2.

REVIEW OF RELATED LITERATURE

2.1. Theoretical Review Of Related Literature

2.1.1. Concept Of and Definition of Credit Risk
Credit risk is a financial exposure resulting from a Bank’s dependence on another party
(counterparty) to perform an obligation as agreed (National Bank of Ethiopia 2010). Credit risk,
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). It can also be
defined as the potential that a contractual party will fail to meet its obligations in accordance
with the agreed terms. Credit risk is also variously referred to as default risk, performance risk or
counterparty risk (Brown and Moles, 2012).

The idea of credit risk is that banks cannot raise the funds they borrow from their customers
(Han, 2015). Han (2015) asserts that credit risk consists of three main forms: risk of principal
loss, the risk for loss of interest, and the risk of loss of benefit. Al-Khouri (2010) explains some
of the key causes of credit risk, including inadequate institutional capability, inadequate credit
guidelines, unpredictable interest rates, inefficient management, inadequate legislation,
increasing numbers of banks, incompetence in credit valuation, and ineffective methods of
lending, government intervention, and insufficient central bank supervision. Naomi (2011)
claims that the possible difference in net income from non-payment or delay in credit facility
payment to customers reflects credit risk. Credit risk is most clearly described, according to the
Basel Banking Supervision Committee, as the potential for bank counterparty failing to meet
their responsibilities under agreed conditions (Ekinci and Poyraz, 2019).

Banking risks are many, and include among many others, market, liquidity, operational,
concentration, and credit risk (Sbârcea, 2017). Credit risk has commonly been identified as a
greatest risk on bank’s performance (Boffey& Robson, 2007, p.66). It is a risk that counterparties
in loan transactions and derivatives transactions might default, which means counterparties fail
to repay the principal and interest on a timely basis (Koch& MacDonald, 2000, p. 109). Credit
risk attracts the most attention, and is the most vital risk exposure, which is unavoidable in banks
due to the nature of business. Credit risk refers to the uncertainty presented when one party in a
transaction fails to honour their financial obligation (Smit, Swart, & van Niekerk, 2003). In other
words, it is risk which arises from the prospect that a borrower will fail to meet the terms of a
contractual agreement, by defaulting on the payment of interest or the principal amount. The
granting of credit entails uncertainty, because the future is unknown. Furedi (2009) goes further
to states that not only are risks in the time to come unknown, but future risks are also
unknowable.

Credit risk refers to a financial risk that can lead to bank failure if it is not controlled. Therefore,
according to the Bank of International Settlement (BIS), credit risk must be identified, measured,
monitored, and properly managed so as to ensure that the credit risks on loans are properly
priced to acquire the set targets of returns from the information obtained during loan
documentation (Kithinji, 2010). Deciding on how to price a loan is not easy in the process of
granting credit. The desire to attain the highest profits possible involves charging higher
interests, yet to have borrowers who repay loans requires lower than reasonable interest rates.
Credit risk is the most regulated key risk in the banking sector (Alizadehjanvisloo &
Muhammad, 2013), where competition on the credit market plays a role in regulating prices, as
borrowers have the option to choose from a range of banks.

Credit risk can also be a risk of loss on credit derivative market. It can be credit migration such
as a downgrade in credit rating (Choudhry, 2011, p. 131). Or when the bank invests in debt to
high-quality borrower whose risk profile has deteriorated (Choudhry, 2011, p. 131). In the case
of liquidation, the price at which the debt is sold is lower than the price at which the debt was
bought by the bank, which induces a net loss of bank on the market (Van Gestel & Baesens,
2008, p.25). In a full default, the extent of loss can be observed immediately to be the full from
the administrators which is known as “recovery value” (Choudhry, 2011, p. 131). Generally, the
loss for the bank does not have to be high. The loss of default relies on the percentage that one
can recover from the defaulted counterpart and the total exposure to the counterpart (Van Gestel
& Baesens, 2008, p.25). The recovery may depend on the presence of collateral and guarantees
(Van Gestel & Baesens, 2008, p.25).

High indebtedness places a distinct burden on both the economy and social system (SARB
Quarterly Bulletin, 2018). It is not obvious that all applications received by banks in the loan
approval process are approved and processed, especially when the NCA is enforced correctly
according to its mandate (NCA, 2005). Decision making on awarding loans is not complicated
through use of data analysis (Salkic, 2013). When borrowers fail to meet the required standards
they are rejected, with reasons given to the applicants. Transparency strengthens credence in the
banking system, and helps banks avoid fallacies on loan disbursement. It is imperative to
circumvent giving credit to troublesome borrowers, and to deny the opportunity to borrowers
who would have turned out not to honour the obligations. Credit risk is a notable financial risk,
which has to be cautiously monitored and supervised so as to reduce default rate (Noomen &
Abbes, 2018).

2.1.2. Sources of Credit Risk

A total of two primary sources are used to determine credit risk criteria. These risk factors could
be classified as external or internal. The risk factors are addressed as follows, according to
Afolabi, Obamuyi and Egbetunde (2020): In trying to investigate the financial conditions of the
risk associated with credit, it is important to indicate that as a result of changes in market series,
currency exchange rate, interest rate, credit availability and credit quality, changes in countries
revenue and unemployment level would have an effect on credit risk. The willingness of the
lending firm to perform its responsibility is a cash crunch or financial issue. Furthermore, the
changes in legislation and regulations will lead to financial institutions altering their transaction
processing, as well as their debt collection efficiency and capacity (Olson & Zoubi, 2017).

