The impact of credit risk management on

profitability: Evidence from Nepalese commercial

banks
Ritesh Shrestha

Abstract
This study examines the impact of credit risk management on profitability of Nepalese commercial banks.
The profitability in terms of return on assets and return on equity are selected as dependent variables.
Capital adequacy ratio, non-performing loan ratio, cost per loan assets, cash reserve ratio, assets growth
ratio and leverage ratio are taken as independent variables. The data are collected from bank supervision
reports published by Nepal Rastra Bank and annual reports of selected commercial banks. The survey is
based on 126 observations from 18 commercial banks in Nepal. In case, descriptive statistics, correlation
analysis some diagnostic tests for the linear regression model assumption was presented. The regression
models are estimated to test the significance and importance of credit risk management on profitability in
Nepalese commercial banks.

The result shows that capital adequacy ratio, cost per loan assets and assets growth ratio are positively
related with return on assets and return on equity. It indicates that higher the capital adequacy ratio,
higher would be the return on assets and return on equity. Similarly, increase in cost per loan assets
leads to an increase in return on assets and return on equity. Likewise, higher the assets growth ratio,
higher would be the return on assets and return on equity. The results also shows that non-performing
loan ratio, cash reserve ratio and leverage ratio are negatively related with return on assets and return
on equity which reveals that increase in non-performing loan ratio leads to decrease in return on assets
and return on equity. Similarly, higher the cash reserve ratio, lower would be the return on assets and
return on equity. Likewise, increase in leverage ratio leads to a decrease in return on assets and return
on equity. The beta coefficient is positive for capital adequacy ratio, cost per loan assets and assets
growth ratio and bank performance whereas the beta coefficient is negative for non-performing loan
ratio, cash reserve ratio and leverage ratio and bank performance. The beta coefficient is significant for
capital adequacy ratio, non-performing loan ratio, assets growth ratio and leverage ratio at 5 percent
level of significance.

Keywords: Return on assets, Return on equity, Capital adequacy ratio, Non- performing loan
ratio, Cost per loan assets, Cash reserve ratio, Assets growth ratio and leverage ratio.

Electronic copy available at: https://ssrn.com/abstract=2938546

1. Introduction

Banks are very important in every economy because they provide special functions or services in the
country (Altman et al., 2002). There are plenty of differentiations between types of banks. And much of
this differentiation rests in the products and services that banks offer (Howells and Bain, 2008). For
instance, commercial banks hold deposits, bundling them together as loans, operating payments
mechanism etc. Nowadays, a highly significant role, even vital, in an economy is played by the financial
institutions. Rajaraman and Vasishtha (2002), Kroszner et al., 2007) and (Kristo, 2013) examined that the
stability of the financial system is the basis of the modern macroeconomic policy and, at the same time, a
prerequisite for strong economic growth, which ensure macroeconomic stability and enable strong
financial institutions (Bairamli and Kostoglou, 2010).

The power of financial institutions especially commercial banks to create money is of great importance in
business operations. Commercial banks are the major financial intermediaries in any economy and they
are the major providers of credits to the household and corporate sector (Magnifique, 2011). They deal
with both retail and corporate customers, have well diversified deposit and lending book and generally
offer a full range of financial services. The policy of commercial banks to make money results in the
elastic credit system that is necessary for economic progress at relatively steady rate of growth.
Particularly, banks make profits by selling liabilities with one set of characteristics (a particular
combination of liquidity risk and return) and using the proceeds to buy assets with different set of
characteristics i.e. asset transformation.

In today’s fast-moving business environment, banks are exposed to a large number of risks such as credit
risk, liquidity risk, market risk, operational risk, interest rate exchange risk etc. Due to such exposure to
various risks, efficient risk management is required. Managing risk is one of the basic tasks to be done,
once it has been identified and known. Shafiq and Nasr (2010) argued that managing a risk in advance is
far better than waiting for its occurrence. The focus of good risk management is the identification and
treatment of risks. Its objective is to add maximum sustainable value to all the activities of the
organization.

The traditional role of a bank is lending and loans make up the bulk of their assets (Njanike, 2009).
According to Louzis et al. (2011), interest on loans contributes significantly to interest income of
commercial banks. Reed and Gill (1989) pointed out that traditionally 85 percent of commercial banks‟
income is contributed by interest on loans. Loans therefore represent the majority of a bank’s assets
(Saunders and Cornett, 2005). Lending is not an easy task for banks because it creates a big problem
which is called non-performing loans (Carey, 2002).Due to the nature of their business; commercial banks
expose themselves to the risks of default from borrowers (Waweru and Kalami, 2009).

