provide credits the capital-asset ratio and the

risks as measured by NPLs. It might appear that we have ignored revenue considerations but this is taken into account through the impact of other earning assets. In other words we would expect the growth rate of this element of the portfolio to reflect the relative (to lending) benefits of this class of asset in the portfolio. The basic model is as follows:
LGRi ,t = a 0 + a1 DGRi ,t + a 2 CGRi ,t + a3 OEAGRi ,t + a 4 NPLGRi ,t 1

(1)

where the index i is the index for individual banks and t is the index for time period. LGR i ,t is the loan growth rate for each bank in each time period t , DGRi ,t is the deposit growth rate,
CGR i ,t is the capital growth rate, OEAGRi ,t is the other assets growth rate, and NPLGR i ,t 1

is non-performing loan growth rate of the previous time period. The balance sheet constraint implies that there will be an adding-up relationship between the growth rates but note that we have not included all balance sheet items so this is implicit. In other words shocks to the balance sheet are absorbed by the non-included items such as cash and non-deposit liabilities. We have argued above that macroeconomic conditions may also affect loan growth. Rather than specify the variables we add year dummies to reflect these macro variables which will affect all banks but vary over time. We can make conjectures about the signs of the coefficients above. As deposits increase at a faster rate, lending capacity of the bank increases and hence loan growth should rise. A ceteris paribus increase in other earning assets growth would be a signal that they are becoming relatively profitable (their return/risk relationship is more favourable). This would reduce lending growth. The impact of capital growth would be expected as positive. The reason is that higher capital gives the bank more capacity to take risk and hence makes more credit available. Finally an increase in NPLs last period would signal worsening lending conditions with higher associated risks and a reduction in loan growth as a result. As indicated we intend to adopt a threshold approach to our empirical analysis. We can also identify how we might expect our responses to be sensitive to the level of NPLs. However as will become clear the actual effect is dependent on whether we believe banks are subject to moral hazard or not. This is going to be very helpful in establishing the implication of our results.

Firstly we consider the case where banks are not subject to moral hazard. Deposit growth is likely to exert a smaller positive impact as NPLs rise since banks will use deposit growth to rebuild their capital and consequently increase credit less. Similarly when the banks are affected by an increasing non-performing loan problem, they are likely to switch to safer assets, such as government bonds or treasury bills. As a result of this increased substitution effect, the other earning asset growth should have larger negative effect on loan growth. The positive impact of capital growth will be moderated as NPLs increase since banks will be concerned to build a buffer against loan losses. Finally we would expect that as NPLs increase the NPL growth rate has a stronger negative effect. Now suppose that banks are subject to moral hazard in that they take more risk as they suffer declining performance due to rising NPLs. Increases in deposit growth will now have a larger effect on lending since banks will choose to make more risky loans in order to generate higher return. The impact of other earning assets will be reduced as the substitution effect fails to operate even though there is an increased risk of making loans. Finally we would see an increase in lending to be enhanced by capital growth as NPLs increase and banks can offset higher capital by taking more risk. Finally we would expect to see a declining effect of NPL growth on credit. Beyond this basic specification we also propose to consider an additional threshold based on the banks capital ratio. Under the Basle Accord II framework banks are required to adjust their capital to reflect the riskiness of the assets they hold. Increases in NPLs would be expected to impact on capital requirements as the riskiness of loans increases. According to the Basle Accord II, the target ratio of capital to risk weighted assets is set at 8%. Not surprisingly, given the need to have a buffer-stock of capital we observe from our data set that the mean capital ratios in our samples are all above the required 8%. We define a dummy variable which identifies if the capital ratio of the bank is above or below a specific value. We then run an adjusted regression equation which is:
LGRi ,t = a 0 +a1 DGRi ,t +a 2 CGRi ,t +a 3 OEAGRi ,t +a 4 NPLGR i,t - 1 +a 5 Dummy i ,t +a 6 Dummy i ,t NPLGRi ,t 1

(2)

The point of equation (2) is that we expect loan growth to be influenced directly by the effective capital ratio, as well as allowing the response of lending to growth of NPLs to be influenced by whether the bank has met the effective capital ratio. What is exactly this effective capital ratio is an empirical question.

