LONDON SCHOOL OF BUSINESS AND FINANCE

Title of Dissertation
CREDIT RISK AND SHAREHOLDER VALUE;
EVIDENCE FROM THE UK BANKING SYSTEM

Author
[M. Adeel Ashraf, F1005880]

Supervisor
[Dr. Fara Madehah Ahmad Farid]

Academic Year
[2013-2014]

Submitted in support of: [Master of Business Administration Global]

 ACKNOWLEDGEMENT
I am grateful to ALLAH, the almighty, for His countless blessing upon me and for giving me

the strength to complete this work.

I express my gratitude to my parents for their prayers and moral support. They always stood

along with me to tap my back in the times of frustration.

I am deeply acknowledged and thankful to my respected supervisor Dr. Fara Madehah

Ahmad Farid, a highly remarkable, sage and visionary teacher. Her support, guidance and

encouragement have been the most valuable asset for me during this study. It was her guidance who

made it possible for me to achieve this milestone.

I am also indebted to express my thankfulness to my very respectful teachers and academic

staff of London School of Business and Finance for the continuous support and lastly, I will show my

gratitude to all my friends and other family members for their moral support and best wishes.
 ABSTRACT
The banking business is exposed to a number of risks. Credit risk is the most important one
among these risks because of the large scale credit operations of the bank. The bank may use various
techniques for the management of credit risk. These risk management practices should be aligned with
the basic principle of financial management i.e. shareholders’ wealth maximization. This study is
evaluating the relationship of credit risk with shareholders’ wealth maximization. The study is
focused on the banking system in UK. The researcher has focused on three dimensions of credit risk
i.e. credit risk exposure, credit risk measurement and credit risk management. The impact of these
dimensions has been evaluated on two dimensions of shareholders’ wealth i.e. ROE and ROS. This
study has collected both secondary and primary data for the analysis. The secondary data has been
collected from the annual reports of 7 selected banks for the past 10 years. The primary data has been
collected through semi-structured interviews. The secondary data has been analysed using the
techniques of panel data analysis. The results of the panel data analysis reveals that credit risk
exposure is playing an important role in determining shareholders’ value. These results also revealed
the risky attitude of the investor trading in the market as they prefer the banks with higher credit risk
exposure. The results of the primary data analysis reveal that employees in the banking system are not
aware of the alignment of various practices with the objectives of shareholders’ wealth maximization.
They are of the view that it is responsibility of board of directors to review the alignment of policies
with this basic objective. The study highlights that employees are required to be educated in this
regard. Moreover, the study also emphasize on review the credit risk exposure and CAR i.e. being
used for the management of credit risk. The bank management should determine the optimal level of
CAR. The study has been performed on a limited sample size. The future researchers may take a large
sample size and a cross country analysis can also be performed.

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 TABLE OF CONTENTS
Acknowledgement ................................................................................................................................................... i
Abstract ................................................................................................................................................................... i
Table of Contents.................................................................................................................................................... ii
List of Tables ......................................................................................................................................................... iv
List of Figures......................................................................................................................................................... v
List of Abbreviations ............................................................................................................................................. vi
1. Introduction .................................................................................................................................................... 1
1.1. Background of the Study .................................................................................................................... 1
1.2. Aim of the Study ................................................................................................................................ 3
1.3. Research Questions............................................................................................................................. 3
1.4. Objectives of Study ............................................................................................................................ 4
1.5. Industry Background .......................................................................................................................... 4
1.6. Structure of the Study ......................................................................................................................... 5
2. Literature Review ........................................................................................................................................... 7
2.1. Introduction ........................................................................................................................................ 7
2.2. Credit Risk .......................................................................................................................................... 7
2.3. Causes of Credit Risk ......................................................................................................................... 9
2.4. Credit Risk and Economic Conditions.............................................................................................. 10
2.5. Effects of Credit Risk ....................................................................................................................... 12
2.6. Credit Risk Management .................................................................................................................. 13
2.7. Failure of Penn Square and Continental Illinois ............................................................................... 17
2.8. Credit Risk Management and Shareholders’ Value .......................................................................... 18
2.9. Summary........................................................................................................................................... 19
3. RESEARCH METHODOLOGY ................................................................................................................. 20
3.1. Introduction ...................................................................................................................................... 20
3.2. Achievement of Objectives............................................................................................................... 20
3.3. Variables and their measurement...................................................................................................... 21
3.3.1. Independent Variables ..................................................................................................... 21
3.3.1.1. Credit Risk Exposure ...................................................................................... 21
3.3.1.2. Credit Risk Measurement ................................................................................ 21
3.3.1.3. Credit Risk Management ................................................................................. 21
3.3.2. Dependent Variables ....................................................................................................... 22
3.3.2.1. ROE................................................................................................................. 22
3.3.2.2. ROS ................................................................................................................. 22
3.3.3. Control Variable .............................................................................................................. 22
3.4. Type of Study ................................................................................................................................... 23
3.5. Population and Sample ..................................................................................................................... 23
3.6. Research Approach ........................................................................................................................... 23
3.6.1. Qualitative Approach....................................................................................................... 23
3.6.2. Quantitative Research...................................................................................................... 23
3.6.3. Approach of the Present Study ........................................................................................ 24
3.7. Research Philosophies ...................................................................................................................... 24
3.7.1. Pragmatism ...................................................................................................................... 24
3.7.2. Interpretivism .................................................................................................................. 25
3.7.3. Realism ............................................................................................................................ 25
3.7.4. Positivism ........................................................................................................................ 25
3.7.5. The Philosophy of the Present Study ............................................................................... 25
3.8. Data for the Study ............................................................................................................................. 26
3.8.1. Primary Data.................................................................................................................... 26
3.8.2. Secondary Data................................................................................................................ 26

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 3.9. Time Period ...................................................................................................................................... 26
3.10. Method of Analysis ......................................................................................................... 26
3.11. Validity and Reliability ................................................................................................... 27
3.12. Ethical Considerations ..................................................................................................... 27
4. Results and Analysis .................................................................................................................................... 28
4.1. Quantitative Data Analysis ............................................................................................................... 28
4.1.1. Descriptive Statistics ....................................................................................................... 28
4.1.2. Unit Root Test ................................................................................................................. 29
4.1.3. Test for Auto Correlation ................................................................................................ 29
4.1.4. Correlation Analysis ........................................................................................................ 30
4.1.5. Panel Data Analysis ......................................................................................................... 31
4.2. Supplementary Analysis ................................................................................................................... 34
5. Findings, Conclusion and Recommendations .............................................................................................. 41
5.1. Findings ............................................................................................................................................ 41
5.2. Conclusion ........................................................................................................................................ 42
5.3. Limitations and Recommendations for Future Researchers ............................................................. 43
Appenidix ‘A’ ....................................................................................................................................................... 44
Questionnaire ............................................................................................................................................... 44
References ............................................................................................................................................................ 46

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 LIST OF TABLES
Table 1: Descriptive Statistics .............................................................................................................. 29
Table 2: Levin-Lin-Chu Test ................................................................................................................ 29
Table 3: Wooldridge Test ..................................................................................................................... 30
Table 4: Correlation Matrix .................................................................................................................. 31
Table 5: FE (within) regression with AR (1) disturbances (ROE)........................................................ 32
Table 6: FE (within) regression with AR (1) disturbances (ROS) ........................................................ 33

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 LIST OF FIGURES
Figure 1: A General Framework of CR Model..................................................................................... 12

v
 LIST OF ABBREVIATIONS
BCBS Basel Committee on Banking Supervision
CAR Capital Adequacy Ratio
CM Credit Risk Measurement
CR Credit Risk
CRE Credit Risk Exposure
CRM Credit Risk Management
FI Financial Institution

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 1. INTRODUCTION

1.1. BACKGROUND OF THE STUDY

Economic stability and growth is ensured by the soundness of a country’s banking system
(Halling & Hayden, 2006). The financial sector of an economy is mainly comprised of banks. These
banks perform very valuable activities on both sides of the balance sheet. One assets side, these banks
provide funds to different users to promote the industry and increase investment in the economy;
whereas, on the liability side, they provide a safe haven to the depositors and also provide them with
liquidity (Diamond & Rajan, 2001).
The rapid rise in inflation and instability of exchange rate has exacerbated the vulnerability of
the banking system during the last few decades. There has been intensive banking crisis faced by
various economies round the globe during the last quarter of the previous century. These crises have
results in a high cost for the shareholders, governments, management and other stakeholders of the
banking system. Many of the large banks collapsed during these crises. These crises have resulted in
economic downturns and lead to an increase in poverty. Although, many of the stat of art methods and
models have been formulated for the prediction of banking crises, but still these models are unable to
make 100% correct predictions. These banking crises mainly emanate from credit operations of the
banking system (Honohan & Laeven, 2005).
The main source of income for any of the bank is its credit operations. However, credit risk
also emerges from these operations that are a major threat for the stability of the banking system.
Among all other risks credit risk the main risk faced by the financial institutions due to their large
scale credit operations. This risk is being faced by the banking system since its inception in the world.
The main aim of the risk officers is to mitigate and manage the credit risk by various means, thereby
controlling the negative effects of credit risk (Akhtar, 2007). The credit operations of the bank may
become a massive source of loss if they are not managed properly. Risk management officers deploy
various credit risk management techniques in order to mitigate the credit risk. These techniques and
tools include credit monitoring, credit screening, credit scoring, and assets’ securitization (Rajeev et
al., 2008).
Major risk faced by the banking system is credit risk that requires a vigilant management and
mitigation mechanism. There can be number of various techniques that can be used for the
management of credit risk. The banks are required to make periodical reviews of the performance of
their loan portfolios. The loopholes should be promptly identified and addressed. Bank should also
consider it loan issuance strategy if it is line with market structure and situation. The strategy should
not be made complex but it is kept flexible (Fatemi & Fooladi, 2006).
It is going to be a very important issue for the banking system to manage and mitigate the
credit risk. The academicians, policy makers and practitioners have been actively investigating this

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important risk. One after another natural catastrophe has intensified this problem in the economy. A
number of crises have been emerged. The situation of each crisis should be evaluated thoroughly. The
traditional techniques are no longer workable anymore. Many of the researchers have carried out
research on this important issues but most of this research is theoretical in nature. There is lack of
empirical evidence. The gap between theory and practices is very huge. There are very few empirical
studies on the risk management practices (Carty, 2000; Al-Tamimi & Al-Mazrooei, 2007). Therefore,
there is strong desired to test the effectiveness of each of the credit risk management technique. The
present study will try to fill this gap.
Researchers and practitioners of risk management have made lot of efforts in measuring the
parameters of credit risk. Among the financial institutions, banks are more prone to credit risk.
Loubergé & Schlesinger (2005) have decomposed credit risk into an eccentric and a systematic factor.
A counter party default may occur due to the reasons particular to that borrower (Loubergé &
Schlesinger, 2005). This can be poor management, bad intentions or bad luck etc. Financial
recessions, political instability or the widespread crashes of stock markets are also the key factors that
exacerbate the credit risk (Leightner & Lovell, 2005). This credit risk can prove to be slayer for the
banking system if not managed properly. The credit risk may give birth to liquidity risk that may lead
to bankruptcy under sever circumstances.
Risk management is an integral part of the banking system. This system is mainly aimed at
creating value for the shareholders, under the basis assumption of financial management (Pagano,
2001). It is only worthwhile for a financial institution to engage in risk management activities, if they
are creating some value for the shareholders. Any of the financial institutions will only engage in risk
management practices if it helps to enhance shareholders’ wealth (Ali & Luft, 2002). The banks
performing the risk management activities that are not aligned with the basic principle of
shareholders’ wealth maximization may run the risk of conflict between management and
shareholders. The shareholders of banks may question the usefulness of risk management activities
performed by the banks.
Although, many of the previous researchers have investigated the credit risk in banking
system; but most of these researchers have remained focused either on mitigating the credit risk or its
effects on profitability of the banking system. The credit risk in particular and risk management in
general has not been discussed with respect to shareholders’ value. Most of the work in this area is
theoretical in nature and there is a lack of empirical evidence (Sackett & Shaffer, 2006). This
empirical evidence lack in risk management as an overall functions and with respect to individual
risks as well. The previous researchers have remained busy in a debate on role of risks and their
management in shareholders’ wealth maximization but they have not given due consideration to
empirical testing between the relationship between risks, their management and shareholders’ wealth.
Most of the researchers have been focusing on the theory of Modigliani & Miller, (1958) that states
that risk management activities at organizational level are irrelevant with respect to shareholders’

