Credit Risk Management

Submitted By

Mahnoor Rafiq
(BB-15-09)

Session 2015-2019

Submitted to

Sir Sadiq Shahid

INSTITUTE OF MANAGEMENT SCIENCES

BAHAUDDIN ZAKARIYA UNIVERSITY, MULTAN

 ABSTRACT

The primary objective of this study was to enhance my knowledge

about credit risk and credit risk management and main focus are

banks either Islamic or Commercial banks not only of Pakistan but

also western countries like the United States of America, Malaysia

Jordan, Albania.
 Article#1
Risk in Islamic Banking
Pejman Abedifar*, Philip Molyneux†c, Amine Tarazi*
Introduction and Objectives
This paper investigates risk and stability features of Islamic banking using a sample of 553 banks
from 24 countries between 1999 and 2009. Small Islamic banks that are leveraged or based in
countries with predominantly Muslim populations have lower credit risk than conventional
banks. In terms of insolvency risk, small Islamic banks also appear more stable.
Variables used are Liabilities, Assets, Complexity of Islamic Modes of Finance, Islamic
Banking: Principles and Practice, Investment Limitations, Relationship between Clients’ Risk
Aversion and Religiosity
Research objective is to find the Relationship between Risk and Stability Features of Islamic
Banking

Methodology
Credit_Riski,t = α0 + α1×Islamic_Banki,t + α2×Islamic_Window_Banki,t + α3×Sizei,t-1 +
α4×Market_Sharei,t-1 + α5×Capital_Asset_Ratioi,t-1 + α6×Loan_Growthi,t-1 +
α7×Noninterest_Incomei,t-1 + α8×Cost_Inefficiencyi,t-1 + α9×State_Banki,t + α10×
Foreign_Banki,t + α11×Subsidiaryi,t + α12×Young_Banki,t + α13×Middle_Aged_Banki,t + α
14×Muslim_Sharei + α15×Domestic_Interest_Ratei,t-1 + α16×HHIi,t-1 +α17×
GDP_Per_Capitai,t-1 + α18×GDP_Per_Capita_Growthi,t-1 + ∑ α
,×Year_Dummies, + ∑ α,×
Country_Dummies, - + εi,t

Insolvency_Riski,t = β0 + β1×Islamic_Banki,t + β2×Islamic_Window_Banki,t + β3×Sizei,t-1 +

β4×Market_Sharei,t-1 + β5×Loan_Total_Earning_Asset_Ratioi,t-1 + β6×Asset_Growthi,t-1 +
β7×Noninterest_Incomei,t-1 + β8×Cost_Inefficiencyi,t-1 + β9×State_Banki,t + β10×
Foreign_Banki,t + β11×Subsidiaryi,t + β12×Young_Banki,t + β13×Middle_Aged_Banki,t + β
14×Muslim_Sharei + β15×Domestic_Interest_Ratei,t-1 + β16×HHIi,t-1 + β17×
GDP_Per_Capitai,t-1 + β18×GDP_Per_Capita_Growthi,t-1 + ∑ β
,×Year_Dummies, +∑
β,×Country_Dummies, - + ƞi,t

Bank_Interest_Ratei,t = γ0 + γ1×Islamic_Banki,t + γ2×Islamic_Window_Banki,t + γ3×Sizei,t-1

+ γ4×Market_Sharei,t-1 + γ5×Capital_Asset_Ratioi,t-1 + γ6×Noninterest_Incomei,t-1 +
γ7×Cost_Inefficiencyi,t-1 + γ8×Credit_Riski,t-1 + γ9×State_Banki,t + γ10×Foreign_Banki,t + γ
11×Subsidiaryi,t + γ12×Young_Banki,t + γ13×Middle_Aged_Banki,t + γ14×Muslim_Sharei +
γ15×Domestic_Interest_Ratei,t-1 + γ16×HHIi,t-1 + γ17×GDP_Per_Capitai,t-1 + γ18×
GDP_Per_Capita_Growthi,t-1 + ∑ γ ,×Year_Dummies,
+ ∑ γ,× - Country_Dummiesi,c + Ɵi,t

