Mekelle University

College of Business and Economics

Department of Management MBA program

Research Proposal

CREDIT RISK AND COMMERCIAL BANKS

PERFORMANCE

(Case Study on Commercial Bank of Ethiopia)

For the partial fulfillment of the course Business

research

Submitted to: Assistant Prof. Tesfay aregawi

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 By: Getenet Arega
CBE/PE023/06AA

October, 2014

Addis Ababa

Table of Contents

1. Introduction
1.1 Background
1.2 Statement of the problem
1.3 Objective of the study
1.4 Significance of the study
1.5 Delimitation of the study
1.6 Scope of the study
2. Litrature Review
2.1 Credit risk
2.2 The way how to manage credit risk
2.3 What type of risk is being considered
2.4 Credit risk measurement strategies
I. Credit derivatives
II. Credit securization
III. Compliance to Basel accord
IV. Adoption of sound internal lending policies
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 V. Credit bureau
2.5 Credit risk measurement
2.6 Credit risk models
2.7 Bank performance and its determinants
3. Methodology
3.1 Research desighn
3.2 Model specification
3.3 Data used in research
3.4 Method of analysis and interpritation

CHAPTER ONE

INTRODUCTION

1.1 BACK GROUNDS

Banks are financial intermediaries that accept deposits from individuals and institutions and make
loan. As a result they are vital and we can say that they are back bone to Economic development.
The efficient and effective performance of the banking industry over time is an index of financial
stability in any nation. The extent to which a bank extends credit to the public for productive
activities accelerates the pace of a nation’s economic growth and its long-term sustainability (from
monetary course teaching material).

The diversity of the business and economic conditions has led to the development of highly
sophisticated tools and models to measure the exposure of a financial institution to credit risk
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(Banks for international settlement /BIS/ capital adequacy guide lines, 1988). In case of an
individual loan portfolio, the probability of default, loss given default or credit rationing are the
most commonly used ones to measure the exposure to credit risk.

Credit creation is the main income generating activity for the banks. But this activity involves huge
risks to both the lender and the borrower. The risk of a trading partner not fulfilling his or her
obligation as per the contract on due date or anytime thereafter can greatly jeopardize the smooth
functioning of a bank‘s business. On the other hand, a bank with high credit risk has high
bankruptcy risk that puts the depositors in jeopardy. Among the risk that face banks, credit risk is
one of great concern to most bank authorities and banking regulators.

1.2 STATEMENT OF THE PROBLEM

Credit risk in banking is commonly defined as the probability of a borrower defaulting his loan
commitments. The higher exposure of a bank to credit risk, higher the tendency of banks to
experience financial crises and vice versa (Kargi, 2011).

Commercial banks are in the risky business. In the process of providing financial services, they
assume various kinds of financial risks. Over the last decade our understanding of the place of
commercial banks within the financial sector has improved substantially. Market participants seek
the services of these financial institutions because of their ability to provide market knowledge,
transaction efficiency and funding capability. In performing these roles they generally act as a
principal in the transaction. As such, they use their own balance sheet to facilitate the transaction
and to absorb the risks associated with it (Santimero, 1997).

The principal concern of our proposal was just to assess to what extent commercial banks can
manage their credit risks, what tools and techniques they are using to overcome this risk and to
what extent their actual performance can be affected through proper credit risk management.

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1.3 OBJECTIVE OF THE STUDY:-

The main objective of the study is to assess the impact of credit risk on performance of Ethiopian
commercial bank over a period of 5 years. In line with general objective the paper will assess the
following specific objectives.

Specific objectives

 To know how bank use credit risk evaluation and assessment tools to mitigate its credit risk
exposure.
 To assess the relationship between the theories, concepts and models of credit risk and what
goes on practically in banking.

1.4 SIGNIFICANCE OF THE STUDY:-

In addition to academic importance, significance of the paper is:

 The findings will serve as basis to provide policy measure to various stockholders on how to
tackle the effect of credit risk in order to enhance quality of bank’s risk assets.
 It will be used as an input for further studies.

