Credit risk Management on Bank performance

of

commercial banks in Nepal

 Chapter I
Introduction
1.1. Background of the study
Banks obtain equity through owners’ funds, reserves and share capital. The profit
earning capacity of banks depends on the prudent combination of assets and liabilities
to meet the liquidity and solvency requirements imposed by the environment
including the monetary and banking policies. Banks primary role is to ensure the
growth and development of an economy. To ensure availability of funds at any point
in time (in meeting with customers’ needs and demands), statutory requirements must
be in place to regulate and measure banks’ capital. Capital plays an important role in
enhancing banks’ performance. Capital adequacy which is determined by capital –
asset ratio is a requisite for banks’ effective operation which is a function of the
deposits and capital funds[ CITATION Chi11 \l 1033 ].
Credit risk management is an integral part of the loan process in banking business.
Credit risk is the current and prospective risk to earnings or capital arising from an
obligor’s failure to meet the terms of any contract with the bank or otherwise to
perform as agreed. A credit facility is said to be performing if payment of both
principal and interest are up to date in accordance with agreed repayment terms. The
non- performing loans (NPL) represent credits which the banks perceive as possible
loss of funds due to loan defaults. Bank credit in lost category hinders bank from
achieving their set targets (Kolapo et al, 2012).
Credit risk management is an integral part of the loan process in banking business.
Credit risk is the current and prospective risk to earnings or capital arising from an
obligor’s failure to meet the terms of any contract with the bank or otherwise to
perform as agreed. A credit facility is said to be performing if payment of both
principal and interest are up to date in accordance with agreed repayment terms. The
non- performing loans (NPL) represent credits which the banks perceive as possible
loss of funds due to loan defaults. Bank credit in lost category hinders bank from
achieving their set targets (Kolapo et al, 2015).
Adequately managing credit risk in financial institutions (FIs) is critical for the
survival and growth of the FIs. In the case of banks, the issue of credit is of even of
greater concern because of the higher levels of perceived risks resulting from some of
the characteristics of clients and business conditions. The banks also provide loans,
credit and payment services such as checking accounts, money orders and cashier‘s
checks. Banks also may offer investment and insurance products and a wide whole
range of other financial services which they were once prohibited from selling
[ CITATION Fit07 \l 1033 ].

Credit risk management is risk assessment that comes in an investment. Risk often
comes in investing and in the allocation of capital. The risks must be assessed so as to
derive a sound investment decision and decisions should be made by balancing the
risks and returns. Giving loans is a risky affair for bank sometimes and certain risks
may also come when banks offer securities and other forms of investments. The risk
of losses that result in the default of payment of the debtors is a kind of risk that must
be expected. It’s very important for a bank to keep substantial amount of capital to
protect its solvency and to maintain its economic stability. The greater the bank is
exposed to risks, the greater the amount of capital must be when it comes to its
reserves, so as to maintain its solvency and stability, credit risk management must
play its role then to help banks be in compliance with Basel II Accord and other
regulatory bodies [ CITATION Ess11 \l 1033 ].

For assessing the risk, banks should plan certain estimates, conduct monitoring, and
perform reviews of the performance of the bank. The bank should also do loan
reviews and portfolio analysis in order to determine risk involved. The progress has to
be made for analyzing the credits and determining the probability of defaults and risks
of losses. A typical credit risk management framework in a bank as per NRB risk
management guidelines can be broadly categorized into four main components: Board
and senior Management’s Oversight, Organizational structure, Systems and
procedures for identification, acceptance and measurement, and Monitoring and
control risks.

Credit creation is the main income generating activity for the banks. But this activity
involves huge risks to both the lender and the borrower. The risk of a trading partner
not fulfilling his or her obligation as per the contract on due date or anytime thereafter
can greatly jeopardize the smooth functioning of a bank‘s business. On the other
hand, a bank with high credit risk has high bankruptcy risk that puts the depositors in
jeopardy. Among the risk that face banks, credit risk is one of great concern to most
bank authorities and banking regulators. This is because credit risk is that risk that can
easily and most likely prompts bank failure [ CITATION Ach08 \l 1033 ].
The very nature of the banking business is so sensitive because more than 85 percent
of their liability is deposits from depositors (Saunders, Cornett, 2005). Banks use
these deposits to generate credit for their borrowers, which in fact is a revenue
generating activity for most banks. This credit creation process exposes the banks to
high default risk which might led to financial distress including bankruptcy. All the
same, beside other services, banks must create credit for their clients to make some
money, grow and survive stiff competition at the market place.

Although the businesses are the major sources of capital, they also have to raise
capital to run business. Especially, the banks’ capital plays a vital role because it has
obligations to mass people, its depositors and society as a whole. Thus, the banks
should hold an adequate capital to secure the interest of depositors. Capital adequacy
has become one of the most significant factors for assessing the soundness of banking
sector. Raising and utilization of funds are the primary functions of commercial
banks. As such, commercial bank collects a large amount of deposits from general
public. The depositors think that depositing their money in bank is safe and relaxing.
But, what does happen if the bank doesn’t have enough capital funds to provide a
buffer against future, unexpected losses? Therefore, Nepal Rastra Bank as a Banker’s
Bank has made rule of capital adequacy so that every Commercial Bank have 10
percent on capital adequacy ratio. Capital must be sufficient to protect a bank’s
depositors and counterparties from the risks like, credit and market risks. Otherwise,
the banks will use all the money of depositors in their own interest and depositors will
have to suffer loss [ CITATION Shr03 \l 1033 ].

Performance evaluation is the important approach for enterprises to give incentive and
restraint to their operators and it is an important channel for enterprise stakeholders to
get the performance information (Sun, 2011). The performance evaluation of a
commercial bank is usually related to how well the bank can use its assets,
shareholders’ equities and liabilities, revenues and expenses. The performance
evaluation of banks is important for all parties including depositors, investors, bank
managers and regulators. Thus, this study is focused towards analyzing how much of
impact does the adequate capital and the management of credit risk holds in defining
the performance of Nepalese banking sectors. It is crucial to know whether this
optimism is truly warranted. It is against this backdrop that the present study set out to
 empirically ascertain whether credit risk management and capital requirement have
enhanced profitability of Nepalese banks.

