THE IMPACT OF CREDIT RISK MANAGEMENT ON PROFITABILITY OF COMMERCIAL BANKS
CHAPTER ONE:
OVERVIEW OF THE STUDY
1.1 Introduction
Credit risk management has significantly impacted on the profitability of commercial bank worldwide due to the nature of the banking sector and its operations. This issue has seen an extensive amount of empirical investigation in the recent years, at the heart of an economy’s financial system is the banking industry; which in developing countries; is the biggest player in the role of financial intermediation (Hawkins and Mihaljek, 2001). However, Mutukua (2016) postulates that all banks operate in an unstable and fragile environment and confront various risks which may, in one way or the other, lead to the closure of a commercial bank as a result of inability to meet its financial obligations. More importantly, Shah et al (2016) denotes that in the financial system, there are at least three broad categories of risks being; financial risk, business risk and operational risk.
Despite the perceived positive role of risk management on improving bank financial performance, studies in this area have offered inconsistent results. In one end of the spectrum are studies that assert a positive relationship and among others: Botswana (Maritim, 2013; Mwangi, 2010); Nigeria (Adeusi, Akeke, Adebisi & Oladunjoye, 2014; Olamide, Uwalomwa, and Ranti, 2015). The positive role of credit risk management on profitability of commercial banks could be seen in terms of better management of funds, and reducing unnecessary costs such as doubtful advances (Mutukua, 2016). At the opposite end are those studies that stress that a negative relationship exits: India (Shetty and Yadav, 2019); Kenya (Muteti, 2014). The negative relationship could be due to less leverage and risk taking, as risk management practices get tightened and this reduces bank profitability.
In developing economies, where financial sophistication is low, banks play the primary role of moving capital from households to businesses with productive purposes. It is, therefore, imperative that this role is efficient and is maximized to ensure growth in the economy. A large part of this role, therefore, is to assess credit risks of potential borrowers and taking appropriate decision, whilst making the investments worthwhile for the funding bank. Therefore, one of the bank’s biggest functions is striking the balance of correctly assessing and managing risk whilst creating sustainable profits and value for shareholders (Sinha, 2011).
1.2 Background of the study
Credit risk is the risk that promised cash flows from loans and securities and financial institutions may not be paid in full (Cornett (2003). Credit risk is recognized in today’s business as an integral part of good management practice. In its broadest sense, it entails the systematic application of management policies, procedures and practices to the tasks of identifying, analysing, assessing, treating and monitoring credit risks. Credit risk is important for the success of banks since they determine its profitability, liquidity, solvency and quality of the loan portfolio. When commercial bank managers are aware of the effect credit risk towards profitability, then they are bound to take care of their credit decision and adopt best credit risk mechanisms which will be good for the bank.
The importance of credit risk is increasing with time because of some reasons like; economic crises and stagnation, company bankruptcies, infraction of rules in company accounting and audits, growth of off-balance sheet derivatives, declining and volatile values of collateral, borrowing more easily of micro finance institutions.
A recent study by Sleimi (2020), emphasized that the components of risk management procedures had a good and significant influence on bank performance. These assertions have been extensively validated in the western contexts and emphasize the need for risk management in the diverse banking environment. According to Li & Zou 2014, banks face a variety of risks, all of which play a critical role in ensuring that their objectives of good banking management to earn maximum income for the benefit of shareholders and stakeholders are met. Banks’ management manages their various cash measurement tools to meet their daily financial requirement. In this essence Sleimi (2020) suggested that banks and financial institutions are facing various risks. These risks include interest rate risk, foreign exchange, political risk, market risk, operation risk, and credit risk (Cooperman, Gardener & Mills 2000). According to Harvett (2013), risk management is a continuous process that helps in minimizing the bad impact of unknown possible losses.
There are various processes of risk management which include measurement using better tools and control. Some researchers like Ngare (2008), Waweru and Kalani (2009), and Buchan (2011) explained various techniques which help managers to minimize risk management. Every organization, particularly banks and financial institutions, have to achieve their objectives and risk management helps these issues to minimize foreign exchange losses, effective control of cash flow, and earnings from the business at the time of business uncertainties (Chapman and Ward 2010). Survivals of the banks and financial institutions are in continuous growth due to increase in their incomes. Banking business otherwise is very much sensitive as almost 85% of bank liabilities comprise on deposit (Husted 2005).
However, emphasizing on banks credit management, Mbole (2004) determined that commercial banks accept deposits and then provide them to needy borrowers to stimulate the economy and to get income in the shape of interest/profit. In essence, the loan portfolio of the banks is very much important as unprofessional decisions may result in default risk which has a very much impact on the financial stability of banks and imprudent credit may result in losses which may also result in bankruptcy. Even in developing countries like Botswana, banking plays a critical role in economic development. Richard (2006) highlighted that the business community of Botswana is demanding various credits from banks and financial institutions but to meet the unforeseen default risk. The banking industry gathers useful information from its borrowers and creditors. Then each commercial bank has a capable risk management system to evaluate these demands. Kimondo, Serakwane, and Davel (2012) concluded that the banking industry is very cautious to reduce their expected losses in the shape of defaults. All the commercial banks are properly and effectively monitoring the risk management system to provide credit with minimum risk.
