Credit Risk Management in Commercial Banks; A Case Study of UBA Bank
Chapter One
Objective Of The Study
The overall objective of the study is to investigate the impact of credit risk and bank performance in Nigeria. However, the study will certify the following objectives:
- To investigate the nature of credit risk in Nigeria.
- To examine if credit risk affects the profit of commercial banks in Nigeria
CHAPTER TWO
LITERATURE REVIEW
Introduction
The current chapter provides an overview of relevant literature written on the effect of credit risk on the financial performance of Commercial Banks in Nigeria. The chapter starts with a theoretical literature review, an empirical literature, and then the chapter conclusion.
Theoretical Review
Theoretical framework involves an exploration of the theories that inform the relationships of the variables under study. These theories are extensive, but the selected theories explored within the scope of this study are; the Financial Distress theory, The Agency theory, as well as the Information Asymmetry theory.
Agency theory
According to Jensen and Meckling (1976), agency relationship is a contract whereby one or more parties – in this case the principal – engage the other party or agent to do a specific task on their behalf. By doing this, according to Jensen and Meckling (1976) the principle delegates some authority to the agent to make some decisions on behalf of the principle. The assumption is that the aim of both the agent and the principle is to maximize utility. Thus, the agent may fail to act as expected by the principal or in the principal’s best interest. Thus, in such a case, the principal has to incur monitoring costs as well as include incentives to motivate the agent. In essence, such acts limit the principal’s interests.
Adam Smith posits that directors of a company –since they manage the money for other people and not their own cash- cannot be expected to have vigilant watch over it as they would their own (Smith, 1776). Moral hazard also arises owing to limited liability which gives bank shareholders an increased risk appetite. Since the government protects bond holders, they tend towards risk aversion and reduced need of monitoring (Demsetz, Saidenberg, & Strahan, 1997). This theory is relevant to this study as managers make bank decisions which influence credit risk and/or financial performance. Agency costs incurred also affect the company’s bottom line, which translates to profitability and overall bank performance.
Financial distress theory
Financial distress refers to an entity’s inability to pay its debts. This implies that the operating cash flows of the firm are not able to meet the present needs and obligations. It can be identified through different events like closing the plant, reducing dividend, layoffs, financial losses, among other facets (Ross, Hillier, Westerfield, Jaffe, & Jordan, 2012). Edwards Altman introduced the Z score as a means of testing for bankruptcy which looked at a firm’s profitability, liquidity, solvency, leverage, as well as activity metrics (Cao, 2016). According to Demsetz, Saidenberg and Strahan (1997) the liquidity measure (T1) is difficult to implement on commercial banks as estimating working capital requires consideration of cash, which is a key element in banking operations. Thereby, according to Altman, ability of a firm to meet its obligations and mandate sufficiently and effectively, is by itself a business performance measure. The relevance of this theory arises as banks need to meet their obligations to depositors and suppliers as and when they fall due. Failure to do so would constitute a liquidity problem. Credit risk should also be monitored as it may lead to financial distress.
Information asymmetry theory
George A. Akerlof first introduced this concept where he developed asymmetric information by arguing that in markets, buyers tend to use market statistics when measuring the value of goods. Therefore, the buyer –most of the time –has a perception of averagely the entire market. On the converse, most often the seller possess more detailed information regarding an item. Akerlof adds that this asymmetry proffers an incentive for the seller to offer less goods and services compared to the quality of goods in the market (Auronen, 2003). The less than average quality goods begin to dominate the market, which is referred to as adverse selection. He posits that this asymmetry can be reduced through intermediary market institutions, which allows the owners of goods that are above average to acquire full value for their products ensuring the market does not reduce to zero value (Auronen, 2003).
CHAPTER THREE
RESEARCH METHODOLOGY
Introduction
The chapter is about the research approaches used in generating the data utilized in the study. The chapter entails the rationale and approach used, the study location, the design used in the research and the sampling procedure. Other aspects covered in the chapter include the population of the study, sampling, data collection, data validity, reliability and validity of the instruments used to collect the data, ethical considerations and data analysis as well as the unit of analysis.
Research Design
The research adopted a descriptive research design of the banks listed at the NSE. According to Gatobu (2013), a descriptive research design entails collecting data, which describe events. The data is then organized, tabulated to depict certain output, notably presented in visual aid instrument such as charts and graphs to assist the user comprehend the data distribution. The research design was chosen as the study sought to establish a relationship between various study variables.
