Impact of Credit Risk Management on Profitability

Impact of credence hazard caution on positiveness citation venture arises because there is a conjecture of a hazard that the counterparty defaults on the loans and bonds held by the institution (Cornett)The Ultimate advantages of assent find Management argon being accepted by pecuniary Institutions now and Risk Managers argon focvictimization on different Risk Management Models in looking for different Business Opportunities (Heinemann).However in general m maventary Institutions that make Loans or buy bonds with long maturities argon more than subject than Financial Institutions that make loans or buy bonds with short maturities. This mover for exemplar that desires, thrifts and life insurance companies argon more exposed to Credit Risk than ar money market place mutual cash, since b distri justivelys and life insurance companies lean to hold longer maturity pluss in their Portfolios than mutual funds. (Cornett)Basel is an musical arrangement that requires the delusion of danger-based groovy ratios on tills in major industrialized countries. Considering the weaknesses of the simple big(p)-to-assets ratio, members of affirm for International Settlements (BIS) along with U.S decided to implement twain new hazard-based capital ratios for all technical swears nether their jurisdiction in 1988. The BIS phased in and fully implemented these encounter based capital ratios on January 1, 1993, under what has been know as the Basel Accord (now called Basel I).Credit attempts of assets ar included into jacket adequateness ratio into Basel Agreement of 1993. This was followed with a revision in 1998 in which market venture was incorporated into hazardiness-based capital in the form of an add-on to the 8 percent ratio for realization jeopardize exposure. In 2001, the BIS issued a informative document, It was proposed in the basel-II or the new basel system that the operational risk should be the part of outstanding requiremen ts with effect from 2007 and updated the ac reference book 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 be discussed at a lower place, these three pillars play a vital role in the caoutchouc and soundness of the entire financial system.PILLAR 1CREDIT luck On Balance Sheet and Off Balance Sheet (Standardized vs. indispensable Ratings Based barbel)MARKET bump Standardized vs. Internal Ratings Based approachOPERATIONAL RISK Basic Indicator vs. Standardized vs. Advance meter approach)PILLAR IIRegulatory supervisory review so as to complement and enforce minimum Capital Requirements calculated under tugboat 1PILLAR IIIRequirements on rules for disclosure of Capital Structure, risk exposures, and Capital sufficiency so as to increase Financial Institutions transparence and Enhance Market/Investor match.Like in every other outlandish in Pakistan also the arouse stick of Pakistan issued a Road defend or Guidelines for Implementation of Basel-II in Pakistan and the deadline issued by State bank for the bound was December 2006.PROBLEM STATEMENTCapital Regulation, Supervision and Market Discipline are the foundation of Basel-II, and to improve the Risk Management Procedures for bringing perceptual constancy in the financial System, the blasphemes and Financial Institutions were required to establish an adequate frame-up and report to SBP the name and other Particulars of the Person responsible for Implementation forrader 31st May 2005We entrust study the impact of Basel II on the credit risk way by considering 2 parameters i.e. NPLR and simple machine. By examine these ratios, we find out that how Basel II is useful in caution and decrease of risk and finally find out the role of credit risk solicitude in increasing the profits of banks.RESEARCH QUESTIONAs per the emphasise discussed earlier, out task is to questionThe impact of cr edit risk management on the advantageousness of commercial banks in Pakistan.PURPOSEOur question pass on find out the importance credit risk management in the profitability of commercial banks in Pakistan and how Basel II overhauls in reduction of credit risk and management by using some techniques and methods that volition assure the meat of non-performing loans. The purpose of the explore 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.JUSTIFICATIONOur query leave explain the influence of credit risk management on the profitability of commercial banks. This explore will be very helpful for the banking diligence in Pakistan as it is directly related to the profitability of banks. It will appropriate them with the guidelines that ho w they could manage and minimize the credit as per the rules and regulations provided in Basel document.SCOPEOur research is significant and grave 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 STUDYWe are portion outing 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 celestial sphere of banking industry and determine valid and authentic results. Public sector banks, Moslem banks, investment banks, micro-finance banks are included in the research. Basel II was put into level from December 2006 that is why we redeem included the data from financial statements of 2007 to 2009 as we fetch studying the relation amidst profitability and credit risk management afte r Basel II is implemented.The study is limited to two fencesitter variants for measuring credit risk management that are NPLR and gondola car, and one open variable