The main source of credit risk include, limited institutional capacity, inappropriate credit
policies, volatile interest rates, poor management, inappropriate laws, low capital and liquidity
levels, direct lending, massive licensing of Banks, poor loan underwriting, laxity in credit
assessment, poor lending practices, government interference and inadequate supervision by the
central Bank (Kithinji, 2010).Credit risk is critical since the default of a small number of
important customers can cause large losses, which can lead to insolvency (Bessis, 2002). An
increase in Bank credit risk gradually leads to liquidity and solvency problems. Credit risk may
increase if the Bank lends to borrowers it does not have adequate knowledge about. Robert and
Gary (1994) state that the most obvious characteristics of failed Banks is not poor operating
efficiency, however, but an increased volume of nonperforming loans.

Athanasoglou et al. (2005), suggest that Bank risk taking has pervasive effects on Bank profits
and safety. Bobakovia (2003) asserts that the profitability of a Bank depends on its ability to
foresee, avoid and monitor risks, possible to cover losses brought about by risk arisen. This has
the net effect of increasing the ratio of substandard credits in the Bank’s credit portfolio and
decreasing the Bank’s profitability (Mamman and Oluyemi, 1994). The Banks supervisors are
well aware of this problem, it is however very difficult to persuade Bank mangers to follow more
prudent credit policies during an economic upturn, especially in a highly competitive
environment. They claim that even conservative mangers might find market pressure for higher
profits very difficult to overcome

2.1.3. Credit Management Policy

Credit management policy is the principles and structures developed by top administration that
neglect the company’s credit division and analyze execution against established procedures in
increasing credit benefits (Jim-Franklin, 2010). It effectively places the system of rules to reduce
credit-related costs while expanding its benefits (Saeed and Zahid, 2016). The arrangements for
credit administration include credit, credit and credit policies. The policy is the benchmark for
the actions and aspirations of all employees responsible for credit awards and also serves as a
reference point for standards-built performance measures. Franklin (2010) instructs the
endorsement and use of credit policies to achieve the great goals of the credit administration
technique.

Afriyie & Akotey (2012, p. 6) indicates that credit risk situation of a bank can be exacerbated by
inadequate institutional capacity, inefficient credit guidelines, inefficient board of directors, low
capital adequacy ratios and liquidity, compulsory quota lending as a result of government
interference and lack of proper supervision by the central bank. Therefore, efficient risk
management is crucial and valuable for banks to improve the performance and reduce the
damage caused by risks.

2.1.4. Risk Management

Risk management is mainly focused on reducing earning volatility and avoiding large losses.
One proper risk management procedure needs to identify the risk, measure and quantify risk then
develop strategy to manage risk (Van Gestel& Baesens, 2008, p. 39). Figure 2.1 illustrates the
risk management process.
Figure 2.1: Different Steps of a Continuous Risk Management Process

Sources: Van Gestel& Baesens, 2008, p. 41

As Figure 2.1: indicates, risk management process includes identification, measurement,
treatment and implementation. The most important step of risk management, identification, can
begin from analyzing the sources of potential risks or defining threats. Secondly, measurement
needs to quantify the risk which has been identified in the identification step (Van Gestel &
Baesens, 2008, p.42). For example, individual needs to measure the real default probability and
how much the change of risk drivers influences the default probability. In this step, statistical
analysis is analysis needed for the risk measurement (Van Gestel & Baesens, 2008, p.42).

The third step in risk management is treatment (Van Gestel & Baesens, 2008, p.43). Risk can be
treated through four ways: risk avoidance, risk reduction, risk acceptance and risk transfer (Van
Gestel & Baesens, 2008, p.43). Risk avoidance is a simple way of treatment which refers to
individual investing in the products that are not too risky (Van Gestel & Baesens, 2008, p.43).
Avoidance does not imply avoiding all risks. One strategy can be investing in counterparts with
low exposure risk or investing only small proportion in counterparts with high default (Van
Gestel& Baesens, 2008, p.43). Risk reduction states reducing the portion of risk taken which
means use collateral to reduce the actual loss. Risk acceptance is commonly applied for low-risk
assets (Van Gestel & Baesens, 2008, p.43). It emphasizes the diversification of investments in
various sectors and countries. And risk transfer implies transfer risk to other institutions such as
banks, insurances or companies. This treatment provides a guarantee to credit risk such as credit
derivatives (Van Gestel & Baesens, 2008, p.43).

After finishing the treatment in the risk management procedure, risk management strategy should
be implemented (Van Gestel & Baesens, 2008, p.43). Implementation should put people,
statistical model and IT infrastructure to measure the underlying risk of current and future
investment (Van Gestel & Baesens, 2008, p.42). It also needs a guideline for risk treatment to
select counterparts in which to invest or not; which limit exposure of risky product should be
determined; whether collateral for specific loans is mandatory or not and whether individual
buys financial protection to secure investment (Van Gestel & Baesens, 2008, p.4). Such
implementation of risk management is usually supervised by senior management and the risks
need to be continuously reported and monitored (Van Gestel & Baesens, 2008, p.43). In the end,
effective risk management process is usually evaluated frequently. This step refers to check
whether the final risk taking keeps in line with the strategy and in a correct way of application.
Specifically, it means the evaluation of risk drivers and measurement process (Van Gestel &
Baesens, 2008, p.43).

