HARARE INSTITUTE OF TECHNOLOGY

SCHOOL OF BUSINESS AND SCIENCE MANAGEMENT

DEPARTMENT OF FINANCIAL ENGINERRING

FORECASTING BANK LOAN DEFAULT LOSS AND BANK FAILURE, FOR

COMMERCIAL BANKS IN ZIMBABWE,
(2009-2013).
BY
EPHRAIM TAWANDA CHIKWAWA (H1110405F).
SUPERVISED
BY
MR CHIWANZA.

COURSE: HIT 400

THIS RESEARCH WAS SUBMITTED TO HARARE INSTITUTE OF TECHNOLOGY IN

PARTIAL FULFILMENT OF THE BACHELOR OF TECHNOLOGY (HONOURS) DEGREE
IN FINANCIAL ENGINEERING

YEAR: 2015

1
 TITLE PAGE

Title of project : Forecasting Loan Default Loss and Bank Failure

for Commercial Banks in Zimbabwe,
(2009-2013)

Author : Chikwawa Ephraim . Tawanda

University Name : Harare Institute of Technology

School Name : School of Business and Management Sciences

Department Name : Department of Financial Engineering

Year : 2015

2
 Abstract

The collapse and failure of a bank could have devastating consequences to the entire banking
system and widespread repercussion effect on other banks and the economy as a whole. The main
objective of this paper is to forecast loan default loss and to determine how bank failure in
Zimbabwe can be predicted far ahead of its occurrence using a survival analysis approach.
Considering the influence of loan default loss on survival of a banking institution, due to increase
of non- performing loans as it pose threat of bank crisis, failure to manage the loan losses well.
The paper identifies the financial distress symptoms that can lead to a bank failure by employing
the Cox Proportional Hazards Model using financial covariates as well as employing Fractional
Response Regression Model on identifying factors that affect loan default loss from financial
statements of banks. Panel data covering a period from 2009 to 2013 were analyzed. The study
shows that survival of banks in Zimbabwe is mostly influenced by 8 predictor variables that bank
regulators could watch out for, to forestall bank distress. The study shows that, banks that are
facing challenges of liquidity, capital inadequacy, concentration of assets, growth and making
losses due to high operating costs and loan default losses have higher tendency of failing. The
study therefore recommends that the regulator needs to build a capacity of creating models to
detect bank failure and ensure that the banks returns are well analyzed as they are sent to them to
detect signs of distress early before the banks went down. Bankers should diversify very well their
investments in- order to generate huge returns, so as to maintain solvency and stability into the
banking industry as well as retaining confidence to the public.

Key words: Loan Default loss, Bank Failure,

3
 Declaration.

I Chikwawa Ephraim. Tawanda do here declare that this dissertation represents independent work
that has been generated as a result of original research. The investigation of forecasting loan default
loss and bank failure for commercial banks in Zimbabwe (2009-2013), should accredited to me. I
further confirm that:

1. This work was done in partial fulfillment of the requirements of B.Tech Honours Degree in
Financial Engineering at the Harare Institute of Technology.

2. Where knowledge of other authors were consulted, this is always clearly attributed, and their
work have mate criteria required to be published.

3. No part of this work has been and will be presented to another university for the attainment of
another academic qualification.

Student Signature: …………………………………………………

[CHIKWAWA EPHRAIM. TAWANDA: H1110405F]

Supervisor Signature: …………………………………………………

[MR. CHIWANZA]

Date: May 2015

4
 Copyright.

Permission is hereby granted to Harare Institute of Technology Library to produce copies of this
thesis. The publication rights have been reserved for all the other parties such that no part of this
dissertation may be reproduced, stored in any retrieval system, transmitted in any form by any
means (electronic, mechanical, photocopying or recording) or be consumed without the prior
consent of the author.

5
 Dedication

To my loving family, my grandmother Jennipher and my sisters Ellen and Loice.

6
 Acknowledgements

My utmost and profound gratitude is directed to the Almighty God for the successful completion
of this project. To be appreciated also are the Harare Institute of Technology administration staff,
librarians, teaching and supporting staff for the assistance they accorded me in putting together
this project into meaningful academic document. Special thanks go to my supervisor Mr. Chiwanza
for his untiring dedication and assistance that I was guided through all the aspects of drafting this
project to its completion. The quality of this work would have been very low without his continued
support and monitoring. Words will not suffice to express my uttermost gratitude to my parents
for unending faith in me. I wish to thank my dear friends for their help in making this research a
success and for instilling values in me.

7
Table of Contents

Abstract ........................................................................................................................................... 3
Declaration. ..................................................................................................................................... 4
Copyright. ....................................................................................................................................... 5
Dedication ....................................................................................................................................... 6
Acknowledgements ......................................................................................................................... 7
CHAPTER 1 ................................................................................................................................. 12
1.1 Introduction ......................................................................................................................... 12
1.2 Background ......................................................................................................................... 13
1.2.1 Performance of the Banking Sector ............................................................................. 13
1.3 Statement of the Problem .................................................................................................... 18
1.4 Research Objectives. ........................................................................................................... 18
1.5 Research Questions. ............................................................................................................ 18
1.6 Research Hypothesis ........................................................................................................... 19
1.7 Significance of the Study. ................................................................................................... 19
1.8 Scope of the Research ......................................................................................................... 20
1.9 Assumptions of the Research .............................................................................................. 20
1.10 Limitation of the Study. .................................................................................................... 20
1.11 Delimitation of the Study .................................................................................................. 21
1.12 Organization of the Study ................................................................................................. 21
References ..................................................................................................................................... 21
CHAPTER 2 ................................................................................................................................. 23
LITERATURE REVIEW ............................................................................................................. 23
2.1 Introduction ......................................................................................................................... 23
2.2 Definition of Terms............................................................................................................. 23
2.3 Motivation and description of variables ............................................................................. 25
2.4 Theoretical Literature Review. ........................................................................................... 30
2.4.1 Economic Framework. ................................................................................................. 31
2.4.2 Causes of Defaults on Loans and Bank Failures. ........................................................ 31
2.4.3 Loan Default Loss ........................................................................................................ 33
2.4.4 Bank Failure. ................................................................................................................ 38
2.5 Empirical literature Review. ............................................................................................... 41
2.5.1 Loan default loss .......................................................................................................... 41
2.5.2 Bank failure .................................................................................................................. 43
2.6 Summary of Empirical Studies carried out on Bank Failure. ............................................. 47
2.7 Summary. ............................................................................................................................ 48
References ..................................................................................................................................... 48
CHAPTER 3 ................................................................................................................................. 50
METHODOLOGY ....................................................................................................................... 50
3.1 Introduction ......................................................................................................................... 50
3.2 Research Design.................................................................................................................. 50
3.2.1 Descriptive Research Design ....................................................................................... 50
3.3 Target Population ................................................................................................................ 51
3.4 Sample Population and Sampling Technique ..................................................................... 51
3.5 Sources of data. ................................................................................................................... 52

8
 3.5.1 Secondary Data ............................................................................................................ 52
3.6 Data Presentation ................................................................................................................ 52
3.6.1 Tables ........................................................................................................................... 52
3.6.2 Graphs .......................................................................................................................... 52
3.7 Soft wares Used. ................................................................................................................. 53
3.8 Research methodology ........................................................................................................ 53
3.8.1 Econometric Model specifications. .............................................................................. 53
3.8.2 Procedure for Analysis ................................................................................................. 53
3.9 Assumptions of the Loan default loss model (equation 4) ................................................. 56
3.10 Bank Failure Econometric Model ..................................................................................... 56
3.10.1 Procedure to follow .................................................................................................... 56
3.11 Assumptions of Model. ..................................................................................................... 57
3.12 Justification of the model. ................................................................................................. 57
3.13 Conclusion. ....................................................................................................................... 58
CHAPTER 4 ................................................................................................................................. 59
DATA PRESENTATION AND ANALYSIS .............................................................................. 59
4.1 Introduction ......................................................................................................................... 59
4.2 Model for forecasting Loan default Loss. ........................................................................... 59
4.2.1 Fractional Response Regression Model ....................................................................... 59
Table 4.1 Statistical tests for the assumptions of the model. ............................................... 59
4.2.2 The stepwise process of Fractional Response Regression. .......................................... 59
4.2.3 Analysis of forecasted loan default losses for Operational Banks and Failed Banks. . 60
4.3 Model for predicting bank failure. ...................................................................................... 62
4.3.1 Cox Proportional Hazard model .................................................................................. 62
4.3.2 Analysis for both Operational Banks and Failed Banks results ................................... 63
4.3.3 The stepwise process of Cox Proportional Hazard Model........................................... 65
4.3.4 Benchmarking the model ............................................................................................. 66
4.4 The relationship between Loan default loss and Bank Capital. .......................................... 69
What is the relationship between loan default loss and bank capital. ....................................... 69
4.4 The relationship between loan default losses and Bank (failure/ Survival time). .............. 70
4.5 Variables that determine Loan default loss and Bank failure. ............................................ 71
What are the variables that determine loan default loss and bank failure? ............................... 71
4.6 Summary ............................................................................................................................. 71
CHAPTER 5 ................................................................................................................................. 72
SUMMARY OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS ....................... 72
5.1 Introduction. ........................................................................................................................ 72
5.2 Summary of the Results. ..................................................................................................... 72
5.2.1 Forecasting Loan Default loss ..................................................................................... 72
5.2.2 Bank failure. ................................................................................................................. 73
5.3 Recommendations ............................................................................................................... 74
5.3.1 Future Researchers ....................................................................................................... 74
5.4 Recommendations ............................................................................................................... 75
5.4.1 Bankers and the Regulator. .......................................................................................... 75
5.5 Conclusion .......................................................................................................................... 76
5.6 Summary of Capstone Design ............................................................................................ 77
References ..................................................................................................................................... 78

9
List of tables: Table 3.1: Summary of Chosen Commercial Banks….................. 51

Table 4.1: Statistical tests for the assumptions of the model ……………. 59
Table 4.2: Forecasted loan default losses for Non- defaulted and defaulted banking
Institution…………………………………………………………… .60

Table 4.3: Coefficient for Fractional Response Regression Model………… .62

Table 4.4: Hazard Ratios from Cox Proportional Hazard Model……… .63

Table 4.5: Goodness of Fit for Cox Proportional Hazard Model………… .65

Table 4.6 Significant Variables from Backward Stepwise (Conditional)… .66

Table 4.7: Results of the Benchmarked Model of Cox Proportional Hazard Model..67

Table 4.8: Correlation Matrix for Loan default loss Variables……… .68

Table 4.9: Coefficient of Cox proportional hazard model…………… ..70

List of figures: Fig 1.0 Capitalization of Banking Institutions…………… 12

Fig 1.1: Trend of Non – performing loans, since inception of Multi-currency 14

Fig 1.2: Economic and Financial implications of NPL…… ……. 14

Fig 2.1 Important Influencing Factors of Loan Default Loss….. .38

Fig 4.1: Survival Function graph for Operational banks and Failed banks………….68

List of Appendices: Appendix 1: Backward Stepwise process (Conditional) for Model of Loan
Default Loss………………………………………………………………………………….80

Appendix 2: The Backward stepwise process for Cox Proportional Hazard Model………..82
Appendix 3: Backward Stepwise process (Conditional) for Model of Loan Default Loss…82

10
Abbreviations

RBZ Reserve Bank of Zimbabwe

CAR Capital Adequacy Ratio

LDL Loan Default Loss

NPL Non -performing Loans

COA Concentration of Assets.

Prof Profitability

GDP Gross Domestic Product

LIQ Liquidity

CF Cashflow

CRR Cumulative Recovery Rate

MRR Marginal Recovery Rate

FIDC Federal Insurance Deposit Corporation.

OLS Ordinary Least Squares.

LGD Loss Given Default

HTB Hokkaido Takushoku Bank

LTCB Long Term Credit Bank

NCB National Commercial Bank.

11
 CHAPTER 1

INTRODUCTION

1.1 Introduction

The immediate consequence of large amount of non-performing loans in the banking system is
bank failure. Failure to manage these loans may result to loss of current revenue, low rate of
investment, high risk premium, erosion of bank capital and consequently financial crises. Collapse
of one banking institution with high a level of non-performing loans might be contagion to some
other banking institutions due to lending and borrowing activities among themselves. Perhaps, it
is difficult for the regulatory and the banking institutions to mitigate these risks in foreseeable
future if they fail to plan for these disastrous events. Planning to cater for these events needs to
consider various factors for the regulator and the banker to make good and effective decisions in
operating and financing their institutions. Forecasting of bank loan default losses and bank failure
is of paramount importance to players in the banking industry. Use of relevant models assist the
players to manage sources of funds and use of funds effectively and efficiently. Thus, this research
is an attempt to construct a prediction model that would predict bank loan default loss to curb for
losses that are being generated with non -performing loans. Failure to manage the losses may result
in deterioration of bank capital, consequently bank failure. This has motivated the researcher to
study the impingement of losses being generated with non – performing loans upon bank capital.

12
1.2 Background

For the past four years, since dollarization the Zimbabwean banking industry consist of Reserve Bank of
the Zimbabwe (RBZ) as the regulatory authority and 18 operating banking institutions, comprising 14
commercial banks, One (1) merchant bank and three (3) building societies as well as one (1) savings bank.
The banking industry has been facing number of challenges that have retarded its performance, which
include increase of non – performing loans, liquidity problems as well as capital inadequacy issues.

1.2.1 Performance of the Banking Sector

Capitalization

According to issued, recent Monetary Policy Statement 2014, On aggregate, core capital for the
banking sector amounted to $753.09 million as at 30 June 2014 (excluding Interfin Bank which is
under-curatorship), compared to $790.35 million as at 31 December 2013. The reduction in the
total core capital is largely attributed to increase of non – performing loans.

