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IJMF
7,3 Assessing probabilities of
financial distress of banks in UAE
Ehab Zaki
304 College of Business Administration, University of Dubai, Dubai,
United Arab Emirates
Received 23 November 2010 Rahim Bah
Accepted 23 January 2011
Grenoble Ecole de Management, Grenoble, Paris, France, and
Ananth Rao
College of Business Administration, University of Dubai, Dubai,
United Arab Emirates

Abstract
Purpose – Commercial and Islamic banks are important players in the UAE financial market.
However, little is known about their financial distress because these financial institutions usually
resolve financial distress within their own organisations, which means that outsiders cannot explicitly
observe distress. The purpose of the research is therefore to identify the main drivers of financial
institutions’ financial distress.
Design/methodology/approach – The paper estimates a probability distress prediction model
using the BankScope Database and the annual reports of UAE financial institutions submitted to UAE
Security Exchange Authority. The paper also analyses the impact of macroeconomic information for
forecasting financial institutions’ financial distress.
Findings – The fundamentals of financial institutions in terms of cost income ratio, equity to total
assets, total asset growth and ratio of loan loss reserve to gross loans (all these variables with a lag of
one year) positively impacted the probability of financial distress in the next year. Recent findings for
emerging economies have cast some doubt on the usefulness of macroeconomic information for
financial institutions’ risk assessment. Similar results are found for UAE financial institutions in
predicting the probability of financial distress.
Originality/value – This is the first study to provide empirical evidence on the drivers of financial
distress of commercial and Islamic banks in UAE during 2000-2008, and to examine the extent of the
financial distress that can be can be attributed to internal bank-specific fundamental factors and
external factors in the economy.
Keywords Financial institutions, Distress, Financial distress probability,
Panel binary response analysis, Financial risk, United Arab Emirates
Paper type Research paper

Ehab Zaki acknowledges Professor Rahim Bah and Professor Ananth Rao: the completion of this
International Journal of Managerial second research paper would not have been possible without the support of these supervisors.
Finance
Vol. 7 No. 3, 2011 Ehab Zaki would also like to thank Professor Bah for his support and valuable advice on the
pp. 304-320 topic’s methodology, and is indebted to Professor Rao whose help, stimulating suggestions and
q Emerald Group Publishing Limited
1743-9132
encouragement were a constant help during the writing of this research paper. Ehab Zaki would
DOI 10.1108/17439131111144487 also like to acknowledge the clarifying series of reviewers’ comments.
1. Introduction Probabilities
Financial distress refers to a period when a borrower (either individual or institutional) of financial
is unable to meet a payment obligation to lenders and other creditors. This distress
may be due to borrower specific factors like reputation, leverage, volatility of earnings, distress
collateral or may be due to market specific factors like the economic condition and level
of interest rates. So far, these factors were used by banks to explain the probability of
loan default of borrowers. More generally, it is recommended that “5 C’s”[1] of credit 305
should be included in such analysis and the decision makers may need to weight these
factors in a more objective or quantitative manner (Saunders and Cornett, 2008, p. 315),
rather than letting such factors enter into the decision process in a purely subjective
fashion. In this dissertation, we analyse the financial distress of banks by using the
5 C’s framework, and quantify these 5 C’s so that meaningful and consistent decisions
can be made regarding the creditworthiness of banks in UAE.
The period 2006-2008 in UAE[2] is considered one of the major financial distress
periods due to the recent global economic crisis. During this period borrowers had
difficulty in meeting their obligations, as a result lenders suffered losses. The
importance of this paper is derived from the fact that distress of financial institutions
in UAE has become the most serious issue facing the regulatory authorities and
stakeholders because of its potentially destabilising effect on the financial system
through contagion and because a healthy financial system is a pivotal point for
financial stability.
From a microeconomic perspective also, it is desirable to learn more about the
drivers of financial distress of banks in UAE. For example, the modern risk control
techniques that are permitted under the Revised Capital Framework of the Basel
Committee on Banking Supervision (Basel II) require that creditors be able to estimate
their debtors’ probabilities of distress. For private customers and non-financial firms,
there are many well-established methods for the estimation of probabilities of distress
and a sizeable body of evidence about the main risk drivers. However, there is almost
no empirical evidence for the extent of distress of financial institutions in UAE in
particular and Middle East in general.
The main contribution of this paper is therefore to present empirical evidence of
financial distress probabilities in UAE using the data set for 2000-2008 financial
statements and notes information from 12 commercial banks and four Islamic banks all
incorporated in UAE[3]. We estimate the probability of financial distress for these
commercial and Islamic banks in UAE using a distress prediction model that allows
the identification of the main risk drivers. The main questions posed in this paper are:
.
What were the drivers of financial distress of commercial and Islamic banks in
UAE during 2000-2008?
.
How much of this financial distress can be attributed to internal bank-specific
fundamental factors and how much can be attributed to external factors
(macroeconomic developments)?

