CHAPTER 4 - DATA AND METHODOLOGY
4.1. DATA
4.1.2. Explanatory Variables for EWS
4.1.2.2. Macroeconomic Variables
Sensitivity to market risk measures the preparedness of the bank against market risks such as changes in interest rates, exchange rates, commodity prices. Banks are institutions that are affected by market risks such as excessive price changes. Banks become vulnerable to crises with the deterioration in macroeconomic structure and excessive volatility in financial markets. Moreover, following Mayes and Stremmel (2012) and, Khokher and Alhabshi (2019), the sensitivity to market risk is measured by using the ratio of sensitive liabilities to total assets. If this ratio is low, the sensitivity to market risk increases causing the probability of banking crisis increases.
91 Table 9: Significant Indicators of Banking Crisis in the Literature42
Demirgüç-Kunt and Detragiache
(1998)
Glick and Hutchison (1999)
Kaminsky and Reinhart
(1999)
Hardy and Pazarbaşıoğlu
(1998)
Davis and Karim (2008)
Jing (2013)
Caggiano et al. (2013)
Qin and Luo (2014)
Hmili and Bouraoui (2015)
Kusuma and Asif (2016)
Wang et al.
(2021)
GDP Growth x x x x x x x x x x
change in terms of trade x x x x
real exchange rate x x x x x x x x x
real interest rate x x x x x x x x
inflation x x x x x x x x x
the ratio of central
government budget surplus to GDP
x x x x
ratio of M2 to foreign
exchange reserves x x x x x x x x x
ratio of domestic credit to
private sector to GDP x x x x x x x x
ratio of bank liquid reserves
to bank assets x x
real domestic credit growth x x x x
explicit deposit insurance x x x x
the quality of law
enforcement x
financial liberalization x
International reserves x
M1 x
M2 x
consumption x
Investment x
the ratio of deposit liabilities
to GDP x
the ratio of foreign liabilities to GDP
GDP per capita x x
the ratio of external debt to
GDP x
the ratio of short-term debt to
reserves x
Current Account Balance (%
GDP) x x
42 The table is produced by the author.
As one can see from Table 9, GDP growth, real interest rate, inflation rate, exchange rate, current account balance and money supply are frequently associated with the occurrence of the banking crisis and included as prospective macroeconomic explanatory variables in this study. Furthermore, we also include additional variables which we believe has the ability to explain Islamic banking crises. The macroeconomic variables that are considered as independent variables in the construction of EWS models are given in Table 10.
Table 10: Macroeconomic Variables Macroeconomic Variables
Capital Account Foreign Direct Investment (% of GDP) (FDI) Debt Profile Total Reserves (% of Total External Debt) (TotRes)
Current Account Real Effective Exchange Rate (reer), Current Account Balance (% of GDP) (CAB)
Other Financial The Ratio of M2 to International Reserves (M2toRes, M2 (%of GDP) (M2toGDP)
Real Sector Inflation Rate (inflation), GDP Growth (GDPGrwth), Real Interest Rate (rir)
The macroeconomic variables are categorized according to Kaminsky et al.’s (1998) classification. As it is examined in various studies in the literature, real GDP growth is a leading indicator of a banking crisis. The economic growth is associated with a solid and safe financial system by increasing the asset prices and credit quality (Drehmann et al., 2011; Kindleberger and Aliber, 2005). On the other hand, as Allen and Gale (2007) emphasize, declining growth in the real economy can cause financial sector difficulties where it can lead to declines in asset prices and cause the borrowers repayment difficulties of the loans. Therefore, the recession episodes experienced in the economy is shown as one of the most important indicators of banking crises.
As explained in detail in Chapter 3, although Islamic banks operate on the prohibition of interest principal, they are more sensitive to the interest rate risks. The interest rates are the main indicator of the interest rate risks. On this basis, increasing interest rates increases the credit rationing and leads to moral hazard and adverse selection bias which increase the probability of banking crisis by causing credit crunch and low economic
growth (Berardi, 2011; Obstfeld, 1996; Velasco, 1987). Furthermore, low ability of the banks to protect themselves from interest rate risk causes a more fragile banking system (Davis and Karim, 2008). Therefore, high interest rates is a leading indicator of banking crises.
