Chapter 10

Panel Data

1
‘Introductory Econometrics for Finance’ © Chris Brooks 2008
 The Nature of Panel Data

• Panel data, also known as longitudinal data, have both time series and cross-
sectional dimensions.
• They arise when we measure the same collection of people or objects over a
period of time.
• Econometrically, the setup is

yit    xit  uit

where yit is the dependent variable,  is the intercept term,  is a k  1 vector of
parameters to be estimated on the explanatory variables, xit; t = 1, …, T;
i = 1, …, N.
• The simplest way to deal with this data would be to estimate a single, pooled
regression on all the observations together.
• But pooling the data assumes that there is no heterogeneity – i.e. the same
relationship holds for all the data.

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 The Advantages of using Panel Data

There are a number of advantages from using a full panel technique when a
panel of data is available.

• We can address a broader range of issues and tackle more complex problems
with panel data than would be possible with pure time series or pure cross-
sectional data alone.

• It is often of interest to examine how variables, or the relationships between

them, change dynamically (over time).

• By structuring the model in an appropriate way, we can remove the impact

of certain forms of omitted variables bias in regression results.

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 Seemingly Unrelated Regression (SUR)

• One approach to making more full use of the structure of the data would be to
use the SUR framework initially proposed by Zellner (1962). This has been used
widely in finance where the requirement is to model several closely related
variables over time.
• A SUR is so-called because the dependent variables may seem unrelated across
the equations at first sight, but a more careful consideration would allow us to
conclude that they are in fact related after all.
• Under the SUR approach, one would allow for the contemporaneous
relationships between the error terms in the equations by using a generalised
least squares (GLS) technique.
• The idea behind SUR is essentially to transform the model so that the error terms
become uncorrelated. If the correlations between the error terms in the individual
equations had been zero in the first place, then SUR on the system of equations
would have been equivalent to running separate OLS regressions on each
equation.

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 Fixed and Random Effects Panel Estimators

• The applicability of the SUR technique is limited because it can only be

employed when the number of time series observations per cross-sectional
unit is at least as large as the total number of such units, N.

• A second problem with SUR is that the number of parameters to be

estimated in total is very large, and the variance-covariance matrix of the
errors also has to be estimated. For these reasons, the more flexible full panel
data approach is much more commonly used.

• There are two main classes of panel techniques: the fixed effects estimator
and the random effects estimator.

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 Fixed Effects Models

• The fixed effects model for some variable yit may be written
yit    xit  i  vit

• We can think of i as encapsulating all of the variables that affect yit cross-
sectionally but do not vary over time – for example, the sector that a firm
operates in, a person's gender, or the country where a bank has its
headquarters, etc. Thus we would capture the heterogeneity that is
encapsulated in i by a method that allows for different intercepts for each
cross sectional unit.

• This model could be estimated using dummy variables, which would be

termed the least squares dummy variable (LSDV) approach.

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 Fixed Effects Models (Cont’d)

• The LSDV model may be written

yit    xit  1 D1i  2 D 2i  3 D3i     N DN i  vit

where D1i is a dummy variable that takes the value 1 for all observations on the
first entity (e.g., the first firm) in the sample and zero otherwise, D2i is a
dummy variable that takes the value 1 for all observations on the second entity
(e.g., the second firm) and zero otherwise, and so on.
• The LSDV can be seen as just a standard regression model and therefore it can
be estimated using OLS.
• Now the model given by the equation above has N+k parameters to estimate. In
order to avoid the necessity to estimate so many dummy variable parameters, a
transformation, known as the within transformation, is used to simplify matters.

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 The Within Transformation

• The within transformation involves subtracting the time-mean of each entity away
from the values of the variable.
• So define yi  Tt1 yitas the time-mean of the observations for cross-sectional unit i,
and similarly calculate the means of all of the explanatory variables.
• Then we can subtract the time-means from each variable to obtain a regression
containing demeaned variables only.
• Note that such a regression does not require an intercept term since now the
dependent variable will have zero mean by construction.
• The model containing the demeaned variables is
yit  yi   ( xit  xi )  uit  ui
• We could write this as  uit
yit  xit 
where the double dots above the variables denote the demeaned values.
• This model can be estimated using OLS, but we need to make a degrees of
freedom correction.