The reason for conducting risk management is due to banks and banking activities have evolved
significantly over the time (Van Gestel & Baesens, 2008, p.42). With the introduction of money,
financial services such as deposit taking, lending money and money transfer have gradually
become important. So that banks are exposed to credit, market, operational, interest rate and
liquidity risk. Efficient management on these risks is necessary for banks to reduce its losses on
earning, insolvent and those depositors cannot be refunded (Van Gestel & Baesens, 2008, p. 2).
Another reason why banks need to carefully monitor risk is that regulators require them to do it
(Hull, 2012, p. 16). However, it is error to believe that meeting regulatory requirements is the
sole for establishing a sound, scientific risk management system.

Managers need reliable risk measures to direct capital to activities and estimate the size of
potential losses to stay within limits imposed by available capital, creditors and regulators (Pyle,
1997, p. 2). They need mechanisms to monitor positions and create incentives to be prudent in
taking risk. Consequently, risk management is the process by which managers satisfy these needs
by identifying key risks, obtaining consistent, understandable, operational risk measures,
deciding which risks need to be manage and by which methods, and establishing procedures to
monitor the resulting risk position (Pyle, 1997, p. 2).

2.1.5. Credit Risk Management

Credit risk management in financial institutions has become crucial for the survival and growth
of these institutions (Afriyie & Akotey, 2012, p. 3). It is a structured approach of uncertainty
management through risk assessment, development of strategies to manage it and mitigation of
risk using managerial resources (Afriyie & Akotey, 2012, p. 3). The strategies of credit risk
management involves transferring risk to other parties, avoiding risks, reducing the negative
influence of risk and accepting some or all of the consequences of a particular risk (Afriyie &
Akotey, 2012, p. 3).

According to Van Gestel and Baesens, credit risk is managed in various ways. The most
important method starts with appropriate selection of the counterparts and products (Gestel &
Baesens, 2008, p.43). And good risk assessment model and qualified credit officers are key
requirements for selection strategy (Gestel & Baesens, 2008, p.43). For counterparts with higher
default risk, banks may need more collateral to reduce risk. And the pricing of product should be
in line with the estimated risk. Secondly, limitation rule of credit risk management restricts the
exposure of bank to a given counterpart (Gestel & Baesens, 2008, p.43). It avoids the situation
that one loss or limited number of losses endangers the bank’s solvency (Gestel & Baesens,
2008, p.43). Bank’s determinants on how much credit a counterpart with a given risk profile can
take need to be limited.

Thirdly, the allocation process of banks provides a good diversification of the risks across
different borrowers of different types, industry, and geographies (Gestel & Baesens, 2008, p.43).
As a result, diversification strategy spreads the credit risk thus avoids a concentration on credit
risk problems. Last but not least, banks can also buy credit protection in forms of guarantees
through credit derivative products (Gestel & Baesens, 2008, p.43). By the protection, the credit
quality of guaranteed assets has been enhanced. These techniques are translated in the daily
organization by written procedures and policies which determine how counterparts are selected,
risk profile loans are granted and above which level an expert evaluation is required (Gestel &
Baesens, 2008, p.43).

In summary, a strong credit risk management avoids significant drawbacks like credit
concentrations, lack of credit discipline, aggressive underwriting to high-risk counterparts and
products at inadequate prices (Gestel& Baesens, 2008, p.44). And an effective credit risk
management is verified by internal risk control and audit which monitor credit discipline, loan
policies, approval policies, facility risk exposure and portfolio level risk (Van Gestel & Baesens,
2008, p. 44).

2.1.6. Credit Risk Management Indicators

According to Ara, Bakaeva & Sun’s research (2009, p.13), Basel Accord links the minimum
regulatory capital to the underlying risk exposure of banks, which refers to the greater risk bank
exposed relates to the higher amount of capital bank needs. This regulation indicates the
importance of capital management in risk management and the compliance with the regulatory
requirement can be expressed as risk management indicators. Brewer et al. (2006) regards non-
performing loan ratio (NPLR) 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 NPLR 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 NPLR. 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 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.

The determinants of non-performing loans are interest rates, macroeconomic (external) and
bank-specific (internal) variables (Gila-Gourgoura & Nikolaidou, 2017). Macro-economic
variables cover economic growth rate, inflation rate, and lending interest rate. Risk management
is lacking in the event of high NPLR which diminish profits (Aliu & Sahiti, 2016). Monitoring
and follow-ups help handle default after issuing loans. The financial crisis has led some banks to
become risk averse due to the rise in credit risk (Cucinelli, 2015).
The research of Boudriga, Taktak& Jellouli (2009) illustrates this research found that CAR
seems to reduce the level of problem loans which means higher CAR leads to less credit
exposures. However, Rime (2001) observed a positive relationship in his research between bank
risk and capital ratio of Swiss banks during the period 1989-1995. Goddard et al. (2004) study
the influential factors of profitability of banks in Europe. They found a positive relationship
between the CAR (bank capital and reserves to total assets) (The World Bank, 2014) and
profitability. And Samy and Magda (2009) investigate the effects of capital regulations on the
performance of banks in Egypt. The research provides a comprehensive framework to measure
the impact of capital adequacy on two indicators of bank performance: cost of intermediation and
profitability. The result of the research indicates that higher capital adequacy “increase the
interest of shareholders in managing bank’s portfolio” which generates “higher cost of
intermediation and profitability” (Samy and Magda, 2009, p. 70).

