Asian Development Bank Institute. ADBI Working Paper Series

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1 DI Wokig Pape Seies Estimatig Dual Deposit Isuace Pemium Rates ad oecastig No-pefomig Loas: Two New Models Naoyuki Yoshio, ahad Taghizadeh-Hesay, ad ahad Nili No. 5 Jauay 5 sia Developmet ak Istitute

2 Naoyuki Yoshio is Dea ad CEO of the sia Developmet ak Istitute (DI). ahad Taghizadeh-Hesay is a adjuct eseache at the School of Ecoomics, Keio Uivesity, ad a visitig schola at the Istitute of Eegy Ecoomics of Japa. Cuetly, he is also assistig the DI Dea i his eseach. ahad Nili is adviso to the Goveo of the Cetal ak of Ia (CI) ad diecto of the Moetay ad akig Reseach Istitute, the thik tak of the CI. This pape is a evised vesio of a eseach poject udetake fo the Moetay ad akig Reseach Istitute of the Cetal ak of Ia to calculate the fai deposit isuace pemium ate fo Ia i 3. We would like to thak the Cetal ak of Ia fo povidig us with the ecessay data fo this eseach. We ae also gateful to Pof. Shi-Ichi ukuda ad all paticipats i ou pesetatio at the sia-pacific Ecoomic ssociatio (PE) cofeece at the Koea Istitute fo Idustial Ecoomics ad Tade (KIET) i Seoul o 8 Septembe 4, fo thei valuable commets, which helped us to impove this pape. We would also like to exted ou thaks to all commetatos at the 89th aual cofeece of the Weste Ecoomic ssociatio Iteatioal (WEI) i Deve, Coloado, held o 9 Jue 4. The views expessed i this pape ae the views of the authos ad do ot ecessaily eflect the views o policies of DI, D, its oad of Diectos, o the govemets they epeset. DI does ot guaatee the accuacy of the data icluded i this pape ad accepts o esposibility fo ay cosequeces of thei use. Temiology used may ot ecessaily be cosistet with D official tems. Wokig papes ae subject to fomal evisio ad coectio befoe they ae fialized ad cosideed published. The Wokig Pape seies is a cotiuatio of the fomely amed Discussio Pape seies; the umbeig of the papes cotiued without iteuptio o chage. DI s wokig papes eflect iitial ideas o a topic ad ae posted olie fo discussio. DI ecouages eades to post thei commets o the mai page fo each wokig pape (give i the citatio below). Some wokig papes may develop ito othe foms of publicatio. Suggested citatio: Yoshio, N.,. Taghizadeh-Hesay, ad. Nili. 5. Estimatig Dual Deposit Isuace Pemium Rates ad oecastig No-pefomig Loas: Two New Models. DI Wokig Pape 5. Tokyo: sia Developmet ak Istitute. vailable: Please cotact the authos fo ifomatio about this pape. fahadth@gmail.com; yoshio@adbi.og; f.ili@cbi.i

3 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili bstact Risky baks that edage the stability of the fiacial system should pay highe deposit isuace pemiums tha healthy baks ad othe fiacial istitutios that have show good fiacial pefomace. It is ecessay, theefoe, to have at least a dual fai pemium ate system. I this pape, we develop a model fo calculatig dual fai pemium ates. Ou defiitio of a fai pemium ate i this pape is a ate that could cove the opeatioal expeditues of the deposit isuig ogaizatio, povides it with sufficiet fuds to eable it to pay a cetai pecetage shae of deposit amouts to depositos i case of bak default, ad povides it with sufficiet fuds as pecautioay eseves. To idetify ad classify healthie ad moe stable baks, we use cedit atig methods that employ two majo dimesioal eductio techiques. o foecastig o-pefomig loas (NPLs), we develop a model that ca captue both maco shocks ad idiosycatic shocks to fiacial istitutios i a vecto eo coectio settig. The espose of NPLs/loas to maco shocks ad idiosycatic iovatios shows that usig a model with maco vaiables oly is isufficiet, as it is possible that ude favoable ecoomic coditios some baks show egative pefomace o vice vesa. Ou fial esults show that stable baks should pay lowe deposit isuace pemium ates. JEL Classificatio: G8, G, E44 sia Developmet ak Istitute Kasumigaseki uildig Kasumigaseki, Chiyoda-ku Tokyo -68, Japa Tel: ax: URL: ifo@adbi.og 5 sia Developmet ak Istitute

4 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili Cotets. Itoductio Who Pays the Deposit Isuace Pemium? Model Dual Pemium Rates Model oecastig aks No-pefomig Loas: Maco Shocks vesus Idiosycatic Shocks alysis of aks Cedit Ratig Selectio of Vaiables Picipal Compoet alysis Cluste alysis Robustess Check of aks Cedit Ratig Empiical alysis oecastig aks No-pefomig Loas ai Deposit Isuace Pemium Rate fo Each Goup of aks Coclusio... 4 Refeeces... 6

5 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili. INTRODUCTION Sice the stat of the ecet global fiacial cisis, tiggeed by the collapse of Lehma othes i Septembe 8, thee has bee a ogoig iteatioal debate about the efom of fiacial egulatio ad supevisio iteded to pevet the ecuece of a simila cisis. Stegtheig deposit isuace systems is oe of the fudametal steps i this efom. Deposit isuace is a key elemet i mode bakig, as it guaatees the fiacial safety of deposits at depositoy fiacial istitutios. If a isued depositoy istitutio fails to fulfill its obligatios to its depositos, the isuig agecy will step i to hoo the picipal ad accued iteests up to a pedetemied ceilig. impotat issue ude this system is how to pice deposit isuace (Hovitz 983; Kae 986; Yoshio, Taghizadeh-Hesay, ad Nili 3). o detemiig fai pemium ates to be paid by depositoy fiacial istitutios to the isuig agecy, the cosesus method teds towad adoptio of a isk-based deposit isuace scheme accodig to bak defaults. To achieve this goal, seveal models fo assessig bak defaults have bee poposed: use, Che, ad Kae (98); chaya ad Deyfus (989); atholdy, oyle, ad Stove (3); ad, moe ecetly, Yoshio ad Hiao (). Howeve, i the liteatue o bakig ad fiace we have foud oly a few studies dealig with the deposit isuace system (Hovitz 983; Hwag, Lee, ad Liaw 997; Iakua ad Shimizutai ; Yoshio, Taghizadeh-Hesay, ad Nili 3) ad hadly ay studies o how to estimate ad foecast fai pemium ates fo deposit isuace. I oe of the most ecet studies, Yoshio, Taghizadeh-Hesay, ad Nili (3) povided a model fo calculatig fai pemium ates fo the deposit isuace system. Usig this model, they estimated the fai pemium ate fo the deposit isuace system of Japa ad foud that it is much highe tha the actual cuet pemium ate i Japa. I aothe study they cocluded that, to secue fiacial stability, Japa would eed to aise the deposit isuace pemium ate. It is cucial fo each couty to set fai pemium ates to maitai fiacial system stability, theeby potectig depositos ad esuig a appopiate settlemet of fuds whe fiacial istitutios fail. I this pape, a fai ate efes to a ate that coves the opeatioal expeditues of a isuig agecy (e.g., pesoel costs ad equipmet costs) ad povides it with sufficiet fuds to fiacially assist ay failed depositay fiacial istitutios. The isuig agecy is also obliged to keep adequate pecautioay eseves at the ed of each fiacial peiod to secue itself agaist futhe possible failues. high pemium ate educes the capital adequacy of idividual fiacial istitutios, which edages the stability of the fiacial system; a low pemium ate will educe the secuity of the fiacial system. I this pape, we expad the model fist itoduced by Yoshio, Taghizadeh-Hesay, ad Nili (3) fo estimatig oe fai pemium ate fo the whole deposit isuace system. We coclude that may couties eed to adopt a system that uses moe tha oe fai pemium ate. Depedig o the soudess ad stability of baks, vayig pemium ates should be adopted as it would be ufai fo all baks, iespective of whethe they ae healthy o uhealthy, to pay the same pemium ate to the isuig agecy. Usoud ad iskie baks that edage the stability of the fiacial system should pay highe pemiums tha healthy baks ad fiacial istitutios that have kept thei o-pefomig loas (NPLs) at adequate levels ad have show good fiacial pefomace. Hece, it is ecessay to have at least a dual fai pemium ate system, which is the mai agumet of this pape. I Sectio of this pape, we povide a model fo calculatig dual fai pemium ates, which would allow healthie 3

