Assessing Institutional and Economic Factors as Determinants of Non Performing Loans: Evidence from Pakistani Banks

Abstract

The aim of this research is to investigate the weaknesses of the banking sector in Pakistan by contributing to the understanding of banking sector fragility. Prior literature suggests that the banking sector fragility is the result of high levels of non-performing loans (NPLs) as well the lack of an efficient banking supervision. Thus, this study investigates why Pakistan falls in the high levels of NPLs countries by examining the banking sector of Pakistan with respect to NPLs and its determinants. To examine the determinants of NPLs, this study uses data at the individual bank level as well as country level. The study investigates NPL as driven by factors such as macroeconomic factors, microeconomic banks specific factors, country level institutional factors and company level institutional factors (corporate governance). The empirical analysis initially focus on the sensitivity of the NPLs to macroeconomic and country level institutional factors in Pakistan. Subsequently, the analysis is extended to micro economic and company level institutional factors (corporate governance). In order to account for time persistence in the structure of NPLs, a linear and dynamic panel approach is used. For this purpose four different estimation methods are used (Pooled OLS, fixed effect, random effect and GMM estimators). The empirical investigation suggests that strong performance in real economy results in a lower ratio of NPLs. Moreover, country level institutional factors suggest a negative and significant effect on NPLs with exception to rule of law. Furthermore, the results indicate that microeconomic factors need to be used as an early warning system regarding banking sector vulnerability. Company level institutional factors are also effective in reducing the NPLs. Specially, the board of directors, transparency, disclosure, and accountability are the main factors in reducing the level of NPLs in Pakistani banks. However, ownership and shareholding shows an insignificant relation because of the concentrated ownership or bulk shareholding by individuals. The study concludes that regulatory authorities should expand their regulatory framework to include both economic and institutional indicators in assessing the stability of the banking sector.