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Determinants of non-performing loans in Ghana banking industry

Article · January 2015

DOI: 10.1504/IJCEE.2015.066207

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Int. J. Computational Economics and Econometrics, Vol. 5, No. 1, 2015 35

Determinants of non-performing loans in Ghana

banking industry

Franklin Amuakwa-Mensah*
Department of Economics,
Swedish University of Agricultural Sciences (SLU),
Box 7013, S-750 07 Uppsala, Sweden
Email: franklin.amuakwa.mensah@slu.se
*Corresponding author

Angela Boakye-Adjei
Barclays Investment Bank,
10 South Colonnade,
London, E14 4PU, UK
Email: angela.boakye-adjei@barclays.com

Abstract: The detrimental effect non-performing loans (NPLs) have on banks’

income and the economy makes it necessary to examine the determinants of
NPLs in the banking industry in Ghana. Using panel regression model, it was
found that both bank-specific variables (i.e., previous year’s NPL, bank size,
net interest margin (NIM), and current year’s loan growth) and macroeconomic
variables (i.e., previous year’s inflation, real gross domestic product (GDP) per
capita growth and real effective exchange rate) significantly affect NPLs in the
banking industry. Also the sub-sample estimations showed that both bank-
specific (i.e., previous year’s NPLs and current year’s loan growth) and
macroeconomic factors (i.e., real effective exchange rate, real GDP per capita
growth, and previous year’s inflation rate) affect NPLs of large banks.
However, whereas bank-specific variables (i.e., previous year’s NPLs and
current year’s loan growth) are important in explaining NPLs, macroeconomic
factors are not important in explaining NPLs for small banks.

Keywords: NPLs; non-performing loans; panel model; Hausman test; banking

industry; Ghana.

Reference to this paper should be made as follows: Amuakwa-Mensah, F.

and Boakye-Adjei, A. (2015) ‘Determinants of non-performing loans in Ghana
banking industry’, Int. J. Computational Economics and Econometrics, Vol. 5,
No. 1, pp.35–54.

Biographical notes: Franklin Amuakwa-Mensah is a PhD student at the

Department of Economics, Swedish University of Agricultural Sciences. Prior
to his PhD studies, he worked as a research assistant at the Institute of
Statistical, Social and Economic Research (ISSER), the University of Ghana.
He holds MPhil in Economics and BA in Economics with Mathematics all
from the University of Ghana. He has research interests in youth saving,
financial market analysis, climate change, environmental and natural resource
economics, migration and remittances at the micro level. He is currently
working on the economics of multifunctional ecosystems and environmental
targets as his PhD thesis.

Copyright © 2015 Inderscience Enterprises Ltd.

36 F. Amuakwa-Mensah and A. Boakye-Adjei

Angela Boakye-Adjei holds Master’s Degree in Business Administration from

Lancanster University. She is a Business Analyst with invaluable experience
within a number of UK, European, and US Investment Banks. A 10-year
hands-on experience within business analysis, product control, management
accounting, balance sheet/P&L reporting and reconciliations with a very strong
technical and accounting background and a thorough understanding of Prince 2,
Agile, Lean and Six Sigma methodology. She possesses a detailed–oriented
nature with excellent communication, interpersonal and problem-solving skills,
and is recognised for being a valued team player.

1 Introduction

An efficient and developed banking industry is very central to the growth of any
economy. In recent times the Ghanaian economy has experienced growth in the banking
industry. This growth can be attributed to the implementation of the Financial Sector
Adjustment Programme (FINSAP) in 1986 and the Financial Sector Strategic Plan
(FINSSP) in 2003. Some of the policies implemented under FINSAP and FINSSP
include liberalisation of interest rate, abolition of directed credit, restructuring of
financially distressed banks, strengthening of the regulatory and supervisory framework,
privatisation of state-owned banks, liberalisation of the foreign exchange market,
establishment of capital market, and reform of the legal framework (Bawumia, 2010).
The growth in the banking industry has brought about employment creation, as the
number of employees increased from 6648 in 2001 to 12,345 in 2009 (see Figure A2 in
Appendix). Further, the rise in the number of banks has resulted in increased competition,
thereby allowing credit facilities to be more accessible in the Ghanaian economy
through short-term loans as well as long-term loans. However, some of these credit
facilities given out by the banks have resulted in NPLs, due to the inability of customers
to pay their credit facility at the agreed time. The effect of these NPLs is often
detrimental to banks’ balance sheet and, on a larger scale, has the potential of threatening
the performance and sustainability of the Ghana banking industry.
In every country, the stability of the banking industry is fundamental to sustainable
economic growth as customers’ confidence in the system is enhanced. However, since the
2007 economic crisis, the global banking industry has experienced high rate of bad debts.
These bad debts are mainly associated with NPLs and are usually treated as cost on the
balance sheet leading to a decrease in the bank’s financial performance (Chang, 1999).
The impact of these NPLs in the past decade has in part contributed to bank failures
across the world. Performance of banks is often associated with the quality of loans in
their books. However, the default rate associated with these loans has become prevalent
in the banking industry in Ghana. The continuous occurrence of NPLs in the banking
industry impedes a bank’s ability to settle its liabilities at the required time.
Additionally, it adversely affects the level of private investment that the bank can
make and consequently reduces the banks’ ability to grant further credit facility to
customers. Due to the wide-ranging effect of NPLs on an economy, controlling it is
very vital to the stability and sustainable growth. PricewaterhouseCooper’s Banking
Survey carried out in 2010 on Ghana banking industry reveals that loans and advances
 Determinants of non-performing loans in Ghana banking industry 37