6 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili baks to pay a lowe ate. o this pupose, we eed to have a mechaism fo cedit atig ad classificatio of baks based o thei fiacial soudess, which is peseted i Sectio 3. o ou empiical aalysis, peseted i Sectio 4, we use the deposit isuace system of Ia, which is cuetly i the pocess of establishig a deposit isuace system.. Who Pays the Deposit Isuace Pemium? s its ame suggests, the deposit isuace system is iteded pimaily to povide fo the paymet of isuace claims whe a isuable cotigecy occus. Specifically, thee ae two methods of potectio: the isuace payout method, wheeby isuace payouts ae made diectly to depositos; ad a method wheeby the busiess of a failed fiacial istitutio is tasfeed to a diffeet fiacial istitutio, ad the deposit isuace agecy/copoatio (DIC) povides assistace to this secod istitutio. Whe checkig the DIC websites of vaious couties, we typically fid a setece alog the followig lies: You [depositos] do ot pay fo the deposit isuace. iacial istitutios that ae a membe of ou deposit isuace system pay pemiums to us. lthough membe baks o fiacial istitutios of the deposit isuace system do ideed pay the pemium ate to the DIC, i pactice the deposit isuace pemium ate bude is divided betwee baks ad depositos ad/o baks ad copoatios. igue illustates how the bude of the deposit isuace pemium is shaed. igue : Who Pays the Deposit Isuace Pemium? Souce: uthos compilatio. I igue, is the deposit isuace pemium baks should pay to the DIC. Payig this pemium iceases the baks costs, so they have to lowe the iteest they pay out o custome deposits ad/o aise thei iteest ates o loas gated. I the lefthad-side gaph of igue, it is assumed that baks compesate fo thei pemium bude oly by loweig the iteest they pay out o deposits. I this sceaio, baks ae ot the oly paties that bea the bude of the deposit isuace cost, as it is shaed betwee depositos ad baks. s ca be see i the figue, the highe costs icued by baks due to the lauch of a deposit isuace system decease demad fo deposits ad cosequetly the demad cuve shifts to the left. The esult is a decease i iteest ates o deposits. sigifies the shae of the bude of the 4

7 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili deposit isuace pemium boe by the baks, C is the depositos shae of the bude of the deposit isuace pemium, ad C is the total decease i the iteest paid out o deposits, which is equal to. I the ight-had-side gaph of igue, a sceaio i which the pemium bude of baks is compesated oly by aisig thei ledig ates o loas to copoatios is peseted. I this case, the icease i cost icued by the baks due to the lauch of a deposit isuace system esults i a decease i the povisio of loas to customes ad cosequetly the supply cuve shifts to the left. s a esult, baks ledig ates fo loas ise. This teds to divide the pemium bude betwee baks ad copoatios that ae demades of loas. The copoatios shae is depicted by ba, the baks shae by cb, ad ca depicts the total chage i the baks ledig ate as a esult of payig pemiums to the DIC, which is equal to.. MODEL I this pape we peset two models the fist oe is fo estimatig dual pemium ates of deposit isuace; the secod is fo foecastig NPLs fo each goup of baks, which is a equiemet fo estimatig the pemium ates of deposit isuace. I Sectio., we defie the dual pemium ate model ad i Sectio. we explai how to foecast baks NPLs usig ou model.. Dual Pemium Rates Model I the developmet of ou model we wee ispied by Yoshio, Taghizadeh-Hesay, ad Nili (3). They povided a model usig a discouted peset value mechaism to calculate a sigle fai pemium ate fo deposit isuace systems though which they estimated the fai pemium ate fo the deposit isuace system of Japa. Thei model eables us to calculate a sigle pemium ate fo all fiacial istitutios, which is what may couties use. Howeve, i may othe couties the moetay authoities pefe to use dual o multiple pemium ates fo thei deposit isuace system, which meas healthie fiacial istitutios pay a lowe pemium to the DIC. This gives fiacial istitutios a icetive to impove thei soudess, so they ca attai highe cedit atig levels fo payig lowe pemiums. I this pape, we expad the Taghizadeh-Hesay ad Nili (3) model, ad use a discouted peset value mechaism to calculate dual fai pemium ates fo the deposit isuace system. It ca be expad futhe to calculate multi-pemium ates, should a paticula DIC wish to use moe tha two pemium ates. igue shows the geeal outlie of ou ew model fo calculatig the diffeet pemium ates fo each goup of baks: 5