It may be difficult to establish an optimal credit policy as the best combination of the variables of credit
policy is quite difficult to obtain. A firm will change one or two variables at a time and observe the effect.
It should be noted that the firm’s credit policy is greatly influenced by economic conditions (Pandey,
2008). As economic conditions change, the credit policy of the firm may also change. Credit risk
management is indeed a very difficult and complex task in the financial industry because of the
unpredictable nature of the macroeconomic factors coupled with the various microeconomic variables
which are peculiar to the banking industry or specific to a particular bank (Garr, 2013).

Electronic copy available at: https://ssrn.com/abstract=2938546

Presently, bank credit risk management becomes a major interest among academicians and practitioners.
While previous studies on bank credit risk management were mainly concerned with financial and credit
risks of large commercial banks, little research has attempted to address credit risk of those small banks
(for example, rural and village banks, microfinance institutions, cooperative banks and credit unions).

There are various factors that affect the performance of the bank in any economy. Credit risk management
should be at the centre of banks operations in order to maintain financial sustainability and reaching more
clients. Despite these facts, over the years there has been increased number of significant bank problems
in both, matured as well as emerging economies (Brownbridge and Harvey, 1998; Basel, 1999). Bank
problems, mostly failures and financial distress have affected numerous banks, many of which have been
closed down by the regulatory authorities (Brownbridge and Harvey, 1998). Among other factors,
weakness in credit risk management has all along been cited as the main cause for bank problems
(Richard et al., 2008 and Chijoriga, 1997). Since exposure to credit risk continues to be the leading source
of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from
past experiences. Banks should now have a keen awareness of the need to identify measure, monitor and
control credit risk as well as to determine that they hold adequate capital against these risks and are
adequately compensated for risks incurred (Calomiris and Kahn, 1991).

Jorion (2009) noted that a recognized risk is less “risky” than the unidentified risk. Risk is highly
multifaceted, complex and often interlinked making it necessary to manage, rather than fear. While not
avoidable, risk is manageable – as a matter of fact most banks live reasonably well by incurring risks,
especially “intelligent risks” (Payle, 1997; Greuning and Bratanovic, 1999). Seppala (2000) argued that a
sound credit policy would help to improve prudential oversight of asset quality, establish a set of
minimum standards, and to apply a common language and methodology (assessment of risk, pricing,
documentation, securities, authorization, and ethics), for measurement and reporting of non-performing
assets, loan classification and provisioning. The credit policy should set out the bank’s lending
philosophy and specific procedures and means of monitoring the lending activity (Polizatto, 1990).

The credit policy should set out the bank’s lending philosophy and specific procedures and means of
monitoring the lending activity. The guiding principle in credit appraisal is to ensure that only those
borrowers who require credit and are able to meet repayment obligations can access credit. Lenders may
refuse to make loans even though borrowers are willing to pay a higher interest rate, or, make loans but
restrict the assets growth ratio of loans to less than the borrowers would like to borrow (Mishkin, 1997).
Financial institutions engage in the second form of credit rationing to reduce their risks.

Pazarbasioglu (1999) concluded that the best warning signs of financial crises are proxies for the
vulnerability of the banking and corporate sector and the most obvious indicators that can be used to
predict banking crises are those that relate directly to the soundness of the banking system. Nzuve (2016)
stated credit risk management models included the systems, procedures and control which a company has
in place to ensure the efficient collection of customer payments and the risk of non-payment. The high
level of non-performing loans is a challenge to many commercial banks, which is evidence that
commercial banks are faced by a big risk of their credit. Lending in commercial banks is the main source
of profit making.

Credit provision by foreign owned banks tend to be less sensitive to exogenously determined changes in
interest rate margins than credit supply by domestically owned banks. For being more stable, credit

3
supply by foreign owned banks may limit the magnitude and frequency of lending booms. Since this also
reduces the rate of loan default, the operation of foreign owned banks is expected to stabilize the
performance of the domestic banking system (Sailesh et al., 2005). Gizycki (2001) observed that the
effect of real credit growth on bank’s credit risk is in line with the view that difficulties in monitoring
bank performance can weaken their credit standards in times of rapid expansion of aggregate credit.

