Credit Risk Management in the Development Bank of Ethiopia. Effects on the Quality of Loan Portfolio

TABLE OF CONTENTS

LIST OF TABLES

LIST OF FIGURES

ACKNOWLEDGMENT

ACRONYMS

ABSTRACT

CHAPTER ONE
1. INTRODUCTION
1.1. Background of the study
1.2. Statement of the Problem
1.3. Objective of the study
1.4. Research questions
1.5. Significance of the study
1.6. Scope of the Study
1.7. Organization of the Paper

CHAPTER TWO
2. REVIEW OF RELATED LITRATURES
2.1. Introduction
2.2. Theoretical Literature Review
2.2.1. Definition of credit risk
2.2.1.1. Determinates Portfolio quality
2.2.2. Loan Portfolio Theory
2.2.3. Credit Risk Theory
2.2.4. Credit Risk Management
2.2.5. Portfolio Management
2.2.6. Loan Portfolio Quality
2.2.7. Relationship between Credit Risk Management and Loan Portfolio
2.3. Empirical Literature Review
2.4. Conceptualization Frameworks

CHAPTER THREE
3. METHODOLOGY OF THE STUDY
3.1. Introduction
3.2. Research Design and Approach
3.3. Data Sources and collection Tools
3.4. Validity and Reliability of Research Instruments
3.5. Sampling and Sampling Techniques
3.6. Sample Size Determination and Selection
3.7. Data Analysis Techniques
3.7.1. Model Specification
3.8. Ethical Considerations

CHAPTER FOUR
4. DATA ANALYSIS AND RESULT DISCUSSION
4.1 The General Background of the Respondents
4.2 Credit Risk Management Practice of DBE
4.3 Loan Portfolio Quality Assessment of DBE
4.3.1 Trend of outstanding loan by number of clients and loan amount
4.3.2 The Agriculture sub-sector loan outstanding Assessment
4.3.3 The Manufacturing sub Sector loan Assessment
4.4 Trend of Nonperforming loan by number of clients and loan amount
4.4.1 The Agriculture Sub- Sector Loan Assessment
4.4.2 The Manufacturing Sub Sector Loan Assessment
4.5 Loan Collection Performance
4.5.1 The nexus of NPL and Collections in DBE
4.5.2 Collection Trend and Performance for the Last Five Years
4.6 Credit risk management practice and loan portfolio quality in DBE

CHAPTER FIVE
5. SUMMARY, RECOMMENDATIONS AND CONCLUSION
5.1. Summary of Findings
5.2. Conclusion
5.3. Recommendation

REFERENCES

LIST OF TABLES

Table 3-1 Sample size Determination

Table 4-1: Sex Respondents

Table 4-2: Age Category of Respondents

Table 4-3: Respondents` Level of Education

Table 4-4: Respondents` years of Experience

Table 4-5: Respondents` level of Position

Table 4-6: Presence appropriate credit risk environment

Table 4-7: Presence of appropriate Portfolio loan and Credit granting process

Table 4-8: Credit risk identification, Measurement and Monitoring process

Table 4-9 : existence of well established risk management system and standards

Table 4-10: loan portfolio quality and credit risk control

Table 4-11: Credit Risk Management Practice assessment Parameters score in DBE

Table 4-12: DBE credit risk mgmt practice in evaluating the client’s credit worthiness capacity for Loan Portfolio

Table 4-13: Effectiveness of credit risk management practices

Table 4-14: Loan collection plan & actual, outstanding loan and NPLs in Million Birr

Table 4-15 Loan Collection, Loan Outstanding, NPL Ratio and Loan Recovery Rate Performance of the Bank for the Last Five Years “in Billion Birr”

Table 4-16: Level of risk for loan portfolio encountered

Table 4-17: Existence of relationship between Credit Risk Management practices and Loans portfolio quality?

Table 4-18: Credit risk management practice effect on Loan Portfolio Quality

Table 4-19: Improper preparation of credit risk grading score sheet leads to high non-performing loan portfolio in DBE

Table 4-20: Contributing factors for the existence of banks NPLS in DBE

Table 4-21: Regression Result

LIST OF FIGURES

Figure 1: Conceptual Framework

Figure 2: Risk management Practice Assessment parameters Score

Figure 3: Clint Credit worthiness assessment Capacity

Figure 4: effectiveness of Credit risk Management

Figure 4-4: The number of clients by economic sector

Figure 4-5: Trend of amount of loan outstanding by sector

Figure 4-6: Loan concentration per client by sector

Figure 4-7: Agriculture sector clients by category

Figure 4-8: Loan outstanding by Sub-sectors of Agriculture

Figure 4-9: Loan amount Concentration per client by sub-sectors

Figure 4-10: Outstanding loan by the Manufacturing sub-sector

Figure 4-11: Number of clients having outstanding loan in DBE by manufacturing sub-Sector

Figure 4-12: Loan amount per client by sub-sectors

Figure 4-13: Number of clients with non-performing loan by sector

Figure 4-14: Trend in amount of non-performing loan by sector

Figure 4-15: NPL Ratio Calculated by clients Number

Figure 4-16: NPL Ratio Calculated by loan amount by sector

Figure 4-17: NPL by the agriculture sector sub sectors

Figure 4-18: Number of clients with non-performing loan by sub-sectors of Agriculture