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 The Between Estimator

• An alternative to this demeaning would be to simply run a cross-sectional

regression on the time-averaged values of the variables, which is known as
the between estimator.
• An advantage of running the regression on average values (the between
estimator) over running it on the demeaned values (the within estimator) is
that the process of averaging is likely to reduce the effect of measurement
error in the variables on the estimation process.
• A further possibility is that instead, the first difference operator could be
applied so that the model becomes one for explaining the change in yit rather
than its level. When differences are taken, any variables that do not change
over time will again cancel out.
• Differencing and the within transformation will produce identical estimates in
situations where there are only two time periods.

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 Time Fixed Effects Models

• It is also possible to have a time-fixed effects model rather than an entity-fixed

effects model.
• We would use such a model where we think that the average value of yit changes
over time but not cross-sectionally.
• Hence with time-fixed effects, the intercepts would be allowed to vary over time
but would be assumed to be the same across entities at each given point in time.
We could write a time-fixed effects model as
yit    xit  t  vit
where t is a time-varying intercept that captures all of the variables that affect y
and that vary over time but are constant cross-sectionally.
• An example would be where the regulatory environment or tax rate changes part-
way through a sample period. In such circumstances, this change of environment
may well influence y, but in the same way for all firms.

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 Time Fixed Effects Models (Cont’d)

• Time-variation in the intercept terms can be allowed for in exactly the same way as
with entity fixed effects. That is, a least squares dummy variable model could be
estimated
yit  xit  1D1t  2 D 2t  ...  T DTt  vit
where D1t, for example, denotes a dummy variable that takes the value 1 for the first
time period and zero elsewhere, and so on.
• The only difference is that now, the dummy variables capture time variation rather
than cross-sectional variation. Similarly, in order to avoid estimating a model
containing all T dummies, a within transformation can be conducted to subtract
away the cross-sectional averages from each observation
• Finally, it is possible to allow for both entity fixed effects and time fixed effects
within the same model. Such a model would be termed a two-way error component
model, and the LSDV equivalent model would contain both cross-sectional and
time dummies

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 Investigating Banking Competition with a Fixed Effects
Model
• The UK banking sector is relatively concentrated and apparently extremely
profitable.
• It has been argued that competitive forces are not sufficiently strong and that
there are barriers to entry into the market.
• A study by Matthews, Murinde and Zhao (2007) investigates competitive
conditions in UK banking between 1980 and 2004 using the Panzar-Rosse
approach.
• The model posits that if the market is contestable, entry to and exit from the
market will be easy (even if the concentration of market share among firms
is high), so that prices will be set equal to marginal costs.
• The technique used to examine this conjecture is to derive testable
restrictions upon the firm's reduced form revenue equation.

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 Methodology

• The empirical investigation consists of deriving an index (the Panzar-Rosse H-

statistic) of the sum of the elasticities of revenues to factor costs (input prices).
• If this lies between 0 and 1, we have monopolistic competition or a partially
contestable equilibrium, whereas H < 0 would imply a monopoly and H = 1
would imply perfect competition or perfect contestability.
• The key point is that if the market is characterised by perfect competition, an
increase in input prices will not affect the output of firms, while it will under
monopolistic competition. The model Matthews et al. investigate is given by

ln REVit   0  1 ln PLit   2 ln PKit   3 ln PFit  1 ln RISKASSit 

 2 ln ASSET
where REVit is the ratio of bank  3 ln BRittototal
it revenue  1GROWTH t 
assets for i  viti at time t, PL is
firm
personnel expenses to employees (the unit price of labour); PK is the ratio of
capital assets to fixed assets (the unit price of capital); and PF is the ratio of
annual interest expenses to total loanable funds (the unit price of funds).