Previous studies also show a close relationship between NPLR and credit risk management. For
example, Brewer& Jackson (2006) involves non-performing loans (NPLs) to total assets ratio
(NPLR) as an indication of efficient management of credit risk. In addition, Tafri et al. (2009)
examine the relationship between credit risk and profitability of the conventional and Islamic
banks in Malaysia between the periods from 1996 to 2005. And found a significant relationship
among them. The researcher use “proportion of allowance for the loan loss to total assets” (Tafri
et al., 2009, p.6) which has a close relationship with NPLR to represent the credit risk. And in
the beginning of Tafri et al. (2009) research, they emphasize that profitability as an “ultimate”
test for the effectiveness of risk management. According to Boudriga, Taktak& Jellouli (2009),
NPLs are also involved to assess the role of regulatory supervision on credit risk and they found
a positive relationship between them. Salas and Saurina (2002) indicate the tendency of state-
owned banks to take risker projects then to provide more favorable credits for small and medium
firms. So that it will encourage the development of economy. But such risk taking behavior will
lead to higher level of NPLs.

DelisDietrich, and Wanzenried (2011) was the first study approximating credit risk or credit
quality by the Loan loss provisions over total loans ratio. The ratio of Loan Loss Reserves to
Gross Loans (LOSRES) is a measure of Bank’s asset quality that indicates how much of the total
portfolio has been provided for but not charged off. Indicator shows that the higher the ratio the
poorer the quality and therefore the higher the risk of the loan portfolio will be. In the studies of
cross countries analysis, it also could reflect the difference in provisioning regulations
(Demirguc-Kunt, A. and Huzinga, H. 1999).

The findings of Felix and Claudine (2008) also shows that return on equity ROE and return on
asset ROA all indicating profitability were negatively related to the ratio of non-performing loan
to total loan, NPL/TL, of financial institutions therefore decreases profitability. In addition, many
researchers include operational efficiency as a specific-Bank factor affecting their profitability.
Theoretically more operational efficient Bank is expected to be more profitable. Cost per loan
asset (CLA) is the average cost per loan advanced to customer in monetary term. Purpose of this
is to indicate efficiency in distributing loans to customers (Appa, 1996). CLA ratio can be
calculated as: CLA Ratio= Total Operating Cost/ Total amount of loans.

2.1.6.1. Capital Adequacy Ratio (CAR)

Capital adequacy ratio, calculated as the ratio of the amount of capital to the riskweighted sum of
bank’s assets, is a measure of bank’s capital amount expressed as a percentage of its risk-
weighted credit exposure (Poudel, 2012). It is the percentage of capital that a bank has to hold as
specified by regulatory requirement. It is essential to maintain a specified CAR in order to
determine the capacity of banks in meeting losses and ensure that banks would still bear a
reasonable level of losses in worst scenario (Reddy & Prasad, 2011). In general, banks with high
CAR are considered to have low risk and likely to meet its financial obligations. The higher the
ratio, the more will be the depositors’ protection and stability of the financial system. As banks
with strong capital adequacy are able to absorb possible losses thus preventing them from failure
and insolvency, it could be considered as enhancing profitability.

Capital-based regulation has become a key issue in the banking industry caused by the sub-prime
mortgage problems which led to a financial crisis of 2007 (Hyun & Rhee, 2011). To maintain the
specified capital adequacy ratio, capital constrained banks either collect outstanding loans or
becomes reluctant to issue new lending (Hyun & Rhee, 2011). The bank capital is more likely to
be obligatory during economic downturns, recapitalization would not be easy, and hence, banks
meet the capital ratio by reducing its lending (Hyun & Rhee, 2011).

A number of empirical studies reviewed that used CAR in their analysis have mixed results. For
example, Abdelrahim (2013); Afriyie and Akotey (2012); Bhattarai (2014); Kurawa and Garba
(2014); and Ogboi and Unuafe (2013) found a significant positive relationship between capital
adequacy ratio and bank performance. On the other hand, Alshatti (2015); Zou and Li (2014);
Ndoka and Islami (2016); and Poudel (2012) found a negative association between capital
adequacy ratio and bank performance. Most studies however indicate that CAR is to be
maintained in banks in order to prevent them from possible losses. Thus a positive relationship
between capital adequacy ratio and profitability is expected. The equation for capital adequacy
ratio (CAR) is given by:

Capital
CAR=
Risk Weighted Asset

2.1.6.2. Non-Performing Loan Ratio (NPLR)

Among various indicators of credit risk and financial stability, non-performing loan ratio
(NPLR) holds critical importance as an increase in NPLR is regarded as the failure of credit
policy in banks, a reduction in bank’s earnings and a major reason for the financial crisis (Saba,
Kouser, & Azeem, 2012). It is also viewed a measure of how banks manage their credit
assessment as NPLR indicates the proportion of nonperforming loan to total loan portfolio
(Hosna, Manzura, & Juanjuan, 2009). A nonperforming loan is often characterized as late
payment rather than default loan if the borrower is still undertaking the loan (Choudhry, 2011).
However, once a loan is non-performing, the chances of it being repaid fully are nominal (Saba
et al., 2012). The non-performing loan includes all loans overdue on principal or interest
payment or both for more than 90 days (Wahlen, 1994). According to BIS, the standard loan
classification can be defined as (Hou & Dickinson, 2007):
 Passed: Loans which are repaid back.
 Substandard: The loans whose overdue amount are longer than three months. The banks
usually make 10% provision for the overdue portion.
 Doubtful: The loans whose overdue amount appears doubtful and the exact amount of
which cannot be determined. Banks make 50% provision for doubtful loans.
 Virtual loss and loss (unrecoverable): The outstanding loans provided to firms which
applied for legal resolution and protection under bankruptcy laws. Banks make 100%
provision for unrecoverable loan.
Non-performing loan comprises of substandard, doubtful, and virtual loss and loss, and are
categorized as per their degree of collection difficulty. However, if the borrower starts making
payment again on a non-performing loan, it becomes a performing loan, even though the
borrower has not repaid the entire unpaid amount. Due to the importance of non-performing loan
in financial institutions, numerous studies have been conducted on the relationship between non-
performing loan and financial performance and the author seems to have found mixed results.
Among the studies, Aduda and Gitonga (2011), Li and Zou (2014), Bhattarai (2014), Kaaya and
Pastory (2013), Ndoka and Islami (2016) found an inverse impact of non-performing loans on
the bank profitability while, Afriyie and Akotey (2012), and Alshatti (2015) found a positive
effect of non-performing loans on bank financial performance. On the other hand, Adeusi et al.
(2014), Kithinji (2010), Nawaz (2012), and Ogboi and Unuafe (2013) could not find a
relationship between bank performance and nonperforming loans.

