Impact of Bank Profitability on Default Risk: Empirical Evidence from Pakistan
Risk Management
Keywords:
Bank profitability; Default risk; Bank-specific determinants; Stability; Banking sector; Pakistan.
Abstract
This empirical study investigates the effect of the bank-specific determinants of bank profitability on the default risk of the banks listed on the Stock Exchange of Pakistan. For this purpose, the study considers balanced panel data covering the period 2009-2018 for the 20 selected commercial banks of Pakistan, and the probability of default is used to measure the default risk of these banks. The bank profitability is measured using bank-specific determinants such as the net interest margin, non-interest income to total assets, return on assets, return on equity, and spread ratios. The empirical findings of the fixed effects model reported that net interest margin, non-interest income, and spread ratio are the significant determinants of default risk. The findings highlight that the bank profitability determinants can act as early warning signs of a bank’s deteriorating stability level. The study recommended that the central bank of Pakistan should guide the commercial banks to disclose the probability of default values in their financial reports. The study also suggested that the risk management department of a bank should consider these bank-specific determinants of profitability to manage default risk.
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References
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Ahn, S. C., & Moon, H. R. (2001). Large-N and Large-T Properties of Panel Data Estimators and the Hausman Test. USC CLEO Research Paper No. C01-20.
Albertazzi, U., & Gambacorta, L. (2009). Bank profitability and the business cycle. Journal of Financial Stability, 5(4), 393-409.
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Ali, M., & Puah, C. H. (2019). The internal determinants of bank profitability and stability. Management Research Review.
Altman, E. (1968). Financial ratios, Discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609.
Arena, M. (2008). Bank failures and bank fundamentals: A comparative analysis of Latin America and East Asia during the nineties using bank-level data. Journal of Banking & Finance, 32(2), 299-310.
Asteriou, D., & Hall, S. (2011). Applied Econometrics (Second ed.). Basingstoke: Palgrave Macmillan.
Athanasoglou, P. P., Brissimis, S.N., & Delis, M. D. (2008). Bank-specific, industry-specific and macroeconomic determinants of bank profitability. Journal of International Financial Markets, Institutions and Money, 18(2), 121-136.
Beaver, W. (1966). Financial Ratios As Predictors of Failure. Journal of Accounting Research, 4, 71-111. doi: DOI: 10.2307/2490171.
Berger, A. N. (1995), The profit-structure relationship in banking–tests of market-power and efficient structure hypotheses. Journal of Money, Credit and Banking, 27(2), 404-431.
Betz, F., Oprică, S., Peltonen, T. A., & Sarlin, P. (2014). Predicting distress in European banks. Journal of Banking & Finance, 45, 225-241.
Bharath, S., & Shumway, T. (2008). Forcasting Default with the Merton Distance to Default Model. The Review of Financial Studies, 21(3), 1339-1369.
Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), 637-653.
Calmès, C., & Liu, Y. (2009). Financial structure change and banking income: A Canada–US comparison. Journal of International Financial Markets, Institutions and Money, 19(1), 128-139.
Calmès, C., & Théoret, R. (2010). The impact of off-balance-sheet activities on banks returns: An application of the ARCH-M to Canadian data. Journal of Banking & Finance, 34(7), 1719-1728.
Castro, V. (2013). Macroeconomic determinants of the credit risk in the banking system: The case of the GIPSI. Economic Modelling, 31, 672-683.
Chaibi, H., & Ftiti, Z. (2015). Credit risk determinants: Evidence from a cross-country study. Research in International Business and Finance, 33, 1–16. https://doi.org/10.1016/j.ribaf.2014.06.001
Cleary, S., & Hebb, G. (2016). An efficient and functional model for predicting bank distress: In and out of sample evidence. Journal of Banking and Finance, 64, 101–111.
Coccorese, P., & Santucci, L. (2019). The role of downward assets volatility in assessing the book value distance to default. Journal of Financial Economic Policy.
Cole, R. A., & White, L. J. (2012). Déjà vu all over again: The causes of US commercial bank failures this time around. Journal of Financial Services Research, 42, 5-29.
Curak, M., Poposki, K., & Pepur, S. (2012). Profitability determinants of the Macedonian banking sector in changing environment, Procedia - Social and Behavioral Sciences, 44, 406-416.
Dar, A., & Qadir, S. (2019). Distance to default and probability of default: an experimental study. Journal of Global Entrepreneurship Research, 9. doi:https://doi.org/10.1186/s40497-019-0154-6
Dietrich, A., & Wanzenried, G. (2014). The determinants of commercial banking profitability in low, middle, and high-income countries. The Quarterly Review of Economics and Finance, 54(3), 337-354
Drechsler, I., Savov, A., & Schnabl, P. (2017). The deposits channel of monetary policy. The Quarterly Journal of Economics, 132(4), 1819-1876.
