Original Article

Credit Risk Management and Profitability: A Study From Nepalese Commercial Bank

CREDIT RISK MANAGEMENT AND PROFITABILITY: A

STUDY FROM NEPALESE COMMERCIAL BANK
Miku Shah* Dr Virachai Vongbusin *

ABSTRACT

The main aim of the study is to investigate the impact of credit risk management on bank profitability
in Nepalese commercial banks. Non-performing loan ratio, Leverage ratio, Capital adequacy ratio,
Loan loss provision, Credit interest to credit facilities are independent variable whereas return
on assets is dependent variable. Data has been collected from the Annual Reports of selected
commercial banks, Banking and Financial Statistics and Bank Supervision Report published by
Nepal Rastra Bank. The study is based on 25 samples making 250 observations. The independent
study is completed using a blend of Independent t-test, Pearson’s Correction, analysis of variance
(ANOVA), multiple regression analysis. The result shows that, capital adequacy ratio, leverage
ratio, non-performing loan ratio, loan loss provision ratio is negative relationship to dependent
variable return on assets. Likewise, credit interest to credit facilities is positively related to return
on assets.

Keywords: Credit Risk Management, Profitability, Analysis of Variance, Multiple Regression

1. Introduction Banks today are the largest financial

institutions around the world, with branches
Banks are financial institutions that play and subsidiaries. There is abundance of
intermediary role in the economy through differentiations between types of banks and
channeling financial resources from surplus much of this differentiation rests in the products
economic units to deficit economic units. In turn, and services that banks offer (Howells, 2008).
they facilitate the saving and capital formation For instance, commercial banks hold deposits
in the economy. Banks are exposed to different bundling them together as loans and operate
types of risks, which affect the performance payments mechanism. The various functions
and activity of the banks. Bank plays a vital role of banks are making business loans, offering
in emerging economies where most borrowers deposit services (saving deposits), supporting
have no access to capital markets. Thus, bank government activities like credit, granting
is considered as an intermediary between the consumer loans, financial advising, cash
depositors and borrowers. A commercial bank management offering, equipment leasing,
is an institution that provides financial services safekeeping of valuables, carrying out currency
including issuing money in various forms, exchanges and discounting commercial notes
receiving deposits of money, lending money etc.
and processing transactions and the creating of
credit (Campbell, 2007).
* MBA Student, Global College International
* Faculty, School of Management, Shinawatra University