The positive impact of the non-performing loan on financial performance signifies that even
though the borrowers are not paying the loan, profitability is increasing. A similar result is found
by Afriyie and Akotey (2012) who found that the rural banks in Ghana shift the cost of loan
default to other customers by increasing their interest rate on loans, thus rural banks remained
profitable. Despite the mixed results, a negative relationship is hypothesized between non-
performing loan and bank profitability. The equation for Non-performing loan ratio (NPLR) is
expressed as:

Non−Performing Loans (NPLs)

NPLR=
Gross Loan

2.1.6.3. Cash Reserve Ratio (CRR)

Cash reserve ratio is specified as a percentage of total deposit of customers held with the central
bank. It is one of the monetary policy tool used by the reserve bank to control money supply in
the economy (Abid & Lodhi, 2015). This in turn has a significant impact on the interest rates,
liquidity (Teja, Tejaswi, Madhavi, & Ujwala, 2013) and profitability of the banks (Bhattarai,
2014). When a central bank lowers CRR; the availability of funds in the bank increases, the
interest rate decreases, and the bank profitability increases with the availability of money for
funding generating more interest earnings. In contrast, when CRR increases, the availability of
fund decreases with the banks, which means that less money to loan out is available resulting to
fewer interest earnings and decline in profitability. The increase and decrease of CRR will result
in non-availability and availability of fund in the banks denoting liquidity status of the banks.
However, CRR itself does not earn any income for the financial institutions but acts as a
hindrance to the profitability of the banks. The specified regulatory requirement of CRR to be
maintained at the central bank of Nepal has been stated different rate for different types of bank
and financial institutions. As per Nepal Rastra Bank directives 2014/15, the CRR to be
maintained by commercial banks has been fixed at 6% (Bank, 2015b).

Few studies based on the effect of credit risk management on bank performance have considered
CRR as control variable. Bhattarai (2014) has found that cash reserve ratio has an inverse impact
on bank profitability. Therefore, based on the literature survey a negative relationship between
CRR and bank profitability is expected. The equation for cash reserve ratio (CRR) is given by:

Reserve Requiremnets withthe central Bank

CRR=
Total Deposits of Customers

2.1.6.4. Liquidity Ratio (LR)

Liquidity in banks refers to a situation where they can manage sufficient funds either by
increasing liability or converting their assets to cash at a reasonable cost in a short span of time
(Abdelrahim, 2013). It is the ability of banks to fund all short-term obligations when they fall
due. These short-term obligations may include lending, deposit withdrawals, investment
commitments, and liability matures (Amengor, 2010). It is measured by the ratio of credit facility
to total deposit (Cole, Gunther, & Cornyn, 1995). The risk of liquidity to a bank is the risk of
loss resulting from the inability to meet its need for funding (Lartey, Antwi, & Boadi, 2013). A
high liquidity ratio means that a bank is holding too much of its liquid assets which could be
utilized in other profitable areas whereas, a low liquidity ratio denotes that a bank might struggle
to fund its short-term obligations, which is a greater concern to investors.

A number of empirical studies based on the relationship between liquidity ratio and bank
profitability showed mixed results. Abdelrahim (2013) found a strong significant positive impact
of LR on bank performance whereas, Adeusi et. al. (2014) and Ogboi and Unuafe (2013) found a
negative effect of liquidity ratio on the financial performance of banks. Hence, in view of
previous studies and theory, a negative relationship could be expected between change in
liquidity ratio and bank’s financial performance. This is because when the bank holds too much
of it in cash, it losses opportunity to capitalize its fund in more profitable areas. The equation for
liquidity ratio (LR) is mathematically given by:
 Loan
LR=
Total Deposits

2.1.6.5. Asset Quality (AQ)

Asset quality determines the strength of financial institution against the loss of assets value
(Kwan & Eisenbeis, 1997). It can be measured by calculating the growth of total loans
(Abdelrahim, 2013). Monitoring growth of loan is very important in banks since they provide
earnings to the bank and that decreasing the value of loans often relates to the risk of solvency to
financial institutions (Hassan & Bashir, 2003). The growth of gross loan also enhances bank
profitability unless bank takes on an unacceptable level of risk (Anbar & Alper, 2011). However,
growing value of the asset in banking is not enough if they are not of food quality, meaning that,
the loans approved and sanctioned by the banks should be good quality loans. Bad quality loans
have high chances of becoming non-performing loan thus creating no return to the bank.