Findings
The results show a negative relationship between size and credit risk, which is consistent
with possible diversification and scale economies benefits. Loan growth is associated with lower
credit risk in the following year as also identified by Clair (1992). We also find that higher
domestic interest rates have a positive influence on credit risk (loans are more difficult to repay if
rates are higher).
Islamic banks may have lower credit risk compared to conventional banks due to the
religiosity of clients that enhances loyalty and mitigates default and/or due to their special
relationship with their depositors. To investigate the former we include an interaction term for
the
Islamic bank dummy and Muslim share in population (Islamic_Bank × Muslim_Share). The
result shows that there is a negative relationship between the credit risks of
Islamic banks and the share of Muslims in the population. We find similar results
when we use Legal_System in lieu of Muslim_Share as the religiosity proxy. The model now
includes the Islamic bank/domestic interest rate interaction term (Islamic_Bank ×
Domestic_Interest_Rate) and here we find that the credit risk of Islamic banks is not significantly
sensitive to domestic interest rates, while a one percent increase in domestic rates (on average) is
associated with 0.232 percent increase in the Loan_Loss_Reserve of conventional banks. To
analyze whether the relationship between Islamic banks and their depositors can explain the
higher loan quality of Islamic banks we include the interaction term of the Islamic bank dummy
and capital to asset ratio (Islamic_Bank × Capital_Asset_Ratio) The result shows that higher
leverage is associated with lower credit risk for Islamic compared to conventional banks.

References
Abdul-Majid, M., Saal, D.S. and Battisti, G. (2010) Efficiency in Islamic and conventional
banking: An international comparison, Journal of Productivity Analysis 34, 25-43

Accounting and Auditing Organization for the Islamic Financial Institutions “AAOIFI” (1999)
Accounting, Auditing and Governance Standards for Islamic Financial Institutions, Bahrain

Aggarwal, R.K. and Yousef, T. (2000) Islamic banks and investment financing, Journal of
Money, Credit and Banking 32, 93-120.

Ahmad, A. (1993) Contemporary practices of Islamic financing techniques, Research Paper No.
20, IRTI, Islamic Development Bank, Jeddah.
 Article#2
Cyclical patterns in profits, provisioning and lending
of banks and procyclicality of the new Basel capital
requirements
JACOB A. BIKKER and HAIXIA HU
Introduction and Objectives
The upcoming new Basel accord on capital requirements, expected to enter into force end 2006,
is a topical case in point (BCBS 2001). The main purpose of the new accord is to introduce a
more risk-sensitive method for determining the minimum capital required to absorb losses, in
particular credit losses.

Methodology
Procyclicality in banking
Banks’ profits and the business cycle
Credit loss provisioning and the business cycle
Lending and the business cycle

Findings
According to current proposals for a new Basel capital accord, capital requirements for lending
will be determined in greater measure than at present by current credit risk. Many assume that
banks during a cyclical downturn are less willing to loan money on account of increased credit
risk, thereby reinforcing the cyclical downswing in a so-called credit crunch
Real GDP growth and other cyclical variables all turn out to have a significant effect on profits
or profit margins. Profits, at a GDP growth level of over 2%, turn out to be almost 2.5 times
those at GDP growth levels below 2%. This mechanism demonstrates how capital and reserves
(augmented by profits after deduction of taxes and dividends) generally accumulate much faster
during a multi-year cyclical boom than in adverse cyclical years, while at the same time
additional capital is far easier to come by during an economic boom.

References
AKHTAR, M.A. (1994), Causes and Consequences of the 1989-92 Credit Slowdown: Overview
and Perspective. Studies on Causes and Consequences of the 1989-92 Credit Slowdown, Federal
Reserve Bank of New York.

ARESTIS, P., P.O. DEMTRIADES and K.B. LUINTEL (2001), “Financial development and
economic growth: the role of stock markets”, Journal of Money, Credit and Banking, vol. 33, pp.
16-41.

BALTAGI, B.H. (1995), Econometric Analysis of Panel Data, John Wiley & Sons, New York.
 Article #3
The Mortgage and Financial Crises:
The Role of Credit Risk Management and Corporate Governance
William W. Lang Julapa Jagtiani

Introduction and Objective

This paper analyzes the role of risk management and corporate governance in the events leading
up to the end of 2007, the “first phase” of the financial crisis. Extremely high rates of mortgage
defaults in 2006 and 2007 precipitated a collapse in the asset-backed commercial paper (ABCP)
market. This collapse set off a chain of events resulting in the most severe international financial
crisis since the Great Depression.1 The financial crisis that started in 2007, in turn, ignited a deep
global recession with enormous consequences for economic and social welfare. This was a
direct result of concerns about the solvency of many of the world’s largest financial firms that
suffered catastrophic losses as a result of the mortgage crisis. This paper explores the following
question: Given the tremendous advances in financial risk measurement and management, why
was the solvency of large and complex financial firms threatened by large losses in the mortgage
market

