ADDIS ABABA UNIVERSITY

SCHOOL OF GRADUATE STUDIES

DEPRATMENT OF ACCOUNTING AND FINANCE

The Impact of Credit Risk Management on Financial Performance of Private

Commercial Bank in Ethiopia

By: Ato Habtamu Ayalew

Advisor: Ato G/Medhin G/Hiwot

A Thesis Submitted To: - The Department Of Accounting and Finance

College Of Business and Economics

Presented In Partial Fulfillment of the Requirements for the Degree of Master of Science in
Accounting and Finance

Addis Ababa

March 2018

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 DECLARATION

I hereby declare that this thesis entitled “the impact of credit risk management on the financial
performance of private commercial banks in Ethiopia.” Has been carried out by me under the guidance
and supervision of Ato. G/medhin G/hiwot.

This thesis is my original work and has never been submitted to any university for academic credit.

Researcher Name Date Signature

Habtamu Ayalew …………………………… …………………………

Adviser Name Date Signature

G/medhin G/Hiwot ……………………… ………………………………

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 ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

CERTIFICATION

This is to certify that the thesis prepared by Habtamu Ayalew, entitled: The Impact of Credit Risk
Management on Financial Performance of Private Commercial Banks in Ethiopia and submitted in partial
fulfilment of the requirements for the Degree of Master of Science in Accounting and Finance act in
accordance with the regulations of the University and meets the accepted standards with respect to
originality and quality.

Approved by:

Internal examiner:............................... Signature .........................Date .............................

External examiner:............................... Signature ...........................Date ...........................

Advisor: Ato G/Medhin G/Hiwot Signature ..........................Date ............................

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 Acknowledgements

First and foremost I thank the Almighty God who gave me power and patience in every endeavor of my
life. Next, I would like to extend my deeper indebtedness to my advisor Ato G/Medhin G/Hiwot for his
professional guidance, constructive comments, and valuable suggestions. Finally, I would like to express
my immense thankfulness to my family and friends who provided me all the necessary assistance in
finishing my thesis.

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 Abstract

This study aimed at examining the impact of credit risk management on the financial performance of
private commercial banks in Ethiopia. The study used secondary data for eight private banks which
stayed in the industry more than ten years among sixteen private commercial banks which is functional at
the moment in Ethiopia banking industry. The Data to do the analysis is obtained from banks annual
report, National bank report. In this study correlation and multiple regression analysis done with random
effect model and E-Views 9 software used for the regression of the panel data. Random effect panel
regression was used for the data of eight private commercial banks in Ethiopia for the sample covered the
period from 2007 to 2016.Return on Asset and Return on Equity were dependent variables while non-
performing loan, capital adequacy, bank size, leverage ratio, credit interest income ratio, loan loss
provision ratio and operation cost efficiency have taken as an independent variables. The results of panel
data regression analysis showed that credit risk indicator variables of Loan loss provision (LLP), Capital
adequacy ratio (CAR), credit interest income (CIR) and size of the bank (SIZE) had positive and
statistically significant effect on financial performance of private commercial banks in Ethiopia. And
credit risk indicator of Nonperforming loans (NPLs), Leverage ratio (LR) and operational cost efficiency
(OCE) had negative and statistically significant effect on banks’ financial performance. The study
suggests that Ethiopian commercial banks should/need to work more to improve their financial
performance and to reduce their credit risk. Moreover, banks should exert additional effort to properly
manage their loan portfolio in order to enhance their profitability.

Key words: Non-performing loans, financial performance, Commercial Banks, Ethiopia

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Contents
DECLARATION .................................................................................................................................... ii
CERTIFICATION.................................................................................................................................. iii
Acknowledgements ................................................................................................................................ iv
Abstract................................................................................................................................................... v
List of Tables and Figures ....................................................................................................................... x
List of Acronyms .................................................................................................................................... xi
CHAPTER ONE ..................................................................................................................................... 1
1. INTRODUCTION ............................................................................................................................... 1
1.1Back Ground of the study ................................................................................................................... 1
1.2. Statement of the Problem .................................................................................................................. 3
1.3 Research Questions ............................................................................................................................ 4
1.4. Objectives of the Study ..................................................................................................................... 4
1.4.1. General objective ........................................................................................................................... 4
1.4.2. Specific objectives ......................................................................................................................... 5
1.5. Hypothesis of the Study .................................................................................................................... 5
1.6. Significance of the Study .................................................................................................................. 6
1.7. Scope of the Study ............................................................................................................................ 6
1.8 Limitation of the Study ...................................................................................................................... 6
1.9 Organization of Study ........................................................................................................................ 7
CHAPTER TWO .................................................................................................................................... 8
2. REVIEW OF RELATED LITERATURES .......................................................................................... 8
Introduction............................................................................................................................................. 8
2.1. Theoretical Review ........................................................................................................................... 8
2.1.1. The Pecking Order Theory ............................................................................................................. 8
2.1.2 Asymmetric Information Theory ..................................................................................................... 8
2.1.3 Agency Theory ............................................................................................................................... 9
2.1.4 Modern Portfolio Theory .............................................................................................................. 10
2.1.5. Theory of Multiple-Lending ......................................................................................................... 11
2.1.6. The Signaling Arguments............................................................................................................. 11
2.2 Related Pervious Empirical Studies .................................................................................................. 12

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2.2.1 International Empirical Review ..................................................................................................... 12
2.2.2 Local Empirical Review ................................................................................................................ 15
2.3 Summary and Knowledge Gap ......................................................................................................... 16
2.4 Conceptual Framework of the Study ................................................................................................ 18
CHAPTER THREE ............................................................................................................................... 19
3. METHODOLOGY ............................................................................................................................ 19
3.1. Research Design ............................................................................................................................. 19
3.2. Research Approach Adopted ........................................................................................................... 20
3.3. Sampling Design ............................................................................................................................ 21
3.3.1. Study Population.......................................................................................................................... 21
3.3.2 Sampling Technique ..................................................................................................................... 22
3.3.3. Sample Size ................................................................................................................................. 22
3.4 Nature of Data, Instrument of Data Collection, Data Analysis and Presentation ............................. 23
3.4.1. Nature of Data and Instrument of Data Collection ........................................................................ 23
3.4.2. Data Analysis and Presentation .................................................................................................... 23
3.5. Study Variables .............................................................................................................................. 24
3.5.1 Dependent Variables ..................................................................................................................... 24
3.5.1. Return on Assets (ROA) .............................................................................................................. 24
3.5.2 Independent Variables .................................................................................................................. 24
3.5.2.1. Non Performing Loans (NPL) ................................................................................................... 24
3.5.2.2. Loan Loss Provision ratio (LLP) ............................................................................................... 25
3.5.2.3. Capital Adequacy Ratio (CAR) ................................................................................................. 25
3.5.2.3. Leverage Ratio .......................................................................................................................... 26
3.5.2.4. Credit Interest Income Ratio (CIR) ............................................................................................ 27
3.5.2.5. Bank Size (SIZE) ...................................................................................................................... 28
3.5.2.6. Operational Cost Efficiency ...................................................................................................... 28
3.6 Model Specification ......................................................................................................................... 29
CHAPTER FOUR ................................................................................................................................. 32
RESULTS AND DISCSSIONS ............................................................................................................. 32
4.1. Descriptive Statistics....................................................................................................................... 32
4.2 Correlation Analysis ........................................................................................................................ 34
4.3 Regression Model Test .................................................................................................................... 37
4.3.1 Classical Linear Regression Model Assumption ............................................................................ 37

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4.3.1.1. Test for Average Value of the Error Term is Zero Assumption .................................................. 37
4.3.1.2. Test for Heteroskedasticity Assumption .................................................................................... 37
Table 4.3.Heteroskedasticity Test: the Breusch- Pagan-Godfrey test ...................................................... 38
4.3.1.3. Test for Absence of Autocorrelation Assumption ...................................................................... 38
4.3.1.4. Test of Normality ...................................................................................................................... 39
4.3.1.5. Test for Multicollinearity .......................................................................................................... 40
4.4. Choosing Random Effect (RE) Vs Fixed Effect (FE) Models .......................................................... 42
4.5. Regression Analysis of Financial Performance (Return on Asset) .................................................... 43
4.5.1 Operational Model ........................................................................................................................ 44
4.5.2. Interpretation of Regression Results ............................................................................................. 44
4.5.2.1 Loan Loss provision ratio (LLP) to Return on asset (ROA) ........................................................ 45
4.5.2.2 Non performing Loan Ratio (NPLs) to Return on Asset (ROA) .................................................. 46
4.5.2.3 Bank Size (SIZE) to Return on Asset (ROA) .............................................................................. 46
4.5.2.4 Leverage Ratio (LR) to Return on Asset (ROA) ......................................................................... 47
4.5.2.5 Credit Interest Income Ratio (CIR) to Return on Asset (ROA) .................................................... 48
4.5.2.6 Capital Adequacy Ratio (CAR) to Return on Asset (ROA) ......................................................... 48
4.5.2.7 Operational Cost Efficiency (OCE) to Return on Asset (ROA) ................................................... 49
Table 4.9. Comparison of test results with the hypothesis....................................................................... 50
CHAPTER FIVE ................................................................................................................................... 51
5.1 Summary of Finding ........................................................................................................................ 51
5.2 Conclusion ...................................................................................................................................... 52
5.3. Recommendations .......................................................................................................................... 54
5.4. Future Research Recommendations................................................................................................. 55
REFERENCES...................................................................................................................................... 56

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Annexes…………………………………………………………………………………………………

Annex-1: Hetroscedasticity Test: Breausch-Pagan-Godfrey…………………………………...............

Annex-2: Serial correlation LM Test: Breausch-Pagan-Godfrey ………………………………….……

Annex -3: Normality Test………………………………………………………………………………

Annex -4: Correlated Random Effects: Hausman Test…………………………………….…………….

Annex -5: Random effects model regression results (Return on Asset)…………………………………

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 List of Tables and Figures
Table 1.1: Asset Classification Category and Minimum provision…………………………………………

Table 4.1: Descriptive statistics of the dependent and independent variables……………………………….

Table 4.2: Correlation Matrix of Dependent and Independent Variables……………………………………

Table 4.3: Heteroskedasticity Test…………………………………………………………………………...

Table 4.4: Breusch-Pagan-Godfrey Serial Correlation LM Test……………………………………………

Table 4.5: Correlations matrix of explanatory variables…………………………………………………….

Table 4.6: Hausman test……………………………………………………………………………………...

Table 4.7: Random effects model regression results (Return on Asset)…………………………………….

Table 4.8: Random effects model regression results (Return on Equity)……………………………………

Table 4.9: Comparison of test result with the hypothesis……………………………………………………

Figure 2.1: The conceptual framework or model of the study……………………………………………...

Figure 4.1: Normality test for residuals……………………………………………………………………

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 List of Acronyms
AB Abay Bank S.C

AdIB Addis International Bank S.C

AIB Awash International Bank S.C

BOA Bank of Abyssinia S.C

BIB Berehan International Bank S.C

BUIB Buna International Bank S.C

CAR Capital Adequacy Ratio

CBO Cooperative Bank of Oromia S.C

CIR Credit Interest Income Ratio

DB Dashen Bank S.C

DGB Debub Global Bank S.C

EB Enat Bank S.C

LIB Lion International Bank S.C

LLP Loan Loss Provision

LR Leverage Ratio

OCR Operational Cost Efficiency

OIB Oromia International Bank S.C

PCBs Private Commercial Banks

NBE National Bank of Ethiopia

NIB Nib International Bank S.C

NPLs Non-performing Loans

ROE Return on Equity

UB United Bank S.C

VIF Variance Inflation Factor

WB Wogagen Bank S.C

ZB Zemen Bank S.C

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 CHAPTER ONE

1. INTRODUCTION

1.1Back Ground of the study

Financial institutions are performing a key role in economic growth as they are mobilizing savings for
productive investments through facilitating role in capital flows towards various sectors of the economy
(Shanmugan and Bourke, 1990) and (Sufian and Paraman, 2009). It is also worth to note that commercial
banks in most of the world economies are dominant type of financial institution that provides installment,
facilitates the internal and external trade and the movement of money and capital when compared to any
other financial institution (Greuning and Bratanovic, 2003. Saini and Sindhu, 2014).

Banks are intermediaries between depositors and borrowers in an economy in which they are
distinguished from other types of financial firms by collecting deposit and offering loan products,
(Heffernan, 1996). According to (Bossone,2001) banks are special intermediaries because of their unique
capacity to finance production by lending their own debt to agents willing to accept it and to use it as
money. Hence, commercial banks are the dominant financial institutions in most economies of developing
or developed countries. They play a critical role to emerging economies where most borrowers have no
access to capital markets. Well-functioning commercial banks accelerate economic growth, while poorly
functioning commercial banks are an obstacle to economic progress and aggravate poverty, (Richard,
2011).
The beginning of modern banking system in Ethiopia dated back to 1905 with the establishment of bank
of Abyssinia. But it was only after the dawn fall of the Derge regime that the private owners are allowed
to participate in the banking business. The change of government in 1991 and the consequent changes in
economic policy witnessed transformation in the banking industry. Monetary and banking proclamation
of 1994 established the national bank of Ethiopia as a judicial entity, separated from the government and
outlined its main functions. Monetary and banking proclamation no.83/1994 and the licensing and
supervision of banking business no.84/1994 laid down the legal basis for participation of private sector in
banking business. Now a days there are about two governmental banks namely Commercial Bank of
Ethiopia and Development Bank of Ethiopia and around sixteen private banks namely Dashen Bank,
Awash International Bank, Cooperative Bank of Oromia, Oromia International Bank, Nib International
Bank, United Bank, Bank of Abyssinia, Addis International Bank, Bunna International Bank, Wegagen
Bank, Zemen Bank, Berehan International Bank, Lion International Bank, Debub Global Bank, Abay
Bank and Enat Bank S.C (NBE, 2011).

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Banking sector provides a wide range of financial services and plays important & central role in the
economy and the society as a whole. Particularly, Commercial banks play a vital role in the economic
resource mobilization and allocation of countries by which they make the community’s surplus of
deposits and investments useful by lending it to people for various investment purposes. Loans and
advances, therefore, represent the majority of commercial banks’ assets and source of income.

According to directives of national bank of Ethiopia “Loan” or “Advance” means any financial asset of
the bank arising from the direct or indirect advances by a bank to a person that are conditioned on the
obligation of the person to repay the fund, either on a specified date or dates usually within interest (NBE
2002).

The efficient and effective performance of the banking industry over time is an index of financial stability
in any nation. The extent to which a bank extends credit to the public for productive activities accelerates
the pace of a nation’s economic growth and its long-term sustainability.

