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Credit Risk Management


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This section discusses some empirical and theoretical literature on the effect of credit risk management on financial performance, and introduces an overview of BancABC and its credit risk management practices 2.2Brief Company overview
ABC Holdings Limited is the parent company of a number of banks operating under the BancABC brand in Sub-Saharan Africa, with operations in Botswana, Mozambique, Tanzania, Zambia and Zimbabwe. A group services office is located in South Africa.Historically, BancABC was a merchant bank offering a diverse range of services including wealth management, corporate banking, treasury services, leasing, asset management, and stock broking.ABC Holdings had Its primary listing on the Botswana Stock Exchange, and a secondary listing on the Zimbabwe Stock Exchange (BancABC annual report 2009)

During 2014, the ABC Holdings Group was acquired by Atlas Mara. As at 31 December 2014, Atlas Mara had a 98.7% equity stake in ABC Holdings, held directly (60.8%) and indirectly (37.9%). Subsequent to the takeover, ABC Holdings was delisted from the Botswana Stock Exchange on 30 January 2015, and from Zimbabwe Stock Exchange on 12 February 2015.Atlas Mara is a British Virgin Islands registered company with a standard listing on the London Stock Exchange(BancAbc Annual report 2014) The seeks to review the credit risk management methods implemented by the bank
Definition of terms 2.3.1Credit According to Onyeagocha (2001), the term credit is used specifically to refer to the faith placed by a creditor in a debtor by extending a loan usually in the form of money, goods or securities to a debtor .According to Onyeagocha‘sview for a bank to grant some credit to its client there should be element of creditworthiness on the part of the borrower.
Credit can also be defined as a transaction between two parties in which the creditor or lender supplies money, goods and services or securities in return for promised future payments by the debtor or borrower.Kamla-Raj 2010 J Economics, 1 (2010) from the definitions mentioned above one can easily ascertain that credit entails some risk especially in markets where there is a lot of information asymmetry.

2.3.2 Risk is the uncertainty or probability that a negative event occurs. Many authors and scholars define risk in different ways but all views seem to share a common aspect that risk is probability of loss .Risk means the possibility of losing the original investment and the amount of interests accrued on it. Risk can be explained further as the position where the actual return of an investment are different from expected return (Gestel Baesens 2008), this shows that as long as there is a possibility of loss there is risk. Risk means the possibility of losing the original investment and the amount of interests accrued on it.(Investment Management and Financial Innovations Volume 1)

2.1.3Credit risk is the risk that money owed is not repaid; it is unarguably the principal and perhaps the most important type of risk that has been present in finance, commerce and trade transactions from ancient cultures till today (GestelBaesens 2008). (Campbell, 2007) defines credit risk as 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, there is credit risk if there is probability of non-payment. According to the Reserve bank of Zimbabwe (RBZ) risk management operating document (2004) credit risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial transaction The most crucial assets of banks are loans and bonds whilst major liabilities are customer deposits this entails that as long as a bank lends to customers it is most likely going to face some form of credit risk therefore this risk needs to be managed. Chen and Pan (2012) further defined credit risk as the extent of value fluctuation of loans and derivatives due to change in the credit quality of borrowers and counterparts these fluctuations may be caused by political, economic, social, technological, environmental and legal factors. Coyle (2000) then goes on to define credit risk as inability or refusal of customer to pay what he is owing.

Credit risk is the most obvious risk that banks face because of the nature of their business activities. In terms of potential losses, it is typically the largest type of risk, this is because the default of a small number of customers may result in huge loss for the bank especially if there is high debt concentration Cornett and Saunders (2005), therefore to ensure that financial institutions are in good health, credit risk needs to be managed effectively because if bank makes bad loans to customers, the bank will face serious problems if those loans are not repaid.

An analysis of credit administration in Commercial banks
2.4.1Credit administration is concerned with gathering, analyzing, and presenting data, monitoring the loan portfolio, maintaining files and databases and administering credit processes action plans using the credit controls (microwave briefing number 21 Robert Dressen and Samson Odele) (Egbe, 2011) goes on to define credit Administration as the management of loan portfolio, which involves evaluation of loan proposal as well as appraising the capacity of borrowers and the disbursement and monitoring of loan. Credit administration can further be defined as standards and practices followed in extending servicing, and collecting loans, Factors such as loan purpose, size, type, and complexity, the borrower’s financial condition, earnings history, intrepidity, and ability; and the impact of macro economic conditions on the institution’s territory influence . (guidelines for commercial banks and DFI 1999). Credit administration can go a long way to determine the profitability of banks because credit department has become a vital function of banking operations due to its direct effects on profitability and business development.

Credit administration in commercial banks help to reduce risks of delinquency and default. An efficient loan appraisal system is very important in this respect, loan appraisal is the process of determining in advance the various lending parameters and determining investment opportunities available to borrowers that remain unexploited if they want credit, loan appraisal also involves determination of overall loan limit for each borrower based on his debt capacity; loan duration The Credit Administration Department’s responsibility is to make sure that all financing facilities are well documented and fully cover Pak Oman’s exposure. . Credit administration function is basically a back office activity that supports and controls extension and maintenance of credit. Credit administration performs following functions (guidelines for commercial banks and DFI 1999)

