Practical Panel-Data CMI

Macro stress Testing Credit Risk: A Panel Econometric Estimation with
Ugandan Data
by
Charles Augustine Abuka
Director, Financial Stability Department
BANK OF UGANDA
Prepared for the CMI Course on Macro stress testing

August 22, 2013
KSMS, Nairobi, Kenya
OUTLINE
2
Outline
• Applications in modelling the financial sector
• Introduction to Panel Data Models
• Practical Applications Using Ugandan Data
• Further Topics
• Concluding Remarks
3
APPLICATIONS IN MODELLING
SOURCES OF SYSTEMIC RISK IN THE
BANKING SECTOR
4
The empirical literature overview
Author (s) Methodology and Economies Results

Gambera [2000] The authour used bivariate VAR This study revealed the link between
(employing variables such as macroeconomics dynamics and banks
unemployment, sector income, number asset quality, where yields can be used
of bankrupcies, car sales and to make accurate predictions of future
agricultural, commercial, industrial effects of the business cycle on assets
and real estate loans) and investigated quality and cyclical factors can be used
the impact of economic development for asset quality forecasting.
on loan portfolio quality for the case of
the USA.
Arpa et al [2001] The authours used single equation The authours conclude that the share
regression analysis, focusing on risk of risk provisions in the total loans of
provisions and the operating income of the banking sector varies indirectly
Austrian banks. with real GDP and real interest rates
and directly with CPI inflation and real
estate price inflation.
Blaschke and Jones [2001] The authors applied a VAR The authours discuss the impact of
methodology to investigate the GDP growth and the business cycle on
transmission from real GDP, inflation, credit risk and also on the quality of
nominal interest rate and the terms of bank loans
trade to NPL ratio for the case of the
USA.
5

Gropp et al [2002] The authours suggested a comparison of an equity- The spreads do contract in line with a
based indicator (distance to default) and a bond- positive outlook for economies, corporate
market related (subordinated debt spread) in emerging bond yield decline, generally maintaining
market economies. their spreads to government bonds at
fairly low levels, amid signs of stable-to-
improving credit quality and favourable
liquidity conditions.
Gerlach et al, [2005] The author relied on regression analysis (for the case of The analysis indicates that the NPL ratio
Hong Kong) and employed nominal interest rates, the rises with increasing nominal interest
CPI, property prices, equity prices, and number of rates and an increasing number of
bankruptcies, the unemployment rate and real GDP as bankruptcies, but decreases with higher
explanatory variables. CPI inflation, economic growth, and
property price inflation. Deflation
squeezes out corporate profitability and
adversely affects borrowers ability to pay.
Quagliariello [2003] The authour presents a regression between the The authour concluded that decreasing
evolution of NPLs as a dependent variable and a set of real GDP growth and increasing
explanatory variables for the case of Italy: the real GDP unemployment have a significantly
growth rate, the growth of real gross fixed investment adverse effect on loan portfolio quality,
and consumption, changes in the unemployment rate, while the real exchange rate and consumer
the CPI, the real exchange rate and the M2 growth rate. price index fail to significantly affect it.
6

Popiera [2006] The author explored the relationship The study revealed the significant positive
between banking sector performance and impact of higher compliance with the
the quality of regulation and supervision Basel Core Principles on banking sector
as measured by the Basel Core Principles performance as measure by NPL and net
for Effective Supervision using the panel interest margin (after controlling for the
data for 65 economies. level of development of the economy and
financial system).
Manasoo and Mayes [2009] The authours presented a panel logit The authours claim that declining GDP
model for the CEE between the evolution growth and the instability of external and
of NPLs and set of explanatory variables: internal environments leads to a
liquidity ratio, inverse liquidity ratio, loan worsening of banking sector results and
to asset ratio, equity to asset ratio, cost to financial stability indicators in the CEE.
income ratio and macroeconomic
variables.
Baboucek and Jankar [2005] The authours investigated economic The study showed that the appreciation of
developments in the Czech banking sector the real effective exchange rate does not
through unemployment, real GDP growth, deteriorate the NPL ratio; increasing
exports, imports, the real effective unemployment and inflation deteriorate
exchange rate, the CPI and credit growth the NPL ratio, while faster GDP growth
as indicators of NPL ratio performance decelerates the NPL ratio.
using an unrestricted VAR methodology.
7