In the context of Nepal, Udas (2007) stated that there was significant impact of NRB directives of capital
adequacy on the various aspects of the commercial banks and it also helped in maintaining the stability of
commercial banks in the financial market and to uplift the banking sector in Nepal to international
standard. Bhattarai (2014) revealed that 'non-performing loan ratio' has negative effect on bank
performance whereas 'cost per loan assets' has positive effect on bank performance. The result also
revealed that credit risk indicators and assets growth ratio have positive effect on bank performance.
Capital adequacy ratio and cash reserve are not considered as the influencing variables on bank
performance. This study concluded that there is significant relationship between bank performance and
credit risk indicators. Poudel (2012) stated that credit risk management is important predictor of financial
performance of commercial banks. The success of bank performance depends on effectiveness of credit
risk management among other things which leads to surge an academic paper on credit risk management
and effect on bank performance in the context of Nepal and other developing countries. The study
revealed a significant inverse relationship between commercial bank performance measured by ROA and
credit risk measured by default and capital adequacy ratio.

Dhakal (2015) found that the capital adequacy has negative and significant relation with provision for
loan loss. However, there is no significant relationship between bank size, GDP growth rate and inflation
with provision for loan loss. Manandhar (2015) found that credit risk has negative relationship with return
on equity, capital adequacy ratio, gross domestic product and bank branch but positive relationship with
inflation and capital to total deposit. Shrestha (2014) found that return on assets, return on equity, net
interest margin and capital adequacy ratio have significant positive relation with non-performing loans.
However, ratio of total loans to total deposit and logarithm of total assets have negative relationship with
non-performing loans.

The above discussion shows that the studies dealing with impact of credit risk on the performance of
Nepalese commercial bank are of greater significance. Though there are these findings in the context of
different countries and in Nepal, no such findings using more recent data exist in the context of Nepal.
Hence, this study attempts to analyze Athe relationship between performance and credit risk in Nepalese
commercial banks.

2. Methodological aspects
This study is based on the secondary data. Data were pooled for 7 years from 2007/08 to 2013/14 for 18
commercial banks in Nepal leading to a total of 126 observations. The secondary data have been obtained
from annual reports of respective sample banks, supervision report published by Nepal Rastra Bank and
annual reports of respective banks. The ordinary least square method has been used to measure the
relationship between bank performance and credit risk variables. The research design adopted in the study
is descriptive and causal comparative.

Table 1 shows the number of commercial banks selected for the study along with the study period and
number of observations.

4
 Table 1: Selection of banks along with study period and number of observations

S.N. Name of Organization Study Period No. of Observation

1 Bank of Kathmandu Limited 2007/08-2013/14 7
2 Citizens Bank Limited 2007/08-2013/15 7
3 Everest Bank Limited 2007/08-2013/16 7
4 Grand Bank Limited 2007/08-2013/17 7
5 Himalayan bank limited 2007/08-2013/18 7
6 Kumari Bank Limited 2007/08-2013/19 7
7 Lumbini Bank Limited 2007/08-2013/20 7
8 Machhapuchre Bank Limited 2007/08-2013/21 7
9 Nabil Bank Limited 2007/08-2013/22 7
10 Nepal Bangladesh Bank Limited 2007/08-2013/23 7
11 Nepal investment bank limited 2007/08-2013/24 7
12 Nepal SBI Bank Limited 2007/08-2013/25 7
13 NIC Asia Bank Limited 2007/08-2013/26 7
14 NMB Bank Limited 2007/08-2013/27 7
15 Prime Bank Limited 2007/08-2013/28 7
16 Siddharth Bank Limited 2007/08-2013/29 7
17 Standard Chartered Bank Limited(SCB) 2007/08-2013/30 7
18 Sunrise Bank Limited 2007/08-2013/31 7
Total Observations 126
Thus, the study is based on 126 observations.

The Model

The theoritical statement of the model is that bank performance is regarded as subject to the constraints of
capital adequacy ratio (CAR), non- performing loan ratio (NPLR), cost per loan assets (CPLA), cash
reserve ratio (CRR), Assets growth ratio (AGR) and leverage ratio (LEV). Therefore, the model takes the
following form: PROFITABILITY =f (CAR, NPLR, CPLA, CRR, BS, LEV)

More specifically,

ROAit = β0+β1CARit+β2NPLRit+β3CPLAit+β4CRRit+β5AGRit+β6LEVit+εit (1)

ROEit = β0+β1CARit+β2NPLRit+β3CPLAit+β4CRRit+β5AGRit+β6LEVit+εit (2)
Where,
ROA= Return on assets
ROE= Return on equity
CAR= Capital adequacy ratio
NPLR= Non-performing loan ratio
CPLA= Cost per loan assets
CRR= Cash reserve ratio
AGR\= Assets growth ratio
LEV= Leverage ratio