The credit function of banks enhances the ability of investors to exploit desired profitable ventures. It’s
crystal clear that credit creation is the main income generating activity of banks. However, it exposes the
banks to credit risk (Basel Accord, 2001). Credit remains the primary source of revenue for any bank
around the world. However the probability of default borrowers’ loan commitments has been an
increasing concern for those banks particularly for unsecured bank loans. This risk could be categorized
as credit risk. The risk poses a significant exposure not only to the banks (lenders) but also to the entire
economy, this is because of the fact that the banking is a vital industry of any economy. This emphasizes
the importance of managing the credit risk within the banking sector. Banks grant loans to the customer
with an expectation of receiving the capital together with an interest. A loan facility is considered to be
performing if payment of both capital and interest are paid accordingly with agreed repayment terms. The
Non Performing Loans (NPL) represents credits which the banks perceive as possible loss of funds due to
customers failure to repay the monthly installments. They are further classified into substandard and
doubtful bank credit category hinders bank from achieving their set targets. Proper risk management is
essential for the survival of a bank, and it enables management to allocate resources to risk units based on
a tradeoff between risk and return potential (Charles, Okaro Kenneth (2013). Credit risk is the potential
that a contractual party will fail to meet its obligations in accordance with the agreed terms (Brown and
Moles, 2012). It, as defined by the Basel Committee on Banking Supervision (2001), is also the
possibility of losing the outstanding loan partially or totally, due to credit events (default risk). Credit risk
is an internal determinant of bank performance. The higher the exposure of a bank to credit risk, the
higher the tendency of the bank to experience financial crisis and vice-versa.

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1.2. Statement of the Problem
Banks play very important roles in the economic development and growth of any nation. As an important
component of the financial system, they channel scarce resources from the surplus economic units to the
deficit economic units in the form of credit as such this activities form part of their existence (Iwedi &
Onuegbu, 2014).

The financial performance of these banks can be affected by internal and external determinants. The
internal determinants are termed as micro or bank-specific determinants of bank performance It includes
factors like bank lending, size of the bank, the efficiency of the management, deposit volume, bank
liquidity, bank capitalization level, bank growth while the external determinants are macroeconomic
variables that are not related to bank management but reflect the monetary, economic and legal
environment that affect the operation and performance of financial institutions (Gaiotti & Secchi, 2006).

According to Comptroller (1998) lending is the principal business for most commercial banks and
consequently, loan portfolio is the largest asset and source of revenue for banks. It contributes about 80%
of commercial banks earnings interest income (Vong eal., 2009). In view of the significant contribution of
loans to the financial health of banks through interest income earnings, these assets are considered the
most valuable assets of banks.
However, lending is also the most risky activity of the banking industry which requires banks to carry out
credit risk management as one of their core activities. When we assess all the risks banks face, credit risk
is considered as the most lethal as non-performing assets would impair banks financial performances. A
sound financial system, among other things, also demands maintenance of a low level of non-performing
assets so as to facilitate the economic development of a country (Addisu, 2015).

Credit risk management in a financial institution starts with the establishment of sound lending principles
and an efficient framework for managing the risk. Adequately managing credit risk in financial
institutions is critical for the survival and growth of the financial Institution. In the case of banks, the
issue of credit risk is greater concern because of the higher levels of risks resulting from some of the
characteristics of clients and business conditions that they find themselves in.

Literatures on Ethiopian banking sector documented that credit risk and non-performing loan have been
major challenges of bank performance in Ethiopian (Tekilebirhan and Melkamu, 2012; Gethun, 2012;
Mekonen, 2012; NBE, 2009; Alemauhy, 1991). Nonetheless, very few (Berhanu 2016; Misiker 2015;
Addisu, 2014) examined the extent at which credit risk affected profitability performance of banks in
Ethiopia.

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Most of the studies emphasized only on return on asset as their only measure of financial performance
(Berahnu 2016; Addisu 2015; Million 2014).There are some studies that focused on the extent at which
credit risk management affect the financial performance of banks in the industry very few of them like
Miskier (2015) had incorporated return on equity as their measure of their financial performance.

Consequently, this study tried to fill this gap by focusing on only bank specific factors by including new
determinant variables of credit interest income, leverage ratio and operational cost efficiency(credit
administration cost) that had not been studied in the previous studies in the country and find evidence of
the determinants of the financial performance of privately owned commercial banks in Ethiopia.

1.3 Research Questions

Given the various issues relating to the impact of credit risk management on performance of Ethiopia
private commercial banks, a number of research questions will be raise as follows:
1. Does loan loss provisioning affect banks’ profitability measured by ROA?
2. Does Capital adequacy ratio affect bank performance measured by ROA?
3. What is the impact of credit administration (cost per loan) on performance measured by ROA?
4. What is the impact of Bank size on performance measured by ROA?
5. What is the impact of leverage ratio on performance measured by ROA?
6. What is the impact Credit interest income on performance measured by ROA?
7. Does nonperforming loan ratio affect bank performance measured by ROA?

1.4. Objectives of the Study

1.4.1. General objective

 The primary objective of the study is to find out the impact of credit risk management on
financial performance of private commercial banks in Ethiopia.

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1.4.2. Specific objectives
 To examine the effect of Non-performing loans (NPLs) on financial performance of private
commercial banks in Ethiopia which measured by ROA.
 To examine the effect of Loan loss provision (LLP) on financial performance of private
commercial banks in Ethiopia which measured by ROA.
 To examine the effect of Capital Adequacy ratio (CAR) on financial performance of private
commercial banks in Ethiopia which measured by ROA.
 To examine the effect of Leverage ratio (LR) on financial performance of private commercial
banks in Ethiopia which measured by ROA.
 To examine the effect of Credit interest income (CIR) on financial performance of private
commercial banks in Ethiopia which measured by ROA.
 To examine the effect of Bank size (SIZE) on financial performance of private commercial banks
in Ethiopia which measured by ROA.
 To examine the effect of credit administration cost on financial performance of private
commercial banks in Ethiopia which measured by ROA.

1.5. Hypothesis of the Study

H1 - Non-performing loans (NPL) has significant negative effect on Return on Asset (ROA).

H2 –Loan loss provision (LLP) has significant negative effect on Return on Asset (ROA).

H3-Capital Adequacy ratio (CAR) has significant positive effect on Return on Asset (ROA).

H4-Credit Interest income ratio (CIR) has significant positive effect on Return on Asset (ROA).

H5-Leverage ratio (LR) has significant negative effect on Return on Asset (ROA).

H6- Bank Size (SIZE) has significant positive effect on Return on Asset (ROA).

H7- Credit Administration cost or operational cost efficiency (OCE) has significant negative effect on
Return on Asset (ROA).

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1.6. Significance of the Study

The study is important in assisting the management of different Private commercial Banks of Ethiopia to
properly carry out credit risk management and to know the relationship between credit risk and the
profitability of banks then it enables them to reduce losses and increase profitability. The findings from
this study will also assist in providing more literature to support existing theoretical propositions on the
impact of credit risk management on profitability of private commercial banks in Ethiopia and provide a
basis for further studies. the findings of the study contributes to immense benefit to private as well as
public commercial banks in terms of using them as inputs in formulating guidelines with which to
effectively manage their lending activities in the economy.

1.7. Scope of the Study

This study is limited to quantitative impacts of credit risk management on financial performance of
banks though credit risk has a huge impact on qualitative aspects of banks’ performances. The eight
private banks are selected among the sixteen commercial banks which are in operation in the industry.
The selection is purposive based on the criteria of the number of years of operation in the industry which
is more than or equal to ten years. Since all the sixteen banks have different year of establishment,
financial performance and credit policies, the eight representative private commercial banks will make the
study more meaningful. The reference period selected for this study is restricted to 2007-2016. This
helped the study to capture the result that reflects the present trend in the operations of private
commercial banks.

1.8 Limitation of the Study

The study focused on financial related variables only and did not consider non-financial measure
variables which may have influence and might need further investigation. Financial performance within
ten years may be affected by different variables in the state of the economy which in turn influence the
measurement of the actual effects of credit risk management on financial performance of the banks.
Moreover, quantitative data only may limit the findings of the study to generalize for the population.

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1.9 Organization of Study

The research report consists of five chapters with different sections and sub-sections which are structured
as follows. Chapter one discusses introduction of the study that would give a brief overview of the
background of the study. This chapter also discusses objectives, research hypotheses, scope, significance
and delimitation and limitation of the study. In chapter two theoretical foundations of the study and
empirical studies conducted on relevant studies are presented. Chapter three focuses on methodology of
the study. It explains the research design, the target population, data collection method, measuring
instruments, and data analysis techniques. Chapter four provides the data analysis and presentation of the
study. It mainly covers the analysis of the outcomes and discussion of the research results. The last
chapter as usual explains conclusion and recommendation based on interpretation of the research results
with further research directions

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 CHAPTER TWO

2. REVIEW OF RELATED LITERATURES

Introduction
This chapter presents what other scholars have written about the impact of credit risk management in
relation to financial performance of banks, the variables and methodology they used as well as their
findings and recommendations. In addition this part defines and looks at the theories which are written
about each dependent and independent variables including the measurement of bank performance and
credit risk management by various authors.

2.1. Theoretical Review

This presents review of the relevant theories that explains the impact of credit risk management on
financial performance of commercial banks in Ethiopia. The theoretical reviews covered are; Asymmetric
Information Theory, Agency Theory and Modern Portfolio Theory, multiple lending theory and signaling
argument.

2.1.1. The Pecking Order Theory

The pecking order theory of (Myers and Majluf, 1984) advocate that the firm will borrow, rather than
issuing equity, when internal cash flow is not sufficient to fund capital expenditures. Thus the amount of
debt will reflect the firm's cumulative need for external funds. It concludes a negative association
between leverage and profitability because high profitable firms will be able to generate more capitals
through retained earnings and then have less leverage. Therefore, it is expected that there is negative
relationship between leverage and profitability ratio.

2.1.2 Asymmetric Information Theory

This is a theory relevant for situations where there is imperfect knowledge. In particular it occurs where
one party has different information to another. Asymmetric information is a problem in financial markets
such as borrowing and lending. In these markets the borrower has much better information about his
financial state than the lender.

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(Akerlof, 1970) first presented this theory in the easy; "The Market for Lemons”. It is the single most
important study in the literature on economics of information. (Mirrlees,1996) study Asymmetry of
information related to access to information among participants in the process of making economic
decisions.

(Pagaon and Jappelli,1993) show that information sharing reduces adverse selection by improving banks
information on credit applicants. According to (Auronen, 2003) the theory of asymmetric information tells
us that it may be difficult to distinguish good from bad borrowers, which may result into adverse selection
and moral hazards problems. The theory explains that in the market, the party that possesses more
information on a specific item to be transacted (in this case the borrower) is in a position to negotiate
optimal terms for the transaction than the other party (in this case, the lender) (Auronen, 2003). The party
that knows less about the same specific item to be transacted is therefore in a position of making either
right or wrong decision concerning the transaction. Adverse selection and moral hazards have led to
significant accumulation of non-performing loans in banks (Bofondi and Gobbi, 2003).

Commercial bank managers may know more about impact of credit risk management on profitability of
commercial banks than other stakeholders. In this case, they could fail to disclose nonperforming loans
and/ or use provisions for losses on non-performing loans for profit smoothening.

2.1.3 Agency Theory

The first scholars to propose, explicitly, that a theory of agency be created, and to actually begin its
creation, were (Ross and Mitnick, 1973) independently and roughly concurrently. (Ross, 1973) is
responsible for the origin of the economic theory of agency, and (Mitnick, 1973) for the institutional
theory of agency, though the basic concepts underlying these approaches are similar. Indeed, the
approaches can be seen as complementary in their uses of similar concepts under different assumptions.
The agency theory is gaining a lot of popularity in explaining the financial performance of organizations.

The theory seeks to explain the relationship that exists between the management of an organization and the
owners of the organization who are usually the people holding stocks for the organization. The theory
posits that there is an agency conflict. The management of an organization is usually considered as an
agent who has been contracted by the stockholders to work towards enhancing the stockholder value
through good financial performance. The management is therefore expected to act in the best interests of
the owners and enhance the financial performance of the organization. However, the theory suggests that
the managers who are agents may be involved in activities that are aimed at serving personal interest at the
expense of the owners of the organization (Kirui, 2014).

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The theory suggests that when this happens, the financial performance of the organization may easily
suffer. Stockholders therefore can employ a number of strategies to ensure the management acts in the
interest on the organization. The theory suggests that management can be rewarded financially in order to
motivate them to work for the interests of the company. The owners can also issue threats such as hostile
takeover to force management to perform the required duties (Kirui, 2014).

2.1.4 Modern Portfolio Theory

(Markowitz, 1952) Modern portfolio theory (MPT) is one of the most important and powerful economic
theories dealing with finance and investment. Modern portfolio theory measures the benefits of
diversification, known as “not putting all your eggs in one basket”. Modern portfolio theory (MPT) is an
investment theory which tries to explain how investors could maximize their returns and minimize their
risks by diversification in different assets.

(Tobin, 1958) expanded the theory of Markowitz’s (portfolio theory) by adding the analysis of risk free
assets which made it possible to influence portfolios on the efficient frontier. (Markowitz,1952) and Tobin
(1958) showed that it was possible to identify the composition of an optimal portfolio of risky securities,
given forecasts of future returns and an appropriate covariance matrix of share returns.

The portfolio theory approach is the most relevant and plays an important role in bank performance studies
(Atemnkeng and Nzongang, 2006). According to the Portfolio balance model of asset diversification, the
optimum holding of each asset in a wealth holder’s portfolio is a function of policy decisions determined
by a number of factors such as the vector of rates of return on all assets held in the portfolio, a vector of
risks associated with the ownership of each financial assets and the size of the portfolio. It implies
portfolio diversification and the desired portfolio composition of commercial banks are results of decisions
taken by the bank management.
The portfolio theory integrates the process of efficient portfolio formation to the pricing of individual
assets. It explains that some sources of risk associated with individual assets can be eliminated or
diversified away, by holding a proper combination of assets (Bodie et al, 1999).

By taking advantage of its size a bank manager can diversify considerable amounts of credit risk as long as
the returns on different assets are imperfectly correlated with respect to their default risk adjusted returns
(Blackwell, 2008).

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Further, the ability to obtain maximum profits depends on the feasible set of assets and liabilities
determined by the management and the unit costs incurred by the bank for producing each component of
assets (Atemnken and Nzongang, 2006).

Commercial Banks should consider diversifying investments portfolio to minimize risk of credit takers
defaulting in loans repayments and causing non-performing loans portfolios that affects profitability. The
concept of revenue diversifications follows the concept of portfolio theory which states that individuals
can reduce firm-specific risk by diversifying their portfolios (Kirui, 2014).

The proponents of activity diversification or product mix argue that diversification provides a stable and
less volatile income, economies of scope and scale, and the ability to leverage managerial efficiency across
products and for the case of commercial banks, reduce non performing Loans and increase Return on
Assets which is a measure of profitability (Kirui, 2014).

2.1.5. Theory of Multiple-Lending

It is found in literature that banks should be less inclined to share lending (loan syndication) in the
presence of well-developed equity markets. Both outside equity and mergers and acquisitions increase
banks‟ lending capacities, thus reducing their need of greater diversification and monitoring through share
lending (Carletti, 2006; Karceski, 2004; Degryse, 2004; Ongene and Smith, 2000).