Hoggarth et al [2005] The authours applied the VAR approach to investigate The important factors indirectly influencing financial
the link between loan write-offs and the output gap, stability and loan portfolio quality are the dynamics
retail prices, real estate prices, the nominal short term of inflation and interest rates.
interest rates and the real exchange rate for the case of
the United Kingdom.
Chihak et al [2007] The authours compared system focused stress testing The authours suggest (besides banking sector
methods (VAR, Monte Carlo Simulations, etc) and indicators such as capital adequacy, credit risk and
discussed issues related to the design of stress tests for other relevant factors) incorporating different
the Czech banking system. shocks into models, non bank financial indicators
and relevant macroeconomic factors ( e.g. the
exchange rate and the interest rate) in order to
perform stress testing
Babihuga [2007] The authour investigated the relationship between The authour showed that financial stability
macroeconomic variables and financial stability indicators fluctuate strongly with the business cycle
indictors (like capital adequacy, asset quality and and the inflation rate.; and that the cycle component
profitability) in the case of the European, Asian and of real GDP has a negative relationship with capital
Sub-Saharan Africa economies. The authour presented adequacy and NPLs. There is also an important
a regression between the evolution of NPL as a degree of heterogeneity across the sample of
dependent variable and a set of explanatory variables: countries (European, Asian and Sub-Saharan Africa
the quality of banking sector supervision measured by economies) between macroeconomic and financial
an index of compliance with the Basel Core Principles, stability indicators. The relationship between the
terms of trade, unemployment, lending rates, the real business cycle and capital adequacy is more
effective exchange rate and the business cycle ambiguous and it appear to be counter cyclical
component of GDP. (except in Asian and Sub Saharan African, where it is
procyclical).
8
Jakubik [2007] The authour employed the regression The default rate for the corporate sector is
method for NPL inflow estimation (in determined by the appreciation of the real
the case of the Czech Republic) using effective exchange rate and by the increase
real GDP, real effective exchange rates, in the loan to GDP ratio; meanwhile, the
the CPI, the loan to GDP ratio, default rate for households deteriorates via
unemployment, and the real interest rate unemployment and interest-rate increases.
as explanatory variables.
Zeman and Jurca The authors applied the multivariate Real GDP, the nominal exchange rate and
[2008] regression method using real GDP, the nominal interest rate are the most
output gap, exports, industrial important variable influencing NPL
production, oil prices, the CPI, M1, dynamics. A slow down in GDP growth is
nominal interest rates, and nominal not expected to substantially threaten the
exchange rates as explanatory variables banking system. Exposure to interest rate
for NPL dynamics in the case of slovakia. growth through direct channels and
foreign currency risk through indirect
channels was shown to be due to the high
level of openness of the economy.
9
Uhde and Heimeshoff The authours provided empirical The authours reveal that Eastern
[2009] evidence in the case of the EU-25, European Banking markets exhibit a lower
that the national banking market level of competitive pressure, fewer
concentration has a negative impact diversification opportunities and a higher
on European Banks’ financial fraction of government-owned banks,
soundness as measured by the Z which are more prone to financial fragility.
score technique (while controlling
for macroeconomic, bank-specific
regulatory and institutional factors.
10
PANEL DATA REGRESSION MODELS
11
Time Series Example
Year = t System NPLs=Yi LAR=X1 Inflation rate=x2
2009 3.8 55.0 7.0
2010 5.0 60.8 10.0
2011 8.5 66.5 12.0
2012 10.6 70.5 15.0
12
Panel Data Example
Year=t Bank = I NPL=Y LAR=X1 Inflation=X2
2009 CITI 3.4 48.0 7.0
2010 CITI 3.5 50.0 10.0
2011 CITI 3.6 60.0 12.0
2012 CITI 4.0 65.0 15.0
2009 BOB 3.2 60.0 7.0
2010 BOB 3.4 64.0 10.0
2011 BOB 3.7 66.0 12.0
2012 BOB 4.0 70.4 15.0
2009 KCB 4.0 30.4 7.0
2010 KCB 4.6 35.6 10.0
2011 KCB 4.4 40.5 12.0
2012 KCB 5.0 50.6 15.0
13
Panel Data Regression Models
• Same cross-section unit (family or firm or a state) is surveyed over
time.
• Panel data have space as well as time
Advantages
1. Panel data estimation takes into account heterogeneity in individuals,
firms states, countries, etc. This is done by allowing for individual
specific variables.
2. By combining time series of cross-section observations, panel data
gives “more informative data, more variability, less collinearity among
variables, more degrees of freedom and more efficiency”
14
3. Panel is suited to study dynamics of change because it studies
repeated cross sections of observations.
4. Panel data can better detect and measure effects that simply
cannot be observed in pure-cross-section or pure time series
data.
5. Enables study of more complicated behavioural modes than
purely time series or cross section data e.g. economies of scale
and technological change.
6. Panel data can minimize bias that might result if we aggregate
individuals or firms into broad aggregates.
15
• Limitations of Panel data include:
– Design and data collection problems – problems of
coverage, non response, recall etc,
– Distortions of measurement errors – faulty responses
due to unclear questions, memory errors etc.
– Selectivity problems
• Self selectivity
• Non response
• Attrition
• Short time series dimension
16
EXAMPLE
• Non performing loans depend on loan to
asset ratio and macroeconomic variables .
For four banks BOB, BOA, CITI and DFCU.
1993-2013.
17
Estimation of Panel Data Regression Models
• Four cross sectional units

