Loan growth and bank solvency: evidence from the Pakistani banking sector

Abstract

Background: The dramatic loan growth and changes in the Pakistani banking system in mid-2000s have led to significant research attention on borrowers and lenders. This expansion and diversification in financial sector was driven by structural reforms, political stability and significant economic growth. Against this background, this study investigates the loan growth and risk-taking behavior of the banks during the expansionary periods of lending. Method: This study used dynamic two-step system generalized method of moment’s estimation technique, based on data taken from 32 banks in Pakistan over 2006–2014. Result: Loan growth has a significant effect on bank-specific and macroeconomic-specific variables. Loan growth in the previous year raises non-performing loans and decreases the solvency of banks with a time lag of many years. The driving force behind this phenomenon is weak prudential regulation among competitors, the asymmetric information of the borrowers, and, most importantly, that banks underestimate the risk of lending during credit booms. Conclusion: More regulatory measures are required to ensure a strong financial system when the volume of non-performing loan grows significantly. An increase in the capital requirement policy for rapidly growing banks is also needed because the problem of abnormal loan growth cannot be detected at the current time. At the same time, strong supervision is necessary to avoid the adverse consequences of borrower selection.