Safety-First and Portfolio Selection: An Econometric Study for Pakistan’s Banking Sector

A.D. Roy's original formulation of the Safety-First Principle is used to derive models of the portfolio composition of the banking sector in Pakistan. To estimate the models we use data for 1964-2005 and for 2005-2008 for forecasting. Various models are estimated, wherein loads are segrated into … their various classes, with and without restrictions implied by the theory, such as symmetry on asset characteristics and the equivalent of Engel conditions. The best specification of the system of asset demand equations is a dynamic version which allows for adjustment costs or adjustment constraints in the alignment of the portfolio. It is also demonstrated that a model that diaggregates the various types of bank loans dominates one wherein they are treated as perfect substitutes. The superior model provides information on the complements and the substitutes amongst the assets that conforms to economic intuition. That model also fits the data well.