CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND TO THE STUDY
It is difficult to imagine another sector of the economy where as many risks are managed jointly
as in Banking. Banks and banking activities have evolved significantly through time. With the
introduction of money, financial services like acceptance of deposits, lending money, currency
exchange and money transfers became important because of the central role of money, Banks
had had and still have an important role in the economy. Like any other firm banks are exposed
to classical operational risks like infrastructure breakdown, problems, environmental risks e.t.c.
More typical and important for a bank re the financial risk it takes by the transformation and
brokage function.
By its very nature, banking is an attempt to manage multiple and seemingly oozing needs. Bank
stands ready to provide liquidity on demand to depositors through the checking account and to
extend credit as well as liquidity to their borrowers through lines of credit (Kashyap, Rajan, and
Stein 1999). Because of these fundamental roles, banks have always been concerned with both
solvency and liquidity. Traditionally, Banks held capital as a buffer against insolvency and they
held liquid assets like cash and securities to guard against unexpected withdrawals by depositors
or draw downs by borrowers. Banks are germane to economic development through the financial
services they provide. Their intermediation role can be said to be a catalyst for economic growth.
In recent years, risk management at banks has come under increasing scrutiny. Banks have
attempted to sell sophisticated credit risk management systems that account for borrowers risk
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and perhaps the risk reducing benefits of diversification across borrowers in a large portfolio.
Banks that manage their credit risk (buy and sell loans) hold more risky loan than banks that
merely sell loans or banks that merely buy loans. For banks, credit risk typically resides in the
assets in its banking books (loans and bonds held to maturity). Credit risk refers to the risk that a
borrower will default on any type of debt by failing to make required payments. The risk is
primarily that of the lender and includes lost principal and interest, disruption to cash flows and
increased collection costs. The loss may be complete partial and can rise in a number of
circumstances for example consumer may fail to make a payment due on mortgage loan, credit
card, or other loan. Traditionally, the five c‟s representing the borrowers characters, capacity,
collateral and conditions have been recommended.
Credit management is the process of collecting payments from customers. This is the
function within a bank or company to control credit policies that will improve revenues and
reduce financial risks. Credit management is also the process for controlling and collecting
payments from customers. A good credit management system will help you reduce the amount of
capital tied up with debtors and minimise your exposure to bad debts. Credit management
generally is usually regarded as assuring that buyers pay on time, credit costs are kept low and
poor debts are managed in such a manner that payment is received without damaging the
relationship with a customer. .A credit manager is a person employed by an organisation to
manage the credit department and make decision concerning credit limits, acceptable level of
risks and terms of payment to their customers. Credit risk is the potential loss due to failure of a
borrower to meet its contractual obligation to repay a debt in accordance with the agreed terms.
Credit risk management is undoubtedly among the most crucial issues in the field of financial
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risk management. Credit risk management is to maximise a banks readjusted rate of return by
maintaining credit risk exposure.
More lenders employ their own models to rank potential and existing customers according to
risk, and then apply appropriate strategies. With products such as unsecured personal loan or
mortgages, lenders charge a higher price for a higher risk customer and vice versa. With
revolving products such as credit cards and over drafts, risk is controlled through the setting of
credit limits. Some products also require collateral in fact almost all products requires collateral
in case anything happens to be able to prevent bad debt. For most banks loans are the largest and
most obvious source of credit. However there are other sources of credit risk both on and off the
balance sheet. Off balance sheet items includes letter of credit, unfunded loan commitments and
lines of credit. Other products, activities and services that expose a bank to credit risks are credit
derivatives foreign exchange and cash management services.
Credit scoring models also form an art of the framework used by banks or lending institution to
grant credit to clients. For corporate and commercial borrowers, these models generally have
qualitative and quantitative sections outlining various aspects of credit risk including, but not
limited to, operating experience, management expertise, asset quality, leverage and liquidity
ratio. Once this information has been fully reviewed by credit officers and credit committees, the
lender provides the funds subject to the terms and conditions resented within the contract.
The strategies to manage threats typically include transferring the threat to another party,
avoiding the threat, reducing the negative effect or probability of the threat or even accepting
some or all of the potential or actual consequences of a particular threat, and the opposites for
opportunities. Certain aspects of many of the risk management standards have come under
criticism for having no measurable improvement on risk, wether the confidence in estimates and
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decisions seem to increase. In ideal risk management, a priotization process is followed whereby
the risks with the greatest probability of occurrence are handled first, and risks with lower loss
are handled in descending order. In practice, the process of assessing the overall risk can be
difficult and balancing resources used to mitigate between risks with a high probability of
occurrence but lower loss versus a risk with high loss but lower probability of occurrence can be
often mis-handled.