Documentation. Credit administration is responsible for ensuringcompleteness of documentation (loan agreements, guarantees, transfer oftitle of collaterals in accordance with approved terms and conditions. Outstanding documents should be tracked and followed up to ensureexecution and receipt.
Credit Disbursement. The credit administration function should ensure that the loan application have proper approval before entering facility limits into computer systems the department ensures that disbursement are effected only after the completion of covenants and receipt of collateral holdings. In case of exceptions necessary approval should be obtained from relevant authorities authorities.
Credit monitoring. After loan is approval and draw down allowed, the loan should be continuously watched over. These include keeping track of borrower’s compliance with credit terms, identifying early signs of irregularity, conducting periodic valuation of collateral and monitoring timely repayments.
Loan Repayment. The obligors should be communicated ahead of time as and when the instalment becomes due. Any exceptions such as non-payment or late payment should be tagged and communicated to the management. Proper records and updates should also be made after receipt.
Maintenance of Credit Files. Institutions should devise procedural guidelines and standards for maintenance of credit files. The credit files not only include all correspondence with the borrower but should also contain sufficient information necessary to assess financial health of the borrower and its repayment performance. Information should be filed in an organized way so that external / internal auditors or RBZ inspectors could review it easily.
Collateral and Security Documents. Institutions should ensure that all security documents are kept in a fireproof safe under dual control. Registersfor documents should be maintained to keep track of their movement. procedures should also be established to track and review relevantinsurance coverage for certain facilities/collateral. Physical checks onsecurity documents should be conducted on a regular basis.( guidelines for commercial banks and DFI) Credit administration entails more than credit risk management is also concerned with rewards and risks that have to be objective through cautious and careful risk management, failure of which may possibly bring about legal action, economic loss or harm the banks’ name (Reserve Bank of Zimbabwe (RBZ) Guideline No. 1, 2006; and as citied in Mavhiki, Mapetere, &Mhonde, 2012)
Analysis of credit risk management
2.5.1Credit risk management is defined as the identification, measurement, monitoring and control of risk arising from the possibility of default in loan repayments (Early, 1996; Coyle, 2000). It also involves mitigating credit losses by understanding the adequacy of both a bank’s capital and loan loss reserves at any given time, this is a process that has long been a challenge for financial institutions ( . Effective management of credit risk is inextricably linked to the development of banking technology which will enable an increase in the speed of decision making and simultaneously reduce the cost of controlling credit risk. This requires a complete base of partners and contractors (Lapteva, 2009).Credit risk is one of the most significant risks that banks face because of the nature of their activities and through effective management of credit risk exposure, banks not only support the viability and profitability of their own business but also contribute to systemic stability and to an efficient allocation of capital in the economy (Psillaki, Tsolas, and Margaritis, 2010, p. 873).
Credit risk management is important to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolios as well as the risk in individual credits or transactions (.Basel 2000) For most banks, loans are the largest and most obvious source of credit risk, however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Banks are increasingly facing credit risk or counterparty risk in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension ofcommitments and guarantees, and the settlement of transactions

2.5.2Credit risk management principles under Basel committee

Principle 1: The board of directors should have responsibility for approving and periodically (at least annually) reviewing the credit risk strategy and significant credit risk policies of the bank. The strategy should reflect the bank’s tolerance for risk and the level of profitability the bank expects to achieve for incurring various credit risks.
Principle 2: Senior management should have responsibility for implementing the credit risk strategy approved by the board of directors and for developing policies and procedures for identifying, measuring, monitoring and controlling credit risk. Such policies and procedures should address credit risk in all of the bank’s activities and at both the individual credit and portfolio levels.
Principle 3: Banks should identify and manage credit risk inherent in all products and activities. Banks should ensure that the risks of products and activities new to them are subject to adequate risk management procedures and controls before being introduced or undertaken, and approved in advance by the board of directors or its appropriate committee.
Operating under a sound credit granting process
Principle 4: Banks must operate within sound, well-defined credit-granting criteria. These criteria should include a clear indication of the bank’s target market and a thorough understanding of the borrower or counterparty, as well as the purpose and structure of the credit, and its source of repayment.
Principle 5: Banks should establish overall credit limits at the level of individual borrowers and counterparties, and groups of connected counterparties that aggregate in a comparable and meaningful manner different types of exposures, both in the banking and trading book and on and off the balance sheet.
Principle 6: Banks should have a clearly-established process in place for approving new credits as well as the amendment, renewal and re-financing of existing credits.
Principle 7: All extensions of credit must be made on an arm’s-length basis. In particular, credits to related companies and individuals must be authorised on an exception basis, monitored with particular care and other appropriate steps taken to control or mitigate the risks of non-arm’s length lending. Maintaining an appropriate credit administration, measurement and monitoring process
Principle 8: Banks should have in place a system for the ongoing administration of their various credit risk-bearing portfolios.

Principle 9: Banks must have in place a system for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves.
Principle 10: Banks are encouraged to develop and utilise an internal risk rating system in managing credit risk. The rating system should be consistent with the nature, size and complexity of a bank’s activities.
Principle 11: Banks must have information systems and analytical techniques that enable management to measure the credit risk inherent in all on- and off-balance sheet activities. The management information system should provide adequate information on the composition of the credit portfolio, including identification of any concentrations of risk.
Principle 12: Banks must have in place a system for monitoring the overall composition and quality of the credit portfolio.
Principle 13: Banks should take into consideration potential future changes in economic conditions when assessing individual credits and their credit portfolios, and should assess their credit risk exposures under stressful conditions. Ensuring adequate controls over credit risk
Principle 14: Banks must establish a system of independent, ongoing assessment of the bank’s credit risk management processes and the results of such reviews should be communicated directly to the board of directors and senior management.
Principle 15: Banks must ensure that the credit-granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits. Banks should establish and enforce internal controls and other practices to ensure that exceptions to policies, procedures and limits are reported in a timely manner to the appropriate level of management for action.
Principle 16: Banks must have a system in place for early remedial action on deteriorating credits, managing problem credits and similar workout situations.
The role of supervisors
Principle 17: Supervisors should require that banks have an effective system in place to identify measure, monitor and control credit risk as part of an overall approach to risk management. Supervisors should conduct an independent evaluation of a bank’s strategies, policies, procedures and practices related to the granting of credit and the ongoing management of the portfolio. Supervisors should consider setting prudential limits to restrict bank exposures to single borrowers