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wealth. The researchers and practitioners have been performing an extensive debate on the findings of
Modigiliani & Miller.
The researcher believes that present study will be following a novel approach. The previous
researchers have been either focusing on various tools for managing and mitigation the risks (Fatemi
& Fooladi, 2006), or the performance of banking system measured through cost and production
functions (Berger & Humphrey, 1997) or accounting ratios (Sensarma & Jayadev, 2009), and on
efficiency of banking system in mitigating the risks through quantifying the risks faced by the banking
system(Altman et al., 1998). While in this study, researcher has tried to encompass multiple functions
and to analyse their impact on shareholders’ value. The present study provides an empirical evidence
of relationship between credit and shareholders’ value. Therefore, the study is an attempt to fill some
gap between theory and practice. The study has tried try to address risk exposure, risk quantification
and risk management simultaneously.
After the current financial crisis, prevailing throughout the world, much research is being
conducted in the field of risk management. This study will contribute to the theory and practice of risk
management, particularly to credit risk management. It will also provide useful information to the
policy makers regarding the existing practices in Banking Sector of UK and practical insight into the
difficulties in managing credit risk from current perspective. It would help to develop comprehensive
strategies and to modernize credit risk management system in banking sector of UK that would lead to
the enhancement in performance of banks. Moreover, the present study will also help the banking
system to avoid any possible conflicts between the management and shareholders because of
misalignment between risk management and shareholders’ wealth. This study will also guide the
shareholders to evaluate the risk management activities of the banking system. The study may play a
guiding role for making the investment decision of shareholders who are interested in banking system.

1.2. AIM OF THE STUDY

The aim of the present study is to evaluate the role of credit risk in shareholders’ value. Credit
risk is the major risk faced by the banking system emanated from the credit operations that are main
source of income as well. The present study will seek to evaluate that how shareholders’ value is
affected by credit risk.

1.3. RESEARCH QUESTIONS

The present study is an attempt to answer the following important research questions?
i. What is the role of credit risk in shareholder’s wealth maximization?
ii. How can credit risk be managed in a way to maximize shareholder’s wealth?

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1.4. OBJECTIVES OF STUDY
Following are the main objectives of this research study.
i. To find out different dimensions of credit risk.
ii. To find out an empirical evidence of the association between credit risk and shareholders’
value.
iii. To investigate the role of credit risk in fluctuation in stock returns.

1.5. INDUSTRY BACKGROUND

There have been extensive refinements in banking system in UK during the last decade. Most
of the banks are offering similar services to their customers. Most the services are being distinguished
on the basis of interest rates only. Most of the banks are not advertising their interest rates now. The
outlook of the banking system in UK was quite stable during the last few decades. However, this
outlook became negative after the recent financial crisis, but it has changed to stable again from
negative after this crisis during the last few years. The UK economic growth have been slow during
last few years but still it has been stable and did not face any fluctuations. The stable economic
environment has resulted in improvement in asset quality of the banking system. Capital ratios have
experienced remarkable improvement, though there have been stringent capital requirement after the
financial crisis. It is generally expected that banking system in UK will be successful in maintain
improvements in its funding and liquidity. This situation will have positive effects on profitability of
the firm. The loan impairments in banking system are declining. Concomitantly, these positive
benefits should be transferred to shareholders. The banking system must produce shareholders’ value
(Wearden & Collinson, 2009).
The economy of UK is continuously facing a low to medium economic growth; however,
operating environment is least likely to deteriorate. Moreover, the unemployment in the economy has
remained under control. The rate of unemployment has been low as compared to previous phases of
recession. Although, banks like Northern Rock had to face failure during the recent financial crisis,
but contagion effect has been kept under control. The contagion effect could not overwhelm the
banking system in UK (Norris, 2008).
According to Moody’s report, though some banks are facing the downside of the risk because
of their over concentration in the real estate market, the impairment of assets at aggregate level faced
decline and banking system has remained successful in stabilizing the non-performing loans up to the
level of 5% only. Moody expects that banks operating in UK are well capitalized, thus having a
sufficient cushion against the expected losses emerging from various exposures in the market. The
capital buffer requirements imposed by the Prudential Regulatory Authority (PRA) have enabled the
banking system in UK to strengthen their capital buffer against the expected losses. The banks in UK
are standing in a favourable position as compared to their European counterparts (Moody's, 2013).

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 The profitability of the banking system has remained stable during the last few years. After
the financial crisis, the banking system has rapidly recovered from low level of profitability. This
recovery of profitability shows the improvement in asset quality of the banking system. However, it is
expected that profitability of the banking system will remain under the pressure of interest rate.
Moreover, the cost associated with application of prudential regulation and scrutiny of various
operations performed by banking system has pressurized the profitability of the banking system.
The changing regulatory reforms are exacerbating uncertainty in the market for banking
system in UK. The gradual enforcement of regulatory reforms is creating various challenges for the
banking system in UK. However, higher capital requirements are likely to reduce the systemic risk in
banking system of UK. The capital requirements have enabled the banking system to absorb most of
the losses emanating from various activities of the banking system. The liquidity position of the
banking system is quite stable in UK. The banking system in UK has decreased their reliance on
short–term wholesale funding.
The stable outlook of the banking system has compatibility with stable outlook of credit
assessment of the banking system in UK. However, Moody’s report highlights that long-term debt of
the banking system in UK and deposits rating of most of the larger banks in UK have a negative
outlook. Like any other banking system, banks in UK are also largely dependent of credit operations
as a biggest source of income. Although, banks are diversifying their operations and their loan
portfolios as well, but credit risk is the biggest threat hovering around the stability of a bank operating
in UK. Moreover, in the light of Moody’s report about long term debt and deposit rating, situation has
become bit worrisome for the shareholders. Shareholders may show their concern about the large
scale credit operations, as a bank may face significant losses if credit risk become uncontrollable. This
situation stipulates to evaluate the role of credit risk in determining shareholders’ value.

1.6. STRUCTURE OF THE STUDY

The present study is comprised of five chapters. Chapter 1 is about introduction. The topic
under investigation has been introduced generally and research questions and objective have been
described in this chapter. This chapter also provides industry background.
Chapter 2 is about literature review. This chapter has explained various aspects of credit risk
with reference to previous studies. The researcher has mainly focused on recent studies in this chapter,
but a good amount of some old studies have also been included in order to observe the trend of
development of studies in this field and variation in concepts provided by different researchers.
Chapter 3 deals with the employed methodology for the completion of this study. This chapter
explains the research philosophy and approach being followed in the present study. This chapter
explains that what type of data is required for this study and how this data has been collected and
analysed.

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 Chapter 4 provides the results of the analysis performed on the collected data. This chapter is
technical in nature. The results of various statistical tools have been provides and interpreted in this
chapter.
Chapter 5 is the last chapter of this study. This chapter provides the findings of the present
study. These findings have been thorough discussed and various identified relationships have been
discussed in detail. This chapter also provides conclusion and some important recommendations.

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 2. LITERATURE REVIEW

2.1. INTRODUCTION
This chapter deals with the review of literature. The chapter has discussed various aspects of
credit risk and how it is important in terms of shareholders’ value. The researchers has focused on
most recent articles for the preparation of literature review, but some of the key articles from the past
have also been excluded to make a good blend of old and new stories. The inclusion of these old
studies is also helpful in understand the changing patterns in field of credit risk management and
approach of researchers.
This chapter explain the credit risk first. The importance of credit risk has been discussed in
details. Afterwards, developing the understanding of credit risk, particularly in banking system,
causes of credit risk have been discussed. It has been explained that how credit risk arises in a banking
system. Credit risk has also been discussed with relation to economic conditions. The variations in
credit risk have been explained with respect to changes in economic conditions. This chapter makes a
detailed discussion on credit risk management and at the end credit risk has been linked with
shareholders’ wealth.

2.2. CREDIT RISK

The importance of financial institutions in an economy cannot be denied. They play a similar
role in an economy as heart plays in human body. Heart pump the blood to whole body and financial
institutions pump financial resources to the economy (Shanmugan & Bourke, 1990). Commercial
banks are the type of financial institutions that are mainly responsible for the provision of financial
resources to the various segments of the economy. The role of commercial banks is more crucial in
case of emerging economies where access to capital markets is not available to borrowers (Greuning
& Bratanovic, 2003). There are enough evidences in the past that well-functioning commercial banks
accelerate the economic growth. Conversely, a poor banking system in an economy give rise to
unemployment and poverty (Barth et al., 2004).
The nature of business of commercial banks is very risky. Modern banks are exposed to a
number of risks that can be broadly categorized into three categories. These categories are financial
risks, operations risks and strategic risk. Credit risk is a component of financial risks (Cornett &
Saunders, 1999). There are various implications of these risk types of performance and stability of the
banks. However, credit is considered as the most prominent risk among all other types of risk,
especially financial risks. The magnitude of the loss is quite severe because of credit risk as compared
to other categories of risk. Credit risk is the major reason of number bank failures in the past
(Chijoriga, 1997). There has been an increase in problems of banking system because of credit risk
both in mature and emerging economies. A number of researchers have focused on banks problems

7
and issues emanating from credit risk (Santomero, 1997; BCBS, 2004). Most of the researchers have a
consensus the credit problems comes from a weak credit risk management (CRM) system. These
problems can be avoided by strengthening the credit risk management system.
Credit risk is insidious in all financial markets. All participants of financial markets are facing
this risk at varying levels (Berrada et al., 2001). Financial institutions are supposed to take the heavy
burden of credit risk. The credit risk in banking system is stems from loans and future commitments
e.g. forward contracts. There are various credit insurance companies operating in different economies
these days. These companies provide coverage for the credit risk faced by different company
providing goods, services and investments to the market. These companies have a varied nature of
operations in different economies. For instance public insurers like ECGD in UK provide the
coverage for credit risk linked with export trade and overseas investment (Louberge & Schlesinger,
2005).
There are many other institutions that have specialization in a particular segment. These
institutions provide credit insurance as part of a large basket of financial services. Moreover,
propagation of financial contract that have an implicit risk of default by counter party has largely
shifted the focus on credit risk that is pervasive in the market. The parties involved in any financial
contract work to find out various means through which credit risk can be managed. According to a
Survey of British Banker’s Associated, credit derivatives’ market was expected to reach at the level of
$4.8 trillion in UK (British Banker’s Association, 2004). Moreover, now a day insurance companies
have come with a variety of products out of which many of the products are backed up by large
capital markets e.g. insurance linked securities and finite risk contracts (Shimpi, 1999).
Credit risk is the most fundamental risk to which modern banks are largely exposed. The bank
management is required to have vigil insight and policy debate for the mitigation and management of
the credit risk. It is can be defined as “the risk of loss resulting from failure of obligors or borrowers
to honour their payments” (Pesaran & Schuermann, 2003). Basel Committee on Banking Supervision
(1999) defines credit risk as “the potential that a bank borrower or counterparty will fail to meet its
obligations in accordance with agreed terms.”
According to Lopez (2001) credit risk can be defined as “the risk that the value of a loan (or
more generally, a stream of debt payments) will decrease due to a change in the borrower’s ability to
make payments, whether that change is an actual default or a change in the borrower’s probability of
default.”
Credit risk is the most important risk faced by the banking sector that should be thoroughly
managed. There are numbers of techniques available through which a bank can evaluate the level of
credit risk faced by it in its different types of exposures. Banks are required to perform a periodical
review their credit portfolio, at least on quarterly basis. This review must include the analysis with
respect to borrower size, sector and category of collaterals held by the banks against the issues. The
value of collateral should also be assessed periodically so that its value may not decline as compared

8
to the issued loans against it. The major limits granted to various borrowers should also be reviewed
on the basis of this analysis and required adjustments must be made promptly. The scale of credit
activities should also not exceed the prescribed limit (SBP, 2009).
There are many efforts made by the practitioners and researchers to investigate various
aspects of credit risk. The commercial banks that are considered as the main victim of this credit risk
are required to understand the fact that credit risk has two components i.e. idiosyncratic risk and
systematic risk. The presence of these two components in credit risk is a matter of great concern for
the banks. The default by the counter party takes place because of specific characteristics of a
borrower e.g. bad luck and poor management. Credit risk is also augmented by the recession phases of
economy, crashes of financial markets and political instability (Crouhy et al., 2000). The number of
defaults after 9/11 incident endorse this argument.

