CHAPTER ONE

INTRODUCTION

1.1 Background of Study

The increased competition associated with the process of capitalization, liberalization and globalization and the attempts of Nigerian banks to increase their presence in other markets may have affected the efficiency and credit risk of the Nigerian banking institutions. The Nigerian banking sector has witnessed several financial liberalization reforms over time, resulting in a dynamic but increasingly complex risk environment for deposit money banks (Bolarinwa & Akinlo, 2022). The first of these aspects, already analyzed in other studies, is based on the incentive to the banks to reduce costs and to improve the management of their resources in order to gain competitiveness. The second aspect is explained by the poorer knowledge of the new markets by the newly entered banks and/or the greater permissiveness in the acceptance of risk with a view to increasing the market share in certain sectors and/or regions. Despite the importance of these two aspects, banking literature has usually analysed banking efficiency without considering them together.

The risk focused examination process has been adopted to direct the inspection process to the more risk areas of both operations and business. Skills in risk-focused supervision are continually being developed by exposing examiners to relevant training. By adopting this approach, the banking industry, and specifically the commercial banks are sensitized on the need to have formal and documented risk management frameworks. Notably, the more complex a risk type is, the more specialized, concentrated and controlled its management must be (Seppala, 2000; Matz & Neu, 1998; Ramos, 2000). Financial institutions are exposed to a variety of risks among them; interest rate risk, foreign exchange risk, political risk, market risk, liquidity risk, operational risk and credit risk. Nigerian banks encounter persistent difficulties in efficiently managing and disclosing credit and liquidity risks, which considerably affects their financial performance and shareholders’ confidence (Olawale & Obinna, 2023). In some instances, commercial banks and other financial institutions have approved decisions that are not vetted; there have been cases of loan defaults and nonperforming loans, massive extension of credit and directed lending.

Credit risk is the possibility that the actual return on an investment or loan extended will deviate from that which was expected (Conford, 2000). Coyle (2000) defines credit risk as losses from the refusal or inability of credit customers to pay what is owed in full and on time. More recently, Tomomewo et al. (2023) describe credit risk in the Nigerian banking context as encompassing non-performing loans, loan loss provisions, loan and advance ratios, and capital adequacy all of which collectively determine the quality of a bank’s credit portfolio. The main sources of credit risk include limited institutional capacity, inappropriate credit policies, volatile interest rates, poor management, inappropriate laws, low capital and liquidity levels, directed lending, massive licensing of banks, poor loan underwriting, reckless lending, poor credit assessment, laxity in credit assessment, poor lending practices, government interference, and inadequate supervision by the central bank. To minimize these risks, it is necessary for the financial system to have well-capitalized banks, service to a wide range of customers, sharing of information about borrowers, stabilization of interest rates, reduction in non-performing loans, increased bank deposits, and increased credit extended to borrowers. Loan defaults and non-performing loans need to be reduced (Basel Committee on Banking Supervision, 2006). The Central Bank of Nigeria (CBN), recognizing these threats, has implemented stricter regulations and established the Asset Management Corporation of Nigeria (AMCON) to reduce non-performing loans and improve bank resilience and asset quality (CBN, 2023).

Commercial banks employ different credit risk management policies majorly determined by ownership of the banks (privately owned, foreign owned, government influenced and locally owned), credit policies of banks, credit scoring systems, banks’ regulatory environment and the calibre of management (Nworji, Olagunju & Adeyanju, 2011). Banks may however have the best credit management policies but might not necessarily record high profits. The market may thus regard an individual bank’s poor performance more leniently when the entire banking sector has been hit by an adverse shock such as a financial crisis. Banks may be forced to adjust their credit policy in line with other banks in the market where a herding behaviour is practised (Altman, 2008). Bolarinwa and Akinlo (2022) empirically established that low competition increased non-performing loans in the Nigerian banking industry, while bank size and capitalization enhanced competition to further increase non-performing loans underscoring the role of market structure in shaping credit risk outcomes.

In Nigeria, commercial banks play an important role in mobilizing financial resources for investment by extending credit to various businesses and investors. Lending represents the heart of the banking industry and loans and advances are the dominant assets as they generate the largest share of operating income. Loans however expose the banks to the greatest level of risk. Many banks that collapsed in the late 1990s and up to the recent restructuring of the commercial banks in Nigeria were as a result of poor management of credit facilities, which was portrayed in the high levels of non-performing loans. Using panel data from listed deposit money banks, Chukwu et al. (2024) found that non-performing loans exert a significant negative impact on the financial performance of Nigerian commercial banks, with higher NPL ratios consistently reducing return on assets (ROA) and diminishing overall bank stability. Similarly, Ogunwale and Isibor (2024) demonstrated that non-performing credits and capital adequacy ratios significantly influence equity returns of major Nigerian deposit money banks including First Bank, Zenith Bank, Access Bank, GTBank, and UBA over a ten-year period. Looking at the emphasis that is laid on credit risk management by commercial banks in the recent time, the level of contribution of this factor to financial performance has not been fully analysed, which called for this study. Researchers have therefore turned to the study of credit risk management, which offers natural experiments for the betterment of performance assessment of commercial banks in Nigeria.