Methodology
Incentives, Corporate Governance, and the Failures of Risk Management
Failures of Risk Management: Conscious Choices vs. Lack of Transparency
The Role of Credit Rating Agency
Firms’ Overreliance on Untested Risk Models
The ‘Originate-to-Distribute’ Model

Findings
The events leading up to the financial crisis of August 2007 were the types of events that modern
financial risk management systems were designed to avoid. Risk management systems are
designed to avoid excessive harm from unexpected but knowable events. The risk of large scale
defaults generated by house price depreciation was precisely that type of event. This suggests a
fundamental failure of the risk control systems at large financial firms. These controls failed to
pierce through the lack of transparency in these complex structured financial instruments that
generated excessive concentration of risk in the mortgage market. Business line managers
making huge bonuses from increasing their firm’s investment in structured financial products
gained from these instruments’ lack of transparency. It allowed them to increase these exposures
unchecked. As noted by Federal Reserve Chairman Bernanke (2009b), “One of the lessons
learned from the current financial crisis has been the need for timely and effective internal
communication about risks.”

References
Acharya, V.& Schnabl, P. (2009). Securitization without risk transfer. Working Paper, NYU
Stern School of Business, April.
Arteta, C., Carey, M., Correa, R., & Kotter, J. (2009). Revenge of the steamroller: ABCP as a
window on risk choices. Unpublished Working Paper, Federal Reserve Board, Division
of International Finance, May

Altman, E., & Saunders, A. (1998). Credit risk measurement: developments over the last 20
years. Journal of Banking and Finance 21, 1721-42.

Article #4
Is Credit Risk Really Higher in Islamic Banks?
Aniss Boumediene

Introduction and Objective

This article explores empirically the assertion that Islamic Banks have higher credit risk than
Conventional Banks. A definition, identification and the way to manage credit risk are given to
each Islamic financial tool. This risk is, then, measured on nine Islamic and nine Conventional
Banks, using Contingent Claims Analysis (CCA). Merton’s model (1974), based on Black &
Scholes’ (1973) option pricing formula, allowed the measure of the Distance-to-Default (DD)
and Default probability (DP) from 2005 to 2009. Islamic Banks have a mean DD of 204
significantly higher than conventional Banks (DD = 15). Mean DP equals 0.03 and 0.05
respectively. Afterward, cumulative logistic probability distribution has been used to derive DP
from DD. Results are more satisfying; the distribution of DP has larger tails which respond to the
critic against the use of a normal distribution.

Methodology
dV= µvVdt+ σvVdz

Where v µ is the instantaneous expected rate of return on the assets per unit time; ² v σ is the
instantaneous variance of the return per unit time; dz is a standard Wiener process

Findings
Results show that Islamic Banks are far from default than Conventional Banks (Mean of
Distance-to-Default equal to 204 and 15 respectively). Default probability (3.5% and 5.7%) is,
then, higher for Conventional Banks which reflects higher credit risk; but this probability is
abnormally high for both types of banks. It is, with no doubt, due to the recent financial crisis
which started in July 2007. But the difference between Conventional and Islamic Banks is that
Conventional Banks were directly affected by the crisis. IBs were immunized from the Subprime
crisis but have been probably affected by the effect of the crisis on the real economy95. This can
be seen in appendix 2. In nine Conventional banks, eight have had their DD plummeting from
2007 to 2008 but only three of nine IBs were in the same case
References
Adams, A.T., Bloomfield, D.S.F., Booth, P.M., England, P.D., (1993). Investment Mathematics
and Statistics. London: Graham & Trotman.
Akkisidis, I., Khandelwal, S., (2008). Financial Risk Management for Islamic Banking and
Finance. Palgrave Macmillan Edition
Al-Bashir, M.M.A., (2008). Risk Management in Islamic Finance – An Analysis of Derivative
Instruments in Commodities Markets. Brill Academic Publishers.