2.3. CAUSES OF CREDIT RISK

Most of a bank’s assets are comprised of loans. Banks have a heavy reliance on these loans
for the income. These loans are major source of credit risk as well. Usually, a bank has loans that are
10 to 15 times of its equity (Bluhm et al., 2003). Therefore, a slight deterioration in the quality of
loans issued by a bank may lead to massive problems for it. The quality of loan is deep rooted in
mechanism of a bank for processing of information. The poor mechanism results in poor quality of
loans. The problems emanating from credit risk are in an acute phase in emerging and under
developed economies. The problems related to loan portfolio of a bank start with the receipt of
applications for issuance of loan. The problems get severe during approval, monitoring and
controlling stages. The dearth of guidelines for developing and monitoring CRM system worsen these
problems (Richard et al., 2008).
Lending is being used by the banking system as mainstream of income, especially in
emerging economies. The economies that are in a transitions phase are facing lot of controversies
regarding lending activities. It is difficult tasks for the bank to manage these lending activities in an
effective manner. Most of the businesses complain about lack of access to credit and strict standards
of banking system for the issuance of loans. However, banks are compelled to set high standards
because of losses resulting from bad loans (Richard, 2006). An effective CRM system is required to
be developed by the commercial banks to minimize the losses (Santomero, 1997). Banks must
develop a mechanism, especially when an asymmetry of information is existent between lenders and
borrowers, to ensure proper evaluation of not only default risk that is not known ex ante but ex post as
well. This will help to avoid adverse selections in case of ex ante and moral hazards in case of ex post
(Richard et al., 2008).
Most of the researchers (Goodhart, 2005; Fatemi & Fooladi, 2006; Akhtar, 2007; Sensarma &
Jayadev, 2009)are at a consensus that credit risk is the most significant risk faced by the banking

9
system. Banks are largely involved in credit operations that are the major source of credit risk. The
balance sheets of individual banks are different, but credit operations are the main part of the banking
business (Ojo, 2010). Banks have a heavy reliance on credit operations for their income (Akhtar,
2007), but credit risk also emerges from these operations. This risk is considered as the primary risk to
which any FI is exposed. Banking business faces this risk -since the start of banking. The risk
management of an FI especially focuses on the mitigation and management of credit risk so that FI
does not face the massive losses which may result due to the poor management of credit risk.
The banks are highly prone to credit risk due their nature of business. There is a high cost
associated with credit risk in the shape of bankruptcy if it is not properly managed. The prime reasons
of the banking crisis can be enlisted as the lax regulations and policies governing the credit issuance
to borrowers, poor risk mitigation and management system in place, and negligence to the changing
economic conditions at the domestic and global level (BCBS, 1999; Baele et al., 2005). The changing
economic conditions are very important as they can weaken the paying power of the borrowers which
in turn increase NPLs.
The commercial banks are in a high competition of attracting customers. They set different
acceptance criteria for the advancement of loans to the customers. It is very important for banks to
determine whether the borrower meet the set criteria before the issuance of loan to him (Gorton & He,
2008). They are also required to consider the regulatory requirement. The banks may earn a high per-
period profit by relaxing the acceptance criteria. However, this deteriorates the quality of the loan
portfolio of the bank and they have to tolerate a higher credit risk (Bolt & Tieman, 2004). The banks
can increase the demands for loans by slackening the acceptance criteria, but it negatively affects the
quality of loan portfolio. This situation may give rise to the high default probability.
Lending quality plays a very important role in the soundness and safety of the financial
institutions (Chortareas et al., 2011). Higher loan losses show a higher level of risk (Jokipii & Milne,
2010)and poor quality of lending (Chortareas et al., 2011). This high risk may cause the bank to
exhibit a lower level of risk adjusted assets in the future. The loan losses are positively associated
with the capital requirements. A high ratio of loan losses demands for the high capital requirement to
comply with the regulations imposed by the regulator and to avoid the default risk (Jokipii & Milne,
2010). Banks are also required to conduct a categorical review of the performance of their corporate
portfolio. This review should also include the evaluation of collaterals held against the advances to
assess the quality of bank lending (SBP, 2009).

2.4. CREDIT RISK AND ECONOMIC CONDITIONS

Economic conditions play an important role in credit risk variation (Altman et al., 1998).
Growth in the economy motivates the banks to issue more and more advances (Sufian, 2009)and
competition among the banks increases (Keasey & Veronesi, 2008). More business opportunities are

10
produced in the market and banks try to capture them by offering different products and services.
Every bank tries to avail most of the available opportunities to earn more profits. However, in the urge
of earning profit, bank management ignores the fact that the credit operations are also associated with
credit risk. The bank can be trapped in credit risk because of abrupt changes in the economic
conditions. These abrupt changes can be shattering for banks as they may affect their stocks and
profitability (Baele et al., 2005).
Baele et al. (2005) also stresses that worthiness of a borrower becomes difficult to assess in a
recessive economy. The cash flows of the borrowers are negatively affected by the downfalls in the
economy causing a large number of defaults by the borrowers on the loans issued by the banks. Most
of the applications for the loans are evaluated in a subjective way in such a situation and net present
value (NPV) of different projects becomes uncertain. This recession in the economy also causes a
reduction in the value of collaterals and companies, which impair the credit worthiness of a borrower.
According to Altman et al, (1998), credit risk mitigation is largely affected by the changing
economic conditions. A bank is required to strengthen its mitigation and management system of credit
risk to avoid the shocks of credit risk resulting from changing economic scenario. A more vigil and
state of the art mechanism for mitigation and management of credit risk is required under uncertain
economic conditions. Credit market is overwhelmed by the competition when economy is in a growth
phase. There is a high demand for the credit market and various creditors try to compete with each
other various grounds. Banks design different lucrative and customized products and services for the
customers to grab a large market share, exploiting the favourable economic conditions. Therefore,
many a time a proper risk evaluation before issuance of credit is ignore in quest of attracting more and
more customers. Many of the borrowers who do not have authentic credit worthiness also remain
successful in getting loans in this situation. Concomitantly, credit risk rises to an unacceptable level
that may lead to default by a large number of borrowers, thereby effecting shareholders’ value
(Keasey & Veronesi, 2008).
The loss profile of a bank can be summed up in distribution of its loss under varying
economic circumstances. Different models dealing with credit portfolio follow the simulation process
to provoke this loss distribution in a precise manner. For ensuring the survival in the market in case of
excessive losses, a bank may set a particular level of capital that must be maintained under all
circumstances to avoid the bank run. This is depicted here in Figures 1 by the tail region. There is
widespread linkage of economic conditions with loss profile of a bank, as developed by most of the
credit portfolio models (Pesaran & Schuermann, 2003).

11
 Figure 1: A General Framework of CR Model

Source: (Pesaran & Schuermann, 2003)

Traditionally, banks are considered as mediators who take deposits from the depositors, issue
the loans to their lenders and make their earnings from interest income. The increased competition in
the banking system has reduced the chances of this traditional income. The banks are diversifying
now and finding other sources of income (Reserve Bank of Australia, 2004) as diversification is a
cost-reduction option for controlling the risk that helps to hedge the risk (Merton, 1989). Although
non-interest income provides diversification to a bank but it is more risky than traditional income.
However, shareholders may take benefit from the diversification provided by this non-interest income
(Williams & Prather, 2010).

2.5. EFFECTS OF CREDIT RISK

Variations in credit risk impair the quality of loan portfolio of banking system which
ultimately affects the aggregate performance of banks (Sufian, 2009). Duca and McLauglin (1990)
also support this claim. They emphasised bank profitability is significantly affected due to the
variation in credit risk. Miller and Noulas (1997) advocate that large exposures in risky loans cause an
increase in NPLs, thereby decrease the earnings of the bank. Moreover, over-reliance on interest
income increases the volatility of a bank’s stock and beta value of these banks is also high (Baele et
al., 2006).
The recent Global financial crisis of 2008 has shown that credit risk largely affected the
unregulated FIs. The situation affected the liquidity position in other regulated entities through the
contagion effect. The contagion effect rose due to off-balance sheet activities, highly leveraged firms

12
and unregulated intermediaries. The transfer of risk from the regulated institutions to unregulated ones
provided the regulated institutions a way to increase the leverage, but credit losses could not be
avoided (Carvajal et al., 2009).
There is a strong association between credit and liquidity risk. The worsening credit quality
and deviousness in the market make it difficult for the banks to generate more funds by taking loans
or issuing bonds. Sometimes the banks have to pay a high premium for these funds. It is a big
challenge for the practitioners to understand the relationship between funding liquidity, asset market
liquidity and credit risk (Grundke, 2010).

2.6. CREDIT RISK MANAGEMENT

Performance optimization of financial institutions is largely dependent upon a well-developed
CRM system. The management of financial institutions is required to understand the importance of
CRM for ensuring their stability and optimizing their performance. The CRM importance is
intensified especially because of illiquidity of loans. Most of the loans issued by commercial banks
are long term; therefore, they cannot be liquidated in a rapid fashion. Therefore, credit risk becomes a
major concern for the management of financial institutions (Koch & MacDonald, 2000). According to
theory of asymmetric information it is quite impossible for the managers to differentiate between
good and bad borrowers (Auronen, 2003). This inability of the bank to distinguish bad borrowers
from good borrowers makes it difficult to avoid adverse selection and moral hazards. These two
problems (adverse selection and moral hazards) lead to accumulation of massive non-performing
loans in banks (Bofondi & Gobbi, 2003)
The stability of a bank in the market place in face of uncertainty and overwhelming credit risk
is dependent on overcoming three basic problems related in asymmetry of information. These three
problems are named as ex ante, interim and ex post (Uyemura & Deventer, 1993; Kealhofer, 2003). A
good CRM system is a combination of various processes, including risk identification, risk
measurement, risk evaluation, risk monitoring and risk control. The banks are required to identify
emerging risk in terms of its severity in a prompt fashion and its consequences should be estimated
with precision. The causes of the risks should be identified and evaluated. The identification of causes
will help the bank to monitor the lending activities of the bank that are exposed to credit risk.
Concomitantly, a vigilant and effective control mechanism can be easily developed on the basis of
this evaluation. The bank should make all these processes implicit in its operation and strategic
framework (Crouhy et al., 2000).
There are number of risk adjusted measures used for evaluation of performance of loans
proposed by various researchers (Heffernan, 2004; Jokipii & Milne, 2010). Most of these measures
are concentrated on a risk-return trade-off. These measures estimate the risk involved in various
activities and capital is also estimated that is required to support the involved risk. Therefore, these

