Impact of Credit Risk Management on Profitability

Impact of Credit Risk Management on Profitability Credit Risk arises because there is a possibility of a risk that the counterparty defaults on the loans and bonds held by the institution (Cornett) The Ultimate advantages of Credit Risk Management are being accepted by Financial Institutions now and Risk Managers are focusing on different Risk Management Models in looking for different Business Opportunities (Heinemann). However in general Financial Institutions that make Loans or buy bonds with long maturities are more exposed than Financial Institutions that make loans or buy bonds with short maturities. This means for example that banks, thrifts and life insurance companies are more exposed to Credit Risk than are money market mutual funds, since Banks and life insurance companies tend to hold longer maturity assets in their Portfolios than mutual funds. (Cornett) Basel is an agreement that requires the imposition of risk-based capital ratios on banks in major industrialized countries. Considering the weaknesses of the simple capital-to-assets ratio, members of Bank for International Settlements (BIS) along with U.S decided to implement two new risk-based capital ratios for all commercial banks under their jurisdiction in 1988. The BIS phased in and fully implemented these risk based capital ratios on January 1, 1993, under what has been known as the Basel Accord (now called Basel I). Credit risks of assets are included into Capital adequacy ratio into Basel Agreement of 1993. This was followed with a revision in 1998 in which market risk was incorporated into risk-based capital in the form of an add-on to the 8 percent ratio for credit risk exposure. In 2001, the BIS issued a consultative document, It was proposed in the basel-II or the new basel system that the operational risk should be the part of Capital requirements with effect from 2007 and updated the credit risk assessments in 1993 agreement. This agreement was adopted in June, 2004. (Cornett) Basel-II or the new basel system consists of three pillars which are discussed below, these three pillars play a vital role in the safety and soundness of the entire financial system. PILLAR 1 CREDIT RISK: On Balance Sheet and Off Balance Sheet (Standardized vs. Internal Ratings Based approach) MARKET RISK: Standardized vs. Internal Ratings Based approach OPERATIONAL RISK: Basic Indicator vs. Standardized vs. Advance measurement approach) PILLAR II Regulatory supervisory review so as to complement and enforce minimum Capital Requirements calculated under Pillar 1 PILLAR III Requirements on rules for disclosure of Capital Structure, risk exposures, and Capital Adequacy so as to increase Financial Institutions transparency and Enhance Market/Investor Discipline. Like in every other Country in Pakistan also the State Bank of Pakistan issued a Road Map or Guidelines for Implementation of Basel-II in Pakistan and the deadline issued by State bank for the completion was December 2006. PROBLEM STATEMENT Capital Regulation, Supervision and Market Discipline are the foundation of Basel-II, and to improve the Risk Management Procedures for bringing stability in the financial System, the Banks and Financial Institutions were required to establish an adequate setup and report to SBP the name and other Particulars of the Person responsible for Implementation before 31st May 2005 We will study the impact of Basel II on the credit risk management by considering two parameters i.e. NPLR and CAR. By studying these ratios, we find out that how Basel II is useful in management and reduction of risk and finally determine the role of credit risk management in increasing the profits of banks. RESEARCH QUESTION As per the background discussed earlier, out task is to research: The impact of credit risk management on the profitability of commercial banks in Pakistan. PURPOSE Our research will find out the importance credit risk management in the profitability of commercial banks in Pakistan and how Basel II helps in reduction of credit risk and management by using some techniques and methods that will control the amount of non-performing loans. The purpose of the research is to explain the impact of credit risk management on profitability of commercial banks in Pakistan, that what is the role of BASEL-II in the management and reduction of credit risk by controlling the amount of non performing loans through methods, Processes and limits imposed in BASEL II. JUSTIFICATION Our research will explain the influence of credit risk management on the profitability of commercial banks. This research will be very helpful for the banking industry in Pakistan as it is directly related to the profitability of banks. It will provide them with the guidelines that how they could manage and minimize the credit as per the rules and regulations provided in Basel document. SCOPE Our research is significant and important in a way that it will determine the dependency of profitability on credit risk management and it will study Basel I and Basel II and determine their difference and whether the regulations in Basel II puts any betterment in managing the risk. LIMITATIONS OF THE STUDY We are conducting our research on the private commercial banks of Pakistan based on the conventional banking system. It will help us on concentrating and focusing only on one sector of banking industry and determine valid and authentic results. Public sector banks, Islamic banks, investment banks, micro-finance banks are included in the research. Basel II was put into account from December 2006 that is why we have included the data from financial statements of 2007 to 2009 as we have studying the relation between profitability and credit risk management after Basel II is implemented. The study is limited to two independent variables for measuring credit risk management