1.2. Statement of the problem

Credit risk management plays an important role in banks as it is an integral part of the
loan process. It maximizes bank risk, adjusted risk rate of return by maintaining credit
risk exposure with view to shielding the bank from the adverse effects of credit risk.
Ogboi, Charles, Unuafe & Kenneth (2013) showed that sound credit risk management
strategies and enhanced capital requirement can promote banks profitability. The
study also found that it is imperative to state that the strategy of making provision for
loan loss or reducing non-performing loan has never been misleading which means
there is a higher chance of profitability if bank manages provision of loan loss and
non performing loan appropriately.
Iloska (2015) indicated that the strength and quality of capital influence bank
profitability. Clearly, lower capital ratios imply higher leverage and risk leading to
higher borrowing costs. Flamini et al. (2014) forwarded that capital is an important
variable in determining bank profitability and a well-capitalized bank could provide a
signal to the market that a better-than-average performance should be expected. Well-
capitalized banks are less risky and generate lower profits as they are perceived to be
safer. Thus, a negative association between capital and profits is generally expected.
Non Performing loan is one of the indicators of credit risk as higher non performing
leads to create more risk which will lead in to decrease in the performance of banks
and it is also found that NPL fairly affect profitability of some banks and this is a
result of shifting cost on loan default to other customers. Nair and Fissha (2010) also
discovered high levels of non-performing loans among commercial banks and
indicated the danger that this posses to the industry. The findings of Felix and
Claudine (2008) also showed that return on equity and return on asset all indicating
profitability were negatively related to the ratio of non-performing loan to total loan
(NPL/TL) of financial institutions therefore decreases profitability.

Odunga et.al (2013) analyzed the credit risk ratios had a significant impact on
operating efficiency of the banks, which implied that in a bid to minimize credit risk,
banks should ensure that the agency problems between shareholders and management
were minimized, at the same time, experience and superior management should be
employed to manage credit risk affairs of banks. Whereas, the study also showed
capital adequacy measures alone had no effect on operation efficiency. This implies
that banks need not concentrate on capital adequacy as a way of improving their
operating efficiency. From the study it was found that capital adequacy was the least
important variable in explaining the variability in operating efficiency of banks
among the two.

The increase in loan loss provision decreases the profitability whereas increase in total
loan and advances increase profitability. The effect of credit risk on bank performance
measured by the return on assets of banks is cross-sectional invariant. That is, nature
and managerial pattern of individual firms do not determine the impact. Loan and
advances ratio (LA) coefficient exerts most significant positive effect on the
profitability across the banking firms (Funso et.al, 2012).

The capital adequacy ratio is a key measure to determine the health of banks and
financial institutions. Capital adequacy refers to the sufficiency of the amount of
equity to absorb any shocks that the bank may experience. In Nepal the commercial
banks need to maintain at least 6 percent Tier-1 capital and 10 percent total capital
(Tier 1 and Tier 2), that is, core capital and supplementary capital respectively. Tier 1
capital consists of paid-up capital, share premium, non-redeemable preference share,
general reserve fund, accumulated profit, capital redemption reserve, capital
adjustment fund, and other free reserves. The Tier 2 capital comprises of capital
comprises of general loan loss provision, assets revaluation reserve, hybrid capital
instruments, subordinated term loan, exchange equalization reserve, excess loan loss
provision, and investment adjustment reserve. These minimum capital adequacy
requirements are based on the risk-weighted exposures of the banks [ CITATION
Etz10 \l 1033 ].

Credit risk is one of the factors that affect the health of an individual bank while asset
quality analysis involves taking account of the likelihood of borrowers paying back
loans. The extent of the credit risk depends on the quality of assets held by an
individual bank. The quality of assets held by a bank depends on exposure to specific
risks, trends in non-performing loans, and the health and profitability of bank
borrowers (Baral, 2005). Poor asset quality and low levels of liquidity are the two
major causes of bank failures. Poor asset quality led to many bank failures in Kenya
in the early 1980s (Olweny & Shipo, 2011).
 Mostly the composition of assets, nonperforming loan to total loan ratio, net
nonperforming loan to total loan ratio is used as the indicators of the quality of assets
of the commercial banks.[ CITATION Bar05 \l 1033 ] The maximum NPL allows for
a healthy bank is 5 percent. Management quality plays a big role in determining the
future of the bank. The management has an overview of a bank’s operations, manages
the quality of loans and has to ensure that the bank is profitable. Though there are
above mentioned studies, still there are no such studies using more recent data are
available in Nepal. This study therefore deals with the following issues in the context
of Nepalese banks:

i. What are the structure and pattern of return on assets return on equity,
nonperforming loan, loan loss provision, loans & advances, capital adequacy
ratio and liquidity?
ii. What are the major factors affecting the performance of commercial banks in
Nepal?
iii. Is there any relationship between loans & advances and performance of bank?

1.3. Objectives of the study

The major objective of this study is to analyse the effect of credit risk management
and capital adequacy on performance of commercial banks in Nepal. The specific
objectives are as follows:

i. To examine the structure and pattern of return on assets, return on equity,

nonperforming loan, loan loss provision, loans & advances, capital adequacy
ratio and liquidity.
ii. To determine whether credit risk measured by nonperforming loan, loan loss
provision, and loans & advances affects bank performance in terms of ROA and
ROE

1.4. Significance of the study

In today’s world the performance of commercial banks are affected by many factors.
But the major concern of the study here is to understand how the capital adequacy and
credit risk management influences the overall profitability of the bank. The
importance of the capital is to finance the assets as well as to protect the long term
and short-term creditors who make the fund available to the business. The health of
 the financial system has important role in the country as its failure can disrupt
economic development of the country (Das & Ghosh, 2007). Financial performance is
company’s ability to generate new resources, from day-to-day operation over a given
period of time and it is gauged by net income and cash from operation.

Similarly Credit risk management plays a crucial role in maintaining a framework of

controls to ensure credit risk-taking is based on sound credit risk management
principles, in identifying assess and measure credit risk clearly and accurately ,
control and plan credit risk-taking in line with external stakeholder expectations and
avoiding undesirable concentrations, monitoring credit risk and adherence to agreed
controls and to ensure that risk-reward objectives are met. The credit
risk management is an important predictor of bank financial performance thus success
of bank performance depends on risk management.

1.5. Operational definition

This section deals with the operational definition of the variables that have been used
in this study. Basically, this section describes and defines the various independent and
dependent variables. The study attempts to measure or investigate the relationship
between the variables defining capital adequacy, credit risk management and bank
performance. The brief discussion on how these variables have been used or
interpreted in this study is made below:

1.6.1. Bank performance variables

Bank performance actually indicates the profitability of the bank. The higher
profitability always explains the favorable situation for any bank or financial
institution to succeed and grow. Thus, in this study profitability has been used to
measure the bank performance. Here, the basic focus of the study is to analyze the
impact of credit risk and capital adequacy in bank performance. Return on assets
(ROA) and return on equity (ROE) has been taken as proxies for performance of the
banks.

a) Return on assets

An indicator of how profitable a company is relative to its total assets. ROA gives an
idea as to how efficient management is at using its assets to generate earnings.
Calculated by dividing a company's annual earnings by its total assets, ROA is
 displayed as a percentage. Sometimes this is referred to as Return on Investment. The
assets of the company are comprised of both debt and equity. Both of these types of
financing are used to fund the operations of the company. The ROA figure gives
investors an idea of how effectively the company is converting the money it has to
invest into net income. The higher the ROA number, the better, because the company
is earning more money on less investment. In the previous studies Barrios & Blanco
(2000), Samuel et al. (2012) and Ogboi & Unuafe (2013) used return on assets as
dependent variable to find out the effect of credit risk and capital adequacy on bank
performances.

b) Return on equity

The amount of net income returned as a percentage of shareholders equity. Return on

equity measures a corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested. Return on equity (ROE)
measures the rate of return on the ownership interest or equity of the common stock
owners. It measures a firm's efficiency at generating profits from every unit of
shareholders' equity which is also known as net assets or assets minus liabilities. ROE
shows how well a company uses investment funds to generate earnings growth.
Odunga et.al (2013), Samuel (2012), and Kargi (2011) used return o equity as
dependent variables to find the effect of credit risk and capital adequacy on bank
performances of commercial banks.