reached GH¢ 6208 million, a growth of 11% compared with 44.9% recorded in 2008
(see Figure 1) (PricewaterhouseCoopers, 2011, 2012). By December 2010, 17.6% of
Ghana Banks outstanding loans were deemed as non-performing (Ghana Business &
Finance, 2011). Also, growth in bad debts in the years 2008 and 2009 were 180.4% and
77.8% respectively as shown in Figure 1. The increasing NPLs faced by the Ghana
banking industry have the potential of negatively impacting on the overall performance,
profitability, and liquidity of financial institutions. Loan is one of the main sources of
revenue for the Banking Industry; as a result NPLs could be seen as causes for locked-up
capital. From this point of view, it is therefore essential that a research is carried out to
find the determinant of NPLs in the banking industry in Ghana.

Figure 1 Growth in bad debt and loans in the Ghanaian banking industry from 1998 to 2009
(see online version for colours)

Source: Bank of Ghana

This study finds answers to the following central questions:

• What are the effects of bank-specific variables on NPLs?
• What are the effects of macroeconomic variables on NPLs?
• Are the determinants of NPLs different for large and small banks?
The uniqueness of this study in the literature within the Ghanaian setting is such that it
considers 12 banks using data from 1998 to 2008. Further, after examining the
determinants of NPLs for all the banks together we also examined the determinants for
two sub-samples (that is, small and large banks). There is no such study in Ghana to the
best of our knowledge. The remaining sections of this paper are organised as follows:
Section 2 discusses the literature review, Section 3 explores the methodology
for the study, Section 4 discusses the result, and Section 5 concludes and provides
recommendations.
38 F. Amuakwa-Mensah and A. Boakye-Adjei

2 Literature review

NPLs are facilities or loans which generate no income. Whereas, Fofack (2005) used
NPLs and bad loans interchangeably, Berger and De Young (1997) described NPLs as
‘problem loans’. In the broader context, NPLs can be considered as loans that are
outstanding in both interest and principal for a period of time contrary to the terms and
conditions spelt out in the loan agreement. There are varied descriptions of NPLs in the
literature. Alton and Hazen (2001) described NPLs as loans that are 90 days or more past
due or no longer accruing interest. Similarly, Caprio and Klingebiel (1990) considered
NPLs as loans which for a relatively long period of time do not generate income. This
comprises of the principal and interest on the debt for at least 90 days. Thus, NPLs can be
referred to as loans that are not earning income and full payment of principal and interest
is no longer anticipated, principal or interest is 90 days or more, or the maturity date has
passed and payment in full has not been made. The next subsection discusses the
theoretical and empirical determinants of NPLs.

2.1 Determinants of non-performing loans

In the literature, determinants of NPLs have been categorised into macroeconomic
factors, bank-specific factors, and those caused by debt crises. NPLs and its interactions
with macroeconomic performances are grounded in theoretical business cycle models
with an explicit role for financial intermediation (Williamson, 1985). Naturally,
discrepancies in financial regulation and supervision affect banks’ behaviour and
risk management practices which are important in explaining cross-country differences
in NPLs. The macroeconomic environment inevitably influences borrowers’ balance
sheets and their debt-servicing capacity. Thus, adverse economic shocks coupled with
high cost of capital and low interest margins (Fofack, 2005) have been identified to cause
NPLs. According to Goldstein and Turner (1996), build-up of NPLs is mostly attributed
to a number of factors which include economic downturn, macroeconomic volatility,
terms of trade deterioration, high interest rate, excessive reliance on overly high-priced
inter-bank borrowings, and moral hazard.
Sudden market changes are also seen as factors which do account for NPLs. Thus,
any sudden market change can bring about changes in the loan market by affecting
how much money people can take as loans and make payments (Bloem and Gorter,
2001). In an event that the market suddenly changes and prices of items increase due to
shortage or increased demand, borrowers will have less money to pay off their loans
which can lead to loan default. According to Krueger and Tornell (1999), the credit
crunch in Mexico after the 1995 crisis was partially attributed to bad loans. They found
out that banks were burdened with credits of negative real value, thereby reducing the
capacity of the banks to provide new fund for new projects. Moreover, Agung et al.
(2001) using the macro and micro panel data analyses to study the presence of a credit
crunch in Indonesia after the crisis realised that the credit crunch was characterised
by an excess demand for loans which emerged in August 1997. Further, Agung et al.
(2001) also investigated the relationship between loan supply and real lending capacity,
lending rates, real output, bank’s capital ratio, and NPLs. Their results show that the
coefficients on NPLs are negative and significant indicating that bank credit supply
declines with the worsening of the NPLs problem.
 Determinants of non-performing loans in Ghana banking industry 39