that are NPLR and CAR, and one dependent variable for measuring profitability which is ROE, the reason for choosing the above mentioned variables will be discussed in the methodology. LITERATURE REVIEW ROE PROFITABILITY INDICATOR ROE (Return on Equity) refers to the ratio of Net Income to the Total equity capital. ROE indicates that how much the bank has earned with the investors capital. It measures that how well and efficiently a company uses its investors funds to generate profit. It is used as a comparative too between two companies or banks. Its the ratio of net income and share holders equity. But in the Case of Bank ROE can be increased if the Capital decreases, but as the Capital decreases, the bank is exposed to risk of insolvency, and thats the reason that regulators continuously monitor the minimum capital requirements for Banks. ROA(Return on Assets) indicates that how efficiently the management uses its assets to generate income. Its the ratio of net income and total assets. Both ROA and ROE are expressed in percentage. CREDIT RISK MANAGEMENT INDICATORS According to a research of Risk management practices followed by commercial banks in Pakistan. It was identified that the major risk faced by banks in Pakistan as well as internationally is the Credit Risk. Because the core banking business is all about creation of Credit, through which commercial banks generate their Profits. When it comes to Credit Risk, the most important aspect are the financing decisions followed by the commercial banks, because ultimately it ends into Credit risk. The State bank has also introduced some tough regulations when financing individual as well as SMEs and Corporate Customers, such as obtaining the BBFS(Borrowers basic fact sheet) and other restrictions as mentioned in the Prudential Regulations. Now what indicates that Credit Risk is increasing for the Banks is the NPLR(Non Performing Loans Ratio) which indicates that the financing generated by the banks are not recovering and as such the Non performing Loans are increasing which ultimately leads to Credit Risk. (Nasr, 2009) CAPITAL TO ASSETS RATIO It measures the Ratio of a Banks Book value of core Capital to the Assets book value. The Lower this Ratio, the more highly leveraged the bank is. Primary or core Capital Banks common Equity (book value) and perpetual preferred stock plus minority interests in consolidated subsidiaries (Cornett). RISK IN BANKS As Banks perform different financial services to their Clients they face many types of risk. There are number of assets in a banks Portfolio which are subject to different types of risks, such as default or Credit Risk. As Banks expand their services, they are exposed to foreign exchange risk. When the Assets and Liabilities in the Balance Sheet of Banks mismatch, they are further exposed to a risk known as Interest Rate Risk. If financial institutions actively trade these assets they are further exposed to Market Risk or asset price risk. Increasingly FIs hold contingent assets and liabilities off the balance sheet which represents off balance sheet risk, Moreover some all Financial Institution and Banks are exposed to some degree of Liability or withdrawal which exposes them to Liquidity risk. Finally the Risk that the Bank may not have enough Capital reserves to offset a sudden loss incurred as a result of one or more of the risks they face creates insolvency risk for the Banks. ( HOUSTON, 2008) CREDIT RISK MANAGEMENT Capital Adequacy Ratio (CAR) is used by Regulators of Banking System to assess the Banks financial Position especially the Capital to Assets Ratio as it does not falls below the required level so the bank is stable enough against the losses. State Bank of Pakistan the Regulator of Commercial Banks in Pakistan Monitor the Capital Adequacy Ratio of Commercial Banks to Provide Protection to the Depositors. A minimum Capital Ratio affects the leverage of Commercial Bank since highly leverage commercial Banks are more towards the chance of Credit and Interest rate risk and ultimately falling into Bankruptcy There are major 2 types of Capital for Banks. Tier-I Capital is closely linked to banks book value of equity, reflecting the contribution of a banks owners. Tier two is a broad array of secondary capital resources, which includes the loan reserves upto 1.25 % of risk adjusted assets plus various debt instruments. BENEFITS OF CAPITAL ADEQUACY RATIO In the initial Phase capital adequacy ratio does not take into account different risk Profiles of different class of Money market instruments, since some assets are highly risky and some debt instruments are almost risk free, such as Government bonds, where as the some instruments such as loans granted to Individual by a commercial bank can result in a default which accounts for Risk. So the advantage of Capital adequacy is as it takes into account risk profiles of all investment. (Schweser, 2008) BANKING REGULATIONS IN PAKISTAN The banks in Pakistan works under the BANKING COMPANIES ORDINANCE, 1962 (L VII OF 1962) and THE BANKING COMPANIES RULES 1963 made under the ordinance. (As amended up to 30th June, 2007) (State Bank of Pakistan, 2007)) METHODOLOGY RESEARCH APPROACH While doing the research, we are focusing on our research task and not to go beyond our specified boundary. Thus, were using deductive approach. We are also referring previous researches and theories related to our field of interest because we are studying a general phenomena i.e. relationship between profitability and credit risk management in conventional banking system of Pakistan. We are using quantitative method of study. We analyze the data with the help of regression model and the annual reports of the selected banks. The regression output makes us answer our research question. RESEARCH RESIGN We are conducting the research based on two factors i.e. profitability of banks