These issues have growing importance, since deregulation and increased competition
seem to have tightened the link between the riskiness of financial institutions and
macroeconomic developments. In fact, the recent economic downturn, with numerous
insolvencies and the collapse of the stock market, have probably had a greater impact
IJMF on their resilience than ever before in the post-war period (see, for example,
7,3 International Monetary Fund, 2003, 2009, 2010a, b).
The paper is organised as follows. Section 2 briefly reviews the financial distress
literature and describes the conceptual framework of financial distress more precisely.
Section 3 discusses the methods used for estimation and states the set of hypotheses.
Section 4 discusses the results. Section 5 concludes the study findings with statement
306 of limitations and direction of future research.

2. Literature review and conceptual framework

Altman (1968) and Beaver (1968) were the first to use discriminant analysis to predict the
probability of default. They were followed by Sinkey (1975) and Martin (1977), who used
discriminant analysis to predict the probability of the default of bank borrowers. The
drawback of discriminant analysis is that the probability of default could fall outside the
0-1 range (Saunders and Cornett, 2008, p. 317). As an alternative, logit and probit
methods, which use maximum-likelihood methods, have been used more frequently
(Martin, 1977; Lennox, 1999). Logit and probit procedures are advantageous not only for
statistical reasons but also because they are non-linear and estimate the probability of
default (PDs) directly. More recently, Porath (2006) estimated the probabilities of default
for German savings banks and cooperative banks using logit, probit and clog log
specifications. Porath (2006) concluded that relevant factors for the estimation of a bank’s
probability of default comprised the general macroeconomic environment and the bank’s
return, credit risk, market risk, and – most importantly for determining the default risk
– the capitalisation. This study also concluded that savings banks and cooperative
banks are affected by the same risk drivers, but that savings banks are more
risk-sensitive, and that rating tools that rely solely on financial ratios may not be suitable
for capturing the risk level of a bank. At the same time, adding macroeconomic
information to the model greatly improves the forecasting performance.
Porath (2006) used a hazard technique for the distress data, which were available on
an annual basis. In our case since distress data are available only annually (after audit
by regulatory or supervisory authorities to assess the quality of financial institutions’
assets), we apply logit, probit and variants of these techniques to the annual data of
banks, which has a panel structure (i.e. both time series and cross-sectional data). For
panel data, hazard models are equivalent to panel binary response models, which are
also a regression method, but the variable Y is a binary random variable that takes on
only the value 0 (meaning that there was no financial distress in the financial
institution during the year t) and 1 (meaning that there was financial distress in the
financial institution in the year t). The econometric problem is to estimate the
conditional probability Y ¼ 1, i.e. the banks that are in financial distress as a function
of the explanatory variables.

3. Conceptual framework
The following is the conceptual framework:
X X
Y it ¼ FðS it Þ with S it ¼ b0 þ bj X it21 þ gjþ1 Z it21 þ 1it
j jþ1 ð1Þ
ði ¼ 1; . . . ; m andJ þ 1 ¼ 1; . . . ; nÞ;
where Yit gives the probability of distress (PD) of financial institution i at time t, Sit is Probabilities
the score that constitutes an order of the ith financial institution according to their
riskiness in time t, F is the link function that transforms the score into the PD, X it21
of financial
(m £ 1) is the vector of covariates (i.e. financial institution specific variables such as the distress
5 C’s), Z it21 (n £ 1) is the vector of covariates (i.e.,macroeconomic factors that are
constant for all i ), b and g ((1 £ m and 1 £ n) are vectors of coefficients, and 1it is an
error terms with various assumptions of distributions stated in equations (2)-(4). 307
The rationale for the one-year lag is that the information as to whether or not bank i
experiences financial distress in time t £ 1 becomes available only during the audit of
the bank in time t. For financially distressed banks i ¼ 1; . . . ; n in time t, Yit is a
sequence of 1 for that particular year t, and is a sequence of 0 for banks not
experiencing financial distress in year t. When it includes such a restriction, the binary
panel model is also called a “time-discrete hazard model” (Porath, 2004, 2006). Some
researchers use logit (for its closed functional form), while some researchers use probit
or its variant (for its open functional form). In what follows, we estimate the model with
the following specifications:
Logit:
exp S it
FðS it Þ ¼ : ð2Þ
1 þ exp S it
Probit:
pffiffiffiffiffiffi Z S it
FðS it Þ ¼ ð1= 2pÞ e 2 0:5x 2 dx: ð3Þ
21

Complementary log-logistic (clog log) link function:

S it ¼ ln½2lnð1 2 lit Þ
: ð4Þ
Equation (2) is the logit specification and is computationally simple. Equation (3) is the
probit specification and has the popularity of the normal distribution. Both equation (2)
and equation (3) are symmetric and give similar values, although the tails of the
logistic distribution are fatter than that of the normal distribution. Equation (4) is the
discrete-time version of the proportional Cox model and is asymmetric (for more
technical details, see Kalbfleisch and Prentice, 1980). All three specifications contain
similar information on the marginal effects of independent variables with probability
of financial distress. The criteria for choosing the best model are:
.
lowest log-likelihood ratio;
.
lowest Akaike information criterion (AIC);
.
lowest Bayesian information criterion (BIC); and
.
lowest Hannan Quinn information criterion (HQIC) (for more technical details of
these criteria, see SAS Institute, 2008).