13
measures are not able to solve the recovery issue of bad debts. The problems related with asymmetric
information can be resolved and loan losses can be reduced by developing an effective CRM system.
Thus, it can be said that an effective system of CRM is vital for the long term success of a bank (IAIS,
2003). A bank is required to create an appropriate environment of credit risk for the development of
an effective CRM system. An appropriate credit risk environment can be made by working under a
sound credit granting process, good administration system and vigilant monitoring and control
mechanisms (Greuning & Bratanovic, 2003).
The intrusion of top management is inevitable here. Top management must take the
responsibility of developing and providing guideline for the CRM. These guidelines should be
communicated all levels in the banks and all levels should have similar level of understanding of these
developed guidelines. A different of understanding can also be slayer for the effectiveness of CRM
system. Therefore, top management must ensure that understanding of guidelines in true letter and
spirit is made possible. A strong communication mechanism is required to fulfil this purpose (Ojo,
2010).
The policies and strategies of a bank provide the grounds for the development of a sound
CRM system. These policies and strategies outline the structure of the mechanism through which
lending activities and other activities should be performed. The management of credit portfolio is
governed by these policies and strategies. These policies provide the ways through issuance,
appraisal, supervision and collection of loans is performed (Loubergé & Schlesinger, 2005). Many of
the researchers are of the view that screening of active borrowers of the bank is most important among
all other activities related with CRM (Derban et al., 2005). It has been strong recommended by the
previous researchers that credit assessment should be performed periodically. The asymmetric
information exert that quality of information received by the banks depends on the reliability of the
source and this information is vital in determining the success of the screening process.
Screening is a process which is practiced before the loan advancement to a borrower. The
borrower is properly evaluated and the probability of defaults is assessed by the bank (Preece &
Mullineaux, 1996). In case, borrower credibility is not authenticated and probability of default is very
high the applicant is denied to grant a loan. The banks use techniques like credit scoring and credit
rating for the purpose of screening. Usually this scoring and rating is practiced by the larger banks
(Treacy & Carey, 2000).
A mix of quantitative and qualitative techniques is available for the assessment of borrowers
of a bank. However, the challenge faced by the banking system in using qualitative approaches is their
subject nature (Kealhofer, 2003). However, some scale can be developed for assigning numbers to
qualitative observations. The borrowers attributes that are usually assessed through use of qualitative
techniques are assigned numbers by summing up the values in comparison with a pre-define
threshold. This is term as “credit scoring” (Sackett & Shaffer, 2006). The processing cost and
subjectivity, both are reduce by the use of this technique (Derban et al., 2005). The rating system

14
developed by the bank must be capable enough of generating signal about the changes in expectation
of loan losses as a result of credit risk (Sensarma & Jayadev, 2009). According to Chijoriga (1997),
quantitative techniques are more useful in evaluating the various factors associated with credit risk,
default risk, relative importance of various factors, and improving the pricing mechanism of default
risk. The bad loan applicants be easily screened out and reserves can be estimated in a precise way to
provide a buffer against the loan losses. Moreover, the use of quantitative techniques eliminates the
problem of subjectivity that is implicit in the use of qualitative techniques.
According to Mwisho (2001), establishment of clear processes for the approval of new loans
and extension of already issued loans is very important in management of credit risk. Moreover, the
payback capacity of the borrowers must be monitored on continuous basis, as exposures of banks may
change with the passage of time and because of changes in underlying variables. The moral hazards
can also be avoided with the help of a good monitoring mechanism (Derban et al., 2005). Monitoring
involve a number of factors like creation of an environment in which bank is perceive as an agent that
has the capability of solving some particular problems, establishment of good contacts with
borrowers, building of trust in bank, development of a supportive culture for borrowers in which they
are promptly helped out, monitoring the flow of business activities of borrower’s business through his
account in the bank, reviewing reports of borrowers on regular basis, updating records of borrowers
and periodical review of rating assigned to various borrowers (Mwisho, 2001).
Credit risk management (CRM) occupies a core position in the traditional banking business,
and it has become the top priority of the banking system. The previous financial crises faced by the
world’s economy stress to find out the new techniques for the measurement and mitigation of credit
risk. It may help to avoid the losses caused by credit risk, and world economy may not face a further
banking crisis. The recent financial crisis of 2007-2008 has put a question mark on the credibility and
worthiness the existing CRM techniques (Angkinand et al., 2010; Grundke, 2010). The banks are now
shifting their information technology expertise from market risk to credit risk. They are trying to
establish a sophisticated credit risk management system by utilizing their expertise in quantitative and
information technology disciplines (Ross, 2000).
An effective system for the assessment and mitigation of credit risk must be in place. This
system should help the FI to classify the loans. The classification should be made on the basis of the
credit risk grading system or the payment felony status (BCBS, 2006). This system should be strong
enough to assess the potential factors threatening the stability of the bank. The loan losses should be
properly managed and controlled. The bank stability will be questioned in case loan losses start
increasing at an alarming rate. The role of supervisors is very important in this type of scenario. They
should take the steps for the prudent measurement and effective management of credit risk so that
loan losses may not exceed the bearable limit. This system reduces the losses due to credit risk, and
maximizes the risk adjusted rate of return as CR is kept under the bearable range (BCBS, 1999).

15
 Extensive work has been performed and a number of tools have been developed for CRM, but
it is still a challenge for the bank management to mitigate the credit risk. According to Keasey &
Veronesi (2008) managers are in an illusion that they can manage and mitigate the credit risk with the
newly developed tools and techniques. They argue that existing techniques for the management of
credit risk depends on the available data, which is not always reliable. Mostly, the available data is
suspicious and a jumble of fake figures. This claim finds support from the example of inflated values
of property and other collaterals held against the advances. The effectiveness of the CRM techniques
is questionable if data obtained from the borrowers is not authenticated.
According to BCBS (1999), a CRM system should be capable of effectively addressing the
four key areas as follows:
(i) Establishment of an appropriate credit risk environment

(ii) A sound credit evaluation process

(iii) Maintenance of suitable process of measurement and monitoring

(iv) Ensuring the adequate controls over credit risk

BCBS (2006) emphasises that while assessing bank’s capital adequacy, managers and
supervisors should keep in mind the practiced policies and procedures for the credit issuance and
evaluation. The holding of more capital protects the bank from solvency risk, but the profitability of
the lending activity is not buttressed. The credit losses might not be properly assessed despite a well-
administered credit issuance and evaluation system is in place. This might be caused due to some
external factors jeopardizing the managers’ ability to assess the losses emanating from credit risk.
Mostly, credit risk is assessed on the previous indication and substantiations which are subjective in
nature (Kao, 2000).
Securitisation has been a widely used technique for the credit risk management in the banking
system for the last three decades (Casu et al., 2011). Securitisation motivates the banks to structure a
portfolio with high risk and high return assets (Cebenoyan & Strahan, 2004). However, the recent
financial crisis of 2007-2008 revealed that securitising creates a number of problems for the banks.
The usefulness of this technique has become questionable by the researchers and practitioners. This
technique failed to save the banking system from the credit losses.
Sackett & Shaffer (2006) have described three important CRM tools that are widely used by
the banking system. These three tools are screening, monitoring and collection. They have
investigated in their study whether these three tools are substitutes or complements of each other.
Their results have revealed that screening and monitoring can be used as substitutes while collecting
complements both of these.
The banks have been using various tools like credit agreements, holding collateral,
securitization of loans, credit insurances and syndications to control loan losses (Casu et al., 2011).

16
The ability of intellectual staff that is responsible for CRM is also of critical importance. The
knowledge and understanding of the staff plays a key role in judgement and decision on basis of it
(Rajeev et al., 2008). There are some researchers that are of the view the inception of new
technologies, like use of computers and internet in banks has facilitated the assessment, monitoring
and control of credits. The track record of various borrowers is maintained in an easier, efficient and
convenient way (Chijoriga, 1997; Santomero, 1997). However, Marphatia and Tiwari (2004) argue
that people are mainly responsible for risk management. The effectiveness of risk management is
based on their understanding and perception of underlying facts. Technology can be used merely as a
tool and it cannot use beneficial results if it is in wrong hands, but it may increase the catastrophe in
such a situation (Marphatia & Tiwari, 2004).

2.7. FAILURE OF PENN SQUARE AND CONTINENTAL ILLINOIS

The failure of Penn Square and Continental Illinois is connected with each other. However,
the major reason of the failure of Continental Illinois is linked with Penn Square.
The Penn Square was a small U.S. Bank based in Oklahoma City. This bank was established
in 1960. This bank was a highly reputed lender to Oil and Gas Industry. The bank’s assets
experienced a rapid growth in the period of 1974-1982. At the time of collapse it had total assets of $
526.8 million and deposits of $ 470.4 million. The bank followed an aggressive lending strategy for
oil and gas sector. Although the majority of interest of these loans was sold to other banks, but still
Penn Square was responsible for the servicing of these debts. The documentation for the advancement
of the loan was very poor and the sole criterion for the issuance of loan was the value of collateral.
The ability of the borrower to repay was never assessed and all the decisions were only made on the
collateral value. This situation deteriorated the quality of the bank’s loan portfolio, which became the
main reason of failure of Penn Square.
Continental Illinois was the largest bank in Chicago and it was among the top ten Banks in the
USA. It failed due to large-scale NPLs, which in turn created the liquidity risk for the bank 1. The bank
was the 5th biggest bank that purchased oil and gas loans from the Penn Square. After the failure of
Penn Square, Continental Illinois experienced a loss of $ 63.1 million. The NPLs of the bank rose to $
1.3 billion and the convalescence also slowed down to the alarming level. This situation worsened in
the subsequent quarters when the NPLs reached up to $ 2 billion.
It was revealed in the first quarter that NPLs had risen to $ 2.3 billion. This amount was 7.7%
of the total loan portfolio of the bank. The domestic loan portfolio was being funded by the short term
deposits. These deposits were insecure which made the bank more vulnerable to the bank run. On 17
May 1984, a financial assistance program was launched by the Federal Deposit Insurance Corporation
(FDIC) and the Federal Reserve Bank. A capital injection of 2 billion was made in Continental

1
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17
Illinois, but the problems of the bank could not be resolved (Heffernan, 2004). Eventually, the bank
was nationalised at a cost of $ 1.1 billion on September 26, 1987 2.

2.8. CREDIT RISK MANAGEMENT AND SHAREHOLDERS’ VALUE

Most of the times managers in a bank get themselves engaged in various risk management
activities without considering the alignment of these activities with the objective of shareholders’
wealth maximization. This situation arises because a conflict of interest between managers and
shareholders. Manager may engage themselves in these activities because of their personal interest
and they forget the interest of shareholders. Managers are willing to get the benefit of changes in
interest rates, foreign exchange rates and commodity prices. Risk management practices are
performed by the managers in order to take benefits of these situations for their personal interest and
shareholders’ wealth maximization principal is ignored (Baele et al., 2006; Fatemi & Fooladi, 2006).
There are four key areas that must be addressed by a robust credit risk management system of
a bank. These four areas are: (i) development a suitable credit risk environment; (ii) sound credit
issuance process; (iii) a vigil credit administration, measurement and monitoring mechanism; (iv) and
appropriate control of credit risk within bearable ranges (BCBS, 1999). Most of the times banks
assess the credit risk on the basis of previous trend. The past evidence may provide trivial support in
credit risk evaluation; therefore, risk managers must perform this analysis in precautious manner
(Kao, 2000).
Though a number of tools for the mitigation and management of credit risk have been
introduced, it is still a great challenge for the banking system to manage the credit risk in an effective
way. A large number of banks are still unable to manage credit risk in an appropriate way. According
to Keasey & Veronesi (2008), it is a widespread illusion that managers are able to mitigate the credit
risk with newly developed tools and techniques. They argue that validity of the practiced techniques is
dependent on the available data. The authentication of this data itself is questionable. It can also be
understood by the help of example of self-certification and inflated values on property to support their
argument. If authentication of the data provided by borrowers is not properly assessed, then all the
techniques for managing the risk are useless.