• 20 time periods
• 80 observations
• Instead of running 20 cross-sectional regressions and
getting into degrees of freedom problems, we can pool all
the 80 observations as follows:
Yit  1   2 X 2it  3 X 3it  it 1
i  1,2,3,4 t  1,2,................20
18
• Estimation depends on the assumptions we make about the
intercept, the slope coefficients and the error term unit.
There are several possibilities:
1. Assume the intercept and slope coefficients are constant across
time and space and the error term captures differences over
time and individuals i.e. a pooled regression.
2. The slope coefficients are constant but the intercept varies
over individuals.
3. The slope coefficients are constant but the intercept varies
over individuals and time.
4. All coefficients (the intercept as well as slope coefficient) vary
over individuals.
19
1. All coefficients constant across time and individuals.
• Simplest & naïve approach, disregards space and time
dimensions of data
• Pooled regression
• Note significance of coefficients as well as the signs
• Comment on the value of Durbin-Watson-if low suggest
autocorrelation in data or specification errors
• Model assumes intercepts of BOB, BOA, CITI and DFCU are the
same
• It assumes slope coefficients of X2 and X3 are the same for
all the banks.
• Highly restrictive assumptions.
20
2. Slope coefficients constant but the intercept varies across

individuals
• Fixed effects or least-square Dummy Variable (LSDV) regression
modes.
• One way to take into account “individuality” of each bank or
each cross section is to let the intercept vary for each bank but
assume that the slope coefficients are constant across banks.
• Yit  1i   2 X 2it  3 X 3it  it 2
• The subscript on the intercept term suggests that the intercepts
of the four banks may be different due to differences in
managerial style or managerial philosophy.
21
• Each individual’s intercept does not vary over time. It is

