The Effect Of Credit Risk Management On Profitability In Commercial Banks: A Case Study Of UK Banks

1.INTRODUCTION

a. Research Background

The recent 2007-2009 financial crisis has brought about significant changes in how banks operate and particularly how they manage risks. During the crisis and in its aftermath, banks were severely exposed to consumer credit risks in terms of payment defaults in credit cards, loans, mortgages as well as corporate risks. They were also exposed to internal risks concerning the management of individual investment portfolios in securitised assets (BankofEngland.co.uk, 2010). The backlash of the crisis was that it exposed the risks inherent in the operational activities of financial institutions across all tiers of banking in the country. There were risks that occur whenever consumers defaulted on their loans or mortgages, or when businesses fail and go bankrupt. While many of these crises were part of the operational challenges encountered by banks in their day to day functions before the financial crisis, the crisis had a more severe impact on banks credit risk exposures and other financial risks.

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Credit risk was defined by Basel (1999a) as “the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed term”. The severity of these credit risks did reached an alarming proportion as reflected in the increased ratio of consumer credit defaults in the balance sheet of financial institutions during and after the crisis.

Most banks, with the exception of certain Islamic Banks, typically make money on the interests they charge for loans and mortgages that are provided to individuals and businesses. They receive savings from depositors at a particular interest rate, and then offer the funds to debtors at a higher interest rate, making money off the difference in interest rates (BankofEngland.co.uk, 2010). Therefore, all banks need to lend money and provide loans if they were to make money in any competitive climate. However, the risks inherent in such practice as encountered in the face of the financial crisis shows that their lending practices should be in line with appropriate risk management systems which would ensure best practice and a healthy administration of good corporate governance practices. Theoretically, if banks do not manage their risks effectively, they would have higher number of defaults, which would reflect negatively on their profitability (Barth et al, 2004). Indeed, Jackson and Perraudin (1999) suggests that credit risks are some of the most prevalent risk elements in the books of most financial institutions and if not managed in the most efficient manner, “can weaken individual banks or even cause many episodes of financial instability by affecting the whole banking system. Thus to the banking sector, credit risk is definitely an inherent and crucial part”.

To better understand the nature of risks as well as how it affects the operations and profitability of financial institutions, it is important to explore some of the types of existing credit risks. In the work of Henie (2003) he describes three different kinds of major risks, the first he describes as consumer risk, second is corporate risk and the third sovereign which are also referred to as country risk. In a dissimilar view, Horcher (2005), explains credit risks in six different forms, they include settlement risk, concentration risk, default risk, counterparty pre-settlement risk and counterparty sovereign risk.

A number of other academic views on credit risks have followed Horcher’s viewpoint particularly given that in the aftermath of the recent financial crisis, default and counterparty risks were the most reported sources of credit risks. Besides, Horcher’s view on credit risks have been most preferred because they are broader and touches on ever forms of known major risks in financial operations. Hence, the dissertation would look at credit risk from Horcher’s holistic perspective.

Given the wide-ranging effects of these individual credit risks on the operations of banks during and in the aftermath of the financial crisis, more emphasis has been increasingly placed on credit risk management in UK corporate governance. Since the assumption of the crisis, more stringent measures on credit risk management has been imposed on banks all financial institutions by the UK financial ombudsman, the FSA.

The authorities have since placed a minimum standard requirement on all banking operations while credit rating management as well as larger exposure restrictions have been employed. Although some changes are still on the way to further manage the severity of the credit crisis, for example the Basel 3 arrangement which will be implemented by 2013. However, the little changes instituted so far have had tremendous impact on credit risks in UK banking.

In light of these changes as well as the impending changes to the management of credit risks, the proposed dissertation would seek to understand and explore measures to credit risk management and importantly the impact of credit risks on banks. How does it affect profitability and what are the best approaches to measuring risks.