The credit risk management needs to foster a climate for good banking where prices are in line
with the risks taken..
If revenue is the energy that powers a company, credit management is the engine that keeps it
flowing. The credit management engine acts as a power house, driving revenue and motivation to
every art of an organisation. As the credit management engine becomes more refined and
efficient, so any business becomes more productive and profitable. Credit allows for the
expanded movement of products and for economic growth and prosperity. Without risk
management functions, it is unlikely that the bank succeeds In achieving It‟s long term strategy
and to remain solvent. A strong strategic risk management avoids important pitfalls like credit
concentrations, lack of credit discipline, aggressive underwriting to high risk counterparts and
products at inadequate prices.
BANK PERFORMANCE
The term „performance‟ means carrying into execution or achievement; or accomplishment of
specific activities, or the performance of an undertaking of a duty. „Bank performance‟ may be
defined as the reflection of the way in which the resources of a bank are used in a form which
enables it to achieve its objectives.
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Furthermore, the term bank performance means the adoption of a set of indicators which are
indicative of the bank‟s current status and the extent of its ability to achieve the desired
objectives.
As the banking sector is considered a vital segment of a modern economy, its efficiency is of
vital importance. In order to ensure a healthy financial system and an efficient economy, banks
must be carefully evaluated and analysed.
While banks help business organisations by rendering a wide range of products and services, the
products and services are more or less identical from one bank to another, and there is little scope
for differentiating between them. Therefore, it is necessary to measure the banks‟ individual
performance to determine their contribution to business development.
It is inevitable that banks continue to attract significant attention from the public and scrutiny by
financial regulators as there is a growing need to evaluate banks in a more efficient manner. Not
only supervising institutions, regulators and bank management bodies, but also clients of banks,
are becoming increasingly concerned about the stability and sustainability of these financial
institutions.
There are other reasons to evaluate the performance of banks to determine their operational
results and their overall financial condition; measure their assets quality, management quality
and efficiency, and achievement of their objectives; as well as ascertain their earning quality,
liquidity, capital adequacy, and level of bank services.
According to the interdisciplinary journal of contemporary research business, the major cause of
serious banking problems continues to be directly related to low credit standards for borrowers
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and counterparties, poor portfolio management, and lack of attention to changes in economic or
other circumstances that can lead to deterioration in the credit standing of bank‟s counter parties.
And it is clear that banks use high leverage to generate an acceptable level of profit. Credit risk
management comes to maximize a bank‟s risk adjusted rate of return by maintaining credit risk
exposure within acceptable limit in order to provide a framework of the understanding the impact
of credit risk management on banks profitability. The excessively high level of non-performing
loans in the banks can also be attributed to poor corporate governance practices, lax credit
administration processes and the absence or non- adherence to credit risk management practices.
The health of the financial system has important role in the country (Das & Ghosh, 2007) as its
failure can disrupt economic development of the country. Financial performance is company‟s
ability to generate new resources, from day-to-day operation over a given period of time and it is
gauged by net income and cash from operation. The financial performance measure can be
divided into traditional measures and market based measures (Aktan & Bulut, 2008). During the
1980‟s and 1990‟s when the financial and banking crises became worldwide, new risk
management banking techniques emerged. To be able to manage the different types of risk one
has to define them before on can manage them. The risks that are most applicable to banks risk
are: credit risk, interest rate risk, liquidity risk, market risk, foreign exchange risk and solvency
risk.
Risk management is the human activity which integrates recognition of risk, risk assessment,
developing strategies to manage it, and mitigation of risk using managerial resources (Appa,
1996) whereas credit risk is the risk of loss due to debtor‟s non-payment of a loan or other line of
credit (either the principal or interest or both) (Campbell, 2007). Default rate is the possibility
that a borrower will default, by failing to repay
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principal and interest in a timely manner. A bank is a commercial or state institution that
provides financial services, including issuing money in various forms, receiving deposits of
money, lending money and processing transactions and the creating of credit (Campbell, 2007).
Credit risk management is very important to banks as it is an integral part of the loan process. It
maximizes bank risk, adjusted risk rate of return by maintaining credit risk exposure with view to
shielding the bank from the adverse effects of credit risk. Bank is investing a lot of funds in
credit risk management modeling.
Credit risk management comes to maximize a bank‟s risk adjusted rate of return by maintaining
credit risk exposure within acceptable limit in order to provide a framework of the understanding
the impact of credit risk management on banks profitability.