Capital adequacy ratio

Banks capital creates liquidity for the bank due to the fact that deposits are most fragile and prone to bank
runs. Moreover, greater bank capital reduces the chance of distress (Diamond and Rajan, 2000). However,
it is not without drawbacks that it induce weak demand for liability, the cheapest sources of fund capital
adequacy is the level of capital required by the banks to enable them withstand the risks such as credit,

5
market and operational risks they are exposed to in order to absorb the potential loses and protect the
bank’s debtors. Capital adequacy ratio is a ratio used to measure a bank’s capital adequacy to cover all the
potential inherent risk in the bank earning assets, mostly in the form of loans. CAR based on the principle
that any assets owned by the bank carries the risk that banks should provide capital for a certain
percentage of total earning assets. Banks often maintain capital ratios above the minimum regulatory
capital ratio in expanding its business through the provision of credit. Capital adequacy is the
determination of the minimum capital amount required to satisfy a specified economic capital constraint
(Merkley and Miccolis, 2002). Ultimately it determines how well financial institutions can cope with the
shocks to their balance sheet. Thus it’s useful to track capital adequacy ratios that take financial risks,
foreign exchange credit and interest rate risks.

Jha and Hui (2012) found negative association between capital adequacy ratio and ROA and the
coefficient was statistically significant. Gizaw et al. (2015) found that CAR has a significant positive
effect on ROE, but not on ROA. Ezike and Oke (2013) mentioned that holding capital beyond the optimal
level would positive effect on the efficiency and profitability of commercial banks. Aruwa and Musa
(2014), Kurawa and Garba (2014) found significant positive relationship between capital adequacy
variable and financial performance of banks. Alshatti (2015) found positive effect of the capital adequacy
ratio on the financial performance of banks. Based on it, this study develops the following hypothesis:

H1: There is positive relationship between capital adequacy ratio and bank performance.

Non-performing loan ratio

Non-performing loans ratio (NPLR) reflects the bank's credit quality and is considered as an indicator of
credit risk management. NPLR, in particular, indicates how banks manage their credit risk because it
defines the proportion of loan losses amount in relation to total loan amount (Hosna et al., 2009). NPLR
has been used as the default rate on total loan and advances. Gizaw et al. (2015) assert that non-
performing loan ratio (NPLR) is the major indicator of commercial banks' credit risk. They showed a
statistically significant negative effect on profitability measured by ROA. Since it measures the default
rate, a negative relationship could be expected between non-performing loan ratio and financial
performance of commercial banks.

However, empirical studies produce mixed results. Li and Zou (2014) and Alshatti (2015) found the
positive effect of non-performing/ gross loans ratio on the financial performance of banks. Contrary to
these findings, Felix and Claudine (2008), Kargi (2011) and Kodithuwakku (2015) found an adverse
impact of non-performing loans on the profitability. However, Kithinji (2010) asserted that the bulk of the
profits of commercial banks are not influenced by the amount of non-performing loans. Jha and Hui
(2012) found negative association between NPL ratio and ROA but the coefficient is statistically
insignificant. Although there are conflicting evidences on this issue, in view of the theory and majority of
the empirical literature, a negative relationship is expected between non-performing loan and bank’s
performance. Based on it, this study develops the following hypothesis:

H2: There is negative relationship between Non-performing loan ratio and bank performance

6
Cost per loan assets

Cost per loan assets (CLA) is the average cost per loan advanced to customer in monetary term. Cost per
loan assets is calculated dividing total operating costs by total amount of loans. The function of this is to
point out efficiency in distributing loans to customers (Ahmed and Ariff, 2007); Kolapo et al., 2012).
Thus, cost per loan assets is considered as a determinant of the bank`s performance and is viewed as an
indicator of credit risk. Banks that are efficient in managing their expenses (costs), holding other factors
constant, earn high profits. Therefore, it is expected that cost per loan assets and bank performance to be
negatively associated. This may not always be true because in cases where there are high expenditures
due to a lot of businesses done, the bank can still increase the returns.

However, the empirical studies show the mixed results on this issue. In Nepalese context, Poudel (2012)
has found negative but statistically insignificant association between cost per loan assets (CLA) and bank
performance (ROA) but in the Nigerian perspective, Kurawa and Garba (2014) have found significant
positive association between cost per loan assets (CLA) ratio and banks’ profitability (ROA). In view of
theoretical perspective and empirical evidences, a negative relationship is expected between cost per loan
assets and bank’s performance. Based on it, this study develops the following hypothesis:
H3: There is negative relationship between cost per loan assets and bank performance.