2.1.6. The Signaling Arguments

The signaling argument states that good companies should provide more collateral so that they can signal
to the banks that they are less risky type borrowers and then they are charged lower interest rates.
Meanwhile, the reverse signaling argument states that banks only require collateral and or covenants for
relatively risky firms that also pay higher interest rates (Chodechai, 2004; Ewert and Schenk, 1998).

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2.2 Related Pervious Empirical Studies
Many researchers have studied impact of credit risk management from different perspective and in
different Social, political and economic environment. Some of the studies which are related and useful for
this study are discussed herewith.

2.2.1 International Empirical Review

Charles, Okaro Kenneth (2013) examined the impact of credit risk management on capital adequacy and
banks financial performance in Nigeria. For this purpose six banks were selected by using positive
sampling technique. Data were obtained from the published financial statements from 2004 to 2009. Panel
data model was used to estimate the relationship that exists among Loan Loss Provisions (LLP), Loans and
Advances (LA), N0n-performing Loans (NPL), Capital Adequacy (CA), and Return on Assets (ROA).
Results showed that sound credit risk management and capital adequacy related positively on banks’
financial performance with the exception of loans and advances which was found to have a negative
impact on banks’ profitability in the period under studied.

Sokol Ndoka & Manjola Islami. (2016) studies the impact of credit risk management on the profitability
of commercial banks in Albania during the period 2007-2015. To analyze the relationship between credit
risk management and profitability of banks secondary data published by the Bank of Albania were
collected for 16 commercial banks operating in Albania during the period 2007-2015. ROE and ROA are
used as indicators to measure the profitability of banks and NPLR and CAR as indicators of credit risk
management. Statistical program Eviews was applied on the collected data. The econometric results
confirmed that there exist a correlation between the credit risk management of commercial banks in
Albania and their profitability. The results of the regression analysis indicate that the correlation between
CAR and ROA and CAR and ROE is not statistically significant. Also the results of the regression analysis
show that there exist a negative correlation between NPLR and ROA and NPLR and ROE and this
correlation is statistically significant.

Ali Sulieman Alshatti (2015). Investigating the effect of credit risk management on financial performance
of the Jordanian commercial banks. Data from annual reports of the Jordanian commercial banks were
used to analyze for the study years (2005-2013). The panel regression model was employed to estimate the
effect of credit risk management indicators (Capital adequacy ratio (CAR), Credit interest/Credit facilities
ratio, Facilities loss/Net facilities ratio, Facilities loss/Gross facilities ratio, Leverage ratio, Non-
performing loans/Gross loans ratio) on the banks’ financial performance.

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The empirical findings show that there is a positive effect of the credit risk indicators of Non-performing
loans/Gross loans ratio on financial performance, and a negative effect of Provision for Facilities loss/ Net
facilities ratio on financial performance, and no effect of the Capital adequacy ratio and the credit
interest/Credit facilities ratio on banks’ financial performance when measured by ROA.

Ms. Sujeewa Kodithuwakku (2015). Study examine is to identify the impact of credit risk management on
the performance of the commercial banks in Sri Lanka. This study is primarily based on both primary and
secondary data. Primary data were collected from eight (08) commercial banks from 24 commercial banks
in Sri Lanka. The primary data was collected mainly through an interview. The secondary data were
obtained from various sources such as Annual Reports of the selected commercial banks, relevant articles,
books and magazines etc. The panel data of a five year period from 2009 to 2013 from the selected banks
were used to examine the relationship between credit risk and performances. The Return on Assets (ROA)
is used as performance indicator and Loan provision to Total (LP/TL), Loan Provision to Non-Performing
Loans (LP/NPL), Loan Provision to Total Assets (LP/TA) and Non-Performing Loans/ Total Loans
(NPL/TL) were used as indicators of credit risk. Further, a regression model was used to establish the
relationship between amounts of loan as well as non-performing loans and profitability during the period
of study by using E-views software. The regression results of the study suggest that all the independent
variables except loan provision to total loan have negative impact on profitability. The non-performing
loan, loan provision and loan provision to nonperforming loans of the banks are significantly negatively
related with ROA.

Yuga Raj Bhattarai (2016). This study has examined the effect of credit risk on performance of Nepalese
commercial banks. The descriptive and causal comparative research designs have been adopted for the
study. The pooled data of 14 commercial banks for the period 2010 to 2015 have been analyzed using
regression model. The regression results revealed that 'non-performing loan ratio' has negative effect on
bank performance whereas 'cost per loan assets' has positive effect on bank performance. In addition to
credit risk indicators, bank size has positive effect on bank performance. Capital adequacy ratio and cash
reserve are not considered as the influencing variables on bank performance. This study concludes that
there is significant relationship between bank performance and credit risk indicator

Kithinji (2010) assessed the effect of credit risk management on the profitability of commercial banks in
Kenya. Data on the amount of credit, level of non-performing loans and profits were collected for the
period 2004 to 2008. The findings revealed that the bulk of the profits of commercial banks are not
influenced by the amount of credit and non-performing loans, therefore suggesting that other variables
other than credit and non-performing loans impact on profits.

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Kargi (2011) evaluated the impact of credit risk on the profitability of Nigerian banks. Financial ratios as
measures of bank performance and credit risk were collected from the annual reports and accounts of
sampled banks from 2004-2008 and analyzed using descriptive, correlation and regression techniques. The
findings revealed that credit risk management has a significant impact on the profitability of Nigerian
banks. It concluded that banks’ profitability is inversely influenced by the levels of loans and advances,
non-performing loans and deposits thereby exposing them to great risk of illiquidity and distress.

Poudel (2012) studied the factors affecting commercial bank performance in Nepal for the period of 2001
to 2012 and followed a linear regression analysis technique. The study revealed a significant inverse
relationship between commercial bank performance measured by ROA and credit risk measured by default
rate and capital adequacy ratio.

Hosna et al. (2009) also found similar result with Poudel in his study of four Swedish banks covering a
period of 2000 to 2008. The result showed that the rate of non-performing loan and capital adequacy ratios
was inversely related to ROE through the degrees vary from one bank to the other.

Boahene (2012) found a positive and significance relationship of commercial banks performance and
credit risk in his study of six Ghanaian commercial banks covering a period of 2005-2009. The Panel data
analysis model employed in the study revealed that indicators of credit risk, namely: non-performing loan
rate, net charge-off rate, and the pre-prevision profit as a percentage of net total loans and advances were
positively related with profitability measured by ROE.

Felix and Claudine (2008) investigated the relationship between Bank performance and credit risk
management. It could be inferred from their findings that return on equity (ROE) and return on assets
(ROA) both measuring profitability were inversely related to the ratio of non-performing loan to total loan
of financial institutions thereby leading to a decline in profitability.

Onaolapo (2012), while analyzing the credit risk management efficiency in Nigerian commercial banking
sector from 2004 through 2009 provides some further insight into credit risk as profit enhancing
mechanism. They used regression analysis and found rather an interesting result that there is a minimal
causation between deposit exposure and bank’s performance.

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2.2.2 Local Empirical Review
(Girma, 2011) who made his research study on ‘Credit risk management and its impact on performance of
commercial banks in Ethiopia’ attempted that there is a significant relationship between bank performance
(in terms of return on asset) and credit risk management (in terms of loan performance). From the
population of all banks operational in Ethiopia, six banks were selected by using purposive sampling
technique.

The researcher employed quantitative research design. A panel data of 10 years financial data of banks
under the study was used to examine the relationship between return on asset (ROA) which is performance
indicator and non-performing loan to total loan(NPL/TL), loan provision to total loan (LP/TL), loan
provision to total loan outstanding (LP/NPL), and loan provision to total asset (LP/TA). The findings of
the study reflected that there is a direct but inverse relationship between return on asset (ROA) and the
ratio of non-performing loans to total loan (NPL\TL) and loan provision to total loan. The regression
analysis showed that nonperforming loan and loan provision of the financial institutions are significantly
negatively related to performance (ROA). On the other side, the regression result revealed that loan
provision to non-performing loan and loan provision to total asset of the financial institution is
significantly positively related to return on asset.

(Tibebu, 2011) also carried out an empirical investigation on ‘Credit risk management and profitability of
commercial banks in Ethiopia’. The researcher took seven banks purposively that have ten year and above
life span in Ethiopia and collect the necessary data from 2001 to 2010 which is used for regression
purpose. Tibebu examines the impact level of credit risk management towards the profitability of
commercial banks in Ethiopia and argued that credit risk management has significant impact on
profitability of banks of our country. The researcher uses multiple regression models by taking 10 years
ROE as dependent variable, NPLR (non-performing loan ratio) and CAR (capital adequacy ratio) as
independent variables from each bank along with questioners. The research finding revealed that both non-
performing loan ratio and capital adequacy ratio has a negative impact on profitability of commercial
banks in Ethiopia in terms of ROE. According to the study a single unit increase in non-performing loan
ratio leads to a decrease in profitability of commercial banks by 0.5941 where as a unit increase of capital
adequacy ratio leads to a decrease in profitability of commercial banks measured as ROE by 0.8318.

(Addisu, 2015) studied “Non-performing Assets and Their Impact on Financial Performance of
Commercial Banks in Ethiopia” indicated that negative correlation coefficient between non-performing
loans, loan loss provision and financial performance measured as return on asset.

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Non- performing loans and loan loss provision to non-performing loans ratios are negatively related to
financial performance (ROA) with a Pearson correlation coefficient of r = -.447 and - .037, and with a
significance level of .001 and .789 respectively. The correlation coefficient of non-performing loans (NPL)
ratio (r=-0.447 at p=0.001) reveals that there exists a strong inverse relationship between non-performing
loans and financial performance (ROA) of commercial banks in Ethiopia.. Loan loss provision to total loan
(LLP) which had a value of r=-0.037 at p=0.789 indicates a weak negative relationship with financial
performance which is not also found significant contrary to the hypothesis. In line with the hypothesis, the
strong significance value of the relationship between non-performing loans and financial performance
(ROA) help us gain confidence on the genuine relationship between financial performance and non-
performing loans.

(Elias 2015). This study examine how the credit risk management affects the profitability in the seven
sample selected commercial banks using a balanced panel data from 2009-2013 and 35 observations have
been used for the analysis. The main purpose of the study is to describe the impact level of credit risk
management on profitability in the seven commercial banks in Ethiopia. The study only uses the
quantitative approach and focuses on the description of the outputs from SPSS, used regression model to
do the empirical analysis. In the model the researcher defined ROE as profitability indicator while Loan
loss provision, liquidity, loan growth and capital adequacy ratio as credit risk management indicators. The
regression results revealed that loan loss provision & loan growth have positive and statistically significant
impact on banks profitability (Return on Equity). Finally, the results indicate that liquidity & capital
adequacy have a negative but statistically significant relationship with banks Return on Equity.

2.3 Summary and Knowledge Gap

A strong banking system is the backbone for economic growth as well as financial stability and
development process of any country. In the case of Ethiopia, after the liberalization policy and transition to
a market oriented economic policy, many private commercial banks have been established and brought a
tremendous economical and developmental effect in the country’s growth.

As the banking sector in Ethiopia is at its growing stage, it has been facing various challenges. One of the
biggest challenges is management of Credit risk The soaring Credit risk in some banks may have adverse
impact on the financial performance of commercial banks as well as the progress of the economy, and
hence a matter of great concern for the Ethiopian financial system.

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In this regard, most of the related empirical studies made were conducted in organizational settings of
other countries which could not be generalized to Ethiopian organization setting. Also, despite the fact that
several studies were conducted by different researchers on the Ethiopian Banking sector, specific empirical
studies on the impact of credit risk management on financial performance of commercial banks in Ethiopia
could hardly be traced. In Ethiopia, the empirical studies on this area are the research under taken by
(Addisu ,2015), (Muluwork 2015) and (Birhanu, 2016) which focused on the effect of both internal and
external factors in general on the financial performance of private commercial banks in the country.
However, in those studies, credit interest income, leverage ratio and operational cost efficiency
explanatory variable are not included in their studies. Thus, this study mainly concentrated on those above
explanatory variable and the remaining important variables and their effect on financial performance of
commercial banks in Ethiopia which is proposed to fill the existing knowledge gap and to test the existing
theories in the Ethiopian context.

The studies by (Miskier 2015; Gaddise 2014; Berhanu; 2012) utilized macro economic factors like
inflation rate and gross domestic product but the focus of this research is only on bank specific factors.
Furthermore all studies except (Miskir,2015) used return on asset as the only measurement of financial
performance excluding return on equity which is as important as return on asset in measuring financial
performance.

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2.4 Conceptual Framework of the Study
From the literature review, discussed above, the researcher constructed the following research framework.
It discussed the interrelationships among the variables that are deemed to be integral to the dynamics of
the situation being investigated.

Figure 2.1. The conceptual framework of the study

BANK SIZE (SIZE)

NON PERFORMING
LOANS (NPLs)

LOAN LOSS
PROVISION (LLP)
SIGNIFICANT
FACTORS
REGRESSION AFFECTING
ON (ROA) FINANCIAL
LEVERAGE RATIO FINANCIAL PERFORMAN
(LR) PERFORMANC CE OF
E OF PRIVATE PRIVATE
COMMERCIAL COMMERCIA
OPERATIONAL BANKS REGRESSION
L BANKS
COST EFFICIENCY ON (ROE)
(OCE)

CREDIT INTEREST
INCOME (RATIO
(CIR)

CAPITAL
ADEQUCY RATIO
(CAR)

Source: Adopted from Berhanu (2016) with modification by the researcher

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 CHAPTER THREE

3. METHODOLOGY

The preceding chapter of the study has attempted to discuss the theories as well as empirical studies
related to impact of credit risk and their impact on financial performance and finally the existing
knowledge gap. The purpose of this chapter is to present the underlying principles of research
methodology and the choice of the appropriate research method for the study. The chapter is arranged as
follows: Section 3.1 deals with research design. Section 3.2 presents research approach adopted by the
study. This is followed by sample design under section 3.3. Next, the nature of the data, instrument of data
collection, data analysis and presentation techniques are explained in section 3.4. Section 3.5 describes
study variables. Finally, section 3.6 deals with model specification.

3.1. Research Design

Research design is the "blue print" of the study. The design of a study defines the study type (descriptive,
co-relational, semi-experimental, experimental, review, meta-analytic) and sub-type (e.g., descriptive-
longitudinal case study), research question, hypotheses, independent and dependent variables,
experimental design, and, if applicable, data collection methods and a statistical analysis plan. Research
design is the framework that has been created to seek answers to research questions.

Many research designs could be used to study business problems (Hair et al., 2011). Depending on the
way in which researchers ask their research questions and present their purpose, the research design could
be classified into three groups, namely exploratory, descriptive and explanatory studies (Saunders et al.,
2009, p. 138& 139).

According to (Hair et al., 2011) exploratory study is performed when the researcher has little information.
This accord with (Ghauri and Grønhaug, 2005) who state: “When the research problem is badly
understood, a (more or less) exploratory research design is adequate.” It is particularly useful to clarify
the understanding of a problem, such as if you are unsure of the precise nature of the problem (Saunders
et al., 2009, p. 139). Therefore, exploratory research must be flexible and adaptable to change. That is to
say, researchers are willing to change their direction as a result of new data that appear and new insights
that occur to them (Saunders et al., 2009, p. 140). A number of researchers have claimed that the
exploratory approach leads to new and useful theories. But there is also the danger that the research will
produce false leads or useless theories (Armstrong, 1970, p.2).