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 Methodology (Cont’d)

• The model also includes several variables that capture time-varying bank-
specific effects on revenues and costs, and these are: RISKASS, the ratio of
provisions to total assets; ASSET is bank size, as measured by total assets;
BR is the ratio of the bank's number of branches to the total number of
branches for all banks.
• Finally, GROWTHt is the rate of growth of GDP, which obviously varies
over time but is constant across banks at a given point in time; i is a bank-
specific fixed effects and vit is an idiosyncratic disturbance term. The
contestability parameter, H is given as 1 + 2 + 3
• Unfortunately, the Panzar-Rosse approach is only valid when applied to a
banking market in long-run equilibrium. Hence the authors also conduct a
test forlnthis,
ROAwhich centres
  ' ' ln PL on
 the
' ln regression
PK   ' ln PF   ' ln RISKASS 
it 0 1 it 2 it 3 it 1 it

 2 ' ln ASSETit   3 ' ln BRit   1 ' GROWTH t  i  wit

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 Methodology (Cont’d)

• The explanatory variables for the equilibrium test regression are identical to
those of the contestability regression but the dependent variable is now the
log of the return on assets (lnROA).
• Equilibrium is argued to exist in the market if 1' + 2' + 3'
• Matthews et al. employ a fixed effects panel data model which allows for
differing intercepts across the banks, but assumes that these effects are fixed
over time.
• The fixed effects approach is a sensible one given the data analysed here
since there is an unusually large number of years (25) compared with the
number of banks (12), resulting in a total of 219 bank-years (observations).
• The data employed in the study are obtained from banks' annual reports and
the Annual Abstract of Banking Statistics from the British Bankers
Association. The analysis is conducted for the whole sample period, 1980-
2004, and for two sub-samples, 1980-1991 and 1992-2004.

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 Results from Test of Banking Market Equilibrium
by Matthews et al.

Source: Matthews, Murinde and Zhao (2007)

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 Analysis of Equilibrium Test Results

• The null hypothesis that the bank fixed effects are jointly zero (H0: i = 0) is
rejected at the 1% significance level for the full sample and for the second
sub-sample but not at all for the first sub-sample.
• Overall, however, this indicates the usefulness of the fixed effects panel
model that allows for bank heterogeneity.
• The main focus of interest in the table on the previous slide is the
equilibrium test, and this shows slight evidence of disequilibrium (E is
significantly different from zero at the 10% level) for the whole sample, but
not for either of the individual sub-samples.
• Thus the conclusion is that the market appears to be sufficiently in a state of
equilibrium that it is valid to continue to investigate the extent of competition
using the Panzar-Rosse methodology. The results of this are presented on the
following slide.

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 Results from Test of Banking Market Competition
by Matthews et al.

Source: Matthews, Murinde and Zhao (2007)

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 Analysis of Competition Test Results

• The value of the contestability parameter, H, which is the sum of the input
elasticities, falls in value from 0.78 in the first sub-sample to 0.46 in the second,
suggesting that the degree of competition in UK retail banking weakened over
the period.
• However, the results in the two rows above that show that the null hypotheses
that H = 0 and H = 1 can both be rejected at the 1% significance level for both
sub-samples, showing that the market is best characterised by monopolistic
competition.
• As for the equilibrium regressions, the null hypothesis that the fixed effects
dummies (i) are jointly zero is strongly rejected, vindicating the use of the fixed
effects panel approach and suggesting that the base levels of the dependent
variables differ.
• Finally, the additional bank control variables all appear to have intuitively
appealing signs. For example, the risk assets variable has a positive sign, so that
higher risks lead to higher revenue per unit of total assets; the asset variable has
a negative sign, and is statistically significant at the 5% level or below in all
three periods, suggesting that smaller banks are more profitable.