Population and Sample
The study used all the Nigerian Commercial banks listed in NSE. The number of commercial banks listed in NSE are 27 (NSE, 2018). Therefore, the population of the study was the 27 commercial banks. As such this study employed judgmental sampling technique to select the size of UBA bank a commercial bank for the study.
CHAPTER FOUR
DATA ANALYSIS, PRESENTATION AND INTERPRETATIONS
Introduction
This chapter covers data analysis, presentation and interpretation on the impact of credit risk management on the financial performance of commercial banks listed at the Nigeria Securities Exchange. Full data was available for the banks chosen hence indicating 100% response rate.
CHAPTER FIVE
CONCLUSIONS AND RECOMMENDATION
Introduction
This chapter covers the conclusions and recommendations, carried out on study variable on the impact of credit risk on financial performance of commercial banks listed in NSE. The study variable included; ROA, ROE capital adequacy ratio, asset quality, credit rating, loan to deposit ratio and cost to income ratio and GDP.
Conclusion
This study sought to establish the impact of credit risk on financial performance of commercial banks in Nigeria. Credit risk in this study was measured using credit rating and asset quality. While loans stand out to be banks biggest asset, their credit rating has a meaning on credit risk management. The study found out that credit rating has positive impact on financial performance. This is to mean, credit ratings awarded to financial institutions effect on decisions made. For instance, in making portfolio allocation decisions, investors rely on credit ratings; financial sector notably banks and insurance firms use credit rating on investment decisions and allocating regulatory capital. Credit rating also is an important proxy for collateral quality.
Asset quality is an assessment of credit risk towards a particular asset. In this study, asset quality was done in relation to loans as the biggest bank asset. The findings indicated that lower asset quality leads to higher financial performance. Asset quality in terms of non-performing loans and total loans effect negatively to financial profitability of commercial banks.
Capital adequacy was found to have positive and significant effect on ROA. Capital adequacy are needed because capital acts as the buffer against financial performance and losses.
Moreover, due to their nature of limited liability, the tendency of commercial banks to engage in activities that have high risks tends to decrease based on the capital at risk compared to the banks’ assets. A higher capital adequacy above the requirement by national regulator indicated that the firm is save and less to be insolvent in cases of losses. It is also a guarantee to depositors that their savings are secure. Therefore, commercial institutions with high capital adequacy are likely to foster higher performance which also translates to lower credit risks.
This study therefore adds to the body of knowledge that credit risk has a negative impact on financial performance measured by both ROA and ROE.
Recommendations
Credit rating has been identified as significant factor to affect financial performance. Also it is an indicator firms’ credit risk. Therefore credit rating can be used by depositors to assess credit risk for banks and whether their money is safe. This study recommends commercial banks to support credit rating aspect as it gives depositors a sense of safety.
Having have identified that credit risk has a significant effect on financial performance, there is need for commercial banks to implement guidelines to share credit worthiness of borrowers. This will increase quality of loans as a bank’s asset and minimize non-performing loans. In addition, good financial management in expenditure need to be in place. Maintaining expenses at the lowest levels will help maximize its profits.
BIBLIOGRAPHY
- Altunbas (2005): Mergers and Acquisitions and Bank Performance in Europe – The Role of Strategic Similarities. European Central Bank, working paper series, No.398
- Anthony M.C. (1997): “Commercial Bank Risk Management; An analysis of the Process”. The Wharton school. University of Pennsylvania. Financial institutions centres.
- Athanasoglou, P., Brissimis, S N., and Delis, M D. (2005): ‘‘Bank-specific, industry specific and macroeconomic determinants of bank profitability’’. MPRA Paper No.153
- Banking Supervision and Regulation (1998): “Sound Credit Risk Management and the use of Internal Credit Risk Ratings at Large Banking Organisations”, Sr 98-25. Sup September 21, 1998. Washington D.C. www.federalreserve.gov.
- Basel Committee on Bank Regulation (2004): “International Convergence on Capital Measurement and Capital Standards”, BIS, June.
- Basel Committee on Banking Supervision (1982): “Management of Banks’ International Lending”, Country Risk Analysis and Country Exposure Measurement and Control. www.bis.org
- Basel Committee on banking Supervision (1999): “Principles for the Management of Credit Risk”, CH – 4002 Basel, Switzerland Bank for International Settlements.
- Basel Committee on banking Supervision (2001): “Risk Management Practices and Regulatory Capital: Cross-sectional Comparison”. Basel Committee on Banking Supervision, www.bis.org
