Non-Performing Loans of Commercial Banks in South Asian Countries: Adverse Selection and Moral Hazard Issues

In the South Asian region, a major cause of an increase in non-performing loans (NPL) is the bank’s adverse selection of borrowers. Using the GMM estimator, we empirically studied the bank-specific, industry specific and macroeconomic specific determinants of non-performing loans of banks in South Asian countries (Bangladesh, India, Nepal and Pakistan) from 1997 to 2012 and found that the adverse selection hypothesis of Stiglitz and Weiss (1981) was still effective. We found evidence for the bad luck, bad management, skimping and moral hazard hypotheses of Berger and DeYoung (1997) and their effect on the credit risk determination but we contributed to the literature by showing that ‘moral hazard type II’ (moral hazard between the bank management and the depositors) significantly affected the increase of non-performing loans. Bank size, industry concentration, inflation and GDP growth rate all significantly affected the sample countries’ non-performing loans. Empirical results showed a moderate degree of persistence of NPL and a late-hit of the global financial crisis in the region’s banking sector.