Article #5
Islamic Financing and Bank Risks:
The Case of Malaysia
Janice C. Y. How Melina Abdul Karim Peter Verhoeven

Introduction and Objective

We examine whether Islamic financing can explain three important bank risks in a country with
a dual banking system: credit risk, interest-rate risk, and liquidity risk. Using Malaysian data, we
find that commercial banks with Islamic financing have significantly lower credit and liquidity
risks but significantly higher interest-rate risk than banks without Islamic financing. There is also
evidence that bank size is significantly related to credit risk; the proportion of loan sales to total
liabilities and bank size are significant determinants of interest-rate risk; and off-balance-sheet
financing, the extent of securitization, loan volatility, bank capital, and bank size are statistically
significantly related to liquidity risk

Methodology
Hypothesis 1
H1: Banks with Islamic financing facilities have, on average, lower credit risk than banks
without Islamic financing facilities.
Hypothesis 2
H2: Banks with Islamic financing facilities have, on average, higher interest-rate risk than banks
without Islamic financing facilities.
Hypothesis 3
H3: Banks with Islamic financing facilities have, on average, lower liquidity risk than banks
without Islamic financing facilities.

Findings
Using a sample of 23 commercial banks in Malaysia for the period 1988–1996, we find that
commercial banks in Malaysia with Islamic financing have significantly lower credit and
liquidity risks but significantly higher interest-rate risk than banks without Islamic financing.
Our results also show that bank size is a significant determinant of credit risk. The proportion of
loan sales to total liabilities and bank size can explain differences in interest-rate risk across
banks. Off-balance-sheet financing (derivative contracts and documentary credits), the extent of
securitization, loan volatility, bank capital, and bank size are significant determinants of liquidity
risk of Malaysian banks.

References
Abdul-Rahman, Y. (1999). Islamic instruments for managing liquidity. International Journal of
Islamic Financial Services, Retrieved November 24, 2004, from
http://www.islamicfinance.net/journal.html
Al-Harran, S. (2000). Time for long-term Islamic financing. Retrieved November 24, 2004, from
http://www.islamic-finance.net/harran1.html
Baldwin, K. (2002). Retrieved November 24, 2004, from www.gulf_news.com/Articles/ people-
places.asp?ArticleID=6350

Article #6
Credit risk rating systems at large US banks
William F. Treacy, Mark Carey

Introduction and Objectives

Internal credit risk rating systems are becoming an increasingly important element of large
commercial banks’ measurement and management of the credit risk of both individual exposures
and portfolios. This article describes the internal rating systems presently in use at the 50 largest
US banking organizations. We use the diversity of current practice to illuminate the relationships
between uses of ratings, different options for rating system design, and the effectiveness of
internal rating systems. Growing stresses on rating systems make an understanding of such
relationships important for both banks and regulators.

Methodology
Uses of internal ratings
An aggregate bank risk profile
Tuning rating criteria, quantifying loss characteristics, and the lack of data
Bank systems relative to rating agency systems
Operating design
Architecture

Findings
It is our impression that at most banks, internal rating systems were first introduced mainly to
support loan approval and loan monitoring processes and to support regulatory requirements for
identification and tracking of problem assets. A close reading of Udell (1987) implies that as
recently as a decade ago, it was common for bank internal scales to have three Pass grades.
The uses of internal ratings have multiplied over the past 10 years and promise to continue to
grow, and thus a banks’ decisions about its internal rating system can have an increasingly
important effect on its ability to manage credit risk. At the same time, development of
appropriate internal rating system architectures and operating designs is becoming an
increasingly complex task. The central role of human judgment in the rating process and the
variety of possible uses for ratings mean that internal incentives can influence rating decisions.
Thus, careful design of controls and internal review procedures is a crucial consideration in
aligning form with function.

References
Altman, E.I., Saunders, A., 1997. Credit risk measurement: Developments over the last 20 years.
Journal of Banking and Finance 21, 1721±1742.
Altman, E.I., Suggitt, H.J., 2000. Default rates in the syndicated bank loan market: A mortality
analysis. Journal of Banking and Finance 24 (1/2), 229±253, this issue.
Asarnow, E., Edwards, D., 1995. Measuring loss on defaulted bank loans: A 24-year study. The
Journal of Commercial Lending 11±23.
Brady, T.F., English, W.B., Nelson, W.R., 1998. Recent changes to the Federal ReserveÕs
survey of terms of business lending. In: Federal Reserve Bulletin. vol. 84, Washington, DC, pp.
604±615.
 Article #7
Credit risk management in banks:
Hard information, soft Information and manipulation
Brigitte Godbillon-Camus and Christophe Godlewski LaRGE

Introduction and Objective

The role of information’s processing in bank intermediation is a crucial input. The bank has
access to different types of information in order to manage risk through capital allocation for
Value at Risk coverage. Hard information, contained in balance sheet data and produced with
credit scoring, is quantitative and verifiable. Soft information, produced within a bank
relationship, is qualitative and non verifiable, therefore manipulable, but produces more precise
estimation of the debtor’s quality. In this article, we investigate the impact of the information’s
type on credit risk management in a principalagent framework with moral hazard with hidden
information.

