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1. Introduction
Financial distress refers to a period when a borrower (either individual or institutional) is unable to meet a payment obligation to lenders and other creditors. This distress may be due to borrower specific factors like reputation, leverage, volatility of earnings, collateral or may be due to market specific factors like the economic condition and level of interest rates. So far, these factors were used by banks to explain the probability of loan default of borrowers. More generally, it is recommended that "5 C's"[1] of credit should be included in such analysis and the decision makers may need to weight these factors in a more objective or quantitative manner ([26] Saunders and Cornett, 2008, p. 315), rather than letting such factors enter into the decision process in a purely subjective fashion. In this dissertation, we analyse the financial distress of banks by using the 5 C's framework, and quantify these 5 C's so that meaningful and consistent decisions can be made regarding the creditworthiness of banks in UAE.
The period 2006-2008 in UAE[2] is considered one of the major financial distress periods due to the recent global economic crisis. During this period borrowers had difficulty in meeting their obligations, as a result lenders suffered losses. The importance of this paper is derived from the fact that distress of financial institutions in UAE has become the most serious issue facing the regulatory authorities and stakeholders because of its potentially destabilising effect on the financial system through contagion and because a healthy financial system is a pivotal point for financial stability.
From a microeconomic perspective also, it is desirable to learn more about the drivers of financial distress of banks in UAE. For example, the modern risk control techniques that are permitted under the Revised Capital Framework of the Basel Committee on Banking Supervision (Basel II) require that creditors be able to estimate their debtors' probabilities of distress. For private customers and non-financial firms, there are many well-established methods for the estimation of probabilities of distress and a sizeable body of evidence about the main risk drivers. However, there is almost no empirical evidence for the extent of distress of financial institutions in UAE in particular and Middle East in general.
The main contribution of...