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Bobbie (2004) in another way states that the major shortcoming of this research design is that it seldom
provides satisfactory answers to the research question. As to the descriptive studies, they are designed to
obtain data that describe the characteristics of the topic of interest in the research (Hair et al., 2011,
p.148). The objective of descriptive study is to represent an accurate profile of persons, events or
situations (Robson, 2002, cited in Saunders et al., 2009 p. 140). In descriptive research, the research
problem is structured and well understood (Ghauri and Grønhaug, 2005, p. 58).Saunders et al. (2009)
expanded the idea like “it is necessary to have a clear picture of the phenomena on which you wish to
collect data prior to the collection of data.” (Hair et al., 2011, p.149).

The last category is explanatory study (Saunders et al., 2009, p. 140) or in some book scaled “causal
research design” (Hair et al., 2011, p.147). In this research, the problems are well structured as in
descriptive studies. In contrast to descriptive studies, the researcher is facing with “causes-and-effects”
problems. The main task is to separate such causes and to say to what extent they lead to such effects
(Ghauri and Grønhaug, 2005, p. 59). In other words, it is to explain the causal relationship between
variables (Saunders et al., 2009, p. 140).

Based on the study of three research designs and the purpose of this research, the Explanatory study is the
most suitable for the topic. Even though this research starts with the description about credit risk
management and profitability of commercial banks, its ultimate goal is to test if the relationship exists and
how the credit risk management could impact on profitability of commercial banks in Ethiopia. That is to
say, the aim is to find causes of profitability. Hence, it is considered explanatory study as this research
design.

3.2. Research Approach Adopted

As noted in (Creswell, 2003) in terms of investigative study there are three common approaches to
business and social research namely qualitative, quantitative and mixed methods approach. Qualitative
research approach is a means for exploring and understanding the meaning individuals or groups ascribe
to a social or human problem with intent of developing a theory or pattern inductively (Creswell, 2009).
On the other hand, Quantitative research is a means for testing objective theories by examining the
relationship among variables (Creswell, 2009).Quantitative methods are frequently described as deductive
in nature, in the sense that inferences from tests of statistical hypotheses lead to general inferences about
characteristics of a population and also this method is frequently characterized as assuming that there is a
single “truth” that exists, independent of human perception (Guba & Lincoln, 1994).

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As of (Morse, 1991) if the problem is identifying factors that influence an outcome, the utility of an
intervention or understanding the best predictors of outcomes` then a deductive (quantitative) approach is
best; it is also the best approach to test a theory or explanation. Also (Creswell, 2003) indicated that the
researcher tests a theory by specifying narrow hypotheses and the collection of data to support or refute
the hypotheses.

Finally, mixed methods approach is an approach in which the researchers emphasize the research problem
and use all approaches available to understand the problem (Creswell, 2003). Hence, based on the above
discussions of the three research approaches and by considering the research problem and objective, in
this study, the quantitative method was used.

3.3. Sampling Design

The "best" sample design depends on survey objectives and on survey resources. For example, a
researcher might select the most economical design that provides a desired level of precision. Or, if the
budget is limited, a researcher might choose the design that provides the greatest precision without going
over budget. Sample design deals with study population, sample frame, sample size and sampling
technique. Sampling is a technique of selecting a suitable sample for the purpose determining parameters
of the whole population. Population is the list of elements from which the sample may be drawn. A
sample is drawn to overcome the constraints of covering the entire population with the intent of
generalizing the findings to the entire population (John, 2007).

3.3.1. Study Population

According to (Sekaran, 2003) Population refers to the entire group of people, events or things of interest
that the researcher wishes to investigate. The study population or participants of this research are all
private commercial banks in Ethiopia. As per NBE report, currently there are sixteen private commercial
banks in Ethiopia (NBE, 2015). These includes: Abay Bank S.C (AB), Addis International Bank S.C
(AdIB), Awash International Bank S.C (AIB), Bank of Abyssinia S.C (BOA), Berehan International Bank
S.C (BIB), Buna International Bank S.C (BUIB), Cooperative Bank of Oromia S.C (CBO), Dashen Bank
S.C (DB), Debub Global Bank S.C (DGB), Enat Bank S.C (EB), Lion International Bank S.C (LIB), Nib
International Bank S.C (NIB), Oromia International Bank S.C (OIB), United Bank S.C (UB), Wegagen
Bank S.C (WB) and Zemen Bank S.C (ZB).

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3.3.2 Sampling Technique
Sampling involves the various procedure uses to select a part to represent a population. According to
(Zikmund, 2000) there are two main alternative procedures which could be used in the selection of an
appropriate sample and these include probabilistic/random sampling and non-probabilistic/non-random
sampling. The probabilistic sampling is a sample procedure which gives each one in the population non-
zero probability of selection. In other words it is about giving every element in the population equal
Chance of selection. On the other hand, non-probabilistic sample involves the selection of a sample on the
basis of personal judgment or purposive sampling. Purposive sampling offers the researcher to
deliberately select items for the sample concerning the choice of items as supreme based on the selection
criteria set by the researcher. In order to obtain representative data, non-probabilistic or purposive
sampling technique was employed in this study.

3.3.3. Sample Size

Sample size determination is the act of choosing the number of observations or replicates to include in a
statistical sample. The sample size is an important feature of any empirical study in which the goal is to
make inferences about a population from a sample. In practice, the sample size used in a study is
determined based on the expense of data collection, and the need to have sufficient statistical power. In
complicated studies there may be several different sample sizes involved in the study: for example, in a
stratified survey there would be different sample sizes for each stratum. In a census, data are collected on
the entire population; hence the sample size is equal to the population size. In experimental design, where
a study may be divided into different treatment groups, there may be different sample sizes for each group
In this study, the number of banks in the sample are eight private commercial banks. the accuracy and
validity of the works never guaranteed by increasing the sample size beyond specified limit
redundancy(Ayalew, 2011).That is why this study used eight experienced private commercial bank in
Ethiopia that have been in operation for the last ten years from eighteen banks in the country. Thus, the
sample banks are Awash International Bank S.C (AIB), Bank of Abyssinia S.C (BoA), Dashen Bank S.C
(DB), Nib International Bank S.C (NIB), United Bank S.C (UB) and Wogagen Bank S.C (WB), Lion
International Bank (LIB), Cooperative Bank of Oromia (CBO).

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3.4 Nature of Data, Instrument of Data Collection, Data Analysis and
Presentation

3.4.1. Nature of Data and Instrument of Data Collection

As noted in (Baltagi,2005) the advantage of using panel data is that it controls for individual
heterogeneity, less co linearity among variables and tracks trends in the data which simple time-series and
cross-sectional data cannot provide. Besides, by combining time series and cross-section observations, it
gives more informative data. Furthermore, panel data can better detect and measure effects that simply
cannot be observed in pure cross-section or pure time series data (Gujarati, 2004). Therefore, data used
for this study was panel data.

Data collection method is a phrase used to describe the way or manner in which a researcher gathers
relevant information which he or she is going to use to answer the research questions. There are basically
two main sources by which the researcher can collect data; the primary and secondary source. Primary
data source is when the researcher collects new information either through observations, interviews,
questionnaires and then uses this data for analysis (Saunders et al., 2009). Secondary data is data that
exists somewhere having been collected and used for some other purposes (Gupta, 2012). After
evaluating all possible data collection methods, the researcher found that the most appropriate method
that provides practical answers to the research questions and the stated objectives of the study is the use of
secondary data. Hence, the data used for this study is secondary in a nature which was obtained from
audited annual financial reports of each purposively selected private commercial bank for bank-specific
factors and publications of the National Bank of Ethiopia (NBE).

3.4.2. Data Analysis and Presentation

The collected panel data were analyzed using descriptive statistics, correlations and multiple linear
regression analysis. Descriptive statistics used to analyze the general trends of the data from 2007-2016
based on the sample of eight private commercial banks. Correlation matrix was used to examine the
relationship between the dependent variables and explanatory variables. A multiple linear regression
model was used to determine the relative importance of each independent variable in influencing credit
risk and its impact on the financial performance of the banks. Finally, Ordinary Least Square (OLS)
regression approach including all of its assumptions were conducted using E-views 9 econometric
software package, to test the casual relationship between credit risk management and commercial banks
performance.

The assumptions were tested to see the applicability of the regression models developed first to test the
relationship between banks loans and advances and independent variables and then to see the impact of

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credit risk management on financial performance through the significant factors explaining lending of
commercial banks in Ethiopia.

Since this study uses a panel data, there are two types of panel estimator approaches that can be
employed, namely: fixed effects models (FEM) and random effects models (REM) (Brooks, 2008). To
examine whether individual effects are fixed or random, a Hausman specification test was conducted.

3.5. Study Variables

3.5.1 Dependent Variables

3.5.1. Return on Assets (ROA)

Following (Golin, 2001) study, ROA has become the key ratio for measuring bank profitability in recent
literature. It gives an idea as to how efficient management is using its assets to generate earnings and
reflects the ability of a bank’s management to generate profits from the bank’s assets. It presents the
return on each Birr of invested assets and can be measured simply by net profit after tax over total assets.
One major drawback however is that it may have an upward bias. This is because total assets fail to take
into account off-balance sheet activity, but those activities are reflected in the numerator through income.
But many scholars believe ROA is the best measure of bank profitability (Hassen & Bashir, 2003).
(Rivard and Thomas,1997) suggest that bank profitability is best measured by ROA in that ROA is not
distorted by high equity multipliers and it represents a better measure of the ability of the firm to generate
returns on its portfolio of assets. According to Wen (2010) a higher ROA shows that the company is more
efficient in using its resources and calculated as:

Return on Asset (ROA)

3.5.2 Independent Variables

3.5.2.1. Non Performing Loans (NPL)

Brewer et al. (2006) regards non-performing loan ratio (NPL) as a significant economic indicator. It
implies that lower NPLR is related with the lower risk and deposit rate. Meanwhile, there might be a
positive relationship between deposit rate and NPL rate based on the possibility that bank’s deposit base
will be increased by the high deposit rate for funding high risk loans. And the increasing high risk loans
might enhance the probability of higher NPL rate. So that the allocation of banks risk management deeply
relies on the diversification of credit risk to decrease the NPL amount. NPL is also a probability of loss

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which requires provision. The amount of provision is “accounting amount” which can be further
subtracted from the profit. Thus high NPL increases the provision while reduces the profit.

Non-performing loan over total assets shows the level of banks’ exposure to credit risk. If the ratio goes
above 25%, is an indication that the bank is getting into the zone of weak credit risk control system
(Agborade, 2002).

Deterioration in asset quality is much more serious problem of bank unless the mechanism exists to
ensure the timely recognition of the problem. It is a common cause of bank failure. Poor asset quality
leads nonperforming loan that can seriously damage a banks’ financial position having an adverse effect
on banks operation (Lafunte, 2012). It distresses the performance and survival of banks (Mileris, 2012).It
is measured or indicated by the amount of NPLs to Total Loan.

The author of this research share this measurements with (Addisu 2015; Birhanu 2012; Belayneh 2011;
Tibebu 2011;Flamini et al.,2009). From the literature review, empirical studies indicated that Non-
performing loans & advances are inversely related with financial performance.
Hence, the researcher of this study also expected a negative relation between non –performing loans &
advances and financial performance.
NPL ratio

H1: Non performing loan ratio has significant negative effect on banks profitability as measured by ROA.

3.5.2.2. Loan Loss Provision ratio (LLP)

Banks operating under generally accepted accounting principle (GAAP) follow a multi-step process to
determine their allowance for loan and lease losses (LLA). At the end of each accounting period, a bank
determines the probable value of the loan losses in its existing portfolio. The bank then debits its loan loss
Or provision by an amount equal to the difference between its estimated loan losses and the current
balance in its LLA. The offsetting credit increases the bank’s LLA. The LLA is shown on the balance
sheet as a reduction in the value of its outstanding loans in accounting terms; it is a contra-asset account
(Iftekar, 2003). It is calculated as:

LLP

H2: Loan loss provision ratio has negative effect on banks profitability as measured by ROA.

3.5.2.3. Capital Adequacy Ratio (CAR)

In this study Capital adequacy was measured by a ratio of total equity over total risk weighted assets. The
study employed this ratio to proxy the capital variable because ROA has been used as a measure of

P a g e | 25
financial performance. Bank’s capital is widely used as one of the determinants of bank profitability since
it indicates the financial strength of the bank (Athanasoglo et al., 2005). CAR is a ratio that regulators in
the banking system use to watch bank's health, particularly to ensure its capacity to absorb a reasonable
amount of potential losses. It is a measure of how much capital is used to support the banks' risk assets.
Loans and advances are the most risky assets due to borrowers’ default which requires a reasonable
amount of capital to absorb the expected losses. It is expected that the higher the Equity to Asset ratio, the
lower the need for external funding and therefore the higher the profitability of the commercial bank.
Bank with higher capital to asset ratio are considered relatively safer and tend to have a better margin of
cushion, remaining profitable even during economically difficult times. Conversely, banks with lower
capital adequacy are considered riskier relative to highly capitalized banks

Moreover, considering the regulatory requirement on the minimum capital required to be maintained by
banks, capital adequacy also indicates the ability of bank to undertake additional credit deployment and
other businesses. Various empirical studies indicated a positive correlation between returns on asset and
capital adequacy (Habtamu, 2012; Birhanu, 2012; Belayneh, 2011, Addisu 2015).
The researcher also expected positive relation between capital adequacy and financial performance of
commercial banks in terms of ROA. It is calculated as:

CA

H3: Capital adequacy ratio has positive effect on banks profitability as measured by ROA.

3.5.2.3. Leverage Ratio

The cause of the global financial crisis was the build-up of excessive leverage in financial Intermediaries,
both on and off the balance sheet. In many cases, banks cranked up their leverage to Perilous levels while
maintaining risk-based capital ratios that, to all outward appearance, still looked solid (BCBS (2014a)).
To remedy this vulnerability, the new regulatory framework of Basel III has introduced a minimum
leverage ratio, defined as a bank’s Tier 1 capital over an exposure which is independent of risk
assessment (Ingves, 2014).

The aim of the leverage ratio is to act as a complement and a backstop to risk-based capital requirements.
It should counterbalance the build-up of systemic risk by limiting the effects of risk weight compression
during booms (Altunbas , Gambacorta and Marques-Ibanez 2014; Adrian and Shin 2013; Vallascas and
Hagendorff 2013; Borio and Zhu; 2012). In good times, better economic conditions increase the number
of profitable projects in terms of expected net present value and hence increase the demand for credit
(Kashyap, Stein and Wilcox, 1993). The Basel III framework requires that the leverage ratio and the more

P a g e | 26
complex risk-based requirements work together. The leverage ratio indicates the maximum loss that can
be absorbed by equity, while the risk-based requirement refers to a bank’s capacity to absorb potential
losses. The use of a leverage ratio is not new. A similar measure has been in force in Canada and the
United States since the early 1980s (Crawford et al.; and D’Hulster 2009). It is calculated as:

LR

H4: Leverage ratio has negative effect on banks profitability as measured by ROA.