1.5 DELIMITATION OF THE STUDY:-

The researcher will try to accomplish the objective of the study successfully. But time concern
and source of fund will be the main limitation that may hinder the successful accomplishment
of the paper.
Data limitation and sample limitation are the other sides to the limitation part of the study.

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1.6 SCOPE OF THE STUDY:-

Among the 19 Governmental and private commercial banks of the country the researcher only
focus on commercial bank of Ethiopia which is owned by the government due to time limitation
and limitations of organized data availability problems in the other banks.

CHAPTER TWO

REVIEW OF RELATED LITERATURE

The relevance of banks in the economy of any nation cannot be overemphasized. The economies
of all market-oriented nations depend on the efficient operation of complex and delicately balance
systems of money and credit. Banks are an indispensable element in these systems. They provide
the bulk of the money supply as well as the primary means of facilitating the flow of credit."
Consequently, it is submitted that the economic well being of a nation is a function of advancement
and development of her banking industry (Alex, 2012).

2.1 CREDIT RISK

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loans, will decline in value and possibly become worthless. Because banks hold little owners
‘capital relative to the aggregate value of their assets, only a small percentage of total loans need
to go bad to push a bank to the brink of failure. Thus, management of credit risk is very important
and central to the health of a bank and indeed the entire financial system. As banks make loans,
they need to make provisions for loan losses in their books. The higher this provision becomes,
relative to the size of total loans, the riskier a bank becomes. An increase in the value of the
provision for loan losses relative to total loans is an indication that the bank‘s assets are becoming
more difficult to collect (Tshore, Aboagy and Koyerhoah Coleman).

Credit risk is the risk of a loss resulting from the debtor's failure to meet its obligations to the Bank
in full when due under the terms agreed (R.S. Raghavan 2003).

Credit risk has the highest weight among risks taken by the Bank in the course of its banking
activities. The main source of credit risk include, limited institutional capacity, inappropriate credit
policies, volatile interest rates, poor management, inappropriate laws, low capital and liquidity
levels, direct lending, massive licensing of banks, poor loan underwriting, laxity in credit
assessment, poor lending practices, government interference and inadequate supervision by the
central bank (Kolapo,2012) (Kithinji, 2010). An increase in bank credit risk gradually leads to
liquidity and solvency problems. Credit risk may increase if the bank lends to borrowers it does
not have adequate knowledge about.

Credit risk management in the Bank is carried out using the following main procedures:
putting in place limits for operations to limit credit risk;
putting in place indicative limits for credit risk concentration and the share of unsecured
loan portfolio;
creation of security for credit operations;
setting value conditions for operations with respect to payment for risks taken;
Permanent monitoring of risks taken and preparation of management reporting for the
Credit Committee, the Bank's management and units concerned;
Evaluation of regulatory and economic capital necessary to cover the risks taken in respect
of the Bank's operations and ensuring its sufficiency;

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 carrying out hedging operations;
Permanent internal control over the Bank's units in respect of observing regulations on
operations procedure and risk assessment and management procedures by independent
units.

The main tool to restrict and control the credit risk taken by the Bank is the credit limit system.
The following types of credit risk limits are put in place:

 counterparty limits;
 limits for independent risk-taking by the Bank's branches; and
 credit risk limits by countries/industries/regions.

Credit risk limits are determined by the Credit Committee and approved by the Bank's
Management Board (in case the Credit Committee does not have the required authority). A part of
authorities for putting credit limits in place is delegated to Branch Credit Committees (for standard
credit operations within the special limit for independent credit risk-taking by branches), as well
as to the Small Credit Committee.

2.2 THE WAY HOW TO MANAGE CREDIT RISK

As to Laurent Clerc (2004) Participants analyzed the different risk management techniques by
taking a look at the following two aspects: the emergence of a risk culture and the prevention of
risk by building up regulatory capital in proportion to the level of risk exposure of each credit
institution.

Pillar 1 of the new Basel II framework provides banks with several options for calculating their
capital requirements relative to their credit risk and their operational risk. The most innovative one
is the possibility that banks have been given of using —19 under the control of the supervisory
authorities — their internal assessment systems. Because calibrating these models tends to come
up against the problem of the reliability and availability of data in some emerging economies, the

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Basel Committee has proposed a simplified standardized approach designed specifically for these
economies.