The next section explains the rationale as well as the aims and objectives of the dissertation in addition to the research question which would help to navigate the rest of the chapters.

b. RATIONALE

The main rationale behind the proposed dissertation is to gain further understanding of credit risk management in UK banks and indeed to contribute to scarce literature on risk management measures. This would be done by investigating the effects that credit risk has on banks profitability. The chosen banks are HSBC, Barclays, Lloyds TSB and RBS because the four banks are the largest in the UK and have accessible data on credit risks. Achieving the stated purpose would entail reviewing the current credit risk management of these banks over a certain period of time and comparing them to profitability at the same period of time, in order to ascertain the effect that risk management practices have on eventual profitability. Policy wise, the results from the proposed dissertation could help policy makers enact certain laws that could protect financial institutions from future systemic collapses in the wake of potential financial crisis. The dissertation would entail the quantitative review of financial data of the stated banks especially in terms of credit risk ratios such as Non-Performing Loans and Capital Adequacy Ratio, measured against profitability ratio and return on Equity (ROE).

c. Aims and Objectives

Given the foregoing, the specific aims and objectives of the dissertation would be to:

Examine the theoretical concept of credit risks, types, and banks’ typical approach to the management of such risks
Examine both traditional and newer approaches to credit risk management
Identify credit risk exposures in banks and the impact of financial crisis
Understand the relationship between credit risks and profitability in terms of non –performing ratios and return on equity, as well as other profitability measures within UK banks.

d. Research Questions

To what extent does credit risk management affect the profitability, measured in terms of Return on Equity, within UK banks.

e. Outline of proposed dissertation

Given the underlying background and the importance of coherence, flow and understating – the rest of the dissertation will be divided as follows:

Introduction: The introduction (chapter one) would include all relevant information on Credit risks, risk history of UK banks, a brief background of the four UK banks being assessed, and an overview of the effect of the financial crisis on risk management.

Literature Review: The literature review would entail a survey of existing research on credit risk management and its effect on profitability in financial institutions.

Methodology: This chapter would entail an extended description of the method in which we intend to quantitatively measure the effect of risk management practices within the banks, against its ROE.

Results and Discussion: This chapter would include a breakdown of the results derived through quantitative analysis of all relevant variables. A descriptive overview of all results would be displaced within this chapter.

Conclusions: The final chapter would include an overview of the methodology utilised in answering the research question, then compare the results of the research to the literature review, in a bit to accurately depict how exactly risk management affects profitability.

2.Literature Review

According Shanmugan and Bourke (1990), financial institutions are important parts of the economy based on their main role which is to provide financial resources for economic growth. Banks are a key part of those financial institutions that provide this useful service to the economy, as they play one of the most critical roles to developing and developed economies, especially when borrowers do not have access to capital markets (Greuing and Bratanovic, 2003). Loans constitute a large portion of the assets within a bank, its biggest revenue generating asset and also the most illiquid and risky (Koch and MacDonald, 2000). According to Auronen (2003), it is hard for financial institutions to distinguish good borrowers from bad borrowers, though banks rely hugely on existing technology and algorithms, thereby leading to potential adverse selection and moral hazards, being the major cause of non-performing accounts in banks (Shanmugan and Bourke (1990). Risk management within banks is therefore important in banks, as it involves the “identification of potential risk factors, estimate their consequences, monitor activities exposed to the identified risk factors and put in place control measures to prevent or reduce the undesirable effects” (Meulbroek, 2002).

Knight (1921) defines risk in terms of the variability in actual outcome of an action or event as opposed to that expected, irrespective of whether that outcome is worse than expected or better than expected. Managers and Investors are often more concerned with opposing the downside as much as possible, whilst protecting the upside benefits (Meulbroek, 2002), thereby giving rise to a seemingly skewed perception of risk within an organisation. According to Auronen (2003), financial risks within a company can be detrimental to a firm’s value. This new ideology opposes that of Modigliani and Miller (1958) who argued that risk management should be left to investors and not the bank. Credit risk management is relevant under conditions of incomplete and imperfect capital markets, it enables managers to stabilise their operating cash flows, which in turn helps to facilitate efficient planning of future capital investment decisions and strategic development of operating activities (Froot et al, 1994). The subsequent reduction in cash flow volatility reduces the cost of financial distress within the bank; smoothes tax charges and reduces investors monitoring cost (Meulbroek, 2002). Credit risk management is also preferable to investors risk management, due to the superior access of managers to risk management instruments and for other information asymmetry benefits (Joseph and Hewins, 1997).

