See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/345214694

Transnational Corporations Review Differential effects of credit risk and

capital adequacy ratio on profitability of the domestic banking sector in Ghana
Differential effects of cr...

Article  in  Transnational Corporations Review · December 2019

CITATIONS READS

0 59

1 author:

Tncr Special
Denfar Transnational Development
22 PUBLICATIONS   0 CITATIONS   

SEE PROFILE

Some of the authors of this publication are also working on these related projects:

East Meets West: From Chinese Multinationals to Internationalization View project

Macroeconomic factors and stock market development in sub-Saharan Africa: does the measure of stock market development matter? View project

All content following this page was uploaded by Tncr Special on 03 November 2020.

The user has requested enhancement of the downloaded file.

 Transnational Corporations Review

ISSN: 1918-6444 (Print) 1925-2099 (Online) Journal homepage: https://www.tandfonline.com/loi/rncr20

Differential effects of credit risk and capital

adequacy ratio on profitability of the domestic
banking sector in Ghana

Ali Hussam Madugu, Muazu Ibrahim & Joseph Owusu Amoah

To cite this article: Ali Hussam Madugu, Muazu Ibrahim & Joseph Owusu Amoah
(2020) Differential effects of credit risk and capital adequacy ratio on profitability of the
domestic banking sector in Ghana, Transnational Corporations Review, 12:1, 37-52, DOI:
10.1080/19186444.2019.1704582

To link to this article: https://doi.org/10.1080/19186444.2019.1704582

Published online: 28 Dec 2019.

Submit your article to this journal

Article views: 25

View related articles

View Crossmark data

Full Terms & Conditions of access and use can be found at

https://www.tandfonline.com/action/journalInformation?journalCode=rncr20
TRANSNATIONAL CORPORATIONS REVIEW
2020, VOL. 12, NO. 1, 37–52
https://doi.org/10.1080/19186444.2019.1704582

RESEARCH ARTICLE

Differential effects of credit risk and capital adequacy ratio on profitability

of the domestic banking sector in Ghana
Ali Hussam Madugua,b, Muazu Ibrahima,c,d and Joseph Owusu Amoaha
a
Department of Banking and Finance, School of Business and Law, University for Development Studies, Wa, Ghana; bBudget Office,
Tamale Metropolitan Assembly, Tamale, Ghana; cAfrican Centre on Philanthropy and Social Investment (ACPSI), Wits Business School
University of the Witwatersrand, Johannesburg, South Africa; dMacroeconomic and Governance Division (MGD), United Nations
Economic Commission for Africa (UNECA), Addis Ababa, Ethiopia

ABSTRACT ARTICLE HISTORY

Examining credit risk and banks’ solvency effects on profitability are essential for overall health Received 28 July 2019
of the banking sector. However, earlier studies on these nexuses are not instructive given their Revised 24 November 2019
failure to examine how credit risk and capital adequacy levels impact on profitability for the dif- Accepted 7 December 2019
ferent types of banks. In addition to re-examining the effect of credit risk and capital adequacy
KEYWORDS
ratio (CAR) on profitability of the overall banking sector, this study aims at determining their dif- Non-performing loans;
ferential effects on profitability of local and foreign banks within Ghana’s banking sector. The capital adequacy ratio;
study relies on data from 11 banks spanning 2006–2016 while employing the fixed effects esti- return on asset; return on
mation approach. Results from the study show a positive and significant effect of credit risk on equity; credit risk;
profitability with huge effect for local relative to foreign banks. However, CAR negatively affects profitability
profitability of foreign banks with no apparent impact on local banks.

1. Introduction
The provision of credit continues to play a pivotal role in the business of banking but at the same time, ineffect-
ive credit risk management remains a major cause of serious banking problems in the world (Boahene, Dasah, &
Agyei, 2012). The result of this ‘high risk’ is non-performing loans (NPLs) that lead to financial fragilities for both
the banks and the customers. NPL traps valuable collateral of the debtor and the unresolved debt makes it more
difficult to obtain new funding and make new investment (Bernanke, Gertler, & Gilchrist, 1999). The lender also
has to concurrently meet the costs of the NPL, including the wind-down costs. Indeed, rising NPLs also distort
allocation of credit, worsen market confidence thus slowing overall economic growth (Cucinelli, 2015; Jorda,
Schularick, & Taylor, 2013; Peek & Rosengren, 2000, 2005).
Indeed, Ghana’s banking sector has seen a steady growth over the years. In 1988, the total number of banks
was nine, and by 2011, it rose to 27. There were only two foreign-controlled banks in the year 1988 which
increased to 7 out of a total of 16 banks in the year 2000. By 2008, out of the 26 registered banks the number of
foreign-controlled and the domestic-controlled banks evened up. As in 2011, the number of foreign banks sur-
passed the number of local banks with a percentage of 52–48% out of the 27 total number of banks recorded
(Saka, Aboagye, & Gemegah, 2012). The total number of universal licenced banks rose up to 35 by the end of the
year 2017 with the foreign banks recording 17, and 18 of which are local banks (PwC, 2017).
In April 2017, the banking sector recorded a mixed performance in profitability. Whilst profitability increased
there was a decrease in profitability ratios. According to the Bank of Ghana (2017), the annual income before tax
of the industry grew by 13.7% as at April 2017 as against the 1.4% growth recorded in April 2016. Also, net profit
after tax of the banking industry increased from GH₵675.5 to GH₵ 739.3 million for the period April 2016 and
2017 respectively. This represents 9.4% growth in April 2017 compared with the 0.7% growth for the same period
in 2016. There was also a favourable year-on-year growth in the banks’ net interest income as it grew from 16.6%
to 18.1% as at April 2017. According to Gil-Diaz (1994), the major cause of banking problems can be directly
linked to lax credit standards for borrowers and counterparties, poor portfolio risk management, or lack of

CONTACT Muazu Ibrahim imuazu@uds.edu.gh Department of Banking and Finance, School of Business and Law, University for Development
Studies, Post Office Box UPW 36, Wa, Ghana
ß 2019 Denfar Transnational Development INC.
38 A. H. MADUGU ET AL.

attention to changes in albeit economic circumstances, that can lead to deterioration in the credit standing of a
bank’s counterparties. Carey (2001) emphasised that risk management is more important in the financial sector
than in other parts of the economy. In the case of banks, the issue of credit risk is even of a greater importance
because of the higher levels of risk resulting from the actions or the inactions of clients relative to the type of
business activities the clients finance. According to available evidence from Bank of Ghana (2015), NPL increased
from 11% in 2014 to 14.7% in 2015. The episodes of NPLs in Ghana’s banking sector coincided with reduced prof-
itability of the deposit money banks. For example, return on equity (ROE) decreased from 33.1% in 2014 to 22.2%
in 2015 while ROA also reduced from 6.6% to 4.6% in the same period. Empirically, Adu and Adjare (2014) exam-
ine the determinants of credit risk of commercial banks in Ghana from 2007 to 2014 relying on least squares
regression analysis. The authors find a negative and significant effect of credit risk on profitability. Similarly,
Amidu and Hinson (2006) examined how credit risk affects bank’s profitability in Ghana relying on data over a
six-year period spanning 1998–2003. Consistent with Adu and Adjare (2014), results from Amidu and Hinson
(2006) ordinary least squares (OLS) show a significantly negative relationship between profitability and credit risk
of banks.
This notwithstanding, Afriyie and Akotey (2013) study suggests that higher credit risk is associated with higher
bank’s profitability in Ghana. Indeed, what is clear from the foregoing literature is mixed and inconclusive find-
ings on credit risk–profitability nexus. Such mixed evidence makes it difficult for policy making. What is more pro-
nounced is that, none of these studies have examined the effect of credit risk on profitability of banks given the
type of bank. In other words, earlier studies on credit risk–profitability nexus are not instructive given their failure
to examine how credit risk uniquely impacts on profitability of local and foreign banks. This study, therefore, fills
this gap in the literature. It makes significant contributions to the literature in so many ways. First, in addition to
re-examining the effect of credit risk on profitability of the overall banking sector, this study provides a pioneer-
ing evidence on the differential effects of credit risk on profitability of local and foreign banks within Ghana’s
domestic banking sector. In the case of Ghana, this is imperative given the proliferation of foreign banks in the
domestic banking sector. Second, relative to the use of OLS which produces bias results, we invoke the fixed
effects estimation strategy on a more recent data over a comparatively longer time period in examining the
impact of credit risk on profitability. The findings reveal a positive and significant effect of credit risk proxied by
NPL to total assets (NPLTA) on profitability, measured by return on assets (ROA). Further evidence suggests that
the positive impact of credit risk is huge for local banks relative to foreign banks. On the other hand, when credit
risk and profitability are respectively proxied by capital adequacy ratio (CAR) and ROE, we found a negative effect
of credit risk on profitability. However, this evidence is only significant for foreign and not for local banks. Our
conclusion is that, whether credit risk improves or lowers profitability depends on the measure of credit risk and
profitability. This study can, therefore, be thought of as a re-examination of the standard paradigm relating credit
risk and banks’ performance.
The rest of this article is organised as follows: Section 2 presents some brief stylised facts on credit risk in
Ghana’s banking sector while Section 3 reviews the literature on credit risk–profitability nexus. Section 4 outlines
our methodology with Section 5 discussing the empirical findings. Section 6 concludes the study with some
implications for policy.

