Academic journal article Journal of Business Economics and Management

The Overheating of Five EU New Member States and Cyclicality of Systemic Risk in the Banking Sector

Academic journal article Journal of Business Economics and Management

The Overheating of Five EU New Member States and Cyclicality of Systemic Risk in the Banking Sector

Article excerpt

1. Introduction

In response to a global financial crisis in the 1980s and 1990s, national and international institutions began monitoring the soundness of the financial system carefully. As a result, the bulk of financial stability indicators have been greatly extended (Mottinen et al. 2005): regulatory capital vs risk-weighted assets, interest margins and non-interest expenses vs gross income, a return on assets and a return on equity, spread between the highest and lowest inter-bank rates, liquid assets to short-term liability ratios, liquid assets to total assets as well as the cost-income ratio. As well, credit relative to GDP, the net open position in foreign currency to capital, the geographical distribution of loans to total loans, the share of non-performing loans to total loans as well as foreign-currency-denominated loans to total loans are usually used as indicators of financial stability and balance-sheet quality. When observing the study of Schinasi (2005) and Kool (2006), common exposure to macroeconomic risk factors across banks is a source of systemic risk that influences the quality of a loan portfolio, which can be expressed as the non-performing loan to total gross loan (NPL) ratio.

An increasing ratio may be a signal of deterioration in banking sector results. According to theory, we would expect that the non-performing loans to total loans ratio is assumed to be procyclical within the economic cycle.

In Bulgaria and Romania the banks recorded a decline in their non-performing loans ratio, while in the Baltic States they recorded the lowest share of non-performing loans among New EU Member States. The outlook for the banking sector results possibly reflects a favourable assessment of their economic growth. The increasing indebtedness of the private sector could become a cause for concern if the macroeconomic environment develops less favourably.

We analyzed the relationships between the non-performing loan ratio and macroeconomic/banking sector variables as a source of systemic risk in order to assess the banking sector's vulnerability to bad loan performance on a macroeconomic level. In the second chapter the literature overview and the theoretical background of empirical analysis are presented. In the third chapter, we have summarized the characteristics of the macroeconomic environment and the banking sector in the Baltic States, Bulgaria and Romania. In the fourth chapter, the methodology, the empirical analysis and the results are explained. The implications of the empirical analysis are revisited in the conclusion.

2. The literature overview

The empirical findings presented in the literature (in the text below) are an important source of the hypothesis when it comes to the responsiveness of the NPL ratio on macro/banking factors.

Quagliariello (2003) presented a regression between the evolution of NPL ratio as the dependent variable and a set of explanatory variables: real GDP growth rate, the growth of real gross fixed investment and consumption, changes in the unemployment rate, the consumer price index (CPI), the real exchange rate and the M2 growth rate. Baboucek and Jancar (2005) investigated economic developments by unemployment, GDP growth, export, import, appreciation, CPI and credit growth as the indicators of the NPL ratio performance. Hoggarth et al. (2005) investigated the link between loan write-offs and output gap, retail prices, real estate prices, the nominal short-term interest rate and the real exchange rate. Fofack (2005) investigated the NPL ratio performance via macro economic variables and banking variables like return on asset, return on equity, equity as a share of total asset, deposit to asset ratio, deposit to liability ratio, net interest margin and net income. De Nicolo et al. (2003) employed credit to asset ratio, deposit to loan ratio, credit to liability ratio and net foreign asset to net asset ratio as the set of explanatory variables for the evolution of NPL ratio. …

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