Synopsis on

Impact of nonperforming loan on bank profitability: A case of Nepalese commercial banks.

Graduate Research Project, MBA Finance, Uniglobe College
Friday, September 11, 2015
Presenter: Ravi Bhandari

Research Context
There seems to be a consensus that bank profitability is directly related to the quality of the assets on its balance sheet; i.e., poor credit quality
has a negative effect on bank profitability and vice versa. This relation exists because an increase in the doubtful assets, which do not accrue
income, requires a bank to allocate a significant portion of its gross margin to provisions to cover expected credit losses; thus, profitability will
be lower. The credit function of banks enhances the ability of investors to exploit desired profitable ventures. Credit creation is the main income
generating activity of banks (Kargi, 2011). The major cause of serious banking problems continues to be directly related to low credit standards
for borrowers and counterparties, poor portfolio management, and lack of attention to changes in economic or other circumstances that can lead
to deterioration in the credit standing of bank’s counter parties. Among other risks faced by banks, credit risk plays an important role on banks’
profitability since a large chunk of banks’ revenue accrues from loans from which interest is derived. (Drehman et. al. 2008). The cause of credit
risk occurs due to the prevalence of Non-Performing Loan (NPL). Non-performing loan is the percentage of loan values that are not serviced for
three months and above (Ahmad & Ariff, 2007). A high level of NPL suggests high probability of a large number of credit defaults that affect
the profitability and net-worth of banks and also erodes the value of the asset. The NPL growth involves the necessity of provisions, which
reduces the overall profits and shareholders’ value (Parul, 2012) .
Purpose of Study
The main purpose of this study is to examine the relationship between nonperforming loan and bank profitability in Nepalese context. More
specifically, it tries to analyze the role of nonperforming loan, loan loss provision, firm size, total loan to total deposit and capital adequacy in
the bank profitability of Nepal.
Significance of the Study
The share of non-performing loan in total bank loans is an important indicator of banking and financial institutions health. The high share of
nonperforming loan in the Nepalese banking sector in aggregate has been of concern in the past. The finding of the study is of interest to
commercial banks managers as they will get to know effects of nonperforming loans on profitability and encourage them take necessary
measures to control occurrences of nonperforming loans. The present study may contribute to the NPLs literature in Nepalese banking industry.
This study may add literature regarding the factors affecting the credit risk of commercial banks in Nepal. In Nepal, banking industry is facing
the problem of non-performing loan. Furthermore, this study is of great significance to academics as the new framework proposed in this study
can be useful for future research.
Hypotheses
Based on the objectives of the study, the following alternative hypothesis have been formulated and tested:
Hypothesis 1: NPLTL is negatively related to ROA.
Hypothesis 2: NPLTL is negatively related to ROE.
Hypothesis 3: LLP is negatively related to ROA.
Hypothesis 4: LLP is negatively related to ROE.
Hypothesis 5: There is a positive relationship between TLTD and ROA.
Hypothesis 6: There is a positive relationship between TLTD and ROE.
Hypothesis 7: Bank size is positively related with ROA
Hypothesis 8: Bank size is positively related with ROE
Hypothesis 9: Capital adequacy ratio is positively related with ROA.
Hypothesis 10: Capital adequacy ratio is positively related with ROE.
Literature Review
(Dermirgue-Kunt, 1989) and (Barr & Siems, 1994) indicated that failing banking institutions always has high level of non-performing loans
prior to failure. A high level of NPL suggests high probability of a large number of credit defaults that affect the profitability and net-worth of
banks and also erodes the value of the asset (Parul, 2012) . Mustafa, Ansari & Younis (2012) examined the impact of loan loss provisions of the
banks on the performance of the banks operating in Pakistan and found that loan loss provision has negative impact on profitability. Poudel
(1994) found positive influence of size on profitability of the bank. Jha & Hui (2012) revealed total loan to total deposit is positive related with
return on assets and return on equity. Similarly, Dang & Uyen (2011) found that capital adequacy ratio shows the internal strength of the bank to
withstand losses during crisis. The study conducted by Ochei (2013) resulted positive relationship between capital adequacy ratio and
commercial bank profitability in Nigeria.
Data description
The study is based on secondary data of 16 commercial banks of Nepal for the period from 2003/04 to 2012/13 with total of 160 observations.
The data have been obtained from official website of concern commercial banks, Nepal Stock Exchange Limited (NEPSE), Security Board of
Nepal (SEBON), and Nepal Rastra Bank (NRB). The panel data analysis has been undertaken in the study. Data of variables were extracted
from balance sheet, and income statement of respective banks. The research design adopted in this study is casual comparative type as it deals
with relationship of nonperforming loan to total loan ratio, loan loss provision, total loan to total deposit ratio, firm’s size and capital adequacy
ratio with proxy of profitability (i.e., Return on assets and return on equity). More specifically, the study examines the impact of nonperforming
loan to total loan ratio, loan loss provision, total loan to total deposit ratio, firm’s size and capital adequacy ratio on profitability.
 Methodology
The research design adopted in this study consists of descriptive, casual comparative analysis and stepwise regression analysis to deal with the
various issues raised in this study. The descriptive research design has been adopted to undertake fact-finding operation searching for adequate
information in the context of nonperforming loan and bank profitability. The casual comparative analysis has been adopted to establish the
directions, magnitude and forms of the observed relationship nonperforming variables and bank profitability. Moreover, the study has adopted
