The Impact of Credit Risk Management on Profitability of

1 The Impact of Credit Risk Management on Profitability of Commercial Banks: A Study of Europe Authors: Fan Li Yijun Zou Supervisor: Catherine Lions Student Ume School of Business and Economics Spring semester 2014 Degree project, 30 hp ABSTRACT Banks today are the largest financial institutions around the world, with branches and subsidiaries throughout everyone s life. However, commercial banks are facing risks when they are operating. Credit risk is one of the most significant risks that banks face, considering that granting Credit is one of the main sources of income in commercial banks. Therefore, the Management of the risk related to that Credit affects the Profitability of the banks.

2 The aim of the research is to provide stakeholders with accurate information regarding the Credit risk Management of commercial banks with its Impact on Profitability . The main purpose of the research is to investigate if there is a relationship between Credit risk Management and Profitability of commercial banks in Europe. We also aim to investigate if the relationship is stable or fluctuating. In the research model, ROE and ROA are defined as proxies of Profitability while NPLR and CAR are defined as proxies of Credit risk Management . The research collects data from the largest 47 commercial banks in Europe from 2007 to 2012 and formulates four hypotheses which are related to the research question.

3 A series of statistical tests are performed in order to test if the relationship exists. Other statistical tests are performed to investigate if the relationship is stable or not. The findings reveal that Credit risk Management does have positive effects on Profitability of commercial banks. Between the two proxies of Credit risk Management , NPLR has a significant effect on the both ROE and ROA while CAR has an insignificant effect on both ROE and ROA. However, from 2007 to 2012, the relationships between all the proxies are not stable but fluctuating. Key words: Credit risk Management , Profitability , Commercial banks, CAR, NPLR, ROA, ROE ACKNOWLEDGEMENT We want to thank and express our great gratitude to all those who helped with the completion of the thesis.

4 First, we would like to thank our supervisor Catherine Lions, who helped us to overcome many difficulties, and always lead us in the right direction. Additionally, we offer our gratitude to our friends and family that supported us through the writing of this research. All of you have contributed to a successful and rewarding writing process. Thank you! Ume , May 21st Fan Li Yijun Zou Table of Contents Chapter 1 Introduction .. 1 Problem Background .. 1 Research question .. 4 Research Purpose .. 4 Research Gap and Contribution.

5 5 Limitations .. 5 Choice of subject .. 6 Disposition .. 6 Chapter 2 Methodology of the Research .. 8 Preconceptions .. 8 Perspectives .. 8 Scientific Approach .. 8 Research philosophy .. 9 Epistemology .. 10 Ontology .. 11 Research Approach .. 12 Research Design .. 14 Research Strategy .. 15 Time horizon .. 18 Research Method .. 19 Literature and Data source .. 19 Summary of theoretical Methodology .. 20 Societal and Ethical Considerations .. 21 Chapter 3 Theoretical Framework.

6 23 Regulations: The Evolving Basel Accord .. 23 Basel I: The Basel Capital Accord .. 23 1996 Amendment .. 24 Basel II .. 24 Basel III .. 26 Profitability of Commercial Bank .. 27 DuPont Model .. 28 Return on Equity (ROE) .. 29 Return on Assets (ROA) .. 30 Bank s Risk Management .. 32 risks in banks .. 32 Risk Management .. 34 Credit Risk Management .. 36 Credit Risk Management Indicators .. 37 Our research model .. 44 Chapter 4: Practical method .. 46 Population and Sample Data.

7 46 Time Horizon .. 47 Data Collection .. 47 Proxies for Credit risk Management .. 48 Proxies of Profitability .. 48 Excluding Outliers .. 49 Hypotheses .. 49 Statistic Tests .. 51 Control variable and summary of variables .. 51 Multivariate regression analysis .. 51 R2 .. 53 Multicollinearity .. 53 Heteroskedasticity .. 54 Chapter 5: Empirical Findings .. 55 Descriptive Statistics .. 55 Multicollinearity and Heteroscedasticity Test .. 58 Regression Results .. 59 Hypothesis 1.

8 59 Hypothesis 2 .. 60 Hypothesis 3 .. 60 Hypothesis 4 .. 62 Chapter 6 Discussion of Results .. 64 Insignificant results .. 64 Significant results .. 65 Stability of relationship .. 66 Improved research model .. 67 Chapter 7: Conclusions and Recommendations .. 69 conclusion .. 69 Quality of the Results .. 70 Reliability .. 70 Validity .. 71 Theoretical and Practical Contribution .. 72 Suggestions for Further Research .. 72 Reference list: .. 74 Appendix .. 83 APPENDIX 1: 47 Largest Commercial Banks in Europe by Total Assets.

9 83 APPENDIX 2: Scatterplots of variables including outliers .. 84 APPENDIX 3: Histograms for variables including outliers .. 85 APPENDIX 4: Whit tests for heteroscedasticity .. 86 LIST OF FIGURES FIGURE 1 THE POSSIBLE RESEARCH LAYOUTS .. 9 FIGURE 2 DEDUCTIVE AND INDUCTIVE APPROACH .. 13 FIGURE 3 SUMMARY OF THEORETICAL METHODOLOGY .. 21 FIGURE 4 CALCULATION OF CAPITAL RATIO UNDER BASEL II .. 25 FIGURE 5 DUPONT MODEL .. 29 FIGURE 6 DIFFERENT STEPS OF A CONTINUOUS RISK Management PROCESS .. 35 FIGURE 7 OUR RESEARCH MODEL.

10 44 FIGURE 8 DISTRIBUTIONS OF BANKS ACCORDING TO TOTAL ASSETS ( BILLION) .. 57 FIGURE 9 DISTRIBUTION OF COUNTRIES AMONG BANKS .. 57 FIGURE 10 TREND FOR CORRELATION COEFFICIENT OF CAR, NPLR AND ROE ACROSS YEARS .. 61 FIGURE 11 TREND FOR CORRELATION COEFFICIENT OF CAR, NPLR FOR ROA ACROSS YEARS .. 63 FIGURE 12 IMPROVED RESEARCH MODEL LIST OF TABLES TABLE 1 TIER 1 CAPITAL .. 40 TABLE 2 TIER 2 CAPITAL .. 41 TABLE 3 TOTAL CAPITAL .. 41 TABLE 4 SUMMARY OF VARIABLES .. 51 TABLE 5 DESCRIPTIVE STATISTICS OF VARIABLES EXCLUDING OUTLIERS.