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Flamini, V., McDonald, C., & Schumacher, L. (2009). The determinants of commercial bank profitability in sub-Saharan Africa. Working Paper No. WP/09/15, IMF, Washington, DC.
Freixas, X., & Rochet, J. C. (2008). Microeconomics of banking. MIT press.
Funso, K., Kolade, A., & Ojo, O. (2012). Credit risk and commercial banks’ performance in Nigeria: A panel model approach. Australian Journal of Business and Management Research, 2(2), 31–38.
Gujarati, D. (2004). Basic Econometrics. McGraw-Hill companies.
Harada, K., Ito, T., & Takahashi, S. (2010., Is distance to default a good measure in predicting Bank failures?. National Bureau of Economic research.
Keeley, M. C. (1990). Deposit insurance, risk, and market power in banking. The American Economic Review, 80, 1183-1200.
Lin, C. C., & Yang, S. L. (2016). Bank fundamentals, economic conditions, and bank failures in East Asian countries. Economic Modelling, 52, 960-966.
Louzis, D. P., Vouldis, A. T., & Metaxas, V. L. (2012). Macroeconomic and bank-specific determinants of non-performing loans in Greece: A comparative study of mortgage, business and consumer loan portfolios. Journal of Banking & Finance, 36(4), 1012-1027.
Männasoo, K., & Mayes, D. G. (2009). Explaining bank distress in Eastern European transition economies. Journal of Banking & Finance, 33(2), 244-253.
Martynova, N., Ratnovski, L., & Vlahu, R. (2015). Bank Profitability and Risk-Taking. International Monetary Fund, IMF. Working Paper No. WP/15/249.
Merton, R. (1974). On the pricing of corporate debt: a risk structure of interest rates. Journal of Finance, 29(2), 449-470.
Merton, R. (1977). An Analytic Derivation of the cost of Deposit Insurance and loan Guarantees; An application of modern option pricing theory. Journal of Banking and Finance, 1, 3-11.
Muvingi, J., Mazuruse, P., Nkomo, D., & Mapungwana, P. (2015). Default Prediction Models a Comparison between Market Based Models and Accounting Based: Case of the Zimbabwe Stock Exchange 2010-2013. Journal of Finance and Investment Analysis, 4, 39-65.
Nielsen, L. T. (1992). Understanding N(d1) and N(d2): Risk-Adjusted Probabilities in the Black-Scholes Model. Finance, 14, 95-106.
Ohlson, J. (1980). Financial Ratios and the Probabilistic Prediction of Bankruptcy. Journal of Accounting Research, 18(1), 109-131. doi:10.2307/2490395.
Pasiouras, F. & Kosmidou, K. (2007). Factors influencing the profitability of domestic and foreign commercial banks in the European Union. Research in International Business and Finance, 21(2), 222-237.
Podpiera, J., & Weill, L. (2008). Bad Luck or Bad Management? Emerging Banking Market Experience. Journal of Financial Stability, 4(2), 135–148.
Rashid, A., & Abbas, Q. (2011). Predicting Bankruptcy in Pakistan. Theoretical & Applied Economics, 18(9).
Schenck, N. A. (2014). Distance-to-default measures and determinants for systemically important financial institutions. Journal of Financial Regulation and Compliance, 22(2), 159–172.
Short, B.K. (1979). The relation between commercial bank profit rates and banking concentration in Canada, Western Europe, and Japan. Journal of Banking & Finance, 3(3), 209-219.
Shumway, T. (2001). Forecasting Bankruptcy More Accurately: A Simple Hazard Model. The Journal of Business, 74(1), 101-124. doi:DOI: 10.1086/209665.
Studenmund, A., & Johnson, B. (2016). Using econometrics : a practical guide (S. Edition) Boston: Pearson.
Waqas, H., & Md-Rus, R. (2019). Predicting financial distress: Importance of accounting and firm. Cogent Economics and Finance. doi:10.1080/23322039.2018.1545739.
Wheelock, D. C., & Wilson, P. W. (2000). Why do banks disappear? The determinants of US bank failures and acquisitions. Review of Economics and Statistics, 82(1), 127-138.
Wooldridge, J. (2012). Introductory Econometrics. 5191 Natorp Boulevard: South-Western.
Xu, M. T., Hu, K., & Das, M. U. S. (2019). Bank profitability and financial stability. International Monetary Fund, IMF. Working Paper No. 19/5.