3). The Empirical analysis of Lending and NPLs

In this paper we use a panel of individual banks balance sheet data across a range of countries. We use the standard BIS definition of NPLs1. The argument for this is firstly that the standard definition makes it possible to compare the non-performing loan problem across countries and banks. Secondly, the BIS definition is a prudential definition for NPLs, which includes loans with loss uncertainty as well as those for which a loss has been incurred and hence should be a reasonable guide to the banks estimate of how large is the NPL problem. Since the variables we use in the regression as explanatory variables are potentially endogenous as they are simultaneously determined through banks balance sheet constraints, we apply the method of two-stage least squares method using instrumental variables (see Wooldridge (2002) for details of this technique in a panel context). We assume banks behaviour is continuous and they re-balance the portfolio to the desired level each period (which is reasonable in the context of our use of annual data). Threshold regression techniques are used to address the question of how bank credit decisions relate to the level of NPLs. Threshold models have a wide variety of applications in economics. Applications include separating and multiple equilibrium, sample split, mixture models,
1

According to the BIS, the standard loan classifications are defined as follows: Passed: Solvent loans; Special Mention: Loans to enterprises which may pose some collection difficulties, for instance, because of continuing business losses; Substandard: Loans for which interest or principal payments are longer than three months in arrears of lending conditions. The banks make 10% provision for the unsecured portion of the loans classified as substandard; Doubtful: Full liquidation of outstanding debts appears doubtful and the accounts suggest that there will be a loss, the exact amount of which cannot be determined as yet. Banks make 50% provision for doubtful loans; Virtual Loss and Loss (Unrecoverable): Outstanding debts are regarded as not collectable, usually loans to firms which applied for legal resolution and protection under bankruptcy laws. Banks make 100% provision for loss loans. E use the last three of these classes to define NPLs

switching models, etc. Hansen (2000) argues that the understanding of threshold models is a preliminary step in the development of statistical tools to handle more complicated statistical structures. The development of threshold regression models can be traced back to Dagenais (1969). He uses the threshold regression technique to analysis the step-like-time-path discontinuous character of durable goods. Hansen (1999) develops the panel threshold regression methods for non-dynamic panels with individual-specific fixed effects. In the model, the observations are divided into two regimes depending on whether the threshold variable q it is smaller or larger than the threshold

. The two regimes are distinguished by differing regression coefficients 1 , 2 . He shows that
for any given , the slope coefficient can be estimated by ordinary least squares (OLS). The threshold level is identified as the one which generates minimisation of the sum of squared errors. Hansens (1999) threshold model is based on a balanced panel. Khan and Senhadji (2001) extend the technique to an unbalanced panel. The estimation is carried out using the conditional least squares and the threshold is determined at the point that minimises the sum of squared residuals. Caner and Hansen (2004) further develop a model with endogenous variables but an exogenous threshold variable. We can extend their model to be used for panel data with individual-specific fixed effects. The estimation is sequential. The first step is to estimate the reduced form parameters by least squares. The second step is to estimate the threshold using predicted values of the endogenous variables z it . And the third step is to estimate the slope

. The 2SLS parameters 1 and 2 by 2SLS on the split samples implied by the estimate of
estimator for is the minimiser of the sum of squared errors. Caner and Hansen (2004) demonstrate that if the threshold variable is exogenous, the estimator is consistent. However, it is difficult to know if it is efficient as other estimators are possible and efficiency is difficult to establish in nonregular models. In our estimation model, there are two thresholds, the non-performing loan rate and capital ratio. As both of the two variables are treated exogenous in our model, we can follow Caner and Hansen (2004) three step method. In the first step, we estimate the fitted value of

OEAGRi ,t , DGRi ,t , CGRi ,t by

using the lagged variables

OEAGRi ,t 1 , DGRi ,t 1 , CGRi ,t 1

as

the instruments. The second step is to estimate the thresholds using predicted values of the
' ' ' endogenous variables OEAGRit , DGRi ,t , CGRit . And the third step is to estimate the parameters

by 2SLS on the split samples implied by the estimates. And the 2SLS estimator is the maximiser
2 of QL where QL = j =1 n j ln( j ) .For the full sample, the threshold for NPLRit is chose
2

within the interval of ( 0%,

15% ) with an increment of 0.1% . And for each level of NPLRit , we 20%) 2 with an increment of

estimate different capital ratio level within the interval of ( 8%, combination of the two thresholds where the QL is maximised.3

