Risk can be basically defined as the degree of uncertainty of net future returns. Those interacting in the financial markets will usually face different types of risks since uncertainty come in several ways. This is the reason why uncertainty is used as a source to classify risk.
David H.Phyle (1997) defined risk as a fall in a firm's value because of the changes in the dynamic business environment. In my study, I will be focusing mainly on credit risk.
The Monetary Authority of Singapore (2006) has defined credit risk as the "risk arising from the uncertainty of an obligor's ability to meet its contractual obligations."
Regarding the importance of this kind of financial risk, Kaminski and Reinhart, as cited by Jackson and Perrraudin (1999) think of it to be the largest element of risk in the books of most banks and if not managed in a proper way, can weaken individual banks or even cause many episodes of financial instability by impacting on the whole banking system. In the same line, according to M.J Mc Donough (1999) "credit risk remains the predominant risk for most banks".
Since this risk carries the potential of wiping out enough of a bank's capital to force it into bankruptcy, managing this kind of risk has always been one of the predominant challenges in running a bank (Broll, Pausch and Welzel, 2002).
The question of how to measure and manage credit risk is an ever debatable one. In fact, different authors have expressed differ Suresh N, Anil Kumar S, and Gowda D.M (2009) conducted a study to establish a framework for measuring and managing credit risk for fifteen private banks in India. The main aim of the research was to evaluate the Non Performing Assets (NPAs) as a percentage of total assets of private banks. It was concluded that the NPAs level of private banks had a decreasing trend and by comparing the critical values, it was found that homogeneity does not exists among banks with their credit exposures.
In addition, Xiuzhu Zhao (2007) studied the credit risk management in the major British banks. He found that the UK banks are generally maintaining same level of credit exposure from 2004 to 2006. In fact, following the analysis, he argued that the major British banks with larger size have managed credit risk in a more comprehensive manner when compared to the smaller banks. He further argued that the larger banks follow the Basel guidelines better and have adopted different means for assessing, granting and mitigating credit risk.
Prof Rekha Arunkumar and Dr. G. Kotreshwar (2004) also conducted a study on risk management in commercial banks and investigated upon both public and private sector banks in India. They concluded that banks need to develop a competitive Early Warning System (EWS) combining strategic planning, competitive intelligence and management action in order to provide for better management of credit risk.
Capital and profitability
The issue whether capital requirements limit or enhance bank performance and stability is largely dealt with in theory. To protect the banking system, it is argued that banks must invest prudently. In the same line, there is the introduction of the capital adequacy regulations which enable banks to better face negative shocks. It should be noted that these rules may also cause a shift of loans provisions from private sector to public sector. Banks can comply with capital requirement ratios either by decreasing their risk weighted assets or by increasing their capital.
Various studies have been performed to establish the relationship between capital and profitability.
Anna P. I. Vong and Hoi Si Chan (2006) studied the determinants of profitability in Macao. They concluded that "banks with more equity capital are perceived to have more safety and such an advantage can be translated into higher profitability".
This confirms the study of Goddard, Molyeux and Wilson (2004). They analyzed the determinants of profitability of European banks and found a considerable endurance of abnormal profits from year to year and a positive relationship between the capital-to-asset ratio and profitability.
In the same line, a study by Demirguc-Kunt and Huizinga (1999) reveals that capital requirement has indeed an effect on the incentives that bank face. They confirmed that there is a positive relationship between capitalization and profitability.
In addition, Samy and Magda (2009) focus on the impact of capital regulation on the performance of the banking industry in Egypt. Their study provides a framework to measure the effects of capital adequacy on indicators of bank performance. They concluded that as "Capital Adequacy Ratio internalizes the risk for shareholders; banks increase the cost of intermediation, which supports higher return on assets and equity. Nonetheless, the evidence does not support the hypothesis of a sustained effect of capital regulations over time, or variation in the effects with the size of capital across banks."