Figure 3-16: Trends of NPL by the manufacturing sub sectors

Figure 3-17: Number of client with their loan under NPL by sector

Figure 3-18: Amount of loan collected and non-performing loan trend

Figure 3-19: Loan Collection & outstanding Plan and Actual

Figure 3-20: NPL Ratio and Loan Recover Rate Plan Vs Actual

Figure 5: common Risks Encountered in DBE

ACKNOWLEDGMENT

The successful completion of this thesis would not have been without the support and encouragement of individuals who assist me from the beginning to the end.

I heartily thank my God for his blessing by letting me persistent strength; He always extended to me emotional and spiritual support while writing this thesis.

Next and for most, I would like give grateful thanks to my advisor Adanech Getahun ( Asst.Professor) for her professional assistance especially, her valuable and prompt advice, constrictive corrections, comments, suggestions and encouragement from beginning to end.

Next I grateful to thanks to Development Bank of Ethiopia employees working in credit Management units for their great support in supplying relevant and up to date information’s for my thesis.

Finally, I am glad to thank my lovely family for their normal support throughout my education and writing this thesis paper.

ACRONYMS

ACRE Appropriate Credit risk environment

ANOVA Analysis of Variance

APA American Psychological Association

CIR Cost Income Ratio

DBE Development Bank of Ethiopia

DFI Development Financial Institutions

LF/TA Liquid Funds to Total Assets

LPM Loan portfolio management

LLP/GLA) Loan Loss Provision to Gross Loan Advances

LPP Loan Portfolio Profitability

NBE National Bank of Ethiopia

NPL Non Performing Loan

RIMMP Risk Identification, Measurement and Monitoring Process

RMSS Risk Management System and Standard

SCGP Operating under a sound Credit granting process

SPSS Statistical Package for Social Sciences

ABSTRACT

The main objective of the thesis is to assess the effect of credit risk management on the quality of loans portfolio in the case of Development Bank of Ethiopia. A sample of 84 respondents was drawn from the employees of the Development Bank of Ethiopia by using purposive sampling technique. Both primary and secondary data were used. Data related to loan portfolio and loan position is obtained from the bank whereas, primary data are collected using structured questioners from the employees of the bank. Descriptive and inferential statistics were used to conduct the research and Multiple Regression Analysis was run using SPSS Version 21.0 to analyze the data. With regard to credit risk management practices, the result show that DBE has not satisfactory risk Management practice. Precisely, using score 1 (poor) to 5 (best), all the parameters of risk management practice assessment have a score value below 3.40, i.e. Credit Risk Granting and Portfolio Quality Control (3.40), Credit Risk System and Standard (3.20), Credit Risk and Portfolio Quality Control (3.17), Risk Identification, Measurement and Control (3.03), and Risk Environment (2.98) . The Bank`s loan portfolio is also more vulnerable to various types of risks, such as to unpredictable risk, predictable, and controllable risks. The bank’s NPL ratio was above 15% for the last five years. The regression result also showed that sound credit granting process and the existence of comprehensive risk management system and standards are the significant variables that affect loan portfolio quality of the Bank. Credit risk management practice of the bank has insignificant effect on loan portfolio quality. Both in terms of Non-performing loan and concentration, DBE has poor loan portfolio quality which is due to the bank’s poor credit risk management practice. Therefore, there is a need to improve and enhance credit risk management practice of the Bank, especially, by improving the credit granting process to have sound credit risk management, and by updating credit risk management system and standards so as to have strong credit management.

Keywords: Credit Risk Management Practice; Loan Portfolio Quality; Credit Risk Management System and Standards

CHAPTER ONE

1. INTRODUCTION

This part of the paper presents an introduction to the study, which includes: Background of the study, description of the study, statement of the problem, the research questions that govern the study, the intended objectives, significance of the study, and scope of the study and organization of the research

1.1. Background of the study

Risk management is core concept in bank and financial sector because it has substantial effect not only on the behavior of financial institution, but also economy of a country as well as entire world. For that reason, the risk management issue is paid more and more attention in the every level of any organization over the world. In addition, as financial industry becoming more competitive as well as complex, bankers and financial managers have been shifted away from consideration on profit or spread towards to risk pricing. In other words it is not only insufficient to earn high return rate on an investment; but also earn return that compensates the banks properly for the risk assumed. Thus, the quantifying risk and finding optimal mix between taking risks, maximizing returns by creating own capital provisions are crucial for financial world (Togtokh, 2012).

Similarly, credit risk can be defined as- the possibility of losses associated with reduction in the credit quality of borrowers or counter parties. In a bank’s credit portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet their commitments in relation to lending. Literature show that losses result from reduction in portfolio value are arising from actual or perceived deterioration in credit quality.