1.6.2. Capital adequacy and credit risk management variables

Credit risk management is the lending institution's primary line of defence to protect
itself against customers who fail to meet the terms of the loans or other credit that was
extended to them. Whereas, capital adequacy is a measure of the financial strength of
a bank or securities firm, usually expressed as a ratio of its capital to its assets. The
credit risk variables taken for the study are non-performing loan, loan loss provision,
loans and advances and liquidity. The variable taken to define the impact of capital
adequacy is capital adequacy ratio.

a) Non-performing loan
Non-performing loan is a sum of borrowed money upon which the debtor has not
made his or her scheduled payments for at least 90 days. A nonperforming loan is
either in default or close to being in default. Once a loan is nonperforming, the odds
that it will be repaid in full are considered to be substantially lower. If the debtor
starts making payments again on a nonperforming loan, it becomes a re-performing
loan, even if the debtor has not caught up on all the missed payments. In other words,
a non performing loan is one in which maturity date has passed but at least part of the
loan is outstanding.  Rodrik (1992) found a positive relation between non performing
loan and bank performances. Claudine (2008) also shows that return on equity ROE
and return on asset ROA all indicating profitability were negatively related to the ratio
of non-performing loan to total loan (NPL/TL) of financial institutions therefore
decreases profitability

b) Loan loss provision

A loan loss provision is an expense that is reserved for defaulted loans or credits.  It is

an amount set aside in the event that the loan defaults. Generally, banks conduct their
business by taking deposits and making loans using those deposits.  It is a bit more
complicated however; this is the basic banking model.  Banks must balance
their loan receivables  with the demand for deposits in any group of loans, banks
expect there to be some loans that do not perform as expected.  These loans may be
delinquent on their repayments or in default of the loan entirely, creating a loss for the
bank on expected income.  Therefore, banks set aside a portion of the expected loan
repayments from all loans in its portfolio to cover all, or a portion, of the loss. In the
event of a loss, instead of taking a loss in its cash flows, the bank can use the amount
set aside to cover the loss. Funso, Kolade & Ojo (2012) observed that increase in loan
loss provision decreases the profitability whereas increase in total loan and advances
increase profitability.
c) Loans and advances

A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of
financial assets over time, between the lender and the borrower. In a loan, the
borrower initially receives or borrows an amount of money, called the principal, from
the lender, and is obligated to pay back or repay an equal amount of money to the
lender at a later time. The amount raised as loan may be repaid within a short period
to suit the convenience of the borrower. Thus business may be run efficiently with
 borrowed funds from banks for financing its working capital requirements. Loans and
advances are utilized for making payment of current liabilities, wage and salaries of
employees, and also the tax liability of business loans and advances from banks.
Kithinji (2010), Ogboi & Unuafe (2013) and Samuel et al. (2012) observed a positive
and significant relationship between credit risk and bank profitability.

d) Liquidity
The degree to which an asset or security can be bought or sold in the market without
affecting the asset's price. Liquidity is characterized by a high level of trading activity.
Assets that can be easily bought or sold are known as liquid assets. Simply, liquidity
is the ability to convert an asset to cash quickly. It is also known as marketability also,
a liquid business generally has more financial flexibility to take on new investment
opportunities. Demirguc - Kunt and Huizinga (2001) found a negative relation
between liquidity and bank performances.

1.7 Limitation of Study

For the completion of this study, some facts are to be considered as the limitations
which are presented as below:
1. The study is based on secondary source of data. Therefore, the reliability of
result maynot be accurate since it ignored primary source of data.
2. The significant size of sample and observations in this study are only form
bank and insurance companies. It doesn't include non-financial institution in
the study.
3. The survey will be be conducted in major cities (Kathmandu, Bhaktapur and
Lalitpur) of Nepal. Hence, the study does not incorporate wide geographical
character of the respondents.
4. Regression and correlation analysis will be based. Therefore it will be better if
other statistical tool had been used.

1.8. Organization of the study

The whole study will be divided into five chapters. The first chapter will cover
introduction, Second chapter will deal with review of the different literature in regard
to the theoretical analysis and review of book, articles and thesis related to this study.
Third chapter will deal with research methodology that is used to carry out the
research. This chapter includes research design, population and sample, nature and
source of data and technique of data collection, data analysis tools. Fourth chapter
will include presentation, analysis and interpretation of the data using financial and
statistical tools. Fifth chapter will show the summary and conclusions of the study and
recommendations for the commercial banks and for further studies. Beside these
references and appendices will be presented at the end of the report. Similarly,
acknowledgement, table of contents, list of tables, list of figures, abbreviations will be
included in the front part of this report.
 Chapter II
Literature review
This chapter provides conceptual framework of the study and deals with review of
empirical studies associated with the impact of capital adequacy and credit risk
management on bank performance that have been carried out previously in context of
both the developed and the underdeveloped countries. The chapter has been divided
into three sections. First section presents an in-depth review of related studies in the
context of both developed and emerging economies where the reviews are put in to
chronological order. This section also deals with brief review of empirical studies
conducted in Nepal. The third section highlights the conceptual framework of the
study which not only helps in identifying the variables taken for the purpose of the
study but also contributes in understanding the relationship among them.

2.1. Review of literature

Myers & Majluf (1984) examined that in the absence of periodic adjustments in the
capital ratio, banks would never hold more capital than required by the regulators or
the market. In practice, however, adjusting the capital ratio may be costly. Equity
issues may, in the case of information asymmetries, convey negative information to
the market on the bank’s economic value. Moreover, shareholders may be reluctant to
contribute new capital if the bank is severely undercapitalized, as most of the benefits
would accrue to creditors. In the absence of these capital adjustments, banks falling
under the legal capital requirements will not be able to react instantaneously. They
may then be subject to repeated regulatory penalties, or even worse, closed down.

Keeton & Morris (1987) argued that banks with relatively low capital respond to
moral hazard incentives by increasing the riskiness of their loan portfolio, which in
turn results in higher non-performing loans on average in the future. More generally,
Keeton & Morris (1987) argued that banks that tend to take more risks, including in
the form of excess lending eventually absorbed higher losses. The finding was
supported by Salas & Saurina (2002) and Jimenez & Saurina (2005).