2. Stylised facts on credit risk and profitability in Ghana’s banking sector

The banking sector is one of the drivers of economic growth in Ghana because of the stability it enjoys. The chal-
lenges in that sector have included decrease in profitability owing to higher operational cost mainly due to the
energy crisis, and increasing NPLs. According to Arhin (2017), the banking sector of Ghana has experienced a
high growth rate of NPLs since the year 2007 to the first quarter of the year 2015. The author argues that the
high growth rate of NPLs impacted on the financial performance of the majority of local banks thus increasing
NPLs in the banking sector. The primary cause of defaults in 2016 has been debts owed to banks by state-owned
enterprises especially in the energy sector. The energy sector levy was introduced to help address ‘these nagging
facilities in the books of the banks’ (PwC, 2017: 29). Amuakwa-Mensah, Marbuah, & Marbuah (2017) described the
trends of the NPLs in Ghana as being in a state of oscillation. For instance, there was a sharp rise in NPLs from
1998 to 2001, but from 2002, the financial institutions recorded a consistent fall in NPLs up to 2007 which was
the beginning of the financial crises. After 2009, the downward trend of NPLs in Ghana resumed up to 2011.
 TRANSNATIONAL CORPORATIONS REVIEW 39

NPLs started rising again sharply from March 2015 to December 2016. The consequence of the energy sector
(legacy) debt is that the organisations are neither able to discharge their loan obligations to the banks nor service
their debt obligations as agreed. Bank of Ghana with the support of IMF requested a review of the loans and
advances of the banks in 2015 in order to ensure that sufficient impairment allowances are made available to
deal with the NPLs. This move was to address the possible impact of NPLs on the solvency of the commercial
banks and the economy of Ghana at large (PwC, 2016). The ongoing payment of the legacy debts and the
restructuring exercise has been useful with respect to reducing the NPL ratios in the last three months of 2016.
NPL ratio decreased from 19% to 17.3% from September to December 2016, with the payments of Tema Oil
Refinery and Volta River Authority debts. This was done through negotiating with banks and with the proceeds
from the Energy Sector Levy (PwC, 2017). Table 1 presents background statistics on NPLs of some selected local
and foreign banks. Barclays bank recorded the lowest NPLs of 0.77% in 2007 before increasing to 5.52% in 2008.
Around the same period, NPLs for all the local banks namely CAL bank, ADB and Unibank reduced. It is also evi-
dent that between 2009 and 2014, the behaviour of NPLs is not non-monotonic and does not follow a definitive
pattern. For instance, NPLs for ADB increased from 8% in 2009 to 11.82% in 2010 before decreasing to 6.69% in
2011 and assumed an increasing trend thereafter. Similar trend is observed for Barclays bank.
This notwithstanding, Barclays bank has the highest NPLs averaging 14.24% over the period 2007–2014 while
HFC has the lowest average. Among the local banks, ADB has the highest NPL relative to CAL bank, HFC and
Unibank. Indeed, the foreign banks are not susceptible to credit risk as seen in the results. On the drivers of NPLs
in Ghana, Arhin (2017) shows that lower economic growth, financial underdevelopment, and lower energy or
electricity supply are associated with higher rate of NPLs whilst higher interest rate on government securities
associated with lower NPLs. However, IMF (2017) reports that, the rising NPLs for a lot of the universal banks
were in part due to the ‘legacy debt’.
The rising NPLs have been a serious concern because of its impact on the solvency of banks. As such, the
Bank of Ghana, with the support of IMF requested a review of the loans, advances and investments of the com-
mercial banks in 2015 in order to ensure that sufficient impairment allowances are made available to take care of
NPLs. The review also put the regulator in a well-informed position on the capital adequacy of commercial banks
to know the right intervention to employ where the need arose. The Bank of Ghana in September 2016 estab-
lished a capital requirement review committee to review and recommend appropriate level of minimum capital
requirement for commercial banks. This was aimed at increasing the ability of banks operating in Ghana to be
able to handle big-ticket transactions and at the same time improve investors’ confidence in the banking sector
(PwC, 2017). Indeed, the banking sector continues to expand because as at the end of 2017, two new banks
namely Beige Capital Bank and Construction Bank were issued with new universal banking licences, bringing the
total number of universal banks to 35. Out of these 18 banks are locally controlled and 17 are foreign owned
(PwC, 2017). The medium-term outlook for the banking industry remains positive. The policies such as the tight-
ening of credit risk management practices and the increase in minimum paid-up capital by the banks inter alia
are expected to have positive impact on the overall performance of the banking industry (Bank of Ghana, 2017).

3. Relationship between credit risk–profitability: a brief review

Indeed, literature on credit risk–profitability nexus has grown in an astonishing manner (Abu-Hanifa, Chowdhury,
Chowdhury, & Pervin, 2015; Akinkunmi, 2017; Ebenezer & Omar, 2016; Hosna, Manzura, & Juajuan, 2009;

Table 1. NPLs (in %) for some selected local and foreign banks (2007–2014).
Local banks Foreign banks
Year CAL bank ADB Unibank HFC Ecobank Standard chartered Barclays
2007 7.30 18.00 7.00 1.53 3.60 4.00 0.77
2008 5.90 12.44 4.00 1.64 3.10 4.50 5.52
2009 10.40 8.00 3.90 1.20 3.20 10.00 9.75
2010 11.40 11.82 2.60 1.10 3.10 12.00 33.00
2011 9.70 6.69 3.32 1.00 0.66 10.00 25.00
2012 5.10 10.78 3.09 1.64 5.10 10.00 16.52
2013 7.90 12.42 3.73 1.96 5.90 16.00 11.05
2014 6.20 23.29 4.00 2.15 1.78 27.00 12.30
2007–2014 7.99 12.93 3.96 1.53 3.31 11.69 14.24
Source: Bank of Ghana (2015).
40 A. H. MADUGU ET AL.

Ntow-Gyamfi & Boateng, 2013; Ogbulu & Eze, 2016; Petria, Capraru, & Ihnatov, 2015; Roman & Tomuleasa, 2013).
These studies have been torn between the developed and developing economies. For instance, a study con-
ducted by Hosna et al. (2009) on credit risk and profitability in commercial banks in Sweden, relying on data
from four banks spanning 2000–2008 where credit risk is proxied by CAR and NPL. Results from the regression
model revealed that credit risk has impact on the profitability of all the four banks on a reasonable level with
25% possibility of NPL and CAR in predicting the difference in ROE. Thus, a strategy in the management of credit
risk is capable of defining a level of profitability to a significant extent. Furthermore, the impact of NPL on profit-
ability is huge relative to CAR. Therefore, NPL had significant effect on profitability than CAR. Roman and
Tomuleasa (2013) conducted an empirical study to evaluate the impact of specific internal and external factors
on bank profitability. The study covered a sample size of 86 commercial banks within the European Union mem-
ber states for a time period spanning 2003–2011 using a balanced panel data.1 The results revealed that, bank
profitability measured by ROE of the majority of the countries considered is influenced significantly by the bank-
specific factors which are NPL and CAR and others. Moreover, higher NPL ratio to total loans and the deterior-
ation of the quality of credit portfolio has negative impact on the profitability of commercial banks. Petria et al.
(2015) assessed the main determinants of banks’ profitability in 27 European Union countries over the period of
2004–2011. The authors relied on fixed and random effects estimation techniques. The fixed effects results
revealed a statistically significant negative impact of credit risk on profitability.
Available evidence shows that the management of credit risk can be seen as a tool for predicting the perform-
ance of banks using NPL as a measure of credit risk can decrease the bank’s value and at the same time destabil-
ise the credit system (Adjeitsey, 2015). Loan default reduces the resource base of a bank hence reducing the
capacity of the said bank to continuously extend credit facility to borrowers as well as reducing borrower confi-
dence (Padmanabham, 1988). As a result of the high cost of managing credit risk or overdue loans the bank’s
profitability levels tend to decrease and in some instances the cost of the unpaid loans is borne by other unsus-
pecting borrowers by way of high-interest margins charged on their loans. It must be noted that the outcome of
studies carried out on the impact of credit risk on banks’ performance produced mixed results. Whilst some stud-
ies found that credit risk management impacted positively on banks financial performance, others found a nega-
tive relationship and some others suggested that there are other factors rather than credit risk management that
affect bank financial performance (Kargi, 2011; Kithinji, 2010; Kolapo, Ayeni, & Oke, 2012). Albulescu (2015)
studied banks profitability and financial soundness indicators: a macro-level investigation in emerging countries2
using IMF monthly data for the period of 2005–2013 and a panel data approach and fixed-effect model.
Profitability was proxied by ROE and ROA and credit risk by NPL, it was discovered that NPLs have negative
impact on banks’ profitability under the fixed effect model. The result was robust irrespective of whether profit-
ability was proxied by ROA or ROE.
Abu-Hanifa et al. (2015) examined the effect of credit risk on profitability of the banking sectors in Bangladesh
using unbalanced panel data and 172 observations from 18 commercial private banks for the period of
2003–2013. The study measured credit risks with NPL ratio based on gross loan, loan loss reserve ratio based on
NPL, loan loss reserve ratio based on gross loan and CAR as well as proxying profitability with net interest margin
ratio, return on average asset and return on average equity. The study finds a robust negative and significant
impact of CAR (credit risk) on ROA (profitability). The study also found a robust negative and significant impact
of NPL on all the profitability indicators. Shingjergji (2014) analysed the impact of bank-specific variables on the
NPLs ratio in the Albanian banking system. The study used the panel quarterly data from 2002 to 2012 and the
OLS estimation showed that CAR is negatively related to NPLs ratio but it is not statistically significant. The net
interest margin showed a positive relationship with NPLs ratio indicating available evidence that when banks
have higher net interest margin it will tend to cause a decreasing assets quality. The results also manifested a
negative relationship between ROE and the NPLs implying that higher NPLs ratios will deteriorate bank
performance.
Kithinji (2010) examined the relationship between credit risk management and profitability of commercial
banks in Kenya. Results from the study reveal that, profitability on one hand and credit risk on the other are com-
pletely independent given the insignificant effect of NPL on banks’ return on total asset (ROTA). Ebenezer and
Omar (2016) investigated the empirical effects of credit risk on profitability of commercial banks by constructing
a panel data set involving eight commercial banks over the period of 2011–2014. The findings of the study show
a negative and significant relationship between NPL and profitability. Ogbulu and Eze (2016) further examined
 TRANSNATIONAL CORPORATIONS REVIEW 41

