This study investigates the impact that credit risk has on bank performances in Mauritius. The proxies used in the study are Non Performing Loan Ratio and Capital Adequacy Ratio to estimate credit risk and Return on Equity to estimate profitability level. For the purpose of the study, a sample of four banks: two major domestic and two major international banks were chosen and data were collected over a period of 10 years. Using data for empirical investigations from the financial statements banks over the period 2001-2010, a fixed effect model of banks' returns was specified and estimated with varying intercepts and coefficients.
The empirical findings of the impact of credit risk management on profitability in our sample suggest the following conclusion. First, there is a negative and significant impact of Non Performing Loan on the level of Return on Equity. This implies that the level of profitability is affected extensively by the level of non performing loans in Mauritius. In fact, high levels of non performing loans leads to a reduction in the liquidity and credit expansion of banks with direct consequences on the performance on banks. High levels of NPLR necessitate banks to increase their provisions for loan loss. This leads to a reduction in the revenue and hence, the profitability level decreases.
Second, there is a negative effect of Capital Adequacy Ratio on the level of profitability, with a strong insignificant coefficient. A higher Capital Adequacy Ratio may result in higher profits in absolute terms but not necessarily a higher percentage of Return on Equity. This is because capital represents a sunk cost and serves both as a moderator against unforeseen events and holds back the institution from delivering the high percentage returns. This is mainly because Mauritian banks are required to abide by stricter requirements of holding 10% of Capital Requirement instead of 8% as provided for in Basel Accord. Contrary to what has been reported with surprising frequency in the past, this study finds that there is no significant relationship between capital and profitability in banking. Higher CAR implies that more capital is tied up the bank. This obstructs the credit creation capacity of banks; and less credit creation implies low level of profits.
To summarize, this study shows that there is a significant relationship between bank performance (in terms of profitability) and credit risk management (in terms of loan performance). It should be highlighted that in the case of Mauritian banks under sample, it is found that there is no significant relationship between capital adequacy ratio and return on equity. Better credit risk management results in better bank performance.
In its endeavour to modernize the banking system, the Bank of Mauritius should provide a platform to inform, share and provide expertise to all the banks and ensure that regulations on proper disclosure are respected and there should be no exception to the rule.
Limitation of Study
It is important to note that there are some limitations with respect to the analysis and data that may affect the accuracy of the results. Firstly, the sample size though satisfactory is not credible enough to extend the results to all commercial banks in Mauritius. The results, therefore, refer only to the sample of the study. In addition, due to time constraint and data availability, the study is based on secondary quantitative data. The research topic could have been further dealt with if a survey was conducted at the credit risk management level of banks. Furthermore, it is important to note that the Mauritian banking sector is an oligopolistic market where two banks, MCB and SBM Ltd hold a major percentage of market shares. The risk attitude of these two banks have a prominent effect on the overall banking sector performance. Adding to this is the fact that the level of profitability is assumed to be dependent on the non performing loan ratio and the capital adequacy ratio. In fact, there are omitted variables of bank performance which could have been included in the model. This includes liquidity ratio; equity ratio and external determinants like GDP growth, interest rate and inflation.
Recommendation
Due to time constraints and data availability, the model in this study does not include variables like liquidity ratios and equity ratios. Previous studies, however, showed evidence that these omitted variables have an impact on bank's profitability. Therefore, this study could be further developed by including more independent variables to the regression model in order to spot more potential influential factors.
Moreover, if this study was supported with qualitative study of credit risk management, the findings would be more objective and informative. The Risk Managers and members of Risk Management Committee of the sample banks can be interviewed to understand the current practices and functioning of the credit risk management departments of the banks.
In addition, further research could be done by increasing the sample size of this study. More banks in the sample imply that the results obtained can be extended to the banking industry.
The study also recommends the development of quantitative modeling of models to enable the analysis of changes in economic business and market environments of the bank's risks profile and the impact that these may have on the banks' profitability. Computer models, therefore, can be used to carry out sophisticated analysis of the risk profile of banks.