0.1% . It yields totally 18000 estimated QL s, and the best estimator is chosen by the

Specifically we determine the thresholds by estimating the models as follows:

a 0 + a1 DGRi ,t ' + a 2 CGRi ,t ' + a3 OEAGRi ,t ' + a 4 NPLGRi ,t 1 + a Dummyi ,t + a6 Dummyi ,t NPLGRi ,t 1 LGRi ,t = ' 5 ' ' ' ' ' ' ' a 0 + a1 DGRi ,t + a 2 CGRi ,t + a3 OEAGRi ,t + a 4 NPLGRi ,t 1 + a ' Dummy + a ' Dummy NPLGR i ,t 6 i ,t i ,t 1 5

NPLRi ,t q
,

NPLRi ,t < q
(3-12)

where q is the threshold level for the rate of non-performing loan to total loan, and
Dummyi ,t =1 if the capital ratio is greater than the effective capital ratio we find for that sample,

and Dummyi ,t = 0 otherwise.

The banks balance sheet data are collected from BankScope Database by Bureau Van Dijk, which provides in-depth comprehensive bank statistics from 1998 to 2005. The banks we have
2

We start the Capital Ratio at 8% as all the samples have the average Capital ratio above 8%, so we want to know whether the effective capital ratio might be higher the 8% required by Basel Accords. 3 We think it is worthwhile to test for the significance of the thresholds. Hansen (1999) uses a bootstrap procedure to attain the first-order asymptotic distribution and the p-values are constructed from the bootstrap procedure. He uses the GAUSS programs to do the simulations. In our thesis, we have unbalanced panel data with two different threshold variables and endogenous variables, which make it more complicated than Hansen s case to attain the asymptotic distribution and to construct p-values, especially that the two confidence intervals of the two threshold variables may be correlated. It will involve more application of econometric theories, while our thesis at this stage is basically an applied economic study. I will consider this as the main future focus of my research and continue to work on it.

included in our study are commercial banks, bank holding companies, and savings banks. The main differences for these three types of banks are the scales and scopes of their business; however, taking deposits and making loans are their fundamental functions, which are suitable for the purpose of our study. The countries / regions we have looked into are as follows:

Region

Country Number of Banks U.S. 1214 Japan 155 4 Asian Crisis Countries Hong Kong 34 The Philippines 30 Indonesia 33 Thailand 14 Republic of Korea 18 Western Europe France 39 Eastern Europe Poland 31 Croatia 11 Latvia 16 Romania 10 Serbia and Montenegro 7 Ukraine 20 Czech Republic 8 Bosnia 6 Hungary 13 Slovakia 9 Turkey 12 Table 3.1 Sample Countries and Regions The US provides us with our largest sample and can serve as a benchmark. We select a range of Asian Countries which suffered a financial crisis in 1998 and allows us to consider how banks have responded. Japan is another interesting example given the difficulties faced by the banking sector since 1990. We also consider the case of Cetral and Eastern Europe and France to give further perspectives on the issue of the interaction between bank lending and NPLs. Descriptive statistics are shown in Table 1 (standard errors are given in brackets).

No data is available for Malaysia.

U.S. 13.87 Asset Growth Rate (%) (31.50 ) 1.93 OEA Growth Rate (%) (39.70 ) 1.12 Loan Growth Rate (%) (15.33 ) -0.48 (13.74 ) 14.86 (90.82 ) 2.52 Equity Growth Rate (%) (23.20 ) 0.83 (2.38) 15.50 (14.61

Japan 0.41 (6.30) 4.11 (10.18 ) -1.51 (4.94) 0.76 (5.47) 3.74 (35.82 ) 3.45 (35.36 ) 6.90 (3.18) 9.96 (12.29

Asian Crisis 14.01 (27.64) 7.68 (49.13) 1.58 (20.79) 1.49 (21.43) 9.36 (88.83) 1.83 (45.35) 12.18 (15.71) 22.30