4. Methodology and data

Economic theory suggests a rough guideline for specifying a financial distress model.
The usual procedure is to define categories of variables that are supposed to impact on
the future financial distress. Examples are the categories of 5 C’s, capital adequacy,
IJMF asset quality, management quality, earnings, liquidity, and sensitivity to market risk,
7,3 called (CAMELS), and Moody’s RiskCalc model, with the categories capital, asset
quality, concentration, liquidity, profitability, and growth (see Kocagil et al., 2002). In
this paper we use the categories of 5 C’s, i.e. capacity, capital, collateral and condition
(both internal and external to financial institution). Table I presents the categories with
the set of variables considered.
308 Thus all 5 C’s except the character (good management) of the financial institutions are
captured in the above set of variables. We argue that if the financial institution manages
all the four C’s stated above well, then implicitly the fifth C is also captured, since good
management implies good control of the financial institution. This rationale also reflects
the active management of financial institutions who are keen that their capacity, capital,
collateral and condition are quite safe. Specifically, variables under 1 to 3 in Table I
pertain to the first three C’s (i.e. capacity, capital and collateral), specific to financial
institutions. Variables under 4A relate to the fourth C, i.e. condition (vulnerability).
Variables under 4B relate to macroeconomic variables to explain the impact of real GDP
growth and the oil price on the financial institution’s financial distress (if any).
Following the practice of rating agencies (e.g. Falkenstein et al., 2000; Kocagil et al.,
2002), we calculate many variables for the empirical analysis. We choose the most
adequate variables based on the 5 C’s rating system used by regulators, mainly for on-site
examination or audit. Like Kocagil et al. (2002), we have accommodated growth through
total asset (TA) growth (total assets growth is change in assets in between current and
past year divided by total asset of past year, i.e. [ðTAt 2 TAt21 Þ=TAt21 ]. Additionally,
concentration and asset quality are subsumed into credit risk and there is a separate
category for market risk (which covers equity price risk through PE and MB). These
market risk variables are readily available publicly for all financial institutions over the
study period and they are well known in the academic and professional community.

4.1 Hypotheses
4.1.1 Net cash flow (NCF). Net cash flow depicts the general health of a financial
institution. This is computed as sum of the net cash flow from operations, the net cash