time invariant.
• To implement this we use the dummy variable technique
(differential intercept dummies)
Y    D  D  D   X   X  
it 1 2 2i 3 3i 4 4i 2 3
2it 3 3it it
D 1
2i
if the observation belongs to BOA, 0 other wise
D 1
3i if the observation belongs to CITI, 0 other wise
D 1
4i if the observation belongs to DFCU, 0 other wise
22
• Three dummy variables are used because we have 4 banks

and need to avoid dummy variable trap (perfect collinearity)
• If there is no dummy for BOB a1 represents the intercept of
BOB and  2 ,  and  4 the differential coefficients that
3
tell by how much the intercepts of BOA, CITI and DFCU

differ from the intercept of BOB. BOB is the comparison
bank.
• THINGS TO NOTE
23
i. Significance of coefficients
ii. Differences in intercepts are due to features that
are unique to each bank.
iii. R squared tends to increase may be due to more
variables.
iv. Note what happens to the Durbin Watson
statistic.
• To test model 1 (the restricted which imposes a
common slope to all banks) and model 2 (the
unrestricted) we use an F test.
24
• The time effect – Time effect allows the NPL function to
shift over time because of factors such as:
 Technological changes
 Changes in government regulatory and/or tax policies
 External effects such as wars or other conflicts
• These are handled by use of time dummies, one for each year.
Since we have 20 years from 1993 to 2013 we can introduce 19
time dummies as:
• Yit  0  1Dum1993  2 Dum1994.......  19 Dum20124i   2 X 2it  3 X 3it  it
4
• Dum1993 takes a value 1 for observation in year 1993 and 0
otherwise, etc.
• Year 2013 is the base year and intercept will be given by 0
25
• THINGS TO NOTE
• Significance of time dummies
• Any change in R2
• Look at the F test – if it is not significant, it suggests that
the credit function has not changed over time.
3. Slope coefficients constant but the intercept varies over
individuals as well as time.
• We combine 3 and 4 to get:
Yit  1   2 DBOAi   3 DCITI i   4 DDFCU i  0  1Dum1993  2 Dum1994.......
 19 Dum 20124i   2 X 2it  3 X 3it  it 5
26
• Are bank dummies as well as coefficients of X significant

• Are time dummies significant
4. All coefficients vary across individuals
• Intercepts and slope coefficient are different for all
individuals, or cross-section units. Are the NPL functions of
BOB, BOA, CITI and DFCU all different.
• Interactive or differential slope dummies hence:
Yit  1   2 D2i   3 D3i   4 D4i   2 X 2it  3 X 3i 
 1 ( D2i X 2it )  2 ( D2i X 3it )  3 ( D3i X 2it ) 

 4 ( D3i X 3it )  5 ( D4i X 2it )  6 ( D4i X 3it )  it 6
27
• The  ' s are the differential slope coefficients

• While 2 , 3 and  4 are the differential intercepts.
• If all the differential intercepts and all the
differential slope coefficients are statistically
significant we conclude that the NPL functions of
BOA, CITI and DFCU are different from that of BOB.
No need to estimate a pooled regression.
28
Problems of LSDV Model
1. Introduces to many dummy variables and you run into the
degrees of freedom problem. Given 80 observations:
55 d.f = 80 -3 d.f for three banks
-19 d.f for year dummies
-2 d.f for two slope coefficients
-1 d.f for the common intercept.
2. Possibility of multicollinearity because of so many variables in
the model – precise estimation of parameters is difficult.
3. May not be able to identify impact of time-invariant variables
such as sex, colour or ethnicity (these do not change over
time).
4. Assume the error term follows the classical assumptions of
normality. However, the error term may need to be modified.
29
• The One way error component model

– The Fixed Effects Model
– The Random Effects Model
• The two way Error Component Model
– The Fixed Effects Model
– The Random Effects Model
30
• One Way Error Component Regression Model