The appreciation of exchange rate affects output growth adversely by decreasing the competitiveness of the economy and the revenues of the banks. High inflation rate, on the other hand, cause economic instability by increasing the interest rates which leads adverse effects on real and financial sector. Furthermore, high level of inflation erodes the value of banks assets, thus, causes distortion of credit distribution in the long run by increasing NPL. Current account balance reflects the external balance of the economy. Increasing rate of current account balance to GDP increases the external financing needs of the economy and creates pressure on the exchange rate. Moreover, budget deficits reduce the national savings and lead to high inflation and interest rates. Therefore, it is expected to be positively related with the banking crises incidence. Furthermore, the ratio of foreign direct investments to GDP is found as a statistically significant explanatory variable and increasing value of this ratio decreases the fragility of the banking sector by recovering the debt profile of the economy.
The ratio of M2 to international reserves measures the ability of the banking system against foreign exchange pressure. Significant reductions in international reserves are indicative of abnormal capital outflows. Furthermore, the decreasing ratio weakens the strength of national currency. Therefore, the variable is a significant indicator of the likelihood of banking crises. The ratio of M2 to GDP, on the other hand, reflects the financial depth of the economy and it is expected to negatively related with the crisis occurrence.
Table 11 below provides the summative information about the definitions and the data sources of each explanatory variable used in our EWS models.
94 Table 11: Data Definitions and Sources of Explanatory Variables
Variable Definition Data Source
Macroeconomic Variables
Capital Account Foreign direct investment (% of GDP)
Foreign direct investment is net inflows of investment to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor.
It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-long-term capital as shown in the balance of payments.
World Bank, WDI
Debt Profile Total Reserves (% of Total External Debt)
International reserves to total external debt stocks. World Bank, WDI
Current Account Real Effective Exchange Rate
Real effective exchange rate is the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs.
World Bank, WDI;
National Central Bank Sources
Current Account Balance (% of GDP)
Current account balance is the sum of net exports of goods and services, net primary income, and net secondary income.
World Bank, WDI
Other Financial Variables
The Ratio of M2 to International Reserves; M2 (%of GDP)
Broad money is the sum of currency outside banks; demand deposits other than those of the central government; the time, savings, and foreign currency deposits of resident sectors other than the central government; bank and traveler’s checks; and other securities such as certificates of deposit and commercial paper.
World Bank, WDI;
National Central Bank Sources
Real Sector Variables
Inflation Rate Inflation as measured by the consumer price index reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services that may be fixed or changed at specified intervals, such as yearly.
World Bank, WDI
GDP growth (annual %) Annual percentage growth rate of GDP at market prices based on constant local currency. Aggregates are based on constant 2010 U.S.
dollars. GDP is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products.
World Bank, WDI
Real Interest Rate Real interest rate is the lending interest rate adjusted for inflation as measured by the GDP deflator.
World Bank, WDI
95
Bank Specific Variables
Capital Adequacy Capital Adequacy Ratio The ratio of the total regulatory capital to risk weighted assets. The total regulatory capital includes all capital as defined by the regulator. This is the sum of Tier 1 and Tier 2 capital.
Bankscope
Asset Quality The ratio of Total Loans to Total Assets
Total loans include net loans+ reserves against possible losses on impaired or non-performing loans.
Total assets include total earning assets+ cash and due from banks+foreclosed real estate+fixed+assets+goodwill+other intangibles+current tax assets+defereed tax+discontinued operations+other assets
Bankscope
Management Quality The Ratio of Total Operating Revenues to Total Operating Expenses
Operating revenues includes income gained from operating activities such as rental income, income from investments and trading and derivatives. Total operating expenses include wages, salaries, social security costs, pension costs and other staff costs, expensing of staff stock options, depreciation, amortization, administrative expenses, occupancy costs, software costs, operating rentals, audit and professional fees and other operating expenses of an administrative nature.
Bankscope
Earnings Ability Return on Assets The ratio shows compares the efficiency and operational performance of banks as it looks at the returns generated from bank's assets.
Fitchconnect
Liquidity Level The Ratio of Total Liquid Assets to Total Assets
Liquid assets include cash and due from banks, central banks, other banks and other credit institutions+deposits+ treasury bills+ other bills+ government securities+ trading securities. Total assets include total earning assets+ cash and due from banks+foreclosed real estate+fixed assets+goodwill+other intangibles+current tax assets+defereed tax+discontinued operations+other assets
Bankscope
Sensitivity to Market Risk
The ratio of Securities to Total Assets
Securities include debt securities, equity securities and other securities. Total assets include total earning assets+ cash and due from banks+foreclosed real estate+fixed assets+goodwill+other intangibles+current tax assets+defereed tax+discontinued operations+other assets
Fitchconnect