Macroeconomic credit risk model for the financial sector in Sri Lanka

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.