Abada (1988) found that recapitalization was defined as a measure that puts up the
dubious practice that largely led to the collapse of many banks therefore, acts as
cleaning effort in the system. The effect of capital adequacy on banks performance
cannot be underestimated since adequate capital directly and automatically influences
the amount of funds available for loans, which invariably affects the level and degree
of risk absorption.

Macaulay (1988) found inadequate credit policies were the main source of serious
problem in the banking industry as a result effective credit risk management has
gained an increased focus. The main role of an effective credit risk management
policy must be to maximize a bank’s risk adjusted rate of return by maintaining credit
exposure within acceptable limits. Moreover, banks need to manage credit risk in the
entire portfolio as well as the risk in individual credits transactions.

Assessing the impact of loan activities on bank risk, Bourke (1989) used the ratio of
bank loans to assets (LTA). The reason to do so is because bank loans are relatively
illiquid and subject to higher default risk than other bank asset, implying a positive
relationship between LTA and the risk measures. In contrast, relative improvements
in credit risk management strategies might suggest that LTA is negatively related to
bank risk measures. It was reported the effects of credit risk on profitability appears
clearly negative.

Stoica (2000) stated that liquidity risk consist in the probability that the organization
should not be able to make its payments to creditors, as a result of the changes in the
proportion of long term credits and short term credits and the no correlation with the
structure of organization's liabilities. Chiuri et al. (2002) examined a panel of data for
572 banks in 15 developing countries and find consistent evidence that the imposition
of capital regulation induced a reduction in loan supply and, hence, in total lending.
The study found evidence that the introduction of higher minimum bank capital
requirements may well induce an aggregate slowdown of bank credit.

Golin (2001) pointed out that a bank guard carefully against liquidity risk-the risk that
it will not have sufficient current assets such as cash and quickly saleable securities to
satisfy current obligations e.g those of depositors especially during times of economic
stress. Without the required liquidity and funding to meet obligations, a bank may fail.
However, liquid assets are usually associated with lower rates of return. In terms of
liquidity measurement, the ratio of liquid assets to customer plus short term funding
and the ratio of liquidity asset to total deposit and borrowing are the most common
ratio used in research as a measure of liquidity. The higher this percentage the more
liquid the bank is and less vulnerable to a classic run on the bank.

Bashir & Hassan (2003) and Staikouras & Wood (2003) showed that higher loan ratio
actually impacts profits negatively. The latter study notices that banks with more non-
loan earnings assets are more profitable than those that rely heavily on loans. Chirwa
(2003) determined the relationship between market structure and profitability of
commercial banks in Malawi by using time series data during1970 and 1994. He finds
a long-run relationship between profitability and concentration, capital asset ratio,
loan-asset ratio and demand deposits-deposits ratio.

Cuthberston & Nitzsche (2003) stated that risk management technology has been
renovated over the last decade. The swiftness of information flow and the complexity
of the international financial markets qualify banks to recognize, evaluate, manage
and mitigate risk in a way that was just not possible ten years ago. The most current
credit modelling software in place is Basel II Accord. This accord has positively been
a substance in leading the drive towards building applicable credit risk modelling and
capital adequacy requirements. Banks will have to decide what their risk enthusiasm
is, how to assign their resources optimally and how to compete in market. Generally
in competitive market, a bank trade off the risk which allows much more competent
risk transfer and portfolio optimization.

Giesecke (2004) found that credit risk is by far the most significant risk faced by
banks and the success of their business depends on accurate measurement and
efficient management of this risk to a greater extent than any other risk increases in
credit risk will raise the marginal cost of debt and equity, which in turn increases the
cost of funds for the bank. Kuo & Enders (2004) of credit risk management policies
for state banks in China and found that mushrooming of the financial market; the state
owned commercial banks in China are faced with the unprecedented challenges and
tough for them to compete with foreign bank unless they make some thoughtful
change. In this thoughtful change, the reform of credit risk management is a major
step that determines whether the state owned commercial banks in China would
survive the challenges or not.

It is the duty of banks regulatory authorities to establish a minimum requirement as

long as banks capital asset ratio is concerned using the Basle Accord standard. In
measuring banks’ capital adequacy, bank capital is divided into two; tier one capital
and tier two capital. Brash, rightly observed that there are also other types of risks
which are not recognized by capital adequacy ratios e.g. inadequate internal control
systems could lead to large losses by fraud, or losses could be made on the trading of
foreign exchange and other types of financial instruments. Other risks involved in
financial transitions must be seen as relevant while determining bank performance. In
other words, capital adequacy ratios are only as good as the information on which
they are based, and should not be interpreted as the only indicators necessary to judge
a bank’s financial soundness (Brash, 2009).

Barrios & Blanco (2009) opined that determining bank’s performance in relation with
its capital adequacy; some variables must be considered. These variables include
banks’ managerial quality and productive efficiency which depends so much on the
degree of competition in the industry. The ability of the bank management to ensure
that bank’s capital is effectively managed, determines how adequate the capital is.
Having capital adequacy ratios above the minimum levels recommended by the Basle
Capital Accord, does not guarantee “safety” of a bank, as capital adequacy ratios is
concerned primarily with credit risks.

Soludo (2010) stated that adequate capital will protect banks customers’ deposits and
confer confidence on them in dealing with banks. In furtherance of his assertion,
Soludo explained that the need for recapitalization arises from the fact that banks have
not played their expected role in the development of the economy because of their
weak capital base and as such, the decision to increase the capital base of banks with
the aim of strengthening and consolidating the banking system.

Li yuqi (2012) examined the determinants of bank’s profitability and its implications
on risk management practices in the United Kingdom. The study employed regression
analysis on a time series data between 1999 and 2006. Six measures of determinants
of bank’s profitability were employed. They used Liquidity, credit and capital as
internal determinants of bank’s performance. GDP growth rate, interest rate and
inflation rate were used as external determinants of banks profitability. The six
variables were combined into one overall composite index of bank’s profitability.
Return on Asset (ROA) was used as an indicator of bank’s performance. It was found
that liquidity and credit risk have negative impact on bank’s profitability.
Naceur & Kandil (2012) appraised the impact of capital requirement on banks cost of
intermediation and performance using Generalized Method of Moment (GMM) on
time series data between 1989 through 2004. The study used ratio of capital to total
asset and ratio of net loans to deposit as independent variables while return on asset
(ROA) and return on equity (ROE) was used as dependent variables. The result of the
study is in agreement with their earlier result that capital adequacy is a predictor of
banks performance.