Westermann (2003) comparing Germany after the credit boom of the late 1990s and
Japan aftermath the bubble burst in early 1990s made the argument that even though the
German banks were in a better condition than Japanese banks, it is at least unlikely that
the German credit slowdown was entirely driven by demand, while that of Japan was
mostly caused by a lack of supply. He further identified increased in the risk of NPLs as
one of the main reasons in Germany for the credit crunch after the credit boom. This is in
line with Kaminsky and Reinhart (1999) proposition that an increasing trend of NPLs in
any country is an indication of financial crisis in that country.
Moreover, Kroszner (2002) claimed that NPLs are closely associated with banking
crises. It is been argued that the magnitude of NPLs is a key element in the initiation
and progression of financial and banking crises (Greenidge and Grosvenor, 2010).
Furthermore, Guy (2011) asserts that NPLs 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) pointed
out that NPLs can be used to mark the onset of a banking crisis. Despite ongoing efforts
to control bank lending activities, NPLs are still a major concern for both international
and local regulators (Boudriga et al., 2009).
Chimerine (1998) further claims that bad lending tradition leads to a huge portfolio
of unpaid loans. This results in insolvency of banks and reduces funds available
for fresh advances, which eventually causes a financial crisis. Goodhart et al. (1998) also
connected lending to the causes of bank failure. Palubinskas and Stough (1999) noted that
lack of dependable financial information on borrowers to help in assessing
creditworthiness causes a bank’s failure. Controlling NPLs is very important for both
the performance of an individual bank and the economy’s financial environment
(McNulty et al., 2001).
Poor management and bank inefficiency have been suggested in the literature as a
cause of NPLs (Berger and De Young, 1997; Tsai and Huang, 1999; Altunbas et al.,
2000; Fan and Shaffer, 2004; Girardone et al., 2004). They argue that managers in most
financial institutions with the problem of NPLs failed to adequately underwrite loan and
also put up poor monitoring and control practices. Furthermore, credit culture is another
factor which has been identified as a cause of NPLs. This is because most often
borrowers decide to apply for loan without thinking about how to invest the loan in
productive ventures to enable them to raise enough money to repay the loan. In most
instances, credit culture can be developed when borrowers take out large loans not
because it is financially wise for them to do so but because they see others doing it, hence
leading to defaulted loans. Berger and De Young (1997) found out from their study that
there exist simultaneity between NPLs and inefficiency. They excluded the link
represented by bad loans from the explicative variables of the function in order to avoid
diminishing the inefficiency measured in the regression residuals, in the case of bad loans
not due to internal factors. From their study, Berger and De Young (1997) focused on
using the cost function only to compute the inefficiency and then leaving to a causality
analysis the job of explaining their relationship.
Accumulation of NPLs in Sub-Saharan Africa has been attributed to terms of trade
deterioration and interbank loans which are present in the context of low equity and
absence of diversification. Interbank loans also have the tendency of increasing the risks
and prospects of moral hazard. Moral hazard can be high in times when banks’
40 F. Amuakwa-Mensah and A. Boakye-Adjei

capitalisation is low and this may result in adoption of imprudent lending strategies with
direct implications for banks’ loans portfolios which are mostly skewed towards high-risk
projects. Fofack (2005) using a pseudo panel-based model for several countries in Africa
found out that economic growth, real exchange rate appreciation, the real interest rate,
NIMs, and inter-bank loans are significant determinants of NPLs in these countries.
Fofack (2005) attributed the strong association between the macroeconomic factors and
NPLs to the undiversified nature of some African economies.
Rouse (1989) in his work, indicated that NPLs can originate from an overdrawn
account where there is no overdraft limit or overdraft taken on account which
has not been actively operated for some time and overdraft taken in excess of the
realistic operational limit. Similar to Berger and De Young (1997), Rouse (1989)
identified lack of good skills and judgement on the part of lenders as a probable cause of
NPLs. Keeton (1999) using data from 1982 to 1996 and a vector autoregression model
analysed the impact of credit growth and loan delinquency in the USA. Based on the
study a strong relationship between credit growth and impaired assets was established.
He further brought to light that rapid credit growth, which was linked with lower
credit standards, contributed to higher loan losses in certain states in the USA. He defined
loan delinquency as loans which are overdue for more than 90 days or which do not
accrue interest.
Bercoff et al. (2002) also provided similar evidence like that of USA after examining
the instability of the Argentinean Banking system over the 1993–1996 periods. They
discovered from their study that NPLs are affected by both bank-specific factors and
macroeconomic factors by using survival analysis. Moreover, using a dynamic model and
a panel dataset covering the period 1985–1997 to investigate the determinants of NPLs of
Spanish commercial and saving banks, Salas and Saurina (2002) disclosed that real
growth in GDP, rapid credit expansion, bank size, capital ratio, and market power explain
variation in NPLs.
Likewise, Jiménez and Saurina (2005) examined the Spanish banking sector from
1984 to 2003 and realised that NPLs are determined by GDP growth, high real-interest
rates, and soft credit terms. The authors attributed the latter to disaster myopia, herd
behaviour, and agency problems that may entice bank managers to lend excessively
during boom periods. Similarly, Rajan and Dhal (2003) employed panel regression
analysis to report that favourable macroeconomic conditions (i.e., GDP growth) and
financial factors such as maturity, cost and terms of credit, banks’ size, and credit
orientation impact significantly on NPLs of commercial banks in India.
Some authors like Hu et al. (2006) have analysed the relationship between NPLs and
ownership structure of commercial banks. Hu et al. (2006) used panel dataset covering
the 1996–1999 in Taiwan to examine this relationship. They showed in their study that
banks with higher government ownership recorded lower NPLs. In addition, they brought
to light that bank size is negatively related to NPLs while diversification may not be a
determinant.
In quite an interesting way Pastor (1999, 2002) uses a non-parametric approach with
the caveats implied for the deterministic techniques that do not allow interpretation on the
functions for the bank management. He uses a data envelop analysis (DEA) at several
stages to estimate the composition of problem loans. Pastor and Serrano (2005) for the
first time used a parametric approach. By using this approach they skip the problem of
 Determinants of non-performing loans in Ghana banking industry 41