5 C’s Examples Variable code

1. Capacity
1A. Cash flow (CF) Net cash flow (CF from operations þ CF from NCF
financing þ CF from investing) (NCF)
1B. Profitability Cost income ratio CIR
1C. Liquidity Current assets/current liability CR
2. Capital (wealth) Equity capital to total assets ETA
3. Collateral (security) Total asset growth TAG
4A. Condition (financial institution – vulnerability)
4A1. Credit risk Non-performing loans to total loans LLRGL
4A2. Market risk Price to earnings (PE) ratio PE
Table I.
Market value to book value (MB) ratio MB
Variables characterising
the financial distress of 4B. Condition (economy)
UAE financial 4B1. Business cycle indicators Real GDP rate (per cent) RGD
institutions 4B.2 Macroeconomic prices Oil price ($/barrel) OIL
flow from investments and financing. In a way NCF (without explicit opening and closing Probabilities
cash balances) represents the free cash available to the financial institution after of financial
accounting for uses (i.e. capital expenditure and financing activities). This NCF is critical
because the new owners typically want to use free cash flow as funds available for retiring distress
outstanding debts. NCF also represents total cash available to the financial institution for
distribution to owners and creditors after funding all worthwhile investment activities. A
positive NCF over time suggests the financial institution is healthy and can substitute 309
debt component in its financial structure through its NCF, and thus reduce leverage. To
that extent the financial institution will not experience financial distress. Thus, we
hypothesise a negative relationship between NCF and financial distress.
4.1.2 Cost income ratio (CIR). CIR is computed as a ratio of costs to total revenue.
Costs include overheads (i.e. general þ administrative expenses). Total revenue
includes net interest revenue plus other operating income. CIR is an indirect measure of
profitability of financial institution. Cost includes interest costs, overhead, general and
administrative costs. A declining CIR over time signifies the prudent management of
the financial institution through cost minimisation, ensuring efficient operations. To
that extent, profitability improves and financial distress declines. Thus, we
hypothesise a positive relationship between CIR and financial distress.
4.1.3 Liquidity (current ratio; CR). Current ratio is measured as a ratio of current
assets to current liabilities. It measures the liquidity status of the financial institution.
With a higher current ratio over time, the financial institution will be able to meet its
current obligations and experience less financial distress. Hence, a negative
relationship is hypothesised between CR and financial distress.
4.1.4 Capital (wealth; ETA). We expect that a rising equity ratio will, ceteris paribus,
lead to a lower PD on the average of all financial institutions, because higher equity
represents lower debt in the capital structure of the firm, with the resultant lower
financial risk. However, there are some exceptions, the most important being variables
that are affected by volatility, which indicate increased riskiness. The growth of the
equity ratio, for example, typically manifests a negative monotone relationship to PD
for low and moderate ETA values. However, due to volatility, very high ETA values
may be associated with growing PDs. Hence, we hypothesise that the relationship
between ETA and financial distress is mixed (i.e. both þ and 2 ) depending on the
magnitude of volatility of ETA.
4.1.5 Collateral (security represented by total asset growth; TAG). TAG is a growth
measure reflecting the notion that a growing firm over time acquires more assets.
Assets of UAE banks comprise more personal and real estate loans relative to
investments. Thus, growth in these loans results in growth in default risks. Thus
banks with higher TAG are more disposed to financial stress. Rapid growth can put
considerable strain on a bank’s resources, and unless management is aware of this
effect and takes active steps to control it, rapid growth can lead to financial distress
and eventually bankruptcy. On the other side of the spectrum, banks that fail to
appreciate the financial implications of slow growth, they will become potential
candidates for takeover by more perceptive raiders. Thus banks should be able to
sustain growth (g ¼ b*ROE, where g is the sustainable growth rate, b is the retention
rate or 1 2 dividend payout, and ROE is a return on equity; Higgins, 2001).
Hence, we hypothesise a positive relationship between TAG and the probability of
financial distress. For example, Emirates NBD, a major UAE bank, experienced a loan
IJMF impairment of 10 per cent during 2008-2009; its non-performing loan ratio is expected
to rise 4.5 per cent despite an increase in asset base over the years. Similarly, another
7,3 major bank (NBAD) saw its loan provision jumped to 12 per cent. This trend is also
quite common in other UAE banks.
4.1.6 Condition (vulnerability/credit risk, non-performing loans to gross loans;
LLRGL). Non-performing loans are those loan amounts that are overdue (including
310 interest). Such debts are considered by financial institution as bad, and a loan loss
reserve is created to charge off such bad debts. Higher loan loss reserves relative to
total loans signify that the loan quality of the financial institution is weak, and hence
more provisions are made for charging off bad debts. The higher the provisions that
are made in the books of financial institutions, the higher the probability of financial
distress, as higher provisions reflect declines in the quality of assets. Hence we
hypothesise a positive relation between the higher loan loss reserve ratio and the
probability of financial distress.
4.1.7 Market risk (price to earnings ratio; PE). A financial institution’s PE ratio
depends principally on two things:
(1) its future earnings prospects; and
(2) the risk associated with those earnings.
In a constant dividend growth model PE ratio is determined by P i =E 1 ¼
½ðD1 =E 1 Þ=ðk 2 gÞ
where D1 is the expected dividend payment to stockholders in the
next year, E1 is the expected earnings in the next year, k is the required rate of return to
stock holders and g is the growth rate of the financial institution. The spread between
k 2 g is the main determinant of the size of the PE ratio. This spread reflects the
riskiness of the financial institution: if the risk is high, k is higher relative to g, the
k 2 g spread is high and the PE ratio falls. Similarly, the numerator (D1/E1) reflects the
dividend payout ratio. The PE ratio rises with improved earnings prospects and higher
dividend payout ratio, and it falls with decreased earnings prospects and increased
earnings, risks signalling financial distress. Thus, we hypothesise a negative relation
between PE and the probability of financial distress.
The market risk (market-to-book value; MB) ratio (also known as the PB ratio)
depends on expected levels of future profitability, while the PE ratio depends on
expected changes in future profitability (Fairfield, 1994). PB is less variable than PEs.
The market value (MV) of the equity of a financial institution is subject to fluctuations
in the required market interest rates. The degree to which the book value (BV) of a
financial institution’s capital deviates from its true economic MV depends on a number
of factors, especially:
.
interest rate volatility (the higher the interest rate volatility, the higher the
discrepancy); and
.
examination and enforcement from financial institution regulators (the more
frequent the on-site and off-site audit examinations and the stiffer the
regulator/examiner standards regarding loan charge-offs of problem loans, the
smaller the discrepancy).
Rising interest rates reduce the MV of banks’ long-term fixed income securities and
loans while floating-rate instruments, if instantaneously re-priced, find their MV
largely unaffected. On the other hand, BVs of assets are acquired at historical costs and
are not affected by interest rates. In the BV accounting world, when all assets and Probabilities
liabilities reflect their original cost of purchase, the rise in interest rate has no affect on of financial
the value of assets, liability or the BV of equity. In other words, BV of equity ¼ par
value þ retained earnings þ loan loss reserves. distress
With regard to the second factor, the ratio MV/BV (or simply MB ratio, also known
as the PB ratio, i.e. the price-to-book ratio) becomes important for a financial institution
to answer the concerns of investors and stock owners of the financial institution and 311
the soundness of the financial institution as perceived by the regulators. The MB ratio
shows the discrepancy between the MV of a bank’s equity capital as perceived by
investors in the capital market and the BV of capital on its balance sheet. The lower
this ratio, the more the BV of capital overstates the true equity of banks as perceived
by investors in the capital market.
The MB ratio is also a function of future profitability relative to book value and
growth in book value, while the PE ratio is a function of future profitability relative to
the current level of earnings. Financial institutions with a high MB and high PE ratio
are the highest performing (high-growth) companies. Thus, if financial institutions are
facing serious difficulties as their existing investments are not expected to earn a
return in excess of the cost of capital, then profitability is expected to decline from
current levels. In such a scenario, we hypothesise a negative relation between MB and
the probability of financial distress.
On the other hand, financial institutions with a high MB and low PE are expected to
report positive residual profits but falling earnings. These financial institutions are still
having positive NPV investments, but are in a state of decline. These are financial
institutions that are not improving their operations, and hence are candidates for
financial distress. In such scenarios, we hypothesise a positive relation between MB
and the probability of financial distress.
4.1.8 Condition (economy; business cycle indicators – i.e real GDP rate – and
macroeconomic prices – i.e. oil price, $/barrel). It is intuitive that if the economy is
growing, real GDP growth rate increases, and financial distress declines due to positive
business sentiments. Similarly, if the oil price increases, liquidity increases for oil
exporting countries and positively impacts business sentiments. In the UAE, the oil
price is a key macro variable that impacts the sentiments since UAE is one of the OPEC
countries. Thus, we hypothesise a negative relationship between these increasing
trends of macro variables and probability of financial distress. The last column in
Table II summarises the hypothesised relationship between the set of variables and the
probability of financial distress. As discussed in the Methodology section, to be
consistent with expectation framework, all independent variables are lagged
1 2 period. These sets of variables have been used in earlier studies (e.g. Porath, 2006).