The idea of risk management is an exceptionally vital idea to numerous organizations as most financial choices spin around the corporate expense of holding risk on account of the critical risk it conveys regarding the survival of organizations. This issue is especially essential to banks since risk is a characteristic piece of their center business operations and activities. By it’s extremely makeup, keeping money is an endeavor to deal with various and apparently restricting needs. Banks give liquidity on interest to investors through the present record and amplify acknowledge and in addition liquidity to their borrowers through lines of credit (Brown & Moles, 2014).

In developing countries, development banks have emerged and evolved over time to play a similar role, namely providing long-term capital to support growth and economic transformation. That is, such banks are key in those countries embarking on accelerated economic growth and thus facing challenges in terms of financing for capital-intensive projects and maintaining institutions that can anticipate new needs, overcome technical and entrepreneurial limitations and help coordinate multiple investments taking place simultaneously.

When we came to Ethiopia case, the Development Bank of Ethiopia (DBE) manual (2008) defined credit risk as the risk of loan repayment default by borrowers. Credit risk arises from poor lending discipline, quite often-inadequate attention to credit analysis, poor follow up and management of loans and too much reliance on collateral. As a result, asset prices decline and credit risk emerges. Loan default is a common feature of credit risk. It is the likelihood that a debtor to the bank will not meet obligation in accordance with agreed terms. Good loans are the most profitable assets for banks and are the base for their existence. Conversely, bad loans pose threats to the financial and institutional sustainability of banks. Credit risk is, therefore, understood as the critical problem in the banking industry that needs to receive management’s priority attention and proper administration (Development Bank of Ethiopia , 2008).

Like any development financial institutions, credit risk is a major problem to the Development Bank of Ethiopia. Looking at the portfolio, the size of non-performing loans has continued to rise from time to time and this has contributed to the deterioration of the portfolio quality in the bank. As of 31stSeptember2018 the loan repayment default of the bank stood about Birr 48.84Billion. Similarly, non-performing loans reached at Birr 17Billion during the same period, and this accounted for 36 percent of the total portfolio, providing evidences to the poor asset quality and the looming threat to capital erosion and financial unsustainability (DBE, 2019).

To cope with the current looming threats, it is imperative to manage credit risk at bank level and ensure sustainability, which is critical to financial institutions. Credit risk management essentially means the process that assesses the qualitative and quantitative factors that support credit worthiness; mainly it focuses on evaluation of borrowers’ creditworthiness, loan security and periodic valuation (IBID).

Concretely, development banks provide finance for long-term investment, including in capital-intensive industries. In addition, such banks provide both lending and equity participation, meaning that they have a clear interest in the close monitoring of projects, thus developing a special form of relationship banking. That is, the banks have a hands-on approach whereby they not only provide close project monitoring but also are in a position to nominate directors to the boards of the companies to which they lend and in which they have an equity stake. Moreover, developing banks have in-house technical expertise that allows them to participate in decisions involving choices of technology, scale and location. Development banks can also help raise capital elsewhere by underwriting the issuance of equity securities. Underwriting implies a leverage capacity, but is not limited to this latter feature. Development banks can leverage resources by attracting other lenders that do not have the same technical capacity to assess a project’s viability and potential, as well as by providing guarantees. In addition, development banks can play a countercyclical role, helping sustain overall investment levels and protect the productive structure of a country during economic down turns (Gottschalk & Poon, 2017).

Lending is one of the main activities of a bank and interest income constitutes the major portion of profit. In the case of the DBE, for instance, lending to manufacturing, agro-processing industries, mining or extractive industries and commercial agricultural projects constitute the major sources of its income.

As a strategic government owned institution, DBE is uniquely positioned in the financial industry as it is empowered to extend both development finance and special line of credit. Like all other financial institutions, however, the major instrument that guides and governs the operational doctrine of the Bank is the Credit Policy. It is thus these carefully crafted policies which ensure that the key requirement of sustainability is met through prudent financial intermediation and sustained resource mobilization.

Traditionally, banks have focused on oversight of individual loans in managing their overall credit risk. While this focus is important, banks should also view credit risk management in terms of portfolio segments and the entire portfolio. Effective management of the loan portfolio and the credit function is fundamental to a bank’s safety and soundness.

According to Basel II, unmanaged credit concentrations are the major problems for financial institutions as evidenced by a number of international bank failures. As it is typical with most financial institutions, DBE is exposed to concentration risk. DBE, therefore, should exert its maximum effort to identify and manage concentration risk in its portfolio by implementing risk mitigating measures or interventions.

Exposure limits are needed in all areas of the Bank’s activities that involve credit risk to ensure that the credit portfolio is adequately diversified. DBE's areas of concentration risk and exposure limits are set based on its mission and best practices. As per the credit policy of DBE, exposure limits to a single borrower and related parties are 25% and 35% of its total capital, respectively. Based on best practice the generally accepted concentration limit for a given industry sub-sector is 10-25% (DBE, 2019).

From the above mentioned theories, studies and reports the effect of credit risk management practice on the quality of loan portfolio in case of DBE. However, there are a few researchers conducted research on the effect of credit risk management on financial performance of DBE, but still, their research did not focus on credit risk identification, credit risk measurement, credit risk monitoring, and credit risk control. Thus, this research tries to lend empirical support issues on the effect of credit risk management on the quality of loan portfolio in DBE, Head office, Addis Ababa.

