Credit Risk Management (Brown & Moles, 2014) Define credit riskas the risk related with the loans; banks lend to the borrower and normallycharge a fee against it. The banks redistribute its finance in the form of debtto borrowers, which is needed to be paid back by the distributors. However, thereis no assurance of the fact that such amount would be re-paid by the borrowersand the risk of default is always there for the banks on lend loans. Financialresearchers and analysts regard such risk as credit risk.
According to (Hosna & Manzura, 2009) credit risk is themost significant risk in the commercial banks due to its association with thepossible losses. The author divided credit risk into three different types suchas default risk, exposure risk and recovery risk. They also argue thatcommercial banks consider credit risk in relation to bank loans. Therefore,there credit risk management is dependent upon the overall analysis andinvestigation of the market. The banks have to take account of the differenttypes of losses within their risk management process. These include expectedlosses (EL), unexpected losses (UL) and loss given default (LGD).Credit riskmanagement is very vital to measuring and optimizing the profitability ofbanks. The long term success of any banking institution depended on effectivesystem that ensures repayments of loans by borrowers which was critical indealing with asymmetric information problems, thus, reduced the level of loanlosses (Basel, 1999).
Effective credit risk management systeminvolved establishing a suitable credit risk environment; operating under asound credit granting process, maintaining an appropriate credit administrationthat involves monitoring, processing as well as enough controls over creditrisk (Greuning & Bratanovic, 2003) Credit risk is the risk that a borrower defaults and does not honor itsobligation to service debt. It can occur when the counterpart is unable to payor cannot pay on time (Gestel & Baesens, 2008). Credit risk isthe likelihood that a borrower will not pay its debt on time or failed to makerepayment at all (Sinkey, 2002), (Coyle, 2000).It is the possibility that the actual return on a loan portfolio will deviatefrom the expected return (Conford, 2000).That is loan delinquency and default byborrowers. While loan delinquencies indicate delay in payment, default denotesnonpayment, and the former if unchecked, leads to the latter (Padmanabhan, 1988).
With regards tothe business of rural banking, credit risk refers to the delay of repayment onloan contact or the inability of a borrower to pay its debts, which can causecash flow problems and affect the banks liquidity position. Credit riskmanagement is the identification, measurement, monitoring and control of riskarising from the possibility of default payment a loan contract (Early, 1996). In past studies,the researchers for determining profitability use several measures. Some usequalitative performance aspects while other associate financial quantitativeindicators with profitability. (Brealey & Myers, 2003) Have stressed thatthere are diverse significant measures that could be used in investigating theprofitability of a business institution. According to them, these include netprofit ratio, ratio of return on assets (ROA), and ratio of return on equity(ROE).The authors discussed the procedure introduced by past researcher DavidCole in 1972. Cole put forth the ratio analysis method for the evaluation andassessment of the banks’ performance (Cole, 1972)In a study of the Kenyan bankingindustry, (Kithinji, 2010) showed that there is an indirectrelationship between non-performing loans, an indicator of credit risk withprofitability.
Other empirical studies outside Africa have established a strongsignificant relationship between credit risk and banks performance. (Gizaw, et al., 2015) Have focused on therelationship between credit risk management and profitability levels of thebanks operating in Ethiopia on commercial basis. The findings of researchrevealed that there is a significant relationship between the non-performingloan, loan loss provisions and capital adequacy within the commercial banks ofEthiopia. (Aduda & Gitonga, 2011) Further stated thatgenerally financial institutions adopt range of techniques for the mitigationof their credit risk. According to them, the commonly used techniques includecollateral, guarantees, and net-off loans.
These loans are net off with thehelp of receipt, leading to decreased credit risk. Financial Performance Profitabilityrefers to the business’s ability to generate sufficient money on investedcapital. A sound and more profitable banking sector is better able to withstandthe negative shocks and give major contribution to the stability and survivalof the financing system (Athanasogluo, 2005) According toTabari, et al., (2013) profitability variable is represented by two deferentindicators.
First one is return on assets and other one is return on equity.According to the (Saunders & Marcia, 2011) ROE value theoverall profitability of the fixed income per dollar of equity. Relationship ofVariables Credit risk hasa significant negative impact on the ROA when they used ordinary least squaresand fixed effect model of regression in studying the determinants ofprofitability, (Staikouras & Wood, 2004). Study of (Kargi, 2014) concluded thatcredit risk has a negative effect on ROA based on the study of six banks inNigeria.
(Erina & Lace, 2013) And (Abbas, et al., 2014) have the sameconclusion that credit risk negatively affects ROA and ROE.