the impact of credit risk management on the performance of deposit money banks in Nigeria by employing the
error correction model (ECM) and Granger causality techniques in addition to the impulse response functions and
variance decomposition analysis. Secondary data were used for a period spanning 1989–2013. The results mani-
fested that the credit risk proxies employed have significant impact on the performance of banks that were
respectively, measured as ROE, ROTA and return on shareholders’ fund.
In the case of Ghana, Adjeitsey (2015) studied the effects of credit risk on the profitability of rural banks in
Ghana using the Atwima Kwanwoma Rural Bank Limited as a case study. The author established a negative cor-
relation between the level of NPLs and profitability of the bank. Additionally, CAR positively impacts on bank’s
profitability. Afriyie and Akotey (2013) examine the impact of credit risk on the profitability of 10 rural and com-
munity banks for a period spanning 2006–2010. The results revealed a significant positive relationship between
NPL and profitability. Boahene et al. (2012), however, used six selected commercial banks in Ghana over the
period spanning 2005–2009 to examine how credit risk affects profitability respectively proxied by NPL and ROE.
Evidence based on their fixed effects estimation suggests that credit risk has positive and significant relationship
with profitability of banks which is consistent with Afriyie and Akotey (2013).
Indeed, the existing study on credit risk effects is largely mixed. The different methodologies and settings may
be driving these inconclusive findings. Beyond the inconclusive evidence, none of the existing studies have exam-
ined the differential effect of credit risk on profitability of banks. We fill this gap in the literature by first discus-
sing our methodology in the next section.

4. Methodology
4.1. Data and data sources
This study relies on annual panel data from 11 local and foreign banks gleaned over a period spanning from
2006 to 2016.3 We use two separate measures of profitability in this study. Our first measure is ROA which is
taken to indicate how efficient and profitable a bank is managed relative to the total assets. In this study, we
compute ROA as the ratio of net income (or profit after tax) to total assets expressed as a percentage. Indeed,
this indicator has also been extensively used in the literature to measure profitability (see Afriyie & Akotey, 2013;
Albulescu, 2015; Alper & Anbar, 2011; Kosmidou, Tanna, & Pasiouras, 2012; Petria et al., 2015; Tee, 2017). Our
second measure is ROE which is used to measure the amount of net income after taxes earned for each Ghana
Cedi of the equity capital paid by shareholders. In other words, ROE values the total profitability of fixed income
per Ghana Cedi of equity. ROE which is computed as the ratio of net income (or profit after tax) to total equity
capital has been used in several studies (Afriyie & Akotey, 2013; Albulescu, 2015; Alper & Anbar, 2011; Boahene
et al., 2012; Eldomiaty, Fikri, & El-Shater, 2015; Petria et al., 2015) to proxy profitability.
To measure credit risk, we use the NPLTA which is regarded as a significant indicator of risk where their low
(high) values indicate low (high) risk (Brewer & Jackson, 2006). This indicator is computed as the ratio of total
amount of NPL in banks’ loan portfolio to total assets. The presence of NPL is a probability that a loss will ensue
which requires provision to be made. Here, the loan loss provisioning is subtracted from the profitability of the
bank. Thus, the higher the NPL, the higher the loan loss provisioning. Boudriga, Taktak, and Jellouli (2009) posit
that the aggregate rate of NPLs is commonly taken as the measure of financial soundness which shows the qual-
ity of banks’ loans. A number of studies have used NPL as measures of credit risk (see for instance djeitsey, 2015;
Afriyie & Akotey, 2013; Albulescu, 2015; Hosna et al., 2009; Kithinji, 2010; Otieno, 2016; Tetteh, 2012; Shingjergji,
2014). To measure banks’ level of solvency, we use the CAR which is the ratio of capital to the risk-weighted sum
of the asset of the bank expressed as a percentage (Hyun & Rhee, 2011). It measures the amount of capital of a
bank in relation to the amount of the bank’s risk weighted credit exposures. Studies such as Hosna et al. (2009),
Li and Zou (2014), Shingjergji (2014), Adjeitsey (2015), Afriyie and Akotey (2013) employed CARs as proxies of
credit risk.
We also control for bank-specific variables such as total overhead costs, non-interest income, statutory reserves
and total deposits in order to examine how they affect influence profitability. In addition, we include macroeco-
nomic indicators such as private sector credit to GDP ratio, trade openness, inflation and GDP per capita. Indeed,
all these controls are chosen in line with the standard literature. We also investigate whether market and foreign
exchange risks respectively influence banks’ profitability. While the former is proxied by 91-day Government
Treasury bill (interest rate) volatility, foreign exchange risk is measured by the Ghana Cedi–US Dollar exchange
42 A. H. MADUGU ET AL.

rate volatility. We follow Alagidede and Ibrahim (2017) to model volatility using the Generalised Autoregressive
Conditional Heteroskedasticity (GARCH) by allowing the log of interest and exchange rates to depend on their
respective previous values for the mean equation.4 We respectively proxy the market and foreign exchange risks
by the interest rate and foreign exchange rate volatilities. As a robustness test, we also use the simple rolling
standard deviation to extract the market and foreign exchange rate. With regard to the data sources, all the data
on credit risk, profitability and bank-specific variables were sourced from the annual reports of the consolidated
financial statements of all the banks while data on interest and exchange rates were gleaned from Bank of
Ghana monetary time series dataset. For the macroeconomic variables, we rely on the World Development
Indicators of the World Bank.

4.2. Empirical strategy

This section discusses the empirical strategy used in examining the effect of credit risk on profitability of banks.

4.2.1. Fixed effects estimation approach

We examine the factors explaining profitability of banks by setting up a model where banks’ profitability is
influenced by credit risk, bank-specific and macroeconomic variables in addition to market and foreign
exchange risks. Specifically, we examine the impact of credit risk on banks’ profitability by specifying the
profitability model in a compact form as:
PROFit ¼ f ðCRISit , BANSPit , MACROit , MRISit , FXRISit , lit Þ
(1)
i ¼ 1, 2, :::, N; t ¼ 1, 2, :::, T
where PROFit is a vector of profitability; BANSPit is a vector of bank-specific variables; MACROit is a vector of
macroeconomic variables; MRISit is market risk; FXRISit represents the foreign exchange risk while lit is the error
term. i and t are the bank and time indices, respectively.
To examine the impact of credit risk on profitability, we re-write Equation (1) as follows:
PROFit ¼ bi þ @1 CRISit þ @2 BANSPit þ @3 MACROit þ @4 MRISit þ @5 FXRISit þ lit (2)
We estimate Equation (2) using the fixed effects approach where the constant term, bi is taken as group-spe-
cific hence allowing for different values for each group.5 On this score, this approach is also known as the least-
squares dummy variables estimator. Following from this, we re-write Equation (2) in matrix notation of the form:
Y ¼ Du þ Zcj þ l (3)
where
0 1 0 1 0 1
Y1 iT 0 0 Z11 Z12 Z1k
B ::: C B Z21 ::: C
B Y2 C B 0 iT 0 C B Z22 Z2k C
Y¼B C
B .. C ; D¼B .. .. .. C ; Z¼B . .. .. C
@ . A @ . . . A @ .. . . A
0 0 iT ZN1 ZN2 ZNk
YN NT1
NTN NTk

while
1 0 01
b1 c1
B b2 C B c2 C
u¼B C
B .. C and cj ¼ B C
B .. C
@ . A @ . A
bN NT1
cN k1

where the dummy variable permits different group-specific estimates for each of the constants for all the differ-
ent banks. Thus, although the constants may differ across the different banks, each individual’s intercept is time-
invariant over time. This notwithstanding, we examine whether to allow the different intercepts for each group
using the standard F-statistics which test the null hypothesis that all b1 , b2 , … ., bN are homogenous against het-
erogeneous alternative hypothesis. Our F test statistic is computed as:
 2 
RFE  R2CC =ðN1Þ
F¼  FðN1, NTNkÞ
ð1  R2FE Þ=ðNT  N  kÞ
 TRANSNATIONAL CORPORATIONS REVIEW 43

where R2FE represents the coefficient of determination of the fixed-effect model while R2CC is the coefficient of
determination of the common constant model. We have evidence to reject the null hypothesis if the computed
F-statistic is sufficiently larger than the F-critical and the associated p value is less than the conventional signifi-
cance levels at 1%, 5% and 10%.