1.2. Statement of the Problem

Credit risk management involves the identification, assessment evaluation, control and management of a company's exposures to loss. It attempts to mitigate the occurrence of losses while initiating advance planning to assure that adequate funds will be available to cover those losses that occur (Yong, 2003).According to Bizuayehu (2015), regardelss of diffeneces in ownership (private vs. public)banks in Ethiopia are generally exposed at least five types of core risks;1) credit risk, 2) asset/liability risk, 3) foreign exchange risk, 4) internal control & compliance risk, and 5) money laundering risk. Among these risks management of credit risk gets most attention. Credit risk is one of the most vital risks for banks. Credit risk arises from nonperformance by a borrower or may arise from either an inability or unwillingness to perform in the pre-commitment contracted manner. The credit risk adversely affects the bank’s profitability, solvency, book value of a bank, and in severe case it cause crises. Poor credit risk management also affects the quality of its assets and increase loan losses and non-performing loan which may eventually lead to financial distress.

Ethiopia has long history by establishing the first Development Bank in Africa. Similarly, DBE has long history in financing Development Projects. However, the bank exhibit poor risk Management practice as compared to its long period practices in the industry. The bank’s high NPL ratio for prolonged period can be evidence to the presences of poor credit management practices. For instance, the bank’s non-performing loan (NPL) ratio grew to almost 40 percent in the year 2018, which is worst performance the bank had experienced. However, the National Bank of Ethiopia’s standard is that NPLs not to be higher than 15 percent for development finance institutions. The 2018 DBE performance report indicate due to high NPL the banks profit significantly.

The report underlines the increase of NPL over recent years. For instance, during the years 2014, 2015, 2016, 2017 and 2018 saw NPLs ratio change from 8%, 13%, 18%, 25% & 39% respectively. This is somehow a shocking phenomenon because it has a bad signal to the banks sustainability. If the bank’s portfolio is not brought under control, it may erode the capital base of the bank and reduce its profitability and even in the worst case can happen where liquidation or bankruptcy may occur due to the banks inability to manage its credit risk efficiently.

Despite employing credit risk management strategies responsible for managing risks related to lending, the bank is still experiencing a sharp rise in the level of NPL’s. Lawer (2012) states that despite innovations in the financial services sector over the years, credit risk is still the major single cause of bank failures, for the reason that for “more than 80 percent of a bank’s balance sheet generally relates to this aspect of risk management. Effective credit risk Management practice has a vital role in maintaining good Quality of Loans Portfolio. One of the concerns is quality of bank lending. Most significant challenge before banks is the maintenance of rigorous credit standards and system, especially in an environment of increased competition for new and existing clients.

Development Bank of Ethiopia, commonly known in providing short, medium, and long-term development credits. Factors causing for poor quality of Loans Portfolio are deficiency in appraisal of loans proposals and in assessment of credit worthiness, inadequately defined lending policies and procedures, absence of credit concentration limits for various industries/business segments, liberal loans sanctioning powers for bank executives without checks and balances, lack of proper coordination between various departments of banks looking into credit functions, lack of well-defined organizational structure and clarity with regard to responsibilities, authorities and communication channels, lack of credit proper systems of credit risk rating quantifying and managing across geographical and product lines, lack of effectiveness of existing credit inspection and audit systems banks and slow progress in removal of deficiencies as revealed in inspection/audit of branches and controlling offices and absence of credit risk Management models. DFI’s thus develop strategies to either eliminate or reduce this credit risk. In the management of this risk, banks are concerned about their Loans Portfolio Quality. However, despite the efforts made to address the poor credit risk management, financial institutions still have difficulties resulting from the credit risk management processes undertaken and changes in customer base leading to decreasing financial performance. To most banks, their credit risk management goal is to arrange the bank’s financial affairs in such a way that however much borrowers fail to pay back the loan in the future, the effect on their return is diminished.

Several studies had been done on DBE, for example a study conducted by (Meheretu, 2015) focused on credit appraisal and credit risk management and tries to investigate the reasons for the accumulation of bad loan at DBE.

Generally, a study done by ( Asfaw, Bogale, & Teame, 2016) on DBE are mainly focused on evaluating its financial performance and more or less on its NPL realization. In other words previous studies done on DBE do not focus on the credit risk management practice of the bank, and this paper identifies as there is no research done on the Effects of credit risk management of DBE on the quality of loans Portfolio in a comprehensive manner. Hence, this study takes a comprehensive approach to assess the credit risk management practice, assess the quality of loan portfolio of DBE, investigate the effect of credit risk management practice on loan portfolio quality of DBE, assess the contributing factors for NPL in DBE, assess the level of NPL of the banks in recent years and to highlight some recommendations that will improve DBE credit risk management practice and that will enhance its loan portfolio quality.

1.3. Objective of the study

The general objective of this study is to assess the effect of credit risk management on the quality of loans portfolio of Development Bank of Ethiopia. Specifically, the study addressed the following objectives.

