Abstract:
Economic development has a direct bearing on the credit quality of financial institutions.
This study attempts to recognize this association of macroeconomic determinants and credit
risk in the Sri Lankan banking sector by way of a macroeconomic credit risk model. The
study employs a Vector Error Correction Model (VECM) to capture the relationship between
macroeconomic variables namely the Real Gross Domestic Product (GDP), Unemployment
Rate and Real Effective Exchange Rate (REER) with Non-Performing Loans (NPL), the
proxy for default rates. The study uses data on Sri Lankan banking sector from 2009 to 2018
for the purpose. As of the findings Unemployment rate and Exchange Rate are found to be
significant determinants of NPL. Unemployment Rate and Exchange rate is observed to have
a significant positive association with Non-performing loans. Additionally, NPL itself is
shown to have a significant feedback effect on credit default.