42 NJMSR Vol.2 Student Focus Issue 1 Jan. 2019

 Credit Risk Management and Profitability: A Study From Nepalese Commercial Bank

Credit risk is one of the most significant risks 2. Research Methodology

that banks face, considering that granting
credit is one of the main sources of income in The study is based on descriptive and causal-
commercial banks. Therefore, the management comparative research designs. This study
of the risk related to that credit affects the establishes the cause and effect relationship
profitability of the banks. The importance between selected bank credit risk variables
of credit risk management in banks is due and the financial performance of commercial
to its ability in affecting the banks’ financial banks in Nepalese context. The study is based
performance, existence and growth. It is on secondary data. More specifically, the
observed that the bank credit depends upon study analyzes the impact of return on assets,
the economic activities in an economy. As capital adequacy ratio, loan loss provision,
economy grows bank credit accelerates while non-performing loan, leverage ratio and
the slow growth of the economic activity or the credit interest to credit facilities on financial
decline in economic activity results decline in performance of the Nepalese commercial
bank credit (Dash & Kabra, 2010). banks. For the study purpose, banks involving
in banking services at least for three years
Effective management of credit risk is have been considered for sample. Since all
complicated. It is linked to the development of them did not provided scope for the study,
of banking technology, which will enable to 25 different Nepalese commercial banks were
increase the speed of decision making and taken out of 29 as a sample for the period of
simultaneously reduce the cost of controlling 2007-2017 making total of 250 observation
credit risk. This requires a complete base of
partners and contractors (Lapteva, 2009). The descriptive research design has been
Credit risk is one of significant risks of banks by adopted for fact-finding and searching for
the nature of their activities. Through effective adequate information about the fundamental
management of credit risk exposure, banks issues associated with variables affecting
not only support the viability and profitability financial performance of Nepalese commercial
of their own business but also contribute to banks. It describes the real and actual condition,
systemic stability and to an efficient allocation situation and facts. Hence, the research design
of capital in the economy (Psillaki et al. 2010). adopted in this study is of descriptive type.
The default of a small number of customers RESEARCH MODEL
may result in a very large loss for the bank
(Gestel and Baesens, 2008). The models employed in this study intend
to analyze the relationship between
In the context of Nepal, Paudel (2006) found performance and credit risk indicators. The
that interest income from loan and advances following regression model is used in this
were the main sources of income, which study in an attempt to examine the empirical
increases the profit of commercial bank. relationship between the impacts of credit
Dhungana and Upadhyaya (2011) found risk management on financial performance
that the sound lending policies and optimum of Nepalese commercial bank. Therefore,
portfolio management of financial institutions the following model equation is designed
as well as effective regulation and supervision to test the hypothesis. From the conceptual
of financial institution ensure the significant framework the function of dependent variables
reduction in non-performing loan and enhance (i.e. profitability) takes the following form:
banking efficiency. Jha and Hui (2012) found
negative relationship of nonperforming loan Profitability (ROA) = f (CAR, LR, NPLR,
and capital adequacy ratio (CAR) with of LLP, CICF)
return on assets (ROA).
NJMSR Vol.2 Student Focus Issue 1 Jan. 2019 43
Credit Risk Management and Profitability: A Study From Nepalese Commercial Bank

More specifically, the given model has been financial profitability.

segmented into following model: H2 : There is a negative relationship between
Model : non-performing loan and bank’s
financial profitability.
ROAit = β0 + β1CARit + β2LRit + β3NPLRit+
β4 LLPit + β5 CICFit + eit H3 : There is a negative relationship between
loan loss provision and bank’s financial
In above model, the dependent variable is the performance
return on assets indicated by the net profit after
tax to total assets. Where, H4 : There is a negative relationship between
leverage ratio and bank’s financial
β0 = Constant term performance.
CAR = Capital adequacy ratio (independent H5 : There is a positive relationship between
variable) credit risk to credit facilities and bank’s
NPLR = Nonperforming loan ratio financial performance.
(independent variable)
LLP = Loan loss provision (independent 4. Presentation and Data Analysis
variable) Descriptive analysis
LR = Leverage ratio (independent variable)
The descriptive statistics used in this study
CICF = Credit interest to credit facilities consists of mean, median, standard deviation,
(independent variable) minimum and maximum values associated
ROA = Return on assets (dependent variable) with variables under consideration. Table
4.9 summarizes the descriptive statistics of
3. Hypothesis variables used in this study during the period
2007/08 through 2013/14 for 25 sample
H1 : There is a positive relationship between commercial banks of Nepal.
capital adequacy ratio and bank’s

Table 1. Descriptive statistics

Variables Minimum Maximum Mean Std. Dev.
ROA -0.9860 18.0400 1.7645 1.7539
CAR 5.5500 41.8200 13.6875 4.6585
LR 1.0300 15.1900 6.8646 2.0678
NPLR 0.0002 0.1980 0.0222 0.0307
CI/CF 1.4859 14.4686 10.2697 2.2408
LLP 0.1441 36.1757 3.6101 4.7836

Table 1 shows that return on assets has to be a minimum value of 5.550 percent to a
minimum value of -0.9860 percent to a maximum of 41.82 percent with an average
maximum value of 18.040 percent with a mean of 13.6 percent and standard deviation 4.65
of 1.764 percent and standard deviation 1.753 percent. The leverage ratio noticed to be a
percent. The capital adequacy ratio noticed minimum value of 1.030 times to a maximum