- Assesses the credit risk management practice of DBE
- Assess the quality of loan portfolio of the bank
- To investigate the effect of credit risk management practice on loan portfolio quality of DBE.
- To assess the contributing factors for NPL in DBE.
- To assess the level of NPL of the banks in recent years.

1.4. Research questions

The study addressed the following research questions in the case of DBE.

- What is the credit risk management practice of DBE?
- To what extent DBE perform loan portfolio quality?
- What is the relationship between credit risk management Practice and Loan quality Portfolio of DBE?
- What are contributing factors for high NPL ratio in DBE?
- To what extent DBE experience NPL from loans provided for development projects?

1.5. Significance of the study

The principal findings of this research are expected to contribute a lot for different stakeholders and the country at large. The following are significance of this study:

Therefore, the outcome of the study is expected to generate pertinent insights for different stakeholders regarding the effects of Credit Risk Management on the quality of loans’ portfolio. Furthermore, it is the belief of the writer that the study benefits the policy makers for their effort in policy formulation and implementation and recommending possible solution for the concerning body.

This study thus will help DBE to get insight on what it takes to improve its loan qualities and the central bank (NBE) to examine its policy in banking supervision pertaining to ensuring asset quality banks maintain.

Finally the study contribute to the existing body of knowledge regarding the effects of credit risk management on quality of loans portfolio and motivate further research on Development Bank of Ethiopia and other Financial Institutions and more specifically on macroeconomic effects of credit risk management on the quality of loans portfolio which will not be studied under this research

1.6. Scope of the Study

Since the term risk is a broad area of study, the paper was focus merely on the effect of credit risk management on the quality of loans portfolio in Development Bank of Ethiopia by ignoring other area of Bank risks such as operational, interest rate, liquidity risks and the like. Even though, credit risk management is a concern of all Banks operating in the country, the paper is limited to cover Development Bank of Ethiopia credit risk management practice. On top of this, due to time and cost constraints, the study was focus only on respondents residing at Head Office of DBE. The head office of Development Bank of Ethiopia is selected due to the fact that huge amount of credit is given at a head office level.

Therefore, data analysis and interpretation and findings have been framed based on the Development Bank of Ethiopia current scenario.

1.7. Organization of the Paper

The research follows the logical steps of establishing the research questions, developing the methodology, gathering and analyzing data and drawing conclusions. Thus the study will be presented in 5 chapters.

Accordingly, the first chapter will present the background of the study, statement of the problem, research questions, objective of the study, significance of the study, scope of the study and methodology which on account to the introduction part.

The second chapter deeply deals with review of related literature on Credit Risk Management. It examines literatures and studies relevant to the study.

The third chapter incorporates brief description of methodology that is the population and sampling technique of the study; the sources of data; the data collection tools/instruments employed; the procedures of data collection; and the methods of data analysis. The fourth chapter will summarizes the results of the study and interpret the findings.

The fifth chapter is devoted to the summary of results, concluding remarks, recommendations and future research directions. More over the lists of bibliography and appendixes will be attached to the research work.

CHAPTER TWO

2. REVIEW OF RELATED LITRATURES

2.1. Introduction

This chapter presents what other scholars have written about the credit risk management and quality of loan portfolio of banks, it specifically looks at theoretical framework and empirical evidences. Finally, this section has present summary of the chapter.

2.2. Theoretical Literature Review

2.2.1. Definition of credit risk

There are various definitions of credit risk in literatures. Most common definition described by Basel Committee on Bank Supervision is credit risk is credit risk is the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms (BIS, 2000). Alternatively, credit risk is defined as the risk that unexpected change in a counter-party’s creditworthiness may generate a corresponding unexpected change in the market value of the associated credit exposure (Andrea Resti & Andrea Sironi, 2016).

Credit risk is the most obvious risk of a bank by the nature of its activity. In terms of potential losses, it is typically the largest type of risk. The default of a small number of customers may result in a very large loss for the bank (Tony & Bart, 2008).

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organization (Supervison, 2000).

2.2.1.1. Determinates Portfolio quality

Loan portfolio is a combination of advances extended to borrowers and is being held for repayment. Loan portfolio is the major asset of financial institution and predominate source of revenue. The determinants of quality of loan portfolio are stated below:

2.2.1.1.1. Credit Risk Identification

Risk identification is one of the vital actions banks take to effectively manage risk. For effective credit risk management, banks have to identify what risks they face. It is therefore important not to miss out any risk during risk identification. There exist a number of techniques that Banks can employ to identify the risk. The first step in establishing the operation of the risk administration function is to determine the crucial segments inside and outside the corporation. Units and the employees are given the responsibilities to identify the specific risk that might need attention ( Kromcshdor F.& Luck C., 1998). (Al-Tamimi H., 2007) Established that commercial banks in United Arab Emirates were exposed to credit risk as the major risk further, the study established that the major methods used to identify credit risk posed by borrowers is inspection by credit managers and financial statements analysis.

The major practices used in risk management are institutionalizing credit standards, credit worthiness evaluation, credit scoring, assignment of risk rating and collateral. Credit risk identification has positive significance on credit risk management practices.