2.5.3Methods implemented by banks in mitigating and hedging against credit risk

a) Credit derivatives: A derivative is an instrument whose value depends on the value of something else and due to the evolution of the banking industry, credit derivatives are used as means of transferring credit risk from one obligor to another, while allowing client relationships to be maintained.(Credit Suisse first Boston) According to the Group of Thirty (1993)derivatives are contract whose value depends on ,or derives from the value of an underlying asset, reference rate or index. Peter Skerrit and Associates (2003) defined a derivative as an instrument which embodies different terms, rights, or obligations, to those prevailing in the ‘underlying market’, ‘cash’, or ‘physical’ market to which the instrument relates .in short the purpose of a credit derivative is to hedge against credit risk..Effenberger (2004) further defined credit derivatives as financial instruments that isolate, and then transfer to investors, the credit risk generated in lending transactions. These investors act as protection sellers, agreeing to cover the cost if a pre-defined credit event occurs. Hull (2001) then defined, credit derivatives as contracts where the payoff depends on the creditworthiness of one or more commercial or sovereign entities. Hull went to say that credit derivatives provide a market in which default insurance can be sold by applying this technique banks do not need to adjust their credit risk. Banks can reduce their capital regulated by them by using these derivatives. Most common of these derivatives is credit default swap in which the seller shifts the credit risk to a protection buyer of loan portfolio risk. with the help of this security banks lend more vigorously even to potentially less reliable clients as their risk is being borne by certain other party. Recently use of credit derivatives by financial institution has increased remarkably.(Basel II credit risk schedule part D)
b)Credit Securitization: Asset securitizations involve the packaging of assets into a bond, which is then sold toinvestors, securitisation can also be defined as the issuance of marketable securities backed not by the expected capacity to repay of a private corporation or public sector entity, but by the expected cash flows from specific assets [OECD (1995)].By using this method banks can shift their credit risk to an insurance or factor firm and by doing so banks do not need to worry about monitoring and evaluation of borrowers and to tackle the classified loan fear. This instrument has become very popular because it enable banks to diversify their concentration of credit risk and provide an alternative source of funding to banks and also equip bank with liquidity and arbitrage opportunity. This is one of the unique ways banks loans are eliminated from balance sheet of banks and are converted into marketable securities and then these securities are sold and traded in the market through an arrangement called the special purpose vehicle (Marsh 2008) however securitisation needs to be done in compliance with Basel accords that is. Banks must apply the securitisation framework for determining regulatory capital requirements on exposures arising from traditional and synthetic securitisations or similar structures that contain features common to both. Since securitisations may be structured in many different ways, the capital treatment of a securitisation exposure must be determined on the basis of its economic substance rather than its legal form. Similarly, supervisors will look to the economic substance of a transaction to determine whether it should be subject to the securitisation framework for purposes of determining regulatorycapital (Basell III documents 2014 c)Credit Reference Bureau: In Zimbabwe it is called the financial clearing bureau (FCB) it is Zimbabwe's leading credit clearing and reference bureau. It was formed in 1990 and since then it has serviced the financial services sector's credit clearing and referencing needs FCB membership is open to all types of credit providers that need to vet customers; these include banks, private and public companies FCB data includes negative records regarding bad debts, civil judgments and criminal records (www. BancABC Zimbabwe is a member of FCB and all loan applications are vetted using this system before approval. This helps lenders assess credit worthiness, the ability to pay back a loan, and can affect the interest rate applied to loans. The bureau also awards credit score called statistical odd to the borrower which makes it easy for banks to make instantaneous lending decisions (Kakapo, et al., 2012).

2.5.4Credit risk management methods implemented by BancABC
BancABC uses the IRB approach in managing credit risk
The IRB approach is defined shortly as a process of classification of debtors in categories of different grades of non-payment risk (Foglia etal. 2001).

BancABC internal ratings model Performing | The credit appears satisfactory | Special mention | The credit appears satisfactory but exhibits potential or inherent weaknesses which, if not attended to, may weaken the asset or prospects of collection in full, e.g. poor documentation or 30 days but less than 90 days in arrears | Sub-standard | The credit has defined weaknesses that may jeopardize liquidation of the debt, i.e. the paying capacity of the borrower is doubtful or inadequate, or more than 90 days but less than 180 days in arrears | Doubtful | Credit facilities with above weaknesses and has deteriorated further to the extent that even with the existing security, full recovery will not be possible, or 180 days but less than 12 months in arrears | Loss | Facilities considered impossible to collect with little or no realizable security, or more than 12 months in arrears |

BancABC manages limits and controls concentrations of credit risk in respect of individual, counterparties and groups, and to industries and countries. The Bank structures the levels of credit risk it undertakes by placing limits on the amount of risk accepted in relation to one borrower, or groups of borrowers, and to geographical and industry segments. Such risks are monitored on a revolving basis and subject to an annual or more frequent review, when considered necessary. Limits on the level of credit risk by product, industry sector and by country are approved by the Board of Directors, and reviewed regularly. Exposure to credit risk is also managed through regular analysis of the ability of borrowers and potential borrowers to meet interest and capital repayment obligations and by changing these lending limits where appropriate.