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 The Random Effects Model

• An alternative to the fixed effects model described above is the random

effects model, which is sometimes also known as the error components
model.
• As with fixed effects, the random effects approach proposes different
intercept terms for each entity and again these intercepts are constant over
time, with the relationships between the explanatory and explained variables
assumed to be the same both cross-sectionally and temporally.
• However, the difference is that under the random effects model, the
intercepts for each cross-sectional unit are assumed to arise from a common
intercept  (which is the same for all cross-sectional units and over time),
plus a random variable i that varies cross-sectionally but is constant over
time.
 i measures the random deviation of each entity’s intercept term from the
“global” intercept term . We can write the random effects panel model as
yit     xit  it , it   i  vit

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 How the Random Effects Model Works

• Unlike the fixed effects model, there are no dummy variables to capture the
heterogeneity (variation) in the cross-sectional dimension.
• Instead, this occurs via the i terms.
• Note that this framework requires the assumptions that the new cross-
sectional error term, i, has zero mean, is independent of the individual
observation error term vit, has constant variance, and is independent of the
explanatory variables.
• The parameters ( and the  vector) are estimated consistently but
inefficiently by OLS, and the conventional formulae would have to be
modified as a result of the cross-correlations between error terms for a given
cross-sectional unit at different points in time.
• Instead, a generalised least squares (GLS) procedure is usually used. The
transformation involved in this GLS procedure is to subtract a weighted
mean of the yit over time (i.e. part of the mean rather than the whole mean, as
was the case for fixed effects estimation).

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 Quasi-Demeaning the Data

• Define the ‘quasi-demeaned’ data as yit*  yit and

yi similarly for x ,
it
  will be a function of the variance of the observation error term, v2, and of the
variance of the entity-specific error term, 2:
v
 1
T 2   v2

• This transformation will be precisely that required to ensure that there are no cross-
correlations in the error terms, but fortunately it should automatically be
implemented by standard software packages.
• Just as for the fixed effects model, with random effects, it is also conceptually no
more difficult to allow for time variation than it is to allow for cross-sectional
variation.
• In the case of time-variation, a time period-specific error term is included and again,
a two-way model could be envisaged to allow the intercepts to vary both cross-
sectionally and over time.

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 Fixed or Random Effects?

• It is often said that the random effects model is more appropriate when the entities in
the sample can be thought of as having been randomly selected from the population,
but a fixed effect model is more plausible when the entities in the sample effectively
constitute the entire population.

• More technically, the transformation involved in the GLS procedure under the random
effects approach will not remove the explanatory variables that do not vary over time,
and hence their impact can be enumerated.

• Also, since there are fewer parameters to be estimated with the random effects model
(no dummy variables or within transform to perform), and therefore degrees of
freedom are saved, the random effects model should produce more efficient
estimation than the fixed effects approach.

• However, the random effects approach has a major drawback which arises from the
fact that it is valid only when the composite error term it is uncorrelated with all of
the explanatory variables.

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 Fixed or Random Effects? (Cont’d)

• This assumption is more stringent than the corresponding one in the fixed
effects case, because with random effects we thus require both i and vit to be
independent of all of the xit.
• This can also be viewed as a consideration of whether any unobserved
omitted variables (that were allowed for by having different intercepts for
each entity) are uncorrelated with the included explanatory variables. If they
are uncorrelated, a random effects approach can be used; otherwise the fixed
effects model is preferable.
• A test for whether this assumption is valid for the random effects estimator is
based on a slightly more complex version of the Hausman test.
• If the assumption does not hold, the parameter estimates will be biased and
inconsistent.
• To see how this arises, suppose that we have only one explanatory variable,
x2it that varies positively with yit, and also with the error term, it. The
estimator will ascribe all of any increase in y to x when in reality some of it
arises from the error term, resulting in biased coefficients.

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 Credit Stability of Banks in Central and Eastern
Europe: A Random Effects Analysis
• Foreign participants in the banking sector may improve competition and
efficiency to the benefit of the economy that they enter.
• They may have a stabilising effect on credit provision since they will
probably be better diversified than domestic banks and will therefore be
more able to continue to lend when the host economy is performing poorly.
• But on the other hand, it is also argued that foreign banks may alter the credit
supply to suit their own aims rather than that of the host economy.
• They may act more pro-cyclically than local banks, since they have
alternative markets to withdraw their credit supply to when host market
activity falls.
• Moreover, worsening conditions in the home country may force the
repatriation of funds to support a weakened parent bank.