2.3 WHAT TYPE OF RISK IS BEING CONSIDERED?

Commercial banks are in the risk business. In the process of providing financial services, they
assume various kinds of financial risks. Over the last decade our understanding of the place of
commercial banks within the financial sector has improved substantially. Over this time, much has
been written on the role of commercial banks in the financial sector, both in the academic literature
and in the financial press. These arguments will be neither reviewed nor enumerated here. Suffice
it to say that market participants seek the services of these financial institutions because of their
ability to provide market knowledge, transaction efficiency and funding capability. In performing
these roles they generally act as a principal in the transaction. As such, they use their own balance
sheet to facilitate the transaction and to absorb the risks associated with it (Santomero 1997).

To be sure, there are activities performed by banking firms which do not have direct balance sheet
implications. These services include agency and advisory activities such as (i) trust and investment
management, (ii) private and public placements through "best efforts" or facilitating contracts, (iii)
standard underwriting through Section 20 Subsidiaries of the holding company, or (iv) the
packaging, securitizing, distributing and servicing of loans in the areas of consumer and real estate
debt primarily. These items are25 absent from the traditional financial statement because the latter
rely on generally accepted accounting procedures rather than a true economic balance sheet.
Nonetheless, the overwhelming majority of the risks facing the banking firm is in on-balance-sheet
businesses. It is in this area that the discussion of risk management and the necessary procedures
for risk management and control has centered. Accordingly, it is here that our review of risk
management procedures will concentrate.

2.4 CREDIT RISK MANAGEMENT STRATEGIES

The credit risk management strategies are measures employed by banks to avoid or minimize the
adverse effect of credit risk. A sound credit risk management framework is crucial for banks so as

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to enhance profitability guarantee survival. According to Lindergren (1987), the key principles in
credit risk management process are sequenced as follows; establishment of a clear structure,
allocation of responsibility, processes have to be prioritized and disciplined, responsibilities should
be clearly communicated and accountability assigned. The strategies for hedging credit risk
include but not limited to these;

i. Credit Derivatives:

This provides banks with an approach which does not require them to adjust their loan portfolio.
Credit derivatives provide banks with a new source of fee income and offer banks the opportunity
to reduce their regulatory capital (Shao and Yeager, 2007). The commonest type of credit
derivative is credit default swap whereby a seller agrees to shift the credit risk of a loan to the
protection buyer. Frank Partnoy and David Skeel in Financial Times of 17 July, 2006 said that
“credit derivatives encourage banks to lend more than they would, at lower rates, to riskier
borrowers”. Recent innovations in credit derivatives markets have improved lenders’ abilities to
transfer credit risk to other institutions while maintaining relationship with borrowers (Marsh,
2008).

ii. Credit Securitization:

It is the transfer of credit risk to a factor or insurance firm and this relieves the bank from
monitoring the borrower and fear of the hazardous effect of classified assets. This approach insures
the lending activity of banks. The growing popularity of credit risk securitization can be put down
to the fact that banks typically use the instrument of securitization to diversify concentrated credit
risk exposures and to explore an alternative source of funding by realizing regulatory arbitrage and
liquidity improvements when selling securitization transactions (Michalak and Uhde,2009). A
cash collateralized loan obligation is a form of securitization in which assets (bank loans) are
removed from a bank’s balance sheet and packaged (tranched) into marketable securities that are
sold on to investors via a special purpose vehicle (SPV) (Marsh,2008).

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iii. Compliance to Basel Accord:

The Basel Accord is international principles and regulations guiding the operations of banks to
ensure soundness and stability. The Accord was introduced in 1988 in Switzerland. Compliance
with the Accord means being able to identify, generate, track and report on risk-related data in an
integrated manner, with full audit ability and transparency and creates the opportunity to improve
the risk management processes of banks. The New Basel Capital Accord places explicitly the onus
on banks to adopt sound internal credit risk management practices to assess their capital adequacy
requirements (Chen and Pan, 2012).

iv. Adoption of a sound internal lending policy:

The lending policy guides banks in disbursing loans to customers. Strict adherence to the lending
policy is by far the cheapest and easiest method of credit risk management. The lending policy
should be in line with the overall bank strategy and the factors considered in designing a lending
policy should include; the existing credit policy, industry norms, general economic conditions of
the country and the prevailing economic climate (Kithinji,2010).

v. Credit Bureau:

This is an institution which compiles information and sells this information to banks as regards the
lending profile of a borrower. The bureau awards credit score called statistical odd to the borrower
which makes it easy for banks to make instantaneous lending decision.