3.5.2.4. Credit Interest Income Ratio (CIR)

Credit interest income is the cash flow banks receive from loans and investments in securities. Cash
inflows and outflows depend directly on the interest rates a bank charges on loans, earns on securities and
on the composition of its assets and liabilities. A bank’s decisions on its prices and balance sheet
structure, in turn, are affected by a variety of market and business conditions outside of its control.

Some factors, such as the regulatory environment and competitive conditions in a bank’s market, are
relatively stable or change slowly over time. Others can change relatively often and quickly, such as the
state of national and local economies and market interest rates. Changes in market interest rates—both the
absolute and relative levels have perhaps the most important effect on net interest income in the short
term. The effect of changes in interest rates on net interest income varies with the maturity structure of a
bank’s assets and liabilities and the extent to which its loans and deposits have rates that reset when
market rates change prior to maturity (Charles and Kristin, 2014).

Credit interest income is affected not only by the maturity and pricing structure of assets and liabilities,
but also by their composition. The interest rate on bank loans generally is higher than on marketable
securities because loans tend to be riskier. In addition, loans are a more costly investment because of the
information requirements to make the loan and high monitoring costs once the loan is made. Moreover,
some types of loans, such as commercial land development loans, are riskier and more costly to make and
monitor than other types of loans. As a result, net interest income should increase with balance sheet
measures such as the ratio of loans to total assets and share of loans to real estate developers (Charles and
Kristin, 2014). It is calculated as:

CIR

H5: Credit interest income ratio has positive effect on banks profitability as measured by ROA.

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3.5.2.5. Bank Size (SIZE)
Bank size (SIZE) is generally used to capture potential economies or diseconomies of scale in the banking
sector. This variable controls for cost differences in product and risk diversification according to the size
of the financial institution. The first factor could lead to a positive relationship between size and bank
profitability, if there are significant economies of scale (Akhavein et al. 1997; Bourke 1989; Molyneux
and Thornton 1992; Bikker and Hu 2002; Goddard et al. 2004), while the second to a negative one, if
increased diversification leads to lower credit risk and thus lower returns. Other researchers however
conclude that marginal cost savings can be achieved by increasing the size of the banking firm, especially
as markets develop (Berger et al. 1987; Boyd and Runkle 1993; Miller and Noulas 1997; Athanasoglou et
al. 2007). (Eichengreen and Gibson,2001) suggested that the effect of a growing bank’s size on
profitability may be positive up to a certain limit. Beyond this point the effect of size could be negative
due to bureaucratic and other reasons. Hence, the size-profitability relationship may be expected to be
non-linear.

Bank size as measured by total deposits (Civelic and Al-Alami, 1991) or assets (Smirlock, 1985) is one of
the control variables used in analyzing performance of the bank system. This is included to control for the
possibility that large banks are likely to have greater product and loan diversification.

The impact of bank size on profitability is uncertain a prior for the fact that on the one hand, increased
diversification implies less risk and hence a lower required return, and on the other hand, bank size takes
into account differences brought about by size such as economies of scale. For large firms their size
permits them to bargain more effectively, administer prices and in the end realize significant higher prices
for the particular product, (Agu, 1992). In most finance literature, total assets of the banks are used as a
proxy for bank size. Bank size is represented by natural logarithm of total asset (LNTA). The effect of
bank size on profitability is generally expected to be positive (Smirlock, 1985). It is calculated as:
Bank size= LN (TA)
H6: Bank size has positive effect on banks profitability as measured by ROA.

3.5.2.6. Operational Cost Efficiency

Operational Cost efficiency is the product of technical efficiency and allocation efficiency. The latter
refers to the ability of a bank to use the optimum mix of inputs given their respective prices.
Consequently, cost efficiency shows the ability of a bank to provide services without wasting resources as
a result of technical or allocate inefficiency (Meryem, 2014).

(Pastor and Serrano, 2006) propose the decomposition of cost inefficiency into composition inefficiency
and intra-specialization inefficiency. The first component indicates the part of inefficiency due to the

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composition of specializations of the banks in each banking sector. The second component reveals the
inefficient use of resources within each of the specialization selected. (Prior, 2003) also deviates from the
above studies by calculating measures of short and long-run cost inefficiency as well as capacity
inefficiency for Spanish banks. The first refers to the case that subsets of inputs are fixed and impossible
to modify in the short-run. Long-run inefficiency estimates are obtained under the assumption that inputs
are variable and under the control of the company. Finally, capacity inefficiency, obtained by the ratio of
long-run to short-run inefficiency, refers to excess in costs as a result of inappropriate level in fixed
inputs. Similar concepts along with an application in the Indian banking sector are discussed in (Sahoo
and Tone, 2008). It is calculated as:

OCE

H7: Operational cost efficiency has negative effect on banks profitability as measured by ROA.

3.6 Model Specification

The aim of this study is to examine the impact of credit risk management on financial performance of
private commercial Banks in Ethiopia. Similar to the most noticeable previous research works conducted
on the impact of credit risk management on banks profitability, this study used ROA and ROE as
dependent variables whereas NPL Ratio, Bank Size, Capital Adequacy ratio, Loan Loss Provision ratio,
Leverage ratio, Operational Cost Efficiency ratio and Credit Interest Income ratio as an explanatory
variables. These variables were chosen since they are widely existent for the commercial bank in
Ethiopia. Accordingly, this study examined the impact of credit risk management by testing those listed
variables on Banks profitability of commercial banks in Ethiopia by adopting a model that is existed in
most literatures.

The nature of data used in this study enabled the researcher to use a panel/longitudinal data model which
is deemed to have advantages over cross sectional and time series data methodology. Panel data involves
the pooling of observations on the cross-sectional over several time periods.

As (Brook, 2008) stated the advantages of using panel data set; first and perhaps most importantly, it can
address a broader range of issues and tackle more complex problems with panel data than would be
possible with pure time-series or pure cross- sectional data alone. Second, it is often of interest to examine
how variables, or the relationships between them, change dynamically (over time). To do this using pure
time-series data would often require a long run of data simply to get a sufficient number of observations

P a g e | 29
to be able to conduct any meaningful hypothesis tests. But by combining cross-sectional and time series
data, one can increase the number of degrees of freedom, and thus the power of the test, by employing
information on the dynamic behavior of a large number of entities at the same time. The additional
variation introduced by combining the data in this way can also help to mitigate problems of
multicollinearity that may arise if time series are modeled individually.

Finally, by structuring the model in an appropriate way, we can remove the impact of certain forms
of omitted variables bias in regression results. Thus, the general panel/longitudinal regression model
was as follows:
Yit = α + βxit + uit
With subscript i denote the cross-section and t representing the time-series dimension. The left-hand
variable yi t is the dependent variable, α is the intercept term, β is a k×1 vector of parameters to be
estimated on the explanatory variables, and xi t is a 1 × k vector of observations on the explanatory
variables, t = 1, . . . , 10 ; i = 1, . . . , 8. Therefore the general models which incorporate all of the
variables to test the hypotheses of the study were:

ROAit= α +β1NPLit+ β2LLPit + β3CARit + β4CIRit + β5LRit + β6SIZEit + β7OCEit

Where,
ROAit: is the Return on Asset of ith bank at year t
NPLit: is the Non-performing Loan ratio of the ith bank at year t
LLPit: is the Loan loss Provision ratio of the ith bank at year t
CARit: is the Capital Adequacy ratio of the ith bank at year t
CIRit: is the Credit Interest Income ratio of the i th bank at year t
LRit: is the Leverage ratio of the ith bank at year t
SIZEit: is the SIZE of the ith bank at year t
OCEit: is the Operational Cost Efficiency of the ith bank at year t

Regression is more powerful than correlation. According to (Brooks,2008), unlike correlation, in the case
of regression if x has significant impact on y, thus change in y is influenced by change in x. Therefore, to
see the impact of banks‟ credit risk management on financial performance, the significant factors
affecting lending decision was used as the representatives for the variation in lending.

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Expected Sign
Description of the variables used in the regression model
Variables Description Notion Used by (Source) Expected
Result
Dependent
Variables
Return on Assets The ratio of net ROA Addisu (2015), Gaddise(2014), NA
income to total assets Kirui (2014)
Independent
Variables
Non-performing The ratio of non- NPL Berhanu (2016), Addisu (2015), -
Loan ratio performing loans to Muluwork (2016)
total loan outstanding
Loan Loss Prov. The ratio of loan loss LLP Ali(2015) -
provision to total loan
outstanding
Capital Adequacy The ratio of Paid up CAR Berhanu (2016), Addisu (2015), +
ratio capital to total asset Muluwork (2016), Misikir (2016)
Credit Interest The ratio of credit CIR Ali(2015) +
Income ratio interest income to total
loan outstanding
Leverage ratio The ratio of total debt LR Ali(2015) -
to total equity
Size Log of total asset of SIZE Berhanu (2016), Misikir(2016) +
the bank
Operational Cost The ratio of total OCE Kirui (2014) -
Efficiency expense to total
revenue

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 CHAPTER FOUR

RESULTS AND DISCSSIONS

This chapter deals with the results and analysis of the findings. The chapter contains three sections. The
first section presents descriptive analysis on variables of the study; the second section; presents the result
of the assumption tests; the third section lays down the results of regression analysis that constitute the
main findings of this study.

4.1. Descriptive Statistics

Table 4.1 provides a summary of the descriptive statistics of the dependent and independent variables for
eight private Commercial Banks from the year 2007 to 2016 with a total of 80 observations. The table
shows the mean, minimum, maximum, standard deviation and number of observations for the dependent
variables return on asset (ROA) and independent variables: operational cost efficiency (OCE), non-
performing loan ratio (NPL), loan loss provision ratio (LLP), size (SIZE), leverage ratio (LR), credit
interest income ratio (CIR) and capital adequacy ratio (CAR).
Table 4.1. Descriptive statistics of the dependent and independent variables

Variables Observations Mean Median Max Min Std. Dev.

ROA 80 0.026360 0.026600 0.038500 0.002300 0.007430

OCE 80 0.548835 0.418850 2.125000 0.31700 0.485594

NPL 80 0.071805 0.045600 0.328700 0.013100 0.140955

LLP 80 0.031466 0.026750 0.254500 0.010600 0.028049

SIZE 80 22.70258 22.83440 23.89580 19.86520 0.919124

LR 80 7.234944 7.595700 11.36880 0.133900 2.425154

CIR 80 0.170144 0.109500 0.385600 0.012800 0.433310

CAR 80 0.083291 0.067500 0.159100 0.013200 0.038459

Source: Financial statement of sampled banks and own computation through E-views 9

Table 4.1 shows the average indicators of variables computed from the financial statements of sampled
banks as well as NBE reports and the standard deviation that shows how much dispersion exists from the
average value. According to (Brooks,2008) a low standard deviation indicates that the data point tend to
be very close to the mean, whereas high standard deviation indicates that the data point are spread out
over a large range of values.

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The mean value of the dependent variable that is return on asset was 2.6 % with a minimum of 0.2% and
a maximum of 3.8 %. That means during the period under consideration sampled PCBs earned an average
of 2.6 cents of profit before tax for a single birr invested in their assets. The standard deviation for ROA
was 0.007 which indicates that the profitability variation between the selected banks was very small.

The standard deviation 0.059 was small which shows that almost few variations were observed in the
profit of private commercial banks (PCBs) in Ethiopia. As far as independent variables concerned, the
mean value of OCE was 54.8% which shows the ratio of expense to revenue, Its maximum value 212%
and minimum value 31.7% shows that there was a higher variation on the operational cost efficiency over
the sample period for this study (i.e. from 2007-2016).

The mean of NPLs was 7.18% with a minimum of 1.3 % and a maximum of 32.8%. This indicates that,
from the total loans that private commercial banks (PCBs) disbursed, an average of 7.18% were being
default or uncollected over the sample period. The lowest NPLs ratio that PCBs experienced over the
sample period was 1.3 %. The disparity between the minimum 1.3 % and the maximum 32.8% of NPLs
indicate the margin that NPLs ratio of PCBs ranged over the sample period. One possible reason for the
declining of the NPLs ratio is that commercial banks may properly work and improve their follow-up
techniques to reduce the amount of nonperforming loans to keep the ratio below the maximum threshold
set by NBE as per Directive № (NBE, 2008). The standard deviation of 14% of NPLs from its mean value
shows the existence of variation among PCBs in terms of their loan recovering capacity even though they
have kept the NPLs ratio below 5%.

The mean value of capital adequacy was 8.32% with a maximum of 15.9%.The average capital adequacy
ratio surpassed the minimum ratio of 8% set by NBE on Directives № SBB/50/2011. This can indicate
existence of sound financial condition in Ethiopian commercial banks. The standard deviation statistics
for capital strength was 3.84% which shows the existence of variation of equity to asset ratio between the
private commercial banks in Ethiopia.

There are some interesting statistics that have to be mentioned. For instance, the Leverage ratio which
was measured by total debt divided by total equity revealed the highest standard deviation (2.4251),
which means, it was the most deviated variable from its mean compared to other variables. This indicates
the existence of high variation among PCBs in terms of their leverage ratio. Another interesting
observation was the size of banks which was measured by natural log of total asset which indicated the

P a g e | 33
second most deviated independent variable after leverage ratio (0.9191) this indicates the existence of
high variation among PCBs in terms of their size.

The credit interest income ratio of banks was between 38% and 1.28% with the standard deviation of
0.433 also indicates relatively high disparity among PCBs interest credit interest income to total asset.
Among the independent variables, the smallest standard deviation was reported in loan loss provision
ratio which was 0.028. This indicates the existence of less variation among the banks in terms of setting
their loan loss provision amount. Among all the variables employed in this study leverage ratio had a
higher standard deviation which was 2.42. This implies that the leverage ratio which is debt to equity
during the study period remains somewhat unstable. On the other hand, the return on asset of the banks
was 2.6%; the standard deviation (0.007) was the lowest of all the variables used in this study. This
indicates that the return on asset of the banks was highly stable over the sample period.

4.2 Correlation Analysis

Correlation is a way to index the degree to which two or more variables are associated with or related to
each other (Brooks, 2008).The most widely used bi-variant correlation statistics is the Pearson product-
movement coefficient, commonly called the Pearson correlation which was used in this study. Correlation
coefficient between two variables ranges from +1 (i.e. perfect positive relationship) to -1 (i.e. perfect
negative relationship). As a sample size approaches to 100, the correlation coefficient of about or above
0.20 is significant at 5% level of significance (Meyers et al., 2006). The sample size of the study was
8*10 matrixes of 80 observations which was close to100 hence the study used the above justification for
significance of the correlation coefficient.

According to (Brooks, 2008) if it is stated that y and x are correlated, it means that y and x are being
treated in a completely symmetrical way. Thus, it is not implied that changes in x cause changes in y, or
indeed that changes in y cause changes in x rather, it is simply stated that there is evidence for a linear
relationship between the two variables, and that movements in the two are on average related to an extent
given by the correlation coefficient.

