Credit Risk Management
(Brown & Moles, 2014) Define credit risk
as the risk related with the loans; banks lend to the borrower and normally
charge a fee against it. The banks redistribute its finance in the form of debt
to borrowers, which is needed to be paid back by the distributors. However, there
is no assurance of the fact that such amount would be re-paid by the borrowers
and the risk of default is always there for the banks on lend loans. Financial
researchers and analysts regard such risk as credit risk.
According to (Hosna & Manzura, 2009) credit risk is the
most significant risk in the commercial banks due to its association with the
possible losses. The author divided credit risk into three different types such
as default risk, exposure risk and recovery risk. They also argue that
commercial banks consider credit risk in relation to bank loans. Therefore,
there credit risk management is dependent upon the overall analysis and
investigation of the market. The banks have to take account of the different
types of losses within their risk management process. These include expected
losses (EL), unexpected losses (UL) and loss given default (LGD).
management is very vital to measuring and optimizing the profitability of
banks. The long term success of any banking institution depended on effective
system that ensures repayments of loans by borrowers which was critical in
dealing with asymmetric information problems, thus, reduced the level of loan
losses (Basel, 1999).
Effective credit risk management system
involved establishing a suitable credit risk environment; operating under a
sound credit granting process, maintaining an appropriate credit administration
that involves monitoring, processing as well as enough controls over credit
risk (Greuning & Bratanovic, 2003) Credit risk is the risk that a borrower defaults and does not honor its
obligation to service debt. It can occur when the counterpart is unable to pay
or cannot pay on time (Gestel & Baesens, 2008).
Credit risk is
the likelihood that a borrower will not pay its debt on time or failed to make
repayment at all (Sinkey, 2002), (Coyle, 2000).
It is the possibility that the actual return on a loan portfolio will deviate
from the expected return (Conford, 2000).That is loan delinquency and default by
borrowers. While loan delinquencies indicate delay in payment, default denotes
nonpayment, and the former if unchecked, leads to the latter (Padmanabhan, 1988).
With regards to
the business of rural banking, credit risk refers to the delay of repayment on
loan contact or the inability of a borrower to pay its debts, which can cause
cash flow problems and affect the banks liquidity position. Credit risk
management is the identification, measurement, monitoring and control of risk
arising from the possibility of default payment a loan contract (Early, 1996).
In past studies,
the researchers for determining profitability use several measures. Some use
qualitative performance aspects while other associate financial quantitative
indicators with profitability.
(Brealey & Myers, 2003) Have stressed that
there are diverse significant measures that could be used in investigating the
profitability of a business institution. According to them, these include net
profit ratio, ratio of return on assets (ROA), and ratio of return on equity
(ROE).The authors discussed the procedure introduced by past researcher David
Cole in 1972. Cole put forth the ratio analysis method for the evaluation and
assessment of the banks’ performance (Cole, 1972)
In a study of the Kenyan banking
industry, (Kithinji, 2010) showed that there is an indirect
relationship between non-performing loans, an indicator of credit risk with
profitability. Other empirical studies outside Africa have established a strong
significant relationship between credit risk and banks performance.
(Gizaw, et al., 2015) Have focused on the
relationship between credit risk management and profitability levels of the
banks operating in Ethiopia on commercial basis. The findings of research
revealed that there is a significant relationship between the non-performing
loan, loan loss provisions and capital adequacy within the commercial banks of
Ethiopia. (Aduda & Gitonga, 2011) Further stated that
generally financial institutions adopt range of techniques for the mitigation
of their credit risk. According to them, the commonly used techniques include
collateral, guarantees, and net-off loans. These loans are net off with the
help of receipt, leading to decreased credit risk.
refers to the business’s ability to generate sufficient money on invested
capital. A sound and more profitable banking sector is better able to withstand
the negative shocks and give major contribution to the stability and survival
of the financing system (Athanasogluo, 2005)
Tabari, et al., (2013) profitability variable is represented by two deferent
indicators. First one is return on assets and other one is return on equity.
According to the (Saunders & Marcia, 2011) ROE value the
overall profitability of the fixed income per dollar of equity.
Credit risk has
a significant negative impact on the ROA when they used ordinary least squares
and fixed effect model of regression in studying the determinants of
profitability, (Staikouras & Wood, 2004). Study of (Kargi, 2014) concluded that
credit risk has a negative effect on ROA based on the study of six banks in
Nigeria. (Erina & Lace, 2013) And (Abbas, et al., 2014) have the same
conclusion that credit risk negatively affects ROA and ROE.