Credit risk and financial integration: An application of network analysis

Introduction
This study explains the financial integration by using network statistics. Study links the credit
risk to the financial networks in the banks with active compounded credit risk. A relation
between credit risk and financial integration is provided by operations of country.
Findings of the study show that borrowing of banks does not promote credit risk. But the
closeness centrality shows that there is reduction in borrowing of the banks. Moreover,
operations of the banks in international market are significant by individuals, country. In this
research we use data of 39 countries from the period of 1988-2014 to analyze the relationship
between credit risk and financial integration. Results show that banks are more involve in the
network to compound the credit risk.
A bidirectional relationship between credit risk and financial connectivity shows the
endogeneity in the model. An application of appropriate econometrical technique is contribution
in the literatue by incorporating potential endogeneity biases in the model. To eliminate this
problem author used instrumental variable. For this purpose internal and external instruments are
used to explain the nature of relationship.

Data and measures of variables

Data consist of the syndicated loans obtained from the loan pricing corporation Dealscan
Dataset. This database provides the information on the contracts of loans that measures the
connectivity. Exposure of the banks in the international market is explained by loan extension in
the syndicated loan market. Linkage of the banks is shown by syndicated loans that provide an
exposure with relevant information on the banking network. This does not able to provide the
overall linkages in the banks but provide the maximum linkage across economies.

The preference for syndicated loans is that they serve for long-term purposes such as
financing of a project, trade financing and acquisitions. Global banking information linkage can
be computed following the network science approach of generating connectivity among entities.
The syndicated loans are mainly large-scale credit lines or loans having several maturity periods.
This entails that the lenders before loan extension acquire substantial information about
borrowers. Therefore, the annual number of direct borrowing and lending activities are used at
the loan-level to generate the index of connectivity among banks across countries.

We employ the information from the syndicated loan market to build a network for all available
entities in the dataset. This ensures that the connectivity of every firm present in the dataset is
accurately measured. After generating the network summaries, we then use the generated values
for banks in developed countries that participate in the loan syndication market. This helps to
reduce the problem of cross-country heterogeneity. We obtain information on the characteristics
of the participating banks from the Bureau van Dijk BankScope database. This database contains
information on financial statements of banks across the globe. After obtaining information about
the borrowing firms, we match the generated network summaries to the borrowing banks’
information as contained in its balance sheet. We match the two data sets by using the industry
classification code (ticker) and the companies’ names. Given that we are interested in the
borrowing banks, we employ the number of observations that uniquely matched to the balance
sheet information of the borrowing companies.
To identify the lending banks, we use information on banks that participate as lead arranger
credit or admin agent, coordinating arranger, agent, lead arranger, arranger, mandated arranger,
mandated lead arranger, lead bank and lead manager. Also, we obtain the US consumer price
index and the prevailing exchange rate at the time of the loan issuance from the DealScan
database. We compute the weight of each firm by using the loan/ facility amount. To generate
the bank-level network statistics, the amount of syndicated loan (amount committed by the
facility's lender pool) is converted to U.S. dollars using the exchange rate on the day of the
signing of the loan contract. We employ annual U.S. consumer price index (CPI) to deflate the
values. The weighted values consist of the loan amount in USD multiplied by the US consumer
price index. Based on the availability of data on syndicated loans and availability of information
from the balance sheet of the borrowers, we merge the two datasets. In some specifications, we
include macroeconomic variables such as the real interest rate and the real gross domestic
product per capita (GDPC). These macroeconomic variables are obtained from the World
Development Indicators series maintained by the World Bank. We include regional and time
dummies in some specifications. The growth rate of GDPC and is used and all variables are
expressed in the logarithmic form (except the measure of financial integration). The balance
sheet data include, cost to income ratio (Cost), size measured by the employment size, return on
average asset (ROAA), regulatory capital, -loan loss provision/net interest revenue. The data
cover the period between 1988 and 2014.

Endogeneity and estimations

We consider the extended instrumental variable (IV) / Generalised method of moments (GMM)
for estimation purposes. IV-GMM uses internal and external instruments to address endogeneity
issues. To generate estimates that are robust to heteroskedasticity and autocorrelation in each
equation estimated, the heteroskedastic and autocorrelation ― consistent (HAC) standard errors
are used. Post-estimation tests for weak instrument and over-identifying restrictions, which are
estimated using the HAC option, are needful for the validity of the results. Thus, we confirm
weak instrument tests using the extended robust test of instruments.

Comments

(1) The article is not comes in the discipline of financial economics because there is no
economic variable that relates with financial variable.
(2) Study didn’t explain why use the data from 1988 to 2014. Data is not up to date 2018
(3) Estimation of GARCH (1,1) is not demonstrated.
(4) Didn’t explain Time dummy and Region dummy
(5) Endogeneity due to the covariance between Ui and Xi is not addressed.
(6) Reverse causality is one of the reasons behind endogeneity. In any model we assume that
the DV is caused by the IV. We have reverse causality when we can argue also the
opposite: the IV is caused by the DV. In order to check whether your regression suffers
from reverse causality, the best solution is to re-estimate the model using a lagged IV so
that the DV(t) is a function of IV(t-1): the logic is that if there is no reverse causality the
link between the IV and the DV has to be the same irrespective of the time lag. Thus, if
 the sign of the IV changes and is significant, this means that your regression suffers from
reverse causality; if there are no changes in the sign of the IV, then you can rule out
reverse causality.

(7) For Instrumentation testing following procedure is used.

 Always test for instrument relevance first.

 If instruments are weak, tests like Hausman and Hansen’s J can give misleading results.
Use the Hausman test to assess the extent to which endogeneity is really a problem.
 If at all possible, ensure the model is overidentified, and test exogeneity and excludability
via Hansen’s J.
 If the model passes all of these tests, then it should provide a reasonable guide for causal
inference.

So, it is recommended that after correcting above thing it should be submitted in finance
journal.