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Table 4.2. Correlation Matrix of Dependent and Independent Variables
Correlation
Probability ROA OCE NPL LLP SIZE LR CIR CAR
ROA 1
OCE -0.3919 1
NPL -0.5725 0.1098 1
LLP 0.1236 0.0836 0.6822 1
SIZE 0.2274 -0.6113 -0.0290 -0.4068 1
LR -0.3435 -0.3593 0.2087 -0.3277 0.5032 1
CIR -0.0115 0.7477 -0.1422 0.2214 -0.6644 -0.4157 1
CAR 0.6704 0.1828 -0.3285 0.3817 -0.3353 -0.7482 0.3874 1

Source: Financial statement of sampled banks, NBE reports and own computation through E-views 9

As indicated in the table above loan loss provision, capital adequacy ratio and size of the banks had
statistically significant and positive relationship with ROA. The capital adequacy ratio positively affect
their performance shows the banks tendency to boost up their paid up capital to gain strength and leading
role in the industry. The other variable that is positively and significantly related with return on asset in
this study is bank size meaning bigger banks or banks with higher total asset amount are more profitable
than smaller banks. On the contrary non- performing loans, operational cost efficiency and leverage ratio
had statistically significant but negative linear relationship with return on asset. When the amount of non-
performing loans increases the interest income from total loans will be reduced, as a result the profit from
these loans become smaller when compared with other banks with few amount of non-performing loans.
Also the liquidity amount of the banks decrease because of the rise of non-performing loans as results the
banks will not grant enough amount of loan to their customers this in turn affect their performance
negatively. The operational cost efficiency and leverage ratio shows negative relation with return on asset
this indicates that the more costly and in debt the banks are the lower their profit will be.

Credit interest income had statistically insignificant negative linear relationship with total Return on asset.
This result was opposing to the hypothesis of the study which states that credit interest income and return
on asset had negative relationship.

P a g e | 35
On the other hand capital adequacy ratio had statistically significant and positive linear relationship with
return on asset with coefficient of 0.67 as the number indicates the relationship is much stronger than the
other variables. The banks have higher tendency to increase their paid up capital when their profit rises.
Since it is a measure of bank`s financial strength it shows the ability to withstand or tolerate operational
and abnormal losses. The result of previous studies such as (Berhanu 2016; Addisu 2015; Goddard et
al.,2004) has shown that banks with higher capital adequacy ratio generate higher profit. On the contrary
other studies such as (Ali 2015; Samy and Magda, 2009) had concluded capital adequacy ratio has no
effect on financial performance of commercial banks which is contradicts with the result of this study.

Non-performing loans had statistically significant and negative linear relationship with return on asset.
This result was in line with the hypothesis of the study, which states that total return on asset and non-
performing loans had negative relationship with a coefficient of -0.57. It is derived from the fact that
when the non-performing loans of the banks increase the profit that can be generated from these loans
become smaller. The result is in agreement with the studies of (Misikir 2017; Berahnu 2016; Addisu
2015) which described that non-performing loan had significant negative effect on the financial
performances banks.

Operational cost efficiency of the bank had negative relationship with the return on asset with a
coefficient of -0.39. When the operational costs of the banks increase in relation with their revenue their
income or return on asset become affected negatively. The result of this study is also in line with the
result of previous studies of (Berger, Hunter & Timme 1993) and Maundos et al (2002) which concluded
that companies that are more efficient or that have lower operational costs are expected to have improved
profitability. On the other hand results from a study by Berger & Mester (1997) and Isik & Hassan (2002)
showed positive correlation between operational costs and financial performance which contradicts with
the result of this study.

Table 4.2 also underlines that the existence of statistically significant negative correlation between
leverage ratio and return on asset. From the result when the banks are engaged in debts beyond their
capacity they struggle to repay their debt it has adverse effect on their performance. The result contradicts
with the study of (Maher, 2014) which indicates the presence of statistically significant impact for
financial leverage on the profitability.

Loan loss provision had insignificant positive correlation with return on asset with a coefficient of 0.12.
The result indicated that the banks are not engaged in increasing their loan loss provision as a result of the
rise of their return on asset. This result disagrees with the finding of (Engidawork, 2014) which stated that
loan loss provision which is an indicator of the level of credit risk has negative effect on profitability.

P a g e | 36
Finally, even though the correlation analysis shows the direction and degree of associations between
variables, it does not allow the researcher to make cause and effects inferences regarding the relationship
between the identified variables. Thus, in examining the effects of selected independent variables on
return on assets, the econometric regression analysis which is discussed in the forthcoming section of the
paper gives assurance to overcome the shortcomings of correlation analysis.

4.3 Regression Model Test

For valid hypothesis testing and to make data available for reliable results, the test of assumption of
regression model is required. Accordingly, the study has gone through the most critical regression
diagnostic tests consisting of errors equal zero mean test, heteroskedasticity, normality, autocorrelation,
multicollinearity and model specification accordingly.

4.3.1 Classical Linear Regression Model Assumption

To maintain the data validity and robustness of the regressed result of the research, the basic classical
linear regression model (CRLM) assumptions must be tested for identifying any misspecification and
correcting them so as to augment the research quality (Brooks, 2008). There are different CLRM
assumptions that need to be satisfied and that are tested in this study, which are: errors equal zero mean
test, normality, heteroskedasticity, autocorrelation, and multicollinearity.

4.3.1.1. Test for Average Value of the Error Term is Zero Assumption
The first assumption required is that the average value of the errors is zero. In fact, if a constant term is
included in the regression equation, this assumption will never be violated. Therefore, since the constant
term (i.e. α) was included in the regression equation, the average value of the error term in this study is
expected to be zero.

4.3.1.2. Test for Heteroskedasticity Assumption

The condition of classic linear regression model implies that there should be homoscedasticity between
variables. This means that the variance should be constant and same. Variance of residuals should be

P a g e | 37
constant otherwise, the condition for existence of regression, homoscedasticity, would be violated and the
data would be heteroskedasticity (Brooks, 2008).

To check this, breusch-pagan- Godfrey test applied. Hence, following the general null hypothesis of
breusch-pagan-Godfrey, the researcher develops the following hypothesis to check the presence of
heteroskedasticity.
H0: There is no heteroskedasticity problem.
H1: There is heteroskedasticity problem.

Table 4.3.Heteroskedasticity Test: the Breusch- Pagan-Godfrey test

Heteroskedasticity Test: Breusch-Pagan-Godfrey

F-statistic 0.876147 Prob. F(7,72) 0.5297

Obs*R-squared 6.279578 Prob. Chi-Square(7) 0.5075
Scaled explained SS 7.317863 Prob. Chi-Square(7) 0.3966

Source: Financial statement of sampled banks, NBE reports and own computation through E-views 9

All versions of the Breusch- Pagan-Godfrey test statistic (F-statistic, Chi-Square and Scaled explained
SS) gave the same conclusion that there was no evidence for the presence of heteroscedasticity in this
particular study. Since the p-values of 0.5297, 0.5075 and 0.3966 for F-statistic, Chi-Square and Scaled
explained SS respectively were in excess of 0.05, the null hypothesis should not be rejected.

4.3.1.3. Test for Absence of Autocorrelation Assumption

Another basic assumption of regression model says that the covariance between error terms should be
zero. This means that error term should be random and it should not exhibit any kind of pattern. If there
exists covariance between the residuals and it is nonzero, this phenomenon is called autocorrelation
(Brooks, 2008). To test for autocorrelation, the researcher apply Breusch- Godfrey test.

Hypothesis of this test are

Following the general null hypothesis of Breusch–Pagan-Godfrey serial correlation LM test, the
researcher develops the following hypothesis to check the absence of autocorrelation:
H0: No autocorrelations errors
H1: Autocorrelations errors

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Table 4.4 Breusch-Pagan-Godfrey Serial Correlation LM Test:

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 0.496816 Prob. F(2,70) 0.6106

Obs*R-squared 1.119686 Prob. Chi-Square(2) 0.5713

Source: Financial statement of sampled banks, NBE reports and own computation through E-views 9

From the table above F test result and the P value of F-statistic 0.61 which is way beyond the significance
level of 5%. Hence, the null hypothesis of no autocorrelation is failed to reject at 5 percent of significance
level.

This implying that there is no significant evidence for the presence of autocorrelation in this model.
The Chi-Square P-value of the model 0.5713 also supports the absence of autocorrelation. Therefore, can
be concluded that, the covariance between residuals is zero, data is normal and absence of autocorrelation
problem was found conclusively from the LM test.

4.3.1.4. Test of Normality

Normality test was applied to determine whether a data is well-modeled by a normal distribution or not,
and to compute how likely an underlying random variable is to be normally distributed. If the residuals
are normally distributed, the histogram should be bell-shaped and the Jarque-Bera statistic would not be
significant. This means that the p value given at the bottom of the normality test screen should be greater
than 0.05 to support the null hypothesis of presence of normal distribution at the 5% level.

Theoretically, if the test is not significant, then the data are normal, so any value above 0.05 indicates
normality. Jarque-Bera formalizes this by testing the residuals for normality and testing whether the
coefficient of skeweness and kurtosis close are zero and three respectively. Skewness refers to how
symmetric the residuals are around zero. Perfectly symmetric residuals will have a skewness of zero.
Skewness measures the extent to which a distribution is not symmetric about its mean value. Kurtosis
refers to the “peakedness” of the distribution.

For a normal distribution the kurtosis value is 3. Kurtosis measures how flat the tails of the distribution
are, the Jarque–Bera test for normality is based on two measures, skewness and kurtosis. The Jarque-Bera

P a g e | 39
probability statistics/P-value is also expected not to be significant even at 10% significant level (Brooks,
2008).

The hypothesis of normality distribution is:

H0: residuals follow a normal distribution
H1: residuals do not follow a normal distribution

Figure 4.1 Normality test for residuals

20
Series: Residuals
Sample 1 80
16 Observations 80

Mean -1.92e-17
12 Median -0.000334
Maximum 0.005996
Minimum -0.005104
Std. Dev. 0.001935
8
Skewness 0.134785
Kurtosis 3.877390
4
Jarque-Bera 2.808272
Probability 0.245579
0
-0.004 -0.002 0.000 0.002 0.004 0.006

Source: Financial statement of sampled banks, NBE reports and own computation through E-views 9

As shown in the histogram above in the figure 4.1 kurtosis close to 3 (i.e. 3.8) and skewness approaches
to 0 (i.e. 0.13).and the Bera-Jarque statistic had a P-value of 0.24 implying that there was no evidence for
the presence of abnormality in the data. Thus, the null hypothesis that the data is normally distributed
should not be rejected since the p-value was considerably in excess of 0.05. Hence, it seems that the error
term in all of the cases follows the normal distribution and it implies that the inferences made about the
population parameters from the samples tend to be valid.

4.3.1.5. Test for Multicollinearity

Multicollinearity indicates a linear relationship between explanatory variables which may cause the
regression model biased (Gujarati, 2004). If an independent variable is an exact linear combination of the
other independent variables, then we say the model suffers from perfect collinearity, and it cannot be

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estimated by OLS (Brooks, 2008). When independent variables are multicollinear, there is overlap or
sharing of predictive power. This may lead to the paradoxical effect, whereby the regression model fits
the data well, but none of the explanatory variables (individually) has a significant impact in predicting
the dependent variable (Gujarati, 2004).

According to (Lewis-Beck, 1993) suggestion in order to find out the multicollinearity problem, the
bivariate correlations among the independent variables should be examined and the existence of
correlation of about 0.8 or larger indicates a problem of multicollinearity. Also, Cooper and (Schendlar,
2003) suggested that a correlation above 0.8 should be corrected. The VIF value calculated as 1/ (1-R2) is
3.28 below the recommended amount of 10. There are various recommendations for acceptable levels of
VIF have been published in the literature. Perhaps most commonly, a value of 10 recommended as the
maximum level of VIF (e.g., Hair, Anderson, Tatham, & Black, 1995; Kennedy, 1992; Neter,
Wasserman, & Kutner, 1989; Marquardt, 1970).

Table 4.5: Correlations matrix of explanatory variables

Correlation
Probability OCE NPLTL LPTL SIZE LR CIR CAR
OCE 1
NPLTL 0.1098 1
LPTL 0.0836 -0.0822 1
SIZE -0.6113 -0.0290 -0.4068 1
LR -0.3593 0.2087 -0.3277 0.5032 1
CIR 0.7487 -0.1422 0.2214 -0.6644 -0.4157 1
CAR 0.1828 -0.3285 0.3817 -0.3353 -0.7482 0.3874 1

Source: Financial statement of sampled banks, NBE reports and own computation through E-views 9

The Pearson correlation, which varies between -1 and 1, if the p-value is 0, there is no linear correlation,
and if the p-value is -1 or 1 we have a perfectly negative or positive relationship between the variables.
According to Pallant (2005), the results in the above correlation matrix table 4.5 shows that the highest
correlation of 0.7477 which is between credit income interest rate and operational cost efficiency.
Since there is no correlation above 0.8 in this study according to Cooper and Schendlar (2003) and Lewis-
Beck (1993), it can be concluded in this study that there is no problem of multicollinearity, thus enhanced
the reliability for regression analysis.

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4.4. Choosing Random Effect (RE) Vs Fixed Effect (FE) Models
The results so far indicate that all CRLM assumptions are not violated, so the ordinary least square
regression can be safely applied. However, since this study uses a panel data, there are two types of panel
estimator approaches that can be employed, namely: fixed effects models (FEM) and random effects
models (REM) (Brooks, 2008).

The simplest types of fixed effects models allow the intercept in the regression model to differ Cross-
sectional but not over time, while all of the slope estimates are fixed both cross-sectional and over time.
The random effects approach proposes different intercept terms for each entity and again these intercepts
are constant over time, with the relationships between the explanatory and explained variables assumed to
be the same both cross-sectional and temporally (Brooks, 2008).

To examine whether individual effects are fixed or random, a Hausman specification test was conducted
providing evidence in favor of the REM model (Baltagi, 2005). The null hypothesis for this test is that
unobservable heterogeneity term is not correlated or random effect model is appropriate, with the
independent variables. If the null hypothesis is rejected then we employ Fixed Effects method.
The Hausman test hypothesis is
H0: Random effect model is appropriate
H1: Fixed effect model is appropriate
Table 4.6. Hausman test
Correlated Random Effects - Hausman Test
Test cross-section random effects

Chi-Sq.
Test Summary Statistic Chi-Sq. d.f. Prob.

Cross-section random 7.313367 7 0.3970

Table 4.6 above shows Hausman specification test, the P-value of the model is 0.3970, which is more
than 5% level of significance. Hence, the null hypothesis of the random effect model is appropriate is
failed to reject at 5 percent of significant level. This implying that, random effect model is more
appropriate than fixed effect model and gives more comfort that random effects model results are valid.