2.5 CREDIT RISK MEASUREMENT FRAMEWORK

Credit risk is conventionally defined using the concepts of expected loss (EL) and unexpected loss
(UL). Because expected losses can be anticipated, they should be regarded as a cost of doing
business and not as a financial risk. Obviously credit losses are not constant across the economic

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cycle, there being substantial volatility (unexpected loss) about the level of expected loss. It is this
volatility that credit portfolio models are designed to quantify.

Volatility of portfolio losses is driven by two factors – concentration and correlation.

Concentration describes the ‗lumpiness‘of the credit portfolio (e.g. why it is more risky to lend
£10m to 10 companies than to lend £0.1m to 1,000 companies). Correlation describes the
sensitivity of the portfolio to changes in underlying macro-economic factors (eg why it is more
risky to lend to very cyclical industries such as property development). In all but the smallest credit
portfolios, correlation effects will dominate. When quantifying credit risk, two alternative
approaches can be used when valuing the portfolio:

Loss-based method: Under this approach an exposure is assumed to be held to maturity.

NPV-based method: Under this approach, the embedded value of an exposure is assumed to be
realizable. If the obligation upgrades then it is assumed to be worth more than par, and if it
downgrades it is assumed to be worth less than par. The value of the obligation can be calculated
using either using market credit spreads (where applicable) or by marking-to-model using CAPM
or similar method.

In general, NPV-based methods are most applicable to bond portfolios and large corporate
portfolios where meaningful markets exist for either the physical assets or credit derivatives. For
the vast majority of commercial bank exposures, where such markets do not exist a more
meaningful risk profile is obtained using a loss-based31 method. Loss-based calculations have the
advantage of requiring less input data (margin and maturity information, for example, is not
required) and being simpler to compute. However, many institutions are starting to run both
methods in parallel, particularly for portfolios where securitization is possible.

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2.6 CREDIT RISK MODELS

Over the last decade, a number of the world‘s largest banks have developed sophisticated systems
in an attempt to model the credit risk arising from important aspects of their business lines. Such
models are intended to aid banks in quantifying, aggregating and managing risk across
geographical and product lines. The outputs of these models also play increasingly important roles
in banks‘ risk management and performance measurement processes, including performance-
based compensation, customer profitability analysis, risk-based pricing and, to a lesser (but
growing) degree, active portfolio management and capital structure decisions. The task force
recognizes that credit risk modeling may indeed prove to result in better internal risk management,
and may have the potential to be used in the supervisory oversight of banking organizations.

However, before a portfolio modeling approach could be used in the formal process of setting
regulatory capital requirements for credit risk, regulators would have to be confident not only that
models are being used to actively manage risk, but also that they are conceptually sound,
empirically validated, and produce capital requirements that are comparable across institutions. At
this time, significant hurdles, principally concerning data availability and model validation, still
need to be cleared before these objectives can be met, and the committee sees difficulties in
overcoming these hurdles in the timescale envisaged for amending the capital accord. Credit
scoring models use data on observed borrower characteristics either to calculate the probability of
default or to borrowers into different default risk classes (Saunders and Cornett, 2007).

Prominent amongst the credit scoring models is the Altman‘s Z-Score. The Z-score formula for
predicting bankruptcy of Dr. Edward Altman is a multivariate formula for measurement of the
financial health of a company and a powerful diagnostic tool that forecast the probability of a
company entering bankruptcy within a two year period with a proven accuracy of 75-80%.

The Altman‘s credit scoring model takes the following form;

Z=1.2x1+1.4x2+3.3x3+0.6x4+1.0x5

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Where,
X1 = Working capital/ Total assets ratio
X2 = Retained earnings/ Total assets ratio
X3 = Earnings before interest and taxes/ Total assets ratio
X4 = Market value of equity/ Book value of long-term debt ratio
X5 = Sales/ Total assets ratio.