As at 30 June 2014, a total of 14 out of 18 operating banking institutions (excluding POSB) were
in compliance with the prescribed minimum capital requirements as shown in Figure1 below.

Fig 1:0: Capitalization of Banking Institutions

Source: RBZ 2014 Monetary Policy Statement

13
Possibly, as depicted with the pie chart above, the banking institutions in Zimbabwe have managed to meet
minimum capital threshold of $25 million, but are still under threat with prevailing environment of
persistent increase in non-performing loans, liquidity problems and solvency problems. Currently, there are
5 banks ( Met-bank, Afri-asia, Tetrad, Capitol and Allied bank) being monitored under the Troubled and
Insolvent Bank Policy due to their status, a situation which might result to reduction of number banks
operating in Zimbabwe. Consequently, the efforts by these banks to increase their capital positions have
been constrained by a number of challenges including the macroeconomic environment and subdued
foreign direct investment.

Banking Sector Profitability

The banking sector remained generally profitable as at 30 June 2014, with an aggregate net profit
of $13.84 million for the half year ended 30 June 2014, up from $4.90 million during the
corresponding period in 2013. A total of 12 banks recorded profits for the period ended 30 June
2014. The losses recorded by the few banking institutions are attributed to high levels of non-
performing loans, lack of critical mass in terms of revenue to cover high operating expenses and
deliberate strategy by some banks to clean up bad loan books through provisioning.

Non-Performing Loans

In the face of challenging economic conditions and increasing cost of doing business, the debt
repayment capacity of the borrowers remained under stress. Credit risk remains a key component
in the risk profile of the banking sector. As a result, the level of non- performing loans has risen
from 15.9% as at 31 December 2013 to 18.5% as at 30 June 2014.

14
Fig 1.1: Trend of Non – performing loans, since inception of Multi-currency.

Source: RBZ 2014 Monetary Policy Statement

The surge in delinquencies and loan losses has dampened banks’ risk appetite. Resultantly, banks
have increasingly adopted a risk averse approach to lending.

Fig 1.2: Economic and Financial implications of NPL

15
Distressed Banks

Guy (2011) agrees arguing that non- performing loans have been widely used as a measure of asset quality
among lending institutions and are often associated with failures and financial crises in both the developed
and developing world. Reinhart and Rogoff (2010) as cited in Louzis et al (2011) point out that non-
performing loans can be used to mark the onset of a banking crisis. Despite ongoing efforts to control bank
lending activities, non- performing loans are still a major concern for both international and local regulators
(Boudriga et al, 2009).

Recently, in 2012, Interfin Bank Limited was placed under recuperative curatorship on 11 June 2012 (Mid-
Term MPS, 2012). The Governor of RBZ issued a press statement advising of the closure of Royal Bank
Limited after the directors (Dermine, 2006) (Asarnow E., 1995) (D., 1996) (D., 1996) (D., 1996) (D.,
1996)of the bank resolved to surrender their license on 27 July 2012 (RBZ Press Statement, 2012). Non-
performing loans were cited as the major common problem that was faced by Interfin Bank Limited.
According to the International Monetary Fund (IMF, 2012), the following were the bank failures in
Zimbabwe, within a period of eight years that Royal Bank Limited, Renaissance Merchant Bank and
Genesis Investment Bank has failed (Mid-Term MPS, 2012 and RBZ Press Statement, 2012).

Apparently in both cases the issue of non- performing loans was mentioned. Across the globe, the existence
and continued presence of weak banks is a matter of concern to supervisory authorities. Currently, in
Zimbabwe there are four banking institutions, namely Met-bank, Allied Bank, AfriAsia Kingdom Bank and
Tetrad facing liquidity and solvency challenges due to micro and macro factors. These banks command low
market shares in terms of loans (8.8%), assets (7.2%) and deposits (6.7%) as at 30 June 2014.Cognisant of
the need to protect the interest of depositors and promote banking sector confidence, the Reserve Bank has
been engaging these institutions to come up with credible plans to turnaround their waning financial
condition. The banking institutions are as follows:

Met-bank

Although Met-bank’s capital is compliant with the minimum capital threshold of $25 million, the
institution has been facing severe liquidity challenges. The bank has embarked on capital raising
initiatives and other turnaround strategies to address its current liquidity challenges. The bank
remains under close monitoring by the Reserve Bank

16
Tetrad Investment Bank

Tetrad Investment Bank is facing liquidity challenges resulting in the institution failing to meet
some outstanding payments. The bank has entered into a scheme of arrangement with its creditors
to put a stay on litigations. The scheme of arrangement is for three (3) months up to 31 October
2014 and is envisaged to protect the institution’s assets for the benefit of all depositors and
creditors. In an endeavor to address its solvency status, the bank is in discussion with a potential
investor for the injection of capital. The scheme of arrangement is also expected to provide ample
time for the potential investor to finalize the recapitalization initiatives.

Afri-Asia Kingdom Bank

The bank is facing liquidity challenges and is instituting various measures to ameliorate the
liquidity situation. The institution is seeking liquidity support from the major shareholder and
concomitantly pursuing a private placement transaction, whose successful consummation will
bolster the bank’s capital level. The Reserve Bank is satisfied with the current efforts by the major
shareholder to strengthen the bank’s financial condition as evidenced by an injection of $10 million
which improved the bank’s capital to $19.20 million as at 30 June 2014.The Reserve Bank will
continue to work closely with the board and senior management of the bank regarding their various
initiatives to strengthen the institution.

Allied Bank

The bank is facing both solvency and liquidity challenges and consequently has been failing to pay
maturing obligations. The board and senior management are working on various capital raising
initiatives including engaging the major shareholder to raise funds to bolster the institution’s
capital and liquidity position. The Reserve Bank will continue to closely monitor the situation at
the bank.

In Zimbabwe, The situation in which banks are saddled with high NPLs that do not decrease and
remain at high levels for a long period would result in the prolonged stagnation of the economy.
Across the globe, it has been noted that the problem of non-performing loans has a mechanism to
drag on the economy in a number of ways including the following:

17
a) Lowering banks' intermediary function due to erosion of bank profits;

b) Deterioration of bank assets and erosion of their capital;

c) Decline in bank lending, as banks with high level of non-performing loans in their portfolio may become
increasingly reluctant to take up new risks and commit new loans; and pose serious challenges to the pursuit
of macroeconomic stability and growth objectives by government.

1.3 Statement of the Problem

According to (Waweru N, and Kalami 2009)failure to manage losses being generated with non-performing
loans are closely associated with banking crises. Thus accurate estimates of potential loan losses are
essential for an efficient allocation of regulat,ory and economic capital to avoid bank failures and for pricing
the credit risk of debt instruments and credit derivatives (Jankowitsch et al., 2008). However, some of the
banking institutions in Zimbabwe have been facing challenges to mitigate risks of increase of non –
performing loans which have resulted some banks fail to operate and retain confidence in the banking
industry due to depletion of capital resulting from losses being generated with non – performing loans. In
essence, how banks account for credit losses is important for the presentation of their true and fair financial
positions and therefore is a big area of interest. Thus the researcher is motivated to design an econometric
model capable of predicting bank loan default loss and failure.

1.4 Research Objectives.

 To develop an econometric model that would forecast bank failure.

 To develop an econometric model that would forecast bank loan default losses.

 To determine the relationship between bank loan default loss and bank capital.

 To determine other factors which contribute to the collapse of a bank.

1.5 Research Questions.

 What is the appropriate model for predicting loan default losses and bank failure?

 What is the relationship between bank loan default loss and bank capital?

18
  What is the relationship between loan default losses and bank (failure/Survival time)?

 What are the variables that determine loan default loss and bank failure?

1.6 Research Hypothesis

H0: Bank loan default losses do not play a pivotal role in forecasting bank failure.

H1: Bank loan default losses play a pivotal role in forecasting bank failure.

1.7 Significance of the Study.

Bankers.

Banks needs accurate estimates of potential losses as there are essential for an efficient allocation of
regulatory and economic capital and for pricing the credit risk of debt instruments and credit derivatives (
Jankowitsch et al., 2008), and therefore banks can gain competitive advantage by improving their internal
loss given default forecasts.

Regulators.

Financial stability, for commercial banks is of paramount importance for financial surveillance. Loan
default loss and bank failure prediction model can be an indicative tool to aid in detecting instability well
in advance before banking institutions reach the extent of bankruptcy .This reduces pressure on funds from
Depositor Protection Fund for bailouts, because the fund will be fully financed before the occurrence of
these negative events thus to retain confidence in the banking industry and regulators need reliable default
prediction models to avert this.

Harare Institute of Technology.

This research is relevant to the university in the fact that the university may convert the idea from this
project into practical business which may be offered into the market. The relevance of this project is based
on that can be used as one of the competitive early warning system in the banking system responsible to
warn players about bank loan default losses and failures in the foreseeable future.

19
Student.

This study is of great significance to the student who carried out the research since it enabled the partial
requirement for the attainment of a Bachelor of Technology Honours Degree in Financial Engineering. It
helped the student in improving his quantitative researching skills which is one of the exit competencies of
the degree program. Through this research, the student identified gaps in knowledge of loan default loss
and bank failures through predicting losses incurred due to increase of non –performing loans.

Future researchers.

This research project is relevant to future researchers, considering the fact that will help academia to
empirically identify the best and appropriate model to forecast loan default loss and bank failure in the
Zimbabwean banking system. The research will also add empirical literature existing on how best the
banking institutions in Zimbabwe can be monitored and financed, in order to avoid these financial crises
and distress and maintain confidence in the banking industry.

1.8 Scope of the Research

The researcher is limited to commercial banks operating in Zimbabwe, using secondary data period
2009 to 2013. The research will be carried out using the data for five (5) commercial banks.

1.9 Assumptions of the Research

 Major losses that banks are experienced are being generated from non – performing loans.
 The historical data is readily available.
 The study assumed that banks are classified as bankrupt and non-bankrupt based on size,
total assets, and level of non-performing loans as well as liquidity and ownership.

1.10 Limitation of the Study.

The researcher faced a challenge on sufficient time to carry out the research due to commitment
to other courses of the curriculum of financial engineering which were done concurrently with the
research project which resulted in him not putting all his concentration to the project but also to
other commitments of the degree program and also access to some financial information which is
restricted with some commercial banking institutions , as well as financial constraints on costs
incurred to gather all needed resources for the project to be successful.

20
1.11 Delimitation of the Study

The research is mainly focusing on forecasting loan default loss and bank failures of commercial
banks in Zimbabwe. Whether the bank is going to fail or not due to losses being generated from
non- performing loans. The study ignores other financial institutions where the study could have
been expanded to forecast probability of default of any financial institutions due to its defaulted
assets (including investment banks, building societies, micro finance and insurance companies).

1.12 Organization of the Study

This research document consists of five chapters. The first chapter is the introduction of the
research constituting of the research objectives, the hypothesis and assumptions of the research
among other introductory topics. The second chapter gives a detailed literature review on the
forecasting of bank loan default loss and failure. Based on the literature review, the writer deduced
the methodology (on Chapter 3) that is used to design the models that can predict the loan default
loss and bank failures. Chapter 3 also presents how the researcher carried out the data collection
for analysis in chapter 4. The last chapter, which is chapter 5, is the concluding chapter showing
the results of the research. The concluding chapter will answer the research questions, and also
give recommendations for future studies.

References

Asarnow E., E. D., 1995. a 24 Year Study. Measuring Loss on Defaulted Bank Loans, 77, No. 7,(The Journal
of Commercial Lending), pp. pp. 11-23.

Dermine, J. N. Carvalho., 2006. a case study Journal of Banking. Bank loan losses given default, pp. 1243-
1291.

Felsovalyi, A. H. L., 1998. Measuring Loss on Latin American defaulted Bank loans: A 27- Year Study of 27
Countries. Journal of Lending & Credit Risk Management.

Fofack, H., 2005. Causal Analysis and Macroeconomic Implications.. Non-performing loans in sub-
Saharan Africa , Volume .World Bank Poilcy Resesarch Working Paper No.3769, Novemeber.

Franks, J. d. A comparative Analysis of the Recovery Process and Recovery Rates for private Companies .

Jankowitsch, R. P. R., 2008. The delivery option in credit default swaps. Journal of Banking and Finance,
pp. 32, 1269–1285..

21
Mangudya, J., 2014. MONETARY POLICY STATEMENT. Harare, Reserve of Zimbabwe.

M, W., 2009. Commercial Banking Crises in Kenya:. Causes and Remedies . Africa Journal of Accounting
Economics , Finance and Banking Research, pp. 4(4), 12 -33.

Laevene, 2009. Bank governance, regulation and risk taking. journal of financial Economics 93, pp. 259-
275.

Shumway, T., 2001. Forecasting bankruptcy more accurately. Asimple hazard model.. The Journal of
Business 74,, pp. 101-124.

22
 CHAPTER 2

LITERATURE REVIEW

2.1 Introduction

The main thrust of this chapter is to review theoretical and empirical literature, cited with various
researchers regarding to the topic of forecasting bank loan default loss and failure in both
developed and developing countries. The results of previous researches obtained from journals,
articles, thesis and dissertations, thus to enable the researcher to comprehend the theories ,concepts
and underlying models used to forecast bank loan default loss and bank failure, as well as getting
a better in site and suitable approach for the Zimbabwe banking environment.

Firstly, the chapter will focus on theoretical literature on internal rating based models to forecast
bank loan default loss and bank failure, initially by giving definition of terms:

2.2 Definition of Terms

 Bank Loan is an amount of money loaned at interest by bank to a borrower, usually on

collateral security, for a certain period of time.

 Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of
view. It is composed of core capital, which consists primarily of common stock and
disclosed reserves (or retained earnings), but may also include non-redeemable non-
cumulative preferred stock.

 Tier 2 capital is supplementary bank capital that includes items such as revaluation
reserves, undisclosed reserves.

 Regulatory capital is the amount of capital a bank or other financial institution has to hold
as required by its financial regulator. This is usually expressed as a capital adequacy ratio

23
 of equity that must be held as a percentage of risk-weighted assets. (Also known as
regulatory capital or capital adequacy). Regulatory Capital is also expressed as capital
adequacy ratio - CAR' A measure of a bank's capital. It is expressed as a percentage of a
bank's risk weighted credit exposures. Also known as "Capital to Risk Weighted Assets
Ratio (CRAR)."

 Economic capital is the amount of risk capital that a bank estimates in order to remain
solvent at a given confidence level and time horizon.

 Loan default loss also known as Loss Given Default (LGD) is the credit that is lost by a
financial institution when a borrower defaults, expressed as a fraction of the exposure at
default.

 Bank failure occurs when a bank is unable to meet its obligations to its depositors or other
creditors because it has become insolvent or too illiquid to meet its liabilities.

 Exposure at Default (EAD) is a parameter used in the calculation of economic capital or

regulatory capital under Basel II for a banking institution. A total value that a bank is
exposed to at the time of default.

 Internal rating based approach (IRB) refers to credit-risk measurement techniques that
are proposed in The New Accord on capital adequacy. Under this approach banks are
encouraged to develop their own internal models to quantify capital, which is required for
the management of the credit-risk (economic capital). Moreover, banks are allowed to use
their internal models to estimate parameters such as PD, EAD and LGD.

 Default Rate. The default rate can be understood as the percentage of all loans disbursed
to borrowers that have gone into default over a certain period of time. In other words, it is
the number of defaulted loans divided by the total number of loans contracted within a
portfolio over a certain period of time

24
  Default. In general, we refer to a default when a debtor has not met his/her financial
obligations (either unwilling or unable to pay his/her debt) according to the debt contract.

2.3 Motivation and description of variables

Apart from macroeconomic variables, there is abundant empirical evidence that suggests that
several bank specific factors (such as, size of the institution, profit margins, efficiency, the terms
of credit (size, maturity and interest rate), risk profile of banks (measured by several proxies
including total capital to asset ratio and loans to asset ratio) are important determinants of bank
failure. Some studies only considers four bank specific variables owing to data availability. These
are: real interest rate (RIR), bank size SIZE), annual growth in loans (∆LOAN) and the ratio of
loans to total asset (L_A).

The empirical evidence relating to the impact of bank size on bank failure appears to be mixed.
For instance, some studies report a negative association between bank failure and bank size ( Rajan
and Dhal, 2003; Salas and Saurina, 2002; Hu et al, 2006). According to these studies, the inverse
relationship means that large banks have better risk management strategies that usually translate
into more superior loan portfolios vis-à-vis their smaller counterparts. There are also studies which
provide evidence of a positive association between NPLs and bank size ( Rajan and Dhal, 2003).

The supporting rationale is that banks that value profitability more than the cost of higher risk
(represented by a high loan to asset ratio) are likely to incur higher levels of NPLs during periods
of economic downturn.

Loan Default Loss (LDL):

Forecasting loan default loss can be determined by use of mortality – based approach to measure
loan recovery rates, used by Dermine and Carvalho (2006), to analyze Portuguese bank loans,
calculating recovery rates on non –performing loans. Mortality based approach, is an approach
used to measure cash flows recovered after a default event. In order to measure the cash flows
recovered after a default event of bank loans, on the basis of the approach. The researcher tracked
the post –default credit balances at the end of each year and determine the capital recovery. Capital

25
recovery is a reduction of the total credit balance. The total cash flow recovered equals the capital
recovery plus the interest on the outstanding balance.

With this approach, the information based on non-performing loans such as features of the
borrower and terms of credit on individual loans are restricted to be disclosed to the public. Thus,
this method is appropriate to determine loan default loss. The non-availability of data on the prices
of loans as at default date, enable the researchers to apply discounted cash flow approach to
calculate recovery rates. According to Asarnow and Edwards, 1995; Carty and Lieberman, 1996)
postulated that this approach needs also calculation of the present value of actual recovered cash
flows related to a specific loan, and thus applied when access to the contractual interest rates
charged on individual loans is limited.

The method mainly examines the percentage of a bad and doubtful loan which is recovered n years
after the default date and the measure is called marginal rate of recovery rate. Thus in order to
explain clearly the method, used for measuring loan recovery rates. Dermine and Carvalho (2006),
provide the next simplified formulae, of marginal recovery rate. Where, the marginal recovery rate
in year t (MRRt) is defined as the proportion of the outstanding loan, which is repaid in period t
(that is. t periods after the occurrence of the default). Therefore, MRRt for each repayment period
can be calculated as:

(1)

Where CFt - represents the repayment cash flow in period t

r - Stands for the discount rate used to calculate the discounted value of the

expected future cash flows.

26
After calculating MRRt, also the researcher calculated cumulative recovery rate (CRRT). Based on
the marginal recovery rate calculation the cumulative recovery rate (CRRT) can be calculated as:

(2)

Where (CRRt) - proportion of the defaulted loan value that has been repaid (in

present value terms), T periods after default.

Finally, the loss given default (LGD) can be calculated as Loan Default Loss = 1 – CRRt. The
calculated loss given default may serve as a basis for loan loss provisioning scheme in the bank.

Loan Default loss (LDL) = 1 – CRRt (3)

Non-Performing Loans Ratio (NPLR):

Non-performing loan ratio (NPLR) is the gross non-performing loans divided by total gross loans.

Mathematically;

NPL is non-performing loans as a percentage of total loans; we expect banks with relatively greater
NPL to exhibit greater failure risk.

27
Bank Size.

Bank size measured as the total value of bank assets, taken in logs; or is relative market share of
bank i at time t

A decrease in bank size means the probability of the bank to fall insolvent is high and when there
is increase in bank size the bank increase its competitive edge.

Liquidity

Liquidity is a measure of the ability and ease with which assets can be converted to cash. Liquid
assets are those that can be converted to cash quickly if needed to meet financial obligations;
examples of liquid assets generally include cash, central bank reserves, and government debt.

Liquidity = total assets – total loans

Total assets

Cash and balances due from depository institutions provide liquidity during deposit withdrawals,
which tend to be higher during economic crises. Hence, a bank with higher liquidity is likely to
face fewer difficulties in meeting withdrawal requests, and be less likely to fail.

Corporate Governance.

According to Hermalin (1998) and Weishbach (2003), it is plausible that an independent board or
board members with appropriate stock ownership will have the incentive to provide effective
monitoring and oversight of important corporate decisions; hence board independence or
ownership can be a good proxy for overall good governance.

Growth Domestic Product (GDP).

The monetary value of all the finished goods and services produced within a country's borders in
a specific time period, though GDP is usually calculated on an annual basis.

28
Lack of confidence in the banking system, low savings, poor liquidity buffers and uncertainty
regarding tenor of multi-currency system cause retardation of economic growth.

Concentration of Assets.

Concentration of assets measure the overall spread of a bank's outstanding accounts over the
number or variety of debtors to whom the bank has lent money. This risk is calculated using a
"concentration ratio" which explains what percentage of the outstanding accounts each bank loan
represents.

𝐶𝑂𝐴𝑖 −𝐶𝑂𝐴𝑖−1
Concentration of Assets =
𝐶𝑂𝐴𝑖−1

Investments within the same industry, geographic region or security type tend to be highly
correlated, meaning that what happens to one investment is likely to happen to the others.

Profitability

This is the income that is generated from sales, after deducting costs incurred from operations of
the business, is measured in various ways which include the formulae below:

ROA = Earnings before interest and tax

Total Assets

ROA is net income as a percentage of average beginning and ending total assets. We expect more
profitable banks to be less likely to fail.

Lending rates.

This is the amount of money charged with the lender upon principal sacrificed over a period of
time, lending the principal to a borrower in return pays the principal and interest at maturity.

29
∆ Lending rates = li – li-1

li-1

This amount tends to accumulate when a borrower fall into default on obligation. There is also
positive correlation between non –performing loans and interest charged on principal with the
lender.

Capital adequacy ratio.

Capital adequacy ratios (CARs) are a measure of the amount of a bank's core capital expressed as
a percentage of its risk-weighted asset.

Capital adequacy ratio is defined as:

TIER 1 CAPITAL = (paid up capital + statutory reserves + disclosed free reserves) - (equity
investments in subsidiary + intangible assets + current & b/f losses)

TIER 2 CAPITAL = A) Undisclosed Reserves + B) General Loss reserves + C) hybrid debt capital
instruments and subordinated debts where Risk can either be weighted assets ( ) or the
respective national regulator's minimum total capital requirement. If using risk weighted assets,

≥ 10%

This ratio determines the capacity of the bank in terms of meeting the time liabilities and other
risks such as credit risk, operational risk. It indicates the stability of the banking institution and its
ability to absorb losses without a bank being required to cease trading.

2.4 Theoretical Literature Review.

There are a lot of theories relating to the forecasting of bank loan default loss and bank failure.
The available theories mainly put emphasis on the two major factors micro and macro factors,
affecting bank loan default loss and bank failure. With the implementation of the Basel II accord,
the development of accurate loan default loss models is becoming increasingly important. In Basel

30
II framework, banks adopting the advanced Internal-Rating-Based (IRB) approach are allowed to
use their own estimates of Loan Default Loss also known as Loss Given Default (LGD), which
denotes the loss quota in the case of the borrower’s default.

2.4.1 Economic Framework.

It is widely accepted that the quantity or percentage of non-performing loans (NPLs) is often
associated with bank failures and financial crises in both developing and developed countries. In
fact, there is abundant evidence that the financial or banking crises in East Asia and Sub-Saharan
African countries were preceded by high non-performing loans. The current global financial crisis,
which originated in the United States, was also attributed to the rapid default of sub-prime
loans/mortgages.

In view of this reality it is therefore understandable why much emphasis is placed on non-
performing loans when examining financial vulnerabilities. Sorge (2004), reported that the stress
testing literature makes extensive use of non-performing loans and loan loss provisions to assess
the vulnerability of the financial system. Keeton and Morris (1987) (Shumway, 2001) present one
of the earliest studies to examine the causes of loan losses. In the latter paper the authors examined
the losses by 2,470 insured commercial banks in the United States (US) over the 1979-85. Using
Non –Performing Loans (NPL) net of charge-offs as the primary measure of loan losses Keeton
and Morris (1987) shows that local economic conditions along with the poor performance of
certain sectors explain the variation in loan losses recorded by the banks. The study also reports
that commercial banks with greater risk appetite tend to record (Felsovalyi, 1998) (Franks, n.d.)
Higher losses.

2.4.2 Causes of Defaults on Loans and Bank Failures.

Generally, the possible underlying causes of defaults of bank loans and bank failures are exposed
to two groups of factors, which include external factors and internal factors. Internal factors cover
factors such as operational and financial management issues.

Operational Management Issues. According to Short, O’Driscoll and Berger (1985, p. 155), said
financial institutions may suffer from excessive-loan portfolio growth and poor risk management.
Indeed, as tremendous amount of literature on banking focuses on the lending behavior of banks
and warns against poorly managed rapid growth generating losses due to risky loans and

31
investments, thus is a robust factor to consider when managing risky loans (unsecured loans).
Possibly, one of the underlying causes of default of banks in Africa is the inexperience of the
management in the sector, a weak management board and poor corporate governance which may
have repercussions on the revenues and profitability of the bank. Inexperienced personnel, namely,
does not have the expertise to screen and monitor the borrowers and thus to distinguish between
good and bad risks according to Mamman and Oluyemi (1994). Consequently, this hypothesis
was proven from the research that was conducted by Altman (1993), recognizes that managerial
incompetence and poor corporate governance was principal cause of individual bank failures.

Financial Management Issues. Basically, financial management failures result from low
solvency and liquidity, poor working-capital management, which are lower than the projected
margins, and insufficient cost control. Similarly, financial management issues and operational
management issues, all lead to lower revenues and higher costs and subsequently, to insufficient
financial resources to repay outstanding debts. Asset and liability management, in case of
illiquidity refers to a situation where a bank’s short term liabilities are higher than its short term
assets and as such is considered a temporary problem, insolvent banks will eventually go into
default because their long term liabilities outweigh their long term assets.

Nonetheless, the study by Fidrmuc, Hainz, and Malesich (2006) on Slovakian bank-loans shows
that higher liquidity lowers the default probability of banks significantly. In addition, the same
effect is encountered for profitability. With respect to financial institutions also a poor capital base
and a poor asset quality matter. The former serves as a buffer for setbacks, and every financial
institution is required to hold sufficient reserves. The latter may represent bad loans that is loans
disbursed to risky clients, which are often associated with excessive lending and excessive risk-
taking, resulting in a low quality of the portfolio.

Poor interest rate, maturity and currency management constitute important default-influencing
factors for financial institutions as well. By undertaking investments (or borrowing and lending),
for example, banks increase the risks to which they are exposed in financial markets. These
include, among other things, interest rate risk, maturity risk and foreign exchange risk. A mismatch
in these variables creates open positions, which may lead to substantial losses. Therefore, all banks
try to mitigate their interest, maturity and currency risks by hedging through constantly operating

32
in the futures market. As already brought up earlier, sound financial management in developing
countries may be troublesome, as relatively less experienced personnel and management are
employed in financial institutions and as financial systems in these countries still lack several
fundamental factors.