Methodology
The hard information’s case
Gains and losses associated to soft information
The soft information’s case
Comparison of results

Findings
Information’s quality, produced by the bank, determines its risk taking characteristics. Existing
literature treats this problem with a distinction of hard and soft information (Petersen, 2004).
Acquiring this information can be done through two methods: transaction lending or relationship
lending. The former can use statistical methods of hard information’s treatment. This type of
information presents several advantages, as low cost, economies of scale and the possibility to
measure Value at Risk within credit risk models. On the opposite, relationship lending gives also
access to soft information, which increases he precision of borrower’s quality prediction
estimation, but implies manipulation’s problem, as this type of information is not verifiable.

In this article, we have focused on information’s type role in credit risk management in banks.
In a principal-agent model with moral hazard with hidden information where a banker requires
information on assets’ return in order to manage credit risk through equity allocation for VaR
coverage, we show that using additional soft information allows to economize equity, thanks to
soft information’s higher precision. However, this type of information being not verifiable, it
requires to implement a particular wage scheme in order to avoid manipulation by the credit
officer.
References
Berger, A.N., 1999, The dynamics of market entry: The effects of mergers and acquisitions on de
novo entry and small business lending in the banking industry, Finance and Economics
Discussion Paper Series 1999-41 Board of Governors of the Federal Reserve System

Berger, A.N., L.F. Klapper, and G.F. Udell, 2001, The ability of banks to lend to informationally
opaque small businesses, Journal of Banking and Finance 25, 2127–2167

Berger, A.N., and G.F. Udell, 2002, Small business credit availability and relationship lending :
The importance of bank organisational structure, Economic Journal 112, 32–53.

Boot, A.W.A., 2000, Relationship banking : What do we know ?, Journal of Financial

Intermediation 9, 7–25.

Article #8
A comparison of performance of Islamic and conventional banks
2004 to 2009
Jill Johnes, Marwan Izzeldin and Vasileios Pappas

Introduction and Objective

We compare, using data envelopment analysis (DEA), the performance of Islamic and
conventional banks prior to, during and immediately after the recent financial crisis (2004-2009).
There is no significant difference in mean efficiency between conventional and Islamic banks
when efficiency is measured relative to a common frontier. A meta-frontier analysis, new to the
banking context, however, reveals some fundamental differences between the two bank
categories. In particular, the efficiency frontier for Islamic banks typically lies inside the frontier
for conventional banks, suggesting that the Islamic banking system is less efficient than the
conventional one. Managers of Islamic banks, however, make up for this as mean efficiency in
Islamic banks is higher than in conventional banks when efficiency is measured relative to their
own bank type frontier. A second stage analysis demonstrates that the differences between the
two banking systems remain even after banking environment and bank-level characteristics have
been taken into account. Our findings have policy implications. In particular, Islamic banks
should explore the benefits of moving to a more standardized system of banking. Conventional
banks should investigate why their managers are apparently underperforming relative to those in
Islamic banks by examining, for example, the ongoing bonus culture.

Methodology
Studying banking efficiency can be done in two ways: by use of traditional financial ratio
analysis (FRA); or by the distance function approach whereby a firm’s observed production
point is compared to a production frontier which denotes best practice. This approach leads to
frontier estimation methods such as data envelopment analysis (DEA) and stochastic frontier
analysis (SFA).