Ahn, S. C., & Moon, H. R. (2001). Large-N and Large-T Properties of Panel Data Estimators and the Hausman Test. USC CLEO Research Paper No. C01-20.
Albertazzi, U., & Gambacorta, L. (2009). Bank profitability and the business cycle. Journal of Financial Stability, 5(4), 393-409.
Ali, M. (2015). Bank profitability and its determinants in Pakistan: a panel data analysis after financial crisis. MPRA paper number 67987.
Ali, M., & Puah, C. H. (2019). The internal determinants of bank profitability and stability. Management Research Review.
Altman, E. (1968). Financial ratios, Discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609.
Arena, M. (2008). Bank failures and bank fundamentals: A comparative analysis of Latin America and East Asia during the nineties using bank-level data. Journal of Banking & Finance, 32(2), 299-310.
Asteriou, D., & Hall, S. (2011). Applied Econometrics (Second ed.). Basingstoke: Palgrave Macmillan.
Athanasoglou, P. P., Brissimis, S.N., & Delis, M. D. (2008). Bank-specific, industry-specific and macroeconomic determinants of bank profitability. Journal of International Financial Markets, Institutions and Money, 18(2), 121-136.
Beaver, W. (1966). Financial Ratios As Predictors of Failure. Journal of Accounting Research, 4, 71-111. doi: DOI: 10.2307/2490171.
Berger, A. N. (1995), The profit-structure relationship in banking–tests of market-power and efficient structure hypotheses. Journal of Money, Credit and Banking, 27(2), 404-431.
Betz, F., Oprică, S., Peltonen, T. A., & Sarlin, P. (2014). Predicting distress in European banks. Journal of Banking & Finance, 45, 225-241.
Bharath, S., & Shumway, T. (2008). Forcasting Default with the Merton Distance to Default Model. The Review of Financial Studies, 21(3), 1339-1369.
Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), 637-653.
Calmès, C., & Liu, Y. (2009). Financial structure change and banking income: A Canada–US comparison. Journal of International Financial Markets, Institutions and Money, 19(1), 128-139.
Calmès, C., & Théoret, R. (2010). The impact of off-balance-sheet activities on banks returns: An application of the ARCH-M to Canadian data. Journal of Banking & Finance, 34(7), 1719-1728.
Castro, V. (2013). Macroeconomic determinants of the credit risk in the banking system: The case of the GIPSI. Economic Modelling, 31, 672-683.
Chaibi, H., & Ftiti, Z. (2015). Credit risk determinants: Evidence from a cross-country study. Research in International Business and Finance, 33, 1–16. https://doi.org/10.1016/j.ribaf.2014.06.001
Cleary, S., & Hebb, G. (2016). An efficient and functional model for predicting bank distress: In and out of sample evidence. Journal of Banking and Finance, 64, 101–111.
Coccorese, P., & Santucci, L. (2019). The role of downward assets volatility in assessing the book value distance to default. Journal of Financial Economic Policy.
Cole, R. A., & White, L. J. (2012). Déjà vu all over again: The causes of US commercial bank failures this time around. Journal of Financial Services Research, 42, 5-29.
Curak, M., Poposki, K., & Pepur, S. (2012). Profitability determinants of the Macedonian banking sector in changing environment, Procedia - Social and Behavioral Sciences, 44, 406-416.
Dar, A., & Qadir, S. (2019). Distance to default and probability of default: an experimental study. Journal of Global Entrepreneurship Research, 9. doi:https://doi.org/10.1186/s40497-019-0154-6
Dietrich, A., & Wanzenried, G. (2014). The determinants of commercial banking profitability in low, middle, and high-income countries. The Quarterly Review of Economics and Finance, 54(3), 337-354
Drechsler, I., Savov, A., & Schnabl, P. (2017). The deposits channel of monetary policy. The Quarterly Journal of Economics, 132(4), 1819-1876.
Engle, R. F., Moshirian, F., Sahgal, S., & Zhang, B. (2014). Banks non-interest income and global financial stability. CIFR Paper (015).
Festić, M., Kavkler, A., & Repina, S. (2011). The macroeconomic sources of systemic risk in the banking sectors of five new EU member states. Journal of Banking & Finance, 35(2), 310-322.
Flamini, V., McDonald, C., & Schumacher, L. (2009). The determinants of commercial bank profitability in sub-Saharan Africa. Working Paper No. WP/09/15, IMF, Washington, DC.
Freixas, X., & Rochet, J. C. (2008). Microeconomics of banking. MIT press.