– Given a Panel data regression model of the
form:
Yit    X it    it ..........................7
i  1,....., N ; t  1,...., T
– Most Panel data applications utilize a one way
error component model for the disturbances,
with  it  i   it
31
–  i = the unobservable individual specific

effect
–  it = the remainder of the disturbance
– Example: For a production function utilizing
data on banks across time Yit will capture
output and X will measure inputs.
it
– The  i will capture things such as
entrepreneurial or managerial skills of the
banks executive.
32
• The Fixed Effects Model

– In this model the  i are assumed to be
fixed effects to be estimated and the
remainder disturbances are stochastic
with  it independent and identically
distributed
IID (0,  2 )
– for all i and t .
33
• This model is appropriate when inference is

restricted to a specific set of N Known
firms whose behavior we are interested in.
• The Fixed Effects (FE) Least Squares is also
known as the Least Squares Dummy
Variables (LSDV).
34
Estimation of Panel Data Regression
Models
• The Random Effects Model
– There too many parameters in the fixed effects
model and the loss of degrees of freedom can be
avoided if  i is assumed to be random. In this
case:
i  IID(0,  2 )
 i  IID (0,  )
2
– and  i are independent of  it .
35
Models
– In addition, theX are independent of the
 i and  it for all i and t.
it
– The random effects model is an appropriate

specification if we are drawing N individuals
randomly from a large population.
– The individual effect is characterized as random
and inference pertains to the population that the
sample was randomly drawn.
36
Models
• Two Way Error Component Regression
Model
– In this case the regression model in equation
(7) above has two-way error component
disturbances i.e.:
 it  i  t  it
i  1,....., N ; t  1,....T ......................................8
 i = the unobservable individual effect
37
Models
– t = the unobservable time effect
–  it = is the remainder stochastic disturbance term.
– Note that t is individual – invariant and accounts for
any time specific effect not included in the regression.
– These include strike year effects that disrupt, oil
embargo effects that disrupt supply of oil and affect its
price, government laws that affect consumption e.t.c.
38
Models
• The Fixed Effects Model
– The  i and t are assumed to be fixed
parameters to be estimated and the remainder
of the disturbances are stochastic with
 it  IID (0,  2 )
• then equation (8) represents a two way fixed

effects error component model.
39
Models
– The X it are assumed independent of all
the  it for all i and t .
– However, inference is conditional on the
particular N Individuals and over the specific
time periods observed.
40
Models
• The Random Effects Model
– If i  IID(0, 2 ),   IID0, 2 and it  IID(0,2 )
– Independent of each other then the equation

(8) is the two way random effects model.
– In addition, if X it is independent of  i , t and  it
for all i and t then inference in that case
pertains to the large population from which this
sample was randomly drawn.
41
SOME PRACTICAL APPLICATIONS WITH
UGANDAN DATA
42
III. Practical Applications
• The Data:
• Quarterly bank and macro level data from Uganda
from 2000q1 to 2013q1. This dataset is found in
a file (bank_data.WF1).
• Contains quarterly macroeconomic variables real
GDP, exchange rate change, inflation and interest
rates 2000q1-2013q1.
• Contains bank level data on non performing loans,
market share of banks assets, total loans loans to
total assets. There are twelve banks.
43
Macroeconomic variables
No. Variable Measures Identification
1 Real GDP Real GDP rgdp
Growth Rate of Real GDP rgdpg
2 Exchange Rate Real effective exchange reer
rate
Nominal exchange ner
3 Inflation Headline consumer price hcpi
index
Annual Inflation rate infla
4 Interest rates Average Lending Rate lr
Real lending rate rir
Treasury securities tb364, tb91
44
Bank level variables
No. Variable Measures Identification
1 Nonperforming loans Nonperforming loans npl
ratio
2 Bank size Market share size

Total assets ta
3 Loans extended Total loans tl
4 Deposits Total deposit liabilities dep