Literature review
There is an abundant literature on the efficiency of banking institutions: detailed (albeit
somewhat outdated) reviews can be found elsewhere (Berger and Humphrey 1997; Berger and
Mester 1997; Brown and Skully 2002). A small subset of this literature focuses on Islamic
banking either in isolation or in comparison to conventional banking. The remainder of this
section will focus predominantly on the comparative literature.
We have previously hypothesized that Islamic banks will typically have lower efficiency than
conventional banks. The evidence from previous empirical studies of Islamic and conventional
banking is mixed: some find no significant difference in efficiency between the two types of
banking
(Abdul-Majid et al. 2005b; El-Gamal and Inanoglu 2005; Mokhtar et al. 2006; Bader 2008;
Hassan et al. 2009; Shahid et al. 2010); some studies (in some cases because the sample size is
small) do not test whether observed differences in efficiency are significant (Hussein 2004; Al
Jarrah and Molyneux 2005; Said 2012); one study claims that Islamic banks are significantly
more efficient than conventional banks, but results of significance tests are not shown and, in any
case, the result is based on a sample which only contains 7 Islamic banks (Al-Muharrami 2008)

Findings
The purpose of this paper has been to provide an in-depth analysis using DEA of a consistent
sample of Islamic and conventional banks located in 18 countries over the period 2004 to 2009.
The DEA results provide evidence that there are no significant differences in gross efficiency (on
average) between conventional and Islamic banks. This result is in line with a number of
previous studies (ElGamal and Inanoglu 2005; Mokhtar et al. 2006; Bader 2008; Hassan et al.
2009).
By using a meta-frontier analysis new to the banking literature we have been able to decompose
gross efficiency into two components: net efficiency provides a measure of managerial
competence, while type efficiency indicates the effect on efficiency of modus operandi, and by
doing this we have discovered that this result of no significant difference in efficiency between
banking types conceals some important distinctions. First, the type efficiency results provide
strong evidence that Islamic banking is less efficient, on average, than conventional banking.
Second, net efficiency is significantly higher, on average, in Islamic compared to conventional
banks suggesting that the managers of Islamic banks are particularly efficient given the rules by
which they are constrained. Thus the Islamic banking system is inefficient, but the managers of
Islamic banks make up for this disadvantage.

References
Abdul-Majid, M., N. G. Mohammed Nor and F. F. Said (2005a). Efficiencies of Islamic banks in
Malaysia. International Conference on Islamic Banking and Finance. Bahrain.

Abdul-Majid, M., N. G. Mohammed Nor and F. F. Said (2005b). 'Efficiency of Islamic banks in
Malaysia'. Islamic Finance and Economic Development. M. Iqbal and A. Ahmad (ed). New
York, Palgrave Macmillan.
Abdul-Majid, M., D. S. Saal and G. Battisti (2008). 'The efficiency and productivity of
Malaysian banks: an output distance function approach.' Aston Business School Research Paper
RP 0815.

Abdul-Majid, M., D. S. Saal and G. Battisti (2010). 'Efficiency in Islamic and conventional
banking: an international comparison.' Journal of Productivity Analysis 34(1): 25-43.

Article # 9
“The effect of credit risk management on financial
performance of the Jordanian commercial banks”
Ali Sulieman Alshatti

Introduction and Objectives

Banks are exposed to different types of risks, which affect the performance and activity of these
banks, since the primary goal of the banking management is to maximize the shareholders’
wealth, so in achieving this goal banks’ managers should assess the cash flows and the assumed
risks as a result of directing its financial resources in different areas of utilization.
Credit risk is one of the most significant risks that banks face, considering that granting credit is
one of the main sources of income in commercial banks. Therefore, the management of the risk
related to that credit affects the profitability of the banks (Li and Zou, 2014).
The importance of credit risk management in banks is due to its ability in affecting the banks’
financial performance, existence and growth

Research problem. This research tries to answer the following main question (Does the credit
risk management effect on financial performance of the Jordanian commercial banks during the
period (20052013), by answering the following questions:
1) What are the indicators of the credit risk management?
2) What are the indicators of banks’ financial performance (profitability)?
3) Does the credit risk management effect on banks’ financial performance (profitability)?

Research objective. The main purpose of this research is to examine the effect of the credit risk
management indicators (particularly: Capital adequacy, Credit interest/Credit facilities, Facilities
loss/Net facilities, Facilities loss/Gross facilities, Leverage ratio, Non-performing loans/Gross
loans) on the financial performance (profitability) of the Jordanian commercial banks during the
period (2005-2013). The profitability measured by (ROA) and (ROE).
Literature review
Hakim and Neaime (2001) tried to examine the effect of liquidity, credit, and capital on bank
performance in the banks of Egypt and Lebanon; they found that there was a sound risk
management actions and application of these banks rules and laws.
Njanike (2009) found that the absence of effective credit risk management led to occurrence of
the banking crisis, and inadequate risk management systems caused the financial crisis.
Kithinji (2010) indicated that the larger part of the banks’ profits was influenced by other
variables other than credit and nonperforming loans.
Effective management of credit risk is inextricable linked to the development of banking
technology, which will enable to increase 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).