BancABC credit risk control and mitigation measures are outlined below.

a)Collateral the bank employs a range of policies and practices to mitigate credit risk. The most traditional of these is the taking of security for funds advanced, which is common practice in modern banking business. The group implements guidelines on the acceptability of specific classes of collateral for credit risk mitigation. The principal collateral types for loans and advances are, * cash collateral , * charges over assets financed * mortgages over residential and commercial properties * charges over business assets such as premises, inventory and accounts receivable * charges over financial instruments such as debt securities and equities. Loans and advances to corporates are generally secured. In addition to this and in order to minimize credit loss, the Group will seek additional collateral from the counterparty as soon as impairment indicators are noticed for the relevant individual loans and advances. Collateral held as security for financial assets other than loans and advances is determined by the nature of the instrument. Debt securities, treasury and other eligible bills are generally unsecured, with the exception of asset-backed securities and similar instruments, which are secured by portfolios of financial instruments.(BancABC annual report 2014)
b) Master netting arrangements the Bank restricts its exposure to credit losses by entering into master netting arrangements with counterparties with which it undertakes a significant volume of transactions. Master netting arrangements do not generally result in an offset of balance sheet assets and liabilities, as transactions are usually settled on a gross basis. However, the credit risk associated with favorable contracts is reduced by a master netting arrangement to the extent that if a default occurs, all amounts with the counterparty are terminated and settled on a net basis. The Bank’s overall exposure to credit risk on derivative instruments subject to master netting arrangements can change substantially within a short period, as it is affected by each transaction subject to the arrangement. .(BancABC annual report 2014)
c)Credit related commitments primary purpose of these instruments is to ensure that funds are available to a customer as required. Guarantees and standby letters of credit carry the same credit risk as loans. Documentary and commercial letters of credit – which are written undertakings by the Bank on behalf of a customer authorizing a third party to draw drafts on the bank up to a stipulated amount under specific terms and conditions they are collateralized by the underlying shipments of goods to which they relate and therefore carry less risk than a direct loan. Commitments to extend credit represent unused portions of authorizationsto extend credit in the form of loans, guarantees or letters of credit. With respect to credit risk on commitments to extend credit, the Group is potentially exposed to loss in an amount equal to the total unused commitments. However, the likely amount of loss is less than the total unused commitments, as most commitments to extend credit are contingent upon customers maintaining specific credit standards. The bank monitors the term to maturity of credit commitments because longer-term commitments generally have a greater degree of credit risk than shorter-term commitments.

d)Derivatives the bank maintains strict control on net open derivative positions that is, the difference between purchase and sale contract by both amount and term. The amount subject to credit risk is limited to expect future net cash inflows of instruments, which in relation to derivatives are only a fraction of the contract, or notional values used to express the volume of instruments outstanding. This credit risk exposure is managed as part of the overall lending limits with customers, together with potential exposures from market movements. Collateral or other security is not always obtained for credit risk exposures on these instruments, except where the Group requires margin deposits from counterparties however in Zimbabwe the use of derivatives has been very minimal.
2.5.5 Components of credit risk
Probability of Default (PD)
It is the likelihood that the borrower will fail to make full and timely repayment of his/her financial obligations (GARP 1999) The probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a client of a financial institution will be unable to meet its debt obligations. The PD is a key parameter used in the calculation of economic capital or regulatory capital in the Basel II for a banking institution.
Exposure At Default (EAD) The expected value of the loan at the time of default (GARP 1999)

Loss given default (LGD) it is defined as the ratio of losses to exposure at default once a default event has occurred. Loss given default includes three losses (W Schuermann 2004) * The loss of the principal * The carrying costs of non-performingloans. That is interest income foregone * Workout expenses collection and legal
Maturity (M) The date when the loan is due and payable

Expected loss is not a risk; it is a costof doing business. The price of a transaction must cover expected loss. When a bank makes a number of loans, it expects some percentage of them to default, resulting in an expected loss due to default.

Unexpected loss is a risk associated with being in the business, rather than a cost of doing business. The price of a transaction should be large enough to cover expected losses and not unexpected losses this is because an unexpected loss is not a cost of doing business it’s a risk. However since capital provides the cushion for that risk, this transaction is going to attract some economic capital for the risk involved. (Charles Smithson 2003)

Credit risk=Exposure*Probability of default*(1-Recovery rate)
Credit exposure it is the cost of replacing or hedging a contract at the time of default. This is the maximum value that will be lost if the counterparty to the contract default

Pre-settlement risk: Pre-settlement risk is the potential loss due to the counterpart’s default during the life of the transaction (loan, bond, derivative product). Pre-settlement risk can exist over long periods, often years, starting from the time it is contracted until settlement. In addition to the counterpart default risk, there is also a risk that the counterpart is prohibited to pay when its country of domiciliation defaults and blocks all foreign payments. This risk is called sovereign transfer risk.(GestelBaesens 2008)
Settlement risk: One is exposed to settlement risk because the payment or the exchange of cash flows is not made directly to the counterparty, but via one or multiple banks that may also default at the moment of the exchange .The risk is present as soon as an institution makes the required payment until the offsetting payment is received. The longer the time between the two payments, the higher the risk. Large payments and payments in different time zones and in different currencies have a higher settlement risk.
Default risk is defined as credit risk by some authors but it is the main form of credit risk. default risk occurs when a debtor has not met his or her legal obligations according to the debt contract. For example a debtor has not made a scheduled payment, or has violated a loan covenant/ condition of the debt contract (Ameyaw-Amankwah, 2011). A default is simply the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt. A loan default occurs when the borrower does not make required payments or in some other way does not comply with the terms of a loan. (Murray, 2011).
Pearson and Greeff (2006) defined default as a risk threshold that describes the point in the borrower’s repayment history where he or she missed at least three instalments within 24 months
Default rate is the possibility that a borrower will default, by failing to repay principal and interest in a timely manner (Campel, et. al.1993 cited in Danson, 2012).