44 NJMSR Vol.2 Student Focus Issue 1 Jan. 2019

 Credit Risk Management and Profitability: A Study From Nepalese Commercial Bank

of 15.190 times with an average of 6.864 Correlation analysis

times and standard deviation 2.06 times. Non- Correlation analysis is a statistical approach
performing loan ratio varies from a minimum used to determine the level of association
of 0.0002 times to a maximum of 0.198 times between two variables. It is worth pointing
with an average of 0.022 times and standard out that correlation does not suggest causality,
deviation of 0.0307 times. Similarly, CI/CF rather, the direction of the change or movement.
is observed with a minimum value of 1.49 A strong, or high, correlation means two or more
percent, maximum value of 14.47 percent and variables have a strong relationship with each
mean value of 10.27 percent. Likewise, the other while a weak, or low, correlation means
LLP varies from a minimum of 0.14 percent that the variables are hardly related. Thus,
to a maximum of 36.17 percent leading to an the Pearson’s correlation has been performed
average of 3.61 percent and standard deviation between dependent and independent variables
of 4.78 percent. and the results are presented in Table 2.

Table 2. Pearson’s correlation matrix for the dependent and independent variables
ROA CAR LR NPLR CI/CF LLP
ROA 1
CAR -.162* 1
.048
LR -.017 -.722** 1
.832 .000
NPLR -.548** -.121 -.125 1
.000 .143 .129
CI/CF .207* -.174* -.126 .299** 1
.011 .034 .124 .000
LLP -.656** -.074 -.155 .932** .228** 1
.000 .368 .059 .000 .005
**. Correlation is significant at the 0.01 level (2-tailed).
*. Correlation is significant at the 0.05 level (2-tailed).

The result shows that non-performing loan ratio to credit facilities is positively associated to
and leverage ratio are negatively correlated return on assets which indicate that higher the
to return on assets which indicate higher the credit interest to credit facilities higher would
non-performing loan ratio lower would be be the return on assets.
return on assets. It also indicates higher the
leverage ratio lower would be return on assets. Regression analysis
Likewise, loan loss provision ratio and capital In order to test the statistical significance and
adequacy ratio are also negatively correlated to robustness of the results, this study relies on
return on assets which indicate higher the loan secondary data analysis based on the regression
loss provision ratio lower would be the return models specified in the chapter three. The
on assets. It indicates that an increase in capital regression result of credit risk variables on
adequacy ratio leads to decrease in the return return on assets is presented in Table 3.
on assets. The result shows that credit interest

NJMSR Vol.2 Student Focus Issue 1 Jan. 2019 45

Credit Risk Management and Profitability: A Study From Nepalese Commercial Bank

Table 3.
Estimated regression results on determinants of return on assets
Mod- Intercept Regression Coefficients of Adj. R2 SEE F
els CAR LR NPLR CI/CF LLPR
1 2.601 -.061 .020 1.77 3.981
(5.87)** (1.99)*
2 1.866 -.015 -.006 1.76 .045
(3.72)** (-.21)
3 1.069 -31.300 .296 1.47 63.107
(7.17)** (-7.94)**
4 .103 .162 .036 1.72 6.564
(.15) (2.56)**
5 .897 -.240 .426 1.33 110.84
(6.56)** (-10.52)**
6 .060 -31.875 .087 -.422 .461 1.29 43.128
(.12) (-3.24)** (1.73) (-6.81)**
7 1.663 -.054 -30.924 -.422 .470 1.28 44.683
(4.81)** (-2.34)* (-3.32)** (-6.900)**
8 5.288 -.138 -.239 .051 1.71 5.018
(4.45)** (-3.16)** (-2.43)**
9 .913 -27.722 -.406 .453 1.29 62.345
(6.84)** (-2.88)* (-6.58)**
10 .625 -.043 -.019 -34.126 .076 -.435 .470 1.27 27.266
(.48) (-1.17) (.23) (-3.47)** (1.44) (-7.02)**
Notes:
1. Figures in parentheses are t-values.
2. The asterisk (**), (*) sign indicates that the results are significant at 1% and 5% level of
significance respectively.