8 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili igue : Icome ad Expeditue of DIC i the Case of Dual Pemium Rates DIC = deposit isuace agecy/copoatio. Note: aks ae healthie baks tha aks. is pemium ate fo Goup, is pemium ate fo Goup of baks. espectively. Souce: uthos. D, D I, I ae pemium icome of the DIC fom Goup ad Goup of baks, ae cumulative deposit of Goup ad Goup of baks, espectively. s igue shows, accodig to ou model, the pemium icome the DIC eas fom each goup of baks (, ) has to be equal to the total amout of fiacial assistace the DIC povides to each goup i case of a bakig default i that goup, opeatioal expeditues icued by the DIC fo each goup, ad pecautioay futue eseves kept by the DIC fo each goup sepaately. s pe ou model, the discouted cumulative amouts of these vaiables ae impotat, meaig: Discouted cumulative pemium icome of the DIC fom each goup of baks (icludig futue expected icome) = Discouted cumulative opeatioal expeditues of the DIC towad each goup of baks (icludig futue expected opeatioal expeditues) Discouted cumulative fiacial assistace of the DIC to failed fiacial istitutios of each goups (icludig futue expected fiacial assistace) discouted pecautioay futue eseves of the DIC at the ed of the peiod fo each goup of baks. elow, i Equatios 8, we peset each of these elemets: Peset value of icome (icludig futue icome) of the DIC fom Goup baks: PVI D = ( ) ( ) ( ) ( ) D D... D () Peset value of icome (icludig futue icome) of the DIC fom Goup baks: PVI D = D D... ( ) ( ) ( ) ( ) D () whee PVI ad PVI deote the peset value of icome (icludig futue icome) of the DIC fom Goup ad Goup baks, espectively; ad ae the cumulative amout of eligible deposits of Goup ad Goup baks, espectively, i each yea; D i D i 6

9 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili ad espectively; ad values i each. ae the deposit isuace pemium ates fo Goup ad Goup baks, i stads fo the aveage log-tem iteest ate used fo discoutig Peset value of opeatioal expeditues (icludig futue expeditues) of the DIC: PVE = E E ( ) ( ) ( ) ( ) PVE stads fo the peset value of the opeatioal expeditues (icludig futue expeditues) of the DIC (e.g., pesoel costs ad equipmet costs) ad E i deotes the opeatioal expeditues of the DIC i each yea. Peset value of fiacial assistace (icludig futue fiacial assistace) of the DIC to Goup baks: PV = E... ( ) ( ) ( ) ( ) E... (3) (4) Peset value of fiacial assistace (icludig futue fiacial assistace) of the DIC to Goup baks: PV = ( ) ( ) ( ) ( )... (5) PV ad PV ae the peset value of fiacial assistace (icludig futue fiacial assistace) of the DIC to Goup ad Goup baks, espectively; ad i ad i ae fiacial assistace of the DIC to Goup ad Goup baks i each yea, espectively. s the cuet yea is, so fo (,, 3,, ) yeas, this is the aticipated amout of fiacial assistace, which will be foecast usig ou secod model (i Sectio. below). Peset value of futue desied pecautioay eseves of the DIC: RES PVRES = ( ) (6) whee PVRES is the peset value of the desied pecautioay eseves of the DIC at the ed of yea ; ad RES is desied futue eseves of the DIC at the ed of yea, also fo pecautioay puposes. The fist yea is the yea the deposit isuace system is lauched i the couty of ou estimatio. This could also be the yea that the bakig system had a stuctual chage o expeieced a fiacial cisis ad the was supposed to calculate the optimal pemium ate followig that specific yea. 7

10 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili The dual pemium ate model is as follows: (7) whee ad ae shaes of Goup baks fom the peset value of the opeatioal expeditues (icludig futue expeditues) of the DIC ad fom the peset value of the desied pecautioay eseves of the DIC at ed of yea, espectively. Substitutig Eqs. 6 i Eq. 7 esults i the followig fial dual pemium ates model: (8). oecastig aks No-pefomig Loas: Maco Shocks vesus Idiosycatic Shocks iacial assistace fom the DIC is maily elated to the amout of NPLs the lage the amout of NPLs, the highe the default isk, which meas the DIC would eed to povide geate fiacial assistace (Yoshio ad Hiao, 3). Hece, we eed to develop a model fo foecastig NPLs. To establish what vaiables have a impact o futue amouts of NPLs, we efeed to two ealie studies, Yoshio ad Hiao () ad Yoshio, Taghizadeh-Hesay, ad Nili (3). They used macoecoomic vaiables to foecast NPLs ad fiacial assistace fom the DIC. We wee ispied by this ealie eseach, but we expaded these papes models. Ou model fo foecastig NPLs is as follows: (9) whee deotes NPLs ad ae the goss domestic poduct (GDP), pice of stock, pice of lad, ad govemet bod iteest ate (safe asset iteest ate), espectively. is the expected shae of loas that would esult i default. is the fiacial pofile of all baks ad is a vaiable to captue idiosycatic shocks to baks. is the total amout of loas of baks. I Yoshio ad Hiao s model, the amout of NPLs ( ) depeds o the vaious ecoomic factos metioed above ( ). Whe lad pices icease, collateal value iceases as well, so default isk will declie. Whe busiess coditios impove, iceases i GDP gowth ad stock pices cause a eductio i default isk, ad whe the govemet bod iteest ate, oe of the safest asset iteest ates, is aised, baks ted to ivest moe i safe assets that will educe default isks. The fou maco vaiables ca captue maco shocks, but some baks ca fail eve if the maco fiacial system is soud. So we eed additioal vaiables that ca captue idiosycatic ucetaity i the ecoomy. This is the easo = = PVRES PV PVE PVI PVRES PV PVE PVI ) ( ) ( β α β α α β ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) = = RES E E E E D D D D RES E E E E D D D D ) ( ) ( β α β α L Z i P P Y L i L S NPL = ),,,, ρ( NPL L L S i P P Y,,, ρ i Z L NPL L L S i P P Y,,, ρ ρ 8