Cash reserve ratio

Cash reserve ratio is one of the control variable used in analyzing effect of credit risk on the performance
of banks. Traditionally, cash reserve ratio (CRR) has been one of the monetary tools in the hands of the
central bank. Cash reserve ratio (CRR) is a specified minimum fraction of the total deposits of customers
which commercial banks have to hold as reserves with the central bank. By changing CRR, the central
bank can control the amount of liquidity. If the reserve requirement is raised, banks will have less money
to loan out and this effectively reduces the amount of capital in the economy, therefore lowering the
money supply. It will mean less money for investment and spending, and would stunt the growth of the
economy. It would also mean that banks earn less interest and expect that their profitability may decline.
Moreover, cash reserve requirement does not earn any income for the commercial banks and thus, may be
viewed as a drain on the profitability of banks.

A number of empirical literatures have investigated the link between the changes in cash reserve ratio
(CRR) and bank profitability. Abid and Lodhi (2015), Maddaloni and Peydro (2011) and Yourougou
(1990) have asserted that changes in cash reserve ratio (CRR) have inverse impact banks profitability.
However, Uremadu (2012) has found a positive relationship between CRR and banks profitability. Based
on the theory and majority of the past empirical evidences, a negative relationship is expected between
cash reserve ratio (CRR) and bank’s performance. Based on it, this study develops the following
hypothesis:

H4: There is negative relationship between cash reserve ratio and bank performance.

Assets growth ratio

Assets growth ratio as measured by total assets is one of the control variables used in analyzing
performance of the bank system (Smirlock, 1985). Assets growth ratio is generally used to capture

7
potential economies or diseconomies of scale in the banking sector. This variable controls for cost
differences in product and risk diversification according to the assets growth ratio of the financial
institution. This is included to control for the possibility that large banks are likely to have greater product
and loan diversification. In most finance literature, natural logarithm of total assets of the banks is used as
a proxy for assets growth ratio.

The effect of assets growth ratio on profitability is generally expected to be positive (Smirlock, 1985).
Likely, positive relationship between assets growth ratio and bank profitability could be found if there are
significant economies of scale (Molyneux and Thornton 1992; Bikker and Hu 2002; Goddard et al. 2004).
Based on it, this study develops the following hypothesis:

H5: There is positive relationship between assets growth ratio and bank performance.

Leverage ratio

A leverage ratio is any one of several financial measurements that look at how much capital comes in the
form of debt (loans), or assesses the ability of a company to meet financial obligations. Leverage
measured as debt-equity ratio, indicates the proportion of a firm’s assets that is financed by debt as
against equity. Raising capital via debt involves periodic interest payments on part of firms; increased use
of debt by a firm would therefore result in higher interest payments and this lowers the earnings available
to equity shareholders. Investors therefore generally prefer firms with lower debt.
Alshatti (2015) found that the leverage ratio positively contributes to banks’ profitability, where
increasing the percent of debt in the capital structure may increase or decrease the ROE. Boahene et al.
(2012) showed that empirical leverage ratio influence bank profitability positively and significantly.
Capital structure has a positive and significant relationship with bank profitability (Agyei, 2010). Based
on it, this study develops the following hypothesis:

H6: There is positive relationship between leverage ratio and bank performance.

3. Presentation and analysis of data

Descriptive statistics

The descriptive statistics of dependent variable (return on assets and return on equity) and independent
variables (capital adequacy ratio, non-performing loan ratio, cost per loan assets, cash reserve ratio, assets
growth ratio and leverage ratio) of the study is shown in table 2.

Table clearly shows that return on assets has minimum value of -0.98 percent and a maximum value of
18.04 percent leading to the average value of 1.87 percent. The average return on equity of selected banks
during the study period is noticed to be 23.13 percent with minimum value of -27.21 percent and a
maximum of 321.55 percent. The capital adequacy ratio of selected banks ranges from a minimum value
of -18.17 percent to maximum value of 33.96 percent with average of 12.70 percent. The non performing
loan ratio has a minimum value of 0.10 percent and a maximum of 43.00 percent leading to the mean
value of 3.24 percent.