The results show that beta coefficient for capital coefficient for non-performing loan ratio and
adequacy ratio and leverage ratio are negative. loan loss provision ratio are negative and
This indicates that lower the capital adequacy significant with return on assets. It indicates
ratio, higher would be the return on assets. This that higher the non-performing loan ratio lower
finding is similar to the findings of Shrieves & would be the return on assets. This finding is
Dahl (1992). The negative beta coefficients for similar to Noman et al (2015) and Jha and Hui
leverage ratio indicate that higher the leverage (2012). Similarly, result reveals that higher the
ratio, lower would be the return on assets. The loan loss provision, lower would be the return
study also reveals that the beta coefficients is on assets.
positive for credit interest to credit facilities
with return on assets. The results, hence,
indicate that higher the credit interest to credit 5. Conclusion
facilities, higher would be the return on assets. Commercial banks play an important role
This finding is consistent with the findings of for economic development, and foster
Zoubi, (2007) and Gizaw (2015). The beta economic growth of any country through their

46 NJMSR Vol.2 Student Focus Issue 1 Jan. 2019

 Credit Risk Management and Profitability: A Study From Nepalese Commercial Bank

intermediation role and financial services 6. References

that they provide to community and nations.
Among risks in banking operation credit
Campbell, A. (2007). Bank insolvency and the
risk which is related to substantial amount
problem of nonperforming loans. Journal
of income generating assets is found to be
of Banking Regulation, 9(1), 25-45.
important determinant of bank performance
(Rose & Hudgins, 2005). Credit risk plays Dash, M. K., & G.,Kabra (2010). The
an important role on banks profitability since determinants of non-performing assets in
a large chunk of banks revenue accrues from Indian commercial bank: An econometric
loans from which interest is derived. study. Middle Eastern Finance and
Economics, 7(2), 94-106.
Effectively managing credit risk in financial
institutions is critical for the survival and Dhungana, B. R., & , T. P., Upadhyaya (2011).
growth of the financial institutions. In the case Non-performing loans and efficiency of
of banks, the default of loans and advances Nepalese financial institutions. Journal
poses serious setbacks not only for borrowers of Business, 2(1), 1-9.
and lenders but also to the entire economy of a
country. The long term success of any banking Gestel, T. V., & B., Baesens, (2008). Credit risk
institution depended on effective system that management basic concepts: Financial
ensures repayments of loans by borrowers risk components, rating analysis, models,
which were critical in dealing with asymmetric economic and regulatory capital. Oxford
information problems, thus, reduced the level University Press.
of loan losses.
Howells, P. G. (2008). The economics of
The major conclusion of the study is that loan money, banking and finance: A European
loss provision ratio and non-performing loan text. Harlow: Prentice Hall.
ratio are the major factors affecting banks
performance in Nepalese commercial banks. Jha, S., & X., Hui (2012). A comparison of
The results reveal that NPL and LLP have financial performance of commercial
negative relationship with profitability of banks: A case study of Nepal. African
banks. This indicates that increase in NPL and Journal of Business Management, 6(25),
LLP leads to decrease in profitability of the 7601-7611.
banks. The study shows that capital adequacy
ratio has negative relationship with return on Lapteva, M. N. (2009). Credit Risk
assets. This study also concludes that credit Management in the Bank, Letter from
interest to credit facility have positive impact the Bank of Russia ‘On typical banking.
on profitability of the Nepalese commercial Retrieved from Available at: https://
banks. This indicates that higher the credit www.google.jo.
interest to credit ratio, higher would be the Paudel, D. (2006). Revenue implications of
bank profitability. Likewise, result shows WTO regime and alternative measures
that capital adequacy ratio, non-performing for revenue mobilization. Economic
loan ratio and loan loss provision ratio have Policy Network (p. 29). Policy Paper.
negative and significant impact on return on
assets. Psillaki, M., I., Tsolas, & D.,Margaritis (2010).
Evaluation of credit risk based on firm
performance. European Journal of
Operational Research, 201(3), 873-881.

NJMSR Vol.2 Student Focus Issue 1 Jan. 2019 47