1.2 Statement of Problem

The health of the financial system has an important role in the country (Das & Ghosh, 2007) as its failure can disrupt economic development. A company’s financial performance is its ability to generate new resources from day-to-day operations over a given period of time, being gauged by net income and cash from operations. The bank performance measure can be divided into traditional measures and market-based measures (Aktan & Bulut, 2008). New banking risk management techniques emerged in the early 1990s, and today encompass credit risk, interest rate risk, liquidity risk, market risk, foreign exchange risk, and solvency risk as the most applicable risks to banks.

According to Appa (1996), risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources. Credit risk specifically is the risk of loss due to a debtor’s non-payment of a loan or other line of credit, whether of principal or interest or both (Campbell, 2007). Empirical evidence from recent Nigerian studies confirms this threat: Okwuosa et al. (2023) found, using panel corrected standard error regression on twelve listed deposit money banks from 2013 to 2022, that liquidity and operational risks have a positive and significant relationship with profitability measured by ROA, while elevated credit risk undermines returns. Furthermore, Uche and Obinna (2022) suggest that higher non-performing loans (NPLs) correlate with lower financial performance as measured by return on assets (ROA), and Kelvin and Odebode (2024) revealed that while non-performing loans have a negative outcome on return on equity (ROE) of selected commercial banks, bank size has a positive impact.

The importance of credit risk management to banks cannot be overemphasized, as it forms an integral part of the loan process. Credit risk management maximizes a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable bounds, thereby shielding the bank from the adverse effects of credit risk. The Central Bank of Nigeria reported that the banking industry Capital Adequacy Ratio (CAR) fell to 11.2 per cent at the end of June 2023 from 13.8 per cent in 2022, driven by foreign exchange market reforms resulting in the revaluation of foreign currency-denominated risk assets, even as the NPL ratio stood at 4.1 per cent, within the 5.0 per cent prudential threshold (CBN, 2023). It is therefore expedient to ask: what is the relationship between performance (ROE, ROA) and the non-performing loans of banks in Nigeria? Is there any relationship between performance (ROE, ROA) and the capital adequacy ratio of banks in Nigeria? This study therefore seeks to investigate whether investment in credit risk management is viable to the banks, and to examine the impact of credit risk management on commercial banks’ performance in Nigeria.

1.3 Research Objectives

The broad objective of this paper is to examine the relationship between credit risk management and financial performance of commercial banks in Nigeria. The specific objectives are to:

1. Examine the significance of credit risk management on the financial performance of commercial banks in Nigeria;

2. Analyse the financial performance of commercial banks under study;

3. Determine and evaluate the effect of non-performing loans on the profitability of commercial banks in Nigeria.

1.4 Research Questions

1. What is the significance of credit risk management on the financial performance of commercial banks in Nigeria?

2. How is the financial performance of commercial banks under study?

3. What are the effects of non-performing loans on the profitability of commercial banks in Nigeria?

1.5 Research Hypotheses

The following hypotheses are tested in this study:

1. Credit risk management has no significant effect on financial performance in Nigerian banks;

2. There is no significant relationship between loan and advances management of commercial banks and their profitability performance; and

3. Non-performing loans and advances have no significant effect on financial performance of commercial banks.

1.6 Significance of Study

At the end of this study, it is expected that the findings would be of immense benefit to stakeholders in the banking industry, including bankers, financial analysts, bank managers, internal auditors, and the top management of commercial banks, as the significant relationship between credit risk management components and financial performance of commercial banks using ratio analysis would be considered. The study is also expected to serve as reference material for students, lecturers, and researchers on the subjects of asset quality, non-performing loans, and credit risk management in relation to the financial performance of commercial banks in Nigeria. Given that recent empirical works such as Tomomewo et al. (2023), Chukwu et al. (2024), and Ogunwale and Isibor (2024) have identified persistent gaps in the literature on credit risk and bank performance in the Nigerian context, this study contributes timely evidence that can inform both regulatory policy and institutional practice.

1.7 Limitations of the Study

There are constraints which hinder the progress of this work. Such constraints include time constraints, limited financial and other resources, reluctance on the part of some interviewees, poor communication, and withholding of vital information by some commercial bank staff that would have aided or facilitated greater efficiency in data collection.

1.8 Definition of Terms

Credit Risk: A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. Operationally, it is measured in this study using the non-performing loan ratio, loan loss provision ratio, and capital adequacy ratio (Tomomewo et al., 2023).

Commercial Banks: Banks that deal in retail banking by accepting deposits from customers and granting loans to companies and individuals.

Bank Performance: This refers to how well a bank is doing in generating returns. It is assessed primarily through return on assets (ROA) and return on equity (ROE), both widely used in the Nigerian banking literature as proxies for profitability (Chukwu et al., 2024; Kelvin & Odebode, 2024).

Non-Performing Loans (NPLs): Loans where banks no longer receive interest or principal payments as agreed, typically after 90 days of non-payment. A loan is considered non-performing if interest or principal payments are overdue by 90 days or more, or if there are reasons to doubt full repayment even if the delay is less than 90 days (Olumide et al., 2024).

Capital Adequacy Ratio (CAR): A measure of a bank’s capital expressed as a percentage of its risk-weighted credit exposures. The CBN mandates a minimum CAR of 15% for banks with international licenses and 10% for others (CBN, 2023).

Loan: A sum of money transferred to another for temporary use, to be repaid with or without interest according to the terms of the loan agreement.

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