5. Findings and discussions

This section presents and discusses findings based on the empirical estimations on the effect of credit risk on
profitability of banks using the fixed effects approach. Profitability is proxied using ROA while credit risk is meas-
ured by NPLTA. In Table 2, we present the results on the effect of NPLTA on profitability of all banks in addition
to the control variables.
In column 1 where only NPLTA is used as the independent variable, we find a positive and significant effect of
credit risk on profitability proxied by ROA. In particular, the coefficient of NPLTA is 0.362 suggesting that a 1%
increase in credit risk increases profitability by 0.362%. The implication is that higher credit risk spurs banks’ prof-
itability. Thus, while NPLTA is expected to reduce profitability, we do not observe this for Ghana. Indeed, we attri-
bute this positive and significant relationship between credit risk and profitability to the prohibitive lending rates
that the banks charge. This finding is consistent with other studies in Ghana notably Afriyie and Akotey (2013)
and Boahene et al. (2012). In column 2, we control for bank-specific variables in examining their effect on ROA in
addition to NPLTA. In this regression, the coefficient of credit risk maintains its positive and significant effect on
ROA albeit reduced coefficients. On the impact of bank-specific variables, the coefficients of total overhead costs,
statutory reserves and non-interest income are positive suggesting that increases in these variables support prof-
itability of banks. However, only non-interest income is statistically significant. The assertion that non-interest
income is profit-enhancing is consistent with the findings of Ahamed (2017) whose findings show that higher
share of non-interest income leads to higher profitability of banks in India. This notwithstanding, our evidence
does not support Lee et al. (2014) study where the authors find that, while non-interest activities of Asian banks
reduce risks, they do not increase profitability. Further evidence also reveals that higher deposits have a negative
effect on ROA although the impact is statistically insignificant. To the extent that banks transform deposits into
interest yielding loans to make profit may well mean that, higher deposit is expected to increase profitability.
However, this assertion is not supported by our data. What is found is that, if increase in deposit is to have any
effect on banks’ profitability in Ghana, such effect is rather a dampening one. In this regression, including the
bank-specific variables do not change the sign and significance of credit risk on profitability.

Table 2. Effect of NPLTA on ROA for all banks.

All banks (pooled)
Variables 1 2 3 4
Constant 2.756 [0.297] 2.210 [0.382] –1.358 [2.653] 1.188 [5.701]
NPLTA 0.362 [0.083] 0.321 [0.082] 0.284 [0.079] 0.284 [0.081]
TOC – 6.60e–09 [4.73e–09] 5.12e–09 [4.76e–09] 4.96e–09 [4.86e–09]
SRES – 8.15e–09 [8.64e–09] (0.348) 5.93e–09 [8.30e–09] (0.476) 5.66e–09 [8.38e–09]
TDEP – –4.95e–10 [6.86e–10] –8.64e–10 [6.96e–10] –8.80e–10 [7.02e–10]
NII – 2.84e–08 [1.24e–08] 1.53e–08 [1.32e–08] 1.43e–08 [1.34e–08]
PCRE – – 0.315 [0.277] 0.308 [0.286]
INFL – – –0.251 [0.110] –0.290 [0.132]
RGDPC – – 0.004 [0.003] 0.003 [0.004]
TRADE – – –0.048 [0.055] –0.047 [0.055]
MRISK – – – –0.010 [0.026]
FXRISK – – – –8.098 [14.688]
Diagnostics
F-statistic (p value) 18.94 (.000) 4.86 (.001) 4.66 (.000) 3.78 (.000)
R-squares:
Within 0.148 0.1909 0.2974 0.3002
Between 0.051 0.0056 0.1340 0.1417
Overall 0.091 0.1057 0.1684 0.1684
Rho 0.264 0.319 0.352 0.350
Number of groups 11 11 11 11
,  and  denote significance at 10, 5 and 1% levels respectively. Values in [ ] are the standard errors.
NPLTA: non–performing loans to total assets; TOC: total overhead cost; SRES: statutory reserves; TDEP: total deposits; NII: non–interest income; PCRE: pri-
vate credit; INFL: inflation; RGDPC: real GDP per capita; TRADE: trade openness; MRISK: market risk; FXRISK: foreign exchange risk.
44 A. H. MADUGU ET AL.

To examine how macroeconomic variables influence profitability, we include private credit, inflation, trade openness
and economic growth (proxied by real GDP per capita) as key variables in column 3. We observe that, the coefficient of
private credit and real GDP per capita are positive suggesting that increases in financial sector development and eco-
nomic growth spur profitability while that of inflation and trade openness are negatively associated with ROA.
However, only the impact of inflation is significant. Indeed, higher inflation may imply higher consumption expenditure
and reduced savings and deposits. To the extent that banks make profit based on customer deposits suggest that
bank profit falls with lower deposits. Thus, the dampening effect of inflation is intuitive. However, the insignificance of
private credit could be attributed to the underdevelopment of the financial markets while that of the economic growth
could be associated with low incomes. Also, the insignificance of the trade openness could be as a result of the rela-
tively closed economy. Perhaps, financial development, economic growth and openness are extremely low that their
impact on profit is benign. Interestingly, the credit risk effect is robust albeit reduced coefficient while the impact of
non-interest income loses its significance. Thus, unique bank characteristics do not matter in determining the profit-
ability of banks once macroeconomic variables are controlled for.
Beyond the impact of macroeconomic variables, we examine, in column 4, how market and foreign exchange
risks affect ROA in addition to NPLTA and bank-specific variables. Our findings show that the coefficients of both
market and foreign exchange risk are negative. This suggests that increases in interest and exchange rate volatil-
ity decrease profitability. However, the impact of both forms of risks is statistically insignificant. Thus, variability
and fluctuations in lending and Ghana Cedi–US Dollar exchange rate do not matter for ROA.6 In this specification,
the coefficient of credit risk maintains its positive and significant effect; an evidence revealing a robust amplifying
effect of credit risk on profitability.
While the above analyses examine the drivers of profitability irrespective of the type of bank by pooling all
banks together, in the next section, we use a sub-sample based on the type of bank in investigating the impact
of credit risk proxied by NPLTA on profitability measured by ROA. Findings based on the effect of credit risk on
profitability for both the local and foreign banks are presented in Table 3.

Table 3. Differential effects of NPLTA on ROA for local and foreign banks.
Local banks Foreign banks
Variables 1 2 3 4 1 2 3 4
Constant 3.689 [0.325] 2.791 [0.327] 0.169 [2.610] 7.575 [4.204] 2.611 [0.432] 1.949 [0.587] –3.065 [3.706] –2.993 [8.348]
NPLTA 1.029 0.673 0.626 0.579 0.329 0.282 0.242 0.221
[0.199] [0.216] [0.202] [0.199] [0.100] [0.099] [0.095] [0.099]
TOC – –6.73e–09 –6.68e–09 –8.09e–09 – 8.09e–09 8.90e–09 1.03e–08
[6.50e–09] [6.10e–09] [5.76e–09] [6.53e–09] [6.55e–09] [6.78e–09]
SRES – 3.74e–09 4.74e–09 3.14e–09 – –1.14e–08 –2.28e–08 –2.62e–08
[5.88e–09] [5.39e–09] [5.10e–09] [2.67e–08] [2.59e–08] [2.63e–08]
TDEP – –1.95e–09 –2.29e–09 –2.15e–09 – 1.47e–09 9.23e–10 8.92e–10
[6.15e–10] [6.65e–10] [6.26e–10] [1.17e–09] [1.15e–09] [1.16e–09]
NII – 3.10e–08 2.57e–08 2.91e–08 – 2.43e–08 8.70e–09 8.63e–09
[9.94e–09] [1.03e–08] [1.06e–08] [2.74e–08] [2.75e–08] [2.77e–08]
PCRE – – –0.018 [0.197] 0.051 [0.187] – – 0.503 [0.427] 0.400 [0.442]
INFL – – 0.083 [0.078] –0.169 – – –0.341 –0.355
[0.088] [0.167] [0.197]
RGDPC – – 0.005 0.001 [0.003] – – 0.003 [0.005] 0.004 [0.007]
[0.002]
TRADE – – –0.047 [0.040] –0.054 [0.038] – – –0.033 [0.081] –0.029 [0.081]
MRISK – – – –0.037 – – – 0.011 [0.039]
[0.017]
FXRISK – – – 9.716 [11.282] – – – –20.198
[22.264]
Diagnostics
F-statistic 26.72 (.000) 13.48 (.000) 10.35 (.000) 10.20 (.000) 10.82 (.001) 2.87 (.021) 3.03 (.004) 2.53 (.011)
(p value)
R-squares:
Within 0.4066 0.6582 0.7503 0.7946 0.1356 0.1856 0.3158 0.3284
Between 0.0004 0.5450 0.1789 0.6199 0.0914 0.0411 0.2098 0.1587
Overall 0.2863 0.6240 0.6172 0.7278 0.0792 0.0715 0.1851 0.1901
Rho 0.388 0.299 0.471 0.379 0.270 0.360 0.358 0.358
Number 4 4 4 4 7 7 7 7
of groups
,  and  denote significance at 10, 5 and 1% levels, respectively. Values in [ ] are the standard errors.
NPLTA: non–performing loans to total assets; TOC: total overhead cost; SRES: statutory reserves; TDEP: total deposits; NII: non–interest income; PCRE: pri-
vate credit; INFL: inflation; RGDPC: real GDP per capita; TRADE: trade openness; MRISK: market risk; FXRISK: foreign exchange risk.
 TRANSNATIONAL CORPORATIONS REVIEW 45