Botswana’s banking sector has not been immune to the above challenge of increased risk management. The regulatory and supervisory oversight by the Bank of Botswana, which is the regulator of all commercial banks and related institutions, continued to focus on ensuring good governance and appropriate risk-taking by regulated institutions. The banking sector was adequately capitalized, profitable and liquid as at December 31, 2021, and the industry’s compliance with the regulatory and prudential requirements was satisfactory (Bank of Botswana Annual Report, 2021).
According to Banking Supervision Annual Report (2018), the number of licensed commercial and statutory banks remained at ten and three, respectively, in 2021 and has continued to improve products and service offerings to remain relevant to the demands of the economy and sustain viable and profitable operations due to increased competition in the banking sector, along with evolving customer needs. Overall, though the banking sector is sound, there are still issues of high credit risk, banking sector being relatively small in relation to GDP, and that the overall estimation shows that the degree of financial sector development and depth has been largely static in the past five years. Thus the needs to carry an examination of the impact of credit risk management on profitability of commercial banks in Botswana.
1.3 Statement of the problem
Banks are exposed to various business risks by providing financial services and other related matters exposed to some financial risks including foreign exchange risk, volatility risk, operation risk, and credit risk, etc. (Alloyo, 2010). Commercial banks have encountered various problems and issues over some years, but the major reason and problem area were terms as serious financial regularities which affect standardized credit borrowings and poor monitoring of such borrowings. Among other risks faced by banks, credit risk plays an important role on banks’ financial performance since a large chunk of banks’ revenue accrues from loans from which interest margin is derived (Kolapo, Ayeni & Oke, 2012).
Despite all efforts put in place by commercial banks in Botswana, their credit risk in the form of nonperforming loans still exists on their bank’s loan portfolio. In addition, the credit experts of these banks sometimes have overlapping functions, which result to them being mixed up with the type of risk to focus on, since other types of risks such as interest rate risk, market risk, liquidity risk, currency risk and operational risk also exist. Also, with the information asymmetry that exists between borrowers and lenders, it had led to credit experts to be more likely to select projects that are dubious than those that will succeed to grant financing. Based on the above problems, the following problems are being examined:
i. What are the credit risk challenges faced by commercial banks in Botswana?
ii. What are the techniques used by commercial banks in the management of credit risk?
iii. What is the relationship between credit risk management and profitability of commercial banks in Botswana?
1.4 Research Objectives
i. To identify credit risk challenges faced by commercial banks in Botswana.
ii. To evaluate the techniques used by commercial banks in the management of credit risk
iii. To investigate the relationship between credit risk management and profitability of commercial banks in Botswana.
1.5 Research Questions
iv. What are the credit risk challenges faced by commercial banks in Botswana?
v. What are the techniques used by commercial banks in the management of credit risk?
vi. What is the relationship between credit risk management and profitability of commercial banks in Botswana?
1.7 Significance of the study
The findings of this study on the impact of credit risk management on profitability of commercial banks have both managerial and academic implications. It is important as it examine the impact of credit risk management on the profitability of commercial banks in Botswana.
Bank Management: The study will be of great benefit to management, as it will assist in identifying and controlling the components of credit risks that affect the profitability of the commercial banks.
Policy Makers: The study will also help policy makers, as it will throw light on critical components that impact financial performance of the selected financial institutions, thereby enabling formulation of relevant policies.
Stakeholders: The findings will be of assistance to stakeholders and prospective investors as the study explains critical risk components that influence organizations’ profitability.
Researchers: Finally, this study my serve as a literature review to other researchers, and students conducting their academic studies in the area of credit risk management in commercial banks.
1.8 Assumptions
An assumption is an unexamined belief: what we think without realizing we think it. Our inferences (also called conclusions) are often based on assumptions that we haven't thought about critically. According to Hoch (2000), assumptions are propositions accepted to be true based upon the belief without preponderance of the facts.
The researcher assumes that the respondents will honestly answer the research questionnaire and that he will get all the questionnaires back within the shortest period of time possible.
1.9 Limitations
Mosha (2007) explains limitations as things beyond the researcher’s control that may get in the way of the research. The study is limited by the following:
1. Uncooperative staffs, there was a challenge of some staffs not willing to give out some information which was beneficial to this research study. To resolve this, I promised them about the confidentiality of their information.
2. Limited time, there being a limited time to conduct this research I prepared a work plan which I strictly followed.
3. There was a financial constraint which I resolved by giving priority to the most important activities related to the research study..
1.10 Delimitations
Delimitation is simply how the researcher will narrow the limitations of the research, explains Rapley (2007). This research specifically focuses on the impact of credit risk management on profitability of commercial banks in Botswana with particular reference to Chartered Bank of Botswana.
1.11 Ethical Considerations
Bearing in mind the ethical issues, the researcher provided the respondents with the necessary information as regards the main purpose of the research, expecting duration and procedures to following, and be in position to keep privacy and not disclose the confidentiality of respondents and researchers responsibility.
1.12 Chapter Summary
This chapter has provided the introductory aspect of the study which centered on the background information, the problem statement, the study objectives, research questions, significance, limitation and delimitations of the study.
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