2.4.3 Loan Default Loss

Loan Default loss is the credit that is lost by a financial institution when a borrower defaults,
expressed as a fraction of the exposure at default. In the literature, loss-given-default is frequently
expressed by its complement, the recovery rate. Accurate estimates of potential losses are essential
for an efficient allocation of regulatory and economic capital and for pricing the credit risk of debt
instruments. Therefore, banks can gain competitive advantage by improving their internal loss-
given-default forecasts.

In several studies which followed the publication of Keeton and Morris (1987) have proposed
similar and other explanations for problem loans in the United States. Sinkey and Greenwalt
(1991), study investigates the loan loss-experience of large commercial banks in the United States;
they argue that both internal and external factors explain the loan-loss rate (defined as net loan
charge offs plus NPLs divided by total loans plus net charge-offs) of these banks. These authors
find a significant positive relationship between the loan-loss rate and internal factors such as high
interest rates, excessive lending, and volatile funds. Similar to the previous study, Sinkey and
Green Walt (1991) report that depressed regional economic conditions also explain the loss-rate
of the commercial banks. The study employs a simple log-linear regression model and data of large
commercial banks in the United States from 1984 to 1987.

According, Grunert and Weber, (2005) said the loan default loss of bank loans may depend on
several factors. These factors may relate to the factors which are listed below:

 Features of the borrower.

 Terms of credit.
 Business connection.
 Macroeconomic factors


33
1) Features of the Borrower

Features of the borrower may include, for example, the creditworthiness, the size and age of the
Company or institution, the industry in which it operates, and variables related to client’s
performance, whereby the credit worthiness of the may be considered as one of the determinants
of loan default loss. The creditworthiness of the borrower may be considered as one of the
determinants of loan default loss. The public credit ratings prepared by credit rating agencies such
as Moody’s, Standard & Poor’s, and Fitch give an indication on the risky ness of a bond or loan.
The higher the ratings on bonds and loans, the lower will be the risk premium required.
Accordingly, the lower the risk, the lower is loan default loss expected to be. The bonds and loans
in developed countries often obtain the highest ratings, AAA+, followed by developing countries
and emerging markets where these ratings can fall into B and C categories. It is worth mentioning
that in less developed countries ratings are performed only occasionally and for some countries
these ratings are not even available, the foremost reason being lack of information. Grunert and
Weber (2005) indeed find that the creditworthiness of the borrower, represented by the risk
premium, is a significant explanatory variable of the loan default loss. Also the study performed
by Siddiqi and Zhang (2004) provides evidence for a lower loan default loss in case a borrower is
more creditworthy

In addition to the above research, Dermine and Neto de Carvalho (2006) explained the fact that
older companies may perform better in terms of the quality of their management and tend to be
less obscure regarding the value of their assets, resulting in better recoveries, thus lower loan
default loss, at the time of financial distress, thus was according to their findings of their research.

The loan default loss may additionally depend on the industry in which the borrower is operating,
as different industries or sectors experience different needs regarding investment intensity. This
means that loan default loss will also depend on the industry classification of the company. For
example, the manufacturing and trade sectors exhibit higher loan default loss than the real sector,
including, for example, agriculture/fishing, mining, construction and real estate.

Apart from focusing on industries as groups, it is also possible to think about industries’
performance as determinant of the loan default loss. For example, defaulting companies whose
industries have suffered from adverse economic shocks may experience significantly higher loan

34
default losses. Thus, presence of (financial) distress within an industry may have undesirable
effects on other companies in the industry (as it is hard to recuperate when the whole industry is
in distress) and, consequently, may depress recoveries.

Acharya, Bharath, and Srinivasan (2004) they found a significant negative impact of industry
distress on recovery resulting in higher loan default loss. Moreover, they find that the industry
concentration raises loan default loss. The authors also explain that this is compatible with the
hypothesis that companies and institutions that operate in more concentrated industries should
exhibit higher losses due to the lack of active market bidders. The obtained effect was, however,
never statistically significant.

2) Terms of Credit.

Factors that may influence Loan Default Loss are related to the terms of credit include collateral,
the seniority, the exposure at default (EAD), and the loan size (EAA). According to Grunert and
Weber (2005), and Franks, Servingny, and Davydenko (2004), collateral is an important
determinant of the loan default loss for bank-loans. This is due to the fact that collateral can be
sold in case of default, resulting in higher revenues and thus lower loan default loss. Dermine and
Neto de Carvalho (2006) they reported that real estate, physical and financial collateral, in
particular, lower loan default loss. In contrast, presence of personal guarantees tends to increase
loan default loss. In general, most studies find a negative correlation between the presence of
collateral and loan default loss. Also, seniority can have an influence on losses incurred, as it
depends on seniority whether a creditor is a first or remaining claimant. Varma and Cantor (2005),
for example, show that loan default loss for senior secured bank-loans is 75% lower than that for
senior unsecured banks, for subordinated bank loans is also75% lower than that for guarantees.
This result is supported by Altman and Kishore (1996) and Grunert and Weber (2005), but is
inconsistent with Acharya, Bharath and Srinivasan (2004), who find seniority to be a non-
significant explanatory variable of LGD.

However, Finance theory suggests that recovery rates should be higher on secured than unsecured
loans since creditors gain a legal right to seize and sell certain designated assets in the event of
default. Collateral has been found to be significantly related to recoveries in both the practitioner

35
and academic literature according to Araten, Jacobs, and Varshney,( 2004); Altman and Kishore,
(1996); and Van De Castle,( 1999).

Higher EAD may also be associated with a lower LGD. Banks tend to be more intensively engaged
in working-out processes or restructurings when the defaults are relatively large in size. This is
very intuitive, since you put more effort into defaults where more can be lost but also more can be
regained. Small defaults may be sooner written-off by banks when the costs of the working-out
process outweigh the revenues. Franks, Servingny, and Davydenko (2004). However, provide
evidence that there is no (negative) correlation between EAD and the LGD. Also Grunert and
Weber (2005), cannot verify this hypothesis.

In contrast to the findings for the relationship between the EAD and the LGD. Dermine and Neto
de Carvalho (2006) and Felsovalyi and Hurt (1998) provided statistical evidence that there was a
positive impact of the size of the loan on the loan default loss. In other words, losses on large loans
tend to be higher than those on smaller loans. While the working-out processes and restructurings
may have a positive effect on recoveries, the costs associated with these procedures may be high.
These costs have to be subtracted from the money regained, and this implies that, when
expenditures rise, losses and thus LGD increase

Moreover, the study that was conducted by Acharya, Bharath, and Srinivasan (2004) on the other
hand, shows that the loan size lowers the losses but that this variable is usually insignificant
statistically and not robust. While these studies present similar results on the impact of the loan
size on LGD, Schuermann (2004, p. 23) claims that the size is an important determinant in models
of the probability of default, but as it fails to explain losses it probably does not matter at all.
Therefore, the impact of the size of loan on the LGD is not clear-cut.

3) Business Connection.

Apart from factors that are related to the features of the borrower and terms of credit, there are
issues concerning business connection, which may influence LGD. One such factor is the number
of years of the client’s relationship with the bank. The longer this relationship has existed, the
higher is the probability that the client is willing to pay back his/her loan in order to retain a good
relation and be able to do business with the bank in the near future. Therefore, longer relationships
are associated with lower LGD. In addition, the more intensive the relation is in terms of distance

36
between the bank and the client, and the more products are contracted with one client, the lower is
the LGD (Franks, Servingny, and Davydenko, (2004) and Grunert and Weber, (2005).

4) Macroeconomic Factors.

Macroeconomic factors may also be important determinants of LGD. Growth of Gross Domestic
Product (GDP) tends to lower LGD, as it increases the value of collateral and enables the company
to stay in business (also after a default has taken place). Due to favorable economic conditions,
fewer defaults occur and Bank Loan Causes of Default. Historical Losses and Determinants of
Loss-Given-Default Aleksandra Gazy, February (2007), said the cost and time devoted to work
out processes is relatively negligible. Therefore, this leads to lower LGD. Inflation, on the other
hand, may raise LGD as rising inflation decreases the value of collateral and creates uncertainty
around revenues and profits as well. While exchange rates have been fairly stable over the past
two decades in developed countries, the same cannot be said about developing countries and
emerging markets. Therefore, exchange rate may constitute an additional factor that influences
LGD. Strong devaluations of borrower’s domestic currency may lead to severe payment
difficulties if financial facilities have been disbursed in foreign currency, as their real value has
increased. This leads to higher losses, and thus higher LGD. On the contrary, when devaluations
are coupled with bank-loans that are denominated in debtor’s domestic currency, the losses are
expected to be lower as the cost of borrowing is lowered. Altman et al. (2005, p. 2206), for
example, argue that the aggregate LGD depends on the supply of defaults. The authors argue that
the value of collateral tends to decrease and LGD tends to increase when the supply of defaults
increases, thus during economic downturns. The hypothesis that macroeconomic conditions have
an impact on LGD is supported by Franks, Servingny, and Davydenko, (2004); and Araten, Jacobs,
and Varshney (2004). The diagram below briefly summarizes the evidence of factors that have
been cited with various authors which influences Loan Default Loss.

37
Fig 2.1 Important Influencing Factors of Loan Default Loss.

Note: The ‘+’ (‘-‘) indicates that a value increase in the explanatory variable (factor) is expected
to lead to a higher (lower) LGD. The ‘0’ means that there is no evidence that the factor influences
the LGD. The signs and the ‘0’ value ascribed to the factors are based on the empirical results
found in the reviewed literature and to the expectation of the sign as described in the text. Source:
Aleksandra Gazy (2007).

2.4.4 Bank Failure.

Occurs when a bank is unable to meet its obligations to its depositors or other creditors because it
has become insolvent or too illiquid to meet its liabilities. Many banking crises have been reported
around the world within the last few years. For example, more than 140 crises were reported since
the 1970s (Reinhart and Rogoff, 2008, 2009: Laeven and Valencia, 2008, 2010). More recently,
Reinhart and Rogoff (2008, 2009) reported only 121 banking crises since 1800s till 1970s. By
failures to rollover debt during panics or rapid withdrawals of debt, and insolvency, these
exogenous shocks introduce pressures on banks, and are associated with the banking system
distress (Calomiris, 2008).

38
Asset and Liability Management.

According to the Federal Reserve Bank of St. Louis, banks also fail because they do not diversify,
which can occur on the asset and the liability side of the balance sheet. For banks, choosing not to
diversify intensifies the need for higher capital ratios. Diversification needs to occur on the liability
side of the balance sheet as well” (Fuchs, 2009). If there is a concentration of assets by loan
category, industry, or geography, the bank creates the potential for material losses in times of
economic stress or recessions.

Possibly, to cement the Federal Reserve Bank findings. In 1989, World Bank carried out a study
on Nigerian Banks identifying poor lending mismatching of assets and liabilities; weak and
ineffective internal control; inadequate policies; lack of standard practices and strategic planning
as the major factor responsible for the persistent crises in the Nigeria banking industry (World
bank, 1989). After the first banking crisis of 1930, crises have been a regular feature of the Nigeria
banking industry. The banking crisis of the 1950s prompted the colonial government to initiate the
first banking ordinance of 1952 which took effect in 1954. Since then, so many reforms had taken
place in the sector but the crises never stopped. Which is still the current situation that is prevailing
in the Nigerian Banking System.

Non- performing Loans.

In scholar studies, problem loans are often used as an exogenous variable to explain banking
outcomes such as bank performance, failures, and bank crises (Boudriga et al., 2009). However,
some studies investigate problem loans as an endogenous variable (Sinkey and Greenwalt, 1991;
Kwan and Eisenbeis, 1997; Salas and Saurina, 2002) in (Boudriga et al., 2009). GDP growth,
inflation and interest rates are common macro-economic factors, while size and lending policy are
micro-economic variables (Greenidge and Grosvenor, 2010). These variables are by no means
exhaustive, but they provide a useful framework for monitoring the development of banking crisis.

Corporate Governance.

In December 2003, Zimbabwe's central bank promoted greater accountability and transparency by
announcing that no management position will be held by a bank owner. Bank management, the
board and/or its chair, was not to have a shareholder with 10% or more shares. Prior to this

39
announcement, and the clampdown by the central bank, Zimbabwe’s 17 banks were reported to
have had some managers who were also major shareholders (Mpofu and Nyakazeya, 2011;
Business Reporter, 2010). Thus, Zimbabwe’s new banks faced failure due to irresponsible
practices including mismanagement and structural ownership weaknesses which led to liquidity
and solvency deficiencies and saw a run on deposits by panicking depositors (Muleya, 2008;
Chimhangwa, 2011; Mambondiani, 2011; Business Reporter, 2011). Corporate governance plays
a pivotal in most modern bank failures. However, it is difficult to come with a certain measure of
corporate governance due to lack of information, which is restricted with most financial
institutions when it comes to its corporate governance structure.

Mergers and Acquisitions and Depositors Insurance Corporation.

According to Cebula (1994), in determinants of bank failures in the US revisited, postulated that a
bank failure occurs when a bank is forced by regulators to close or merge with another institution.
Cebula also assessed the impact of the federal deposit insurance corporation improvement act
(FIDCA), and argues that the depositors’ insurance corporation caused banks to be reluctant in
terms of managing depositor’s funds, thus the banks end up abusing depositor’s funds by investing
in risky investments in an endeavor to make huge returns. Conversely, failure to manage the risks
the depositor’s funds will be lost, in unfavorable financial environment the bank will automatically
fail to meets its obligations and cause the depository insurance fund to intervene. If the depositors

Insurance fund is not well funded will result in a banking crises, number banks closing doors
increases and consequently cause a negative impact to the economy. The author also his study
follows other studies in the field by including many economic and financial variables, these include
the unemployment rate, the cost of funds for banks, and the financial market volatility. The authors
study also adopts the variance in each year of the monthly averages of the S&P 500 stock index,
charge offs to outstanding loans at a commercial bank and interest rate yield on new 30 year fixed
rate home mortgages to run an Ordinary Least Squares (OLS) regression. Bank failures rate over
the study period was an interesting function of these variables which contributed most bank
failures in United States (Cebula, 2010).