4.2 Preliminary descriptive statistics on status of financial distress in UAE banks

Due to a lack of long time series, rating systems (e.g. Falkenstein et al., 2000; Kocagil
et al., 2002; Lane et al., 1986), often incorporate annual changes of ratios. Following this
practice of rating agencies, we compute percentage changes in annual equity[4], annual
return on average equity (ROAE)[5] and annual net interest margin (NIM)[6] for each
year from 2000 to 2008 for UAE banks. We take the median (instead of mean) values of
these variables for the UAE banks (Table III) for each year since the data was skewed,
as can be seen from Figures 1-3. UAE banks experienced largest decline in their NIM
 institutions
UAE financial
the financial distress of
Variables characterising
Table II.

312

7,3
IJMF
Variable Hypothesised relation with the probability of
5 C’s Examples code financial distress

4. Capacity
1A. Cash Flow (CF) Net cash flow (CF from operations þ CF from NCF 2
financing þ CF from investing) (NCF)
1B. Profitability Cost income ratio CIR þ
1C. Liquidity Current assets/Current liability CR 2
5. Capital (wealth) Equity capital to total assets ETA þ/2 (Explained under 4.1.4 below)
6. Collateral (security) Total asset growth TAG þ
4A. Condition (financial institution –
vulnerability)
4A1. Credit risk Non-performing loans to total loans LLRGL þ
4A2. Market risk Price-to-earnings (PE) ratio PE 2
Market value to book value (MB) ratio MB 2/þ (explained under 4.1.7 last paragraph
below)
4B. Condition (economy)
4B1. Business cycle indicators Real GDP rate (per cent) RGD 2
4B.2 Macroeconomic prices Oil price ($/barrel) OIL 2
and ROAE in the year 2006 compared to 2007 and 2008, which were the years when Probabilities
UAE Central Bank and the UAE government intervened in the market by supporting of financial
the distressed banks, which experienced declining profitability and declining equity.
Column 2 in Table III and Figure 1 show that the median equity change of UAE distress
banks was 9.54 per cent in 2000 and 171.14 per cent in 2005 due to an increase in oil
prices during the period. As oil prices started to decline, the equity change also
declined to a peak of 56.569 per cent in 2006. An excessive negative change signifies 313
financial distress. The median equity change during 2000-2008 was 65.66 per cent.
Column 3 of Table III and Figure 2 show that the median ROAE change in UAE was
erratic during 2000-2008 with a median ROAE change of 103.48 per cent. The
maximum decline was 39.86 per cent in 2006.
Similarly, column 4 of Table III and Figure 3 show that the median NIM change of
UAE banks was erratic during 2000-2008, ranging from 2 24.838 per cent in 2006 to
22.544 per cent in 2005. The median equity change during 2000-2008 was 1.11 per cent.
Therefore, we categorised those UAE banks as experiencing financial distress
(Y ¼ 1) in a year if their annual equity change was less than or equal to 65.66 per cent,
the change in NIM was less than or equal to 1.11 per cent and the change in ROAE was
less than or equal to 130.48 per cent. We develop these categorisation criteria of
financial distress from a supervisory and audit perspective. The purpose of prudential
supervision is to prevent financial distress and insolvencies, so the definition covers all