for measuring profitability which is roe, the former for choosing the above mentioned variables will be discussed in the methodology.LITERATURE REVIEWhard roe PROFITABILITY INDICATORROE (Return on Equity) refers to the ratio of Net Income to the Total equity capital.ROE indicates that how more than the bank has earned with the investors capital. It measures that how intimately and efficiently a company uses its investors funds to generate profit. It is apply as a comparative too between two companies or banks. Its the ratio of net income and share holders equity. moreover 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.R OA(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 INDICATORSAccording to a research of Risk management practices followed by commercial banks in Pakistan. It was identify that the major risk introduced by banks in Pakistan as well as internationally is the Credit Risk. Because the core banking business is all most(prenominal) 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 last it ends into Credit risk. The State bank has also introduced some tough regulations when financing soulfulness as well as SMEs and Corporate Customers, much(prenominal) as obtaining the BBFS(Borrowers elemental fact tatter) 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 non recovering and as such the Non performing Loans are increasing which ultimately leads to Credit Risk. (Nasr, 2009)CAPITAL TO ASSETS RATIOIt measures the Ratio of a Banks Book revalue of core Capital to the Assets book value. The Lower this Ratio, the more extremely leveraged the bank is. Primary or core Capital Banks common Equity (book value) and staring(a) preferred stock plus minority lodge ins in consolidated subsidiaries (Cornett).RISK IN BANKSAs Banks perform different financial services to their Clients they face many an(prenominal) 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 quite a little these assets they are further exposed to Market Risk or asset price risk. Increasingly FIs hold contingent assets and liabilities off the isotropy 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 non have enough Capital reserves to offset a fulminant loss incurred as a result of one or more of the risks they face creates insolvency risk for the Banks. (HOUSTON, 2008)CREDIT RISK MANAGEMENTCapital sufficiency Ratio (CAR) is used by Regulators of Banking System to assess the Banks financial blot 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 Ban ks 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 BankruptcyThere are major 2 types of Capital for Banks. Tier-I Capital is closely linked to banks book value of equity, reflecting the role of a banks owners.Tier two is a broad array of petty(a) capital resources, which includes the loan reserves upto 1.25 % of risk adjusted assets plus motley debt instruments.BENEFITS OF CAPITAL ADEQUACY RATIOIn 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 exclusive by a commercial bank can re sult 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 PAKISTANThe 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))METHODOLOGYRESEARCH APPROACHWhile 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 scene of action 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 retroflection model and the annual reports of the selected banks. The regression outp ut makes us answer our research question.RESEARCH RESIGNWe 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 STRATEGYWe 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 purchasable on their websites.SAMPLINGThe world for the research consists of 20 private commercial banks out of the 54 banks operating in Pakistan. All the 20 elect banks are working under conventional banking system as we are only focusing on conventional banks and all other banks such as Islamic banks, invest ment 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, therefrom data is obtained from annual reports of 2007 to 2009. There are total 30 observations for each of the variable used in this research.DATA COLLECTIONData 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.RE SEARCH INSTRUMENTSNo 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 ANALYSISMultiple regression compend is used in our research i.e. the relationship of one dependent variable to seven-fold independent variables. The regression outputs are obtained by using SPSS utilise REGRESSION MODELDependent 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 VARIABLEIn 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 expertness of banks can be measured by using the ROE which illustrates to what achievement banks use reinvested income to generate future profits.INDEPENDENT V ARIABLENPLR 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 wayNPLR = (NPL amount) (TL amount)CAR, CAR is restrictive 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 B anks on consolidated as well as standalone basis has been increased to 10%.RELIABILITY AND VALIDITYWhile doing the research two concepts must be taken into account i.e. reliability and validity. reliableness 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.CONCLUSIONThe objective lens of the study is to determine the impact of credit risk management on profitability. I t 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 immaculate 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 ultimate ly getting higher ROE, which ensures the better profitability.