2
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2.9. SUMMARY
This chapter has covered various aspects of credit risk. A blend of old and new studies have
been used. This blend of old and new studies provide a lucid picture that how the various concepts
have been developed over the period of time. Literature shows that economic conditions are important
in determining the level of credit risk. The level of credit risk varies with changes in economic
conditions. The researchers have developed a number of tools for the management of credit risk but
each of the tools and techniques has certain limitations. These limitations are important to be
considered while application of these tools. Moreover, it is also evident that there is dearth of studies
addressing the linkage of credit risk and shareholders’ wealth. Whereas, it is important, under the
principles of financial management, that all activities of an organization must be aligned with
shareholders’ wealth maximization principle.

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 3. RESEARCH METHODOLOGY

3.1. INTRODUCTION
The employed research methodology is elaborated in this chapter. This chapters deals with
the method through which research objectives have been achieved. The variables under study have
been explained. This chapter provides information about the type of study, required data, data sources
and analysis procedure of the collected data.

3.2. ACHIEVEMENT OF OBJECTIVES

The study will seek to achieve the formulated objectives through testing equations 5 and 6.
These equations have been developed with a view to encompass different factors of credit risk with
respect to their role in determining shareholders’ value. This study will evaluate the impact of credit
risk on shareholder’s wealth. Therefore, the credit risk has been taken as independent variable.
Shareholder’s wealth is being measured with the help of ROE and ROS. ROE is the accounting return
on equity while ROS is the market return on the shares of banking system being traded in stock
market.
Loan Loss Provisions shows the level of credit risk that is being faced by the credit risk. It
measures the credit risk faced by a bank. The banks with higher loan loss provision to total loans ratio
are facing a higher level of credit risk, which may prove catastrophic if not management properly.
This ratio has been taken as quantification of credit risk faced by a bank. Total Advances to Total
Loans Ratio shows the level of credit risk exposure by the banking system. The banks with higher
ratio are likely to face a high level of credit risk. These banks are required to have a vigil eye on its
credit operations. The banks must periodically monitor their credit operations. The quality of loan
portfolio should be reviewed periodically in order to avoid future losses emanating from these credit
operations. This ratio has been taken as measure of credit risk exposure. Capital adequacy ratio has
been taken as a measure of credit risk management. Capital provides a buffer against the losses
emanating from credit operations. The banks can absorb the losses of credit risk if they have an
adequate capital. The chances of bankruptcy are significantly reduced when banks are backup up by a
significant capital cushion against the possible losses. Capital adequacy ratio has been taken as a tool
for managing credit risk as it provides a buffer against the shocks of credit risk.
The shareholders want to have an increase in the value of their shares and overall higher
return on equity provided by them. This study will follow the Du Pont model to calculate the return on
equity. The shareholders of any firm are not only interested to have an increase in ROE but they also
want an increase in the value of their shares. The equations of the framework are as follows:

20
ROEit = βo – β1CREit+ β2CMit + β3CRMit+ Et +εit (1)
ROSit = βo – β1CREit-1 + β2CMit-1+ β3CRMit-1+ Et+ εit (2)
Where:
ROEit = Return on Equity (ROE)
CRE = Credit Risk Exposure
CM = Credit Risk Measurement
CRM = Credit Risk Management
E = Economy
ROS = Return on Shares

3.3. VARIABLES AND THEIR MEASUREMENT

The measurement of all variables used in this study is being explained below under their
respective headings.

3.3.1. Independent Variables

Credit risk is the main independent variable in the present study. Three aspects of credit risk
i.e. credit risk exposure, credit risk measurement and credit risk management have been taken as
dependent variable in the present study.

3.3.1.1. Credit Risk Exposure

Credit risk exposure (CRE) shows that how much a bank is exposed to credit risk. The loans
are the biggest source of a bank for income but these loans are also a source of risk as well. The credit
risk exposure has been measured with formula given in equation 3(Veli, 2007).
Total Advances (3)
CRE =
Total Assets

3.3.1.2. Credit Risk Measurement

Credit risk has been measured with the help of credit risk monitoring ratio. Credit risk
monitoring shows the level of credit risk that a bank is facing. This monitoring is being measured with
the help of percentage of loan loss provisions to loans (Sackett & Shaffer, 2006). The formula is
provided in equation 3.
Loan Loss Provisionsit (4)
CM =
Total Advancesit-1

3.3.1.3. Credit Risk Management

Credit risk management is very important activity of a banking system because of its large
scale credit operations. A bank uses various tools for credit risk management. Many of banks provide

21
a large capital buffer against the shocks of credit risk. The present study has used capital adequacy
ratio (CAR) as a proxy of credit risk management. The formula of CAR is given in equation 5.
Tier I Capitalit + Tier II Capitalit (5)
CM =
Risk Weighted Assetsit

3.3.2. Dependent Variables

Shareholders’ value is the main dependent variable in the present study. The shareholders are
interested to have an increase in their shares value and also in their overall return on equity.
Therefore, the present study has taken two independent variables i.e. Accounting Return on Equity
(ROE) and Market Return on Shares (ROS).

3.3.2.1. ROE
The study adopts Du Pont model to calculate the return on equity.
ROE = Profit After Tax X Total Assets (6)
Total Asset Total Equity
Profit after Tax/Total Assets, is Return on Assets (ROA) whereas Total Assets/Total Equity is

Equity Multiplier (EM). The equation No. 1 can be re-written as follows:

ROE = ROA x E.M. (7)

Whereas:

ROA = Net.II. + Non.II – Prov. (8)

Total Assets
Net.II = Net Interest Income, Non.II = Non Interest Income, Prov. = Provisioning

ROE = Net.II. + Non.II – Prov. X EM (9)

Total Assets

3.3.2.2. ROS
Market return on shares is the second independent variable in the present study. The variable
has been measured on the basis of formula give in equation 10.
Σ{Ln(Pit/Pit-1)}
ROSit = (10)
n

3.3.3. Control Variable

Economy has been taken as control variable in the present study. Economy has been proxied
by growth of growth of nominal GDP (Pesaran & Schuermann, 2003).

22
3.4. TYPE OF STUDY
The study is causal in nature. The study seeks to evaluate the role of credit risk in creation
of value for shareholders.

3.5. POPULATION AND SAMPLE

The commercial banks registered and operating in UK that are also listed on London Stock
Exchange (LSE) are population of the present study. The author has selected 7banks for the collection
of data in the present study. These banks have been selected on the basis of random sampling.
Random sampling is the most reliable sampling strategy that produces the most reliable data. The
current study is using the panel data i.e. combination of cross sectional and time series data. The use
of panel data covers the deficiency of the sample as the data has been collected for the last 10 years,
thereby making total 70 observations.

3.6. RESEARCH APPROACH

There are two types of research approaches that are being widely followed in research i.e.
qualitative and quantitative approach (Ramamurthy, 2011).

3.6.1. Qualitative Approach

Qualitative approach is a set of the interpretive techniques that aims to explain, translate or
draw the meanings from the terminologies related to the certain phenomenon not occurring in a
natural fashion in the social world (Maanen, 1979). The techniques of qualitative methods are used
during the collection of the data as well as analysis of the data. The data collection techniques include
focus group, case studies, unstructured interviews, ethnographies and observations, whereas, the
techniques like content analysis, behavioural observations, trace evidences, or debriefing of the
observers are used during the analysis (Cooper & Schindler, 2007).
The purpose of the qualitative techniques is to obtain an in-depth understanding of the
phenomenon. However, the personal biasness of the researcher cannot be eliminated from the research
following the qualitative approach. This biasness may impair the results of the research. Moreover,
the qualitative researchers have a limited generalizability and reliability (Ramamurthy, 2011).

3.6.2. Quantitative Research

Quantitative research is a set of techniques in which each and every element under the study
is quantified. The different events occurring in the social world are quantified with the help of certain
methods. The quantitative approach is used during the data collection and data analysis as well. The
structure interviews, surveys, and secondary data collection are the measures used for the collection of

23
data. There are large number tools and techniques available for the quantitative analysis (Cooper &
Schindler, 2007, p. 196). These techniques include correlation, regression, structured equation
modelling, co-integration and correlation etc. Each technique is selected according to the requirement
of the study and type of the data (Asteriou & Hall, 2011).
The chances of the biasness are quite reduced in a qualitative study. The study uses the
methods that are recognized by the large pool of researchers and practitioners. The reliability of these
methods is authenticated. Therefore, the studies following quantitative approach have a large
generalizability and reliability (Ramamurthy, 2011).

3.6.3. Approach of the Present Study

The present study will be following approach of double movement of reflective thoughts
(Saunders et al., 2009). The quantitative approach will be integrated with the qualitative approach.
The variables are directly quantifiable. The researcher will perform the statistical analysis for testing
the established hypothesis and to evaluate the relationship of credit risk and shareholders’ value. The
quantitative approach is useful in producing more reliable and generalizable results. The researcher
will also conduct some unstructured interviews from bankers to have a deeper understanding about
the identified relationships and to obtain more knowledge about credit risk being the most significant
risk faced by the banking system. The blend of qualitative and quantitative approach will provide
more knowledge and increase the generalizability and reliability of the study.

3.7. RESEARCH PHILOSOPHIES

According to Guba and Lincoln (1994, p. 105), the questions related to the application of an
appropriate research paradigm are more important than the questions of application of research
methods. The paradigms can be referred to different philosophies. There are four research
philosophies followed in social sciences and business management. The research philosophy basically
directs the researcher’s perception to a particular way. The philosophical commitment with the
research strategy is very important for the researchers from the field of business management, as it
helps out them to understand the matters under investigation (Johnson & Clark, 2006). According to
Saunders et al., (2009, p. 108), there are four major philosophies that are being used in business
management research. These phiolosphies are being explained as follows:

3.7.1. Pragmatism
This philosophy emphasizes on the importance of research questions. This philosophy argues
upon the possibility of mixing of quantitative and qualitative methods. The mix method is regarded as
highly appropriate and effective method of research. According to Tashakkori and Teddlie (1998), the
pragmatism paradigm is very appealing. This paradigm does not limit the researcher’s perception to a

24
single methodology and provides a broader understanding to the researcher (Tashakkori & Teddlie,
1998, p. 30).

3.7.2. Interpretivism
This philosophy advocates that the researcher must comprehend the prevailing differences
among the human with respect to their role played in the society. This philosophy emphasize that the
humans are different from the objects. The research should follow a different perspective while
studying the human as compared to the studies related to objects and events. According to the theatre
allegory human beings are like actors performing their role on the stage of life. Every actor plays
his/her role and interprets the same in a specific way. By following this philosophy, researcher tries to
interpret the role of different human beings in the social settings (Saunders et al., 2009, p. 116).

3.7.3. Realism
The philosophy of realism is related with scientific inquiry of objects and events. According
to this philosophy the existence of objects in this world does not depend upon the human minds.
According to this theory, realities are often different from the perceptions. The perceived phenomenon
does not fall under the philosophy of realism. Realism is an opposite philosophy to idealism. It
negates the idealistic perspective (Saunders et al., 2009, p. 114).

3.7.4. Positivism
The researchers following the philosophy of positivism follow the stance of the natural
scientist. It is preferred to work on an observable social reality. The end product of these researches is
the generalization and formulation of some laws. The researches produce credible data here and
hypotheses are developed for factual testing. The acceptance, partial acceptance or rejection of these
hypotheses leads to the development of a new theory or implementation of new laws (Remenyi et al.,
1998, p. 32).

3.7.5. The Philosophy of the Present Study

The present study will follow the philosophy of pragmatism. Although the variables under
study are directly measureable; but the philosophy of pragmatism is more useful in performing an in
depth analysis of the matter under investigation (Remenyi et al., 1998). This philosophy emphasizes
upon integrating quantitative and qualitative approach. The researcher will not only focus on
quantitative approach but qualitative approach will also be followed to have deeper understanding of
credit risk and its role in determining shareholders’ value.

25
3.8. DATA FOR THE STUDY
The present study is collected two types of data i.e. primary data and secondary data.