and credit risk management thats why the design of research is co-relational. Our research will explain the relationship between the two and how credit risk management affects the profitability of banks in Pakistan. RESEARCH STRATEGY We are identifying the impact of credit risk management on profitability and For it, we have adopted the strategy of taking help from the previous records, studies and researches in this field and the statistics and data required for performing the test is obtained from the annual reports of the respective banks available on their websites. SAMPLING The population for the research consists of 20 private commercial banks out of the 54 banks operating in Pakistan. All the 20 chosen banks are working under conventional banking system as we are only focusing on conventional banks and all other banks such as Islamic banks, investment banks, micro-finance banks and public sector banks are not included in our research. The reason for this is to appropriately focus on one sector. On the basis of random sampling, 15 commercial banks are selected: Habib bank Ltd, MCB Bank ltd, Allied Bank Ltd, United Bank Ltd, Standard Chartered, Bank Alfalah, Faysal Bank Ltd, Bank Al-Habib, NIB Bank ltd, My Bank, RBS, Atlas bank, Arif habib Bank, Habib Metropoliton bank, JS Bank and Askari Bank ltd. In this research we are establishing the relation between profitability and credit risk management after implementation of BASEL II in Dec2006, therefore data is obtained from annual reports of 2007 to 2009. There are total 30 observations for each of the var iable used in this research. DATA COLLECTION Data and statistics for the tests are obtained from annual reports of 2007 to 2009. Well consider credit risk management disclosure, financial statements and notes to financial statements within the annual reports of the sample banks. RESEARCH INSTRUMENTS No research instrument is required in our research because the data used to conduct tests is secondary obtained from the annual reports of the banks from 2007 to 2009. DATA ANALYSIS Multiple regression analysis is used in our research i.e. the relationship of one dependent variable to multiple independent variables. The regression outputs are obtained by using SPSS APPLIED REGRESSION MODEL Dependent variable ROE and independent variables NPLR and CAR are considered in our study and all of them are numeric type. Therefore, multiple linear regression model is applied. DEPENDENT VARIABLE In many of the previous researches, ROE is used for the profitability of banks, Therefore, we have also used it as the indicator of profitability in the regression analysis.. According to Foong Kee K. (2008) indicated that the efficiency of banks can be measured by using the ROE which illustrates to what extent banks use reinvested income to generate future profits. INDEPENDENT VARIABLE NPLR and CAR are the indicators of credit risk management and they chosen as the independent variables because credit risk management affects the profitability of banks. NPLR, in particular, indicates how banks manage their credit risk because it defines the proportion of NPL amount in relation to TL amount. NPL amount is provided in the Notes to financial statements under Loans section. And the total loan amount is provided in the balance sheet of the banks in their annual reports. TL amount, the denominator of the ratio, has been gathered by adding two types of loans: loans to institutions and loans to the public. Thus, calculation of the NPLR has been accomplished in following way: NPLR = (NPL amount) Ã · (TL amount) CAR, CAR is regulatory capital requirement (Tier 1 + Tier 2) as the percentage of Risk weighted asset. The bank has to maintain a specific percentage of CAR to manage their Credit risk according to requirement of State bank of Pakistan. The minimum requirement for Banks on consolidated as well as standalone basis has been increased to 10%. RELIABILITY AND VALIDITY While doing the research two concepts must be taken into account i.e. reliability and validity. Reliability refers that the data is consistent and whatever be the conditions, it would be remain same. But its not necessary that every reliable and consistent data is valid. If we have any systematic error in the instrument then every time it would be encountered in the measurement, thus the observations would be reliable but not valid. In our research, we have taken the data from the annual reports of banks available at their websites. These are the official reports made by the rigorous efforts by the management of banks and authenticated by the higher management; therefore the facts and figures in it would be valid as well as reliable and will help us in getting true results. CONCLUSION The aim of the study is to determine the impact of credit risk management on profitability. It is important to note that sample size represents 75% of the total population i.e. private commercial banks. That covers the major portion of the population, giving more accurate results. The results obtained from the regression model show that there is an affect of credit risk management on profitability on reasonable level with 41.8% possibility of NPLR and CAR in predicting the variance in ROE. So, the credit risk management strategy defines profitability level to an important extent. Especially, NPL amount appears to be adding the most weight to that than CAR. CAR is having negative impact on ROE, but on the other hand the significance value of CAR is 0.171which is greater than the p-value i.e. 0.05, which means that the value of coefficient for CAR is zero, making the affect of CAR on ROE nil. Only NPLR is significantly affecting the value of ROE. In the end it is to be recommended that bank should focus on maintaining and controlling amount of non performing loans to ultimately getting higher ROE, which ensures the better profitability.