Commercial banks within developed and developing economies face various categories of risk, which according to Cornett and Saunders (1999) falls broadly into financial, operational and strategic. These risks impact differently on the performance of the bank, and the risk magnitude caused by credit risk is severe enough to cause bank failures (Chijoriga, 1997). According to Chijoriga, there has been an increased number of significant bank failures in recent years, in both matured and emerging economies, and a significant reason behind these, are credit problems, especially weakness in credit risk management. Loans constitute a large portion of credit risk, and normally account for 10 – 15 times the equity of bank (Kitua, 1996). Thus banking business is likely to face difficulties even when there are slight deteriorations in the quality of loans.

Modern financial institutions are in the risk management business as they undertake the functions of bearing and managing risks on behalf of their customers, through the pooling of risk and sale of their services as risk specialists. Borrowers are assessed through the use of qualitative and quantitative techniques, which measures their subjective nature, and also assesses their attributes and base a decision on a credit score (Cornett and Saunders, 1999). This according to Kraft (2000) helps to reduce the cost of processing credit application, subjective judgements and possible biases. Rating systems signal changes in expected level of loan loss, therefore numerical models make it possible to establish what factors are important in explaining default risk, evaluating the relative degree of importance of the factors, improve the pricing of default risk, and be more able to screen out bad loan applicants and be in a better position to calculate any reserve needed to meet expected future loan losses (Kitua, 1996).

According to Barth et al (2004), empirical evidence supports the notion that well-functioning banks accelerate economic growth, while poorly performing banks impede economic progress and exacerbate poverty. Given the importance of risk management in a bank, the efficiency at which a bank manages its risk is expected to significantly influence financial performance (Harker and Satvros, 1998), as an extensive body of literature also asserts that risk management affects the financial performance of banking institutions. According to Pagano (2001), it is essential in creating value for shareholders and customers. Ali and Luft (2002) thereby conclude that a firm will engage in risk management policies because it enhances shareholder value by improving return on equity investments.

3.METHODOLOGY

a. Research Philosophy

The proposed research would be based on the epistemological philosophical approach which accepts the existence of knowledge in a given scenario or an area of study. (Saunders et al. 2007). This philosophy has three fundamental elements which are positivism, realism, and interpretivism. The proposed study is close to positivism because theory about the present subject is explored and tested in the literature review with the aim of uncovering the salient issues concerning the issue at hand (credit risks). More so, the method allows the researcher to be an objective instrument that stands out and observe the process as an external element. According to Saunders et al (2007) this is vital to maintain validity and reliability of the outcome of the research.

b. Research Approach

While there exist two main approaches to research namely; deductive and inductive methods (Yin, 1994), the deductive approach would be employed in the proposed dissertation given that the overarching objective is to examine the relationship between profitability and credit risks which requires statistical data sets. This methodological approach has followed the viewpoint of Saunders et al (2007), who suggests that the deductive approach is more appropriate where numbers or statistical inputs are required as in the present study. The inductive approach is not suitable because the aim is not to explore the present issue in the scenario in which it occurred. Rather, the aim is to understand the relationship between the data sets which are purely quantitative elements.

To support the deductive approach, a regression analysis would be employed to sort and analyse data. As noted by Cohen et al (2003), regression is the method of analysis that is appropriate where a quantifiable variable is to be measured against its relationship with other factors. “Relationships may be nonlinear, independent variables may be quantitative or qualitative, and one can examine the effects of a single variable or multiple variables with or without the effects of other variables taken into account (Cohen et al, 2003).