3.8.1. Primary Data

The researcher has collected the primary data through interviews from the bankers. This data
is cross sectional in nature. Researcher have adapted questionnaire to proceed with interviews. This
questionnaire has been adapted from the study of Al-Tamimi & Al-Mazrooei (2007). However,
researcher did not only stick to the questionnaires and respondents were provided with the opportunity
to express their point of view with full liberty. This data was qualitative. These interviews provide
useful information and knowledge about credit risk. The bankers provided practical knowledge about
credit risk. This data enhances the understanding of researcher and concomitantly reader of the
present study. Moreover, this data also helps to support the results obtained from the quantitative data
analysis.

3.8.2. Secondary Data

Secondary data have been collected through annual reports of the banks. The researcher
studied income statements, balance sheets and their notes for the collection of the data. The relevant
data to the selected variables were taken from these statements. The data were collected for the last
10 years from these reports. The data are secondary that as it had prior existence. The collected data
are panel data as it have the characteristics of cross sectional and time series data.

3.9. TIME PERIOD

While measuring any of the variables in aggregation, it is important to specify a common time
period for all variables. A time horizon of one year has been taken for all the variables in this study
(Kuritzkes et al., 2002). Aas et al., (2007) also favour the use of 1-year time horizon. 1-year time
horizon is reasonable as it relates to the allocation of internal capital and budgeting cycle. Moreover,
one year is the time period, in which a financial institution can access the market for additional
capital, if required, and this time horizon is also used in the New Basel Accord. The data have
collected for the time period of 10 years i.e. 2003-2012.

3.10. METHOD OF ANALYSIS

The data was arranged in the form of panels. Then data were entered into Stata 10. The
descriptive analyses were obtained to observe the trends of the data. Various statistical tools have
been applied for the analysis of the data to test the equations of framework. The researcher applied

26
panel data analysis with the help of Stata. The models of panel data analysis i.e. fixed effect model,
random effect model and common effect model were applied and the most efficient model was
selected on the basis of Hausman Test.

3.11. VALIDITY AND RELIABILITY

This study will collect secondary data for the analysis purpose. The variables under study are
directly measureable and no instrument is required for the measurement of these variables. Therefore,
validity and reliability is not a problem in this research like studies dealing with primary data. The
data for the study have been collected from the annual reports of banks. Therefore, it is believed that
the data is reliable. However, other test related with assumptions of panel data analysis will be
performed. The researcher has tested the data for multicollinearity, unit root and auto correlation. The
application of these tests rectified the problems existing in the data with respect to auto correlation,
normality, outliers, and unit root. The identified problems were removed before applying panel data
analysis in order to obtain more reliable results from the models of panel data analysis.
The present study is also collecting primary data but this primary data is being conducted
through semi structure interviewed. A questionnaire has been prepared for conducting semi structured
interviews. The questionnaire was discussed with practitioners and academicians in order to tests it
validity. After getting approval of validity, it reliability has been tested through test retest method.
The researcher has selected 10 employees from banking system who are directly involved in credit
operations of the bank. Similar questions were asked to them on two different occasions. A gap of one
week was taken between both sittings with these employees.

3.12. ETHICAL CONSIDERATIONS

The ethical issues are very important in research. A good research design is formulated by
keeping in view the principles of ethics (Tharenou, et al., 2007, p. 317). The researcher has ensured in
this study that all the ethical issues are properly addressed. The secondary data used for this study has
been obtained from the annual reports of the banks that are publicly available. The data have been
collected in its true spirit and in accordance with the defined variables. The researcher has avoided
any tempering in the data. The secondary data used in the literature review has proper references and
researcher gave full credit to the sources. It has not been tried to take any undue credit.

27
 4. RESULTS AND ANALYSIS
This chapter provides the results of the statistical tests applied to the collected data and
analysis of the data collected through questionnaire. The researcher has collected two types of data in
the present study.

4.1. QUANTITATIVE DATA ANALYSIS

The quantitative data has been collected from the annual reports of the bank. This data has
been statistically analysed and the results of these tests have been reported here.

4.1.1. Descriptive Statistics

Descriptive statistics have been reported in Table 1. There are total 7 banks and the data for
these banks have been collected for the 10 years. This makes total 70 observations. This table shows
the values of mean, standard deviation, minimum and maximum.
The mean value of credit risk exposure is .5347 that shows that most of the banks’ assets are
comprised of advances. The banks are largely focused on credit operations. The minimum value is
.3329 and maximum value is .7094. These values show that there is a large variation among the
practices carried out by different banks. Some of the banks are heavily focused on credit operations
while others are not. However, most of the banks are mainly concentrating on credit operations for the
returns.
Credit risk monitoring has been measured with the help of ratio of loan loss provision to total
loans. The mean value of this ratio is .0595 i.e. that is quite lower. It shows that on average only 5%
of the loans are converted into loan loss provision. However, the minimum and maximum values are
showing a huge dispersion. Some of the banks are exceptionally good at managing their loans as their
ratio is very low i.e. 0.0003. Whereas, some banks are not able to manage their credit operations and
this ratio is 1.90 that shows an alarming situation for these banks. These banks are required to pay
immediate attention to this issue.
The mean value of CAR is .1283 that shows a good position of overall banking system. Most
of the banks are maintaining the CAR well above the defined threshold. The dispersion among the
banking system is quite evident here too. The highest ratio of CAR is .4493 whereas some of the
banks have a CAR of only 0.0192.
The return on equity on average for the banking system is 12.01% that is quite good.
However, some banks are having negative ROE as the minimum value is -1.6449 and some of the
banks are earning super normal profits as the maximum value of ROE is 1.4195. The dispersion is
quite higher here again.

28
 The mean value of ROS is -.001076. The maximum value is also not very high i.e. .0078.
This shows the lack of interest of the investors in the stock of banking system. The investors are not
much inclined towards buying the shares of banks. This is perhaps because of the risky nature of the
banking business. The banks are required to take appropriate actions to increase the confidence of the
investors in the stock of banking system.
Table 1: Descriptive Statistics

Variable Obs Mean Std. Dev. Min Max

CRE 70 .5347011 .1182665 .33296 .7094
CM 70 .0595486 .2383646 .0003 1.9073
CAR 70 .1283699 .0551008 .0192 .4493
Eco 70 4.809 2.388937 1.21 8.96
ROE 70 .1201556 .3308629 -1.6449 1.4195
ROS 70 -.001076 .0036638 -.0102 .0078

4.1.2. Unit Root Test

Levin-Lin-Chu Test was applied to test either the data was stationary or not. The results have
been reported in Table 2. These result shows that there is no problem of unit root in the data. The p <
0.05 that rejects the null hypothesis i.e. there is a unit root in the data. Thus, alternate hypothesis is
accepted here i.e. there is no unit root in the data.
Table 2: Levin-Lin-Chu Test
Levin-Lin-Chu test
Null: Data has a unit root.
Alternate: Data is stationary.
Pooled ADF test, N, T = (7, 10) Obs = 63
Variable coefficient t-value t-star P>t
CRE -0.71535 -6.279 -3.86310 0.0001
CM -1.14799 -9.191 -7.12486 0.0000
CAR -0.68897 -8.274 -6.57140 0.0000
ROE -0.81234 -6.407 -3.99234 0.0000
ROS -0.95606 -8.030 -5.69588 0.0000

4.1.3. Test for Auto Correlation

Statistically, auto-correlation represents the extent of similarity among a given lagged version
and time series of it over succeeding time intervals. The term can also be referred to as “serial

29
correlation” or “lagged correlation”. In regression analysis, it is assumed that observations develop a
time series where an observation depends on its predecessor. The linear regression model assumes
these observations to be independent from each other; no auto-correlation that is why auto-correlation
is a serious problem in panel data.
The auto correlation here has been tested with the help of Wooldridge test. The results have
been reported in Table 3. A serial correlation was found in variables of CRE, CAR and ROE.
Therefore, regression with auto regressive disturbances was performed to control the problem of auto
correlation.

Table 3: Wooldridge Test

Wooldridge test for autocorrelation in panel data
H0: no first-order autocorrelation
Variable F (1, 6) P >F
CRE 16.962 0.0062
CM 0.159 0.7043
CAR 20.715 0.0039
ROE 14.024 0.0096
ROS 0.825 0.3989

4.1.4. Correlation Analysis

The correlation matrix is shown in Table 4. The table shows that the variables of CRE, CM,
and Eco have modest correlations with ROE, whereas CRE, CAR and Eco have modest correlations
with ROS. The correlation of CRE is negative with ROE, but positive with ROS. Moreover, CAR has
a positive correlation with ROE but negative correlation with ROS. The correlations among
independent variables are weaker that negates the presence of any problem of multicolinearity.

30
Table 4: Correlation Matrix

CRE CM CAR Eco ROE ROS

CRE 1.0000
CM -0.1847 1.0000
CAR -0.4400 -0.0959 1.0000
Eco -0.1630 -0.0136 0.1121 1.0000
ROE -0.3756 -0.4206 0.0589 0.2469 1.0000
ROS 0.4177 -0.0377 -0.4983 0.4402 0.0020 1.0000

4.1.5. Panel Data Analysis

There are two independent variables in the present study i.e. ROE and ROS. The panel data
has been performed to evaluate the relationship of the dimensions of credit risk with the dimensions
of shareholders wealth. The researchers has applied three models of panel data analysis i.e. common
effect model, random effect model and fixed effect model. However, on the basis of Hausman Test
fixed effect model has been chosen and reported here. It is pertinent to note that the problem of serial
correlation was detected during the application of Wooldridge test. Therefore, fixed effect model has
been applied by controlling the auto regressive disturbances.
Because of the two dependent variables i.e. ROE and ROS, the fixed effect model has been
applied for two times. The results are reported here Table 5 and Table 6.
Table 5 shows the results of fixed effect model with the dependent variable of ROE. The
value of R Square (within) is 0.5241. This value shows that the independent variables bring a change
of 52.41% in the dependent variable i.e. ROE. This is significant impact of credit risk on ROE. The
value of F statistics is 16.412 (p < 0.01). These results signify that credit risk plays an important role
in determining ROE that is one of the components of shareholders wealth and shareholders are always
interested in a firm with higher ROE.
This table also provides the values of coefficients along with t-statistics and significance
values. The coefficient of CRE is -.877879. The negative sign denotes that credit risk exposure has a
negative relationship with the return on equity. The value of t-statistics is -2.01 (p < 0.05). These
results show that CRE has a significant negative relationship with ROE. The firms with large scale
credit operations are likely to have a lower ROE. The banks are required to review their large scale
credit operations and policies should be devised in order to reduce the negative effect of credit risk
exposure on return on equity. These results also signify that banks are required to improve the
management of their credit operations. Currently, it seems that credit operations are not properly
managed by the banking system.