Median equity change Median ROAE change Median NIM change

Year (per cent) (per cent) (per cent)

2000 9.54 5.5689 3.4453

2001 14.304 2 0.0828 24.896
2002 12.137 2 9.189 24.896
2003 64.392 2 25.876 22.655 Table III.
2004 65.998 210.16 21.606 Status of the financial
2005 171.14 87.046 22.544 distress of UAE banks as
2006 56.569 2 39.86 224.838 measured by annual
2007 161.59 972.8 14.899 changes in ROAE, NIM
2008 35.252 2 26.2 215.254 and equity during
Median 2000-2008 65.66 130.48 1.11 2000-2008

Figure 1.
Median equity change
(per cent)
IJMF
7,3

314
Figure 2.
Median ROAE change
(per cent)

events indicating that the banks is in danger of ceasing to exist as a going-concern

without outside intervention. Based on these categorisation criteria, Table IV shows
the financial institutions in UAE that were identified as those experiencing financial
distress during 2001 to 2008.
The data set for the explanatory variables combines financial information about
individual financial institution with market information and macroeconomic data for
UAE[7]. To add the financial distress information to the data set, a dummy variable Yit
is created that takes a value of 1 if distress is experienced by the financial institution
during the year t based on the above definition, and 0 otherwise. This categorisation is
consistent with binary response model stated above.

Figure 3.
Median NIM change (per
cent)

Year Commercial financial institution Islamic financial institution Total financial institution

2001 7 4 11
2002 7 3 10
2003 7 3 10
2004 8 1 9
Table IV. 2005 5 – 5
Number of financial 2006 8 3 11
institutions in financial 2007 3 1 4
distress in UAE 2008 5 1 6
The total number of financial institutions experiencing financial distress is too small to Probabilities
develop two separate models, i.e. one for commercial banks and the second for Islamic of financial
banks. It is to be noted that commercial financial institutions and Islamic financial
institutions are similar in their regional focus and organisation, but differ only from the distress
perspective of the Islamic values of doing business. Recently, many commercial
financial institutions have also resorted to Islamic principles through offering Islamic
financial products in their portfolio. 315
4.3 Results and discussion
Tables V and VI present the marginal effects of each of the independent variable in the
model specifications on the probability of financial distress. The results are organized
into two panels (A and B) for ease of discussion of the models without and with
macroeconomic variables. The probit specification has the lowest log-likelihood ratio,
the lowest Akaike information criterion (AIC), the lowest Bayesian information

Models
Logit Probit Clog log

Panel A: Fixed effects

NCFLAG 0.0004 0.0004 0.0004
CIRLAG 0.0233 * * * 0.0231 * * * 0.0245
CRXLAG 2 0.2797 2 0.2746 2 0.252
ETALAG 0.0515 * * * 0.0505 * * * 0.0514
TAGLAG 0.0108 * * * 0.0104 * * * 0.01
LLRGLLAG 0.0749 * * * 0.0718 * * * 0.0728
PELAG 2 0.0061 * 2 0.006 * 2 0.0063
MBLAG 0.0722 * * * 0.0712 * * 0.0764
RGDPGLAG – – –
OILLAG – – –
LOGLIKELHOOD 2 68.87 2 68.62 2 68.71
AIC 1.4511 1.4472 1.4486
BIC (Fixed) 1.9859 1.9819 1.9834
HQIC 1.6684 1.6644 1.6659

Panel B: Fixed effects (with macro effect)

NCFLAG 0.0004 0.0004 0.0004
CIRLAG 0.0194 * 0.0194 * * 0.0218
CRXLAG 2 0.2408 2 0.2349 2 0.2016
ETALAG 0.0449 * * * 0.0441 * * * 0.0446
TAGLAG 0.0134 * * * 0.0129 * * * 0.0128
LLRGLLAG 0.057 * * 0.0555 * * 0.0546
PELAG 2 0.0047 2 0.0047 2 0.0054
MBLAG 0.0688 * * 0.0681 0.0734
RGDPGLAG 2 0.0175 2 0.0165 2 0.0149
OILLAG 2 0.0048 2 0.0047 2 0.0049
LOGLIKELHOOD 2 68.00 2 67.74 2 67.75
AIC 1.4688 1.4647 1.4648
BIC (Fixed) 2.0481 2.044 2.044
HQIC 1.7042 1.7000 1.700 Table V.
Results of fixed effects of
Notes: *Significant at 6-10 per cent; * *significant at 5 per cent; * * *significant at 1 per cent binary choice models
IJMF
Models
7,3 Logit Probit Clog log