Boahene et al. (2014) conducted the study where the objective of the study was to
determine whether there is a significant relationship between credit risk and
profitability of Ghanaian banks. The study used regression analysis to understand the
relationship between credit risk and profitability of Ghanaian banks. They followed
the line of Hosna, Manzura & Juanjuan (2009) by using Return of Equity as a
measure of bank’s performance and a ratio of non-performing loans to total asset as
proxy for credit risk management. They found empirically that there is an effect of
credit risk management on profitability level of Ghanaian banks. The study also
suggests that higher capital requirement contributes positively to bank’s profitability.

Muhammad et al. (2016) assessed the relationship between credit risk and banks’
profitability in Nigeria by incorporating six commercial banks which were chosen by
using a non-probability method for the period 2004-2008. Data were collected from
annual financial statements of respective banks for the period under study. In their
study, credit risk which was assumed as independent variables were represented by
the ratio of non-performing loans to loan & Advances and the ratio of total loan &
Advances to total deposits. The ratio of profit after tax to total asset (ROA) was
representing the banks’ performance. The collected data was later fitted on the
multiple regression models to test the relationship which exists between those
variables. Their findings show that there is a negative relationship between the ratio of
non-performing loans to loans & advances and the ratio of profit after tax to total
asset (ROA) though that relationship is not significant. They also document that they
observed a negative relation between the ratio of total loan & Advances to total
deposits to total deposits.

Samuel et al. (2016) investigated the relationship between commercial banks’

profitability and credit risk in Ghana by taking into consideration six commercial
banks in their sample which were chosen using purposive sampling techniques for the
period 2005-2009. The study employed secondary data only which were obtained
from annual financial statements of respective banks for the period under study. The
multiple regression models were employed to test the relationship which exists
between the variables in the model. The ratio of Net profit to equity fund (ROE) were
considered as a measure of banks’ profitability and stood as a dependent variable in
the model. Three ratios which were employed to represent credit risk in the model
were (i) Non-performing loan to total loans and advances, (ii) Net charge off
(impairment) to total loans & advances and (iii) Pre-provision profit to net total loans
and advances. In general they observed that credit risk as positive and significant
relationship with banks’ profitability in Ghana. Their observations implied that as the
probability of borrowers to default increases, commercial banks in Ghana realizes
more profits. It shows that the impact of credit risk plays very minimal role in
profitability as the actual result is against the expected relationship.

Kolapo et al. (2016) assessed the impact of credit risk on commercial banks’
profitability in Nigeria by using a sample of five commercial banks which are rated to
be the topmost commercial banks in Nigeria drawn from the population of 25
commercial banks for the period 2000-2010. Data used in the study were secondary
data obtained from audited annual financial statements of respective banks. Ratios
were calculated from the figures obtained from annual financial statements and were
pooled into a panel data set and estimated using multiple regression. The ratio of Net
profit to total bank asset (ROA) was used as a dependent variable in a regression
analysis model representing banks performance. Ratios which presented credit risk in
the regression model were non-performing loan to loan &advances (NPL/LA) and
total loan and advances to total deposits (LA/TD). In conclusion they observed that
ratio of Non-performing loan to loan & Advances is negative related to banks’
profitability, implying that the increase in the ratio of non-performing loans to loan
&advances reduce the banks’ profitability (ROA). They observed also that the ratio of
loan & advances to deposits is positively related to banks profitability, implying that
the increase in this ratio increases the profitability (ROA) of banks in Nigeria.

Tamimi & Obeidat (2017) conducted a study aimed to identify the most important
factors that determine the capital adequacy of commercial banks of Jordan in Amman
Stock Exchange for the period from 2000 - 2008 using multiple linear regression
analysis and the correlation coefficient (Pearson Correlation). The study shows the
following: 1- There is a statistically significant positive correlation between the
degree of capital adequacy in commercial banks and the following independent
factors: liquidity risk, and the rate of return on assets. in another hand, there is an
inverse relationship with statistical significance between the degree of capital
adequacy of commercial banks and factors independent of the following: the rate of
return on equity and interest rate risk. 2 - There is an inverse relationship is not
statistically significant between the degree of capital adequacy in commercial banks
and factors independent of the following: capital risk, credit risk, and the rate of force-
revenue. As shown by the results of the study that the independent variables combined
with a relatively high effect on the dependent variable and the changes that occur
within, as the percentage of the interpretation of the independent variables of the
dependent variable reached approximately 61 percent.

In the study conducted by Odunga et al. (2018) found that commercial banks play an
important role as financial intermediaries for savers and borrowers in an economy. All
sectors depend on the banking sector for their very survival and growth. Operating
efficiency for banks is therefore essential for a well-functioning economy. The
banking sector in Kenya has grown tremendously over years in terms of numbers, size
and profitability. Despite growth in the sector, challenges still remain; market risk,
credit and operational risk possess a major challenge. Kenyan commercial banking is
not the largest supplier of credit yet the largest in terms of assets in the financial
services industry. Guided by operational efficiency theory, this study aimed at
examining the effect of bank specific performance indicators, credit risk and capital
adequacy on the operating efficiency of commercial banks in Kenya. Specifically, we
sought to establish the effect of bank specific credit risk ratios (Net charge off to gross
loans ratio, loan loss provision to total loans ratio, loan loss provision to equity, loan
loss reserves to equity ratio) and capital adequacy ratios (Core capital ratio, risk-based
capital ratio, total capital ratio and equity capital to total assets ratio) on their
operating efficiency. The study adopted an explanatory research design and analyzed
the panel data using Fixed Effects Regression. The results of the study indicated that
the previous year operational efficiency and risk based capital ratio positively and
significantly affected the bank’s operating efficiency. From the regression results, the
overall R2 of 0.4135 was derived, meaning that 41.35 percent of banks operational
efficiency is as a result of credit risk and capital adequacy measures. This implies that
the history of a firm’s performance will definitely influence how a firm moves
forward in an effort to streamline its operational strategies. Banks should seek
mechanisms to improve their risk based capital ratio in order to improve operating
efficiency and remain competitive in the market.

Ogboi & Unuafe (2018) conducted a study to find out the impact of credit risk
management and capital adequacy on the financial performance of commercial banks
in Nigeria. The data for the study were obtained from the published financial
statement of six out of twenty one banks operating in Nigeria as at December 2009.
Panel data regression analysis was used to investigate the extent to which credit risk
management and capital adequacy affect bank’s financial performance in Nigeria in
the period 2000 to 2009. The results showed that sound credit risk management and
capital adequacy impacted positively on bank’s financial performance with the
exception of loans and advances which was found to have a negative impact on
banks’ profitability in the period under study. Based on the findings, it is therefore,
recommended that Nigerian banks institute appropriate credit risk management
strategies by conducting rigorous credit appraisal before loan disbursement and
drawdown. It is also recommended that adequate attention be paid to enhance Tier-
One capital of Nigerian banks.