step wise regression analysis to determine the cause and effect relationship between the nonperforming loan and profitability. The effect of
nonperforming loan variables like nonperforming loan to total loan ratio, loan loss provision, total loan to total deposit, firm size and capital
adequacy ratio on profitability proxy like return on assets and return on equity.
Research Model
Linear regression model is used in this study used to test the hypothesis of the study. Actually, the profitability is represented by two different
proxy viz., return on assets (ROA), and return on equity (ROE). And these models are presented to show the relationship between dependent and
independent variables. Profitability = f (NPLTL, LLP, TLTD, SIZE, CAR)
The model to be estimated is specified as under:
ROAit = α0 +α1 NPLTLit + α2LLPit + α3TLTDit + α4SIZEit + α5CARit +eit…………………... (1)
ROEit = α0 +α1 NPLTLit + α2LLPit + α3TLTDit + α4SIZEit + α5CARit +eit. ………...……… (2)
In equation ROA refer to return on assets, ROE refers to return on equity, NPLTL refers to nonperforming loan to total loan, LLP refers to loan
loss provision, TLTD refers to total loan to total deposit ratio, SIZE refers to firm’s size and CAR refers to capital adequacy ratio. Similarly, α 0
y intercept, αi (i=1, 2, 3, 4) denote regression parameter and eit denote error term.
Major Findings
The study found that average return on assets is highest for Nabil and lowest for LBL. The average values of return on assets have increased
slowly over a study period. It showed highest average return on equity was observed for Nabil whereas lowest was for NBL .The average values
of return on equity have decreased slowly over a period. Lowest average non-performing loan ratio was shown by Laxmi Bank whereas highest
non-performing loan ratio was found to be of RBB. The patterns of nonperforming loan have been decreasing over a period of time. Similarly,
NBB showed highest average loan loss provision whereas lowest was shown by Laxmi Bank. The structures of loan loss provision have been
fluctuating throughout the period. SBL showed highest average total loan to total deposit whereas lowest was observed for RBB. The trend of
average total loan to total deposit of commercial banks during study period was found to be increasing steeply. Similarly, average firm size was
highest for RBB and lowest for LBL. The trend of average size of commercial banks during study period was found to be increasing. Highest
average capital adequacy ratio was found to be of SCB during study period whereas lowest average capital adequacy ratio was found to be of
RBB. The trend of capital adequacy ratio is found to be first decreasing and then increasing during observed period.
The average return on assets and return on equity of total observation throughout the study period was found to be 1.44% and 14.26%
respectively. Similarly, the average value of nonperforming loan to total loan, loan loss provision, and total loan to total deposit of total
observation was observed 6.37 percent, Rs. 1.91 billion and 0.68 ratio respectively. The study also found average size and capital adequacy ratio
of whole observation was found to be Rs. 28.08 billion and 7.16 ratio respectively during study period.
Return on assets is found to have positively related with total loan to total deposit, firm size, and capital adequacy ratio whereas negative
relationship with non performing loan to total loan and loan loss provision. Return on assets has significant with nonperforming loan, loan loss
provision and firm size at 1 percent level of significance. Similarly, return on equity is found positively related with total loan to total deposit
and capital adequacy ratio. And negative relationship was found to be with firm size, non performing loan to total loan and loan loss provision.
Similarly, return on equity found significant with capital adequacy with 1 percent level of significance.
Regression analysis shows that non performing loan to total loan and loan loss provision showed negative relationship with return on assets. It
was found that firm size, total loan to total deposit and capital adequacy ratio was negatively related with return on assets. The result in first
model showed nonperforming loan to total loan, loan loss provision, firm size and capital adequacy ratio have significant impact on return on
assets. Likewise, nonperforming loan to total loan, loan loss provision, firm size showed negative relationship with return on equity. And total
loan to total deposit and capital adequacy ratio was positively related with return on equity. Similarly in second model of regression analysis
among the other independent variable capital adequacy was significantly positive related with Return equity.
Conclusion
The major conclusion of this study is that nonperforming loan has impact on profitabilityof commercial banks in nepal. The empirical evidence
suggest that nonperforming loan to toatal loan, loan loss provision impact negatively on return on assets where as total loan to total deposit, firm
size and capital adequacy ratio impact positively on return on assets. Similarly, in the case of return on equity nonperforming loan to total loan,
loan loss provision, firm size shows negative impact. Meanwhile the impact of nonperforming loan, loan loss provision found significant impact
on proxy of bank profitability.
Future Scope
The study has excluded the firms like non- finance companies, and even in the financial sector this study has not covered development banks,
finance companies and insurance companies The study has focused only bank specific variable it doesn’t involve other macroeconomic variable
like GDP, inflation, unemployment that may affect on the business of Nepalese commercial bank and on its profitability. Though this study aims
to testify the relationship between non performing loan and bank profitability using (ROA,ROE, NPLTL, TDTL, CAR, SIZE, LLP), this study
has not used variables like provision for doubtful loans, net interest margin, stock price, etc that could have high exploratory power. The
research study can be conducted by using this type of institution with including macroeconomic variables that also has affect on profitability of
commercial banks of Nepal. Lack of pertinent literature on banks risk taking behavior and performance evaluation in the Nepalese context.
……………………………………………………………………..Thank you……………………………………………………………………….