2.2.1.2. Risk Analysis and Assessment

Various conceptual studies have been made on risk analysis and assessment with focus to quantification and mitigation of risk. Organizations should classify the different risks the exposed to the ultimate potential of loss (Fuser,K.,Gleiner, W. and Meier, G., 1999).

The classification allows the management to clearly segregate the adverse risk that might affect banks going concern from those that can have slight impact. Normally, there exist an inverse relationship between the probable loss and its equivalent likelihood.

In a study conducted by, it was established that commercial banks in United Arab Emirates are more effective in examining and evaluating risk and there is a significant difference between UAE commercial bank and overseas banks that conduct lending risk analysis and evaluation.

Further, the study established that assessment and analysis of lending risk have bearing on credit risk management practices. (Drzik, 1995)Study established that big banks in the United States had made a considerable progress in development and institutionalizing of risk controls. The measures adopted by the United States have improved pricing and performance measurement as well as credit controls.

2.2.1.3. Credit risk Monitoring and control

Credit risk managers have responsibility of ensuring that there is a proper quantification, monitoring and control of risk arising from credit. Credit risk managers therefore have responsibilities of ensuring there is a proper unearthing of likely events or forthcoming fluctuations that could negatively compromise quality of loans portfolio and the banks potential to counter changes should they occur. Proper risk management requires banks to have in place an adequate structure for evaluation and reporting to ensure that credit risks are adequately identified and assessed and that controls are operational to mitigate the risk. The process of credit monitoring entails performing regular contact with borrowers, creation of an atmosphere and trust to borrowers so as banks can be considered as solution providers, creation of an organizational culture that provides support to borrowers during difficulties and assist the borrowers in any way possible to tackle the challenges, keen monitoring of the state of borrower’s business through their bank accounts, periodic re-examination of the borrower's reports as well as conducting borrower’s call backs and visits, keeping up to date credit files for borrowers and frequent reviewing of borrowers previous credit rating . Credit risk monitoring is vital tools that assist commercial banks to discover lapses and potential defaulters and at early stage and also to test if risk management practices are sound so as to reduce bank exposure to non-performing loans (Al-Tamimi H. , 2002).

Credit risk monitoring refers to incessant monitoring of individual credits inclusive of Off- Balance sheet exposures to obligors as well as overall credit portfolio of the bank. Banks need to enunciate a system that enables them to monitor quality of the credit portfolio on day-to-day basis and take remedial measures as and when any deterioration occurs. Such a system would enable a bank to ascertain whether loans are being serviced as per facility terms, the adequacy of provisions, the overall risk profile is within limits established by management and compliance of regulatory limits. Establishing an efficient and effective credit monitoring system would help senior management to monitor the overall quality of the total credit portfolio and its trends.

Consequently the management could fine tune or reassess its credit strategy /policy accordingly before encountering any major setback. The banks credit policy should explicitly provide procedural guideline relating to credit risk monitoring. At the minimum it should lay down procedure relating to the roles and responsibilities of individual’s responsible for credit risk monitoring; the assessment procedures and analysis techniques (for individual loans & overall portfolio); the frequency of monitoring; the periodic examination of collaterals and loan covenants; the frequency of site visits; and he identification of any deterioration in any loan (SBP, 2012).

2.2.2. Loan Portfolio Theory

According to (Kurui, S. K. & Kalio, A, 2014) Loan portfolio theory relates to the sum total of money loaned out through various lending products to different borrowers. Loan portfolio encompasses salary loans, group bonded loans, individual loans and company loans (Murugu, 2010). Loan portfolio refers to number of bank customers with loans and the total amount loaned out (Crabb P. and Keller T., 2006). According to (Kurui, S. K. & Kalio, A, 2014), continued existence of most financial institutions depends entirely on successful lending program that revolves on funds and loan repayments made to them by the clients. This means a restrictive credit control policy should be adopted to act as a deterrent to unnecessary lending and in the process improve on profitability of the financial institutions (Kipchumba, 2015). Loan portfolio constitutes loans that have been made or bought and are being held for repayment. Loan portfolios are the major asset of Financial Institution. The value of the loan portfolio depends not only on the interest rates earned on loans but also on the likelihood that interest and principal will be paid (Jansson, 2002). Lending is the principal business activity for most commercial banks, the loan portfolio is typically the largest asset and the predominate source of revenue. As such, it is one of the greatest sources of risk to a financial institution’s safety and soundness. Whether due to lax credit standards, poor portfolio risk management, or weakness in the economy, loan portfolio problems have historically been the major cause of losses and failures. Effective management of the loan portfolio and the credit function is fundamental to financial institution’s safety and soundness. Loan portfolio management (LPM) is the process by which risks that are inherent in the credit process are managed and controlled. Because review of the LPM process is so important, it is a primary supervisory activity (Reilly F. K & Brown, K.C).

