Macro-Financial Linkages and Heterogeneous Non-Performing Loans Projections: An Application to Ecuador
International Monetary Fund Working Paper No. WP/16/236
28 Pages Posted: 12 Dec 2016 Last revised: 8 Mar 2018
Date Written: December 7, 2016
We propose a stress testing framework of credit risk, which analyzes macro-financial linkages, generates consistent forecasts of macro-financial variables, and projects NPL on the basis of such forecasts. Economic contractions are generally associated with increases in non-performing loans (NPL). However, despite the common assumption used in the empirical literature of homogenous impact across banks, the strength of this relationship is often bank-specific, and imposing homogeneity may lead to over or underestimating the resilience of the financial system to macroeconomic woes. Our approach accounts for banks’ heterogeneous reaction to macro-financial shocks in a dynamic context and potential cross-sectional dependence across banks caused by common shocks. An application to Ecuador suggests that substantial heterogeneity is present and that this should be taken into account when trying to anticipate inflections in the quality of portfolio.
Keywords: banks, cross-sectional dependence, macro-financial linkages, non-performing loans, credit stress test
JEL Classification: C53, E44, G21
Suggested Citation: Suggested Citation