11 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili we iseted Z i i ou model, i.e., to captue mico shocks to each bak o to each Z i goup of baks. deotes the baks fiacial pofile, which we will futhe explai below. Hece, ou model has the ability to captue maco ad mico shocks. 3. N NLYSIS O NKS CREDIT RTING I ou dual pemium ates model, healthie baks pay lowe pemium ates. To eable us to idetify the healthie goup of baks, classificatio o cedit atig is eeded. Cedit atigs ae opiios expessed i tems of odial measues, eflectig the cuet fiacial ceditwothiess of issues such as govemets, fims, o fiacial istitutios. These atigs ae cofeed by atigs agecies, such as itch Ratigs, Moody s, ad Stadad ad Poo s (S&P), ad may be egaded as compehesive evaluatios of a issue s ability to meet thei fiacial obligatios i full ad o time. Hece, they play a cucial ole by povidig paticipats i fiacial makets with useful ifomatio fo fiacial plaig. To coduct atig assessmets of baks, agecies esot to a boad age of fiacial ad o-fiacial pieces of ifomatio, icludig domai expets expectatios. Ratigs agecies usually povide geeal guidelies o thei atig decisio pocess, but detailed desciptios of the atig citeia ad of the detemiats of baks atigs ae geeally ot povided (Oseigo ad Vecellis 3). I seach of moe objective assessmets of the ceditwothiess of fiacial istitutios, thee has bee a gowig body of eseach ito the developmet of eliable quatitative methods fo the automatic classificatio of baks accodig to thei fiacial stegth. Extesive empiical eseach devoted to aalyzig the stability ad soudess of fiacial istitutios dates back to the 96s. Ravi Kuma ad Ravi (7) povided a compehesive suvey of the applicatio of statistical ad itelliget techiques fo pedictig the default of baks ad fims. Despite its obvious elevace, howeve, the developmet of eliable quatitative methods fo the pedictio of baks cedit atig has oly ecetly begu to attact stog iteest. These studies ae maily coducted withi two boad eseach stads focusig o statistical ad machie leaig techiques, ad may addess both featue selectio ad classificatio. Poo et al. (999) developed logistic egessio models fo pedictig fiacial stegth atigs assiged by Moody s, usig bak-specific accoutig vaiables ad fiacial data. acto aalysis was applied to educe the umbe of idepedet vaiables ad etai the most elevat explaatoy factos. The authos showed that loa povisio ifomatio, ad isk ad pofitability idicatos added the geatest pedictive value i explaiig Moody s atigs. Huag et al. (4) compaed suppot vecto machies ad back popagatio eual etwoks to foecast the atig of fiacial istitutios opeatig i makets i the Uited States ad Taipei,Chia, espectively. I both cases five atig categoies wee cosideed, based o ifomatio eleased by S&P ad TRC. The aalysis of vaiace was used to discad o-ifomative featues. I this study, suppot vecto machies ad eual etwoks achieved compaable classificatio esults. Howeve, the authos foud that the elative impotace of the fiacial vaiables used as iputs by the optimal models wee quite diffeet betwee the two makets. study by Oseigo ad Vecellis (3) peseted a empiical evaluatio of two liea ad oliea techiques picipal compoet aalysis (PC) ad double-bouded tee-coected Isomap (dbt Isomap) to assess thei effectiveess fo dimesioality eductio i bak cedit atig pedictio, ad to idetify the key fiacial vaiables edowed with the geatest explaatoy powe. Extesive computatioal tests coceig the classificatio of six baks atigs 9

12 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili datasets showed that the use of dimesioality eductio accomplished by oliea pojectios ofte iduced a impovemet i the classificatio accuacy, ad that dbt- Isomap outpefomed PC by cosistetly povidig moe accuate pedictios. I ou peset eseach o cedit atig of baks, we employ the statistical techiques used by Yoshio ad Taghizadeh-Hesay (4a) fo cedit atig ad classificatio of small ad medium-sized etepises (SMEs). They used PC ad cluste aalysis ad applied vaious fiacial vaiables of,363 SMEs i sia. I ou peset pape, we assig cedit atigs to ad classify all 3 Iaia baks ito two goups ad i ou empiical aalysis we calculate the pemium ate fo each goup of Iaia baks. To be able to do so ad to esue ou esults ae cedible, we eed to select vaiables that captue all elevat chaacteistics of the baks that ae the subject of ou examiatio. 3. Selectio of Vaiables It is widely kow that atigs ae diectly affected by the fiacial pefomace of baks. ased o this assumptio, we focus o baks fiacial pofiles ad employ eight fiacial vaiables that descibe all geeal chaacteistics of baks. These vaiables ae listed i Table : Table : Vaiables Examied No. Symbol Defiitio L D Total loas/total deposits PR L Popeties/total loas 3 (SDLD) D (Savig deposits log-tem deposits)/total deposits 4 L Total assets/total loas 5 SC L Secuities/total loas 6 C D Cash/total deposits 7 CR D ccouts eceivable fom cetal bak/total deposits 8 OR D ccouts eceivable fom othe baks/total deposits Note: Popeties ae lad, buildigs, ad othe had assets owed by baks. Secuities iclude shaes of copoate stock o mutual fuds, bods issued by copoatios o govemetal agecies, limited pateship uits, ad vaious othe fomal ivestmet istumets that ae egotiable ad fugible. ccouts eceivable fom the cetal baks icludes eseve equiemet (o cash eseve atio) ad othe sums that ae omally i the fom of cash stoed physically i a bak vault (vault cash) o deposits made with a cetal bak. ccouts eceivable fom othe baks ae sums loaed to othe baks. Loas, popeties, secuities, cash, accouts eceivable fom the cetal bak, ad accouts eceivable fom othe baks ae compoets of a fiacial istitutio s assets. The highe these vaiables, the moe stable ad soud a paticula fiacial istitutio teds to be. t the ext stage, two statistical techiques ae used: picipal compoet aalysis (PC) ad cluste aalysis. The udelyig logic of both techiques is dimesio eductio (i.e., summaizig ifomatio o umeous vaiables i just a few vaiables), but they achieve this i diffeet ways. PC educes the umbe of vaiables ito compoets (o factos), wheeas cluste aalysis educes the umbe of baks by placig them i small clustes. I this suvey, we use compoets (factos), which ae the esult of PC, ad subsequetly cay out a cluste aalysis to classify the baks.

13 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili 3. Picipal Compoet alysis Picipal compoet aalysis (PC) is a stadad data eductio techique that extacts data, emoves edudat ifomatio, highlights hidde featues, ad visualizes the mai elatioships that exist betwee obsevatios. PC is a techique fo simplifyig a data set, by educig multi-dimesioal data sets to lowe dimesios fo aalysis. Ulike othe liea tasfom methods, PC does ot have a fixed set of basis vectos. Its basis vectos deped o the data set, ad PC has the additioal advatage of idicatig what is simila ad diffeet about the vaious models ceated (Ho ad Wu 9). Though this method we educe the eight vaiables listed i Table to detemie the miimum umbe of compoets that ca accout fo the coelated vaiace amog the baks. To examie the suitability of these data fo facto aalysis, we pefom the Kaise Meye Olki (KMO) test ad atlett s test of spheicity. KMO is a measue of samplig adequacy to idicate the popotio of commo vaiace that might be caused by udelyig factos. High KMO values (highe tha.6) geeally idicate that facto aalysis may be useful, which is the case i this study: KMO =.6. If the KMO value is lowe tha.5, facto aalysis will ot be useful. atlett s test of spheicity eveals whethe the coelatio matix is a idetity matix, idicatig that vaiables ae uelated. level lowe tha.5 idicates that thee ae sigificat elatioships amog the vaiables, which is the case i this study: sigificace of atlett s test <.. Next, we detemie how may factos to use i ou aalysis. Table epots the estimated factos ad thei eigevalues. Oly those factos accoutig fo moe tha % of the vaiace (eigevalues >) ae kept i the aalysis, which meas oly the fist thee factos ae etaied (Table ). Take togethe, Z though Z3 explai 8.4% of the total vaiace of the fiacial atios. Table : Total Vaiace Explaied Compoet Eigevalues % of Vaiace Cumulative Vaiace % Z Z Z Z Z Z Z Z8.7.9 I uig the PC, we use diect oblimi otatio. Diect oblimi is the stadad method to obtai a o-othogoal (oblique) solutio, i.e., oe i which the factos ae allowed to be coelated. To itepet the evealed PC ifomatio, the patte matix must subsequetly be studied. Table 3 pesets the patte matix of facto loadigs usig the diect oblimi otatio method, whee vaiables with lage loadigs absolute value (>.5) fo a give facto ae highlighted i bold. PC ca be also called the Kahue Loève Tasfom (KLT), amed afte Kai Kahue ad Michel Loève.