In column 1 where only NPLTA is used as the independent variable, a positive and significant impact of credit
risk on profitability is found. This is true for both local and foreign banks. In particular, the coefficients of NPLTA
for the local and foreign banks are 1.029 and 0.329, respectively, suggesting that a 1% increase in credit risk
increases profitability of local and foreign banks by 1.029% and 0.329%. This implies that, while higher credit risk
leads to higher profitability, the profit-enhancing effect is huge for local than foreign banks and measures about
3.12 times higher. This finding is consistent with our earlier finding that NPLTA promotes banks’ profitability.
Indeed, to the extent that local banks register higher ROA relative to the foreign banks suggest that local banks
may have higher interest rates. Available data from the Bank of Ghana (2017) reveal that, lending rates for some
selected local banks namely CAL Bank, Unibank and HFC respectively stand at 32.8%, 36.3% and 34.8% compared
to 23.6%, 22% and 28.7% for Barclays Bank, Standard Chartered Bank and Ecobank which are foreign banks.
Further evidence also reveals an average lending rate of 31.7% in the banking sector. Juxtaposing the lending
rates show higher rates for local banks which exceeds that of the foreign banks and the average rate of the bank-
ing sector. Thus, our argument that the higher interest rates of the local banks explain the higher profit-enhanc-
ing effect of NPLTA for the local banks relative to their foreign counterparts hold.
In column 2, the bank-specific variables are controlled for in order to examine their effect on ROA in addition
to NPLTA. In this regression, it is evident that the coefficients of credit risk maintain the positive and significant
effect on ROA albeit reduced coefficients for both local and foreign banks. More specifically, once the bank-spe-
cific variables are controlled for, the credit risk impact reduces from 1.029% to 0.673% for local banks and from
0.329% to 0.282% for foreign banks. Thus, while NPLTA improves profitability of banks, its effect continues to
matter more for local than foreign banks. Indeed, while we attribute the positive effect of credit risk on profitabil-
ity to the higher lending rates in the financial sector, the relatively huge effect for local banks may well confirm
the higher lending rates among local banks than foreign ones. On the impact of bank-specific variables, only the
coefficient of non-interest income is positive for both local and foreign banks suggesting that an increase in the
non-interest income increases profitability of banks irrespective of whether it is local or foreign. Thus, banks’
income diversification away from their traditional interest generating income improves profitability. Indeed, such
diversification moves are often seen in banks’ charges on withdrawal via the automated teller machines (ATM),
commissions, fees on certain key transactions including but not limited to interbank withdrawals, counter che-
ques clearing, profit on exchange rate, dividends from investments and other non-interest investment income
and service charges. However, while we document the profit-enhancing effect of non-interest income, it is only
statistically significant (at 1%) for local banks.
We also find that statutory reserves have a positive effect on profitability only in the case of local banks whilst
having a negative effect on ROA in relation to foreign banks but statistically insignificant in both cases. Further
evidence also reveals that, higher total overhead costs and higher deposits have a negative effect on ROA for
local banks. However, only the impact of total deposits is significant. With regard to foreign banks, both total
overhead costs and deposits have positive relationship with ROA suggesting that an increase in total overhead
costs and total deposits increased profitability. This notwithstanding, none of these have any significant effect. To
the extent banks make loans to increase their interest income and profitability from customer deposits, our evi-
dence emanating from this study does not support the assertion that deposit is a significant driver of profitability
for foreign banks.
Key macroeconomic variables were included in column 3 in the ROA regression for the purpose of examining
how the macroeconomy influences profitability. It is observed that, the coefficient real GDP per capita is positive
in relation to both local and foreign banks suggesting that increases in economic growth has a corresponding
increase in profitability. Furthermore, economic growth is statistically significant at 5% in the case of local banks
and insignificant for foreign banks. Private credit has a negative correlation with profitability relative to local
banks and a positive correlation with the foreign banks although statistically insignificant in both instances.
Inflation is also similar to real GDP per capita in terms of its signs as it records a positive correlation with ROA in
relation to local banks and a negative relationship with ROA relative foreign banks. While inflation is only signifi-
cant in relation to the foreign banks, the reverse is true for local banks. Trade openness has a consistent negative
effect on ROA whether or not the bank is local or foreign.
In column 4, we control for market and foreign exchange risks in order to determine their effect on ROA in
addition to NPLTA, bank-specific and macroeconomic variables. It is observed that whilst the coefficient of market
risk measured by interest rate volatility is significantly negative at 5% for local banks, it is at same time
46 A. H. MADUGU ET AL.

insignificantly positive for foreign banks. This implies that an increase in market risk significantly decreases profit-
ability proxied by ROA for the local banks. However, an increase in market risk appears to increase profitability of
foreign banks albeit insignificant. Foreign exchange risk records a positive coefficient in relation to local banks
whilst exhibiting a dampening profitability effect for foreign banks. This suggests that increases in exchange rate
volatility spurs ROA for locally-owned banks while decreasing the profitability for foreign-owned banks. However,
the impact of both the market and foreign exchange risks is statistically insignificant at all conventional levels for
both the local and foreign banks suggesting banks in Ghana are insulated from the effect of these risks. With
regard to the model adequacy, we observe that, the models are overall statistically significant at 1% suggesting
that credit risk, bank-specific indicators, macroeconomic variables, market and foreign exchange risks jointly drive
ROA of banks.

5.1. Effect of Capital adequacy ratio on profitability

Beyond examining the relationship between credit risk and profitability respectively proxied by NPLTA and ROA,
this section examines how robust the findings are to different proxies of profitability and CAR. Specifically, we
measure profitability by ROE and its relationship with CAR. Table 4 presents findings on the effect of CAR on ROE
while controlling the bank-specific and macroeconomic factors.
From the table, relative to the positive effect of NPLTA on ROA, we observe a negative and significant effect
of CAR on ROE. In column 1 where only CAR is used as the independent variable, a negative and significant
impact of credit risk on profitability is registered for all banks. In particular, the coefficient of CAR for all banks
recorded (–0.653) suggesting that a 1% increase in credit risk decreases profitability by 0.653%. This implies that
higher CAR lowers ROE of banks. From column 1 in Table 4, the coefficient of NPLTA is positive (0.362) which
means increases in credit risk measured by NPLTA increases profit by 0.362%. Comparing this to column 1 in
Table 4, the coefficient of credit risk measured by CAR is negative (–0.653) suggesting that higher credit risk
reduces profit by 0.653% following a unit-percentage rise in CAR. It could be observed that dampening effect of
credit risk measured by CAR is more than the profit-enhancing effect of credit risk measured by NPLTA. Mendoza
and Rivera (2017) stated that an inverse relationship between CAR and profitability is generally to be expected
because a bank that is adequately capitalised tend to be less risky and generate lower profits because of the per-
ception that it is safer. Our finding is consistent with Kutsienyo’s (2011) study who found that capital adequacy
negatively and significantly affects banks’ ROE of commercial banks in Ghana. The finding is also akin to Poudel
(2012) who found an inverse relationship between CAR and profitability of banks in Nepal.

Table 4. Effect of CAR on ROE for all banks.

All banks (Pooled)
Variables 1 2 3 4
Constant 30.388 [4.251] 25.320 [4.663] 26.117 [17.559] 67.626 [36.497]
CAR –0.653 [0.178] –0.457 [0.172] –0.421 [0.175] –0.421 [0.177]
TOC – 8.55e–08  [2.99e–08] 8.89e–08  [3.14e–08] 8.38e–08 [3.19e–08]
SRES – 7.69e–08 [5.40e–08] 7.27e–08 [5.40e–08] 6.88e–08 [5.42e–08]
TDEP – –2.46e–09 [4.23e–09] –2.26e–09 [4.46e–09] –2.45e–09 [4.47e–09]
NII – 1.75e–07 [7.68e–08] 1.46e–07 [8.48e–08] 1.37e–07 [8.56e–08]
PCRE – – 1.368 [1.825] 1.541 [1.857]
INFL – – –1.305 [0.722] –1.898 [0.856]
RGDPC – – 0.020 [0.024] 0.000 [0.029]
TRADE – – –0.436 [0.355] –0.432 [0.357]
MRISK – – – –0.211 [0.170]
FXRISK – – – –63.189 [94.229]
Diagnostics
F-statistic (p value) 13.48 (.000) 5.10 (.000) 3.63 (.000) 3.11 (.001)
R-squares:
Within 0.1100 0.1984 0.2480 0.2609
Between 0.3349 0.0028 0.0271 0.0200
Overall 0.1438 0.1392 0.1563 0.1662
Rho 0.253 0.330 0.349 0.347
Number of groups 11 11 11 11
,  and  denote significance at 10, 5 and 1% levels respectively. Values in [ ] are the standard errors.
NPLTA: non–performing loans to total assets; TOC: total overhead cost; SRES: statutory reserves; TDEP: total deposits; NII: non–interest income; PCRE: pri-
vate credit; INFL: inflation; RGDPC: real GDP per capita; TRADE: trade openness; MRISK: market risk; FXRISK: foreign exchange risk.
 TRANSNATIONAL CORPORATIONS REVIEW 47