simultaneity recurring to ad hoc instrumental variables to represent the internal and

external causes of NPLs and then inefficiency. Accordingly, the evaluation of the cost of
the NPLs, as well as the structure of the cost function, is strongly affected by the
discretion about the choice of instruments and the use of the possible combinations which
are appropriate.
According to Bloem and Gorter (2001), individual decisions and natural occurrence
(natural disasters, decrease in disposable income and unforeseen hike in certain product
etc.) mostly lead to predictable level of NPLs, though it may change from year to year.
Usually most companies will allow bad debts provision in their books to cater for
predictable share of NPL, even though some companies might insure against such
predictions instead of making provisions. In a bid to cover these provisions and
insurance, companies often pass on the cost to customers by including premium for the
risk in the interest charged on the loans granted.
Based on the reviewed literature, it can be realised that studies on the determinants of
NPLs in the Ghanaian banking industry are scanty and as such this study fills the gap by
investigating into the subject matter. Specifically, this study considers the determinants of
NPLs for pool sample which comprises of 12 banks and subsamples of large and small
banks. This will inform us in designing policy specific to large and small banks.

3 Methodology

3.1 Econometric model

This study relies on panel data models, fixed effect and random effect models. The
Hausman’s test is used to decide whether the fixed effect or random effect model is
appropriate.
Given a basic regression model of the form (Greene, 2002);
yit = xit′ β + zi′α + ε it = xit′ β + c i +ε it (1)

From equation (1), the vector xit contains K regressors which do not include a constant
term. The heterogeneity or individual effect is represented by zi′α where the vector zi
contains a constant term and a set of individual or group-specific variables which may be
observed or unobserved, all of which are taken to be constant over time t.
With regards to the fixed effect model, if zi in equation (1) is unobserved though
correlated with xit, then the least squares estimator of β (vector) will be biased and
inconsistent due to an omitted variable. In such a case the model from equation (1) will
now be;
yit = xit′ β + α i +ε it (2)

where α i = zi′α , which represents all observable effects and specifies an estimable
conditional mean. The fixed1 effect approach takes αi to be a group-specific constant term
in the regression model.
In the case of random effect, if the unobserved individual heterogeneity (though
formulated) can be assumed to be correlated with the individual variables, then in the
case of random effect the model in equation (1) turns to;
42 F. Amuakwa-Mensah and A. Boakye-Adjei

yit = xit′ β + E [ zi′α ] + { zi′α − E [ zi′α ]} + ε it = xit′ β + α + ui + ε it (3)

Equation (3) is a linear regression model with a compounded disturbance that may be
consistent, although inefficient, when estimated by least squares. This random approach
specifies that ui is a group-specific random element, similar to εit except that for each
group, there is but a single draw that enters the regression identically in each period.
A random effect model is estimated by generalised least squares (GLS) when the
variance structure is known and feasible generalised least squares (FGLS) when the
variance is unknown. In our study we made use of GLS when carrying out an estimation
of a random effect model. In a case where the variance is assumed to be known, GLS
based on the true variance components is BLUE and all the feasible GLS estimators
considered are asymptotically efficient as either the sample size approaches infinity
(Baltagi, 2001).
In relation to the Hausman specification test, it compares the fixed vs. random effects
under the null hypothesis that the individual effects are uncorrelated with the other
regressors in the model (Hausman, 1978). In a situation where it correlates, the null
hypothesis is rejected, implying that a random effect model produces biased estimators,
violating one of the Gauss-Markov assumptions; hence fixed effect model is preferred.

3.2 Empirical model

Based on the reviewed literature in this study, it is evident that NPLs might be explained
by both macroeconomic and bank-specific factors. The empirical model used to ascertain
the determinants of NPLs in the Ghanaian banking sector is adapted from Jiménez and
Saurina (2005). The model is a simple linear regression function that links the ratio of
NPLs to total loans and key macroeconomic and bank-specific variables. The general
regression equation is of the form:
ln NPL _ Ai , t = β 0 + β1 ln NPL _ Ai , t −1 + β 2 ln CreditRiski , t + β 3 Sizei , t
+ β 4 ∆Loani , t + β 5 ln NIM i , t + β 6 ln INFt −1 + β 7 ∆GDP _ PCGt (4)
+ β 8 ∆GDP _ PCGt −1 + β 9 ln REERt + ε i , t for i = 1, …, N , t = 1,…, T

where
ln NPL_Ai,t and ln NPL_Ai,t–1 represents the natural log of the ratio of bad debt charges
to total loans for bank i in year t and t – 1 respectively. In our study we define NPLs as
the ratio of bad debt charges and total loans. We made use of bad debt charges reported
by banks on their income statement and the total loans and advances on their balance
sheet.
ln CreditRiski,t represents natural log of credit risk for bank i in year t.
Sizei,t is the ratio of the relative market share of each bank’s assets that captures the size
of the institution at time t.
∆Loani,t, represents the growth in loans for bank i in year t.
ln NIMt denotes the natural log of NIM for the banking industry at time t.
 Determinants of non-performing loans in Ghana banking industry 43