14 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili Table 3: acto Loadigs of iacial Vaiables afte Diect Oblimi Rotatio Vaiables (iacial Ratios of aks) Compoet Z Z Z3 L D (.38) (.9) (.43) PR L (SDLD) D (.87).89 (.3) L SC L (.96) (.4).875 C D.379 (.536).39 CR D.954 (.4) (.) OR D.98 (.) (.7) ( ) = egative. Note: The extactio method is picipal compoet aalysis. The otatio method is diect oblimi with Kaise omalizatio. o defiitios of the vaiables, please efe to Table. s ca be see i Table 3, the fist compoet, Z, has thee vaiables with a absolute value (>.5), which ae all positive (i) total assets/total loas, (ii) accouts eceivable fom cetal bak/total deposits, ad (iii) accouts eceivable fom othe baks/total deposits. o Z, the vaiables with lage loadigs ae maily assets, hece Z geeally eflects the assets of the examied baks. s this facto explais the geatest vaiace i the data, it is the most ifomative idicato of a bak s oveall fiacial health. Z epesets deposits ad this compoet has thee majo loadig vaiables: (i) total loas/total deposits, which is egative; (ii) (savig deposits logtem deposits)/total deposits, which is positive; ad (iii) cash/total deposits. If the amout of deposits iceases, Z iceases. Z3 has two majo loadigs, which ae (i) popeties/total loas, (ii) secuities/total loas, so it eflects /total loas. The lage the amout of loas, the smalle Z3. Table 4 pesets the coelatio matix of the compoets ad shows thee is o coelatio betwee these thee compoets. This meas we could have used a egula othogoal otatio appoach to foce a othogoal otatio. ut i this suvey we used a oblique otatio method, which still povided a othogoal otatio facto solutio, because these thee compoets ae ot coelated with each othe ad ae distict etities. Table 4: Compoet Coelatio Matix Compoet Z Z Z3 Z (.8).59 Z (.8).6 Z ( ) = egative value. Note: The extactio method is picipal compoet aalysis. The otatio method is diect oblimi with Kaise Nomalizatio. igue 3 shows the distibutio of the thee compoets (Z, Z, ad Z3) fo 8 out of a total of 3 Iaia baks.

15 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili igue 3: Distibutio of actos fo 8 aks Compoet (Z) L K I E T N J Q C S EE V R P O DD W U D X Y CC Z Compoet (Z) Compoet 3 (Z3). I.8 D.6.4 L K DD Y X EE U V O S P C. R Q J T N E Z CC Compoet (Z) Compoet 3 (Z3) I D L K V S DD EE W C P O J U Q X R T Y N E CC Z Compoet (Z) Note: Each sta epesets oe bak, which has bee amed alphabetically,,, C,, Z,,, CC, DD, EE ad fo 3 Iaia baks. ou baks (baks, G, H, ad M) wee outlies i positive pats of the gaphs ad ae ot visible i the above gaphs. 3.3 Cluste alysis I this sectio, we take the thee compoets that wee obtaied i the pevious sectio ad idetify those baks that have simila taits. We the geeate clustes ad place the baks i distict goups. To do this, we employ cluste aalysis, which ogaizes a set of data ito goups so that obsevatios fom a goup with simila chaacteistics ca be compaed with those fom a diffeet goup (Matiez ad 3

16 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili Matiez 5). I this case, baks ae ogaized ito distict goups accodig to the thee compoets deived fom the PC obtaied i the pevious sectio. Cluste aalysis techiques ca themselves be boadly gouped ito thee classes: hieachical clusteig, optimizatio clusteig, 3 ad model-based clusteig. We use the method most pevalet i the liteatue hieachical clusteig. This poduces a ested sequece of patitios by megig (o dividig) clustes. t each stage of the sequece, a ew patitio is optimally meged with (o sepaated fom) the pevious patitio accodig to some adequacy citeio. The sequece of patitios ages fom a sigle cluste cotaiig all the idividual baks to a umbe of clustes () cotaiig a sigle bak. The seies ca be descibed by a tee display called the dedogam (igue 4). gglomeative hieachical clusteig poceeds by meas of a seies of successive fusios of the objects ito goups. y cotast, divisive hieachical methods divide the idividuals ito pogessively fie goups. Divisive methods ae ot commoly used because of the computatioal poblems they pose (see Eveitt et al. [] ad Ladau ad Chis Ste []). elow, we use the aveage likage method, which is a hieachical clusteig techique The veage Likage Method The aveage likage method defies the distace betwee clustes as the aveage distace fom all obsevatios i oe cluste to all poits i aothe cluste. I othe wods, it is the aveage distace betwee pais of obsevatios, whee oe is fom oe cluste ad oe is fom the othe. The aveage likage method is elatively obust ad also takes the cluste stuctue ito accout (Matiez ad Matiez 5; ege ad safu-djaye 4). The basic algoithm fo the aveage likage method ca be summaized as follows: N obsevatios stat out as N sepaate goups. The distace matix DIS = (dij) is seached to fid the closest obsevatios, fo example Q ad R. The two closest obsevatios ae meged ito oe goup to fom a cluste (QR), poducig N total goups. This pocess cotiues util all the obsevatios ae meged ito oe lage goup. igue 4 shows the dedogam that esults fom this hieachical clusteig: 3 The mai diffeece betwee the hieachical ad optimizatio techiques is that i hieachical clusteig the umbe of clustes is ot kow befoehad. The pocess cosists of a sequece of steps i which two goups ae eithe meged (agglomeative) o divided (divisive) accodig to the level of similaity. Evetually, each cluste ca be subsumed as a membe of a lage cluste at a highe level of similaity. The hieachical megig pocess is epeated util all subgoups ae fused ito a sigle cluste (Matiez ad Matiez 5). Optimizatio methods, o the othe had, do ot ecessaily fom hieachical classificatios of the data as they poduce a patitio of the data ito a specified o pedetemied umbe of goups by eithe miimizig o maximizig some umeical citeio (ege ad safu-djaye 4). 4