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 Table 2: Descriptive statistics

Table shows descriptive statistics - mean, standard deviation, minimum and maximum values variables
associated with 18 sample banks for the period 2007/08 to 2013/14. The dependent variables are return
on assets (ROA in percent) and return on equity (ROE in percent). The independent variables are capital
adequacy ratio (CAR in percent), non-performing loan (NPLR in percent), cost per loan assets (CPLA in
percent), cash reserve ratio (CRR in percent), assets growth ratio (AGR in percent) and leverage ratio
(LEV in percent). N is the number of observations.

Variable Minimum Maximum Mean Std. Deviation

ROA -0.98 18.04 1.87 .019
ROE -27.21 321.55 23.13 .343
CAR -18.17 33.96 12.70 .046
NPLR 0.10 43.00 3.24 .066
CPLA 0.71 20.53 3.99 .032
CRR 1.91 37.61 12.83 .079
AGR -35.61 225.81 23.73 .284
LEV -528.53 1994.51 10.25 3.35

The cost per loan assets has a minimum value of 0.71 percent and a maximum of 20.53 percent with an
average of 3.99 percent. Cash reserve ratio varies from a minimum of 1.91 percent to a maximum of
37.61 percent with an average of 12.83 percent. Similarly, average assets growth ratio is observed to be
23.73 percent with a minimum value of –35.61 percent and a maximum value of 225.81 percent.
Likewise, the leverage ratio varies -528.53 percent to 1994.51 percent leading to an average of
10.25percent. Correlation analysis

Having indicated the descriptive statistics, the Pearson’s correlation coefficients have been computed and
the results are presented in table 3.

The result shows that there is a positive relationship of capital adequacy ratio with return on assets which
indicates that higher the capital adequacy ratio, higher would be the return on assets. However, the study
observed negative relationship of h non performing loan ratio with return on assets. This indicates that
increase in non-performing loan leads to increase in return on assets. Similarly, the positive relationship
between cost per loan assets and return on assets reveals that an increase in the cost per loan assets leads
to an increase in the return on assets. The result also shows that cash reserve ratio and leverage ratio are
negatively correlated to return on assets, which indicates that higher the cash reserve ratio and leverage
ratio, lower would be the return on assets. Assets growth ratio has positive relationship with return on
assets which indicates that an increase in assets growth ratio leads to an increase in return on assets.
The result shows that there is positive relationship of capital adequacy ratio with return on equity which
indicates higher the capital adequacy ratio, higher would bet the return on equity. Similarly, the study
observed negative relationship of non-performing loan ratio with return on equity which revealed that
higher the non-performing loan ratio, lower would be the return on equity. Likewise, costs per loan assets
also have positive relationship with return on equity. It indicates that an increase in the cost per loan
assets leads to an increase in the return on equity. The result shows that cash reserve ratio and leverage
ratio are negatively correlated to return on assets, which indicates that higher the cash reserve ratio and
leverage ratio, lower would be the return on equity. Assets growth ratio has positive relationship with

9
return on equity. It indicates that an increase in the assets growth ratio leads to increase in the return on
equity.
Table 3: Pearson’s correlation matrix for the dependent and independent variables
This Table reveals the Pearson correlation coefficients between dependent and independent variables. The dependent variables
are return on assets (ROA in percent) and return on equity (ROE in percent). The independent variables are capital adequacy
ratio (CAR in percent), non-performing loan (NPLR in percent), cost per loan assets (CPLA in percent), cash reserve ratio (CRR
in percent), assets growth ratio (AGR in percent) and leverage ratio (LEV in percent). The correlation coefficient is based on the
data from 18 sample firms listed in NEPSE with 126 observations for the period 2007/08 through 2013/14.
Variable ROA ROE CAR NPLR CPLA CRR AGR LEV
ROA 1
ROE 0.496** 1
**
CAR 0.240 0.108 1
NPLR -0.232** -0.067 -0.376** 1
CPLA 0.090 0.048 -0.264** 0.412** 1
CRR -0.037 -0.049 -0.016 0.037 -0.206* 1
AGR 0.109 0.103 0.091 0.081 -0.101 0.183* 1
LEV -0.109 -0.103 0.091 0.081 -0.101 0.183* -0.109 1
**. Correlation is significant at the 0.01 level (2-tailed)
*. Correlation is significant at the 0.05 level (2-tailed)

Regression analysis
In order to test the statistical significance and robustness of the results, this study relies on secondary data
analysis based on the regression models. It basically deals with regression results from various
specifications of the model to examine the estimated relationship of credit risk variables with bank
performance.