40
2.5 Empirical literature Review.

This section will review a description of the empirical researches which have been done in relation
to the research questions of this project. The major issues will point out on the real processes
employed in previous methodologies which are related to the methodology which has been used
in this project.

2.5.1 Loan default loss

Based on various literature review of forecasting loan default loss and bank failure, it is clear that
there is extensive international evidence which suggests that Non –performing loans generate huge
losses to each and every individual bank, which is faced with such challenge. This area of study
have motivated many researchers to find econometric models that are competitive to forecast these
losses, Jimenez and Saurina (2005). Thus, this has been promoted with the Basel II (2004) that had
allowed banks the opportunity to estimate LGD using their own models via the IRB approach.
Several studies consider forecasting LGD using various methodologies, which, are based on
financial environment setup of individual country of research, and thus as long as the model create
competitive edge for the bank.

Multifactor Models.

According to Dermine and Neto de Carvalho (2006) empirical results obtained by these authors
from their research estimated loss given default by constructing models on the basis of individual
loan transactions and estimating the economic determinants of the LGD of European bank loans
granted to small and medium-sized companies using multifactor models included explanatory
variables such as loan size, type of guarantee/collateral support, industry sector, default year, and
age of the firm. Nevertheless, macroeconomic variables such as GDP growth, frequency of default
in the industry sector, and the interest rate were additionally tested with no statistical significance.
This fact was explained by the absence of a sufficient recession during the period under
consideration. Bellotti and Crook (2009) on the contrary found a significant relationship between
LGD and a number of bank specific variables and macroeconomic variables in their analysis of
credit card LGDs on individual loan transactions.

41
Linear Regression.

Hurt (1998), Franks et al. (2004), Araten et al. (2004) and Caselli et al. (2008) said the frequency
of complete recoveries increases with the recovery horizon as more cash-flows are collected in the
work-out process. Empirical studies show that it is not easy to find explanatory variables that
strongly influence recovery rates. The most straightforward technique for modeling recoveries is
the linear regression model estimated by ordinary least squares methods. For example, this
approach is employed in Caselli et al. (2008), Davydenko and Franks (2008) and Grunert and
Weber (2009). However, modeling and predicting recoveries with a linear model has serious
limitations. First, because the support of the linear model is the real line it does not ensure that
predicted values lie in the unit interval. Also, given the bounded nature of the dependent variable,
the partial effect of any explanatory variable cannot be constant throughout its entire range.

Fractional Response Regression.

Possibly, to overcome the limitations of the models created by Hurt (1998), Franks et al. (2004)
led Dermine and Neto de Carvalho (2006) and Chalupka and Kopecsni (2009). To improve the
model by employing an econometric methodology specifically developed for modeling
proportions, such as the (nonlinear) fractional regression estimated using quasi-maximum
likelihood methods (Papke and Wooldridge,(1996). In the context of credit losses, this approach
was adopted in an alternative procedure to perform the regression on appropriately transformed
recoveries.

Decision Trees

Bastos (2010) suggested the use of nonparametric regression trees for modeling recoveries on bank
loans default losses. The advantage of this technique is its interpretability, since tree models
resemble ‘look-up’ tables containing historical recovery averages. Furthermore, because the
predictions are given by recovery averages, they are inevitably bounded to the unit interval. A
distinct approach is offered by nonparametric models, in which the functional form for the
conditional mean of the response variable is not predetermined by the researcher but is derived
from information provided by the data. Regression trees were also suggested by (Breiman et al.,
1984) claims that are nonparametric and nonlinear predictive models in which the original dataset
is recursively partitioned into smaller mutually exclusive subsets using a search algorithm, are

42
more efficient according to the author’s study, comparing to other models. A regression tree model
is represented by a series of logical if–then conditions. Suppose one has a set of observations (i.e.,
bank loans) described by several attributes and a target variable (i.e., recoveries). The algorithm
begins with a root node containing all observations. Then it searches over all possible binary splits
of all available attributes for the one which will minimize the intra-subset variation of the target
variable in the newly created daughter nodes. Also, the classification trees are used when the
response variable is quantitative discrete or qualitative (Yousefi, 2011). Classification tree model
is based on maximizing purity measure of the response variables of the observations. Thus, the
major advantage of this method is that it is a white box model and so it is simple to understand and
explain, but the limitation of this model is that, it cannot be generalized a designed structure for
one context to the other contexts (Hung, 2010).

Neural networks.

The parametric model against which the performance of neural networks is benchmarked is the
fractional regression of Papke and Wooldridge (1996). The performance of these techniques is also
benchmarked against simple predictions given by average recoveries. It is shown that neural
networks have better predictive ability than parametric regressions, provided the number of
observations is sufficiently large. The statistical relevance of explanatory variables and the
direction of partial effects given by the neural network and fractional regression models are
compared. Because the opaqueness of neural networks precludes the derivation of valid statistical
tests to assess the importance of input variables, the sampling distributions and appropriate critical
values are obtained using a resampling technique known as the bootstrap (Efron, 1979). It is shown
that the significance of the explanatory variables and the direction of the partial effects given by
the neural network models are, in general, compatible with those given by the fractional
regressions.

2.5.2 Bank failure

A well-functioning banking system, critically, plays important role as a determinant of a country’s
economic growth (Levine 2005). Conversely, a banking crisis would generate an independent
negative real effect (Dell’ Ariccia et al 2008; Campello et al 2010), and cause serious disruptions
of a country’s economic activities (Hoggarth et al ( 2002). Perhaps, to curb against these events

43
many researchers have researched much upon this area, of forecasting bank loan default loss and
bank failure, which have led many authors to develop various models to forecast these catastrophic
events. Possibly, models which suit certain financial environment setup.

Camels Model.

Most previous studies of bank failures rely upon bank-level accounting data, occasionally
augmented with market-price data (e.g., Meyer and Pifer (1970); Martin (1977); Pettaway and
Sinkey (1980)). These studies aim to develop models of an early warning system for individual
bank failure. The indicators of these early warning models are closely related to supervisory rating
system of banks. The most widely known rating system is CAMELS, which stands for Capital
Adequacy, Asset Quality, Management, Earnings, Liquidity, and Systemic Risk. However, Cole
and Gunther (1998) find that the information content of the CAMEL rating decays as the financial
conditions of banks change over time, becoming obsolete in as little as six months; they also report
that a static probit model using publicly available bank-level accounting data almost always
provides a more accurate prediction of bank failure than does a bank’s CAMEL rating.

Cox proportional Hazard Model.

Whalen (1991), Rocha (1999) and Sales (2005) used the survival analysis to develop models for
prediction of bank insolvency, which use semi-parametric analysis of survival analysis model,
called Cox proportional hazards model, while Sales (2005) introduced the use of a technique called
parametric analysis of survival. The authors were mainly concerned to assess the ability of their
models to predict bank failure. Conclusively, the authors determine that both their models had
relatively high ability to predict bank failure. Thus, Whalen (1991) examined the capacity of
adjustment of the model developed for 12, 18 and 24 months preceding the bankruptcy of
American banks. The author concluded that, for all periods, the model presented a high ability to
hit: 88%, 81%, 75% of accuracy, the respective horizons of 12, 18 and 24 months prior to
bankruptcy. Similarly, Rocha (2001) developed models for prediction of insolvency for banks in
Brazil in two different periods, 12 and 24 months prior to insolvency of banks, and came with
same conclusion. Below is the cox proportional hazard model.

44
One notable exception is Wheelock and Wilson (2000), study which uses the Cox proportional
hazard model with time-varying covariates, estimated by partial likelihood, to analyze bank
failures during 1984-93. They analyze traditional CAMEL variables and find that poorly
capitalized banks, less profitable banks, less liquid banks and less managerial efficient banks are
more likely to fail, as are banks holding more risky asset portfolios. Hence, they provide strong
evidence confirming the CAMEL paradigm, using cox proportional hazard model, thus accounting
information improves the predictability of the model.

Secondly, the authors analyzed, the entire population of U.S. banks, using data on more than
12,000 banks, of which 1,277 failed. Wheelock and Wilson analyzed using a non-random selected
sample of only 4,022 banks, of which only 231 failed. Thirdly, the authors utilizes the full-
information of likelihood hazard model proposed by Shumway (2001), which it was much more
tractable and more efficient than the partial-likelihood Cox model estimated by Wheelock and
Wilson (see Effron, 1977). As demonstrated in a proof by Shumway (2001), the discrete-time
hazard model is estimated using a Logit program with appropriate adjustment of the test statistics,
and this can produce more consistent and efficient estimators than alternative estimators.

KMV distance to default on Japanese banks

Ito (2009) had interest in showing whether distance to default was a good measure in predicting
bank failures It gave a report on how the distance to default of failed Japanese banks moved since
the late 1980s thus prior to default .It gave results on how three banks distance to default moved
the last 12 months before the respective bank failure HTB, LTCB and NCB. From the study it
showed that distance to default had been gradually falling and became very low before the news
of the failure was announced. Looking at the distance to default for the period of 12 and 6 months
prior to failure it concluded that the distance to default is a good measure for the cases of HTB and
LTCB .However NCB was an exceptional case the financial statements of NCB was not reliable,
as it was later determined that its nonperforming loans were under-reported. With the window-
dressed financial statements, it was not surprising that the distance to default of NCB did not show
the declining pattern before the failure.

45
During the bubble phase in the late 1980s the distance to defaults of failed banks were positive and
relatively stable .What is interesting is the fact that distance to defaults of banks that would
eventually fail were higher than that of the benchmark during the bubble period. This finding
suggests that failed banks appeared to have performed very well during the bubble period, probably
taking risks in lending to the bubble sectors such as real estates and construction. Of course, as the
bubble burst, the distance to defaults of failed banks would falter.

Discriminant analysis and Logistic model

Meyer and Pifer (1970) and Sinkey (1975). They developed a failure prediction model for banks,
which the authors used discriminant analysis to create the model. The authors deduced that it was
possible to verify a state of bankruptcy up to two years ahead of the time using the model.
However, the values of financial indicators presented by the discriminant analysis were not able
to foresee a situation of the future failure, from three years prior to bankruptcy. Thus also, it is
important to remember that the use of discriminant analysis is restricted, due to normality of data.

Moreover, due to weaknesses of discrimant analysis led other authors to seek other techniques to
use constructing failure prediction models for banks such as logistic regression analysis and
survival analysis. It is a probabilistic model where the response variable is between 0 and 1, where
0 represents a solvency bank and 1 represents insolvency. The technique of logistic regression
analysis was widely used. However, only Martin (1977), Lane, Looney and Wansley (1986),
Espahbodi (1991) and Janot (2001) were concerned with the comparison of statistical techniques
used to develop models to predict the insolvency of banks. The authors compared the logistic
analysis with discriminant analysis, while Janot (2001) compared this analysis with the statistical
technique of survival analysis. Martin (1977) discovered that the models share some similarities,
however, the models had low ability to forecast better results.

Espahbodi (1991) showed that both models had high capacity to provide correct results for the
insolvency, but the logistic regression model was more accurate to predict the bankruptcy a year
ahead, while the model of discriminant analysis was more precise to predict it two years ahead. To
Janot (2001), the model estimated by analysis of survival obtained a better result to classify a bank
as a solvent or insolvent at a time frame of six months prior to bankruptcy. Lane, Looney and

46
Wansley (1986) were also concerned to compare the techniques for development of failure
prediction models. However, the authors found that both survival analysis and discriminant
analysis models had similar ability to predict, although the model developed using the technique
of survival analysis has shown better results for a horizon of two years prior to the insolvency of
banks.

Logit Model.

Lanine and Vander Vennet (2006) employ a Logit model and a Trait Recognition approach to
predict failures among Russian commercial banks. The authors test the predictive power of the
two models based on their prediction accuracy using holdout samples. Although both models
perform better than the benchmark, the Trait Recognition approach outperforms Logit in both the
original and the holdout samples. For the predictable variables, they find that expected liquidity
plays an important role in bank failure prediction, as well as asset quality and capital adequacy.

2.6 Summary of Empirical Studies carried out on Bank Failure.

47
2.7 Summary.

Basing on the previous researches it can be concluded that fractional response regression and Cox
Proportional Hazard Model are effective in Forecasting Bank loan Default Loss and Bank Failure.
However, the choice of the model to be used, depends on circumstances .The effect can be positive
or negative but either way the model should fit to forecast bank loan default loss and bank failure.
In addition little research has been carried out on forecasting bank loan default loss and Bank
failure on commercial banks in Zimbabwe. The remaining chapters of the paper are organized as
follows: Chapter three describes the data and methodology; Chapter four reports the empirical
regression analysis, results, and discussion; finally, chapter five summarizes the conclusion of the
study.

References

Asarnow E., E. D., 1995. a 24 Year Study. Measuring Loss on Defaulted Bank Loans, 77, No. 7,(The Journal
of Commercial Lending), pp. pp. 11-23.

Dermine, J. N. d. C. Carvariho, 2006. a case study Journal of Banking. Bank loan losses given default, pp.
1243-1291.

Felsovalyi, A. H. L., 1998. Measuring Loss on Latin American defaulted Bank loans: A 27- Year Study of 27
Countries. Journal of Lending & Credit Risk Management.

Fofack, H., 2005. Causal Analysis and Macroeconomic Implications.. Non-performing loans in sub-
Saharan Africa , Volume .World Bank Poilcy Resesarch Working Paper No.3769, Novemeber.