17 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili igue 4: Dedogam Usig veage Likage The esultig dedogam (hieachical aveage likage cluste tee) povides a basis fo detemiig the umbe of clustes by sight. I the dedogam show i igue 4 the hoizotal axis shows 8 Iaia baks, which have bee amed alphabetically. s metioed above, 3 Iaia baks have bee the subject of ou examiatio. Howeve, fou baks have outlyig positive data which ae fa emoved fom the data fo the othe 8 baks. We do ot iclude these fou baks i ou cluste aalysis as ou esult would ot be a atioal clusteig. This is the easo igue 4 shows oly 8 baks o the hoizotal axis. The dedogam classifies the baks ito two mai clustes (Goup ad Goup ), but it does ot show which of these two clustes cotai the fiacially healthie baks, so we have to take oe futhe step. y compaig the classificatio esultig fom cluste aalysis ad the distibutios of factos i igue 3, we ca coclude that the sequece of baks o the hoizotal axis of ou dedogam is based o thei soudess. mog these 8 baks, bak has the highest stability ad soudess, wheeas bak W has the lowest. 3.4 Robustess Check of aks Cedit Ratig o obustess, we check the akigs of thee baks out of the 8 baks fo all eight examied fiacial vaiables. We adomly pick oe bak fom Goup ad oe fom Goup, ad the bak that is i the middle of the cedit akig selected. The esults ae summaized i Table 5: ak Cedit ak Table 5: Robustess Check fo Thee Sample aks Rak of L D Rak of PR L Rak of (SDLD) D Rak of L Rak of SC L Rak of C D Rak of CR D Rak of OR D I R W Note: Cedit ak is the akig show by ou dedogam the lowe this umbe, the healthie the bak. o defiitios of the vaiables, please efe to Table. The fist adomly picked bak fom Goup is bak I. ak I is the secod most soud ad stable bak accodig to ou cedit atig esult, ad as is clea fom Table 5, the obustess check suppots this esult. This bak shows faily stable ad healthy status i most of ou eight fiacial vaiables. It is the top bak fo PR L 5

18 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili (popeties/loas), meaig this bak has a elatively lage amout of popeties compaed with the amout of loas, which meas it is stable. It aks secod fo OR D (accouts eceivable fom othe baks/total deposits), fifth fo SC L (secuities/loas), ad thid fo L (assets/loas) these esults idicate that this bak has sufficiet assets, which favos its stability ad soudess. lthough it has oe of the lowest aks fo L D (loas/deposits), this suggests this bak is tusted by depositos, ad theefoe the amout of deposits is lage compaed with loas. The secod bak i ou obustess check is bak R, which ca be foud i the middle of the hoizotal axis of ou dedogam with a cedit ak of 4, which is close to the middle of these 8 baks. Whe cosideig bak R s akig i tems of the eight vaiables, fo most of these vaiables it appeas i the middle of the akig. If we take a simple aveage of the ak of this bak i ou eight vaiables, the esult is almost, which is close to the cedit ak of 4 suggested by ou method. The thid bak i ou obustess check is bak W, a bak we picked adomly fom Goup. ak W has the lowest soudess ad stability i this goup ad amog all 8 baks. Whe cosideig the akig of this bak i ou eight vaiables i Table 5, it is appaet that this bak is ot soud. It has vey low akigs fo PR L (popeties/loas), (SDLD)/D ((savig deposits log-tem deposits)/total deposits), L (assets/loas), ad OR D (accouts eceivable fom othe baks/total deposits), which suggests this bak is usoud ad ustable it has the lowest cedit ak of the baks examied. 4. EMPIRICL NLYSIS I Sectio 4., we will fist use the model developed i Sectio. to foecast NPLs fo each goup of Iaia baks. We will the use the esults of the estimatios obtaied i Sectio 4. to calculate a fai deposit isuace pemium ate fo each goup of baks, usig the model we developed i Sectio. of this pape. 4. oecastig aks No-pefomig Loas To foecast each goup of baks NPLs, we u egessios usig the vecto autoegessio o vecto eo coectio (VR/VEC) model. s metioed above, fo ou empiical aalysis i this pape we use Iaia data, so we use Iaia macoecoomic data ad all 3 Iaia baks fiacial pofiles to foecast the NPLs fo each goup of Iaia baks (Goup ad Goup ). s pe Eq. 9, we eed to use macoecoomic vaiables (eal GDP, pice of lad, pice of stock, govemet bod iteest ate) ad Zi, which epesets the fiacial pofile of baks ad captues idiosycatic shocks, to foecast NPLs. I ou empiical aalysis, fo the macoecoomic vaiables we employed eal GDP, ad istead of the pice of stock the ad pice of lad, due to lack of data, we used the cosume pice idex (CPI), which is the best epesetative fo the pice level i a ecoomy ad ca be used as a substitute fo these two pice levels. I this study, usig the govemet bod iteest ate is ot pactical sice Ia has implemeted Islamic bakig ad fiscal ules, which ae quite diffeet fom covetioal ules. d as iteest ates ae affected by moetay policy, istead of the eal iteest ate, we use aothe moetay vaiable, M, which has a high coelatio with the iteest ate, as show i may pevious studies. Eq. 9 has two categoies of vaiables fo foecastig NPLs the fist categoy cosists of the macoecoomic vaiables descibed above; the secod elemet is Zi, eflectig the fiacial pofile of baks. The latte categoy is made up of thee sigificat compoets Z, Z, ad Z3 obtaied usig picipal compoet aalysis i Sectio 6

19 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili 3.. with thei facto loadigs peseted i Table 3. Usig the loadigs of each eight fiacial atios (Table 3), we obtaied Z, Z, Z3 fo each goup of Iaia baks (Goup ad Goup ), ad sice those eight fiacial atios of baks ae time-seies vaiables, Z, Z, Z3 will be also time-seies vaiables. o ou empiical aalysis, we use mothly data fom M to 3M fom the Cetal ak of the Islamic Republic of Ia. Sice we have two goups of baks, we should u two egessios oe fo each goup. The left-had-side of Eq. 9 fo each goup s egessio will be the sum of NPLs of that goup/total loas of that goup of baks; the ight-had-side of Eq. 9 will be the macoecoomic vaiables ad Z, Z, Z3 fo that goup of baks. 4.. Data alysis To evaluate the statioaity of all seies, we used a ugmeted Dickey ulle (D) test. The esults we obtaied imply that all vaiables ae o-statioay. These vaiables iclude GDP gowth ate; CPI iflatio ate (iflatio ate of each moth compaed to the same moth of the pevious yea); M gowth ate (gowth ate of M i each moth compaed with the same moth of the pevious yea the oigial quately data wee coveted to mothly data); sum of NPLs/sum of total loas fo Goup ad Goup of the baks; ad Z, Z, Z3 fo each goup of baks. Howeve, whe we applied the uit oot test to thei fist diffeeces, we wee able to eject the ull hypothesis of uit oots fo each of the vaiables. These esults suggest that all vaiables each cotai a uit oot. Whe we pefomed the uit oot test ad discoveed that the vaiables ae o-statioay i level ad statioay at fist diffeece level, they wee itegated of ode oe. The ext step was to coduct a coitegatio aalysis to examie whethe a log-u elatioship exists amog these vaiables. 4.. Coitegatio alysis We coduct a coitegatio aalysis usig Johase s techique by assumig a liea detemiistic ted ad fo two cases with itecept, ad with itecept ad ted. Give the shot peiod of ou data, the kaike Ifomatio Citeio (IC) suggests usig vaiables with oe lag. The esults of the coitegatio ak test usig tace ae peseted i Table 6. 7