2.5.6indicators of credit risk

Nonperforming loans
NPLs are usually defined as the total of nonaccrual loans and restructured (troubled) loans. Nonaccrual loans are loans on which interest accruals have been discontinued due to borrowers’ financial difficulties. Typically an unsecured loan is placed on non-accrual status once interest payments are 90 days past due, but this is not a requirement. A loan is considered restructured when the bank grants a concession to the debtor that changes the terms of the loan to prevent it from being charged-off so long as the debtor can fulfill the new terms. Non-performing loans lead to a credit crunch as banks become increasingly reluctant to lend to new customers. (RBZ Report 24 February 2015).

Impairment Loss on loans and advances according to IAS 36 impairment loss occurs when an asset is carried at more than its recoverable amount that is if its carrying amount exceeds the amount to be recovered through use or sale of the asset. If this is the case, the asset is described as impaired and the standard requires the entity to recognize an impairment loss. Banks its major assets are loans which are greatly affected by impairments. Under IFRS, impaired loans are considered to be the best measure of problem loans. Per IFRS, a loan is deemed to be impaired if there is objective evidence of impairment that is a loss event , and that loss event or events has an impact on the estimated future cash flows from the loan that can be reliably estimated. losses expected as a result of future events, no matter how likely are not recognized.
Capital adequacy ratio

Capital adequacy ratios is a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures. An international standard which recommends minimum capital adequacy ratios has been developed to ensure banks can absorb a reasonable level of losses before becoming insolvent. Applying minimum capital adequacy ratios serves to protect depositors and promote the stability and efficiency of the financial system.( Reserve Bank of New Zealand Bulletin of March 1996 ) minimum regulatory capital adequacy ratio in Zimbabwe is at 12% and BancABC has 16% as at 31 December 2014 (BancABC annual reports 2014).

Loan delinquency a loan is delinquent when a payment is late (CGAP, 1999). A delinquent loan becomes a defaulted loan when the chance of recovery becomes minimal. Delinquency is measured because it indicates an increased risk of loss, warnings of operational problems, and may help to predict how much of the portfolio will eventually be lost because it never gets repaid. There are three broad types of delinquency indicators: * Collection rates which measures amounts actually paid against amounts that have fallen, * Due arrears rates measures overdue amounts against total loan amounts; * Portfolio at risk rates which measures the outstanding balance of loans that are not being paid on time against the outstanding balance of total loans (CGAP, 1999)

2.6.1Analysis of bank profitbility

Profitability is how well a business is performing over a specific period and its ability to have financial resources for current and perpetual use (JuliePoznanski, Bryn Sadownik 2013) profitability is usually used as a measure for earnings generated by the company during a period of time based on its level of sales, assets, capital employed, net worth and earnings per share. and it is considered as an indicator for its growth, success and control Profitability ratios are indicators of the firm's overall efficiency.

2.6.2Major indicators of profitability in commercial banks

a)Return on Equity (ROE)
ROE is a financial ratio that refers to how much profit a company earned compared to the total amount of shareholder equity invested. ROE is what the shareholders look for in return for their investment. A business that has a high return on equity is more likely to be capable of generating cash internally. Therefore the higher the ROE the better the company is in terms of profit generation. It represents the rate of return earned on the funds invested in the bank by its stockholders. ROE reflects how effectively a bank management is using shareholders’ It is calculated as follows Net Income after taxes/Shareholder's Equity capital as explained by by (Khrawish (2011)
b)Return on Asset (ROA)
ROA is also another major ratio that indicates the profitability of a bank. It is a ratio of income to bank total asset (Khrawish, 2011). It measures the ability of the bank management to generate income by utilizing company assets at their disposal. It shows how efficiently the resources of the company are used to generate the income. It further indicates the efficiency of the management of a company in generating net income from all the resources of the institution (Khrawish, 2011)Wen (2010), states that a higher ROA shows that the company is more efficient in using its resources. it indicateshow well a bank’s assets are being used to generate profits.
c) Net Interest Margin (NIM)
NIM measures the difference between the interest income generated by banks and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interestearning) assets. It is usually expressed as a percentage of what the financial institution earns on loans in a specific time period and other assets minus the interest paid on borrowed funds divided by the average amount of the assets on which it earned income in that time period (the average earning assets). The NIM variable is defined as the net interest income divided by total earnings assets (Gul et al. 2011Net interest margin measures the gap between the interest income the bank receives on loans and securities and interest cost of its borrowed funds. It reflects the cost of bank intermediation services and the efficiency of the bank. The higher the net interest margin, the higher the bank's profit and the more stable the bank is. Thus, it is one of the key measures of bank profitability. However, a higher net interest margin could reflect riskier lending practices associated with substantial loan loss provisions (Khrawish, 2011)


2.7.1Credit risk management and profitability

Credit risk represents a measureable threat to the banks’ profitability; as a result, several researchers have examined the impact of CRM on bank performance in different scopes. Ahmed, Takeda, and Shawn (1998) employed multi-variant regression and found that loan loss provision has an important positive impact on non-performing loans. Therefore a raise in loan loss provision implies an elevation in credit risk and decomposition in the value of loans subsequently distressing bank performance negatively. In another study, Ahmad and Ariff (2007) used regression analysis in their study to establish the most important determinant of credit risk of commercial banks in emerging economies banking systems weighted against the developed economies banking systems. It establishes that a rise in loan loss provision is as regarded as a major determinant of potential credit risk. They added that credit risk in emerging economies banks is greater than that in developed economies.