Funso, K., Kolade, A., & Ojo, O. (2012). Credit risk and commercial banks’ performance in Nigeria: A panel model approach. Australian Journal of Business and Management Research, 2(2), 31–38.
Gujarati, D. (2004). Basic Econometrics. McGraw-Hill companies.
Harada, K., Ito, T., & Takahashi, S. (2010., Is distance to default a good measure in predicting Bank failures?. National Bureau of Economic research.
Keeley, M. C. (1990). Deposit insurance, risk, and market power in banking. The American Economic Review, 80, 1183-1200.
Lin, C. C., & Yang, S. L. (2016). Bank fundamentals, economic conditions, and bank failures in East Asian countries. Economic Modelling, 52, 960-966.
Louzis, D. P., Vouldis, A. T., & Metaxas, V. L. (2012). Macroeconomic and bank-specific determinants of non-performing loans in Greece: A comparative study of mortgage, business and consumer loan portfolios. Journal of Banking & Finance, 36(4), 1012-1027.
Männasoo, K., & Mayes, D. G. (2009). Explaining bank distress in Eastern European transition economies. Journal of Banking & Finance, 33(2), 244-253.
Martynova, N., Ratnovski, L., & Vlahu, R. (2015). Bank Profitability and Risk-Taking. International Monetary Fund, IMF. Working Paper No. WP/15/249.
Merton, R. (1974). On the pricing of corporate debt: a risk structure of interest rates. Journal of Finance, 29(2), 449-470.
Merton, R. (1977). An Analytic Derivation of the cost of Deposit Insurance and loan Guarantees; An application of modern option pricing theory. Journal of Banking and Finance, 1, 3-11.
Muvingi, J., Mazuruse, P., Nkomo, D., & Mapungwana, P. (2015). Default Prediction Models a Comparison between Market Based Models and Accounting Based: Case of the Zimbabwe Stock Exchange 2010-2013. Journal of Finance and Investment Analysis, 4, 39-65.
Nielsen, L. T. (1992). Understanding N(d1) and N(d2): Risk-Adjusted Probabilities in the Black-Scholes Model. Finance, 14, 95-106.
Ohlson, J. (1980). Financial Ratios and the Probabilistic Prediction of Bankruptcy. Journal of Accounting Research, 18(1), 109-131. doi:10.2307/2490395.
Pasiouras, F. & Kosmidou, K. (2007). Factors influencing the profitability of domestic and foreign commercial banks in the European Union. Research in International Business and Finance, 21(2), 222-237.
Podpiera, J., & Weill, L. (2008). Bad Luck or Bad Management? Emerging Banking Market Experience. Journal of Financial Stability, 4(2), 135–148.
Rashid, A., & Abbas, Q. (2011). Predicting Bankruptcy in Pakistan. Theoretical & Applied Economics, 18(9).
Schenck, N. A. (2014). Distance-to-default measures and determinants for systemically important financial institutions. Journal of Financial Regulation and Compliance, 22(2), 159–172.
Short, B.K. (1979). The relation between commercial bank profit rates and banking concentration in Canada, Western Europe, and Japan. Journal of Banking & Finance, 3(3), 209-219.
Shumway, T. (2001). Forecasting Bankruptcy More Accurately: A Simple Hazard Model. The Journal of Business, 74(1), 101-124. doi:DOI: 10.1086/209665.
Studenmund, A., & Johnson, B. (2016). Using econometrics : a practical guide (S. Edition) Boston: Pearson.
Waqas, H., & Md-Rus, R. (2019). Predicting financial distress: Importance of accounting and firm. Cogent Economics and Finance. doi:10.1080/23322039.2018.1545739.
Wheelock, D. C., & Wilson, P. W. (2000). Why do banks disappear? The determinants of US bank failures and acquisitions. Review of Economics and Statistics, 82(1), 127-138.
Wooldridge, J. (2012). Introductory Econometrics. 5191 Natorp Boulevard: South-Western.
Xu, M. T., Hu, K., & Das, M. U. S. (2019). Bank profitability and financial stability. International Monetary Fund, IMF. Working Paper No. 19/5.
Published
2021-08-27
How to Cite
Khalid, W., Khan, S., Zahra, A., & Shah, N. (2021). Impact of Bank Profitability on Default Risk: Empirical Evidence from Pakistan. Journal of Quantitative Methods, 5(2), 1-33. https://doi.org/10.29145/2021/jqm/52/01
Section
Articles
Copyright (c) 2021 Waqar Khalid, Saifullah Khan, Anum Zahra, Naveed Hussain Shah
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