Macro-financial linkages and heterogeneous non-performing loans projections: An application to Ecuador

Abstract

Economic contractions are generally associated with increases in NPL ratios. However, despite the common assumption used in the empirical literature of homogenous impact across banks, the strength of this relationship is often bank-specific, and imposing homogeneity may lead to over- or underestimating the resilience of the financial system to macroeconomic woes. We introduce a three-stage approach to generate forecasts of macro-financial variables and project non-performing loans (NPLs) in a way that accounts for banks’ heterogeneous reactions to macro-financial shocks in a dynamic context and for potential cross-sectional dependence across banks caused by common shocks. An application to Ecuador suggests that both substantial heterogeneity and cross-sectional dependence are present and that should be taken into account when trying to anticipate inflections in the quality of the portfolio.