Panel A: Random effect

NCFLAG 0.0001 0.00003 0.00005
CIRLAG 2 0.0003 2 0.0003 2 0.00033
316 CRXLAG 2 0.2829 2 0.06149 2 0.10705
ETALAG 0.01 0.00221 0.00348
TAGLAG 0.0022 0.00046 0.00057
LLRGLLAG 0.0244 0.00538 0.00723
PELAG 0.001 0.00025 0.00045
MBLAG 0.0057 0.00117 0.00146
RGDPGLAG – – –
OILLAG 2 79.21 2 283.06 2 100.06
LOGLIKELHOOD – 2 76.89 2 88.66
AIC 1.3783 4.548 1.6885
BIC 1.5788 0.3412 0.3412
SIC – 4.7263 1.8667
HQIC 1.4598 0.222 0.222
Hosmer-Lemeshow x 2 (NS) 12.54 7.34 –
Correct classification percentage: distress 65.15 65.15 59.09
Correct classification percentage: non-distress 51.61 51.61 51.61

Panel B: Random effects (with macro effect)

NCFLAG 0.0004 0.00006 0.0001
CIRLAG 2 0.0002 2 0.0001 2 0.00007
CRXLAG 2 0.0878 2 0.04922 2 0.0709
ETALAG 0.0091 0.00518 0.0062
TAGLAG 0.0039 0.00204 0.002
LLRGLLAG 0.0183 0.00962 0.0088
PELAG 0.0014 0.00081 0.0011
MBLAG 0.0129 0.00721 0.0078
RGDPGLAG 2 0.0193 2 0.01041 2 0.0124
OILLAG 2 0.0031 2 0.00171 2 0.0022
LOGLIKELHOOD 2 76.89 2 88.66 2 88.66
AIC 1.3734 4.54 1.6848
BIC 1.6185 0.41697 0.4169
SIC – 4.77 1.9076
HQIC 1.4729 0.2715 0.2715
Hosmer-Lemeshow x 2 (NS) 10.45 9.53 –
Correct classification percentage: distress 0.697 0.6969 68.18
Table VI. Correct classification percentage: non-distress 0.5645 0.5484 59.68
Results of random effects
of binary choice models Notes: *Significant at 6-10 per cent; * *significant at 5 per cent; * * *significant at 1 per cent

criteron (BIC), and the lowest Hannan Quinn information criterion (HQIC), which are all
desirable in estimating the probability of financial distress. Hence we restrict our
discussion to the probit model specification.
4.3.1 Discussion of fixed effect model results. The results in panel A of Table V
indicate that of the 5 C’s (discussed in Table III), the first C, i.e. capacity, as measured
by the cost to income ratio variable (CIR), was positive and statistically significant.
 Consistent with our hypothesis, a 1 per cent increase in CIR of financial institutions Probabilities
in time t is expected to increase the probability of financial distress by 0.02 per cent in of financial
time t þ 1.
As regards the second C, capital, as measured by equity to total assets (ETA), a distress
higher ETA of financial institutions in time t should lead to a reduction in the
probability of financial distress in time t þ 1. However, the results show a positive and
significant relation between the ETA and the probability of financial distress. While 317
this may at first glance seem counter-intuitive, the results are plausible (as explained in
section 3.1.4) because the volatility of the ETA increased from 5.4 per cent in 2003 to
10.34 per cent in 2006, reflecting the uncertainty in capital adequacy of the banks
during the study period. This is one of the reasons for the promoted intervention of the
UAE regulatory authority to infuse capital to support ailing banks.
As regards the third C, i.e. collateral, as measured by total asset growth (TAG),
variable increased assets also lead to increased loan default, as explained earlier.
Consistent with the hypothesis, a growing financial institution that is experiences
higher growth in total in time t requires more cash in time t þ 1 to sustain growth even
when it is profitable. Institutions can meet this need for some time by increasing
leverage, but eventually they will reach their debt capacity, thus increasing their
leverage risk, and hence the probability of financial distress is expected to increase.
The statistically significant result indicates that a 1 per cent growth in total assets of
the financial institution in the last year resulted in a 0.0104 per cent increase in the
probability of financial distress of financial institution in the current year. The
implication from this result is that, rapidly growing, marginally profitable financial
institutions show cash deficits in their operations, probably leading to an increased
probability of financial distress. While slowly expanding, profitable financial
institutions imply cash surpluses and probably do not experience financial distress.
As regards the fourth C, i.e. condition, as measured by the credit risk variable, as
hypothesised the marginal impact on the probability of financial distress was highest
and statistically significant. A 1 per cent increase in the loan loss reserve to gross loan
in the last year resulted in a 0.0708 per cent increase in the probability of financial
distress for the financial institution in the current year. This result implies that a
higher perceived credit risk in the previous year at a financial institution will result in
an increased probability of financial distress in the current year.
In panel B of Table V, two macro economic variables – i.e. real GDP growth rate
and oil prices ($/barrel) – are added to the set of variables discussed above to examine
the second research issue of whether macro economic variables impacted financial
distress of the financial institution. The test statistics AIC, BIC and HQIC increased
marginally when macro economic variables were added to the model. While the
marginal effects of real GDP growth rate and oil prices on the probability of financial
distress were negative as hypothesised, they were not statistically significant. Hence
we conclude that macro economic variables did not influence the probability of
financial distress of the financial institutions in UAE. It is basically the fundamentals
of the financial institution that triggered financial distress in UAE financial
institutions, as explained by the five C variables. Because there are no open-market
operations in UAE, unlike other well developed economies, the equity market is in its
nascent stages of growth, the bond market is yet to catch on, and competition is very
IJMF intense since UAE is over-banked, and hence banks are struggling to maintain
7,3 profitability through the management of bank fundamentals.
All the other variables (in Table V) had the right signs on their marginal effect
coefficients but were statistically less significant.