In column 2, we control for bank-specific variables in order to examine their effect on ROE in addition to CAR.
From the table, it is evident that the coefficient of credit risk maintains its negative and significant effect on ROE
albeit reduced coefficient for all banks. On the impact of bank-specific variables, all the coefficients except total
deposits have a positive effect on profitability suggesting that increases in total overhead costs, statutory reserves
and non-interest income culminate into increases in profitability for all banks. Out of the four bank-specific varia-
bles, total overhead costs and non-interest income are statistically significant at 1% and 5%, respectively. To the
extent that total deposits negatively influence profitability albeit insignificantly, this study does not support the
opinion that increasing deposits support profitability of banks in Ghana.
We also control for macroeconomic variables in the ROE regression in column 3. Consistent with the earlier finding,
the coefficient of credit risk is significantly negative and slightly lower. Also consistent with our earlier evidence, among
the macroeconomic variables, only the impact of inflation on profitability is significant suggesting that higher macro-
economic instability constraints banks’ profitability. Private credit and real GDP per capita appear to positively influence
profit although the effect is insignificant statistically. Trade openness does not also matter for ROE of banks.
Market and foreign exchange risks were also included to determine their effect on ROA in addition to CAR,
bank-specific variables and macroeconomic variables. It is clear that the coefficient of CAR maintains its negative
and significant effect on ROE albeit reduced coefficient in contrast to columns 1 and 2. Interestingly, the impact
of CAR on ROE does not change once we control for market and foreign exchange risks (columns 3 and 4). We
find that both market and foreign exchange risks have negative effect on banks’ profitability. The implication is
that an increase in the volatilities of interest and exchange rate decreases ROE. However, both market and foreign
exchange risks effect is statistically insignificant at conventional levels.
So far, in this analysis, we have examined the impact of CAR on profitability measured by ROE for all banks
without disaggregating the effect for the different types of banks. In Table 4, we continue with the analysis of
ROE–CAR nexus with specific interest on how credit risk affects the profitability of local and foreign banks.
Overall, we find that, while the impact of CAR is largely negative for both local and foreign banks, the effect is
only significant for foreign banks irrespective of the model specifications. For instance, in column 1 where only
CAR is used as the independent variable, our finding shows a positive and an insignificant impact of credit risk
on profitability of local banks when credit risk is proxied by ROE. For the foreign banks, a unit–percentage
increase in CAR significantly reduces ROE by 0.844% (Table 5).
Following this positive and a significant impact of NPLTA on ROA noticed in Table 4, the coefficient of NPLTA
effect on ROA regression analysis is 0.362 and that of CAR on ROE is –0.653. By comparing the effect of the two
proxies of credit risk on profitability it is clear that the dampening effect is greater than the profit-enhancing
effect with CAR effect measuring about 1.804 times than that of NPLTA. This evidence is not consistent with the
theory that a well-capitalised bank potentially enjoys higher profitability. In column 2, bank-specific variables
were controlled for so as to examine their impact on ROE in addition to CAR. In this robustness analysis, it is clear
that the coefficients of credit risk do not maintain the positive impact on ROE for the local banks because it
changed signs. On the other hand, the coefficients of credit risk for the foreign banks maintained a negative and
significant relationship in all the regressions.
On the impact of bank-specific variables, the coefficients of statutory reserves and non-interest income have
positive effect on profitability for local banks suggesting that an increase in statutory reserves and non-interest
income support profitability of local banks. This notwithstanding, only the effect of non-interest income is signifi-
cant while statutory reserves effect is insignificant. However, non-interest income maintained its positive effect
with profitability albeit increased coefficient only that it became statistically insignificant relative to the foreign
banks. Total overhead costs and total deposits exhibit similar characteristics in the sense that they both have a
negative relationship with profitability with respect to local banks and a positive relationship with profitability
regarding foreign banks. The positive relationship implies that an increase in total overhead costs and total
deposits lead to a corresponding increase in profitability in the case of local banks. However, only total deposits
are statistically significant at all conventional levels. Contrasting it to the foreign banks, the negative relationship
implies that an increase in total overhead costs and total deposits decreases profitability of the foreign-owned
banks. However, only total deposits effect is robustly significant at all conventional levels. Thus, relative to local
banks, foreign banks are able to enhance profitability on the back of higher customer deposits. Therefore, the
extent to which banks transform deposits into interest yielding loans for the purpose of increasing profitability
48 A. H. MADUGU ET AL.

Table 5. Differential effects of CAR on ROE for local and foreign banks.
Local Banks Foreign Banks
Variables 1 2 3 4 5 6 7 8
Constant 15.197 [5.785] 23.546 [5.987] 19.813 81.820 35.135 [5.718] 29.967 [6.826] 24.467 57.903
[28.325] [46.458] [22.242] [49.331]
CAR 0.157 [0.295] –0.244 [0.278] –0.222 [0.284] –0.256 [0.278] –0.844 –0.635 –0.606 –0.552
[0.217] [0.215] [0.224] [0.233]
TOC – –8.78e–08 –8.14e–08 –8.85e–08 – 1.09e–07 1.18e–07 1.21e–07
[6.14e–08] [6.19e–08] [5.94e–08] [3.69e–08] [3.95e–08] [4.12e–08]
SRES – 1.62e–08 2.09e–08 2.10e–09 – –7.65e–10 –2.21e–08 –3.85e–08
[5.48e–08] [5.46e–08] [5.21e–08] [1.51e–07] [1.54e–07] [1.57e–07]
TDEP – –1.87e–08 –1.90e–08 –1.61e–08 – 1.07e–08 9.43e–09 8.98e–09
[4.72e–09] [5.52e–09] [5.43e–09] [6.58e–09] [6.81e–09] [6.88e–09]
NII – 1.73e–07 1.69e–07 2.23e–07 – 4.69e–08 1.91e–09 1.14e–08
[8.98e–08] [1.04e–07] [1.04e–07] [1.57e–07] [1.68e–07] [1.70e–07]
PCRE – – 0.256 [2.046] 0.676 [1.942] – – 2.067 [2.628] 1.912 [2.684]
INFL – – –1.015 [0.799] –1.543 [0.915] – – –1.389 [1.019] –1.961 [1.214]
RGDPC – – 0.011 [0.028] –0.029 [0.033] – – 0.022 [0.035] 0.010 [0.041]
TRADE – – –0.032 [0.413] –0.125 [0.390] – – –0.500 [0.481] –0.478 [0.486]
MRISK – – – –0.296 [0.186] – – – –0.127 [0.233]
FXRISK – – – 164.980 – – – –133.26
[112.339] [135.341]
Diagnostics
F-statistic 0.28 (.5985) 3.41 (.0129) 2.46 (.0302) 2.82 (.0124) 15.00 (.000) 5.60 (.000) 3.57 (.001) 2.97 (.003)
(p Value)
R-squares:
Within 0.0072 0.3276 0.4166 0.5171 0.1786 0.3076 0.3526 0.3644
Between 0.0003 0.7876 0.5451 0.9635 0.5590 0.0185 0.0177 0.0096
Overall 0.0054 0.3515 0.3753 0.5976 0.2181 0.2151 0.2414 0.2413
Rho 0.292 0.249 0.296 0.112 0.257 0.375 0.380 0.383
Number 4 4 4 4 7 7 7 7
of groups
,  and  denote significance at 10, 5 and 1% levels respectively. Values in [] are the standard errors. NPLTA: non–performing loans to total assets;
TOC: total overhead cost; SRES: statutory reserves; TDEP: total deposits; NII: non–interest income; PCRE: private credit; INFL: inflation; RGDPC: real GDP
per capita; TRADE: trade openness; MRISK: market risk; FXRISK: foreign exchange risk

may well be true in the case of foreign banks as higher deposit is expected to increase profitability. Thus, this
assertion supports only the foreign banks.
Macroeconomic variables were included in the ROE regression for the purpose of examining how macroeco-
nomic variables influence profitability. In column 3, it is observed that, the coefficients of real GDP per capita and
private credit are positive in relation to both local and foreign banks suggesting that increases in economic
growth has a corresponding increase in profitability irrespective of whether the bank has local or foreign owner-
ship. However, both real GDP per capita and private credit are statistically not significant at all levels for both
local and foreign banks. Further evidence suggests that inflation and trade openness negatively influence profit-
ability proxied by ROE. Thus, increases in inflation and trade openness reduce profitability. This is true for both
local and foreign banks. However, none of these is statistically significant.
By including market and foreign exchange risks in column 4, the study observes that the coefficient of market
risk is negatively related with profitability of local and foreign banks. However, market risk is not significant at
conventional levels for both banks. The study also finds a positive effect of foreign exchange risk for local banks
whilst recording a negative coefficient for foreign banks. Similar to the market risk, the impact of foreign
exchange risk on profitability is flatly insignificant. Thus, based on our sample evidence, whether we pool or dis-
aggregate the data, market and foreign exchange risks do not matter for banks’ profitability.