Methodology
Ho: the credit risk management effects on financial performance (expressed by ROA and ROE)
of the Jordanian commercial banks.
Subset hypothesis:
Ho1: the Capital adequacy ratio effects on financial performance.
Ho2: the Credit interest/Credit facilities ratio effects on financial performance.
Ho3: the Facilities loss/Net facilities ratio effects on financial performance.
Ho4: the Facilities loss/Gross facilities ratio effects on financial performance.
Ho5: the Leverage ratio effects on financial performance.
Ho6: the Non-performing loans/Gross loans ratio effects on financial performance

Findings
The empirical findings show that there is a positive effect of the credit risk indicators of Non-
performing loans/Gross loans ratio on financial performance, and a negative effect of Provision
for Facilities loss/ Net facilities ratio on financial performance, and no effect of the Capital
adequacy ratio and the credit interest/Credit facilities ratio on banks’ financial performance when
measured by ROA.
This is in agreement with Li and Zou (2014) who found that Non-performing loans/Gross loans
has positive effects on the financial performance of firms, as measured by ROA and ROE, and
with Abdelrahim (2013) and Li and Zou (2014) who concluded in their separated studies that the
capital adequacy ratio has no effect on credit risk management, and with Boahene, Dasah and
Agyei (2012) who found that some of credit risk indicators have a positive effect on banks’
financial performance.
The researcher also found a positive effect of Nonperforming loans/Gross loans ratio, and
negative effect of Provision for facilities loss/Net facilities ratio on bank’s financial performance,
this conclusion is consistence with findings of Hosna, Manzura and Juanjuan (2009), and is on
contrary to the results of Boahene, Dasah and Agyei (2012) who found that the Non-performing
loan and other indicators have a positive effect on bank’s financial performance.

References
Abdelrahim, K.E. (2013). Effectiveness of Credit Risk Management of Saudi Banks in the Light
of Global Financial Crisis: A Qualitative Study, Asian Transactions on Basic and Applied
Sciences, 3 (2), pp. 73-91. Available at: http://asian-transactions.org.
Abiola, I. and Olausi, A.S. (2014). The Impact of Credit Risk Management on the Commercial
Banks Performance in Nigeria, International Journal of Management and Sustainability, 3 (5),
pp. 295-306. Available at: http://pakinsight.com.

Adeusi, S.O., Akeke, N.I., Adebisi, O.S. and Oladunjoye, O. (2013). Risk Management and
Financial Performance of Banks in Nigeria, Journal of Business and Management, 14 (6), pp. 52-
56. Available at: http://iosrjournals.org.

Aduda, J. and Gitonga, J. (2011). The Relationship between Credit Risk Management and
Profitability Among the Commercial Banks in Kenya, Journal of Modern Accounting and
Auditing, 7 (9), pp. 934-946. Available at: file:///C:/Users/alial_000.

Article # 10
The Impact of Credit Risk Management in the Profitability of
Albanian Commercial Banks During the Period 2005-2015
Sokol Ndoka, Manjola Islami

Introduction and Objective

Albanian Financial institutions face difficulties for a multitude of reasons but the major cause of
Albanian banking problems are related to the credit risk. For the Albanian banks, loans are the
largest source of credit risk as they are not active is trading derivatives. Banks objective is to
manage credit risk in order to prevent losses and to maximize its profitability. The main purpose
of this research is to study if it exist a relationship between Credit risk management and
profitability of commercial banks in Albania. The main indicators used in this study are Return
on Equity, Return on Assets, Non-performing Loans Ratio and Capital Adequacy Ratio. The
research collects data from the 16 banks operating in the Albanian banking system from 2005 to
2015. Statistical test are performed in order to test the relationship between the four indicators
and the profitability of commercial banks in Albania. This study provides a contribution within
the identification of credit risk factors that affect more the profitability of the Albania Banks and
the finding of a scientific solution in order to manage the credit risk in a more efficient way.

