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Summary of Research Article

Credit quality, bank provisioning and systematic risk


in banking business

Sameer Tariq

Introduction: This research is related to the identification of the effect of loss loan
provisioning and other credit-risk exposure variables on the banks cost of capital. The three
main reasons for this research are; the influence of social and economic environment coupled
with managerial strategies on earnings and exposure to risk, difference in the cost of capitals
across countries due to difference in economic cycle, international competition and various
industrial arrangements, and the new EU reporting regulations and their implication as regard
to the pricing of risks and the allocation of funds across the banking sector.
Literature Review: Some of the important studies in this regard are mostly related to the US
banks while considering the single hypothesis either income smoothing, capital management
or signaling.
Income Smoothing Hypothesis: The study by Greenawalt and Sinkey (1988), Ma (1988),
Wahlen (1994) in US banks found that the bank managers increase LLPs to reduce reported
earnings and vice versa. Bhat (1996) found that banks who use LLPs are typical of small,
badly capitalized, and with poor financial conditions. Kanagaretnam (2004) finds that the
banks managers use LLPs to save income for the future. While for non-US banks the study
by Norden and Stoian (2013) gives supporting evidence to income smoothing hypothesis.
Capital management hypothesis: The study by Moyer (1990) and Kim and Kross (1998) are
the major contributions in this regard. Where Moyer (1990) states that managers tend to
increase LLPs to raise the capital ratio to prevent it from falling from 5.5% while after Basel I
LLPs were no longer used. Kim and Kross (1998) states that bank with low capital ratios
used LLPs prior to Basel I whereas in the later years it was non-existent.
Income Smoothing and Capital Management Hypothesis: Collins (1995) find supporting
evidence of income smoothing hypothesis while no relationship between LLPs and capital
ratios. While using a small sample size by Beatty (1995) and Ahmed (1999) find no
supporting evidence of income smoothing while found that banks use LLPs for capital
management. The studies in non-US banks in Australia, EU, Spain and Middle Eastern
countries including Islamic Banks also show significant results of income smoothing while
no result for use of LLPs for capital management.
Signaling Hypothesis: Increase the LLPs to indicate the financial strength or market value of
the banks. It could contain good or bad news. Bad news if increasing LLPs signals high
default risk and good news if it shows the willingness of the managers to deal with
problematic and performing loans. Beaver (1989) and Wahlen (1994)shows that banks which
shows high LLPs have higher market to book values supporting the idea of signaling
financial strength of the bank. Elliot (1991) used announcements of increased LLPs which
was assessed positively by the investors except for the Bank of Boston which was interpreted
negatively due to the fact that it would decrease capital adequacy ratio. Liu and Rayan (1995)
differentiated their loans on small and infrequently renegotiated loans and large and
frequently negotiated loans. The LLPs for later are assessed positively and for former ones
are assessed negatively.
Determinants of Beta: A variety of factors such as different time spans, frequency of
observations and proxies for market portfolio can lead to significant differences in betas.
Different studies argue about whether to use fundamental beta or the historical beta. The
rationale behind using the fundamental beta is to use fundamental data to capture systematic
risk. The fundamental beta differ in sensitivity to macro-economic conditions. As systematic

risk is related to corporate factors including payout ratios, financial leverage and earnings
yield volatility. One feasible way of determining banks betas against an average sectorial
beta and investigating which risk factors differentiate each bank from sectorial average. So,
the sectorial betas capture the macroeconomic and systematic variables impact over riskiness
of the sector.
Hypothesis: This study aims at investigating the betas against the quality of loans portfolio
with the provisioning behavior, riskiness of loans and the impact of performances.
1) Betas are responsive to risk exposure and risk-coverage policies rather than current
performances. Loan loss provisions have a significant impact on systematic risk.
2) The relation between banks betas and sectorial betas weakens during crisis periods as
the impact of banks fundamentals is expected to increase and widely affect volatility.
3) In crisis times, capital adequacy turns to assume a significant role in driving betas due
to increasing concerns as of bank soundness.
Methodology:
Sample:
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59 major European Banks covering 10 countries


Selection based on total assets criteria; 10 billion in total assets
Collected consolidated balance sheet (Bankscope Database)
Betas for each bank are collected from Bloomberg database for calculation of
sectorial betas

Model:

Discussion and Implications: There is a positive relation between betas and RWATA (Ratio
of risk weighted assets on total assets). It implies that the incentive to optimize risk exposure
in order to economize in cost of capital. And it might hinder an incentive for banks managers
to dampen the magnitude of risk on total assets should the bank have future growth
opportunities to exploit.
The significant impact of LLPGL (Ratio of loan impairment charges on gross loans) on betas
turns to be positive in a crisis environment in an underestimation of losses during benign
conditions which would lead to overcharge provisioning in bad times. The banks would lack
flexibility when growth opportunities would arise in this condition.
Loan loss provisioning proves to be significant in determining betas and, therefore, the cost
of capital. And indirectly in support of income smoothing. Our results goes in favor of
reducing the cyclicality of capital requirements through a system of dynamic provisioning
such that experienced in Spain.
Finally, our results casts significant concerns as regards different forbearance behaviors and
heterogeneous definitions of non-performing exposure across countries. The major concerns
here arise with regard to forbearance practices potentially leading to delay loss recognition

and masking asset quality deterioration and the consistency of asset quality assessment across
countries.
Conclusions: Our test was to indicate the determinants of banks systematic risk and to what
extent betas respond to fundamentals. Apart from being affected by the fundamental betas,
the bank betas are affected by the credit risk exposure. The magnitude of LLPs plays
significant role in explaining systematic risk. And there is no evidence found as to relation of
banks soundness with betas. The implications of this study are; efforts of supervisors to
strengthen bank resilience and bank recapitalization and harmonization of regulatory
framework of forbearance practices and non-performing loans definitions.