5 Loans to total assets Loans to total assets ratio lota
45
III. Practical Applications: Static Model
• The dependent variable is non performing

assets (LNPL)other regressors are:
– real GDP growth rate (RGDPG),
– real interest rate (RIR),
– change in the exchange rate (DLNER),
– the inflation rate (INFLA),
– the market share (SIZE),
– loans to total assets (LLOTA).
46
Estimating a Panel Least Squares Equation: One way error -
fixed
• Using: bank_data.WF1
• Quick/Estimate Equation
• Type equation in the command window
– i.e. lnpl c rgdpg rir dlner infla lsize llota
• Panel options:
– Cross section – Fixed
– Period - None
47
fixed
48
Random
• Using Using: bank_data.WF1

• Panel options:
– Cross section – Random
– Period - None
49
Random
50
Estimating a Panel Least Squares Equation: Two way error -
Fixed
• Will not be estimated, nature of the data set.
51
Random
• Using Using: bank_data.WF1

• Panel options:
– Cross section – Random
– Period - Random
52
Random
53
III. Practical Applications: Dynamic Model
• Estimate a dynamic panel least equations using:

– The nonperforming assets ratio (LNPL) and other
regressors such namely regressors are
• lagged NPL ratio (LNPL(-1),
• real GDP rate (LRGDP), RGDPG
• real interest rate (RIR), LTB364, LTB91, LR
• change in the exchange rate (DLNER), LREER
• the inflation rate (INFLA), LHCPL, DLHCPI
• the market share (SIZE),
• loans to total assets (LLOTA), LTA
• growth in total loans (DLTL). LTL
54
• Estimate the following Dynamic Panel Least Squares Equations:

– One way error fixed (cross section- fixed; period –none)
– One way error random (cross section- Random; period –none)
– Two way error random (cross section- Random; period –
Random)
– Equation: LNPL C LNPL(-1) LRGDP RIR DLNER INFLA LSIZE LLOTA
DLTL
• What are your results and how might they compare with the
static model results?
• What are some of the problems with these regression
equations?
• What are the implications for model search?
55
One way error fixed
56
One way error random
57
Two way error random
58
FURTHER TOPICS
59
Further Topics
• Further Topics
– Non Stationary Panel Data Models
– Panel Cointegration
– GMM estimation etc, etc
60
REFERENCES
61
REFERENCES
• Baltagi B.D., 2001 Econometric Analysis of

Panel Data, John Willwy and Sons, LTD.
• Eviews 6 and 7 Users Guides
• Green, W.H., 2005 Econometric Analysis,
Prentice Hall.
• Wooldridge, J.M, 2002 Econometric Analysis
of Cross Section and Panel Data, The MIT
Press.
62

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Macro stress Testing Credit Risk: A Panel Econometric Estimation with

Prepared for the CMI Course on Macro stress testing

Author (s) Methodology and Economies Results

Author (s) Methodology and Economies Results

Author (s) Methodology and Economies Results

Author (s) Methodology and Economies Results

• Four cross sectional units

2. Slope coefficients constant but the intercept varies across

• Each individual’s intercept does not vary over time. It is

• Three dummy variables are used because we have 4 banks

tell by how much the intercepts of BOA, CITI and DFCU

 19 Dum 20124i   2 X 2it  3 X 3it  it 5

• Are bank dummies as well as coefficients of X significant

 1 ( D2i X 2it )  2 ( D2i X 3it )  3 ( D3i X 2it ) 

• The  ' s are the differential slope coefficients

• The One way error component model

• One Way Error Component Regression Model

–  i = the unobservable individual specific

• The Fixed Effects Model

• This model is appropriate when inference is

– and  i are independent of  it .

– The random effects model is an appropriate

 i = the unobservable individual effect

• then equation (8) represents a two way fixed

– Independent of each other then the equation

2 Bank size Market share size

4 Deposits Total deposit liabilities dep

• The dependent variable is non performing

• Using Using: bank_data.WF1

• Will not be estimated, nature of the data set.

• Using Using: bank_data.WF1

• Estimate a dynamic panel least equations using:

• Estimate the following Dynamic Panel Least Squares Equations:

• Baltagi B.D., 2001 Econometric Analysis of

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