In this context, Hassan and Bashir (2003) recommend that the quality of asset depends on the
quality of credit assessment, monitoring and collection within the bank. The quality can be
improved by securitizing the loans by collateral, having adequate provisions for potential losses
and avoiding risky lending. Few studies on the impact of credit risk management on profitability
have been undertaken considering asset quality as control variable. Abdelrahim (2013) found an
insignificant negative impact of asset quality on the effectiveness of credit risk management.
However, taking into account theory, this study hypothesizes a positive relationship between
change in asset quality and financial performance of the bank.

2.1.6.6. Leverage Ratio (LER)

As noted earlier, one of the causes of the global financial crisis is widely believed to be excessive
leverage ratio in the banking system (Board, 2009; Turner, 2009). Leverage ratio indicates how
much debt a bank is using to finance their operations in relation to the shareholder’s equity value
(Reddy & Prasad, 2011). It measures how much capital in the bank is in the form of debt and
assesses the bank’s ability to meet its financial obligations. Bank relies on a mixture of
shareholder’s equity and liabilities to finance their operations. High leverage ratio shows that a
bank is aggressive in financing with debt. An aggressive leveraging practice often indicates a
high level of risks as uncontrollable debt indicates too much liabilities to pay off. Also, high
leverage ratio would potentially result in unstable earnings to banks due to additional interest
expense. In this case, shareholders benefit as long as earnings increases with the same amount of
shareholders and their investment. However, if the cost of debt exceeds returns, it can even lead
to bankruptcy, leaving shareholders without any return. Further high leverage ratio indicates less
protection to depositors and is always risky to them (Reddy & Prasad, 2011). Maintaining
leverage ratio in banking is extremely important as it limits the bank to build up excessive
leverage which could damage the overall financial system and the economy; and strengthen risk
control measures (Miu, Ozdemir, & Giesinger, 2010). The central bank of Nepal has directed the
commercial banks to maintain minimum leverage ratio at 4% (Bank, 2016).

Very few studies investigating the impact of credit risk management on banks financial
performance have used leverage ratio as an indicator of credit risk management. Alshatti (2015)
found a negative effect of leverage ratio on banks financial performance. Following previous
studies, it is hypothesized that a negative association exist between leverage ratio and bank
performance. The equation for leverage ratio (LER) is:

Total Liabilities
L E R=
T otal Common Equity

2.1.6.7. Bank Size (BS)

Bank size accounts for the existing economies and diseconomies of scale in the banking market
(Athanasoglou, Brissimis, & Delis, 2008). Larger banks tend to be more active in markets, have
a greater product and have better possibilities for risk diversification (Lehar, 2005). Also, larger
banks can make efficiency gains as they do not operate in the too competitive market (Flamini,
Schumacher, & McDonald, 2009). However, Demirgüç‐Kunt and Maksimovic (1998) have the
view that the extent to which financial, legal and other factors affect the profitability of bank is
closely related to its size. Bank size, measured by the log of the book value of total assets
calculated in its currency (Lehar, 2005) has been taken as one of the control variables in this
study to analyze bank financial performance.

Only a few authors have used bank size as a control variable to investigate the impact of credit
risk management on bank profitability. Bhattarai (2014) found that bank size has a positive
relationship with bank performance, which implies that as bank size increases profitability also
increases, especially in the case of small and medium-sized banks. In contrast, Abdelrahim
(2013) found a significant strong negative impact of bank size on the effectiveness of Saudi
bank’s credit risk management. Hence, in view of theory and past studies a positive relationship
is expected between bank size and bank profitability. The calculation for bank size used in this
study is as follows:

Bank Size = Natural Logarithm of total asset

2.1.7. Banks Performance and its Determinants

In many of the literature reviewed, it is explained that bank performance is represented mainly
by quantifiable financial indicators. The literature on the determinants of bank performance has
closely tied same with profitability measures such as ROA, ROE and NIM. Smirlock(1985),
Civelec and Al-Almi(1991),Agu(1992) and Chirwa (2001). Profitability accounts for the impact
of better financial soundness on bank risk bearing capacity and on their ability to perform
liquidity transformation (Rauch et al. 2008; Shen et al. 2010). According to Popa et al. (2009),
popular measures of bank performances are return on assets (ROA), return on equity (ROE), net
banking income and the efficiency ratio. Gilbert (1984) in a survey of literatures argued that
bank profit is an appropriate measure of bank performance.

Based on the examination of relationship between bank performance (measure by ROA and
ROE) and credit risk (measured by nonperforming loan) by Felix and Claudine (2008), they
found a negative relationship. For instance, an increase in non-performing loan will lead to a
decline in the bank’s profitability. On the other hand, Boaheme et al., (2012) found that there is
positive correlation between credit risk and bank performance.

2.1.7.1. Return on Asset (ROA)

Return on Asset (ROA) is the ratio of net income to total assets which measures net income
earned per dollar of assets. It reflects how well the management is utilizing the bank’s real
investment resources to generate profit (Vong & Chan, 2009). Thus, it shows how efficient and
profitable a bank’s management is, on the basis of its total asset. Mathematically, ROA is
expressed as:

Net Income
ROA=
Total Asset
For banks with similar risk profiles, ROA is a useful static for comparing bank profitability as it
avoids distortions produced by differences in financial leverage (Bhattarai, 2014). From an
accounting perspective, ROA is a comprehensive measure of overall bank performance (Jr
Sinkey & Sinkey Jr, 1992). ROA has been widely used as a metric of bank profitability while
examining the relationship between credit risk management and bank performance in earlier
studies such as that of Alshatti (2015), Berríos (2013), Bhattarai (2014), Kaaya and Pastory
(2013), Kurawa and Garba (2014), Nawaz et al. (2012), Ndoka and Islami (2016), Ogboi and
Unuafe (2013), Adeusi et al. (2014), Poudel (2012), Zou and Li (2014), Zubairi and Ahson
(2014) etc. thus, providing us an argument for using return on asset (ROA) as an indicator of
bank performance.