Franks, J. d. . A comparative Analysis of the Recovery Process and Recovery Rates for private Companies.

Jankowitsch, R. P. R., 2008. The delivery option in credit default swaps. Journal of Banking and Finance,
pp. 32, 1269–1285..

Mangudya, J., 2014. MONETARY POLICY STATEMENT. Harare, Reserve of Zimbabwe.

Waweru N and Kalami V, 2009. Commercial Banking Crises in Kenya:. Causes and Remedies . Africa
Journal of Accounting Economics , Finance and Banking Research, pp. 4(4), 12 -33.

Laevene .L 2009. Bank governance, regulation and risk taking. journal of financial Economics 93, pp. 259-
275.

Shumway, T., 2001. Forecasting bankruptcy more accurately. Asimple hazard model.. The Journal of
Business 74,, pp. 101-124.

48
Chinamasa P. 2012, Mid Term Fiscal Policy

International Monetary Fund (2012), Article IV Consultation, Zimbabwe: Country Report No. 12/279,
September 2012.

Bellotti, T., Crook, J., 2007.Basel Committee on Banking Supervision, 2006. International convergence of
capital measurement and capital standards. Bank for International Settlements.

Centre. Bonfim, D., 2009, ‘Modelling and predicting loss given default for credit cards. Working paper,
Quantitative Financial Risk Management. Credit risk drivers: evaluating the contribution of bank level
information and of macroeconomic dynamics. Journal of Banking and Finance 33, 281–299.

Calabrese, R., Zenga, M., 2010. Bank loan recovery rates: measuring and nonparametric density
estimation. Journal of Banking and Finance 34, 903–911.

49
 CHAPTER 3

METHODOLOGY

3.1 Introduction

This chapter fully expounds detailed information on how the researcher achieved, research
objectives stated in Chapter 1 and provides information on the type of research design the
researcher used, the sources of data as well as techniques used to manipulate data thus to ensure
precision, applicability and meaningful results, through suitable statistical approaches determining
goodness of fit of the models used to forecast bank loan default loss and bank failure. Major
emphasis has been put on various processes employed by the researcher in studying the research
problem with a key intention of answering the research questions. The chapter ends by providing
analysis and justification of the tools used in analyzing and presenting data in Chapter 4.

3.2 Research Design

The researcher employed descriptive research design in attempt to answer the research questions
of the study. Descriptive research design attempts to describe what exists and may help to uncover
new facts and meaning. This is done by using the scientific method to test the evidence to extend
an idea put forth or use it to reach into new areas and issues as well as new topics which science
can address in an attempt to improve the quality of life for people. The primary research question
of the study is to find the most suitable method of forecasting loan default loss and bank failure
for local banks in Zimbabwe. The primary concern of the descriptive research design is to uncover
new facts and meaning upon existing theories, ideas and concepts. The goals of adopting an
descriptive research design are to generate new ideas and assumptions on the area of study as well
as to determine the feasibility of the study in the future and this research design will uncover theory
of forecasting bank loan default loss and failure, through reviewing previous literature in relation
of forecasting bank loan default loss and bank failure

3.2.1 Descriptive Research Design

It presents an opportunity to fuse both quantitative and qualitative data as a means to reconstruct
what is the topic all about as well as it offers a unique means of data collection, such as a survey
can provide statistics about an event while also illustrative how people experienced that event.

50
However, descriptive research also has specific disadvantages such as the possibility for error and
subjectivity, the study may contain errors, as the researcher may record what he or she wants to
hear and ignore data that does not conform to the research project's hypothesis. Overcoming a
research bias is an extreme difficulty for descriptive research practitioners.

3.3 Target Population

This research project targeted all the banking institutions operating in Zimbabwe. The target
population comprised of both local banks and foreign banks which makes up all the commercial
banks operating within Zimbabwe, between the period of 2009 and 2013.

3.4 Sample Population and Sampling Technique

In this study, the researcher employed purposive sampling in choosing a sample of eight
commercial banks, on the basis of capital base, status of the bank defaulted and non- defaulted as
well as bank ownership, mainly focusing on indigenously owned. For the purpose of this study
non probability sampling was used with the researcher. Non probability sampling is useful since
selected elements will be unrestricted and accessible to the researcher and is able to tests
ideas about the area of research. The sampling process was done such that the sample gives a
detailed description of the population of all the commercial banks in Zimbabwe and the chosen
banks are listed in the table below:

Table 3.1 Summary of Chosen Commercial Banks.

Commercial banks in Zimbabwe

Operational Banks Failed Banks
FBC Bank Trust Bank
NMB bank Allied Bank
Metbank Interfin Bank
Agri - Bank Afri- Asia Kingdom Bank

51
3.5 Sources of data.

The sources of data researcher used in this research some were extracted from audited financial
statements of each selected bank and some of the data is also obtained from the regulator, Reserve
Bank of Zimbabwe (RBZ).

3.5.1 Secondary Data

The research made use of secondary data which comprised of the financial figures that were
obtained from financial statements of banking institutions to reveal their financial positions. The
secondary data is believed to be authentic and highly standardized since it is subject to a lot of
regulatory supervision such that it will have been audited by accredited auditors. The data is
cheaper to gather and more easily obtainable than the primary data. The collected secondary data
supported the assessment of a bank’s situation in terms of assets, finances, and income.

Paradoxically, despite the advantages of using published financial statements, the researcher was
aware of the major disadvantage of secondary data on financials being subject to creative
accounting, thus for banking institutions in endeavor to protect themselves from scrutiny.

3.6 Data Presentation

Data presentation entails how the data and the findings were presented during course of the
research project. The major data presentation techniques that were used in the research are tables
and graphs used to clearly present data so as to come up with summarized information which aids
quick viewing and interpretation of data.

3.6.1 Tables
Tables have been used in this research for the numerical presentation of data. The use of tables in
this research also comes with, displaying relative multiple classes of data for example in displaying
results of model summary and also permits a visual check of the reasonableness or accuracy of
calculations.

3.6.2 Graphs
In this research, graphs were mainly used for data presentation purposes. The key graphical
presentations that have been used in this project were under the selection of the ultimate survival
of the banking institution.

52
3.7 Soft wares Used.

The researcher used three major soft wares in the research design to fulfil various purposes. The
major soft wares that were used are Microsoft –Excel and SPSS.

3.8 Research methodology

3.8.1 Econometric Model specifications.

Fractional response regression model has the least requirements regarding certain statistical
assumptions compared to the other alternative methods models (linear regression model, decision
trees model, multifactor model and neural networks), the researcher used the fractional regression
model to predict the bank’s loan default loss. The fractional response regression operate under
conditions, of which the dependent variables have two possible outcomes (dichotomous).

3.8.2 Procedure for Analysis.

 Step 1: Creation of parametric regression.

In this section, a parametric regression of the loan default loss, LDL, as a function of the loan and
bank characteristics, Xi, i = 1,. . . ,k. is expressed as follows

E (LDL/X) = β0 + β1 X1 + …………… + βK XK = Xβ …………………………… (1)

Where E (LDL/X) - is the expected loan default loss given all bank characteristics variables X and
is the output from the fractional response regression model component. This variable will be
transformed (as shown in equation 2) to attain forecasted loan default loss mostly bounded
between 0 and 1.

Βi - is the coefficient of the ith predictor variable. The coefficients measure the effect on the loan
default loss due to a unit change in the corresponding independent variables.

Β0 - is the constant.

53
Xi -is the independent variable. These are also called predictor variables or explanatory
variables, constituting a vector of explanatory variables (Capital, Corporate Governance,
Liquidity, lending rates, concentration of loans, non –performing loans)

k – refers to the number of financial indicators included in the model.

 Step 2: Introduction of Logistic Function.

The loan default loss is restricted to the interval between 0 and 1, since its outcome is probability.
Due to the bounded nature of the dependent variable one cannot implement an ordinary least
squares (OLS) regression as shown in the above equation (1). Thus, the left hand-side-value from
equation (1) above can take any value from -∞ to +∞ which make it difficult to forecast loan default
loss. To overcome this problem of linear probability model, the logistic function is used such that
the output values are in the interval between 0 and 1 instead of the interval -∞ to +∞ as is in the
linear regression model. The outcome fractional response regression model could be shown as in
the equation 2 below:

E (LDL/X) = G (Xβ) = … ………………… (2)

Where G (Xβ) - is the logistic function, thus the formulae below is created to have estimators
which lie within unit interval of between 0 and 1, thus to have final expected loan default loss
which lie the same range. Therefore fitting (equation 1 into 3), the whole model will appear as
below:

………………………………………… (3)

Where G (.) satisfies 0 < G (Xβ) < 1 for all Xβ ∈ LDL. This condition guarantees that the predicted
loan default loss lie in the unit interval.

54
  Step 3: Forecasting loan default loss
The equation (4), below is derived from the equation above equation (3), and it is depicted as
equation below:

𝑒 (𝛽0 +𝑋1𝛽1+⋯…….+ .𝑋𝑘 𝛽𝑘)

E (LDL/X) = G (Xβ) = …………… (4)
1+ 𝑒 (𝛽0 +𝑋1𝛽1+⋯……+ .𝑋𝑘 𝛽𝑘)

To ensure the model fit, to forecast loan default loss, bounded between 0 and 1. The researcher
perform test of maximum of likelihood, which is performed with following step below.

 Step 4: Estimation of Maximum Likelihood.

According to Papke and Wooldridge (1996), using a linear model for a log-odds function makes it
difficult to retrieve the expected value of the fractional dependent variable. One common method
to handle data with the characteristics of mostly binary loan default loss is the quasi-maximum
likelihood estimation (QMLE). The estimation is obtained from the following maximization
problem:

Ldli + ( 1 - Ldli)

The attractiveness of this method is that the quasi maximum likelihood estimator (QMLE) of β
is simple for a member of the linear exponential family, consistent, and √ N -asymptotically
normal, irrespective of the distribution of the (LDL) conditional on Xi. The quasi-maximum
likelihood estimator of β is consistent and asymptotically normal regardless of the distribution of
the loan default lossi conditional on (Gourieroux et al., 1984).

 Step 5: Model Validation.

Wald test for the null hypothesis that the set of coefficients are jointly zero.

55
3.9 Assumptions of the Loan default loss model (equation 4)

These results obtained with the log–log functional form, with conclusions for the logistic
functional form are similar.

3.10 Bank Failure Econometric Model.

In this paper, the researcher rely on survival analyses that use Cox Proportional hazard models to
study the relation between bank failure, loan default loss and other variables. Hazard models are
appropriate to the context of this study, since they incorporate information about the time that
elapses before an event (in case of this study, a bank failure) occurs. These models have been used
in numerous research contexts, especially when the “hazardous” event of interest is rare (e.g., Lee
and Urrutia 1996; Shumway 2001; Carpenter and Lewis 2004).

For example, Shumway (2001) demonstrates that hazard models outperform static models such as
logit models in predicting bankruptcy.

3.10.1 Procedure to follow

 Step 1: Creation of the parametric regression model.
The researcher tests rely on the widely used Cox proportional hazard model (Cox 1972; Cox and
Oakes 1984), which has the following form:

h (t) = h0(t) exp ( β1 X1 + 𝛽 2 X 2 + ………… 𝛽 i X i ) ………………….. (6)

Where Xi - is a vector of explanatory variables (Capital, Corporate Governance, Liquidity, Non

– performing loans, loan default loss, Concentration of Assets, Profitability, Bank Size, GDP,
Interest Rates)

βi - is a vector of coefficients.

h0 (t) - is the baseline survival function. This expression represents the likelihood that a

56
 Bank will continue to be in existence at time t, in view of the baseline rate of

Survival among observed banks in the Zimbabwe economy.

exp (Xiβi) - represents the dependence of the hazard rate on a vector of explanatory

variables X.

h (t ) - is the hazard of bank (failure/survival time) at time t, t is the number of days

from January 1, 2009 to 2014. The initiation date of survival analysis is January

1, 2009 and final date is December 31 2014.

3.11 Assumptions of Model.

 Proportional hazards assumes that the ratio of hazard in one group to another remains the
same throughout the follow-up period.
 Survival times usually follow an exponential or Weibull distribution.
 The predictors are assumed to act additively on log [ hi (t)]
 The effect of the predictors is the same at all times t.
 The estimated coefficients have an approximate normal distribution, when there are
adequate numbers of events.

3.12 Justification of the model.

Shumway (2001) cites two reasons why hazard models are preferable to static models in predicting
the bankruptcy or failure of a bank. First, static models do not, whereas hazard models do, control
for how long a bank is at risk of failure. Some firms fail quickly while others fail after a much
longer period at risk. Failure to correct for period at risk introduces a selection bias to static models,
such that parameter estimates are biased and inconsistent.

Secondly, dynamic hazard models produce more accurate out-of-sample forecasts because they
incorporate information from many more observations. For example, the researcher can analyze

57
ten years of data, so that the hazard model can utilize ten times as many observations as a static
model that uses cross-sectional data from a single year. The researcher more data points which
would take advantage of the model by a rise from a factor of 10 to a factor of 40. More observations
result in more precise parameter estimates and more accurate forecasts.

3.13 Conclusion.

This chapter provided a roadmap on how the research was conducted to answer the research
questions. A quantitative research design was employed in which parsimonious Fractional
Regression and Cox Proportional hazard model was developed, suitably for Zimbabwean
environment. Results obtained from this methodology were presented in Chapter 4.

58
 CHAPTER 4

DATA PRESENTATION AND ANALYSIS

4.1 Introduction

This chapter presents the empirical results that were obtained in the research process. The results have
been analyzed and interpreted using the statistical and financial theories so as to answer the research
questions.