ln INFt–1 indicate the natural log of the annual inflation rate at time t – 1. Previous year’s
inflation was used rather than current year’s inflation because banks adjust their nominal
interest rate considering the lagged inflation rate.
∆GDP_PCGt and ∆GDP_PCGt–1 represent the annual growth in real GDP per capita at
time t and t – 1 respectively.
ln REERt indicates the natural log of the real effective exchange rate at time t; and
εi,t is the white noise error term. In the model βi (where i = 1, …, 9) represents the
coefficient of each variable.
The prevailing literature provides confirmation that there is a strong relationship between
NPLs and several macroeconomic variables. These macroeconomic factors proposed by
the literature to be determinant of NPLs include annual growth in GDP, credit growth,
real interest rates, the annual inflation rate, real effective exchange rate (REER), annual
unemployment rate, broad money supply (M2), and GDP per capita etc. However, this
study only considers the growth in real GDP per capita (∆GDP_PCG), annual inflation
(INF), and the real effective exchange rate (REER). Annual inflation rate and money
supply have a positive relationship in the Ghanaian economy as suggested by Bawumia
(2010, p.86). As a result, inclusion of annual inflation rate in our model implies inclusion
of money supply. In addition, real GDP per capita growth portrays the average living
condition of individuals in the economy and introducing it in our model helps to examine
how changes in income effects NPLs.
From the reviewed literature, there is a significant empirical evidence of a negative
relationship between the growth in real GDP and NPLs (Salas and Suarina, 2002; Rajan
and Dhal, 2003; Fofack, 2005; Jiménez and Saurina, 2005). The negative relationship is
due to the fact that when there is a strong positive growth in real GDP, it usually
translates into more income which improves the debt-servicing capacity of the borrower
which in turn contributes to lower NPLs. On the other hand, in situations where there is a
slowdown in the economy (low or negative GDP growth) the level of NPLs mostly
increases. In relation to inflation rate and NPL, there is a positive relationship between
them. According to Fofack (2005), inflationary pressures contribute to the high level of
impaired loans in a number of Sub-Saharan African countries with flexible exchange rate
regimes. Thus, inflation is responsible for the rapid erosion of commercial banks’ equity
and consequently higher credit risk in the banking sectors in the African countries
considered by Fofack (2005). Further, a positive relationship between non-performing
and real effective exchange rate was found by Fofack (2005). Thus, real effective
exchange rate has a positive impact on NPLs of commercial banks that operate in some
Sub-Saharan African countries with fixed exchange rate regimes.
Aside macroeconomic factors which affect NPLs, there are bank-specific variables
(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)) which also affect NPLs as suggested
by the literature. However, this study only considers four bank-specific variables (that is,
net interest margin (NIM), bank size (SIZE), annual growth in loans (∆LOAN) and credit
risk) due to data availability. The percentage change in annual loan portfolio for each
bank (∆LOANS) is used to capture credit growth. This variable is introduced in the
empirical model for the current year. It is expected that this variable will have a
44 F. Amuakwa-Mensah and A. Boakye-Adjei

significant positive relationship with NPLs since the literature shows that rapid credit
growth is often associated with higher NPLs.
The empirical evidence relating to the impact of bank size on NPLs appears to be
mixed. Some studies report a negative association between NPLs and bank size (Rajan
and Dhal, 2003; Salas and Saurina, 2002; Hu et al., 2006). According to these studies, the
negative relationship is attributed to the fact that large banks have better risk management
strategies that usually translate into more superior loan portfolios compared to their
smaller counterparts. Conversely, there are instances where positive relationship was
found between NPLs and bank size (see Rajan and Dhal, 2003). Pertaining to credit risk
there is also evidence in the literature that shows a strong positive relationship with NPLs
(see Sinkey and Greenwalt, 1991). 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.
It could have been interesting to consider the effect of the recent financial crisis on NPLs.
However the panel data for this study spans from 1998 to 2009; hence introducing a
dummy in 2007 to capture the financial crisis would not be accurate due to data problem.
The impact of real interest rates on NPLs is extensively documented in the literature.
Several studies report that high real interest rate is positively related to NPLs (see for
example, Jiménez and Saurina (2005) and Fofack (2005)). Inferring from this association
it is expected that a positive relationship will exist between NIM and NPLs.
Table 1 shows how each variable was computed and their a priori coefficient signs.

Table 1 Summary of variables used in regression model

Expected
Variable Description sign
ln NPL_Ai,t Natural log of the ratio of bad debt charges to total loans for bank i in year t
ln NPL_Ai,t–1 Previous ln NPL_Ai,t (+)
ln CreditRiski,t Natural log of the ratio of loans to total asset of bank i in year t (–)
Sizei,t The relative market share of bank i in year t (+) (–)
∆Loani,t Growth in loans of bank i in year t (i.e., percentage change in loan) (+)
ln NIMt Natural log of net interest margin (+) (–)
ln INFt–1 Natural of inflation at year t – 1 (+)
∆GDP_PCGt GDP per capita growth rate at year t (–)
∆GDP_PCGt–1 Previous ∆GDPt–1
ln REERt Natural log of effective exchange rate (+)

The study makes use of data solely from secondary source. In relation to the bank-
specific variables, data was sought from Central Bank of Ghana. However, data on
macroeconomic variables were sought from the World Bank development indicator
dataset. The bank-specific data is a panel data from 1998 to 2009 and it considers banks
with information within the period under review. As such the macroeconomic variables
also cover the same period. A brief descriptive summary of the banks considered in the
study is presented in Table 2 and Figure A1 (see Appendix).
 Determinants of non-performing loans in Ghana banking industry 45

