CHAPTER 3: RESEARCH METHODOLOGY

3.0 Introduction

This section will first look at determinants of NPLs using a combination of static and dynamic
models. This study will first analyze determinants of NPLs in local and foreign banks separately
before analyzing the sector in aggregate. The researcher will then analyze the linkage between
banking sector and real economy using panel vector autogression regression (PVAR). PVAR
analysis will include five endogenous variables which will include NPLs, real GDP growth,
unemployment rate, inflation and credit-to-GDP. Panel VAR model will be used to allow for
endogeneity in study variables (Love et al., 2013). This study will investigate the strength of
macro-financial linkages using a panel of banks over nine-year period.

3.1 Model Specification

This study will perform seven regressions estimation techniques pooled or ordinary least squares
(OLS), fixed effects (FE), random effects (RE), difference generalized methods of moments
(DIFFGMM) and system GMM (SYSTGMM). OLS, GLS, FE and RE models are static models
which only shows a snapshot at a particular point in time. In Contrary, DIFFGMM and
SYSTGMM are dynamic models which capture the evolution of NPLs over time. Diagnostic
checks done in this study chose RE as the most appropriate static model, while in the dynamic
case, the SYSTGMM was found to be the most appropriate one. Other models were used for
robustness checks

3.1.1 Static and Dynamic Model

This study will adopt dynamic model used by Klein (2013) with minor modifications on the
equation. Equation 1 is a static model and equation 2 is a dynamic model.

𝒚𝒊,𝒕 = 𝜶𝒊 + 𝜷𝑩𝒊,𝒕 + 𝜸𝑴𝒕 + 𝝓𝑮𝑵𝑼 + 𝜺𝒊,𝒕 (1)

𝒚𝒊,𝒕 = 𝜶𝒚𝒊,𝒕−𝟏 + 𝜷𝑩𝒊,𝒕 + 𝜸𝑴𝒕 + 𝝓𝑮𝑵𝑼 + 𝜺𝒊,𝒕 (2)

Where:
𝒚𝒊,𝒕 is the non-performing loans ratio for bank I at time t.

𝒚𝒊,𝒕−𝟏 is the lagged dependent variable.

𝑩𝒊,𝒕 are bank-level variables.

𝑴𝒕 are macroeconomics variables.

𝑮𝑵𝑼 is a political dummy variable.

Inputs into 𝑩𝒊,𝒕 and 𝑴𝒕 are presented in Table 2.

3.2 Justification of explanatory variables

Table 1: Explanatory variables

Variable Proxy Definition Expected Source Data

Sign Frequency
NPL Non- Nonperforming Bank Annual
performing loans/ Gross loans statements
loans
RGDP Real GDP [(Current year real Negative Global Annual
growth rate GDP/Previous year Finance
real GDP)-1]
INFR Annual Annual inflation Positive Worldbank Annual
inflation rate rates as given in database
worldbank
database
CAR Capital [(Tier 1 capital + ? Bank Annual
Adequacy Ratio Tier 2 capital)/ statements
Risk weighted
Assets]
UR Unemployment Unemployment Positive Worldbank Annual
Rate rate as given in database
 worldbank
database.
IR Interest rates Average lending Positive Monetary Annual
rates policy
statements
LTD Loan-to-deposit Total loans/ Total Positive Bank Annual
Ratio deposits statement
ETA Equity to assets Total equity/Total Bank Annual
assets statement
LGR Loan growth [(Current year Positive Bank Annual
rate gross statement
loans/Previous year
gross loans)-1]
ROA Return on Net income/total Negative Bank Annual
assets assets statement
LTA Loan-to-assets Total loans/Total Positive Bank Annual
Ratio assets statement
GNU Government of Negative Annual
national unity

3.3 Diagnostic and Model Specification Test

The study will perform correlation analysis through the construction of correlation matrix.
Variables showing correlation coefficients above 0.8 will be dropped from the analysis. Several
panel unit root test tests will be conducted. Three panel unit root tests namely Harris-Tzavalis, Im-
Pesaran-Shin and Fisher-type will be conducted to determine whether research data was stationary
or not. Hausman test will be performed to select the best model between random effect and fixed
effect models. The test will be performed under the following hypotheses:
H0: Random effect model is appropriate
Ha: Fixed effect model is appropriate.
If Hausman test favors random effect model, the researcher will proceed to perform Bruesch &
Pegan LM test for random effects to see whether best model has been selected. Bruesch and Pagan
LM Test will be performed under the following hypothesis:
H0: Pooled regression model is appropriate.
Ha: Random effect model is appropriate.
3.4 Panel Vector Autoregression

The researcher will estimate an unrestricted VAR and uncover impulse responses. The model is
adopted from Love et al. (2006) and is specified as follows:

𝒚𝒊𝒕 = µ𝒊 + 𝜽(𝑳)𝒚𝒊𝒕 + ԑ𝒊𝒕 (3)

Where

𝒚𝒊𝒕 is a lag operator.

𝜽(𝑳) is a vector of bank-level and macroeconomic variables.

Love et al. (2013) opined that panel autoregression model accounts for individual bank
specificity in the level of variables by incorporating fixed effects (µ𝒊 ). This imply isolation of
response of the bank credit channel to macroeconomic shocks but at the same time allowing for
unobserved bank heterogeneity.

The study will employ Cholesky decomposition in order to determine orthogonal shock in
variables of interest as well as examining their effects on other variables while holding other
shocks constant. Impulse response functions will be used to analyze response of study variables
to orthogonal shocks.

3.5 Data Type

Secondary data will be used in the analysis. Data will be generated from bank financial
statements and monetary policy statements.

3.6 Estimation procedure

The study will first present multicollinearity and panel unit root tests respectively. The researcher
will move on to performing descriptive statistics followed by regression analysis. Lastly the
researcher will conduct PVAR analysis.

Summary of main areas to be looked at:

• Pairwise correlation analysis

• Panel Unit root test
• Johansen Cointegration test
• Static and dynamic models
• Breusch-Pagan LM Test
• Hausman Test
• Robustness-GMM
• PVAR (Advantages compared to traditional VAR-Authors that used similar technique)
• Panel VAR dynamics assessment by variance decomposition-Klein pg 20)
• Variance decomposition
• Data decomposition
• Lag selection test