Samuel Olausi & Abiola (2019) conducted a study to analyse the impact of credit risk
management on the commercial banks performance in Nigeria. The aim of this study
was to investigate the impact of credit risk management on the performance of
commercial banks in Nigeria. Financial reports of seven commercial banking firms
were used to analyze for seven years (2005 – 2011). The panel regression model was
employed for the estimation of the model. In the model, Return on Equity (ROE) and
Return on Asset (ROA) were used as the performance indicators while non-
performing loans (NPL) and capital adequacy ratio (CAR) as credit risk management
indicators. The findings revealed that credit risk management has a significant impact
on the profitability of commercial banks’ in Nigeria.

Karki (2004) analyzed comparative study on financial performance of NABIL Bank

and Standard Chartered Bank Limited with the main objective to compare and analyze
the liquidity, profitability, operating efficiency, capital structure, capital adequacy
leverage and operation, overall performance, analyze the relationship between DPS
and EPS of NABIL and SCBNL Bank. The major finding of the study was that
liquidity ratio was relatively fluctuating over the period, return on the equity is found
satisfactory and there is positive relationship between deposits and loan advances. The
profitability of SCBNL was good in compare to NABIL. The recommendations made
that are the existing condition of the liquidity of the banking and financial institutions
needs to be reduced through an appropriate investment policy. Equally important is
the challenge to minimizing their intermediation cost. In order to help realize the goal
of poverty alleviation, access to increased flow of credit and investment in the
economic activities of direct benefit to the maximum number of low-income people
through micro and medium sizes loan needs serious attention in the days to come.

Udas (2007) examined the efficiency and weakness of capital adequacy ratio to
Nepalese commercial banks. However, the directives of NRB regarding capital
adequacy is taken as the main focus of the study. The study revealed that there was
significant impact on NRB directives of capital adequacy on the various aspects of the
commercial banks and it also helped in maintaining the stability of commercial banks
in the financial market and to uplift the banking sector in Nepal to international
standard. The new directives of capital adequacy issued by NRB have made good
impact on the Nepalese commercial bank and the increased provisioning amount has
decreased the profitability of the commercial banks. The study showed that the
problems of banks are increasing, operating cost are decreasing loan amount resulting
decrease in profits of the bank. But it is only for short term because directives are
more effective to protect the banks from bad loans, which protects the banks from
going bankrupt as well as protecting the deposits of depositors. The capital Adequacy
ratio strengthens the financial position and improves the reputation of the bank and
the increased goodwill. The study also suggested to increase the decreasing profit of
the banks, they should search the alternatives such like more investments in other
business, bank should adopt new technology according to demand of time and must
not depend only in interest income for profit.

Poudel (2016) conducted a study using three commercials banks EBL, NABIL and
SCBNL acting in the country; it however reveals that there was a significant impact of
the directives on the various aspects of the commercial banks. Information was
collected during the period 2058/59 to 2062/63. The result showed that net profit is
closely related with total loan and advances. If the loan and advances increases, there
is increase in net profit too. So, net profit depends on total loan and advances as well
as other investment of banking activities. Since net profit is the net income for the
banks which is net amount i.e. deducting of various expenditure amount. Specially,
increment in pass loan leads the increment in net income of the bank.

Sedhain (2012) mainly focused on disclosure of unanimous facts and difficulties of

Nepalese financial institutions and banks to follow international capital standards. The
dissertation tried to explore the relevancy of Basel Accord in Nepalese perspective
and in which it has succeeded as well. Similarly, the difficulties in maintaining the
minimum capital standard of commercial banks in context of Nepal, which in fact is
an important factor, has been identified to a great extent. Disclosing the NRB
regulations and directives related to capital standard of the Nepalese commercial
banks is one of the major aspects of the study. It has concluded that the management
system of the commercial banks as well as the operating environment of the system
commercial banks has improved significantly. As per the analysis of Basel Capital
Regulation framework, it has been concluded that it has helped in developing suitable
prudential norms to save the banks and financial institutions from financial crisis and
signals of failure. The dissertation further concluded that the operating environment of
the bank has changed radically, and their risk management system has also improved.

Poudel (2017) appraised the impact of the credit risk management in bank’s financial
performance in Nepal using time series data from 2001 to 2011. The result of the
study indicates that credit risk management is an important predictor of bank’s
financial performance. It also concluded that commercial banks are not giving more
focus on credit risk mitigation that could help them to increase their eligible capital
components, which is the another cause that some of the commercial bank have lower
capital adequacy. Majority of the bankers and experts believe that the present capital
adequacy framework prescribed by the central bank is adequate and the banks should
follow the standards for the betterment of every concerned parties associated directly
and indirectly with the performance and risks of the banks.

Jha & hui (2012) analyzed the financial performance of different ownership structured
commercial banks in Nepal based on their financial characteristics and identify the
determinants of performance exposed by the financial ratios, which were based on
 CAMEL Model. The study financially analyzed eighteen commercial banks for the
period 2005 to 2010. In addition, econometric model (multivariate regression
analysis) by formulating two regression models was used to estimate the impact of
bank-specific variables on the financial profitability namely return on assets and
return on equity of these banks. Furthermore, the estimation results reveal that return
on assets was significantly influenced by capital adequacy ratio, interest expenses to
total loan and net interest margin, while capital adequacy ratio had considerable effect
on return on equity.

2.2. Conceptual framework

Profit is one of the indicators of sound performance, which indicates the result of
sound business management. Financial performance can be defined as the measure of
stability of the activity of the bank characterized by low levels of risks of any kind
and a normal trend of profits growth from one analysis to another. It is the main
indicator of success and failure of a firm. So, the management should take appropriate
action towards its weakness and maintain good performance in the strong areas.

There have been debate and controversies on the impact of credit risk management
and bank’s financial performance. Some scholars e.g., (Li Yuqi 2007; Naceur and
Kandil 2006; Kinthinji 2010; Kolapo, Ayeni and Ojo 2012; Kargi 2011) amongst
others have carried out extensive studies on this topic and produced mixed results;
while some found that credit risk management impact positively on banks financial
performance, some found negative relationship and others suggest that other factors
apart from credit risk management impacts on bank’s performance. There have been
many controversies in arriving one definite conclusion of how does capital adequacy
and credit risk influences the bank performance.

Different ratios of capital adequacy are determined as a determinant for profitability

of commercial banks. In Ezike & M.O (2013), has used loan ratio (LR), total deposit
assets (TDA), loan loss provision/ Total loans (LLPT), Loan loss provision/ Equity
(LLPE), loan loss reserves/ equity (LLRE), core capital ratio(CCR), non-performing
loan etc for the measurement of both credit risk and capital adequacy. Here, the
conceptual model proposed by Ogboi & Unuafe (2013) has been employed as the
conceptual framework of this study with ROE taken as the additional variables along
with ROA to measure the bank performance.
This conceptual frame work describes the relationship of profitability with capital
adequacy and credit risk based on the theoretical and empirical perspective. This
study has taken return on equity and return on assets as the dependent variables.
Whereas, non-performing loan/total loans and advances, loan loss provision/total
loan, loans and advances/total deposit, total deposit/ loans and advances and capital
adequacy ratio as independent variables which are used for the measurement of credit
risk and capital adequacy. The empirical results are described from the following
diagram.