2.1.7.2. Return on Equity (ROE)

Return on Equity (ROE) is the ratio of net income to total equity capital which measures the
return to shareholders on their equity. It measures how well the management is utilizing the
shareholder’s invested money to generate profit (Athanasoglou, Brissimis, & Delis, 2008). ROE
is one of the most important measures for evaluating efficiency and profitability of bank’s
management based on the equity that shareholders have contributed to the bank. The equation for
ROE is written as:

Net Income
ROE=
Total Equity

Generally, a bank with higher ROE has a tendency to be able to generate more return to their
shareholders. The higher the bank’s ROE compared to its competitors, the better the bank is.
Therefore, the stockholders of the banks always prefer higher ROE however this could
sometimes be a threat to the bank (Saunders & Cornett, 2011) because an increase ROE implies
that net income is increasing faster relative to total equity. Further, a huge drop in equity capital
may result in a violation of minimum regulatory capital standards which tends to increase the
risk of solvency for the banks (Saunders & Cornett, 2011). A number of previous empirical
studies (Aduda and Gitonga (2011), Afriyie and Akotey (2012), Alshatti (2015), Berríos (2013),
Ndoka and Islami (2016), Adeusi et al. (2014), Zou and Li (2014), Zubairi and Ahson (2014))
examining the relationship between credit risk management and bank performance have used
ROE as a metric of profitability. Thus, the second measure of bank performance will be used in
the proposed study is ROE.

In the proposed study, the dependent variables will be used to measure the effectiveness of
management in utilizing assets and shareholder’s equity of commercial banks are the ROA and
ROE respectively.

2.2. Empirical Literature Review

Achou and Tenguh (2008) show that there is a significant relationship between Bank
performance (in terms of return on asset) and credit risk management (in terms of loan
performance). Better credit risk management results in better Bank performance. Thus, it is of
crucial importance that Banks practice prudent credit risk management and safeguarding the
assets of the Banks and protect the investors’ interests.

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. The study 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.

Epure and Lafuente (2012) examined Bank performance in the presence of risk for Costa-Rican
Banking industry during 1998-2007. The results showed that performance improvements follow
regulatory changes and that risk explains differences in Banks and Non-performing loans
negatively affect efficiency and return on assets while the capital adequacy ratio has a positive
impact on the net interest margin.

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.
Ahmad and Ariff (2007) examined the key determinants of credit risk of commercial Banks on
emerging economy banking systems compared with the developed economies. The study found
that regulation is important for banking systems that offer multi-products and services;
management quality is critical in the cases of loan-dominant Banks in emerging economies. An
increase in loan loss provision is also considered to be a significant determinant of potential
credit risk. The study further highlighted that credit risk in emerging economy Banks is higher
than that in developed economies.

Oludhe (2011) has concluded that capital adequacy, asset quality, management efficiency and
liquidity have weak relationship with financial performance of banks in Kenya. Earnings have a
strong relationship with financial performance. This is because earnings as proxies by return on
assets determine the ability of a bank to increase capital (through retained earnings), absorb loan
losses, support the future growth of assets, and provide a return to investors. Kolapo et al. (2012)
have showed that the effect of credit risk on bank performance measured by return on assets of
the banks is cross sectional invariant. A 100 percent increase in the non-performing loan
decreases return on assets i.e. profitability by about 6.2 percent, a 100 increase in loan loss
provision also decreases profitability by about 0.65 percent whereas a 100 percent increase in
total loan and advances increases profitability by about 9.6 percent.

Fredrick (2012) has concluded that credit risk management by use of CAMEL indicators has a
strong impact on the financial performance of the commercial banks in Kenya. The study reveals
that capital adequacy, asset quality, management efficiency and liquidity have weak relationship
while earnings have strong relationship with the financial performance of the banks. This study
has concluded that CAMEL model can be used as a proxy for credit risk management of the
commercial banks in Kenya. Poudel (2012) has shown that default rate, cost per loan assets and
capital adequacy ratio have an inverse impact of the bank's financial performance whereas
default rate is the most predictor of the bank's financial performance.

Abiola and Olausi (2014) have analyzed the impact of credit risk management on the commercial
banks performance in Nigeria. The panel regression model was employed for the estimation of
the model. In this model, Return on Equity (ROE) and Return on Asset (ROA) were used as the
performance indicators whereas Non-Performing Loans (NPL) and Capital Adequacy Ratio
(CAR) as credit risk management indicators of the commercial banks. The findings have
revealed that credit risk management has a significant impact on the performance of the banks in
Nigeria. Furthermore, the results have shown that the sampled have poor credit risk management
practices; hence the high levels of the non-performing loans in their loans portfolios. Despite the
high levels of the NPLs, their profit levels keep rising as an indication of the transfer of the loan
losses to other customers in the form of large interest margins.

Kodithuwakku (2015) has analyzed the impact of credit risk management on the performance of
the commercial banks in Sri Lanka by using both primary and secondary data. The study has
suggested that all the independent variables except loan provision and total loan have negative
impact on profitability. The non-performing loan, loan provision and loan provision to non-
performing loans of the banks are significantly negatively related with ROA. The results of the
study verify the objectives that better credit risk management results in better bank
performances. The banks should ensure that they deploy a well-established credit risk
management policy framework.