(Hosna& Bakaeva, 2009) conducted a study to determine the impact of credit risk management on profitability of four banks in Sweden using multiple regressions with two independent variables. Their regression model showed that credit risk management had an effect on profitability on a reasonable level with 25,1% possibility of NPLR and CAR in predicting the variance in ROE. With this the credit risk management strategy defines profitability levels to a considerable extent. However their results leave a gap in that ROE of commercial banks could in turn be influenced by other factors other than NPLR and CAR, implying therefore that commercial bank profitability may not be wholly related to credit risk management. This may mean that this bank’s profitability has other predictors or variables that affect ROE more reliably than NPLR and CAR,
(Athanasoglou, et al., 2005) examined the profitability behaviour of bank-specific, industry related and macro-economic determinants, using an unbiased panel dataset of South Eastern European credit institutions over the period 1998-2002. Their estimation results indicate that, with the exception of liquidity, all bank-specific determinants significantly affect bank profitability in the anticipated way. The macro-economic environment has a direct impact on the aggregate performance of the industry. Further, concentration is positively correlated with bank profitability. With respect to the macroeconomic variables, inflation has a strong effect on profitability, while bank profits are not significantly, affected by real GDP per capita fluctuations. These results in South Eastern European countries suggest that commercial bank profitability is not at all related to credit risk management but that the macro-economic environment particularly inflation has a more pronounced effect on the bank profitability. This however seems contrary to evidence in the Zimbabwean market especially BancABC as the bank was profitable in 2009 to 2013 These results were achieved at a time when Zimbabwe was undergoing poor macro-economic conditions.

A majority of the researches done seem to support the view that there is a positive relationship between effective credit risk management and banks’ profitability, and some of these studies support the view that there is a negative relationship between them, as follows. Hakim and Neaime (2001) Hosna Manzura and Juan Juan (2009) found that Non-performing loans indicator affected profitability as measured by (ROE) more than capital adequacy ratio, and the effect of credit risk management on profitability was not the same for all the banks included in their study. Aduda and Gitonga (2011) found that the credit risk management effected on profitability at a reasonable level. Aruwa and Musa (2012) investigated the effects of the credit risk, and other risk components on the banks’ financial performance and found a strong relationship between risk components and the banks ’financial performance

Boahene, Dasah and Agyei (2012) examined the relationship between credit risk and banks’profitability and their investigations proved that there is a positive relationship between credit risk and bank profitability.Gakure, Ngugi, Ndwiga and Waithaka (2012) investigated the effect of credit risk management techniques on the banks’ performance of unsecured loans. They concluded that financial risk in a banking organization might result in imposition of constraints on bank’s ability to meet its business objectives.

Kolapo, Ayeni and Oke (2012) showed that the effect of credit risk on bank performance measured by ROA was cross-sectional invariant, though the degree to which individual banks were affected was not captured by the method of analysis employed in the study. Poudel (2012) explored the various credit risk management indicators that affected banks’ financial performance, he found that the indicator that affected the bank financial performance was the default rate.
Musyoki and Kadubo (2012) seek to assess various parameters pertinent to credit risk management as it affects banks’ financial performance. They concluded that all these parameters had an inverse impact on banks’ financial performance; however the default rate was the most predictor of bank financial performance, on the contrary of the other indicators of credit risk management. Nawaz and Munir (2012) found that credit risk management effected on the banks’ profitability, and they recommended that management should be cautious in setting up a credit policy that might not negatively affect profitability
Abdelrahim (2013) concluded that liquidity and bank size had a strong effect on the effectiveness of credit risk management than other factors. Adeusi, Akeke, Adebisi and Oladunjoye (2013) concluded that risk management indicators (doubt loans, and capital asset ratio) had a negative effect on bank performance. Berrios (2013) then also showed that less discreet lending negatively affected net interest margin. Kaaya and Pastory (2013) then showed that credit risk indicators negatively affect the bank’s financial performance. (Bessis, 2002) further asserts that, those banking institutions that actively manage their risks have a competitive advantage. They take risks more consciously, they anticipate adverse changes, they protect themselves from unexpected events and they gain the expertise to price risks. The competitors who lack such abilities may gain business in the short-term. Nevertheless, they will lose ground with time, when those risks materialize into losses.

Credit risk is by far the most significant risk faced by banks and the success of their business depends on accurate measurement and efficient management of this risk to a greater extent than any other risk (Gieseche, 2004) Increases in credit risk will raise the marginal cost of debt and equity, which in turn increases the cost of funds for the bank and inherently affect profitability (Basel, 1999).
The vast majority of the empirical literature studied utilised regression analysis in evaluating the effect of credit risk management on several independent variables suited to the respective regression models. Most of the reviewed literature used CAR, NPLR and Loan-Loss Provision as the common proxies for measuring Credit Risk Management, whilst ROE and ROA were the commonly used proxies for measuring Profitability.

Ben-Naceur and Omran (2008) found that bank capitalization and credit risk have considerable and positive influence on net interest margin, cost efficiency, and profitability of banks. Similarly in an attempt to find the impact of effective CRM on bank survival, Njanike (2009) appraised the degree to which failure to efficiently deal with credit risk leads to banks’ failure in Zimbabwe between 2003and 2004. The study established that the failure to efficiently handle credit risk led to a higher-level banking crisis. It recommended that banks should establish and implement credit scoring and evaluation methodologies, review and revise the insider loans policies, and implement prudential corporate governancepractices.

In another study conducted in Kenya, Kithinji (2010) measured the effect of CRM on banks’ profitability through the use of regression model. The study uses records on the total credit, level of non-performing loans,and profits for the period of five years. It reveals that the accumulated profits of banks are not influenced by the quantity of credit and non-performing loans. Hence, Kithinji (2010) proposed that other variables other than credit and non-performing loans have greater effects on the profitability of banks. Al-Khouri (2011) further evaluated the effect of bank’s specific risk characteristics and the overall banking environment on the performance of 43 commercial banks operating in six of the Gulf Cooperation Council (GCC) countries over the period of 10 years. The study adopt regression as an analysis tool, and its findingsprove that credit risk, liquidity risk, and capital risk are the key aspects that influence bank profitability in the GCC countries.