1.2 STATEMENT OF PROBLEM
Without risk management functions, it is unlikely that the bank succeeds in achieving It‟s long
term strategy. Hence the need for good credit risk management cannot be overemphasized.
Here are some problems identified with this research work:
1. The major cause of serious banking problems continues to be directly related to low
credit standards for borrowers and counterparties, poor portfolio management.
2. There is no deep or thorough examination on the factors that affect the performance and
competition of a bank.
3. lack of attention to changes in economic or other circumstances that can lead to
deterioration in the credit standing of bank‟s counter parties
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1.3 OBJECTIVES OF THE STUDY
This Study, therefore, was undertaken to:
1. Examine the credit standard for borrowers and counter parties and why portfolio
management is poor in some banks.
2. Empirically examine the factors which affect performance of banks and competition in
the industry.
3. Find out why credit administrators does not pay attention to the changes in the economy
of the country.
1.4. RESEARCH QUESTIONS
This study seeks answer to the following questions
1. Does appropriate management of credit risk affects bank performance in Nigeria?
2. Does mitigation of risk improve bank capital adequacy?
3. What is the impact of non-performing loan on the profitability of banks in Nigeria?
1.5. HYPOTHESES.
Hypothesis 1
HO: Appropriate management of credit risk does not affect bank performance
H1: Appropriate management of credit risk greatly affects bank performance affect bank
performance
Hypothesis 2
H0: Mitigation of risk does not improve bank capital adequacy.
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H1: Mitigation of risk improves bank capital adequacy.
Hypothesis 3
H0: Non-performing loans have no impact on the profitability of banks.
H1: Non-performing loans have no impact on the profitability of banks.
1.6. SIGNIFICANCE OF THE STUDY
Some companies often tend to hide their credit history, particularly when it is unfavourable. If a
company has a record of poor business practices you can find out these things through credit
management and performance reports. Before you make any financial dealings with a new
business, requesting the company credit report is crucial in order to know the credit worthiness
of that company.
Credit management is an important tool that should be used before going into business with other
companies or in the case of a bank, to prevent bad debts and so on. It can help protect any
business from financial dangers and unnecessary risk of losing assets and also to know the
financial performance of that company.
1.7. LIMITATION OF THE STUDY
There is no mechanism for addressing risks holistically as nobody is considering the
interrelationship and potential aggregation of risks across the organisation. Operational activities
most times does not include risk management and my point is that operational activities must
include risk management as a result of this, risk management remains fragmented and provides
poor visibility of risks.
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Traditionally, Return on Assets (ROA) and Return on Capital Employed (ROCE) are the most
popular standard metrics of bank performance. However, these are no longer adequate for the
assessment of bank performance since they do not satisfactorily meet the needs of interest groups
other than shareholders and prospective investors. In recent times, margin measurement and
other ratio analysis have become very important tools to banks‟ management, regulatory
authorities and the general public.
1.8. SCOPE OF THE STUDY
The scope of this study is the Nigerian banking environment.
1.9. ORGANISATION OF THE STUDY
Chapter one provides all the background information about the project topic, chapter two is the
literature review of the project topic. It talks about what other people have said about the project
topic, chapter three is the data analysis and methodology, chapter four is the data presentation,
analysis and interpretation of the project topic, chapter five is the summary, conclusion and
recommendation.
1.10. DEFINITION OF TERMS
Risk: Risk is the potential of losing something of value. This is a probability or threat of
damage, injury, liability loss or any other negative occurrence that is caused by external or
internal vulnerabilities, and that may be avoided trough preemptive action.
Credit: The amount of money available to be borrowed by an individual or a company is
referred to as credit because it must be paid back to the lender at some point in the future.
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Credit risk: The risk of loss of principal or loss of a financial reward stemming from a
borrowers failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises
whenever a borrower is expecting to use future cash flows to pay a current debt.
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REFERENCES
Cheron E.J., Boidin H. and Daghfous, N. (1999), Basic financial services of low income
individuals comparative study in Canada. International journal of Bank Marketing, 17(2), 49-64.
Chen B, Cheng X and Wu L. (2005); Dynamic Interactions Between Interest Rate Credit and
Liquidity Risk “Theory and Evidence From Term Structure Of Credit Default and Swap spreads.
Working Paper Series Aug. 8 2005
Chipembere. (2009). Unlocking funding opportunities for farmers through grass root Saccos.
Available from www.snvworld.org/en/document/mz Focus Group, 2007. Credit Risk
Management Industry Best Practices. Available at: http://www.bangladeshbank. org
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