The higher the value of Z, the lower the borrower‘s default risk classification. According to
Alman‘s credit scoring model, any firm with a Z-Score less than 1.81 should be considered a high
default risk, between 1.81-2.99 an indeterminate default risk, and greater than 2.99 a low default
risk.

2.7 BANKS PERFORMANCE AND ITS DETERMINANTS

The role of bank remains central in financing economic activity and its effectiveness could exert
positive impact on overall economy as a sound and profitable banking sector38 is better able to
withstand negative shocks and contribute to the stability of the financial system (Athanasoglou et
al, 2005). Therefore, the determinants of bank performance have attracted the interest of academic
research as well as of bank management, financial markets and bank supervisors since the
knowledge of the internal and external determinants of banks profits and margins is essential for
various parties.

During the last two decades the banking sector has experienced worldwide major transformations
in its operating environment. Both external and domestic factors have affected its structure and
performance. Correspondingly, in the literature, bank profitability is usually expressed as a
function of internal and external determinants. The internal determinants refers to the factors
originate from bank accounts (balance sheets and/or profit and loss accounts) and therefore could
be termed micro or bank specific determinants of profitability. The external determinants are
variables that are not related to bank management but reflect the economic and legal environment
that affects the operation and performance of financial institutions. A number of explanatory

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variables have been proposed for both categories, according to the nature and purpose of each
study (Yuqi Li).

CHAPTER 3
METHODOLOGY

The methodology part includes Research design, Model Specification, Data Types and Source of
data and Method of analysis and interpretation.

1.1 RESEARCH DESIGN

This research paper will employ quantitative research design. Under quantitative research design
survey method will be employed. The study will be a non-experimental descriptive research
method.

1.2 MODEL SPECIFICATION

The model we will adopte in this study is from model of Kolapo (2012) in his study “Credit risk
and commercial banks’ performance in Nigeria", which measured profitability with Return of

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Asset (ROA) as a function of non-performing loan to total loan, total loan to total deposit and loan
loss provision to classified asset. So, the model becomes;

NPL TL LLP
ROA=f ( 𝑇𝐿 , 𝑇𝐷 , )
𝐶𝐿

Where;

ROA= return on asset

NPL TL LLP
ROA= β0 + 𝛽1 + β2 + β3 +μ
𝑇𝐿 𝑇𝐷 𝐶𝐿

Where;
β0 = Constant parameter/Intercept
β1, β2 &β3 = Coefficients of independent (explanatory) variables
μ = Error term

NPL TL LLP
Here and 𝑇𝐷 are used as indicators of credit risk and as a measure of credit risk.
𝑇𝐿 𝐶𝐿

With the help of empirical data on CBE the study will test the following hypothesis using the above
model.
Null hypothesis (H0): credit risk has an effect on banks performance.
Hypothesis 1 (H1): credit risk has no effect on banks performance.

The “a priori expectation” in the model is that all independent variables are expected to have
negative relationship on bank performance measured by ROA except ratio of total loan to total

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deposit which is expected to have a positive relationship with bank performance. The mathematical
expression is represented as β1, β3 < 0 & β2> 0. This implies a unit increases in the independent
NPL LLP TL
variable such as and will lead to a decrease in ROA by a unit and a unit increase in 𝑇𝐷 will
𝑇𝐿 𝐶𝐿

increase ROA by a unit.

1.3 DATA USED IN THE RESEARCH

Both primary and secondary data will be used. The secondary data will be collected from the

annual financial reports of commercial banks of Ethiopia and the primary data will be obtained by
distributing questioners.

The researchers use the data from commercial banks of Ethiopia for analysis. Time series data of
5 years financial data of the bank used to examine the relationship between the parameters which
is already identified.

1.4 METHOD OF ANALYSIS AND INTERPRETATION

The primary data collected using questionnaires will be analyzed and interpreted using tables and
percentages.

The secondary data collected from 5 years annual financial reports of commercial bank of Ethiopia
will be analyzed and interpreted using the ‘SPSS’ soft ware and OLS (Ordinary Least of Square)
result of the model.

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