In Nigeria, Kargi (2011) reviewed the impact of credit risk on the profitability of Nigerian banks, using five years’ data for the period of 2004-2008. The study examines the relationship through the use of descriptive, correlation, as well as regression model. He established that CRM has an important role in the profitability of Nigerian banking sector. The study supports the claim that profitability of bank is negatively controlled by loans and advances, non-performing loans, and deposits levels, thus exposing banks to huge risk of illiquidityand distress.

In Costa-Rica, Epure and Lafuente (2012) applied regression analysis to study the presence of credit risk on bank performance. They discovered that performance improvements led to regulatory changes and that credit risk accounts for differences in bank performance, while non-performing loans inversely affect efficiencyand return on assets (ROA) and the capital adequacy ratio (CAR) has a positive influence on the net interestmargin.

In another recent study conducted in Nepal, Poudel (2012) assessed the effect of CRM on the financial performance of Nepalese banks using regression analysis. The study establishes that all credit risk factors have an inverse influence on the financial performance of banks; conversely, the default rate exerts a major impact on bank performance. The study proposes banks to create and develop policies with the aim of not only reducing the exposure of the banks to credit risk but also improving profitability.
In another study conducted in Taiwan, Chen and Pan (2012) assessed the credit risk efficiency of banks for the period of four years (2005-2008). The study employs financial ratio to measure the credit risk and evaluate using Data Envelopment Analysis (DEA). The credit risk measures were credit risk technical efficiency, credit risk allocation efficiency, and credit risk cost efficiency. The findings suggest that only one bank is competentin all forms of efficiencies over the assessment periods.
The Ghanaian study of Boahene et al. (2012) utilized regression analysis in an attempt to reveal the connection between credit risk and profitability of selected banks and established that credit risk components non-performing loan rate, net charge-off rate, and the pre-provision profit as a percentage of net total loans and advances have a positive and significant relationship with bank profitability. This shows that banks in Ghana enjoy high profitability regardless of high credit risk, an opposing view to other views expressed in many studies that credit risk indicators are negatively related to profitability.

. | |

2.7.2Other factors which influence profitability other than credit risk management
The ability to manage costs simply means that the organisation has the ability to make profit as a simple profit equation is revenue less costs .Previous studies suggest a positive and highly significant effect of efficiency on profitability for example, Alexiou and Sofoklis, 2009 Athanasoglou et al., 2008;Dietrich and Wanzenried, 2011; García-Herrero et al., 2009; and Pasiouras and Kosmidou, 2007, This relation would imply that operational efficiency is an important factor for improving the profitability of the banking system, with the most profitable banks having the lowest efficiency ratios. On the other hand, Berger and
Humphrey (1994) note that managerial ability in controlling costs called Xefficiency is much more important than economies of scale and scope . Banks may have costs about 20% higher than the industry minimum for the same scale and product mix because of poor management. Also, Berger (1995) concludes that X-efficiency, or superior management of resources, is consistently associated with higher profits.

Expense management offers a major and consistent opportunity for profitability improvement.
,the efficient use of labour is a key determinant of relative profitability. Staff expenses as conventional wisdom proposes, is expected to be inversely related to profitability because these costs reduce the total operation cost of the bank. The level of staff expenses appears to have a negative impact on banks‟ ROA in the study of Bourke (1989).However, Molyneux (1993) found a positive relationship between staff expenses and total profits. As he suggests high profits earned by firms in a regulated industry may be appropriated in the form of higher payroll expenditures.

Performance is also influenced by numerous other forces that are frequently described as demand factors. While all demand factors cannot be identified or quantified, Kaufman (1965) believes that levels and changes in population and income may reasonably be assumed to be among the most important (also Yeats,1974). Nelly and Wheelock (1997) conclude that state per capita income in US exerts a strong positive statistica effect on state bank earnings while income growth explains a relatively small amount of the variation in bank earnings. On the other hand, Heggestad (1977) found that per capita income does not affect bank profits. Per capita income may not be a good proxy for economic shocks that most directly affect bank earnings for example, oil crises or commercial real estate crashes. A sharp downturn in a sector, such as real estate, could dramatically affect bank earnings without having a large impact on per capita income. Zimmerman (1996) found that regional employment conditions are a significant contributing factor for both community bank asset quality and ROA.

Haslem (1968) found that the effects of location on profitability are not important Tirtiroglou and Daniels (2000) suggest strongly that the regional heterogeneity of US banking geography and its temporal dynamics are important determinants of bank performance. On the other hand, Zimmerman (1996) suggests that location is an important factor in determining profitability. Prasad and Harker (1997) found that in the competitive environment are important determinants of profitability
Market concentration also determines commercial bank profitability, which means that commercial banks in highly concentrated markets tend to collude and earn monopoly profits. Concentration may act as a barrier to entry when entering markets where domestic banks are highly concentrated, implying a negative impact on profits while market dominated by foreign banks that have been found to be more efficient than domestic banks, such as in less developed countries for example in Zimbabwe most of the banks performing better are , concentration may in fact be positively related to foreign banks’ profitability, Kosmidou et al (2007) Studies in Tunisia suggest that bank size negatively impact net interest margin (Naceur ,2003, Goaied ,2006).Naceur (2003) opines that concentration was less beneficial to Tunisian commercial banks and that all macroeconomic variables had no impact on banks’ net interest margin and profitability. Naceur and Goaied (2006) findings on bank size and macroeconomic variables conformed to those drawn by Naceur (2003).
Study by Rachdi (2013) showed that before the US subprime crisis, capital adequacy, liquidity, bank size and yearly real GDP growth rate positively influenced performance of the Tunisian banking sector. Cost-income ratio, yearly growth of deposits and inflation rates were negatively correlated to bank profitability. In crisis, bank profitability was mainly explained by operational efficiency, yearly growth of deposits, GDP growth rate and inflation. Rachdi (2013) findings on bank size differed from those drawnbyNaceur (2003) and Naceur and Goaied (2006).