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4.5. Regression Analysis of Financial Performance (Return on Asset)
E-views regression output is divided into three panels. The top panel summarizes the input to the
regression, the middle panel gives information about each regression coefficient, and the bottom panel
provides summary statistics about the whole regression equation. The two most important numbers, “R-
squared” (the one who answered how much percent of the variance in the dependent variable in the
regression accounted for) and “S.E. of regression.” and the one that shows how far is the estimated
standard deviation of the error term. Five other elements, “Sum squared residuals,” “Log likelihood,”
“Akaike info criterion,” “Schwarz criterion,” and “Hannan-Quinn criter.” Used for making statistical
comparisons between two different regressions.

The next two numbers, “Mean dependent var” and “S.D. dependent var,” report the sample mean and
standard deviation of the left hand side variable (Brooks, 2008). “Adjusted R-squared” makes an
adjustment to the plain-old to take account of the number of right hand side variables in the regression.
Measures what fraction of the variation in the left hand side variable is explained by the regression.

The adjusted, sometimes written, subtracts a small penalty for each additional variable added. “F-statistic”
and “Prob (F-statistic)” come as a pair and are used to test the hypothesis that none of the explanatory
variables actually explain anything. Put more formally, the “F-statistic” computes the standard F-test of
the joint hypothesis that all the coefficients, except the intercept, equal zero. “Prob (F-statistic)” displays
the p-value corresponding to the reported F-statistic.

The final summary statistic is the “Durbin-Watson,” the classic test statistic for serial correlation. A
Durbin-Watson close to 2.0 is consistent with no serial correlation, while a number closer to 0 means
there probably is serial correlation (Brooks, 2008).

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4.5.1 Operational Model
The operational panel regression model used to examine the impact of credit risk management on
performance of private commercial banks in Ethiopia which represented by Return on Asset (ROA) was:
ROAit= α +β1 OCE it + β2 NPLTL it + β3 LPTL it + β4 SIZE it + β5 LR it + β6 CIR it + β7CARit+uit…… (1)

Table 4.7.Random effects model regression results

Dependent Variable: ROA

Method: Panel EGLS (Cross-section random effects)
Date: 03/20/17 Time: 14:47
Sample: 2007 2016
Periods included: 10
Cross-sections included: 8
Total panel (balanced) observations: 80
Swamy and Arora estimator of component variances

Variable Coefficient Std. Error t-Statistic Prob.

C -0.042479 0.008771 -4.843364 0.0000

LPTL -0.021113 0.009543 -2.212420 0.0301**
NPLTL -0.008033 0.001895 -4.238441 0.0001*
SIZE 0.003025 0.000389 7.786757 0.0000*
LR -0.000386 0.000163 -2.363468 0.0208**
CIR 0.022585 0.002320 9.734806 0.0000*
CAR 0.109012 0.010274 10.61078 0.0000*
OCE -0.013920 0.001077 -12.92271 0.0000*

R-squared 0.732182 Mean dependent var 0.026260

Adjusted R-squared 0.695589 S.D. dependent var 0.007430
S.E. of regression 0.002027 Sum squared resid 0.000296
F-statistic 141.3809 Durbin-Watson stat 1.956514
Prob(F-statistic) 0.000000

Source: Financial statement of sampled banks, NBE reports and own computation through E-views 9
*and ** correlation coefficient significant at 1% and 5% significance level respectively

4.5.2. Interpretation of Regression Results

Table 4.7 presents the estimation results of the operational panel regression model of Return on Asset as
dependent variable and bank specific explanatory variables for the sample of eight private commercial
banks in Ethiopia. The R-squared and adjusted R-squared 73% and 69% respectively. It indicates that the
model is a good fit. This means, more than 69% of variations in return on asset of private commercial
banks in Ethiopia were explained by independent variables included in the model. However, the

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remaining 31% changes in return on asset of private commercial banks in Ethiopia are caused by other
factors that are not included in the model.

Furthermore, the F-statistic was 141.38 and the probability of not rejecting the null hypothesis that there
is no statistically significant relationship existing between the dependent variable (ROA) and the
independent variables, is 0.000000 indicates that the overall model is highly significant at 1% and that all
the independent variables are jointly significant in causing variation in return on asset.

The panel random effect estimation regression result in the above table 4.7 shows that, coefficient
intercept (α) is -0.04. This means, when all explanatory variables took a value of zero, the average value
ROA would be take -0.04 unit and statistically significant at 1% level of significance.

4.5.2.1 Loan Loss provision ratio (LLP) to Return on asset (ROA)

As Table 4.7 above depicted that, the coefficient of loan loss provision ratio (LLP) which was measured
by the ratio of provision for doubtful loans to total loan and advances is -0.021113 with the p-value of
0.0301. This indicates that holding other independent variables constant at their average value, when loan
loss provision ratio (LLP) increased by one percent, Return on asset (ROA) of sampled private
commercial banks would be decreased by 0.02 percent and statistically significant at 5% of significant
level. Therefore, the researcher fails to rejects the null hypothesis that loan loss provision has negative
impact on return on asset. The negative relationship of LLP with ROA is in line with (Ali 2015, Nigussie
2014, Kaaya and Pastory 2013, Funso et al., 2012, Adebayo 2011 and Mekasha, 2011).

Loan provisioning is the determination or estimation of the amount of non-performing loans

which are likely to be uncollectible and providing for those on the basis of aging and risk class
category of the loans concerned (NBE,2008). It is a measure of capita as well as credit quality of banks.
When banks invest their asset on a risky environment and lack the expertise to control their
lending operation, it will probably result in higher loan loss provision in order to cover the risk (Mustafa
et al., 2012). The major portions of banks operations are lending, they face challenges of credit risk
and hence create a loan loss provision to lessen the risk. This affects profitability of the bank
adversely because the provisions are deducted on annual bases from their income and when the amount of
provision is high, it decreases the bank's ability to give a loan reducing their profitability.

But the result of the study is contrary with the findings of (Elias 2015, Charless and Kennet, 2013 and
Gizaw, 2014) which stated that having direct relationship with profitability is that Provisions are

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liability accounts formed as reserves for potential or actual losses emanating from bad loans. When
provisions increase, the bank will be in a better position to withstand default on loans, and therefore
has a better credit policy. As banks expect some loans do not perform as expected; a loan loss provision
which is an expense that is reserved for defaulted loans will be held to cover all or portion of the
loss.

4.5.2.2 Non performing Loan Ratio (NPLs) to Return on Asset (ROA)

As indicated in the table 4.7 the coefficient of nonperforming loan ratio (NPLs) which was measured by
the ratio of nonperforming loans and advances to total loans and advances is -0.008033 with the p-value
of 0.0001. This indicates that holding other independent variables constant at their average value, when
nonperforming loan ratio (NPLs) increased by one percent, return on asset (ROA) of sampled private
commercial banks would be decreased by 0.008 percent and statistically significant at 1% level of
significance.

Therefore, the researcher failed to rejects the null hypothesis that non-performing loans ratio has a
negative effect on return on asset. This means, there is no sufficient evidence to support the positive
relationship between nonperforming loans and total loans and advances. The result is parallel with the
prior studies of (Hosna et al 2012, Addisu 2015, Girma 2011, korgi 2011, kirui 2014 and Macharia 2012)
who finds that a significant relationship between NPLs and Financial performance and NPLs show a
negative impact on the growth of financial performance (ROA).

This negative association between nonperforming loans and Return on asset could be attributed to the fact
that, when the amount of non-performing loan increases the interest income that the banks get from these
loans will decreases as a result it will decrease the return on asset. This would in-turn affect the banks,
ability to extend more loans to other customers that can generate more income. But the result of the study
is contrary with the findings of (Boahene 2012) which stated that having direct relationship with
profitability.

4.5.2.3 Bank Size (SIZE) to Return on Asset (ROA)

The result of random effect model table 4.7 reveals that banks size had positive Relationship with
profitability, and statistically significant (p-value = 0.0000) at 1% level, and it was in accordance
with the hypothesis. As a result, the null hypothesis which states there is no significant relationship
between Bank size and profitability of core business operations of commercial banks in
Ethiopia was rejected. This implies that every 1% change (increase or decrease) in the banks size

P a g e | 46
keeping the other thing constant had a resultant change of 0.003025 birr (Coeff. = 0.003025) on the
profitability in the same direction. The results also suggested that the bigger the bank, the more
economics of scale and hence more profitable as well. The possible reason is that, larger banks have
economics of scale and lower variance of earnings which resulted in profitability. The result also in
supported by the theory of Modern Portfolio theory and also consistence with some literature, (Youga
Raj Bhattari 2016, Berhanu 2016, Engidawork 2014, Boujelbene 2012, Ayadi, Pasiouras and Kosmidou
2007, and Smirlock 1985) and found out that bank size appear to be an important variable to affect
profitability positively.

4.5.2.4 Leverage Ratio (LR) to Return on Asset (ROA)

The result of random effect model table 4.7 indicates that capital structure as measured by total debt to
asset had negative relationship with profitability, and statistically significant (p value = 0.0301) at 5%
level, and the result was in accordance with the expected sign. As a result, the null hypothesis which
states there is no significant relationship between leverage ratio and profitability of core business
operations of commercial banks in Ethiopia was rejected. This implies that every 1 unit (birr) change
(increase or decrease) in banks leverage ratio keeping the other thing constant has a resultant
change of 5cents (Coeff.= -0.000386) on the profitability in the opposite direction. This result also
shows that debt financing have a negative impact on profitability of private Ethiopian banking
industry. Besides, the result revealed the suggestions that even though, profitable banks may have
better access to external financing, the need for debt finance may possibly be lower, if new
investments can be financed from accumulated reserves.

The possible reason for this result could be that the cost (interest expense) associated debt
financing through non-deposit sources are expensive in the context of Ethiopia banking business
operations/ environment. The result of this study is consistent with the pecking order theory that
suggests Profitable firms prefer internal financing to external financing and hence profitability is
expected to have negative relation with leverage (Myers and Majluf, 1984). Beside the negative
relationship between capital structure/leverage and profitability was observed in the previous empirical
studies of (Rajan and Zingales 1995, Opokuet al. 2013). The negative association between leverage ratio
and return on asset of private commercial Banks in Ethiopia could be attributed to the fact that, when the
amount of debt of the banks increases their commitment will rise this indirectly affect their liquidity as a
result their capacity to provide loans to their customers will decrease because of this their financial
performance will be affected negatively.

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4.5.2.5 Credit Interest Income Ratio (CIR) to Return on Asset (ROA)
Table 4.7 presented that, the coefficient of credit interest income ratio (CIR) measured by credit interest
income to total credit is 0.022585 and its P-value is 0.0000. Holding other independent variables constant
at their average value, when credit interest income ratio (CIR) increased by one percent, return on asset
(ROA) of sampled private commercial banks would be increased by 0.2 percent and statistically
significant at 1% level of significant. The result of the study is in line with the finding of Ali (2015)
which stated that credit interest income ratio affect return on asset positively and significantly. This
indicates that when the interest income from credit activity of the banks increases their income will be
high.
Therefore, the researcher failed to reject the null hypothesis that credit interest income has positive impact
on return on asset. This means, there is no sufficient evidence to support the negative relationship
between credit interest income and return on asset.

4.5.2.6 Capital Adequacy Ratio (CAR) to Return on Asset (ROA)

As indicated in table 4.7 above the coefficient of capital adequacy measured by the ratio of paid-up
capital to total asset is 0.109012 and its p-value is 0.0000. This indicate that holding other independent
variables constant at their average value, when Capital adequacy ratio increased by one percent, return on
asset (ROA) of sampled private commercial banks would be increased by 0.11 percent and statistically
significant at 1% level of significant. Therefore, the researcher failed to rejects the null hypothesis that
capital adequacy ratio has a positive impact on return on asset. This means, there is no sufficient evidence
to support the negative relationship between capital adequacy ratio and return on asset.

The result of this study is in support of the study of (Charles, Okaro Kenneth 2013, Addisu 2015 and
Aruwa and Musa,2012) who found that the rate of capital adequacy ratio has a positive effect on financial
performance of private commercial banks. (Kurawa and Garba, 2014) in their findings also discusses that
capital adequacy ratio has a significant positive effect on the financial performance. The basic argument
of these researchers for the positive relationship between bank capitalization and their financial
performance is that banks with larger capital cushion should have higher capacity to extend risky, long-
term loans. Therefore, increasing banks equity enhances the banks capacity to increase lending this in turn
increase their income and financial performance.

But the result is in contrary to the finding of (Ali 2015, Hosna et al 2009) who finds that there is no
relationship between capitalization of banks and their return on asset. In addition to the finding

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inconsistency among the researcher, opinion differs among experts in banking and finance as to what
constitutes adequate capital.
Because, high levels of capital allow banks to be risk averse and conservatively managed banks that may
be reluctant to issue risky long-term loans. This directly affects negatively their income which on the
other hand reduces their financial performance.

As far as capital adequacy concerned, adequate capital in banking is a confidence booster. It provides the
customer, the public and the regulatory authority with confidence in the continued financial viability of
the bank. Confidence to the depositor that his/her money is safe enhances the deposit of the banks as well
as solvency of the banks. The improvement in the solvency of the commercial banks enables the banks to
extend more loans and advances this directly affect their income positively their return on asset.

4.5.2.7 Operational Cost Efficiency (OCE) to Return on Asset (ROA)

The regression result of random effect model in the above table 4.7 is consistent with the hypothesis
developed in this study. The study hypothesized that there is negative association between operational
cost efficiency rate and return on assets of banks.

Thus, consistent with the hypothesis, the estimated coefficients -0.013920 with the p value 0.0000
showing statistically significant negative effect of operational cost efficiency on the level of return on
asset of private commercial banks in Ethiopia. This implies that every one unit change in operational
cost efficiency rate, keeping other thing constant had resulted 0.013 units change on the levels of return
on assets in opposite direction. The result of this study indicates that the financial performance of private
commercial banks in Ethiopia decrease when the amount of their expense increase. The result of this
study confirms the arguments of (Kirui, 2014). This result implies as the expense of private commercial
banks in Ethiopia gets higher the financial performance of the banks gets lower. This negative and
statistically significant impact of operational cost efficiency on return on asset of private commercial
banks in Ethiopia result as bank shift to reduce their costs in order to increase their financial performance.
(Hess and Francis, 2004) observed that there is an inverse relationship between operational cost effcieny
and financial performance. (Ghosh et al. 2003) also found that the expected negative relation between
operational cost efficiency and profit seems to exist.

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Table 4.9. Comparison of test results with the hypothesis
Independent variables Expected relationship Actual result Statistical significance
with ROA test
Operational cost effic. - - Significant at 1%
Non-performing loans - - Significant at 1%
Size of the banks + + Significant at 1%
Leverage ratio - - Significant at 5%
Credit interest income + + Significant at 1%
Capital adequacy ratio + + Significant at 1%
Loan loss provision - - Significant at 5%

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 CHAPTER FIVE

FINDING, CONCLUSION AND RECOMMENDATIONS

The basic intent of this chapter is to present the overall overviews of the research by summing the main
findings of the analysis part and give future research directions. Accordingly, the chapter starts with its
discussion by briefly sum up the overviews of the study and its main findings. In section two based on the
study finding the researcher highlight some recommendations for the target populations the study
pivoting on and at last highlight further research directions.