France 5.73 (21.22) 1.73 24.57 0.55 (13.33) 0.53 (10.90) -12.81 (42.19) 3.77 (48.17) 8.75 (9.48) 11.95

Eastern Europe 37.21 (56.16) 4.05 (46.11) 7.76 (30.72) 1.53 (15.35) 1.13 (91.21) 0.57 (55.41) 8.88 (10.92) 19.11 (12.11)

Deposit (%)

Growth

Rate

NPL Growth Rate (%)

NPLs to Loans Rate (%)

Capital Ratio (%)

(17.83) (8.43) ) ) Table 1 Basic Data Descriptions of Each Region/County

We can make some general observations. The United States, as a whole, has much lower nonperforming loan levels than other countries: its average NPL rate is only 0.83% compared to the highest 12.18% for Asian crisis countries. These latter countries were severely hit by the nonperforming loans problems as a result of economic collapse following the 1997 financial crisis. The Eastern European banks have experienced fast growth of asset and loans. However there is high volatility consistent with transforming economies. Examining such a heterogeneous group

of countries will provide a perspective on how the external environment, in which banks operate, impacts on their lending behaviour and their reaction to increased lending risk. For the risk-based capital ratio, all the samples have the mean values above the 8% required capital ratio according to Basle Accord II. Compared with other countries, the Asian crisis countries have an especially high capital ratio with the mean value of 22.30%. Much of this increased capital ratio can be attributed to post-1997 government support. It will be helpful to consider the impact of different levels of capital ratios on lending behaviour as a method for capturing further impacts of the external environment on bank behaviour. We now turn to consider the empircal results of our model.

4. Empirical Results and Analysis

Before estimating the threshold for each sample, we first carry out the Hausman specific test to test whether the banks in this sample have individual fixed effects. We find the fixed effects model is appropriate. For each country we identify the two thresholds and report the estimates for each sub-sample. Note that since we have two thresholds the calculation of confidence intervals is not straightforward. We have to calculate confidence intervals for the NPL threshold conditional on setting the Capital Ratio threshold at the QL minimum value. We use bootstrapping to report such confidence intervals. In addition we report the validity of the threshold model using a LR test where the null is no threshold and the alternative is the existence of a threshold.

U.S. We find that the non-performing loan threshold for the U.S. sample is at NPL rate 0.6% and the threshold capital ratio is 14.9%, as at such levels the value of QL is minimised. The regression results are as follows:

Dependent Variable: LGR (t) Coefficient Std. Error Coefficient Std. Error Variable NPL Rate >= 0.6% NPL rate < 0.6% 5 Constant 0.9010** 0.3560 1.3371*** 0.2228 DGR(t) 0.2782*** 0.0203 0.0816*** 0.0193 OEAGR(t) -0.1008*** 0.0052 -0.1494*** 0.0050 CGR(t) 0.0546*** 0.0112 -0.0003 0.0096 NPLGR(t-1) -0.0089** 0.0035 -0.0026 0.0021 Dm -2.8329*** 1.0287 1.0660* 0.6117 Dm*NPLGR(t-1) -0.0018 0.0060 -0.0058 0.0040 6 Table 2 Regression Results for the U.S. Summarising the results reported above we may note that, for banks with NPLs above the threshold value: they have greater (positive) response to deposit growth; they have a smaller (negative) coefficient to other earning asset growth; they have a (positive) significant response to capital growth (insignificant for those below the threshold); the lagged NPL growth is significantly (negatively) related to lending growth; the capital dummy has a negative effect which implies that banks with high capital ratio will have a lower credit growth rate (but for banks below the threshold the capital dummy has a positive significant effect. These results suggest that US Banks with relatively large NPLs will tend to expand lending more quickly when there is a growth in their deposit base or in their capital, that they are less willing to substitute out of loans to other earning assets, that they reduce lending as NPLs increase, and that overall banks with higher capital ratios have lower lending growth rates. These results together suggest that banks with high NPLs are more cautious. For those with low NPLs relatively, we find that deposit growth and capital ratios are important factors beyond the substitution effect. In other words banks that are in a good risk position take actions to protect themselves from becoming more risky. Japan For the sample of Japanese banks, we find the threshold of NPL rate is 6.9%, much higher than that of the U.S. sample. The higher threshold level can be justified by a much higher average NPL rate of the Japanese dataset which is a function of the long-term problems in the Japanese
5 6

*** indicates 1% significance, ** indicates 5% significance, and * indicates 10% significance.

banking system. The threshold capital ratio is 11.4% lower than in the US again likely a product of the long-term difficulties Japanese banks have faced.