2.2.3. Credit Risk Theory

Management practices have been defined as the identification, measurement, monitoring and control of risk arising from the possibility of non-payment of loans advanced to various clients (Kithinji, A. M, 2010). Loans extended to bank's clients might have risks associated with non-repayment in circumstances the bank assumes that the loanees will faithfully pay back amounts borrowed; some borrowers usually don’t repay resulting to decreases performance due to non-performing loans provisioning (Wang, 2013). Every Financial institutions experience a certain amount of uncertainty in instances where it loans funds to individual and corporate customers.

In such scenarios, the financial institution may end up with lending losses should some of the borrowers fail to clear loans as per agreements (Karugu and Ntoiti, 2015). Primarily, credit-risk of a banking institution is the chances that a loss resulting from default of interests and the principal, or the two of them, or in ability of the bank to sell the securities held against the loan (Kithinji, A. M, 2010).

Banks are required to use the Know Your Customer principle as a strategy aimed at minimizing and/or eliminating credit risk ( Basel Committee on Banking,Supervision, 2006). Biased decisions made by banks management might result to insider leading or to individuals associated with the banker or individuals with poor financial background or to fulfill personal motives, which may include tying to be friend persons with higher status in the society. One of the solutions suggested is the use of well-known lending methods and especially quantitative ones as they filter out biasness (Abdifatah, 2010).

2.2.4. Credit Risk Management

According to (Tefera, 2011), the concept of credit risk management can be treated as the heart of any financial institutions. It plays the vital role in the performance of a financial institution as it analyzes credit worth ability of borrowers. (Kithinji, 2010), defined credit risk management has been defined as implementation of policies to limit insider lending and large exposures to related parties this is in addition to controlling risks stemming out of chances that a client may not repay the loan. Inadequate credit risk management practices and absence of care to variations in economy can be named as causes for poor financial performance by banking institutions (Tefera, 2011). The objective of credit risk management in banks is to achieve maximum risk-adjusted rate of return by retaining credit risk exposure within satisfactory limits (Wang, 2013). Indicatively credit risk management may be spell out methodical appliance of management strategies, processes and practices to the tasks of pinpointing, evaluating, gauging, treating and monitoring risk. Earnings due to banks will be exposed to risks of variations in returns and hence fluctuate if the financial institutions are not aware of the percentage of loans that will become delinquent. Loans extended to bank's clients might have risks associated with non-repayment in circumstances the bank assumes that the loaners will faithfully pay back amounts borrowed. A few of the clients ordinarily don’t make the repayments resulting to decreased profits due to the need for provisioning and writing of the loans (Karugu and Ntoiti, 2015). Essentially, the credit risk of a bank is the likelihood of cost arising from non-repayment of interest and the initial loaned amount, or both, or failure to sell of securities pledged on the loan (Kithinji, A. M, 2010).

2.2.5. Portfolio Management

Effective management of the loan portfolio and the credit function is fundamental to a bank’s safety and soundness. Loan portfolio management (LPM) is the process by which risks that are inherent in the credit process are managed and controlled. Because review of the LPM process is so important, it is a primary supervisory activity. Assessing LPM involves evaluating the steps bank management takes to identify and control risk throughout the credit process. The assessment focuses on what management does to identify issues before they become problems. This booklet, written for the benefit of both examiners and bankers, discusses the elements of an effective LPM process. It emphasizes that the identification and management of risk among groups of loans may be at least as important as the risk inherent in individual loans (Chodechai, 2004) . For decades, good loan portfolio managers have concentrated most of their effort on prudently approving loans and carefully monitoring loan performance. Although these activities continue to be mainstays of loan portfolio management, analysis of past credit problems, such as those associated with oil and gas lending, agricultural lending, and commercial real estate lending in the 1980s, has made it clear that portfolio managers should do more. Traditional practices rely too much on trailing indicators of credit quality such as delinquency, non-accrual, and risk rating trends. Banks have found that these indicators do not provide sufficient lead time for corrective action when there is a systemic increase in risk (Sanchez, 2009). Now, many banks view the loan portfolio in its segments and as a whole and consider the relationships among portfolio segments as well as among loans. These practices provide management with a more complete picture of the bank’s credit risk profile and with more tools to analyze and control the risk (Gonzalez-Paramo, J. M. , 2010).

2.2.6. Loan Portfolio Quality

Loan portfolio relates to the sum total of monies loaned out through various lending products to different borrowers (Kurui, S. K. & Kalio, A, 2014). Loan portfolio encompasses salary loans, group bonded loans, individual loans and company loans (Murugu, 2010). Loan portfolio refers to number of bank customers with loans and the total amount loaned out (Crabb P. and Keller T., 2006). According to (Kurui, S. K. & Kalio, A, 2014)continued existence of most financial institutions depends entirely on successful lending program that revolves on funds and loan repayments made to them by the clients. This means a restrictive credit control policy should be adopted to act as a deterrent to unnecessary lending and in the process improve on profitability of the financial institutions (Kipchumba, 2015). Credit management is the managerial responsibility through which customer’s credit ratings are determined as part of the credit control function. Non-performing loans are used as a measure of the quality of loan portfolio. The portfolio is said to be of good quality if there are minimal or no non-performing assets (Onuko, L. K, 2015). According to (Onuko, L. K, 2015), should a loan remain unpaid for a period of time exceeding ninety days, then it is classified as non-performing loans and has limited chances of being serviced either partially or fully. Onuko (2015) suggests that unhealthy loan portfolio rather poor operating efficiency is the clearest sign of failed banks. A fall in loan portfolio quality impends on banks liquidity and hence its daily processes. Onuko (2015) posit that a healthy loan portfolio is very critical to the performance of the individual bank and also entire country’s financial sector. The study concluded that poor loan portfolio tend to reflect on the total net worth of a bank.