5.1 Summary of Finding

The research endeavor at examining the impact of credit risk management on financial performance of the
Ethiopian private commercial banks, all the way through identifying the indicators of credit risk and
financial performance ratios during the time period (2007- 2016), so as to it investigates the overall
impact of the credit risk indicators on banks’ financial performance using certain partial indicators of
credit risk. The empirical findings show that there is a negative effect of the credit risk indicators of Non-
performing loans on financial performance measured by ROA, and also a negative effect of Loan Loss
Provision ratio, Leverage Ratio and Operational cost Efficiency on financial performance measured by
ROA. On the other hand a Positive effect of credit risk indicator of Bank Size, Credit Interest income and
Capital Adequacy Ratio on financial performance of Private commercial Banks measured by ROA.

The result is parallel with the prior studies of (Hosna et al 2012, Addisu 2015, Girma 2011, korgi 2011,
kirui 2014 and Macharia 2012) who finds that a significant relationship between NPLs and Financial
performance and NPLs show a negative impact on the growth of financial performance (ROA). But the
result of the study is contrary with the findings of (Boahene 2012) which stated that NPL having direct
relationship with profitability. Regarding Bank Size, The result also is supported by some literature,
(Youga Raj Bhattari 2016, Berhanu 2016, Engidawork 2014, Boujelbene 2012, Ayadi, Pasiouras and
Kosmidou 2007, and Smirlock 1985) and found out that bank size appear to be an important variable to
affect profitability positively. Those Negative effects of LR capital structure/leverage and profitability
was observed in the previous empirical studies of (Rajan and Zingales 1995, Opokuet al. 2013). The
negative relationship of LLP with ROA is in line with (Ali 2015, Nigussie 2014, Kaaya and Pastory
2013, Funso et al., 2012, Adebayo 2011 and Mekasha, 2011). On the other hand a positive effect of Bank
size with profitability is consistent with a previous study of (Charles, Okaro Kenneth 2013, Addisu 2015
and Aruwa and Musa, 2012) who found that the rate of capital adequacy ratio has a positive effect on
financial performance of private commercial banks.

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The overall effect of the credit risk management on financial performance is statistically significant as
indicated by the computed F-statistic and its probability (0.0000) of the research models. Therefore, the
research submits that there is an effect of credit risk management on bank’s financial performance as
measured by ROA. This result is consistence with the study of Girma 2011, Hosna et al 2009, Tibebu
2011, Ms. Sujeewa Kodithuwakku 2015, Kithinji 2010 and Addisu 2015) who found an effect of credit
risk management on the profitability as measured by ROA. and is in agreement with (Felix & Cloudine
2008) which measured by ROA and ROE.

5.2 Conclusion
The role of Banks remain central in financing economic activity and its effectiveness could exert positive
impact on overall economy as a sound and profitable Banking sector is better able to withstand negative
shocks and contribute to the stability of the financial system (Athanasoglou, Brissimis, and Delis (2005).
The impact of credit risk is usually expressed as a function of internal and external determinants. The
internal determinants are termed as micro or bank-specific determinants of bank lending, while the
external determinants are macroeconomic variables that are not related to bank management but reflect
the monetary, economic and legal environment that affect the operation and performance of financial
institutions (Berhanu, 2016).

However, the main objective of this research was to examine the impact of credit risk management on
financial performance of private commercial banks in Ethiopia. To achieve this broad objective, the study
used quantitative research approach. To this end, data collected from National Bank of Ethiopia (NBE)
and each bank’s annual financial reports and a sample size of eight Ethiopian private commercial banks
over the period of 2007 to 2016.

Empirical literature identified many variables as an influential factor of financial performance. However,
depending on the practical context of Ethiopian commercial banks the researcher selected seven variables
namely: non-performing loans, loan loss provision, leverage ratio, capital adequacy ratio, bank size, credit
interest income, operational cost efficiency as independent variables and two dependent variables return
on asset and return on equity.

The analysis was conducted using panel data estimation technique of random effect model using E-views
9 statistical software. The study goes through all diagnostic tests, including multicollinearity,
heteroskedacity, normality and autocorrelation. Hence, the test result shows that the data was found to be

P a g e | 52
homoskedastic, free of autocorrelation free of multi-collinearity and normally distributed. The descriptive
statistics revealed the data to be normal. Also the coefficient of determination (R2) is 0.695589 and
0.656633 for banks return on asset and return on equity respectively. This indicates that the explanatory
variables were able to explain 69.5% and 65.6 % of the total variations of the dependent variables banks
return on asset and return on equity respectively.

The regression result shows the findings indicated that bank credit risk management measured in terms of
bank size, Credit interest income and capital adequacy ratio had positive and statistically significant effect
on the banks return on asset. On the other hand, non-performing loans, loan loss provision, operational
cost efficiency, and leverage ratio had negative and statistically significant effect on return on asset.

Bank size (SIZE) found to have positive and significant relationship with the return on asset of private
commercial banks in Ethiopia. Banks with strong arm in the industry have more liquid assets than the
smaller ones this gives them the advantage to extend more loans; as a result their return on asset is higher.
Therefore, bigger banks have higher return on asset and vice versa.

Capital adequacy ratio also found to have positive and significant effect on the return on asset of private
commercial banks in Ethiopia. Since credit is the major source of income for banks in Ethiopia, well
capitalized banks extend more loans and advances to their customers and generate more income than
poorly capitalized banks. This due to is the fact that adequate capital in banking on one hand directly
increases the liquidity of the of commercial banks in Ethiopia and on other hand indirectly used as a
confidence booster to the depositor that his/her money is safe and enhances the deposit as well as
solvency of the banks. This enables the banks to extend more loans and advances and generate more
income.

On the other hand, the finding showed that non-performing loans, loan loss provision, operational cost
efficiency and leverage ratio had negative and statistically significant relationship with the Return on
asset of private commercial banks in Ethiopia. This indicates that an increase in non-performing loans,
operational cost efficiency and leverage ratio leads to decrease in the return on asset of private
commercial banks in Ethiopia during sample period.

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5.3. Recommendations

 Among the independent variables capital adequacy ratio and bank size were the major factors that
positively and significantly affect the return on asset of private commercial banks in Ethiopia.
Hence, banks advisable to work more towards improving their assets specially the liquid ones and
level of capitalization so as to increase their lending ability and to ensure their profitability.

 Non-performing loans, operational cost efficiency and leverage ratio were factors that negatively
and significantly affect the return on asset of private commercial banks in Ethiopia. Thus, banks
advisable revise or re-emphasized their credit procedures, policies and analytical capabilities and
these efforts advised to be expanded into full credit management including origination, approval,
monitoring and problem loans management to reduce the nonperforming loans.

 Banks advisable to give due attention in their operational cost efficiency and leverage ratio,
because excess expenses in relation with their revenue and engaging in debts beyond their
capacity will have significant negative effect on their performance. Because of this the banks
advise to reduce expenses and debts for their long term survival.

 Currently, Ethiopian commercial banks that were sampled in this study were considering
collateral as prime factor for assessing loan application in all conditions and hence, providing
appropriate focus for factors such as repayment capacity of the client, the feasibility of the project
and the experience of the management of the company in credit approval process could improve
the quality of their loan portfolios.

 Prudence of policies that govern bank loans advised continuously is ensured in light of
international best practices, macroeconomic situations, level of development of banks and the
economy in general by the regulatory body (NBE).

 To maintain their profitability the banks advice remain innovative especially on cost cutting
techniques which include leveraging in technology.

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5.4. Future Research Recommendations
This study examined the impact of credit risk management and their effects on the financial
performance of private commercial banks in Ethiopia by using selected bank specific variables.
However, these variables are not exhaustive. Thus, it is recommended for future researchers to further
assess the impact of credit risk management and their effects on the financial performance of commercial
banks in Ethiopia by incorporating additional bank specific, industry specific and macro-economic factors
which had on been discussed by previous literatures in the country. Finally, this study use only secondary
data. Therefore, it is recommended for future researchers to study the determinants of financial
performance and their effect on financial performance of commercial banks by using primary data
or the mixture of primary and secondary data.

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ANNEX-1 Hetroskdasticity Test

Heteroskedasticity Test: Breusch-Pagan-Godfrey

F-statistic 0.876147 Prob. F(7,72) 0.5297

Obs*R-squared 6.279578 Prob. Chi-Square(7) 0.5075
Scaled explained SS 7.317863 Prob. Chi-Square(7) 0.3966

Test Equation:
Dependent Variable: RESID^2
Method: Least Squares
Date: 05/09/17 Time: 13:06
Sample: 1 80
Included observations: 80

Variable Coefficient Std. Error t-Statistic Prob.

C 1.81E-05 2.75E-05 0.657330 0.5131

OCE -3.72E-06 3.38E-06 -1.101886 0.2742
NPLTL -6.12E-06 5.95E-06 -1.029345 0.3068
LPTL -7.39E-06 2.99E-05 -0.246783 0.8058
LNTA -5.51E-07 1.22E-06 -0.451677 0.6529
DER 2.18E-07 5.13E-07 0.424718 0.6723
CIR 3.10E-06 7.28E-06 0.426030 0.6714
CAR -1.74E-05 3.22E-05 -0.541138 0.5901

R-squared 0.078495 Mean dependent var 3.70E-06

Adjusted R-squared -0.011096 S.D. dependent var 6.31E-06
S.E. of regression 6.35E-06 Akaike info criterion -21.00281
Sum squared resid 2.90E-09 Schwarz criterion -20.76460
Log likelihood 848.1122 Hannan-Quinn criter. -20.90730
F-statistic 0.876147 Durbin-Watson stat 1.748615
Prob(F-statistic) 0.529665

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ANNEX-2 Autocorrelation LM Test

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 0.496816 Prob. F(2,70) 0.6106

Obs*R-squared 1.119686 Prob. Chi-Square(2) 0.5713

Test Equation:
Dependent Variable: RESID
Method: Least Squares
Date: 05/09/17 Time: 13:18
Sample: 1 80
Included observations: 80
Presample missing value lagged residuals set to zero.

Variable Coefficient Std. Error t-Statistic Prob.

C 0.000345 0.008859 0.038948 0.9690

OCE 0.000202 0.001129 0.178703 0.8587
NPLTL -0.000536 0.002016 -0.266147 0.7909
LPTL -2.39E-06 0.009666 -0.000248 0.9998
LNTA -2.99E-07 0.000392 -0.000762 0.9994
DER -2.48E-05 0.000169 -0.146337 0.8841
CIR -0.000539 0.002430 -0.221605 0.8253
CAR -0.001916 0.010571 -0.181220 0.8567
RESID(-1) 0.043402 0.126712 0.342522 0.7330
RESID(-2) 0.119397 0.126540 0.943553 0.3486

R-squared 0.013996 Mean dependent var -1.92E-17

Adjusted R-squared -0.112776 S.D. dependent var 0.001935
S.E. of regression 0.002041 Akaike info criterion -9.434128
Sum squared resid 0.000292 Schwarz criterion -9.136375
Log likelihood 387.3651 Hannan-Quinn criter. -9.314750
F-statistic 0.110404 Durbin-Watson stat 1.943701
Prob(F-statistic) 0.999352

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ANNEX-3: Normality Test
20
Series: Residuals
Sample 1 80
16 Observations 80

Mean -1.92e-17
12 Median -0.000334
Maximum 0.005996
Minimum -0.005104
Std. Dev. 0.001935
8
Skewness 0.134785
Kurtosis 3.877390
4
Jarque-Bera 2.808272
Probability 0.245579
0
-0.004 -0.002 0.000 0.002 0.004 0.006

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ANNEX-4: Correlated Random Effects- Hausman Test

Correlated Random Effects - Hausman Test

Equation: Untitled
Test cross-section random effects

Chi-Sq.
Test Summary Statistic Chi-Sq. d.f. Prob.

Cross-section random 7.313367 7 0.3970

Cross-section random effects test comparisons:

Variable Fixed Random Var(Diff.) Prob.

OCE -0.012460 -0.013920 0.000001 0.2191

NPLTL -0.009148 -0.008033 0.000002 0.4277
LPTL -0.020086 -0.021113 0.000008 0.7112
LNTA 0.002866 0.003025 0.000000 0.0662
DER -0.000364 -0.000386 0.000000 0.5240
CIR 0.019605 0.022585 0.000005 0.1651
CAR 0.107158 0.109012 0.000026 0.7179

Cross-section random effects test equation:

Dependent Variable: ROA
Method: Panel Least Squares
Date: 05/12/17 Time: 12:17
Sample: 2007 2016
Periods included: 10
Cross-sections included: 8
Total panel (balanced) observations: 80

Variable Coefficient Std. Error t-Statistic Prob.

C -0.039134 0.009057 -4.321000 0.0001

OCE -0.012460 0.001604 -7.767916 0.0000
NPLTL -0.009148 0.002360 -3.876454 0.0002
LPTL -0.020086 0.009938 -2.021179 0.0474
LNTA 0.002866 0.000398 7.200397 0.0000
DER -0.000364 0.000167 -2.184202 0.0326
CIR 0.019605 0.003161 6.202848 0.0000
CAR 0.107158 0.011484 9.331439 0.0000

Effects Specification

Cross-section fixed (dummy variables)

R-squared 0.939041 Mean dependent var 0.026360

Adjusted R-squared 0.925911 S.D. dependent var 0.007430
S.E. of regression 0.002022 Akaike info criterion -9.401655

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Sum squared resid 0.000266 Schwarz criterion -8.955025
Log likelihood 391.0662 Hannan-Quinn criter. -9.222588
F-statistic 71.52049 Durbin-Watson stat 2.060958
Prob(F-statistic) 0.000000

Annex-5: Random Effect Model Regression Results (Return on Asset)

Dependent Variable: ROA

Method: Panel EGLS (Cross-section random effects)
Date: 05/12/17 Time: 12:58
Sample: 2007 2016
Periods included: 10
Cross-sections included: 8
Total panel (balanced) observations: 80
Swamy and Arora estimator of component variances

Variable Coefficient Std. Error t-Statistic Prob.

C -0.042479 0.008771 -4.843364 0.0000

OCE -0.013920 0.001077 -12.92271 0.0000
NPLTL -0.008033 0.001895 -4.238441 0.0001
LPTL -0.021113 0.009543 -2.212420 0.0301
LNTA 0.003025 0.000389 7.786757 0.0000
DER -0.000386 0.000163 -2.363468 0.0208
CIR 0.022585 0.002320 9.734806 0.0000
CAR 0.109012 0.010274 10.61078 0.0000

Effects Specification
S.D. Rho

Cross-section random 6.48E-09 0.0000

Idiosyncratic random 0.002022 1.0000

Weighted Statistics

R-squared 0.732182 Mean dependent var 0.026360

Adjusted R-squared 0.695589 S.D. dependent var 0.007430
S.E. of regression 0.002027 Sum squared resid 0.000296
F-statistic 141.3809 Durbin-Watson stat 1.956514
Prob(F-statistic) 0.000000

Unweighted Statistics

R-squared 0.932182 Mean dependent var 0.026360

Sum squared resid 0.000296 Durbin-Watson stat 1.956514

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