4.4 Random effect model results

318 The results and test statistics in panel A and B in Table V reveal that a random effects
model[8] was not a good specification to analyse the research issue of the financial
distress of a financial institution.
With the selection criteria, viz. AIC, BIC, HQIC test statistics increased, the majority
of the variables had signs opposite to those hypothesised and none of the marginal
effects were statistically significant. Therefore, we conclude that the fixed effects
model described the probability of the financial distress of financial institutions in
UAE during 2000-2008 well. These results are also consistent with other research
findings such as Nuxoll (2003), who demonstrated that macroeconomic information
does not improve the forecasts of bank defaults.

5. Conclusions
This paper presents an evaluation of the fundamentals underlying the analysis of the
financial distress of UAE financial institutions during 2000-2008 as a sequel to the
global financial crisis. The paper also attempts to identify the factors that drive the
probability of financial distress. The data set comprised 16 financial institutions in
UAE (no foreign financial institution were considered to avoid any complexities), of
which 12 were commercial banks and four were Islamic banks. We used panel discrete
choice models. The probit panel model was found to be the best model based on
log-likelihood ratio, AIC, BIC and HQIC criteria.
We conclude that the relevant factors for the estimation of a financial institution’s
probability of financial distress are the following:
.
capacity, expressed as the cost to income ratio (CIR);
.
capital, expressed as equity to total assets (ETA);
.
collateral, expressed as total asset growth; and
.
condition (internal), expressed as the credit risk (represented by the
non-performing loan to total loan ratio; LLRGL) all with one period lag.

We also conclude that macroeconomic information did not significantly impact the
probability of financial distress of financial institution in UAE. These findings are
consistent with similar studies done on German banks by Nuxoll (2003).

5.1 Limitations and future direction of research

The analysis focused exclusively on the UAE, which is a relatively small economy in
the MENA region. Relevant data for other financial institutions in the MENA region
were not available; their availability would have made the analysis more
region-specific. This is the first limitation. Future research could evaluate the
financial distress of banks by including data on the loan default experience of banks in
addition to the three criteria used in this paper for comparing the robustness of
probability distress studied in this paper.
Notes Probabilities
1. These 5 C’s are: character (good citizen in case of individual borrowers and corporate of financial
governance in case of institutional borrowers), capacity (cash flow), collateral (security in
case of individual and quality of assets in case of institutions), capital (wealth in case of distress
individuals and capital adequacy in case of institutions), and condition (economic, especially
downside vulnerability).
2. This working paper exclusively focuses on an analysis of UAE financial institutions. 319
Although initially we proposed a comparative analysis of UAE with European Union
financial institutions, we later found that the size of the UAE economy is quite a small
fraction of the size of the EU, which could be a potential future research area on its own.
3. No foreign banks are included in the study to avoid any spillover effect from foreign
operations.
4. Percentage change in annual equity ¼ ½ðequityt *equityt21 Þ=equityt
*100.
5. Percentage change in return on average annual equity (ROAE) ¼ [(ROAEt 2 ROAEt2 1)/
ROAEt]*100.
6. Percentage change in net interest margin ðNIMÞ ¼ ½ðNIMt 2 NIMt21 Þ=NIMt
*100.
7. Due to the confidential nature of these banks, individual financial institution names are
suppressed through the use of codes.
8. Random effect models (REM) allow the possibility that parameter coefficients may vary
systematically or randomly by introducing interaction terms between independent
variables. In this case, each of the coefficient terms will have a time subscript (bit), which
implies that for each bank observation, all the coefficients may change. The purpose of this
alternative specification is to make the regression function flexible enough to accommodate
the true data generation process. For more technical details, see Judge et al. (1988, pp. 437-9).

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Corresponding author
Ananth Rao can be contacted at: arao@ud.ac.ae

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