6. Conclusion and policy implications

This study examines the effect of credit risk and CAR on banks’ profitability in Ghana relying on data from 11
banks over the period 2006–2016. Results from our fixed effect estimation reveal that, credit risk proxied by NPLs
to total assets is positively and significantly related profitability measured by ROA. This effect holds irrespective of
the model specifications and the type of bank. However, while increases in NPLs to total assets increase ROA, this
effect is consistently huge for local banks relative to foreign banks. By conducting the analysis on the effect of
CAR on profitability proxied by ROE, the evidence shows that CAR negatively and robustly decreases profitability
for all banks suggesting that banks’ profitability decreases with higher solvency levels.7 While this holds, the
 TRANSNATIONAL CORPORATIONS REVIEW 49

negative effect of banks’ solvency is only significant for foreign banks. In the case of local banks, CAR effect
is imaginary.
Indeed, the positive relationship between NPLs to total assets and ROA implies that higher credit risk is associ-
ated with higher profitability. Thus, the rather higher lending rates may explain the positive effect. When banks
charge reasonable interest rate on their customers,’ loan portfolio performances tend to improve hence increas-
ing lender returns. Theoretically, NPLs to total assets reduces profitability. However, where NPLs to total assets
proportionally spurs profitability this may suggest that the lenders pass the cost of loan default to other custom-
ers in the form of higher interest rate on loan facilities. While this holds, the impact is huge for local banks rela-
tive to foreign banks. Indeed, we attribute this to the prohibitive lending or interest rates that the banks charge.
Thus, the profit-enhancing effect of credit risk shows that the relatively huge effect registered by local banks sug-
gest that local banks have higher interest rates compared to the foreign banks. Available data gleaned from the
Bank of Ghana show that the lending rates of all the local banks are higher than that of the foreign banks and
industry average. For instance, lending rate of Unibank is almost one and half higher than that of Standard
Chartered Bank. Thus, a loan facility from a local bank is costlier.
Another finding of this study is that CAR negatively and significantly decreases profitability for all banks. This
implies that, as the solvency of a bank increases its profitability tends to decrease. This is not consistent with the
theoretical concept of capital adequacy espoused by recent Basel III which seeks to promote soundness and sta-
bility of the international banking system by encouraging banks to improve on their capital strength to exact
higher profitability. In other words, CAR was, therefore, introduced to show banks’ strength to withstand risk with
the argument that banks’ ability to deal with risk improves their overall profitability. However, our finding reveals
that capital adequacy is not profit-enhancing as projected by this theoretical framework. Rather, a well-capitalised
bank is less risky and generates lower profits because of the perception that it is safe or because of large capital
immobilisation. This notwithstanding study shows that the dampening effect of CAR only holds for foreign and
not local banks. Since it is trite knowledge in Ghana that the foreign banks are capitalised than their local coun-
terparts, the significance of the CAR–ROE is unsurprising.
Indeed, individual bank-specific variables and non-interest income appear to matter more for profitability espe-
cially for local banks. Thus, the income diversification drive of banks contributes to increasing overall profitability.
The implication is that, a well-diversified bank that generates incomes through the non-traditional interest
income sources such as the ATM charges, fees and commission, investment income and other services charges
potentially improve profits. To the extent that this holds for local banks may well suggest that local banks are
aggressively pursuing income diversification agenda relative to foreign banks.
The main conclusion is that, credit risk impacts positively on profitability when proxied with NPL to total assets
and ROA respectively. Also, CAR negatively affects profitability, when measured by ROE. At the policy level, given
the differential effect of credit risk on profitability, our study provides fresh evidence highlighting that one-size-
does-not-fit-all and for that matter, different policy prescriptions are needed for both local and foreign banks.
Given the relationship between NPLs and ROA, we recommend that commercial banks take steps to improve
their credit risk management strategies in order to improve efficiency. Indeed, while higher NPLs appear to sup-
port profitability, it is imperative for banks to improve on their credit risk management strategies as the higher
profitability stemming from higher NPLs is made possible by the higher lending rates. To the extent that lending
rates are sticky downwards in Ghana may contribute to improved profitability, excessively higher NPLs may be
unhealthy for the overall workings of the financial sector. We, therefore, recommend for reduction of the prohibi-
tive lending rates in Ghana as lower lending rates potentially reduces default and NPLs. Assuming rational bor-
rowers, lower lending rates increase banks’ capacity to grant more credit thus increasing their profitability for the
banks and overall stability of the financial sector. At the same time, given the CAR –profitability nexus, we cau-
tion that policy makers do not implement a blanket enforcement of the CAR policy, because raising the capital
requirements of banks with the aim of making them more solvent does not guarantee higher profitability.

Notes
1. New European Union member states considered are: Bulgaria, the Czech Republic, Hungary, Latvia, Lithuania, Poland
and Romania.
2. Six countries namely: Chile, Colombia, El Salvador, Honduras, Mexico and Paraguay.
50 A. H. MADUGU ET AL.

3. The local banks are four whilst the foreign banks are seven. The local banks included CAL Bank Limited, Home Finance
Company (HFC) Bank Ghana Limited, UniBank Ghana Limited and Ghana Commercial Bank (GCB) Limited. The foreign
banks consist of Banque Sahelo–Saharienne pour I’Investissement et le Commerce (BSIC Ghana Limited), Barclays Bank of
Ghana Limited, Ecobank Ghana Limited, Guaranty Trust Bank (Ghana) Limited, Societe General Ghana Limited, Standard
Chartered Bank (Ghana) Limited and Zenith Bank (Ghana) Limited.
4. For brevity, we do not show the plots of their volatility clustering but they are available upon request from the authors.
5. We do not use the generalised method of moments (GMM) owing to the number of cross-sections (N) relative to the time
span (T). To use the GMM, N > T. However, our T ¼ N ¼ 11. More so, if we disaggregate the sample, we will have N ¼ 7 for
the foreign banks and N ¼ 4 for the local banks which are individually less than T. To the extent that, N < T at the
disaggregated level, the use of the GMM will produce bias results although it is capable of controlling for endogeneity.
6. We also use simple rolling standard deviation to extract the volatility for both market and foreign exchange risks. The
results are qualitatively similar to those found here. We do not report those findings for brevity but are available upon
request from the authors. The suggestion of one of the reviewers is acknowledged here.
7. We are very grateful to one of the anonymous reviewers for raising this.

Disclosure statement
No potential conflict of interest was reported by the authors.

Notes on contributors
Ali Hussam Madugu holds a Master of Commerce (Banking and Finance option) degree from the University for Development
Studies (UDS), Wa, Ghana. He also holds Bachelor of Laws, LLB (Hons) from Coventry University in UK. He is a Budget Analyst
with the Tamale Metropolitan Assembly, Northern region, Ghana.
Muazu Ibrahim holds PhD in Finance from University of the Witwatersrand, South Africa. He also holds MSc. in Development
Economics from School of Oriental and African Studies (SOAS), University of London, UK. He teaches in the Department of
Banking and Finance, School of Business and Law (SBL), UDS, Wa, Ghana.
Joseph Owusu Amoah holds Master of Commerce (Accounting option) and BA in Integrated Business Studies (Accounting
option) degrees both obtained from the University for Development Studies (UDS), Wa, Ghana. He served as a Research
Assistant in the School of Business and Law (SBL), UDS. Ghana.

ORCID
Muazu Ibrahim http://orcid.org/0000-0002-1286-0564

References
Abu-Hanifa, M.N., Chowdhury, N.J., Chowdhury, M.M., & Pervin, S. (2015). The effect of bank specific and macroeconomic deter-
minants of banking profitability: A study on Bangladesh. International Journal of Business and Management, 10, 287–297.
doi:10.5539/ijbm.v10n6p287
Adjeitsey, G. (2015). Effect of credit risk on the profitability of rural banks in Ghana: A case of Atwima Kwanwoma rural bank lim-
ited. Kumasi, Ghana: Department of Accounting and Finance, School of business, Kwame Nkrumah University of Science
and Technology.
Adu, L.A., & Adjare, T.T. (2014). Determinants of credit risk of commercial banks in Ghana. SSRN Electronic Journal, 1–7. doi:10.
2139/ssrn.2679100
Afriyie, H.O., & Akotey, J.O. (2013). Credit risk management and profitability of rural banks in the Brong Ahafo region of
Ghana. European Journal of Business and Management, 5, 24–33.
Ahamed, M.M. (2017). Asset quality, non-interest income, and bank profitability: Evidence from Indian banks, Economic
Modelling, 63, 1–14.
Akinkunmi, M.A. (2017). Determinants of banks’ profitability in Nigeria: Does relative market power matter? Journal of Finance
and Bank Management, 5, 42–50. doi:10.15640/jfbm.v5n1a4
Alagidede, P., & Ibrahim, M. (2017). On the causes and effects of exchange rate volatility on economic growth: Evidence from
Ghana. Journal of African Business, 18, 169–193. doi:10.1080/15228916.2017.1247330
Albulescu, C.T. (2015). Banks’ profitability and financial soundness indicators: A macro-level investigation in emerging coun-
tries. Procedia Economics and Finance, 23, 203–208. doi:10.1016/S2212-5671(15)00551-1
Alper, D., & Anbar, A. (2011). Bank specific and macroeconomic determinants of commercial bank profitability: Empirical evi-
dence from Turkey. Business and Economics Research Journal, 2, 139–152.
Amidu, M., & Hinson, R. (2006). Credit risk, capital structure and lending decisions of banks in Ghana. Banks and Bank Systems,
1, 92–101.
 TRANSNATIONAL CORPORATIONS REVIEW 51