Bhattarai (2016) has conducted research and 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 the regression model. The results revealed that non-performing loan ratio
has negative effect on profitability of the commercial banks while cost per loan assets has
positive effect on profitability. In addition to credit risk indicators, bank size has positive effect
on profitability. Capital adequacy ratio and cash reserve are not considered as the influencing
variables on profitability of the banks. The study has concluded that there is significant
relationship between profitability and credit risk indicators of the selected commercial banks in
Nepal. Nepalese commercial banks have poor credit risk management and hence the banks need
to follow prudent credit risk management and safeguarding the assets of the banks and protect
the interests of the stakeholders.

Nwude and Okeke (2018) have investigated the impact of credit risk management on the
performance of deposit money banks in Nigeria using five banks that had highest asset base. Ex-
post facto research design was adopted using dataset for the period 2000–2014 collated from the
annual reports and financial statement of the selected deposit money banks. Three hypotheses
were proposed and tested using ordinary least square regression model. The findings reveal that
credit risk management had a positive and significant impact on total loans and advances, the
return on asset and return on equity of the deposit money banks. The study recommended that
bank managers need to put more efforts to control the non-performing loan by critically
evaluating borrowers’ ability to pay back. The regulator should strengthen its monitoring
capacity in this regard.

Oduro, Asiedu and Gamali Gadzo (2019) have identified the factors that determine the level of
bank credit risk and further estimate the effects of bank credit risk on corporate financial
performance using financial data from banks on the Ghana Stock Exchange over a 15-year
period from 2003 to 2017. Using the method of 2SLS, it was observed variables such as capital
adequacy, operating efficiency, profitability, and net interest margin are inversely related to
credit risk. Conversely, bank size and financing gap tend to relate positively with credit risk.
Also, anualised changes in inflation tend to positively affect credit risk. Again, it was observed
that, increase in bank credit risk negatively affects corporate financial performance which is
consistent with Basel accord. Thus, for banks to survive in their industry, critical attention needs
to be paid to management of its credit risk exposure.

Gadzo, Kportorgbi and Gatsi (2019) have assessed the effect of credit and operational risk on the
financial performance of universal banks in the context of the structural equation model (SEM).
Data were collected from all the 24 universal banks in Ghana without missing variables and
using the PLSSEM, the results showed that credit risk influences financial performance
negatively contrary to the empirical study but in line with the information asymmetry tenant of
the lemon theory. It was also found that operational risk influences the financial performance of
the universal banks in Ghana negatively. Furthermore, the study indicated that bank specific
variables measured by (asset quality, bank leverage, cost to income ratio and liquidity)
significantly influence credit risk, operational risk as well as the financial performance of the
universal banks positively. We recommend that banks be encouraged to cut-down their lending
rates in other to decrease credit risk and subsequently boost profitability. Regarding operational
risk, banks should reduce leverage and have their portfolio more concentrated on liquid
investment income so as to boost profitability.

Ahmad & Ariff (2007), performed comparative study on a multi countries base by grouping
developed and developing countries in to two different sections. In their study, countries with
developed economy including Australia, France, Japan and the US are included, and the
developing economies are represented by India, Korea, Malaysia, Mexico and Thailand. A total
of 23,499 banks are included under the research for the period of 1996 to 2002 from a crisis
period. The study mainly focused on bank specific variables such as management efficiency,
loan-loss provision, loan to- deposit ratio, leverage, regulatory capital, funding costs, liquidity,
spread and total assets. Their study revealed that management quality is significant in loan
dominated companies and they found the irrelevance of leverage for credit risk which is contrary
to the finding of most researchers.

A study of Ali & Daly (2010) also strived to answer the question of which macro-economic
factors can mostly affect the credit risk of commercial banks in Australia and USA. Using the
logit regression model, they identified that both countries, Australia and USA, are affected by the
same set of macroeconomic variables; GDP and short term interest rate. The study also
confirmed that the US economy is more susceptible for macroeconomic variables shake than that
of the Australian.

Gizaw et al. (2015) have conducted their study and the data were analyzed by using descriptive
statics and panel data regression model. The results revealed that non-performing loan, loan loss
provision and capital adequacy have a significant impact on the profitability of the commercial
banks in Ethiopia. Mutua (2015) has found that there was a significant relationship between bank
performance (in terms of return on asset) and credit risk management (in terms of risk
identification, monitoring and credit sanctions. Better credit risk management results in better
bank performance. Thus, it is of crucial importance that banks practice prudent credit risk
management and safeguarding the assets of the banks and protect the investors' interests.
2.1. Conceptual Framework of the Proposed Study
The conceptual frame work is structured from a set of broad ideas and theories that help a
researcher to properly identify the problem they are looking at and frame their questions and find
suitable literature and it also used to give explanation of how the researcher perceives the
relationship between variables deemed to be important in the study (Muganda, 2004). The
conceptual framework of the proposed study shown in Figure below is developed based on the
literature review. The conceptual framework will illustrate the linkage between Risk
Management Indicators as independent variables and Bank Performance as Dependent variable.

Figure 2.2: Conceptual framework of the proposed study

Independent Variables

Credit Risk Indicators

Dependent Variables

Capital Adequacy Ratio (CAR)

Bank Performance
Non-Performing Loan Ratio (NPLR)
 ROA
Cash Reserve Ratio (CRR)  ROE

Liquidity Ratio (LR)

Leverage Ratio (LER)

Asset Quality (AQ)

Bank Size (BS)

Source: the researcher, (2023)