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 The Data

• There may also be differences in policies for credit provision dependent

upon the nature of the formation of the subsidiary abroad – i.e. whether the
subsidiary's existence results from a take-over of a domestic bank or from
the formation of an entirely new startup operation (a ‘greenfield
investment’).

• A study by de Haas and van Lelyveld (2006) employs a panel regression

using a sample of around 250 banks from ten Central and East European
countries.

• They examine whether domestic and foreign banks react differently to

changes in home or host economic activity and banking crises.

• The data cover the period 1993-2000 and are obtained from BankScope.

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 The Model

• The core model is a random effects panel regression of the form:

grit    1Takeoverit   2Greenfieldi   3Crisisit   4 Macroit
 5Contrit  ( i   it )
where the dependent variable, grit, is the percentage growth in the credit of
bank i in year t; Takeover is a dummy variable taking the value one for
foreign banks resulting from a takeover and zero otherwise; Greenfield is a
dummy taking the value one if bank is the result of a foreign firm making a
new banking investment rather than taking over an existing one; crisis is a
dummy variable taking the value one if the host country for bank i was
subject to a banking disaster in year t.
• Macro is a vector of variables capturing the macroeconomic conditions in
the home country (the lending rate and the change in GDP for the home and
host countries, the host country inflation rate, and the differences in the
home and host country GDP growth rates and the differences in the home
and host country lending rates).

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 The Model (Cont’d)

• Contr is a vector of bank-specific control variables that may affect the

dependent variable irrespective of whether it is a foreign or domestic bank.

• These are: weakness parent bank, defined as loan loss provisions made by
the parent bank; solvency is the ratio of equity to total assets; liquidity is the
ratio of liquid assets / total assets; size is the ratio of total bank assets to total
banking assets in the given country; profitability is return on assets and
efficiency is net interest margin.

  and the 's are parameters (or vectors of parameters in the cases of 4 and
5), i is the unobserved random effect that varies across banks but not over
time, and it is an idiosyncratic error term.

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 Estimation Options

• de Haas and van Lelyveld discuss the various techniques that could be
employed to estimate such a model.
• OLS is considered to be inappropriate since it does not allow for differences
in average credit market growth rates at the bank level.
• A model allowing for entity-specific effects (i.e. a fixed effects model that
effectively allowed for a different intercept for each bank) is ruled out on the
grounds that there are many more banks than time periods and thus too many
parameters would be required to be estimated.
• They also argue that these bank-specific effects are not of interest to the
problem at hand, which leads them to select the random effects panel model.
• This essentially allows for a different error structure for each bank. A
Hausman test is conducted, and shows that the random effects model is valid
since the bank-specific effects i are found “in most cases not to be
significantly correlated with the explanatory variables.”

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Results

‘Introductory Econometrics for Finance’ © Chris Brooks 2008 Source: de Haas and van Lelyveld (2006)
 Analysis of Results

• The main result is that during times of banking disasters, domestic banks
significantly reduce their credit growth rates (i.e. the parameter estimate on the
crisis variable is negative for domestic banks), while the parameter is close to
zero and not significant for foreign banks.

• There is a significant negative relationship between home country GDP growth,

but a positive relationship with host country GDP growth and credit change in the
host country.

• This indicates that, as the authors expected, when foreign banks have fewer viable
lending opportunities in their own countries and hence a lower opportunity cost
for the loanable funds, they may switch their resources to the host country.

• Lending rates, both at home and in the host country, have little impact on credit
market share growth.

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 Analysis of Results (Cont’d)

• Interestingly, the greenfield and takeover variables are not statistically

significant (although the parameters are quite large in absolute value),
indicating that the method of investment of a foreign bank in the host
country is unimportant in determining its credit growth rate or that the
importance of the method of investment varies widely across the sample
leading to large standard errors.

• A weaker parent bank (with higher loss provisions) leads to a statistically

significant contraction of credit in the host country as a result of the
reduction in the supply of available funds.

• Overall, both home-related (‘push’) and host-related (‘pull’) factors are

found to be important in explaining foreign bank credit growth.

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