Amuakwa-Mensah, F., Marbuah, G., & Marbuah, D.A.A. (2017). Re-examining the determinants of non-performing loans in
Ghana’s banking industry: Role of the 2007–2009 financial crisis. Journal of African Business, 18, 357–379. doi:10.1080/
15228916.2017.1308199
Arhin, E.E. (2017). Economic determinants of non-performing loans among nine banks in the Ghanaian economy. Kumasi, Ghana:
Kwame Nkrumah University of Science and Technology (KNUST).
Bank of Ghana. (2015). Annual report. Accra, Ghana: Bank of Ghana. Retrieved March 10, 2017, from http://www.bog.gov.gh/
Bank of Ghana. (2017). Banking sector report. Vol. 2–3. Retrieved October 20, 2017, from http://www.bog.gov.gh/
Bernanke, B., Gertler, M., & Gilchrist, S. (1999). The financial accelerator in a quantitative business cycle framework. In J. Taylor
& M. Woodford (Eds.), Handbook of macroeconomics (p. 1). Amsterdam, Netherlands: Elsevier.
Boahene, S.H., Dasah, J., & Agyei, S.K. (2012). Credit risk and profitability of selected banks in Ghana. Research Journal of
Finance and Accounting, 3, 1–14.
Boudriga, A., Taktak, N.B., & Jellouli, S. (2009). Banking supervision and nonperforming loans: A cross-country analysis. Journal
of Financial Economic Policy, 1, 286–318. doi:10.1108/17576380911050043
Brewer, E., & Jackson, W.E. (2006). A note on the “risk-adjusted” price concentration relationship in banking. Journal of Banking
& Finance, 30, 1041–1054. doi:10.1016/j.jbankfin.2005.06.006
Carey, A. (2001). Effective risk management in financial institutions: The Turnbull approach. Balance Sheet, 9, 24–27. doi:10.
1108/09657960110696014
Cucinelli, D; Financial Intermediation University of Milan. (2015). The impact of non-performing loans on bank lending behav-
iour: Evidence from the Italian banking sector. Eurasian Journal of Business and Economics, 8, 59–71. doi:10.17015/ejbe.2015.
016.04
Ebenezer, O.O., & Omar, W.A.W. (2016). The empirical effects of credit risk on profitability of commercial banks: Evidence from
Nigeria. International Journal of Science and Research, 5, 1645–1648. doi:10.21275/ART2016315
Eldomiaty, T., Fikri, A., & El-Shater, D. (2015). The relative contribution of micro and macroeconomic determinants of bank prof-
itability: Empirical study on MENA and EU. European Journal of Economics, Finance and Administrative Sciences, 76, 89–110.
Froot, K.A., Scharfstein, D.S., & Stein, J.C. (1993). Risk management: Coordinating corporate investment and financing policies.
The Journal of Finance, 48, 1629–1658. doi:10.1111/j.1540-6261.1993.tb05123.x
Gil-Diaz, F. (1994). The origin of Mexico’s 1994 financial crisis. Cato Journal, 17, 303–313.
Hosna, A., Manzura, B., & Juajuan, S. (2009). Credit risk management and profitability in commercial banks in Sweden (Master
thesis). Retrieved from https://Gupea.ub.gu.se
Hyun, J., & Rhee, B. (2011). Bank capital regulation and credit supply. Journal of Banking & Finance, 35, 323–330. doi:10.1016/j.
jbankfin.2010.08.018
IMF. (2017). Article IV consultation, fourth review under the extended credit facility arrangement, request for waiver for nonobserv-
ance of performance criteria, and request for extension and rephasing of the arrangement for Ghana (IMF Country Report No.
17/262). Washington (DC): International Monetary Fund.
Jorda, O., Schularick, M., & Taylor, A. (2013). When credit bites back. Journal of Money, Credit and Banking, 45, 3–28. doi:10.
1111/jmcb.12069
Kargi, H.S. (2011). Credit risk and the performance of Nigerian banks. Zaria, Nigeria: Ahmadu Bello University.
Kithinji, A.M. (2010). Credit risk management and profitability of commercial banks in Kenya: School of business. Nairobi, Kenya:
University of Nairobi.
Kolapo, T.F., Ayeni, R.K., & Oke, M.O. (2012). Credit risk and commercial banks’ performance in Nigeria: A panel model
approach. Australian Journal of Business and Management Research, 2, 31–38.
Kosmidou, K., Tanna, S., & Pasiouras, F. (2012). Determinants of profitability of domestic UK commercial banks: Panel evidence
from the period 1995–2002. Economics, finance and accounting applied research Working Paper Series No. RP08. Retrieved
from http://wwwm.coventry.ac.uk/bes/cubs/aboutthebusinessschool/Economicsfinanceandacconting/Pages/AppliedResearch
WorkingPapers.aspx
Kutsienyo, L. (2011). The determinant of profitability of banks in Ghana (Master’s thesis). Kumasi, Ghana: Kwame Nkrumah
University of Science and Technology.
Lee, C-C., Yang, S-J., & Chang, C-H. (2014). Non-interest income, profitability, and risk in banking industry: A cross-country ana-
lysis. The North American Journal of Economics and Finance, 27, 48–67.
Li, F., & Zou, Y. (2014). The impact of credit risk management on profitability of commercial banks: A study of Europe (pp. 1–30).
Umeå, Sweden: Umea School Business and Economics.
Mendoza, R., & Rivera, J.P.R. (2017). The effect of credit risk and capital adequacy on the profitability of rural banks in the
Philippines. Scientific Annals of Economics and Business, 64, 83–96. doi:10.1515/saeb-2017-0006
Ntow-Gyamfi, M., & Boateng, S.S. (2013). Credit risk and loan default among Ghanaian banks: An exploratory study.
Management Science Letters, 3, 753–762. doi:10.5267/j.msl.2013.01.015
Ogbulu, O.M., & Eze, G. P. (2016). Credit risk management and the performance of deposit money banks in Nigeria: An error
correction analysis. Redfame, Applied Economics and Finance, 3, 97–98. doi:10.11114/aef.v3i2.1356
Otieno, J.J.A. (2016). Credit risk management practices on loan portfolio of Barclays bank of Kenya. Nairobi, Kenya: University of
Nairobi.
Padmanabham, K.P. (1988). Rural credit: Lessons for rural bankers and policy makers. London: Intermediate Technology
Publication Ltd.
 52 A. H. MADUGU ET AL.

Peek, J., & Rosengren, E. (2000). Collateral damage: Effects of the Japanese bank crisis on real activity in the United States.
American Economic Review, 90, 30–45. doi:10.1257/aer.90.1.30
Peek, J., & Rosengren, E. (2005). Unnatural selection: Perverse incentives and the misallocation of credit in Japan. American
Economic Review, 95, 1144–1166. doi:10.1257/0002828054825691
Petria, N., Capraru, B., & Ihnatov, I. (2015). Determinants of banks’ profitability: Evidence from EU 27 banking systems. Procedia
Economics and Finance, 20, 518–524. doi:10.1016/S2212-5671(15)00104-5
Poudel, R.P.S. (2012). The impact of credit risk management on financial performance of commercial banks in Nepal.
International Journal of Arts and Communication, 1, 9–15.
PwC (PricewaterhouseCoopers). (2016). Ghana banking survey for 2016. How to win in an era on mobile money. Retrieved
November 11, 2017, from http://www.pwc.com/gh
PwC (PricewaterhouseCoopers). (2017). Ghana banking survey for 2017. Risk-based minimum regulatory capital regime: What
it means for banks in Ghana. Retrieved November 10, 2017, from http://www.pwc.com/gh
Roman, A., & Tomuleasa, I.I. (2013). Analysis of profitability determinants: Empirical evidence of commercial banks in the new
EU member states. Iasi, Romania: Alexandru Ioan Cuza University of Ias, i, Faculty of Economics and Business Administration,
Department of Finance, Money and Public Administration.
Saka, A.N.A., Aboagye, Q.Q.A., & Gemegah, A. (2012). Technical efficiency of the Ghanaian banking industry and the effects of
the entry of foreign banks. Journal of African Business, 13, 232–236. doi:10.1080/15228916.2012.727755
Shingjergji, A. (2014). The impact of bank specific variables on the non-performing loans ratio in the Albanian banking system.
Research Journal of Finance and Accounting, 4, 148–151.
Tee, E. (2017). Asset liability management and the profitability of listed banks in Ghana. IOSR Journal of Economics and
Finance, 3, 9–14. doi:10.9790/5933-0803040914
Tetteh, F.L. (2012). Evaluation of credit risk management practices in Ghana commercial bank limited (Master thesis). Kumasi,
Ghana: Kwame Nkrumah University of Science and Technology.

View publication stats