Non Performing Loan ratios (NPLs)
Nonperforming loans are loans, especially mortgages, which organizations lend to borrowers but do not capitalize on. In other words, the borrower cannot pay the loan back in full, or even enough for the bank to make a profit.
According to the IMF paper (2001), poor risk management and plain bad luck in form of external independent factors are the two main causes of NPLs. In fact, there is abundant evidence that the financial/banking crises in East Asia and Sub-Saharan African countries were preceded by high non-performing loans. The current global financial crisis, which originated in the US, was also attributed to the rapid default of sub-prime loans/mortgages.
NPL amount can therefore be qualified as an indicator of increasing threat of insolvency and failure. It is argued that financial markets with high NPLs must diversify their risk and create portfolios with NPLs along with performing loans. In this respect, Germany was one of the leaders of NPL markets in 2006 because of its sheer of its "sheer size and highly competitive market." Also, Czech Republic, Turkey and Portugal are noticeable NPL markets in EU according to Ernst &Young's Global Non-performing Loan report (2006).
Brewer et al. (2006) use Non Performing Loan Ratio as an important economic indicator. Efficient credit risk management implies that lower Non Performing Loan Ratio is associated with lower risk and lower deposit rate. However, it also implies that in the long run, relatively high deposit rate increases the deposit base in order to fund high risk loans. This increases the possibility of Non Performing Loans. The study shows that "the allocation of the available fund and its risk management heavily depend on how the credit risk is handled and diversified to decrease the NPL amount."
Risk management and profitability
Numerous studies have been performed to establish the relationship between risk management and its impact on the profitability of banks.
Takang Felix Achou and Ntui Claudine Tenguh (2008) studied the link between bank performance and credit risk in Qatar. The main concern of their thesis was to determine to what extent banks can manage their credit risk and to what extent their performance can be amplified by proper risk management policies. They did a time series analysis of a 5 year financial data to attain their research objective. The study showed that indeed there is a significant relationship between profitability and credit risk management. They argued that better credit risk management leads to better bank performance. In other words, they argued that banks with good policies on credit risk management have lower loan default ratios (bad loans) and higher interest income (profitability). Furthermore, the study revealed that there is a direct but inverse relationship between profitability and the ratio of non performing loans to capital. They concluded that conclusion that banks with higher interest income have lower non-performing loans, hence good credit risk management strategies.
This confirms the work of Sam Hakim and Simon Neaime (1998) who investigated the performance and risk in Egyptian and Lebanese banks. They used annual observations of 43 Lebanese and 62 Egyptian banks and analyzed same using a panel data estimation technique. The study revealed that "return on equity in banking is a direct and an increasing function of the bank's lending activities irrespective of Lebanon and Egypt."
In addition, Mohamed Amidu and Robert Hinson (2006) analysed how credit risk affects a banks' capital structure, profitability and lending decisions in Ghana. Panel regression analysis is used to achieve the research objective. The results showed that there is a positive relationship between risk and equity capital. The results support earlier studies, as the study reveals that larger banks enjoy lower capital ratios and higher lending. They also argued that there is a negative relationship between bank size and capital. Firm's size plays a significant role in determining the credit risk level of banks in Ghana. The results show that larger banks have higher credit risk. The study also shows that, banks that are exposed to higher credit risk turn to have larger equity capital, low liquidity and lower profits.
Another study to determine impact of risk management and profitability is that of Ara Hosna, Bakaeva Manzura and Sun Juanjuan (2009). They studied the relationship between risk management and profitability of Sweden's commercial banks. The proxy used to determine profitability is Return on Equity and that for credit risk management are Non Performing Loan Ratio and Capital Adequacy Ratio. They argued that indeed there is an effect of credit risk management on profitability on reasonable level with 25.1% possibility of Non Performing Loan Ratio and Capital Adequacy Ratio in predicting the variance in Return on Equity.
The above is consistent with static frame model that the more likely a firm is exposed to risk, the greater their incentive to reduce their level of debt within the capital.