The regression tests are very important to obtain a valid outcome for this study because they provide reliable information concerning the nature of relationship between some independent variables and dependent variables.

c. Sampling Method

This research would be based on four major commercial banks in the UK, namely HSBC, Barclays, Lloyds TSB and RBS. These four banks were chosen because they are UK based unlike Santander and other International banks. They were also chosen because they are the biggest banks in the UK and have survived a number of systemic shocks, hence, possessing a considerable amount of data which would be useful to conduct an in-depth analysis in the proposed dissertation. It is also pertinent to state that, given that robustness and survival of many macro financial risks, risk management practices would have determined their survival to a large extent. Lloyds TSB and RBS for instance had to write down a large amount of their assets and accept government shareholding, unlike both HSBC and Barclays, and this would be crucial in explaining how the risk management practices of all four banks had an effect on this outcome. Annual reports from 2005 – 2009 would be used, covering the entire period before, during and post government bailout, thus amounting to 20 observations.

d. Time Horizons

Time horizons are important in explaining how the research would be navigated in terms of approach to observation and variable measurement. Creswell (2003) notes that two forms of time horizons exist, (longitudinal and cross sectional studies). The longitudinal study basically observes development over time, hence, making it possible to measure or observe change as they occur over time in the events studied. The cross sectional study on the other hand is about understanding a specific phenomenon at a particular time (Saunders et al, 2007). The proposed dissertation would make use of the longitudinal study given that changes and relationships between variables would be studied over a 5 year period as stated in the previous section.

e. Data Collection and Analysis

The data needed for analysis would be collected by utilizing primary sources. The main sources would be the annual reports of individual banks within the past 5 years 2005 – 2009, as some banks are yet to release their full year 2010 results. This study necessitates researching their credit risk disclosure, notes on financial statements within the annual reports of all banks. Based on previous studies on credit risk management and profitability (Barth et al, 2004), it has been ascertained that the most effective method of measuring these is to evaluate the Return on Invested Equity as the best form of ascertaining profitability, and Non-Performing Loans and Capital Adequacy Ratios, as the best form of measuring credit risk management. Multiple regression models would be utilised with both independent variables within the study.

f. Study Limitation

The main limitation to the proposed study is that it includes only four commercial banks within the UK therefore the outcome cannot be generalised. Saunders et al (2007) points out that for results to be generalisation they must have the ‘generalizability’ constructs elements like representative sampling. Since this study would not be obtaining data from other countries and other types of banks and financial institutions, the results cannot be taken as representing the total population of UK banks. In addition, the number of observations occurring over a period of 5 years is likely very small to strengthen the validity claim of the study, as a number of disruptive processes has occurred to the banking industry over the same period. That would indeed affect eventual outcome of the study.

g. Strengths of the Methodology

A known advantage of the deductive approach which has been employed is its capacity to facilitate a robust and statistical understanding of the complex relationship existing between studied variables. This strength is represented in the proposed dissertation by the possibility for an extensive and in-depth consideration of credit risks from multiple regression methods. More so, the fact that different banks are studied is also strength of the dissertation because; outcomes would show how credit risks affect not just one bank, but indeed other banks. The advantage is that the nature and issues in the macro environment can be traced and appropriately determined for the specific solution.

4.Conclusions

This research proposal has given an underlying explanation to the concept of credit risk, its types and its approach to management by banks. As explained earlier, the recent financial crisis and its bad aftermath for banks has attracted more attention from the financial authority with regards to minimum requirement for credit risk management.

In addition to understanding the new measures to credit risks, this proposal is useful in helping to explain how banks could attain better profitability with respect to their credit risk management practices. It would assist investors in ascertaining the most likely bank to invest in, based on their current practices, whilst also enabling policy makers enact strict measures to ensure the strength of their banks. Quantitative studies on these variables ensure that this study would be based on objective deductive approaches, which measures the results against previous findings, in a bid to conclude on a reasonable explanation on the effect of risk management on profitability.

5.Timetable: Gantt chart
ActivitiesJuneJulyAugSepOctNov.
Start the thesis
Complete Chapters 1 & 2
Seek Supervisor’s approval
Data collection begins
Begin to analyse data
Meet supervisor
Make corrections and amendments
Complete final chapter
Get the work edited and checked
Get supervisor approval
Correct mistakes
Submission

a. Resources Required

Some of the most important resources that would be required for the dissertation are explained below. They are:

Basic access to research database for updated journals and articles on credit risks amongst UK banks. Gaining access is not an issue as the researcher has access to databases that would be used coupled with the fact that a number of free databases also exist where journals can be searched.