4.2 Model for forecasting Loan default Loss.

What is the appropriate model for predicting loan default loss and bank (failure/ survival time).

4.2.1 Fractional Response Regression Model

The researcher used fractional response regression model to predict loan default loss, due advantages that
the model possess over other models that have been used with other researchers.

Table 4.1 Statistical tests for the assumptions of the model.

The model has proved to fit the data due to statistical assumptions that are met as shown in the
table above -2 log likelihood 59.815, Cox & Snell R square being above 0.503 as well as
Nagelkerke R Square, which is above 0.50 and this prove that the model is slightly strong. The
researcher performed backward likelihood ratio to identify the most significant predictor variables
of Loan default loss, this shown in the table below:

4.2.2 The stepwise process of Fractional Response Regression.

The model to be efficient, goes through iteration of backward stepwise (conditional) were the
statistical software will validate variables that are significant and remove that are insignificant.
First iteration there were 8 variables and no variable was removed. Second iteration the lending

59
rates was removed from the equation and lastly, the iteration variables which include lending rates
and corporate governance were removed and final left with 5 variables that are significant. The
iteration process is shown in (the appendix: 1).

Table 4.2: Significant Variables from Backward Stepwise (Conditional)

The model developed is depicted as below including only significant variables, which are derived
from the table above

E(LDL/X)=G(Xβ)

𝑒 (2.724 −7.784𝐶𝐴𝑅 −5.150 𝑙𝑖𝑞 −18.831 𝑝𝑟𝑜𝑓−24.309 𝑛𝑝𝑙)

=
1+𝑒 (2.724 −7.784𝐶𝐴𝑅 −5.150 𝑙𝑖𝑞 −18.831 𝑝𝑟𝑜𝑓−24.309 𝑛𝑝𝑙)

4.2.3 Analysis of forecasted loan default losses for Operational Banks and Failed Banks.
The summary of the analyzed forecasted loan defaulted losses for operational banks and failed banks
is shown in the table below. The output from the model for either failed banks or operational banks
was bound between 0 and 1, whereby loan default loss that is close to zero depicts that the banking
institution experienced quite low loan default losses and a probability greater than 0.5 depict that the

60
bank experienced slightly high default losses and for above 0.75 depicts extreme losses that were
generated from non- performing loans.

Table 4.2:Forecasted loan default losses for Operational Banks and Failed banking Institution.

The above table shows that operational banks were experiencing low loan default losses from 2009 – 2010
and for failed banks were experiencing huge losses close to probability of 1, from 2009 and low loan default
losses at the end of the 2010. This was due to defaulted banks in an endeavor to restructure their capital in
order to meet minimum capital threshold, thus there were now strict rules in the recovery process of
defaulted loans. Bellotti and Crook (2009) on the contrary found a significant relationship between
LGD and a number of bank specific variables and macroeconomic variables in their analysis of
credit card LGDs on individual loan transactions

61
Table 4.3 : Coefficient for Fractional Response Regression Model.

Also from above (table coefficient ), loan default loss is influenced by 4 predictor variables capital
ratio adequacy, liquidity, profit, non –performing loans and proved to be significant where their p
< 0.05. The mentioned proved to be significant when the model was stepwise.

4.3 Model for predicting bank failure.

4.3.1 Cox Proportional Hazard model

Hazard models do control or determine time, for how long a bank is at risk of failure, which static
models cannot do. Dynamic hazard models produce more accurate out-of-sample forecasts
because they incorporate information from many more observations, for example, the researcher
analyzed five years of data, whereby the hazard model utilized ten times as many observations as
a static model that uses cross-sectional data from a single year. Hazard models provided with many
data points enabled the model to produce more precise results and parameter estimates and more
accurate forecasts. Thus, the researcher to answer the first question, test the model fitness and
obtained the result that are shown below

62
4.3.2 Analysis for both Operational Banks and Failed Banks results

Table 4.4 : Hazard Ratios from Cox Proportional Hazard Model

Source: Author’s computations from study sample (2009-2013)

Table 3 above shows hazard ratios estimated from Cox regression. The Table shows that the survival of
banks in Zimbabwe is most strongly influenced by 8 predictor variables. The 8 influential predictor
variables are capital adequacy ratio (CAR), Loan Default loss (LDL), Concentration of Assets (COA),
profitability, Liquidity and Gross Domestic Product (GDP). The estimated coefficient of predictor variables
mentioned above, exhibit correct signs and highly statistically significant, as their p values < 0.05, except
for two variables corporate governance and bank size

This study derived the survival function from the underlying hazard function as stated in the model
specification, it should be noted that the coefficient from the hazard function appear in the survival
function changed. As a result, in a survivor function coefficients can be expected to exhibit
counterintuitive signs. Coefficients that are expected to be positively associated with the
probability of survival will show as negative and vice versa. For instance loan default loss will

63
exhibit negative sign. Similarly, variables that are expected to be negatively associated with the
probability of survival, such as the loan default loss will have positive coefficient. The hazard ratio
for loan default loss was 0.19 times, implying that banks with loan default loss are 0.19 likely to
fail than banks without loan default loss. On concentration of assets the defaulted and non-
defaulted banks have hazard ratio of 1.31 meaning that the banks were 1.31 times likely to fail
with high concentration of assets, if the loans they advanced to different industry defaulted.
Profitability and liquidity were the major hazard ratios for predictor variables for bank failures in
Zimbabwe, were the hazard were 45916.28 times and 47.465 times respectively. The former
predictor depicting that if a commercial bank in Zimbabwe was making huge losses was likely to
fall 45216.28 times as compared to some other banks making profits and the later, also the bank
was 47, 465 times likely to fail compared with other banks which were not facing liquidity
challenges, and both challenges are significant at 2 percent.

Further on for insignificant variables such as corporate governance and bank size with hazard
ratios of 0.5 and 3.855 times, the former depict that banks without corporate governance in
Zimbabwe are likely to fail 0.5 times than banks with corporate governance and for commercial
banks with small market share are likely to fail with 3.855 times, compared to banks with large
market share. Ultimately, these two variables have correct signs but do not enable the researcher
to make inference.

The adequacy of the fitted cox model was assessed using log minus log plots, the

The adequacy of the fitted Cox model was assessed using log-minus-log plots, the likelihood ratio
test and the AIC (Akaike’s Information Criterion) as diagnostic procedures. All log-minus-log
plots were parallel, showing that the assumption of proportional hazards was satisfied (appendix).

Fitted Cox Proportional Hazard Model

The p- value from the likelihood ratio test was small (0.0001 < 0.05), thereby showing that the 8
variables constituting the fitted Cox model were jointly efficient in explaining the long-term
survival of banks in Zimbabwe at the 5% level of significance

64
Table 4.5 Goodness of Fit for Cox Proportional Hazard Model.

The overall statistics show the log likelihood of 290.005 which is high and significant at 1% when
compared with the critical Chi square at 5% = 44.5, therefore, the final decision is to reject the null
hypothesis and accept the alternative hypothesis. This implies that factors responsible for bank
failure can be predicted in Zimbabwe, including the estimate of loan default loss. Thus loan default
loss plays a pivotal role in predicting bank failure in Zimbabwe.

4.3.3 The stepwise process of Cox Proportional Hazard Model.

The model to be efficient, goes through iteration of backward stepwise regression were the
statistical software will validate variables that are significant and remove that are insignificant.
First iteration there were 10 variables and no variable was removed. Second iteration the non-
performing loans was removed from the equation and lastly, the iteration variables which include
non –performing loans and lending rates were removed and final left with 8 variables that are
significant. The iteration process is shown in (the appendix: 2).

65
Table 4.6 Significant Variables from Backward Stepwise (Conditional)

4.3.4 Benchmarking the model

The cox proportional hazard model estimated is shown below and the survival table used in the model for
time t, (2010) is depicted in the (appendix 1), the estimated survival time with model should reflect the real
world survival time for banks that are operational and banks that have failed. The survival time of a bank
is calculated using exponential of coefficients ( β Betas), which are the hazard rates measuring the changes
of one unit change of variable against change in survival time of the bank h(t).

h (t) =0 .007 exp( 5.145CARi – 3.97LDLi +0.270 COAi + 10.735 PROi + 3.86 LIDi + 14.343 GDPi

The model has been tested for its feasibility, by imputing the data of operational banks and failed banks
into the model. This is shown in the table below:

66
Table 4.7 :Results of the Benchmarked Model of Cox Proportional Hazard Model.

Consequently, the model has proven its feasibility, when the data for non- defaulted banks FBC and NMB
Bank were fitted into the model, produced results for FBC Bank its hazard of bank failure was 16 years at
time t, June (2009) and for NMB Bank was 18 years at time t, June (2009), thus through factoring the
coefficient of the significant variables in to the cox proportional hazard model. The same process was
applied for defaulted banks producing the results where trust bank recorded 8 years hazard of the bank
failure at time t (2010) as well as interfin bank calibrated results were -19 years hazard of the bank to fail,
thus we determine the feasibility of the model predicting bank failure for banks out of the sample as well
as in time of the sample.

67
 Fig 4.1 :Survival Function graph for Operational banks and Failed banks.

Interfin Trust
bank NMB Bank
bank

FBC bank

Author’s computations from study sample (2009-2013).

Interfin bank defaulted early at -19 years, as shown in the diagram, and followed by trust bank at 8 years,
FBC bank at 16 years and lastly, NMB bank at 18 years. All the banks are measured at base date which is
2010.

68
4.4 The relationship between Loan default loss and Bank Capital.

What is the relationship between loan default loss and bank capital.

The relationship between loan default loss and bank capital was determined through the use of correlation
matrix and null hypothesis.

Ho there is no relationship between loan default loss and bank capital.

H1 There is relationship between loan default loss and bank capital.

Consequently, the researcher determined that there is negative relationship between loan default loss and
bank capital, depicted with – 0.6 correlation, and thus enable the researcher to reject null hypothesis and
accept the alternative hypothesis, hence their relationship is depicted in the table below:

Table 4.8: Correlation Matrix for Loan default loss Variables

Perhaps, this relationship between loan default loss and bank capital means that as losses generated
with non- performing loans increases the bank capital decreases. Ironically, the quality of loans in
the bank’s portfolio will diminish in value, pose threat to the stability of the bank, whereby failure
to manage these losses will result to a bank failure, Kroszner (2002) in Waweru and Kalami (2009).
The results above are also in line with the results obtained by (Wall and Koch 2000), asserts that
increase in loan default loss generally reduce net income and consequently, Tier 1 capital.
Practically, were banks regulations allow the add-back of loan loss reserves as Tier 2 capital under
the regulatory philosophy that loan loss reserves represent capital that should be “built up” during
good economic times, to absorb losses during bad times. Conversely, for most local commercial

69
banks in Zimbabwe, results have proven that bankers are failing to forecast the expected losses
from non –performing loans, as there are experiencing challenges since introduction of
multicurrency regime, the situation is worsening due to dysfunctional role of RBZ to act as lender
of last resort. The regulatory RBZ, also does not have power to control the monetary policy, since
it is using the borrowed currency. Thus such situation have left most local banks falling to extricate
themselves from such qaugmirant event of increase in non- performing loans, thereby avoiding
loan default losses.

4.4 The relationship between loan default losses and Bank (failure/ Survival time).

What is the relationship between loan default losses and bank (failure/Survival time)?

When a banking institution is experiencing excessive loan default losses, is likely to face challenges of
insolvency, which in return reduce its survival time as it is exposed to risk of failure at time t, compared to
other banks that are at risk as well at that time. The results depict that there is negative relationship between
bank failure/survival time and loan default loss .The results are depicted in the table below:

Table 4.9 : Coefficient of Cox proportional hazard model.

Source: Author’s computations from study sample (2009-2013).

70
The relationship between loan default loss and bank (failure/survival) time was determined through the use
of correlation matrix and null hypothesis.

Ho there is no relationship between loan default loss and bank (failure/survival) time.

H1 There is relationship between loan default loss and bank (failure/survival) time.

Consequently, the researcher determined that there is negative relationship between loan default loss and
bank (failure/survival) time. , depicted with – 3.97 correlation, and thus enable the researcher to reject null
hypothesis and accept the alternative hypothesis and the relationship means that the loan default loss less
likely to be hazard to the failing of a bank but significant, since its p value < 0,05 and its coefficient is
negative.

4.5 Variables that determine Loan default loss and Bank failure.

What are the variables that determine loan default loss and bank failure?

The other variables that determine loan default loss and bank failure are determined in the table above
which include CAR, LDL, COA, CORP GOV, BS PROF, LIQ and GDP and statistically significant
variables are CAR, LDL, COA, PROF, LIQ and GDP and their p values < 0.05.

4.6 Summary

It can be concluded that liquidity and profitability are the major hazards of commercial banks in Zimbabwe
as it is depicted with their hazard ratio. Consequently, the output of the models was validated so as to check
the feasibility and stability of the model, given data of recovery rates which difficult to analyze, so thus the
data from input variables the goes through a rigorous statistical tests, thus to able to determine correct loan
default loss and survival time of a bank.

71
 CHAPTER 5

SUMMARY OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS

5.1 Introduction.

This chapter concludes the study by giving the summarized findings of the research project. The
chapter also gives recommendations to the bankers as well as the regulator on the level of loan losses
and level bank failure that need to be hedged against. Finally, the chapter concludes by suggesting
areas for further research areas that can enhance the forecasting of loan default losses and bank failure.
It is crucial to note the recommendations, and conclusion from this chapter is in accordance to the
findings from this project in integration with the existing literature on forecasting loan default loss and
bank failure.