31
Table 5: FE (within) regression with AR(1) disturbances (ROE)
Group variable: Company Number of groups =7
R-sq: within = 0.5241 Number of Obs = 63
between = 0.6402 F(4,52) = 16.412
overall = 0.5124 Prob > F = 0.0002
ROE Coef. Std. Err. t P>|t| [95% Conf. Interval]
CRE -.877879 .430492 -2.01 0.021 -1.754883 -.000876
CM -.481651 .157751 -2.04 0.003 -.414303 .251004
CAR 1.206732 .278307 0.08 0.940 -.771843 1.358379
Eco .433143 .172184 2.92 0.000 -.001407 .067695
Constant .595776 .249863 2.38 0.021 .094389 1.09716

The coefficient of credit risk measurement is also negative with ROE. Credit risk has been
measured with the help of ratio of loan loss provision to total loans. The banks that have a higher ratio
of loan loss provision to total loans are likely to have a lower ROE. This relationship is also
significant here. The value of t-statistics is -2.04 (p < 0.01). The losses generated from credit
operations reduce the earnings of the bank that in turn reduces the return on equity and earning is the
basis for calculating the return on equity.
The coefficient of CAR is 1.2067. The relationship of CAR is positive here with ROE.
However, this relationship is insignificant as the value of t-statistics 0.08 (p > 0.05). Therefore, CAR
does not play any role in determining the value of ROE. It can be concluded that credit risk
management is irrelevant in the context of shareholders’ wealth maximization whereas ROE is
concerned. However, the results may different from the perspective of shareholders’ understanding
that has been evaluated with the help of ROS here.
The economy has a coefficient of .433143. The relationship of economic growth is positive
with the return on equity of the banking system. This relationship is significant here. The value of t-
statistics is 2.92 (p < 0.01). When economy is growing, banking system also reaps the benefits of this
growth and enjoys healthier profits. The losses emerging from various operations including credit
operations may decline thereby increasing profitability.
The second dependent variable in the present study is ROS. This is measure of shareholders’
return on the shares being traded in the market. This is the main source of shareholders’ wealth. The
fixed effect model has been applied by taking dependent variable as well. The results have been
reported here in Table 6.
Table 5 shows the results of fixed effect model with the dependent variable of ROS. The
value of R Square (within) is 0.2916. This value shows that the independent variables bring a change
of 29.16% in the dependent variable i.e. ROS. This is quite significant impact of credit risk on ROS.

32
The value of F statistics is 5.35 (p < 0.01). These results signify that credit risk plays an important role
in determining ROS that is major source shareholders wealth and shareholders evaluate the ROS of
the firm while taking the investment decision. The firms with lower ROS fails to gain the confidence
of their shareholders and trading of their shares faced a significant decline.
This table also provides the values of coefficients along with t-statistics and significance
values. The results are quite interesting here. The coefficient of CRE is .706399. The positive sign
denotes that credit risk exposure has a positive relationship with the return on shares. The value of t-
statistics is 4.40 (p < 0.01). These results show that CRE has a significant positive relationship with
ROS. The firms with large scale credit operations are likely to have a higher ROS. This shows that
shareholders prefer that a bank must have higher exposure in credit operations. They are of the view
that the banks with higher credit operations are more like to earn greater return. These results also
show the risk propensity of the shareholders. However, the risky behaviour of shareholders is quite
evident here from these results. The shareholders seem unaware of the negativities associated with
credit operations. Shareholders are required to be educated about the negative impacts associated with
credit risk operations as well apart from the economic return generated from these credit operations.
Moreover, in this study, it has been proved credit operations have negative impact on accounting
return on equity. Shareholders should give consideration to this issue.
Table 6: FE (within) regression with AR (1) disturbances (ROS)
Group variable: company Number of groups =7
R-sq: within = 0.2916 Number of Obs = 63
between = 0.3542 F(4,52) = 5.35
overall = 0.2349 Prob > F = 0.0011
ROS Coef. Std. Err. t P>|t| [95% Conf. Interval]
CRE .706399 .004579 4.40 0.000 -.015589 .002791
CM .001117 .001789 0.62 0.538 -.002483 .004701
CAR -.432037 .013107 -2.44 0.018 .005736 .058338
Eco .200497 .000179 2.73 0.009 .000131 .000851
Constant -.003087 .002898 -1.06 0.292 -.008903 .002730

The coefficient of credit risk measurement is positive. It is .0011. Although, this value shows
a positive relation of ratio of Loan loss provision to total assets with ROS, but this relationship is
insignificant here. The value of t-statistics is 0.62 (p > 0.05). The shareholders are not considering the
losses generated from the credit operations. This also signifies the risky behaviour of the shareholders
towards investment in shares of banks. The due consideration should be given to credit risk faced by a
bank while taking the investment decision for the shares of a bank. The shareholders may face losses
by ignoring the credit risk faced by the bank in which they are investing their hard earned money.

33
 The coefficient of CAR is -0.432. The relationship of CAR is negative here with ROS. This
relationship is significant here as the value of t-statistics -2.44 (p < 0.05). This is bit surprising, but
keeping in view the relationship of other dimensions of credit risk with ROS it does not seem
surprising. The relationships of CRE and CM with ROS reveal the risky attitude of the shareholders.
Therefore, negative relationship of CAR with ROS shows that shareholders do not prefer a higher
CAR. Perhaps they are of the view that maintaining a higher CAR means that banks are just
maintaining a higher amount in order to meet a regulatory requirement and this amount of capital is
idle. The bank should make the use of this capital for the maximization of shareholders’ wealth.
Therefore, CAR has a negative relationship with ROS. These results are different from the results
shown in Table 5 where CAR has a positive but insignificant relationship with ROE.
The economy has a coefficient of .200497. The relationship of economic growth is positive
with the return on shares of the banking system. This relationship is significant here. The value of t-
statistics is 2.73 (p < 0.01). When economy is growing, shareholders feel at ease while making
investment. Resultantly, they earn higher return on their investment. This situation is also prevalent in
the case of banking system. The whole market experiences a growth in such situation and banking
system also reap the benefits of this growth. The shareholders earn healthier returns in this situation
and they make more investment in the market.

4.2. SUPPLEMENTARY ANALYSIS

The primary data has been collected through semi structured interviews. The researcher
selected two employees from each of the selected 7 banks. Hence, semi structured interviews were
conducted with total 14 employees from the banking system. Because this study is focused on credit
risk, therefore, these employees were chosen from the credit department of the banks. Some selected
questions were asked from the respondents. However, the respondents were provide full liberty to
express their opinions about the asked question and use of some definite scale (like likert or
dichotomous scale) was avoided in order to have a broader understanding of the matter under
discussion. The responses of the respondents are reported here with analysis.
The semi structured interviews were conducted from total 14 employees of banking system
selected from credit departments. There were 5 female and 9 male respondents. Most of the
employees have an education equivalent to post graduation and they had an experience of more than
5-7 years working in banking system. The responses of these respondents against the asked questions
are reported here.

34
Q. No. 1: Does your bank undertake a credit worthiness analysis before granting loans?
Almost all of the respondents responded positively to this question. They confirmed the presence of a
well-developed mechanism to evaluate the credit worthiness of the borrower before issuing credit.
The respondents said that there are different tools that are used to assess the credit worthiness of the
borrower. The income and assets held by the borrower are evaluated and his debt paying capacity is
assessed through these tools. The loans are granted to the individuals whose credit worthiness is
proved good.
However, some of the respondents showed their concern upon the evaluation process
currently carried out by the banks. They expressed that most of the times the evaluation is process is
largely dependent upon the information provided by the borrower. The banks do not have independent
sources for authentication of this information provided by the borrower. This issue make the
evaluation process suspicious. The credibility of assessment process is on stake because of this issue.
The respondent showed that they are not 100% confident that current system of credit worthiness
evaluation is credible enough. The loopholes in the system are quite evident and the credit worthiness
of a borrower cannot be ensured without addressing these loopholes.
Q. No. 2: Does your bank undertake a specific analysis including the client’s characters, capacity,
collateral capital and conditions before granting loans?
The respondents had a consensus regarding this question. The banks are following mechanism
for assessing the clients’ character. The previous record of the client is assessed before issuing credit
to the client. The report about the specific borrower is obtained from the system of the central body.
This report shows the complete credit history of the borrower. The borrower with poor credit history
are regretted to issue credit.
Most of respondents told that their bank is more focused on the collateral offered by the client
against the credit. The value of collateral is important in issuing credit to the client. However,
respondents told that after the recent mortgage crisis the collateral is assessed in terms of durability.
Now banks are feeling hesitant while accepting real estate as collateral as the recent crisis emerged
because of the huge mortgage financing against the real estate collaterals. Moreover, the value issued
to borrowers against the collateral is lower than the value of collateral. This scenario has restricted the
credit policies of the banking system. Some of the respondents were of the view that this strict policy
has discouraged the clients from taking loans from banks. The credit operations have become limited
in the presence of these strict policies and banks are now looking for the alternative sources of
income.

Q. No. 3: Does your banks’ borrowers are classified according to a risk factor (risk rating)?
The responses received from the respondents against this question revealed that there is
difference of practices carried out by various banks. Some of the banks are following the risk
classification of various borrowers. Whereas, some of the banks are of the view that this exercise is

35
time taking and consume extra resources of the bank and the benefits are not equitable with the cost
associated with this practices. Therefore, it is not worthy to carry out this practice. Hence, this
classification is not followed by these banks. Moreover, some of the respondents also expressed their
opinion that this risk rating is usually on the past data. Hence, this rating become useless when future
is unpredictable. Under adverse circumstances, a client with a very high rating may also default as
well. Therefore, this rating has limited usefulness.

Q. No. 4: Does your bank also consider essential to require sufficient collateral from the small
borrowers?
A difference of practices between various banks was observable through the responses
received against this question. Some respondents told that their banks require collateral regardless of
the amount involved in the credit operations. The collateral is the primary requirement for the
issuance of the loan. However, some respondents told that their banks do not feel it important to have
collateral against the small loans borrowed by their clients. The credit history of the client and
personal guarantee or working experience of the client with the bank is enough for issuing small loan.
Apparently, this seems bit risky because if the borrowers with these small loans start to default against
their liabilities, a bank may fall into a serious credit crunch that is likely to create a liquidity trap for
the bank. Therefore, these banks are required to review their policies for the issuance of small loans
and mechanism should be developed for the monitoring of these loans issued to the borrowers.

Q. No. 5: Does your bank’s policy require collateral for all granting loans?
The responses of the respondents were same against this question as they responded against
the question No. 4. The practices are different in different banks. Some banks are highly focused on
collaterals and they consider as a primary requirement for granting loan to a client; whereas, some
banks require collaterals only against large loans and small loans are issued on the basis of credit
history, working relationship with bank, amount of account of the client, business record or personal
relationship.

Q. No. 6: Do you think that credit limit of some borrowers should be reviewed?
Almost, all of the respondents showed a consensus on the point that there is dire need to
assess the credit limit of the borrowers of the bank. This assessment should be made on periodical
basis. The changes in the environment change the business situation and so the credit worthiness of
the borrowers of the bank. The worthiness of the borrower does not remain the same throughout the
life span of the loan borrowed by the client. The debt paying capacity of the borrower may deteriorate
because of the external shocks. Therefore, the banks should continually monitor the debt paying
capacity of the borrower. The credit limit should be adjusted in the light of this monitoring. The

36
evaluation of credit worthiness of a borrower will enable the bank to manage its large scale credit
operations and chances of default can be controlled.

Q. No. 7: Does your bank take care of shareholders’ objective while executing various operations?
Some of the respondents said simply yes in response to this question. They were of the view
that they are basically following the guidelines provided by the board of director. A respondent said,
“Obviously, we cannot deviate from the objectives of the shareholders. We are here to follow the
guidelines provided by the board of director who is devising the policies to protect the interest of
shareholders”. The employees were not aware that either an approval from the shareholders is taken
or not before the implementation of the policies.

Q. No. 8: Does your bank devise credit policies by keeping in view shareholders’ wealth
maximization?
The respondents were of the view that the policies are followed in accordance with the basic principal
of shareholders’ wealth maximization. However, one of the respondents said, “The policies are
devised by board of directors who work on the behalf of shareholders. The management is responsible
for their executing these policies developed by the board of directors. The management is not
responsible for assessing the alignment of these policies. Hence, we simply follow the guidelines
provided by the board of director but we believe that board of director devise these policies in
alignment with the shareholders’ objectives”. The overall responses provided the sense that bank
employees at operational level are not aware or they do not analyse that either they are performing the
activities aligned with shareholders’ wealth maximization or not. This situation stipulates that
employees at operational level should be made aware that they are required to follow the principle of
shareholders’ wealth maximization. The alignment of the various activities performed by the
employees in the light of the guidelines provided by board of director should be made explicit to the
employees in order to develop their understanding.