Access to updated books and a quiet area: These are important because books will enormously contribute to the researcher’s present understanding about the studied subject. More so, a quiet area would complement such understanding. These resources are available as they are been provided by the school library, the researcher also has access to the British library where most of the needed most of the needed books exist.

The financial data of the companies under study will also be required so as to obtain the necessary information which would be analysed for the study. Most of these companies only the have their annual reports for the past year on their websites. However, past reports can be obtained from associated financial archives.

Support and guidance of the supervisor is also a very important element of the resources required because with adequate guidance, the researcher can navigate towards the right direction during the research process. This is very important, because some complex areas of the research can be delineated where the supervisor is accessible.

6.REFERENCES

Ali, F., Luft, C. (2002), “Corporate risk management: costs and benefits”, Global Finance Journal, Vol. 13 No.1, pp.29-38.

Auronen, L. (2003), “Asymmetric information: theory and applications”, paper presented at the Seminar of Strategy and International Business, Helsinki University of Technology, Helsinki, May, .

Barth, J.R., Caprio, G. Jr, Levine, R. (2004), “Bank regulation and supervision: what works best?”, Journal of Financial Intermediation, Vol. 13 pp.205-48.

Basel Committee, (1999a) Principles for the Management of Credit Risk. Basel Committee on Banking Supervision, July

Chijoriga, M.M. (1997), “Application of credit scoring and financial distress prediction models to commercial banks lending: the case of Tanzania”, Wirts Chaftsnnversitat Wien (WU), Vienna,

Creswell, J.W., 2003, Research Design: Qualitative, Quantitative and Mixed Method Approaches, California: Sage Publications

Cohen, J., Cohen, P., West, S. G., & Aiken, L. S. (2003). Applied multiple regression/correlation analysis for the behavioral sciences, 3rd Ed. Mahwah, NJ: Lawrence Erlbaum Associates

Cornett, M.M., Saunders, A. (1999), Fundamentals of Financial Institutions Management, Irwin/McGraw-Hill, Boston, MA, .

Froot, K.A., Scharfstein, D.S., Stein, J.C. (1994), “A framework for risk management”, Harvard Business Review, November/December, pp.91-102.

Greuning, H., Bratanovic, S.B. (2003), Analyzing and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk, 2nd ed., The World Bank, Washington, DC, .

Harker, P.T., Satvros, A.Z. (1998), “What drives the performance of financial institutions?”, The Wharton School, University of Pennsylvania, Philadelphia, PA, working paper, .

Hennie, V. G., (2003). Analyzing and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk, 2nd edition. Washington DC: World Bank Publications.

Horcher, K. A., (2005). Essentials of Financial Risk Management, Hoboken: John Wiley & Sons, Incorporated.

Joseph, N.L., Hewins, R. (1997). The motives for corporate hedging among UK multinationals, International Journal of Finance & Economics, Vol. 2 pp.151-71.

Kitua, D.Y. (1996), Application of multiple discriminant analysis in developing a commercial banks loan classification model and assessment of significance of contributing variables: a case of National Bank of Commerce”, .

Knight, F.H. (1921), Risk, Uncertainty and Profit, Houghton Mifflin, Boston, MA,

Kraft, E. (2000), The Lending Policies of Croatian Banks: Results of the Second CNB Bank Interview Project, CNB Occasional Publication – Surveys, CNB, Zagreb, .

Meulbroek, L. (2002), “A senior manager’s guide to integrated risk management”, Journal of Applied Corporate Finance, Vol. 5 No.14, pp.56-70.

Modigliani, F., Miller, M. (1958), “The cost of capital, corporation finance and the theory of investment”, American Economic Review, Vol. 48 No.3, pp.261-97.

Pagano, M.S. (2001), “How theories of financial intermediation and corporate risk-management influence bank risk-taking behavior”, Financial Markets, Institutions and Instruments, Vol. 10 No.5, pp.277-323.

Shanmugan, B., Bourke, P. (1990), The Management of Financial Institutions: Selected Readings, Addison-Wesley Publishing, Reading, MA, .

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