Dependent Variable: LGR (t) Coefficient Std. Error Coefficient Std. Error Variable NPL Rate >= 6.9% NPL rate < 6.9% Constant -0.5232*** 0.2003 0.0265 0.1376 DGR(t) 0.0809 0.0519 0.0223 0.0419 OEAGR(t) -0.2490*** 0.0150 -0.3719*** 0.0132 CGR(t) 0.0174*** 0.0062 0.0175* 0.0099 NPLGR(t-1) 0.0021 0.0044 0.0031 0.0038 Dm 2.0530** 0.9937 0.5814 0.3718 Dm*NPLGR(t-1) -0.0819*** 0.0132 -0.0061 0.0072 Table 5 Regression Results for the Sample of Japan Summarising the results in Table 5 we may observe that for banks with NPLs above the threshold: the substitution effect of other earning asset is smaller negative compared to those with lower NPLs, capital growth has a positive impact (as with those below the threshold) and a high capital ratio increases lending growth. Finally we may observe that NPL growth (lagged) has a negative effect on lending for those banks with high capital ratios only. Overall these results are indicative of problems in the Japanese banking sector. Specifically we observe that the substitution effect is smaller for banks with higher NPLs. This may reflect a strategy of investing in higher risk and return assets. Whilst banks engage in more lending as capital is rebuilt we find that increasing NPL growth will impact negatively only on those banks with high capital. This is suggestive that banks with low capital are taking more risk to rebuild their financial position. For Japanese banks which experience worsening NPLs and have low capital there is no indication that they reduce their lending, although they are not seen to increase it, and hence the evidence of moral hazard is limited. For banks with relatively low NPLs then the main variable that is impacting on behaviour is the substitution effect although they also respond positively to increased capital. They do not pay attention to NPLs in making their credit decisions and hence seem to be pursuing an income driven strategy with some attention paid to capital ratios.

South -East Asian Financial Crisis Countries The threshold for Asian Crisis countries is 5.6% and the effective capital ratio is 13.5%. These are similar to those found for Japan which is interesting given the problems of the banking sector in each.

Dependent Variable: LGR (t) Coefficient Std. Error Coefficient Std. Error Variable NPL Rate >= 5.6% NPL rate < 5.6% Constant 4.5449** 2.1979 4.2506* 2.5045 DGR(t) -0.0310 0.1127 0.1595* 0.0947 OEAGR(t) -0.2879*** 0.0708 -0.2493*** 0.0717 CGR(t) 0.0593** 0.0278 0.0561 0.0592 NPLGR(t-1) 0.0078 0.0226 -0.0425 0.0333 Dm -2.7929 2.5710 1.3652 2.4936 Dm*NPLGR(t-1) -0.0315 0.0253 0.0237 0.0366 Table 6 Regression Results for the Sample of Asian Financial Crisis Countries Summarising the results of table 6 we may observe that for banks with above threshold NPLs : deposit growth rate has no significant effect (and neither for those with below threshold NPLs), there is a marked substitution effect which is larger than for low NPL banks, capital growth has a positive effect while NPL growth and capital ratio dummies have no effect. Overall these results indicate the impact of the financial crisis on this data set of banks. For those with relatively low NPLs we find that deposit growth and the substitution effect are the only important variables. For those with high NPLs then the positive response of credit growth to capital indicates that attention is given to ensuring capital is sufficient but the lack of effect of NPL growth is some evidence that banks are willing to disregard risk. The substitution effect though may indicate risk management as banks shift to lower risk assets. France We have found that threshold for French banks is 5.75% of the NPL rate, and the effective capital ratio is 9.8%. The threshold for NPLs is much higher than that of the U.S. sample. It should be noted that the French legal system favours creditors over shareholders and that could provide an explanation for the high level of NPLs since banks have greater security in recovering their

lending in event of default. It amy also reflect the greater role of the State in supporting the economy relative to the US. The regression results are shown below:

Dependent Variable: LGR (t) Coefficient Std. Error Coefficient Std. Error Variable NPL Rate >= 5.75% NPL rate < 5.75% Constant -0.6065 3.3826 7.9287 8.1714 DGR(t) -0.2394* 0.1324 0.0787 0.1201 OEAGR(t) -0.2623*** 0.0695 -0.0086* 0.0047 CGR(t) 0.0245 0.0252 0.2077** 0.0833 NPLGR(t-1) 0.0164 0.0495 0.5551 0.4644 Dm 3.2989 4.7084 -7.1216 8.6426 Dm*NPLGR(t-1) 0.0519 0.0624 -0.5672 0.4652 Table 7 Regression Results for the Sample of France We may observe that for banks with relatively high NPLs the substitution effect is important. Deposit growth has a negative effect. All other variables are insignificant. French banks with relatively high NPL seem to be pursuing an asset substitution strategy. The impact of deposit growth is difficult to explain. Whilst deposit growth is unimportant for low NPL banks we find that the substitution effect is significant although much smaller quantitatively than for the higher NPL banks. This is confirmation that the substitution effect for high NPL banks is a riskmanagement strategy. These low NPL banks do respond to capital growth indicating that this is how they control risk.

Eastern European Countries The threshold for the Eastern European sample is 4.3% of the NPL rate and the effective capital ratio is 9.2%. This is typical for such dynamic economies. The results are:

Dependent Variable: LGR (t) Coefficient Std. Error Coefficient Std. Error Variable NPL Rate >= 4.3% NPL rate < 4.3% Constant 13.4676** 6.8930 -31.0899* 18.3848 DGR(t) 0.1012 0.1179 -0.1454 0.1630 OEAGR(t) -0.3474*** 0.0277 -0.1172* 0.0715

CGR(t) 0.1033*** 0.0256 0.1483** 0.0736 NPLGR(t-1) 0.0595 0.0996 0.4909* 0.2553 Dm -8.3046 7.0490 39.7979** 18.3526 Dm*NPLGR(t-1) -0.0799 0.1003 -0.4761* 0.2553 Table 8 Regression Results for the Sample of Eastern European Countries For this group of countries we find that, for high NPL banks, there is a significant substitution effect and capital growth is an important determinant of credit growth. For low NPL banks then, in addition, we observe a positive impact of NPL growth although capital ratios are important here and for banks with high capital ratio they will lend more and respond negatively to NPL growth. We might therefore conclude that, in this region, well-managed banks behave responsibly in the face of increasing risk while those with high NPLs or relatively low capital ratios are less willing to engage in proper risk management.

4.

Conclusion

Perhaps not surprisingly in such a heterogeneous group we have a variety of results. Firstly there is no substantial evidence for moral hazard behaviour on the part of banks, which we interpret to be a positive relationship between lagged NPL and loan growth. However there is evidence of risk-taking behaviour which is different across different groups and regions. Using the US as our benchmark we find the clearest evidence for risk management. Banks with relatively high NPLs adjust their lending to both lagged NPLs (negatively) and capital (positively). Those with low NPLs do not take the latter risk factors into account except that they respond to higher capital ratios with a willingness to lend more. For Japan and the South East Asian Countries, affected by banking crises in the past, we observe some similar behaviour. In both cases the substitution effect and capital growth is important for lending growth. For high NPL banks in Japan we find that they also respond to increasing NPL growth by reducing lending, but only when their capital ratios are relatively high. This is suggestive of more risk-taking by banks with relatively low capital ratios. For the South East Asia group there is no evidence of capital ratios of NPL growth having such effects. In the case of France we find that the substitution effect is the main significant variable with capital growth being important for banks with low NPLs. This is consistent with our observation for Japan. Finally for the Central and east European group we identify that for high NPL banks

they engage in substitution and take into consideration cpiatl while the low NPL banks behave in a way which is consistent with good risk management principles.

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Erlend Nier

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and Ursel Baumanna

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Intermediation

Volume 15, Issue 3, July 2006, Pages 332-361