20 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili Hypothesized o. of CEs Table 6: Coitegatio Rak Test (Tace) Eigevalue Goup of aks Itecept Tace statistic Pob. Eigevalue Itecept ad ted Tace statistic Pob. Noe.8 9.6* *. t most * *. t most *..6.8*. t most * *. t most *. t most t most Hypothesized o. of CEs Eigevalue Goup of aks Itecept Tace statistic Pob. Eigevalue Itecept ad ted Tace statistic Pob. Noe *..8.6*. t most.75.6* *. t most t most t most t most t most CE = coitegatig equatio; pob. = pobability. Note: * deotes ejectio of the o-coitegatig hypothesis at the 5% level. Pob. shows MacKio Haug Michelis p-values. s is clea fom Table 6, the above test ejects the ull hypothesis of o-coitegatig vaiables fo Goup ad Goup. This meas that all vaiables ae coitegated ad thee is a log-u associatio amog vaiables, o, i othe wods, i the log u, these seve vaiables (NPL/L, GDP gowth ate, CPI iflatio ate, M gowth ate, Z, Z, ad Z3) fo each goup of baks move togethe. Hece, we should u a vecto eo coectio model (VECM). The IC esults of ou liea detemiistic VEC model idicate estimatig the model by icludig ted ad itecept is slightly bette tha icludig just itecept fo both bak goups, so we have also etaied this fidig. 8

21 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili 4..4 Vecto Eo Coectio Model (VECM) We estimate Model 9 i a VECM settig icludig the seve vaiables NPL/L, GDP gowth ate, CPI iflatio ate, M gowth ate, Z, Z, ad Z3 fo each goup. The VECM ca be defied as follows (see Yoshio et al. 4): fo dv V O dv ΠV t = ( ) t t = ε ( NPL/L, gdp, cpi, m, Z, Z, Z3) t () () whee d deotes the fist diffeeces, O is the lag opeato, ad ε is a eo tem. Π ca be witte as Π = α β, wheeα ad β ae p matices, ad p is the umbe of vaiables i V. gdp is GDP gowth ate, cpi is CPI iflatio ate, ad m is M gowth ate. β is a vecto of the coitegatig elatioship adα is a loadig matix defiig the adjustmet speed of the vaiables i V to the log-u equilibium defied by the coitegatig elatioship. The ak of Π is deoted by. s metioed above, the IC stadad suggests oe lag. Model shows ou VECM fo Goup with fou coitegatig equatios ad oe lag fo each vaiable: d(npl / L ) = Φ [Z, (-) NPL / L (-) P(-).8 Y(-).34 ted -.36] Φ [Z, (-) NPL / L (-) P(-).75 Y(-).5 ted -.55] Φ 3 [Z,3 (-) - 3. NPL / L (-) P(-) 6.89 Y(-).4 ted - 9.] Φ 4 [ M(-) -.9 NPL / L (-) -.7 P(-).35 Y(-).3 ted -.59] Φ 5 d[z, (-)] Φ 6 d[z, (-)] Φ 7 d[z,3 (-)] Φ 8 d[m(-)] Φ 9 d[npl / L (-)] Φ d[p(-)] Φ d[y(-)] Φ () whee NPL / L is the atio of NPLs ove total loas fo Goup ; Z, deotes the fist compoet, Z, is the secod compoet, ad Z,3 is the thid compoet, all thee fo Goup ; d(z, ), d(z, ), d(z,3 ), d(m), d(npl / L ), d(p), ad d(y) ae fist diffeeces of the fist compoet, the secod compoet, the thid compoet (all thee fo Goup ), M gowth ate, NPLs ove total loas fo Goup, CPI iflatio ate, ad GDP gowth ate, espectively. I this VECM, ted is also icluded, sice we calculated the coitegatio with itecept ad ted. Φ, Φ, Φ 3 ad Φ 4 ae the coefficiets of the fou coitegatig equatios; Φ 5 Φ ae the coefficiets of the lagged vaiable fo the seve vaiables of ou model; ad Φ is a costat. 9

22 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili Model 3 shows ou VECM fo Goup with oe coitegatig equatio ad oe lag fo each vaiable: d(npl / L ) = Φ 3 [Z, (-).67 Z, (-) 3.9 Z,3 (-).3 M(-) -.4 NPL / L (-). P(-).4 Y(-).8 ted.97] Φ 4 d[z, (-)] Φ 5 d[z, (-)] Φ 6 d[z,3 (-)] Φ 7 d[m(-)] Φ 8 d[npl / L (-)] Φ 9 d[p(-)] Φ d[y(-)] Φ (3) whee NPL / L is the atio of NPLs ove total loas fo Goup ; Z, deotes the fist compoet, Z, is the secod compoet, ad Z,3 is the thid compoet, all thee fo Goup ; d(z, ), d(z, ), d(z,3 ), d(m), d(npl / L ), d(p), ad d(y) ae fist diffeeces of the fist compoet, the secod compoet, the thid compoet (all thee fo Goup ), M gowth ate, NPLs ove total loas fo Goup, CPI iflatio ate, ad GDP gowth ate, espectively. I this VECM, ted is also icluded sice we calculated the coitegatio with itecept ad ted. Φ 3 is the coefficiet of the coitegatig equatio; Φ 4 Φ ae the coefficiets of the lagged vaiable fo the seve vaiables of ou model; ad Φ is a costat. We use models ad 3 to foecast the NPL/L fo each goup of baks. To do so, we eed some assumptios. s metioed above, i developig ou VECM we used mothly data fom M to 3M. We assume eal GDP gowth of.8%, yeao-yea, fo 4 ad.9% fo 5. We assume a CPI iflatio ate of 3%, yea-oyea, fo 4 ad fo 5 we expect 8%. 4 s fo the M gowth ate, the Cetal ak of Ia, ude a ew goveo sice Septembe 3, 5 cotiues to pusue tighteig moetay policies, as it did i 3, to cotol the high iflatio ate. Hece, we assume that i 4 ad 5, M will gow at the same ate as i 3M9 3M. lso fo NPL/L ad the thee compoets fo each goup of baks fo 4 ad 5, we assume they stay o the same gowth path as i 3M9 3M. Usig these assumptios, we foecast the NPL/L fo each goup ad use these to calculate the pemium ates fo each goup of baks (which ae peseted i Sectio 4.) Impulse Respose alysis I this sectio, we coduct impulse espose (IR) aalysis to povide futhe evidece of the dyamic espose of NPL/L to maco ad idiosycatic iovatios. (o moe ifomatio o IR aalysis, see Yoshio ad Taghizadeh-Hesay 4b.) The accumulated espose of NPL/L to maco ad idiosycatic iovatios fo Goup of the baks is show i igue The goveo of the Cetal ak of Ia is D. Valiollah Seif, who has bee i office sice Septembe 3.