Table 2 Average bank variables for each bank

Bank name NPL Size Credit risk Loan growth NIM

Large banks
ADB 6.51 10.06 40.44 32.44 0.65
BBG 2.96 15.09 42.52 39.40 0.76
SSB 3.69 10.14 33.33 33.74 0.76
STDCHART 1.82 16.53 38.49 27.87 0.67
EBG 1.21 9.15 30.71 57.98 0.64
GCB 4.82 19.83 44.49 51.64 0.72
Small banks
CAL 2.27 2.80 39.38 59.53 0.50
ICB 6.17 0.99 18.21 66.36 0.56
MBG 6.89 5.37 46.90 41.71 0.54
NIB 8.38 4.82 41.72 41.92 0.54
PRUD 1.87 2.60 36.01 60.52 0.45
TTB 2.33 2.61 37.72 50.83 0.60
Total mean 4.07 8.33 37.49 46.99 0.62
Source: Author’s computation

4 Regression result

The results of the regression estimation are presented in this section. The Hausman test
was carried out to help decide on whether the panel estimation assumes a fixed effect or a
random effect model. The discussion of the result of the Hausman test is presented in this
section; however, the tables for the Hausman test are presented in the Appendix. After
discussing the estimation for the pooled sample (that is, all the 12 banks used in the
estimation), discussion on the estimations for the sub-samples (large and small banks)
will follow. Before settling on the fixed effect regression model for the pooled sample,
Hausman test was carried out and this is presented in Table A1. The Hausman test shows
that the null hypothesis (difference in coefficients not systematic) is rejected since the
p-value from the test is less than 0.05 (see Table A1). This suggests that the fixed effect
model should be used in our estimation since there is a systematic difference between the
coefficients of the fixed effect estimation and the random effect estimations as shown in
Table A1.
The panel regression estimation in the column (1) in Table 3 was selected after the
Hausman test for the pool sample. The model is a good one since the p-value for the
F-test is less than 0.05, indicating that the explanatory variables do explain the dependant
variable. It is evident from the results that both bank-specific variables and
macroeconomic variables do significantly affect NPLs. This is in line with earlier studies
by some authors like Bercoff et al. (2002), Jiménez and Saurina (2005), Rajan and Dhal
(2003) and so on. The bank-specific variables which significantly affect non-performance
46 F. Amuakwa-Mensah and A. Boakye-Adjei

include previous year’s NPL, bank size, NIM and loan growth. Previous year’s NPLs
positively affects current NPLs. This result is consistent with the study by Khemraj and
Pasha (2009). From column (1) in Table 3, a 1% increase in previous year’s NPLs will
lead to 0.248% increase in current year’s NPLs, holding all other things constant. This is
because previous NPLs of banks will add up to the current value of NPLs.

Table 3 Determinants of non-performing loan

(1) (2) (3)

Variables All banks Small banks Large banks
ln NPL_1 0.248*** 0.202* 0.452***
(0.0812) (0.109) (0.112)
Size 0.0668*
(0.0350)
ln Credrisk 0.0782 0.0643 0.361
(0.349) (0.517) (0.447)
ln NIM_1 –0.880** –0.456 –1.366
(0.443) (0.492) (0.942)
LoanGro –0.00681*** –0.00629* –0.0108***
(0.00207) (0.00316) (0.00373)
ln Infla_1 –0.539** –0.223 –1.288***
(0.241) (0.306) (0.482)
GDP_PCG –0.163** –0.0684 –0.273**
(0.0725) (0.105) (0.111)
GPD_PC_1 –0.0876 –0.0440 –0.177
(0.0786) (0.111) (0.124)
ln REER –1.312** –0.693 –1.839*
(0.572) (0.750) (0.978)
Constant 8.073** 4.875 12.48**
(3.150) (4.155) (5.216)
Observations 126 64 62
R-squared 0.351 0.228 0.518
F(9,105) 6.30***
F(8,50) 1.85*
Wald chi2(8) 56.88***
Number of BankID 12 6 6
Standard errors in parentheses.
*p < 0.1, **p < 0.05, ***p < 0.01.

Similarly, bank size has a positive effect on NPLs and this is consistent with earlier
studies by Salas and Saurina (2002), Boahene et al. (2012) and Khemraj and Pasha
(2009). This study reveals that a 1 unit increase in a bank’s size will result in the natural
log of NPLs increasing by 0.067, all other things held constant. This suggests that as the
 Determinants of non-performing loans in Ghana banking industry 47