Independent Variables Dependent Variables

Bank Performance

Credit Risk  Return on Assets

 Non- Performing Loan (ROA)
(NPL)  Return on Equity
 Loan Loss Provision
(ROE)
(LLP)
 Loans and (LA)
 Liquidity (LQD)

Figure 2.1: Conceptual framework of the Study

Profitability measures: dependent variables

The Return on Asset (ROA) and the Return on Equity (ROE) have been used
extensively as measures of profitability. ROA indicates how effectively a bank is
managing it assets to generate income. ROA is the income earned on each unit of
asset usually expressed as percentage. The problem with ROA is that it excludes from
the total assets off-balance sheet items (for instance, assets acquired through a lease)
thereby understating the value of assets. This can eventually create a positive bias
where ROA is overstated in the evaluation of bank performance. Nevertheless, Golin
(2001), and Rose et al., (2005) have argued that ROA is one of the most important
measures of profitability in recent banking literature. The studies of Haron (2004),
Hasan et al., (2003), Bashir (2001), Demirguc-Kunt et al., (1998), Naceur (2003),
Alkassim (2005), and Alrashdan (2002) have all adopted ROA as a measure of
profitability.

As an alternative measure of profitability the Return on Equity (ROE) is computed by

dividing net income by equity. It measures the income earned on each unit of
shareholders capital. The shortfall of this measure is that banks with high financial
leverage tend to generate a higher ratio. Banks with high financial leverage may be
associated with a higher degree of risk although these banks may register high ROE.
Thus ROE may sometimes fall short in exposing the true financial health of banks.
Another challenge with using ROE is that it is affected by regulation. However, ROE
is commonly used in conjunction with ROA.

Non-performing loan

The quality of assets held by a bank depends on exposure to specific risks, trends in
non-performing loans, and the health and profitability of bank borrower (Baral, 2005).
Bourke (1989) reports the effect of credit risk on profitability appears clearly
negative, this result may be explained by taking into account the fact that the more
financial institutions are exposed to high risk loans, the higher is the accumulation of
unpaid loans, implying that these loan losses have produced lower returns to many
commercial banks (Miller & Noulas, 1997). The findings of Felix and Claudine
(2008) also shows that return on equity ROE and return on asset ROA all indicating
profitability were negatively related to the ratio of non-performing loan to total loan
NPL/TL of financial institutions therefore decreases profitability.

Loan loss provision

Loan loss provision is an amount of money that a bank set aside from its annual
earnings as a precaution against possible loss of a non performing loan, or to off-set a
lost credit facility. In the study of Delis, Dietrich & Wanzenried (2011) in order to
approximate credit risk or credit quality by the Loan loss provisions over total loans
ratio. Ahmad & Ariff (2007) examined the key determinants of credit risk of
commercial banks on emerging economy banking systems compared with the
developed economies and study found that an increase in loan loss provision is also
considered to be a significant determinant of potential credit risk. In the study of
Ahmed, Takeda & Shawn (1998) showed that an increase in loan loss provision
indicates an increase in credit risk and deterioration in the quality of loans
consequently affecting bank performance adversely.

Loans and advances

Loans and advances is a facility granted to a bank customer that allows the customer
make use of banks funds which must be repaid with interest at an agreed period.
Kithinji (2010) analyzed the effect of credit risk management measured by the ratio of
loans and advances on total assets and the ratio of non-performing loans to total loans
and advances on return on total asset in Kenyan banks. The study found that the bulk
of the profits of commercial banks are not influenced by the amount of credit and non
performing loans. The implication is that other variables apart from credit and non
performing loans impact on banks’ profit.

Liquidity

Liquidity measures the ability of banks to meet short-term obligation or commitments

when they fall due. Liquidity is a prime concern for banks and the shortage of
liquidity can trigger bank failure. Banking regulators also view liquidity as a major
concern. This is because banks without sufficient liquidity to meet demands of their
depositors risk experiencing bank run. Holding assets in a highly liquid form tends to
reduce income as liquid asset are associated with lower rates of return. For instance,
cash which is the most liquid of all assets is a non-earning asset. It would therefore be
expected that higher liquidity would negatively correlates with profitability. Indeed,
Molyneux et al., (1992) and Guru et al. (1999) discovered that negative correlation
exists between the level of liquidity and profitability. However, Bourke (1989), and
Kosmidou et al. (2005) found a significant positive relationship between liquidity and
bank profits. As Golin (2001) mentions it is critical that a bank guard carefully against
liquidity risk, the risk that it will not have sufficient current assets such as cash and
quickly saleable securities to satisfy current obligations e.g. those of depositors –
especially during times of economic stress. Without the required liquidity and funding
to meet obligations, a bank may fail. However, liquid assets are usually associated
with lower rates of return. The ratio of liquid assets to deposit and borrowings (LIQ)
 is used in this study as a measure of liquidity. The higher this percentage the more
liquid the bank is and less vulnerable to a classic run on the bank.

2.3. Research Gap

The review of the literature reveals the existence of many gaps of knowledge in
respect of the factors affecting bank profitability, particularly in the context of Nepal.
As per the review of the literature most of the empirical studies that have been
conducted with the aim of identifying factors affecting bank profitability belong to
European Union and some emerging markets such as Philippines, Malaysia and
Tunisia. Moreover, the literature review also reveals the existence of controversial
conclusions that results from different studies made so far.

Capital adequacy and financial performance has emerged as research area in the
present day context. The new Basel accord consists of three pillars i.e. capital
requirements, supervision and market discipline. In the sophisticated version of
capital requirement pillar capital requirements are based on banks’ own measures of
risk. The new framework is based on the premise that discipline from market and
government is very beneficial but sadly both of them fail. Many research and studies
were conducted to find out the relationship between capital adequacy and bank
performance in both developed and developing countries. However in Nepal there is
few limited research being conducted on the respective topic. Even in those bounded
studies researchers have failed to point out the specific model being employed
independently in order to analyze the extent of share market price and economic
development of Nepal while they have attempted to examine the relationship between
independent variables including capital adequacy and bank performance. There also
have various efforts being made to find out answers for some of the questions like
what is the role of capital adequacy requirement set by NRB?

