Default rates and credit risk modeling in the Nigerian banking industry: a dynamic factor analysis

Abstract

The implementation of the dynamic factor into banking operations has become necessary to help analyze the vulnerability of the bank credit portfolios. This study used quarterly data from the Statistical Bulletin of the Central Bank of Nigeria and the Nigerian Deposit Insurance Corporation, spanning from 2005 to 2020, to analyze default rates (DRs) and credit risk in the Nigerian banking sector using dynamic factor analysis (DFA). The independent variables included the stock market, banking regulations, business cycle, macroeconomics, and price indicators, while the dependent variables were the DRs. Normalization, extraction, determination, and rotation were among the procedures used in the study using the Statistical Package for the Social Sciences (SPSS) (version 27). According to the results, 40.88% of the variability in DRs can be accounted for by the business cycle component, but it was negative and insignificant. The factor for the stock market had an explained variance of 17.65% and was significant and negative. The banking regulatory and the macroeconomic factors were positive and significant, with records of explained variances of 11.62% and 9.32%, respectively. 6.33% of the explained variance in DRs was attributed to the price indicator factor, with a statistically insignificant positive relationship. It can therefore be concluded that the business cycle factor explains the most variability in the DR and hence portfolio credit risk modeling in the context of the Nigerian banking industry. In the banking regulatory factor context, monetary policy plays a key role in promoting a suitable monetary policy regime that minimizes DRs in the Nigerian banking industry to strengthen financial stability in the banking system. This study recommends that Basel III be fully implemented, as it will help create capital buffers beyond the minimum requirements and tackle procyclical effects during an economic boom. Liquidity and stock market efficiency to tactically reduce defaults are premised on the fact that banking and stock market activities positively impact economic growth. The financial regulatory authorities, including the Monetary Policy Committee, should strengthen monetary policies and strive to achieve a single-digit Monetary Policy Rate and variables. Finally, macroeconomic variables should be factored into the model of credit risk to cushion against incidences of credit defaults.