bank size increases there is the high tendency for them to expand their credit base. With a
high expansion of credit there is a possibility of more clients defaulting, hence making
provision for the defaulted loans high. On the contrary, current year’s loan growth has a
negative effect on current year’s NPLs. This sign is consistent with our expectation and
earlier studies. Thus, a 1% increase in current year’s loan growth will lead to 0.007%
decrease in NPLs, with other variables held constant. This effect may be due to the fact
that banks will respond to loan growth by reducing their provisions for bad debt
marginally provided they are sure about repayment. Also, previous year’s NIM has a
negative effect on current year’s NPL. From the result, a 1% increase in previous year’s
NIM will lead to 0.88% decrease in NPLs. This means that as banks NIM increases they
would have recovered enough from their clients who borrowed, hence charging little bad
debt in their books.
Turning our attention to macroeconomic variables, previous year’s inflation, real
GDP per capita growth, and real effective exchange rate are the only macroeconomic
variables which significantly affect NPLs in the Ghanaian banking industry based on this
result. These macroeconomic variables negatively affect NPLs. The sign of previous
year’s inflation rate and real effective exchange rate are however contrary to the study by
Khemraj and Pasha (2009). From column (1) in Table 3, a 1% increase in previous year’s
inflation rate will lead to current year’s NPLs decreasing by 0.54%, given all other things
constant. This can be explained as a decrease in the real NPLs in the current year as the
inflation rate increases in the previous year. In relation to real effective exchange rate, a
1% increase in real effective exchange rate will result in 1.31% decrease in NPLs.
However, the effect of real GDP per capita growth is in line with earlier studies (Salas
and Suarina, 2002; Rajan and Dhal, 2003; Fofack, 2005; and Jiménez and Saurina, 2005).
From the results, a 1% increase in current year’s real GDP per capita growth will lead to
the natural log of NPLs reducing by 0.16, all other things held constant. The negative
relationship is due to the fact that when there is a strong positive growth in real GDP per
capita, it usually translates into more income which improves the debt servicing capacity
of borrower which in turn contributes to lower NPLs.
The sub-sample estimations are presented in columns (2) and (3) of Table 3. While
column (2) of Table 3 represents a fixed effect panel estimation using the small banks
only, column (3) of the same table shows a random effect estimation using only the large
banks. The difference in the type of model used was due to the result of the Hausman test
carried out in both instances. The Hausman test for the large bank sample shows that the
null hypothesis (difference in coefficients not systematic) is accepted since the p-value
from the test is greater than 0.05 (see Table A2 in Appendix). This suggests that the
random effect model is appropriate for the estimation with the large bank sample since
there is a no systematic difference between the coefficients of the fixed effect estimation
and the random effect estimation as shown in Table A2. For instance, from Table A2
(see Appendix) the difference between the coefficient for loan growth in both the fixed
effect and random effect is almost zero. However, the Hausman test for the small bank
sample portray that the null hypothesis (difference in coefficients not systematic) is
rejected since the p-value from the test is less than 0.05 (see Table A3 in Appendix). This
suggests that the fixed effect model is appropriate for the estimation with small bank
sample since the difference between the coefficients of the fixed effect estimation and the
random effect estimations is systematic.
48 F. Amuakwa-Mensah and A. Boakye-Adjei

Now comparing the determinants of NPLs between large and small banks, we
examine the result in columns (2) and (3). The F-test in column (2) and the Wald chi
square test in column (3) are both significant as shown by their respective p-value. Using
a significance level of 0.05, it is quite surprising that both bank-specific variables and
macroeconomic variables do not significantly affect NPLs of small banks. However, with
a significance level of 0.1 only some bank-specific variables (that is, previous year’s
NPLs and current year’s loan growth) do significantly affect NPLs. These variables have
the same signs as in the pool estimation in column (1) in Table 3. With regard to the
determinants of NPLs for large banks, both bank-specific variables and macroeconomic
variables do significantly affect NPLs. The bank-specific variables include previous
year’s NPLs and current year’s loan growth. However, the macroeconomic variables
include previous year’s inflation, real GDP per capita growth, and real effective exchange
rate. With the exception of previous year’s NPLs, all the significant variables negatively
affect NPLs as shown in column (3) of Table 3. Comparing the estimation for large and
small banks, it can be seen that current year’s loan growth and previous year’s NPLs are
the common significant determinants of NPLs for both large and small banks (using
significance level of 0.1).
However, the effect of these variables (that is, previous year’s NPLs and current
year’s loan growth) on the NPLs of large banks is more than that of small banks. We
arrived at this assertion by considering the coefficient of previous year’s NPLs and
current year’s loan growth for large banks (in column (3) of Table 3) and that of small
banks (in column (1) in Table 3) in absolute terms. The greater effect of bank-specific
variables on NPLs of large banks compared to small banks can be attributed to the fact
that large banks have larger and wider customer base than small banks. As a result both
negative and positive effects on NPLs of large banks which are due to bank-specific
factors are greater than that of small banks. In relation to the macroeconomic variables, it
can be argued that large banks are more integrated in the economy than small banks.
As a result, macroeconomic variables would have a significant effect on the activities of
large banks than small banks. The estimations for the pool sample and the sub-samples
using only significant variables are presented in Table A4 (see Appendix).

5 Conclusion and recommendation

This study examined the determinants of NPLs in the banking industry of Ghana.
A panel regression model was used after carrying out Hausman test to decide on whether
fixed effect or random effect model is appropriate. Both bank-specific variables
(that is, previous year’s NPLs, bank size, NIM, and current year’s loan growth), and
macroeconomic variables (that is, previous year’s inflation, real GDP per capita growth,
and real effective exchange rate) do significantly affect NPLs. The sub-sample
estimations portrayed that only some bank-specific variables (that is, previous year’s
NPLs and current year’s loan growth) are the determinants of NPLs for small banks
(using a significance level of 0.1), while the determinants of NPLs for large banks can be
attributed to both bank-specific and macroeconomic factors. These bank-specific factors
include previous year’s NPLs and current year’s loan growth. And the macroeconomic
factors are real effective exchange rate, real GDP per capita growth, and previous year’s
inflation rate.
 Determinants of non-performing loans in Ghana banking industry 49

Based on the findings of the study, it means whereas small banks in Ghana should
pay attention to bank-specific factors when providing loans in order to restrain the level
of NPLs, large banks should pay attention to both bank-specific and macroeconomics
factors when providing loans in order to restrain the level of NPLs. Specifically, large
banks need to consider the international competitiveness of the Ghanaian economy since
this may impair the ability of borrowers who are in the export-oriented sectors to repay
their loans which in turn would result in higher NPLs. Further, the inflation level in the
economy should be monitored and factored in the management of NPLs by commercial
banks especially large banks. Finally, banks should constantly review the interest rates on
loans to encourage clients in paying their loans since previous NPLs have positive effect
on current NPLs. The Central Bank of Ghana should also strength its monitoring
framework which comprises of macroeconomic prudential indicators such as inflation
and real effective exchange rate in assessing the stability and soundness of the banking
system.

