Intermediation Cost and Non-Performing Financing: A Case Study of Pakistan

Abstract

The instinct of bankers is to keep the borrowers alive through recycling and renewals of bad loans into loans, a window dressing exercise; or worse yet, advancing additional fresh loans to effectively insolvent borrowers to tide over what is  perceived as cash flow problems and forthcoming illiquidity, thereby getting deeper into financial distress. In this sense, insolvency occurs first, illiquidity follows later. Increase in the intermediation costs lead to increase in Non-performing  Loans (NPLs). The intermediation cost reflects the operating efficiency of banks. If credit risk is not managed properly it  eventually shows up in NPLs, or the concentration of banking credit in a few sectors of the economy, or in a few  segment of borrowers, or a rising proportion of riskier loans in its portfolio during times of rapid expansion of banking  credit. This paper studies intermediation costs in credit markets within a dynamic Stiglitz and Weiss (1981) framework.  The theoretical predictions of our model gains support by Pakistani banks’ quarterly data for the period 2007-09. Data suggests that an increase in intermediation costs results in an increase in NPLs. Analyses show that, if intermediation cost is administered properly, it ultimately lowers NPLs. We argue that minimization of intermediation costs improves  financial soundness.