5.2 Summary of the Results.

5.2.1 Forecasting Loan Default loss

This study applied parametric fractional response regression to forecast bank loan credit losses,
and has been found to be a successful model in predicting loan default loss, with few explanatory
variables. The fractional regression models capture effects on loan default loss due to explanatory
variables that are statistically significant and insignificant in the fractional response regression.
The forecasting accuracy of the model is evaluated using the data of financial statements, were
The performance of the models is benchmarked against predicted loan default losses that were
incurred with banking institution over a given time period as well as using historical averages, the
model proved to produce better results for longer horizons well as the model estimates. The data
to fit the model, stepwise regression was conducted to ensure efficient of the model, removing
irrelevant variables and left with only significant variables. The number of variables used for this
study was reduced to 5 variables using the stepwise backward elimination procedure. The stepwise
backward elimination procedure was applied with a probability cut-off point of 0.20.

72
5.2.2 Bank failure.
The researcher proposes and empirically evaluate survival time model to predict bank failure using
information from financial statements, for commercial banks in Zimbabwe. The research has been
addressed before by several papers (Lane et al. (1986), Whalen (1991), Henebry (1997)). The
researcher extend this literature in several ways. First, the researcher predict loan default loss
generated from loan and bank characteristics (profit, liquidity, bank size, non- performing loans
and other variables),and thus after determining the impact of these variables the researcher
determine forecasted loan default loss.

Secondly, the researcher took further analysis, by imputing the value obtained of forecasted loan
default loss into the survival model of cox proportional hazard model to see its effects on survival
time of the banks in Zimbabwe. By showing the survival time for non - defaulted and defaulted
banking business that has been in operation in the country up till 2013 when the banking business
nomenclature changes in Zimbabwe. The analyses in this study also show the effect of estimated
macro- economic variables on the survival probability of banks in Zimbabwe. The data for the
study was sourced from the banks financial statements and RBZ as well as Zim-Stats. The result
from this study reveals that we can predict bank failure.

The number of variables used for the study was reduced to 8 using the stepwise backward
elimination procedure. The stepwise backward elimination procedure was applied with a
probability cut-off point of 0.20. At each stage of elimination, variables that could not meet the
minimum criteria for staying in the model or “useless variables” were discarded. The procedure of
discarding “useless variables” was continued until no more “useless variables” could be removed
from the model. The final model consisted of 8 highly influential predictors of bank survival. The
P-values were fixed at the 5% level of Significance. P-value smaller than 0.05 indicates the
significance of variables while p-value greater than or equal to 0.05 indicates insignificance. The
aim of the study was to identify factors that significantly affect the long-term survival of a bank.
Analysis was done using the Cox proportional hazards model, in view of the fact that some of the
4 banks in the study were censored, meaning recognized as defaulted. Hazard ratios were obtained
for key influential predictors of survival. Kaplan-Meier survival probability curves were used for

73
determining average survival time of non –defaulted and defaulted banks. Descriptive and
summary statistics were also obtained. The adequacy of the fitted Cox regression model was
assessed using the likelihood ratio test and Akaike’s information criterion (AIC) statistic. The
fulfillment of the proportional hazards assumption was tested by use of log minus- log plots. The
highlight of the result shows that banks that experience business losses are 45.28 times are more
likely to fail than banks that are not and the opposite is true. The result also shows that banks that
are experiencing liquidity challenges 47 times more likely to fail than banks that are not. This
makes issues of profitability and liquidity to be very important to the banks as well as to the bank
regulator. The result of the findings tells regulators the ratios to watch for to ensure that the health
of the banks is not jeopardize. Other ratios of importance in this analysis are the result obtained on
loan default loss and concentration of assets hazard ratio, even though their ratios are of small
magnitude. The ratio shows that banks that are high on loan default losses are 0.19 times more
likely to fail than banks that are not. The findings of this study coincide with other study of this
nature and this is an innovation in usage of Zimbabwe data.

5.3 Recommendations

5.3.1 Future Researchers

5.3.1.1 Loan default loss

Possibly, the results of this study have used loan characteristics variables and bank characteristics
variables to predict loan default loss and this has proven that it has worked well to come with
results to interpret the situation that local banks in Zimbabwe are experiencing due to a challenge
of increase non- performing loans in which, using Zimbabwe data might be difficult to forecast,
due to limited data availability. Thus for future researches it is imperative that the research be
carried with other models that will predict accuracy using few variables but with huge amounts of
data such as decision tree models and also involve variables such as years of relationship between
the client and the banking institution, collateral, features of the obligor and seniority, variables
which are not involved in this research. Initiation of models which calibrate loan default loss and
probability of default at same time, thus to measure the exact amount the bank is expected to incur
in case of default event.

74
Nevertheless, the results shown here capture several empirical regularities found in previous
studies on loan default loss. The models tested here are parsimonious, gave results that are easily
interpretable and are readily implemented. The results suggest that fractional response regression
is an interesting alternative to the parametric models commonly employed in empirical studies on
loan default loss. In fact, financial institution can benefit from exploring alternative techniques
when developing loan default loss models. The tree models proposed here provide a different
perspective of the data since the structure of the relationship between recovery rates and
explanatory variables is not predetermined, but is constructed according to information derived
from the data.

5.3.1.2 Bank failure

Although the result from this study show the use of financial ratios in predicting long term bank
survival is a good development in the Zimbabwe research circle, but far beyond the variables used
there are other more important variables that contributes to bank failure at the firm level such as
management quality and internal efficiency rating that are not eventually captured in this study
even though they are considered initially. A good, efficient and innovative management is
especially important in situations of financial crisis and in a developing economy like Zimbabwe.
Other macroeconomic variables such as rate of employment, exchange rate and level of inflation
in the economy are other important variables in predicting bank failure. The macroeconomic
environment determines the business environment the banks operate in and this affects the survival
of the bank. Despite the limitations, this paper provides a good starting point in predicting bank
failure in Zimbabwe. The fact that the result from this study shows clearly the predictor variables
that affects bank long term survival in Zimbabwe implies that this paper can be improved upon to
capture other variables of interest in subsequent studies.

5.4 Recommendations

5.4.1 Bankers and the Regulator.

5.4.1.1 Loan default loss

The study therefore recommend that the banks should securitize their non- performing loans in
order to reduce loan default loss, thus to resuscitate their capitals, since there is negative
relationship between loan default loss and capital adequacy. Use of fractional response regression

75
model will create a competitive advantage to the banks for forecasting expected loan losses. These
models will help the banking institutions to allocate regulatory capital and economic capital
effectively and efficiently. Banks should also improve their criteria of evaluating the credit
worthiness of borrowers, in-order to avoid risk of default.

5.4.1.2 Bank failure

The study therefore recommend the regulator should ensure banks maintain their capital base
above minimum threshold as from the results revealed with model that capital adequacy pose great
threat to local banks in Zimbabwe. Bankers should diversify very well their investments in- order
to generate huge returns, so as to maintain solvency and stability into banking industry as well as
retaining confidence to the public. As this is explained with model that concentration of assets,
profitability, bank size and liquidity pose a great hazard to the institution, since their coefficients
are positive and thus reduce the survival of the bank to keep operating. While, corporate
governance and loan default loss do not pose great hazard but there are significant to predict bank
failure. The banks should be mindful about improving liquidity in the banking sector and
monitoring the capital adequacy of banking institutions, so as to ensure that it is well managed.
The regulator needs to build capacity and ensure that the banks returns are well analyzed as they
are sent to them to detect signs of distress early before the banks went down.

5.5 Conclusion

This research has presented the importance of the forecasting loan default loss and bank failure.
Through the use of fractional response regression in forecasting loan default loss and cox
proportional hazard model to predict bank failure and these have proven to be successful. Thus,
this research has found the capability of integrating forecasted loan default loss and bank failure,
concurrently with the annual financial results of a banking institution in an effort to predict the
actual status of the banking institution, when it is facing a challenge of huge portion of non-
performing loans in its balance sheet vis a vi its solvency.

76
5.6 Summary of Capstone Design

The researcher designed the system that was capable of forecasting loan default losses and the
survival time of a bank up until the time it fail, applicable to any banking institution. The system
was built based on the model that had been designed in this research. The research design was
initially done using visual basics so as to measure the capabilities of the model. After gaining the
key requirements from visual basics, the researcher replicated the model using Java language.

The design of the program using Java language was generally based on the capabilities of the
language to produce systems of high performance and which are also platform independent. This
advantage made it possible for the designed system to be installable on any computer (either using
the windows operating system or the Linux operating system). This made it possible for the
designed system to be highly flexible. The designed system is such that it accepts the both input
values for the relevant variables in forecasting loan default loss, which is the probability of a bank
that it is expecting to make a loss when default event occur, bounded between 0 and 1, as well as
the impact of forecasted loan default loss on the level of failure of the institution or survival time
of the bank.

After accepting all the inputs, the system will then calculate the survival time of banking
institution, given all bank characteristics and loan portfolio characteristics, thus based on the model
that has been design in this research. There are only 4 possible outcomes from the system which
one will be focusing on loan default loss, computed outcomes will be graded based on the level of
the outcome divided into categorizes manageable losses , unmanageable losses. Possibly, the same
setup applied to other side of the system that focused of the survival time of banking institution,
which was divided into categorizes, restructure funding, meaning the banking institution can
restructure its funding to improve its survival time or the opposite is true based on the span of time
calculated with the system. The designed system was also capable of generating reports. The
reports that the system generated were based on the entered information. These reports can then
be printed where necessary.

77
 References

Asarnow E., E. D., 1995. a 24 Year Study. Measuring Loss on Defaulted Bank Loans, 77, No. 7,(The Journal
of Commercial Lending), pp. pp. 11-23.

D., C. L. a. L., 1996. Moody's Investor Service. Defaulted Bank Loan Recoveries.

Dermine, J. N. d. C. C., 2006. a case study Journal of Banking. Bank loan losses given default, pp. 1243-
1291.

Felsovalyi, A. H. L., 1998. Measuring Loss on Latin American defaulted Bank loans: A 27- Year Study of 27
Countries. Journal of Lending & Credit Risk Management.

Fofack, H., 2005. Causal Analysis and Macroeconomic Implications.. Non-performing loans in sub-
Saharan Africa , Volume .World Bank Poilcy Resesarch Working Paper No.3769, Novemeber.

Franks, J. d. S. A. D. S., n.d. A comparative Analysis of the Recovery Process and Recovery Rates for
private Companies in the \b.

Jankowitsch, R. P. R., 2008. The delivery option in credit default swaps. Journal of Banking and Finance,
pp. 32, 1269–1285..

Mangudya, J., 2014. MONETARY POLICY STATEMENT. Harare, Reserve of Zimbabwe.

M, W., 2009. Commercial Banking Crises in Kenya:. Causes and Remedies . Africa Journal of Accounting
Economics , Finance and Banking Research, pp. 4(4), 12 -33.

R, l. L. a. L., 2009. Bank governance, regulation and risk taking. journal of financial Economics 93, pp.
259-275.

Shumway, T., 2001. Forecasting bankruptcy more accurately. Asimple hazard model.. The Journal of
Business 74,, pp. 101-124.

Altman, E.I., 2006. Default recovery rates and LGD in credit risk modeling and practice: an updated
review of the literature and empirical evidence. Working paper, Stern School of Business, New York
University.

Hellmann, Thomas F., Kevin C. Murdock, and Joseph E. Stiglitz, 2000, Liberalization, moral
hazard in banking and prudential regulation: are capital requirements enough?, American
Economic Review 90(1), 147-165.

Calabrese, R., Zenga, M., 2010. Bank loan recovery rates: Measuring and nonparametric density
estimation. Journal of Banking and Finance 34, 903–911.

Bellotti, T., Crook, J., 2007. Modelling and predicting loss given default for credit cards. Working paper,
Quantitative Financial Risk Management Centre.

78
Grunert, J. and M.Weber (2009). Recovery rates of commerical lending: Empirical evidence for
german companies. Journal of Banking and Finance Vol. 33, 505–513.

Hutchison, Michael and Kathleen McDill (1999). “Are All Banking Crises Alike? The
Japanese Experience in International Comparison.” NBER Working Paper Nº7253.
Kaminsky, Graciela and Carmen Reinhart (1999). “The Twin Crises: The Causes of
Banking and Balance-of-Payments Problems”, American Economic Review 89(3),
June 1999, p. 473-500.

Kolari, J., D. Glennon, H. Shin, and M. Caputo. (2000). “Predicting large U.S.Commercial
Bank Failures.” Working Paper No. 2000-1, U.S. Comptroller of the Currency
(Washington, D.C.).

Lindgren, C., G. Garcia and M. Saal (1996). Bank Soundness and Macroeconomic Policy. IMF.
Rojas-Suarez, Liliana (2001). “Rating Banks in Emerging Markets: What Credit Rating
Agencies should learn from Financial Indicators.” Institute for International Economics

Sahajwala, Ranjana and Paul Van den Bergh (2000). “Supervisory Assessment and Early
Warning Systems.” BASEL COMMITTEE ON BANKING SUPERVISION, WP 4.

Jarrow, Robert A., 2001, “Default Parameter Estimation Using Market Prices”, Financial Analysts Journal,
Vol. 57, No. 5, pp. 75-92.

Cox, D. R. 1972. Regression models and life-tables. Journal of the Royal Statistics Society 34:
187-220.

Estrella, A., S. Park, and S. Peristiani. 2000. Capital ratios as predictors of bank failure. FRBNY
Economic Policy Review July 2000: 33-52.

Moyer, S. E. 1990. Capital adequacy ratio regulations and accounting choices in commercial
banks. Journal of Accounting and Economics 13: 123-154.

79
Appendix 1 Backward Stepwise process (Conditional) for Model of Loan Default Loss.

80
81
Appendix 2: The Backward stepwise process for Cox Proportional Hazard Model

82
Appendix 3: Survival Table.

83
84
85