Table 4 reveals that beta coefficient for non-performing loan ratio, cash reserve ratio and leverage ratio
are negative. The negative coefficient for non-performing loan ratio with return on assets indicates that
nonperforming loan has significant negative impact on return on assets. This finding is consistent with the
findings of Kargi (2011) and Kodithuwakku (2015). Similarly, the negative coefficient of cash reserve
ratio with return on assets indicates that increase in cash reserve ratio leads to decrease in return on assets.
This finding is similar to the finding of Maddaloni and Peydro (2011) and Yourougou (1990). In the same
way, higher the leverage ratio, lower will be return on assets. This finding contradicts with the finding of
Agyei (2010). Beta coefficients are significant for non performing loan ratio; cash reserve ratio and
leverage ratio at 5 percent level of significance.

The study also reveals that the beta coefficient is positive for capital adequacy, cost per loan assets and
assets growth ratio with return on assets. The results hence indicate that increase in capital adequacy ratio
leads to increase in return on assets. This finding is consistent with the finding of Aruwa and Musa
(2014), Kurawa and Garba (2014). Likewise, higher the cost per loan assets, higher would be return on
assets. However, higher the assets growth ratio, higher would be return on assets. This finding is
consistent with the finding of Akhavein et al (1997). The beta coefficient is significant for capital
adequacy and cost per loan assets is significant at 5 percent level of significance.

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 Table 4: Estimated regression results of return on assets and credit risk variables
The results are based on panel data of 18 commercial banks with 126 observations for the period of 2007/08 to 2013/14 by using
linear regression model. The dependent variables are return on assets (ROA in percent). The independent variables are capital
adequacy ratio (CAR in percent), non-performing loan (NPLR in percent), cost per loan assets (CPLA in percent), cash reserve
ratio (CRR in percent), assets growth ratio (AGR in percent) and leverage ratio (LEV in percent). The model is,
ROAit=β0+β1CARit+β2NPLRit+β3CPLAit+β4CRRit+β5AGRit+β6LEVit+εit..
Model Intercept CAR NPLR CPLA CRR AGR LEV R2 SEE F-value
1 0.031 0.098 .057 .01865 7.557
(6.44)** (2.74)**
2 .017 -0.067 .054 .01869 7.050
(8.89)** (-2.65)**
3 .017 0.053 .008 .01913 1.014
(6.07)** (1.01)
4 .020 0.007 .012 .01910 1.489
(9.20)** (1.88)*
5 .026 0.073 -0.048 .081 .01849 5.410
(4.79)** (1.90)* (-1.77)*
6 .032 0.095 0.006 .065 .01865 4.283
(6.51)** (2.64)** (1.00)
7 -.109 0.109 0.005 -0.023 .088 .01850 3.920
(5.45)** (2.99)** (0.91) (-1.75)*
8 .016 -0.067 0.001 -0.007 .055 .01883 2.349
(3.69)** (-2.36)** (0.01) (-0.32)
9 .026 .074 -0.050 0.014 -0.005 .082 .01863 2.705
(3.75)** (1.90)* (-1.71) (2.24)** (-0.25)
10 .036 0.09 -0.039 0.007 -0.003 -0.022 .096 .01857 2.537
(3.57)** (2.21)* (-1.28) (0.90) (-1.90)* (-0.18)
1. Figures in parentheses are t-values.
2. Asterisk (**), (*) sign indicates that the results are significant at 0.01 & 0.05 level of significance respectively.
3. Dependent variable is ROA (return on assets)

Table 5 reveals regression result of return on equity. It reveals that beta coefficient for non-performing
loan ratio, cash reserve ratio and leverage ratio are negative as indicated in Table 5. The negative
coefficients for non-performing loan ratio with return on equity indicates that nonperforming loan has
significant negative impact on ROE. This finding is consistent with the finding of Alshatti (2015).

Similarly, the negative coefficient of cash reserve ratio with return on equity indicates that higher the cash
reserve ratio, lower would be return on equity. In the same way, higher the leverage ratio lower would be
return on equity. This finding contradicts with the findings of Boahene et al. (2012). The beta coefficient
is significant for non performing loan ratio; cash reserve ratio and leverage ratio at 5 percent level of
significance.

The positive coefficients have been observed for capital adequacy ratio, cost per loan assets and assets
growth ratio with return on equity. Thus, the result indicates that capital adequacy ratio has positive
impact on return on equity. Similarly, increase in cost per loan assets leads to an increase in return on
equity. These findings are similar to the finding of Kurawa and Garba (2014). Likewise, higher the assets
growth ratio, higher would be return on equity. The finding is consistent with the finding of Smirlock
(1985). The beta coefficient is significant for capital adequacy ratio, cost per loan assets and assets growth
ratio at 5 percent level of significance.