The availability of liquidity is another bank profitability determinant. This is the ability of the bank to obtain cash, in order to meet present and necessary needs. For the commercial banks to gain public assurance they should have sufficient liquidity to meet the demands of depositors and loan holder. Thus commercial banks should have effective assets and liabilities management system to reduce the non-compliance of assets and liabilities and to raise returns. Also, due to the inverse relationship between liquidity and profitability, building a perfect balance between these two variables is also vital (Ahmadzade et al., 2005)
In conclusion there has been a review of both empirical and theoretical literature which highlighted that a relationship between credit risk management and profitability of commercial banks actually exists. The researcher shall then proceed in statistically proving the relationship between the variables of NPLs and loan loss provisions which are proxies for credit risk management as well as ROA and ROE which are proxies for commercial bank profitability using the most appropriate. This would assist in ascertaining if this relationship exists for commercial banks in Zimbabwe with a case study of BancABC. T


Ahmed, ., Takeda, C. & Shawn, T., 1998. Bank Loan Loss Provision : A Reexamination of Capital Management and Signaling Effects. Working Paper, Department of Accounting, Syracuse University, pp. 1-37.
Angbanzo, L., 1997. Commercial Banks Net Interest Margins, Default Risk, Interest Rate Risk and Off Balance Sheet Banking. Journal of Banking and Finance, pp. 55-87.
Ara, H., Bakaeva, M. & Sun, J., 2009. Credit Risk Management and Profitability in Sweden. Master Thesis. University of Gothenburg..
Basel, 1999. Principles for the Management of Credit Risk. Basel, Switzerland Bank for International Settlements.
Basel, 2001. The Standard Approach to Credit Risk. The Basel Committee.
Bessis, J., 2002. Risk Management in Banking, 2nd Edition. New York: John Wiley and Sons.
Boa hone, S., Dasah, J. & Agyei, S., 2012. Credit Risk and Profitability of Selected Banks in Ghana.
Coyle, B., 2000. Bank Finance. Kent: Financial World.
Davies, K. & Kearns, M., 1992. Banking operations: UK Lending and International Business. New York: Pitman. .
Ducas, J. & Mclaughlin, M., 1990. Developments Affecting the Profitability of Commercial Banks. Federal Reserve Bulletin, pp. 477-499.
Epure, M. & Lafuente, I., 2012. Monitoring Bank Perfomance in The Presence of Risk. Barcelona GSE Working Paper Series No.61.
Felix, A. & Claudine, T., 2008. Bank Perfomance and Credit Risk Management. Unpublished Masters Dissertation In Finance, University of Skovde.
Gastineau, G., 1992. Dictionary of Financial Risk Management. Chicago: Swiss Bank Corporation.
Ikpefan, O. & Mukoro, D., 2011. Prerequisites for the Success of Asset management Corporation of Nigeria (AMCON) in the Financial Services Industry. Covenant University Ota, Ogun State, Discussion Paper Kithinji, A., 2010. Credit Risk Management and Profitability of Commercial Banks in Kenya. School of Business, University of Nairobi No.61.
Kitua, D., 1996. Application of Multiple Discriminant Analysis in Developing A Commercial Bank Loan Classification Model and Assessment of Significance of Contributing Variables : A Case of National Banking of Commerce. UDSM, Dar es Salam.
Kolapo, F., Ayeni, K. & Oke, O., 2012. Credit Risk and Commercial Banks` Perfomance in Nigeria : A Panel Model Approach. Australian Journal of Business and Management Research Vol.2 No.2 [31-38].


Student name Busani H Msipa

Student number PO126619N Supervisor Mr A Nyathi

Chapter two

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...ADVANCING CREDIT RISK MANAGEMENT THROUGH INTERNAL RATING SYSTEMS At Bank for Investment and Development of Viet Nam JSC (Transaction office no.8 ) Table of Contents Foreword Part I : Overview of Bank Credit risk management and The theoretical basis of Internal rating systems 1. The activities of commercial banks 1.1. The concept of a commercial bank. 1.2. Operation and Performance of Commercial Banks 2. Managing Operational risk in banking 3. Definition of an Internal Rating System 4. Rating models 4.1. Outlines of Rating Models 4.2. Validation of Rating Models 4.3. Adjusting Rating Models 5. Uses of Internal Rating Systems 6. Benefits of Using an Internal Rating System Part II : Current situation of Credit activities and Internal rating systems at BIDV ( Transaction office no.8 ) 1. General introduction of Bank for Investment and Development of Viet Nam JSC ( BIDV ) 2. Current business status of BIDV 2.1. Socio-economic situation in the period of 2008-2012 2.2. Situation of BIDV business operations in the period of 2008-2012 3. Situation of BIDV Credit quality in the period of 2008 – 2012 3.1. Current situation of BIDV Credit quality 3.2. Achivement of BIDV Credit activities 3.3. SWOT analysis on Credit activities of BIDV branches 4. Current situation of Internal rating systems at BIDV 4.1. Current situation of Credit Risk Management at BIDV 4.2. Current situation of Customer rating systems at BIDV (Transaction office no. 8) ...

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