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Note
1
It should be noted that the term ‘fixed’ as used here signifies the correlation of ci and xit, not that ci
is non-stochastic.

Website
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with-high-default-rates.html [Accessed 23/08/2013].

Appendix

Figure A1 Comparison of bank variables between large and small banks (see online version
for colours)

Source: Author’s computation

52 F. Amuakwa-Mensah and A. Boakye-Adjei

Appendix (continued)

Figure A2 Number of employees in the banking industry (see online version for colours)

Source: Bank of Ghana

Table A1 Hausman test for the pooled sample

sqrt(diag
(b) (B) (b – B) (V_b – V_B))
Fixed Random Difference S.E.
ln NPL_1 0.247511 0.501908 –0.2544 0.0345183
Size 0.066798 0.010354 0.056444 0.0311609
ln Credrisk 0.078179 –0.18708 0.265256 0.2389966
ln NIM_1 –0.88042 –0.62733 –0.25309 0.1779473
LoanGro –0.00681 –0.00658 –0.00023 0.0002118
ln Infla_1 –0.53886 –0.67858 0.139726
GDP_PCG –0.16276 –0.15213 –0.01063
DGPD_PCG_1 –0.08765 –0.02116 –0.06649
ln REER –1.31213 –1.17609 –0.13604
b = consistent under Ho and Ha; obtained from xtreg
B = inconsistent under Ha, efficient under Ho; obtained from xtreg
Test: Ho: difference in coefficient not systematic
chi2(9) = (b – B)'[(V_b – V_B)^(–1)](b – B) = 70.52
Prob>chi2 = 0.000
(V_b – V_B is not positive definite)
 Determinants of non-performing loans in Ghana banking industry 53

Appendix (continued)

Table A2 Hausman test for the large banks

sqrt(diag
(b) (B) (b – B) (V_b – V_B))
Fixed Random Difference S.E.
ln NPL_1 0.208044 0.451702 –0.24366 0.072246
ln Credrisk –0.04744 0.36075 –0.40819 0.243026
ln NIM_1 –3.08522 –1.36643 –1.71879 0.760152
LoanGro –0.0105 –0.01075 0.000254 0.00057
ln Infla_1 –1.11643 –1.28776 0.171327
GDP_PCG –0.17622 –0.27282 0.096603 0.035325
DGPD_PCG_1 –0.15746 –0.17735 0.019894
ln REER –2.91546 –1.83946 –1.07599 0.161711
b = consistent under Ho and Ha; obtained from xtreg
B = inconsistent under Ha, efficient under Ho; obtained from xtreg
Test: Ho: difference in coefficient not systematic
chi2(8) = (b – B)'[(V_b – V_B)^(–1)](b – B) = 12.21
Prob>chi2 = 0.1423
(V_b – V_B is not positive definite)

Table A3 Hausman test for the small banks

sqrt(diag
(b) (B) (b – B) (V_b – V_B))
Fixed random Difference S.E.
ln NPL_1 0.202297 0.497599 –0.2953 0.030417
ln Credrisk 0.064298 –0.32588 0.390176 0.431284
ln NIM_1 –0.45564 0.011798 –0.46743
LoanGro –0.00629 –0.00897 0.002679 0.000934
ln Infla_1 –0.22294 –0.17309 –0.04985
GDP_PCG –0.0684 –0.04323 –0.02516 0.006542
DGPD_PCG_1 –0.04401 0.025147 –0.06915 0.037179
ln REER –0.69277 –0.63518 –0.05759
b = consistent under Ho and Ha; obtained from xtreg
B = inconsistent under Ha, efficient under Ho; obtained from xtreg
Test: Ho: difference in coefficient not systematic
chi2(8) = (b – B)'[(V_b – V_B)^(–1)](b – B) = 84.87
Prob>chi2 = 0.000
(V_b – V_B is not positive definite)
 54 F. Amuakwa-Mensah and A. Boakye-Adjei

Appendix (continued)

Table A4 Determinants of non-performing loan using only significant variables

(1) (2) (3)

Variables All banks Small banks Large banks
ln NPL_1 0.272*** 0.217** 0.486***
(0.0782) (0.102) (0.107)
Size 0.0679*
(0.0348)
ln NIM_1 –1.004**
(0.427)
LoanGro –0.00581*** –0.00758*** –0.00740**
(0.00178) (0.00233) (0.00313)
ln Infla_1 –0.440* –0.925**
(0.224) (0.410)
GDP_PCG –0.155** –0.302***
(0.0604) (0.0967)
ln REER –1.274** –1.159
(0.567) (0.920)
Constant 7.491*** 1.333*** 9.551**
(2.822) (0.161) (4.587)
Observations 126 64 62
R-squared 0.342 0.176 0.4722
Number of BankID 12 6 6
Standard errors in parentheses.
*p < 0.1, **p < 0.05, ***p < 0.01.

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