Q. No. 9: Does your bank periodically review alignment of credit risk management strategies with
shareholders’ wealth maximization?
Most of the respondents were unable to answer this question. They were not aware of any
mechanism followed to evaluate the alignment of various activities with the shareholders’ wealth
maximization. However, they said that there should be a mechanism for evaluating this alignment.
Sometimes it may become difficult to maintain this alignment. Therefore, a periodical adjustment in
the policies is required to maintain the alignment of the credit risk management strategies with
shareholders wealth maximization. A respondent said, “Credit risk management strategies are devised
on the basis of various factors including market based factors and regulatory framework. We are in a
tough competition faced from the market. Therefore, we have to ensure the sustainability in the

37
market as well and to maintain our market share. In the fact of this tough competition and regulatory
framework, sometimes it become challenging for us to maintain the alignment of credit risk
management strategies with shareholders maximization”. Another respondent said, “Under certain
circumstances we are compelled to relax the credit conditions. This may not be in alignment with
shareholders’ wealth maximization principle but we do not have any other options because of the
market factors”.

Q. No. 10: Does your bank select a tool for credit risk management after evaluating its usefulness for
management of credit risk as well as maximization of shareholders’ wealth simultaneously?
The respondents said that selection of any tool for credit risk management is primarily made
on the basis of its usefulness in managing the credit risk and in the light of regulatory requirements.
However, they believe that if credit risk is well management it will obviously help to increase
shareholders wealth. Hence, there is an indirect relationship of credit risk management with
shareholders maximization that is established through controlling losses from credit operations.

Q. No. 11: Does your bank strictly follow the principles of shareholders’ wealth maximization?
The respondents were of the view that although they are following the guidelines provided by
the board of directors that are believed to be in conformity with shareholders’ wealth maximization.
However, it is not easy task for a bank to follow the principle of shareholders wealth maximization. A
respondent provided an interesting but somehow a realistic response. She said, “Well, banking
business is bit different from other types of businesses. Shareholders wealth maximization is not the
only thing that is a matter of concern for a bank management but lot of other issues are required to be
addressed vigilantly. There are lot of legal and regulatory requirements that should be fulfilled. Many
a times, these requirements may not have a compliance with the principle of shareholders wealth
maximization, but it is inevitable to fulfil these regulatory requirements”.

Q. No. 12: Please indicate and rank in order of importance the method(s) you use to identify
risks:
a) Audits or physical inspection.
b) Inspection by the bank risk manager.
c) Inspection by outside expert.
d) Risk survey.
e) Benchmarking
f) SWOT(strengths, weaknesses, opportunities, threats) analysis
g) Process analysis
h) Financial statement analysis.
i) Scenario analysis.
j) Internal communication, such as internal conversation with employees.

Three methods were identified as the mostly used methods by the banking system for the
identification of risks. These methods are ranked as follows:

38
 i. Financial Statement Analysis
ii. Inspection by the risk manager
iii. Benchmarking

Q. No. 13: To mitigate risk we undertake the following practices (please indicate and rank in
order of importance):
a. Eliminate risks.
b. Avoid risks.
c. Transfer risks.
d. Actively manage risks.

Most of the respondents responded that their bank is following the practices of actively manage the
risk. They were of the view that because of the nature of banking business risk cannot be eliminate
and it cannot be avoided as well because of the amount involved in most of the transactions. The
transfer of risks may not be a viable option because of the associate cost. Therefore, most of the banks
are following the practice of managing the risk in a vigilant fashion.

Q. No. 14: Please indicate and rank in order of importance the method(s) used in risk management
at your bank:
a) Value at risk (VAR).
b) Statistical methods in risk measurement.
c) Duration (average of life) analysis.
d) Comprehensive risk management.
e) Establishing standards (e.g. credit limits).
f) Periodical reports.
g) Assets diversification.
h) Derivatives (i.e. forwards, futures, options, and swaps)
i) Gap analysis.
j) Hedging.
k) Collateral.
l) Credit worthiness analysis.
m) Instructions.
n) Pricing the loan.
o) Others: please specify
The ranking on the basis of most of the responses is as follows:
a) Credit worthiness analysis.
b) Collateral
c) Comprehensive risk management.
d) Periodical reports.
e) Hedging
f) Statistical methods in risk measurement
g) Gap analysis
h) Instructions
i) Duration (average of life) analysis.
j) Establishing standards (e.g. credit limits)
k) Assets diversification
l) Derivatives (i.e. forwards, futures, options, and swaps)
m) Pricing the loan
n) Value at risk (VAR)

39
These results show that value at risk is ranked as least preferred method for risk management. This is
perhaps the lesson learned from Lehman Brother that was heavily relying on this technique for risk
management.

40
 5. FINDINGS, CONCLUSION AND
RECOMMENDATIONS
This is the final chapter of the present study that provides the main findings of the study,
conclusion, limitations and recommendations for future researchers.

5.1. FINDINGS
The study provides important findings that require the attention of both management and
shareholders of the banks. The results of the study show that credit operations are required to be
management efficiently. Credit operations are currently having a negative impact on return of equity
of the banks (Bofondi & Gobbi, 2003). These credit operations are supposed to generate economic
return for the banks but they are not because of the poor management of these credit operations
(Angkinand et al., 2010). The primary data analysis showed that currently followed practices for
assessing the credit worthiness of borrowers are not sufficient and they require improvement. The
reliance on the information provided by the client and past data often proves misleading in the face of
unpredictable future (Auronen, 2003).
The banks having a higher level of credit risk emanating from credit operations are likely to
face significant losses in the shape of loan loss provision. If a banks fails to manage its credit
operations in an efficient way, these credit operations will start generating losses that may threaten the
survival of well-functioning bank within no time (Sackett & Shaffer, 2006).
The measure of credit risk management (i.e. CAR in this study) does not have a positive
impact on shareholders wealth maximization. It does not have any relationship with ROE and a
negative relationship with ROS (Arif et al., 2012). However, a bank is compelled to maintain a
satisfactory level of CAR because of the risk involved in its operations and regulatory requirements
(BCBS, 2006).
The study also finds that attitude of shareholders trading in the market is quite risky. Most of
the shareholders prefer to invest in the banks that have large scale credit operations. This shows the
high risk propensity of the shareholders. The shareholders are not giving due consideration to the risk
involved in these operations. They are mainly focused on credit operations as they believe that this is
the main source of income for a bank; therefore, bank must undertake these operations (Arif et al.,
2012). Similarly, they have a negative point of view about CAR. They do not think that it is a good
option to maintain a high level of CAR.
The primary data analysis provides some interesting facts. Most of the employees are well
aware of their responsibilities with respect to executing credit operations. They are aware of the
various aspects of credit risk management and issues involved in issuance of credit to borrowers.
They seem to be following the guidelines provided to them by the board of directors. These

41
employees are not aware that either these guidelines have some relevance with shareholders wealth
maximization or not. This situation can be worrisome for the shareholders. The employees are
required to be educated about the alignment of various activities with shareholders wealth
maximization. Employees feel that it is not their responsibility to ensure the alignment of various
activities with shareholders wealth maximization principle but board of directors has this
responsibility. The employees seem to be acting like robots that merely follow the policies devised by
the board of directors. There is dire need to develop the abilities of employees to assess any possible
deviations from shareholders wealth maximization. Such deviations should be timely identified,
assessed and reported to board of directors so that necessary adjustment can be made by the board of
directors.

5.2. CONCLUSION
The present study is important in evaluating the relationship of credit risk with shareholders’
wealth maximization. Shareholders wealth maximization is the basic principle of financial
management and every business operates under this basic principle. However, for a bank it is a big
challenge to maintain compliance with this objective under all circumstance. A bank faces various
kinds of challenges related to market factors, competition, market fluctuations, economic conditions,
regulatory framework and legal requirements. In the face of all these challenges it is not an easy task
to strictly follow the principle of shareholders’ wealth maximization.
Credit operations are the main source of income for a business. However, this source of
income can rapidly turn into a source of loss if credit operations are not management properly.
Concomitantly, losses emanating from these operations will have a negative impact on shareholders’
wealth. Therefore, management of credit operations should be matter of primary concern for a
banking system. However, the selection of tools and techniques used for management techniques is
determined by market factors and guidelines provided by the regulator. The collaboration between
bank and regulator can play a vital role to ensure the alignment of these tools and techniques with
shareholders wealth maximization.
This study explored the different dimensions of the credit risk. These dimensions were credit
risk exposure, credit risk measurement and credit risk management. The shareholders’ value was
measured with the help of the ROE and ROS. The study was aimed at investigating the role of credit
risk in determining the shareholders’ value. This role has been evaluated by the use of two models in
the present study. The results of the first model proved that ROE (one of the dimensions of
shareholders’ value) is significant effected by the dimensions of credit risk (credit risk exposure and
credit risk measurement). Moreover, the study also investigated the role of credit risk in determining
the fluctuation of stock return. The stock returns have been measured with the help of ROS in the

42
present study. The results of the study manifested that the credit risk has a significant impact on stock
returns. The variables of credit risk exposure and credit risk management (CAR) have a significant
impact on stock returns. Thus, the present study achieved all the formulated objectives.

5.3. LIMITATIONS AND RECOMMENDATIONS FOR FUTURE

RESEARCHERS
The researcher openly reports the limitations of the present study and makes some important
recommendations for the future researchers.
i. The present study only took the data from seven banks. The future researchers can take
the data from a large sample size.
ii. The present study only concentrated on few variables. The future researcher can
incorporate more variables in their studies.
iii. The future researchers can also perform a cross country analysis.
iv. The present study only performed qualitative analysis of the primary data. The future
researchers can also perform quantitative analysis of the primary data.

43
 APPENIDIX ‘A’
QUESTIONNAIRE
Gender: Male Female
Age: ...........................................
Designation: ........................................
Education: .........................................
Experience: .......................................
Bank: .................................................
1. Does your bank undertake a credit worthiness analysis before granting loans?
2. Does your bank undertake a specific analysis including the client’s characters, capacity,
collateral capital and conditions before granting loans?
3. Does your banks’ borrowers are classified according to a risk factor (risk rating)?
4. Does your bank also consider essential to require sufficient collateral from the small
borrowers?
5. Does your bank’s policy require collateral for all granting loans?
6. Do you think that credit limit of some borrowers should be reviewed?
7. Does your bank take care of shareholders’ objective while executing various operations?
8. Does your bank devise credit policies by keeping in view shareholders’ wealth
maximization?
9. Does your bank review periodically review alignment of credit risk management
strategies with shareholders’ wealth maximization?
10. Does your bank select a tool for credit risk management after evaluating its usefulness
for management of credit risk as well as maximization of shareholders’ wealth
simultaneously?
11. Does your bank strictly follow the principles of shareholders’ wealth maximization?

12. Please indicate and rank in order of importance the method(s) you use to identify risks:
k) Audits or physical inspection.
l) Inspection by the bank risk manager.
m) Inspection by outside expert.
n) Risk survey.
o) Benchmarking
p) SWOT(strengths, weaknesses, opportunities, threats) analysis
q) Process analysis
r) Financial statement analysis.
s) Scenario analysis.
t) Internal communication, such as internal conversation with employees.
u) Other: please specify………………………………………………………………
……………………………………………………………………………………..
13. To mitigate risk we undertake the following practices( please indicate and rank in order of
importance):
e. Eliminate risks.
f. Avoid risks.
g. Transfer risks.
h. Actively manage risks.

44
14. Please indicate and rank in order of importance the method(s) used in risk management
at your bank:
a) Value at risk (VAR)
b) Statistical methods in risk measurement
c) Duration (average of life) analysis
d) Comprehensive risk management
e) Establishing standards (e.g. credit limits)
f) Periodical reports
g) Assets diversification
h) Derivatives (i.e. forwards, futures, options, and swaps)
i) Gap analysis
j) Hedging
k) Collateral
l) Credit worthiness analysis
m) Instructions
n) Pricing the loan
o) Others: please specify
………………………………………………………

45
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