2.2.7. Relationship between Credit Risk Management and Loan Portfolio

Loans being the major and most apparent source of credit risk to most banks means that credit management techniques needs to be applied (Abdifatah, 2010). Credit risk has been defined as the potential that a bank debtor and other counterparties will not meet their responsibilities occasioning to depressed earnings. Exposure to financial risk, in addition to direct financial loss should also be taken into consideration when it comes to credit risk. As it does not always happen in isolation, credit risk also exposes banks to other risks for instance liquidity risk with both affecting loan portfolio quality. The aim of credit risk management is to maximize banks risk adjusted rate of return by retaining credit risk exposure within acceptable levels (Hempel, G. H. & Simonson, D. G. , 1999). It is imperative for banks to ensure credit risk attached to loan portfolio is well managed in addition to that of individual client’s credit transaction .The financial institutions must also put in mind the connection revolving among interest rates, credit and liquidity risk well-organized credit risk management is vital to the entire risk management structure and is vital to each financial institution profitability and eventually its own survival and growth in the long run (Karugu and Ntoiti, 2015). Comprehensive review risks involved lending decisions is of great significance and goes a long way in mitigating losses that would be occasioned should the loan book turn out to be bad. On the flip side, banks loan portfolio is directly related to the amounts of credits granted and hence strict credit management need to be put in place to lower the credit risk and hence prevent financial loss. Banks must consider and stabilize the two options in order to improve on profitability (Wang, 2013).

2.3. Empirical Literature Review

Several studies have been undertaken to understand the risk arising from credit operations as well as other underlying risks facing financial institutions.

A study by (Mohammad, 2008) did a study on risk management in Bangladesh Banking Sector. His main objective was to investigate the contribution of credit risk on non-performing loans. He found that, the core of the problem lies in the accumulation of high percentage of non-performing loans over a long period of time. As per him unless NPL ratio of the country can be lowered substantially they will lose competitive edge in the wave of globalization of the banking service that is taking place throughout the world. Since they have had a two-decade long experience in dealing with the NPLs problem and much is known about the causes and remedies of the problem, he concluded that it is very important for the lenders, borrowers and policy makers to learn from the past experience and act accordingly. (Zewude, 2011), Conducted a study on credit risk administration and the profitability of commercial banks in Ethiopia. The motivation behind the investigation was to quantify the effect of credit chance administration on profitability of seven noteworthy business banks in Ethiopia. The researcher utilized relapse demonstrates, to examine the information which was gathered from the National Bank of Ethiopia and from seven business banks of the nation. The ROE was taken as the dependent variable while the free factors were the NPL proportion and the Auto. The examination uncovered that both nonperforming credit proportion and capital ampleness proportion negatively affects performance of banks in Ethiopia.

As studied by (Mehretu, 2015)on an assessment of credit appraisal and credit risk management practices on Development Bank of Ethiopia, was provide the following empirical evidences.

The main objective of the study was to evaluate the overall performance of DBE after the 1994 reform, to show whether the performance of BE is improving or deteriorating in various aspects. The study was a case study and it uses both qualitative and quantitative data from secondary sources, it also uses DBE’s financial statement as a primary source. The study concludes in general as the performance of DBE has increased in all aspects except the fact that banks provision for doubtful loan increased which indicates deterioration in loan receivables.

A study was done on Brazilian National Development Bank (BNDES‟) by (Sergio G. Lazzarini,Aldo Musacchio,Rodrigo Bandeira-de-Mello and Rosilene Marcon , 2011) with the title “What do development banks do? Evidence from Brazil 2002-2009”. It examines the selection/Appraisal process through which BNDES capital is allocated to firms. This study is a descriptive study and it started by setting a hypothesis of “Industrial policy and political view on the role of development banks” For this study data were collected from 286 publicly listed companies, between2002-2009, and secondary data were used from Brazilian National Development Bank (BNDES) on loans and equity allocation in the stated period. The findings of the study reveals that BNDES‟ apparently selects firms with good operational performance based on their capacity to repay their loan but, it also provided more capital to firms with political connection.

Finally, the writer of this study couldn’t find research done on the effect of credit risk management on the quality of loan portfolio in DBE in a wide-ranging manner and identifies it as a research gap where this paper is believed to fill in.

2.4. Conceptualization Frameworks

As shown below in figure there are four independent variables that compose credit risk management practices. The Dependent variable is the quality of Loans Portfolio as measured by Non Performing Loans (NPL) to total loans. The four independent variables directly affect the quality of the Bank Loans Portfolio.

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