Research question: What is the relationship between credit risk management and profitability
of commercial banks in Albania during the period 2005-2015?
Hypotheses:
Hypothesis 1 : NPLR (non-performing loan ratio) and CAR (capital adequacy ratio) have an
impact on the ROE (return on equity) of commercial banks in Albania.
Hypothesis 2: NPLR and CAR have an impact on the ROA (return on assets) of commercial
banks in Albania
Methodology
1. ROE is the return on equity which shows the net profit level generated by the equity invested
in the bank. ROE is a dependent variable and it is expressed as a %
2. ROA is the return on assets. ROA indicator shows how well the bank's assets are used to
generate higher profits. ROA is a dependent variable and it is expressed as a %.
3. NPLR is non-performing loan ratio of the banking system and is expressed through the ratio
of non-performing loans outstanding to total loans outstanding. It is an independent variable and
it is expressed as a %.
4. CAR represents the capital adequacy ratio and it is defined as the ratio of banks tier 1 + tier 2
capital to the risk-weighted assets. Also CAR is an independent variable and it is expressed as
a%.

Findings
The econometric results confirmed that there exist a correlation between the credit risk
management of commercial banks in Albania and their profitability. A more efficient credit risk
management will lead to higher profit for the Albanian commercial banks. The results of the
regression analysis indicate that the correlation between CAR and ROA and CAR and ROE is
not statistically significant. Other studies, as Kithinji (2010) in Kenya, have also failed to prove
the correlation between CAR and ROA. The systematic risk during the financial crisis of 2008
could be one of the factors that lead to this result.
Also the results of the regression analysis show that there exist a negative correlation between
NPLR and ROA and NPLR and ROE and this correlation is statistically significant. Keeping all
other coefficients constant, an increase of 1 unit in the variable NPLR will lead to a reduction in
the variable ROA by 0.286940 units and a reduction in the variable ROE by 0.018582 units. This
result is in accordance with the literature and is explained with the fact that a greater NPLR
means less capital available for the banks to invest. Based on these results the commercial banks
in Albania should be more focused on credit risk management, especially on the control and
monitoring of non-performing loans.

References
Abiola, I. and Olausi, A.S. (2014). The Impact of Credit Risk Management on the Commercial
Banks Performance in Nigeria, International Journal of Management and Sustainability, 3 (5),
pp. 295-306.
Albanian Association of Banks, Statistics, (available at www.aab.al)
Banka e Shqiperise, Statistics, (available at www.bankofalbania.org)
Basel Committee on Banking Supervision. (2008). Principles for Sound Liquidity Risk
Management and Supervision. (available at www.bis.org).
 Conclusion
• The results show a negative relationship between size and credit risk, which is consistent
with possible diversification and scale economies benefits. Loan growth is associated
with lower credit risk in the following year.
• We also find that higher domestic interest rates have a positive influence on credit risk.
• According to current proposals for a new Basel capital accord, capital requirements for
lending will be determined in greater measure than at present by current credit risk.
• Real GDP growth and other cyclical variables all turn out to have a significant effect on
profits or profit margins. Profits, at a GDP growth level of over 2%, turn out to be almost
2.5 times those at GDP growth levels below 2%.
• Finally, given the direct link between lending and economic activity as perceived by bank
lending channel theory.
• It is difficult for a bank to raise new external funds on short notice.
• It is also costly for banks to hold the buffer stock of equity capital on balance sheet.
• Results show that Islamic Banks are far from default than Conventional Banks (Mean of
Distance-to-Default equal to 204 and 15 respectively).
• We find that commercial banks in Malaysia with Islamic financing have significantly
lower credit and liquidity risks but significantly higher interest-rate risk than banks
without Islamic financing.
• Our results also show that bank size is a significant determinant of credit risk
• Acquiring hard and soft information can be done through two methods: transaction
lending or relationship lending. The former can use statistical methods of hard
information’s treatment.
• The DEA results provide evidence that there are no significant differences in gross
efficiency (on average) between conventional and Islamic banks. This result is in line
with a number of previous studies.
• We have also discovered that this result of no significant difference in efficiency between
banking types conceals some important distinctions.
• A positive effect of the credit risk indicators of Non-performing loans/Gross loans ratio
on financial performance.
• A negative effect of Provision for Facilities loss/ Net facilities ratio on financial
performance.
• No effect of the Capital adequacy ratio and the credit interest/Credit facilities ratio.
• The results of the regression analysis show that there exist a negative correlation between
NPLR and ROA and NPLR and ROE.