23 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili igue 5: Respose of NPL/L to Iovatios (Goup of aks) Note: ccumulated espose to Cholesky oe-stadad deviatio iovatios. NPL /L is the atio of NPLs ove total loas fo Goup of the baks; Z, deotes the fist compoet, Z, the secod compoet, ad Z,3 the thid compoet, all thee fo Goup ; M deotes M gowth ate, P deotes CPI iflatio ate, ad Y deotes GDP gowth ate. The thee gaphs i the fist ow of igue 5 show accumulated esposes of NPL/L to a uaticipated positive shock to Z, Z, Z3 fo Goup of the baks. The espose of NPL/L to Z is statistically egative ad vey pesistet. This meas a positive shock to Z, which maily epesets assets, will decease NPL/L of Goup. uaticipated positive shock to Z, which epesets deposits, has a statistically egative effect o NPL/L of Goup ad builds up ove the fist 3 moths, afte which it becomes isigificat, meaig a uaticipated icease i deposits will educe the NPL/L fo Goup. uaticipated positive shock to Z3, which epesets /loas, has a statistically egative effect o NPL/L of Goup ad builds up ove the fist 3 moths, afte which it becomes isigificat. The fou othe gaphs i igue 5 show accumulated esposes of NPL/L of Goup of the baks to positive shocks to maco vaiables ad to lagged NPL/L. The espose of NPL/L to M gowth ate shocks is statistically positive ad builds up ove the fist 5 moths, afte which it becomes isigificat. I ecet decades, the Iaia ecoomy has expeieced a sevee easig of moetay policy yet iceasig umbes of NPLs, which is the easo fo this positive espose. uaticipated positive shock to P (CPI iflatio) has a statistically egative ad pesistet effect o NPL/L of Goup, which is cosistet with Yoshio ad Hiao (, 3). Whe pices icease, collateal value iceases, which meas default isk o NPL/L will decease. uaticipated positive shock to Y (GDP gowth ate) has a statistically egative effect o NPL/L of Goup ad builds up ove the fist moths, afte which time it becomes isigificat. This esult is also cosistet with Yoshio ad Hiao s () fidigs. Whe busiess coditios impove, iceases i GDP gowth cause a eductio i

24 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili default isk (NPL/L). Moeove, igue 5 shows that fo Goup, cuet NPL/L affects by lagged NPL/L. igue 6 depicts the accumulated esposes of NPL/L to maco ad idiosycatic iovatios fo Goup of the baks. igue 6: Respose of NPL/L to Iovatios (Goup of aks) ccumulated Respose of NPL/L to Z, ccumulated Respose of NPL/L to Z, ccumulated Respose of NPL/L to Z, ccumulated Respose of NPL/L to M ccumulated Respose of NPL/L to NPL/L ccumulated Respose of NPL/L to P ccumulated Respose of NPL/L to Y Note: ccumulated espose to Cholesky oe-stadad deviatio iovatios. NPL /L is the atio of NPLs ove total loas fo Goup of the baks; Z, deotes the fist compoet, Z, the secod compoet, ad Z,3 the thid compoet, all thee fo Goup ; M deotes the M gowth ate, P the CPI iflatio ate, ad Y the GDP gowth ate. Goup shows simila esposes to iovatios to maco vaiables. It meas focusig oly o a model based o maco vaiables fo foecastig NPLs of diffeet goups of baks would lead to misitepetatio as it is possible that ude good ecoomic coditios some baks shows egative fiacial pefomace ad have high default isk. The esposes of NPL/L of Goup of the baks to a uaticipated positive shock to Z ad Z3 is simila to Goup s esposes, but fo shocks to Z the esposes diffe. The espose of NPL/L of Goup to positive shocks to Z is statistically positive ad pesistet, which goes agaist ou fidig fo Goup. This meas that iceasig deposits, which ae good ews fo baks, ted to esult i a icease i NPL/L fo Goup. This shows that Goup does ot maage thei NPL/L well by expadig thei busiess ad acceptig moe deposits the NPL/L atio iceases, which idicates that Goup is ot as soud as Goup. These esults cofim ou fidigs i the pevious sectios of this pape. Moeove, it backs up ou suggestio that maco vaiables ae ot sufficiet i a NPL foecastig

25 DI Wokig Pape 5 Yoshio, Taghizadeh-Hesay, ad Nili model fo diffeet goups of baks. The model also eeds to have the capability to captue idiosycatic shocks, as does ou Model 9 above. 4. ai Deposit Isuace Pemium Rate fo Each Goup of aks I this pape, a fai pemium ate is defied as a ate that coves the opeatioal expeditues of a isuig agecy (e.g., pesoel costs ad equipmet costs), povides it with sufficiet fuds to eable it to pay a cetai pecetage of deposit amouts to depositos i case of a bakig default, ad povides it with sufficiet fuds as pecautioay eseves to secue itself agaist futhe failues. High pemium ates educe the capital adequacy of idividual fiacial istitutios, which ca i tu edage the stability of the fiacial system. Low pemium ates will educe the oveall safety of the fiacial system. igue 7 shows a bak s balace sheet i case of default. I ode to calculate the fai deposit isuace pemium ate we eed to calculate fiacial assistace of the deposit isuace. igue 7: iacial ssistace of the Deposit Isuace Copoatio/gecy i a ailed ak s alace Sheet Souce: uthos compilatio. To estimate fai pemium ates fo each goup of baks, we eed to make some assumptios egadig: the pecetage shae of isuace coveage fo each type of deposit; the level of the isuig agecy s opeatioal expeditues; the estimated default atio of NPLs; ad the pecetage shae of excess ove the foecasted fiacial assistace fom the DIC ad opeatioal expeditues eeded to be kept by this ogaizatio as pecautioay eseves. To calculate the fai pemium ate fo each goup of baks i the case of Ia, we made the followig assumptios (though these assumptios could be modified to take accout of decisios by policymakes ad moetay authoities): i. ll baks pay the same membeship fee to the DIC, as we do ot have ifomatio about the DIC s opeatioal expeditues. This membeship fee is the oly souce of fiacig opeatios expeditues (e.g., pesoel costs ad equipmet costs) of the isuig ogaizatio ad pemium icome of the DIC will be the oly souce of fiacial assistace fom the DIC i case of bak failue. 3