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 Table 5: Estimated regression results of return on equity and credit risk variables

The results are based on panel data of 18 commercial banks with 126 observations for the period of 2007/08 to 2013/14 by using
linear regression model. The dependent variable is return on equity (ROE in percent). The independent variables are capital
adequacy ratio (CAR in percent), non-performing loan (NPLR in percent), cost per loan assets (CPLA in percent), cash reserve
ratio (CRR in percent), assets growth ratio (AGR in percent) and leverage ratio (LEV in percent). The model is, ROEit =
β0+β1CARit+β2NPLRit+β3CPLAit+β4CRRit+β5AGRit+β6LEVit+εit.
Model Intercept CAR NPLR CPLA CRR AGR LEV R2 SEE F-value
1 0.047 0.053 .084 .00813 11.445
(22.51)** (3.38)**
2 0.040 -0.046 .052 .00827 6.827
(46.46)** (-2.61)**
3 0.044 0.008 .058 .00825 7.659
(30.35)** (2.77)**
4 0.036 0.228 .267 .00728 45.102
(40.17)** (6.72)**
5 0.042 -0.003 .012 .00845 1.478
(42.30)** (-1.22)
6 0.043 0.045 -0.051 .032 .00836 4.035
(30.05)** (2.50)* (-2.00)*
7 0.046 0.043 -0.021 .092 .00813 6.237
(16.71)** (2.33)* (-1.01)
8 0.064 0.031 0.004 0.205 .365 .00691 11.390
(7.51)** (2.25)* (1.53) (5.92)**
9 0.056 -0.101 0.086 -0.055 .048 .00836 2.063
(5.65)** (-1.08) (0.859) (-1.95)*
10 0.049 0.045 -0.016 -0.008 .146 .00792 6.946
(16.55)** (2.50)* (-0.785) (-2.77)**
1. Figures in parentheses are t-values.
2. Asterisk (**), (*) sign indicates that the results are significant at 0.01 and 0.05 level of significance respectively.
3. Dependent variable is ROE (return on equity)

4. Summary and Conclusion

Credit risk management should be at the centre of banks operations in order to maintain financial
sustainability and reaching more clients. Nzuve (2016) stated credit risk management models included the
systems, procedures and control which a company has in place to ensure the efficient collection of
customer payments and the risk of non-payment. To achieve the goal of owners’ wealth maximization,
banks should manage their assets, liabilities, and capital efficiently. In doing this, credit policy should set
out the bank’s lending philosophy and specific procedures and means of monitoring the lending activity

This study examines the impact of credit risk management on profitability of Nepalese commercial banks.
The profitability in terms of return on assets and return on equity are selected as dependent variables.
Capital adequacy ratio, non-performing loan ratio, cost per loan assets, cash reserve ratio, assets growth
ratio and leverage ratio are taken as independent variables. The data are collected from bank supervision
reports published by Nepal Rastra Bank and annual reports of selected commercial banks. The survey is
based on 126 observations from 18 commercial banks in Nepal. In case, descriptive statistics, correlation
analysis some diagnostic tests for the linear regression model assumption was presented. The regression
models are estimated to test the significance and importance of credit risk management on profitability in
Nepalese commercial banks.

The result shows that capital adequacy ratio, cost per loan assets and assets growth ratio are positively
related with return on assets and return on equity. It indicates that higher the capital adequacy ratio,
higher would be the return on assets and return on equity. Similarly, increase in cost per loan assets leads
to an increase in return on assets and return on equity. Likewise, higher the assets growth ratio, higher
would be the return on assets and return on equity. The results also shows that non-performing loan ratio,

12
cash reserve ratio and leverage ratio are negatively related with return on assets and return on equity
which reveals that increase in non-performing loan ratio leads to decrease in return on assets and return
on equity. Similarly, higher the cash reserve ratio, lower would be the return on assets and return on
equity. Likewise, increase in leverage ratio leads to a decrease in return on assets and return on equity.
The beta coefficient is positive for capital adequacy ratio, cost per loan assets and assets growth ratio and
bank performance whereas the beta coefficient is negative for non-performing loan ratio, cash reserve
ratio and leverage ratio and bank performance. The beta coefficient is significant for capital adequacy
ratio, non-performing loan ratio, assets growth ratio and leverage ratio at 5 percent level of significance.

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