Similarly, the studies on profitability measurement are scarce in context of Nepal. In

order to understand the performance of bank it’s necessary to understand the
determinants of profitability. But in Nepalese context there are very few studies with
small sample sizes to analyze the factors affecting profitability. This study has
focused on what is the role of capital adequacy in shaping the bank performance?
What is the effect of bank liquidity in its profitability? How non- performing loan
does contributes in determining the bank performance? How does loan and advances
affect the profitability of bank?
 Chapter III
Research methodology
Research methodology sets overall plan associated with a study. Research
methodology mainly describes the technique, method and process applied in the entire
process of a scientific research. This chapter therefore explains the methodology
employed in this study. So, in this chapter the study has introduce how to get started
to do this study from collecting data, retrieving necessary information, building the
frame of variables to researching philosophy or approaching method. This chapter has
focused on the research design, population and sample of the study, nature and
sources of primary and secondary data. Further, this chapter specifies the major
statistical tools and models used to examine the relationship between the variables of
interest. The methods employed for data analysis and measurement which include the
instrumentations, primary and secondary data analysis technique and details on
overall analysis plan have also been dealt.

3.1. Research design

This study has employed descriptive research design and causal comparative research
design to deal with issues associated with the credit risk, capital adequacy and bank
performance in the context of Nepal. The descriptive research design has been
employed to describe, measure, compare, and classify the financial situations of
Nepalese commercial banks. Similarly, opinions and perceptions of respondents
regarding capital adequacy, credit risk and bank performance have been assessed. The
study also applied casual comparative research design to test the significance of
variables on performance of Nepalese commercial banks. The basic purpose of
employing causal comparative research design in this study is to understand and
examine whether it is possible to predict bank performance measured by ROA and
ROE on the basis of information about capital adequacy and credit risk variables. This
study is also based on correlation research design. This design is adopted to ascertain
and understand the directions, magnitudes and forms of observed relationship of
profitability with capital adequacy and credit risk management. Moreover, this study
employs balance panel data model research design to determine the capital adequacy
and credit risk on cross-sectional profitability of the banks.
3.2. Nature and sources of data
This study is based on secondary sources of data in order to meet its affirmed
objectives and respond the research questions. The secondary sources of data for the
study are obtained from the published financial statement of the sample commercial
bank in Nepal as at the latest fiscal year recorded in the database provided in their
respective websites also in addition data bank of NRB were used to extract the
required data for the purpose of this study. In order to ensure uniformity in
presentation, the banks that are merged or acquired during the period covered in the
study are excluded as far as possible.

3.3. Population and Sample

This study employs panel data techniques to measure the relation between the effect
of credit risk and bank performance of commercial banks in Nepal for a sample period
from 2013-2019. The sample bank for the study will be Nabil Bank Limited, Citizen
Bank Limited and Nepal Bank Limited. The sampling is based on systematic random
sampling method.

3. 4 Method of analysis

a. The Model

In order to explain the effect of credit risk and capital adequacy variables on bank
performance will be use in this study, the multiple regression model of the form
including all variables as specified in following equations have been used:

ROAit = α + β1 NPLit + β2 LAit + β3 LLPit + β4 LQDit +eit…………… (i)

ROEit = α + β1 NPLit + β2 LAit + β3 LLPit + β4 LQDit +eit …………….. (ii)

Where, NPLit refers to non-performing loan to total loans and advances of bank ‘i’ for
period ‘t’, LLPit refers to loan loss provision to total loan of bank ‘i’ for period ‘t’,
LAit refers to loans and advances to total deposit of bank ‘i’ for period ‘t’.

Similarly, e refers to the unexplained residual error terms, β0is the intercept term, and
β1, β2, β3, β4 and β5 are the respective parameters or regression coefficients of the
explanatory variables. Similarly, eitis independent and identically distributed
following the normal distribution with mean 0 and variance δ2
Correlation of Coefficient
This design will adopt to identify the direction and magnitude of relationship between
different pairs of variables. It shows how two variables move together and also shows
the degree of association between them. The relationship will explain by using bi-
variate Pearson correlation coefficient. It will show how two variables move together
and also shows the degree of association between them. The relationship will be
explained by using Pearson correlation coefficient. The value of correlation
coefficient ranges from -1 to +1. If correlation coefficient is exactly -1, two variables
are said to have perfect negative correlation as such that they move together exactly
into opposite direction. On the other hand, if correlation coefficient is +1, the
variables are said to be perfectly positively related.

Descriptive statistics

This study will use the summary of descriptive statistics associated with dependent
and independent variables of sample banks to explain the cross-sectional
characteristics of these variables during the sample period. The descriptive statistics
such as mean, median, standard deviations, minimum and maximum values of the
variables will be used to describe the characteristics of sample banks during the
period 2013-2019.

Among others, mean and standard deviation for the variables of interest can be
calculated using the following formula:

Mean ( X )=
∑X
n−1

Where, X is the value of ROA, ROE, NPL, LLP, LA and LQD and n is the total
numbers of the sample observation. The mean is the measure of central tendency. It
gives the idea about the average statistics from the sample observations.

Standard Deviation ( δ ) =
√ ∑ ( X −X )
n−1

where, X is the ROA, ROE, NPL, LLP, LA and LQD,; X is the mean value of
variables and n is the total numbers of the sample observation. The standard deviation
 is the measure of dispersion. It gives the idea about the how far and wide the
observations fluctuate on an average.

Test of significance

The test of statistical significance of regression coefficient is a procedure by which

sample results are used to verify the truth or falsity of priori hypothesis. This study
will employ t-statistic to perform significance test of regression coefficients. In the
language of significance test, a regression coefficient is said to be statistically
significant if the critical p-value of test statistic is less than the level of significance
specified. In other words, the statistical significance of the coefficients validates the
explanatory power of the associated independent variables. The levels of significance
will be at 1, 5, and 10 percent level. By the same way, a test statistic is said to be
statistically not significant if the critical p-value of test statistic is greater than the
level of significance specified.

Besides the statistical test of significance of individual regression coefficient, it is

necessary to test the joint hypothesis that all regression coefficients are
simultaneously significant. This is called the test of overall significance of the model.
This can be done by using adjusted coefficient of determination (Adj.R2) and F-
statistics. The adjusted coefficient of determination will be used to identify the
percentage of total variation in dependent variable that will be explained jointly by all
explanatory variables. The statistical significance test of this joint explanatory power
will be conducted by using F-statistic. The p-value of F-test will be examined to
confirm whether the regression models are significant at 1, 5 and 10 percent level.
Generally, higher value of Adj. R2 and significant F-statistic indicate the better
explanatory power of the model.

3.8. Analysis plan

Data analysis consists of selecting, categorizing, comparing, synthesizing, interpreting
and generalizing the available data. The analysis of secondary data intends to study
the relationship and cause and effect between the variables. The analysis starts with
the analysis of secondary data. This section is divided into various subsections first of
which deals with the descriptive statistics of the sample observations including the
mean, standard deviation, minimum and maximum values of the observations.
Correlation analyses have been carried out in the second section followed by the OLS
regression analysis. Test of significance, multicolinearity and the autocorrelation will
also be tested to make the results more valid. All the observed relationship and
findings will be interpreted to derive the meaningful conclusions regarding the capital
adequacy and credit risk and their impact on performance of the banks.