CHAPTER ONE

INTRODUCTION

1.1. BACKGRAUND OF THE STUDY

This paper provides a comprehensive overview of topic related to the assessments, analysis
and management of credit risk, i.e. non-performing loan (NPL) in the field of banking
industry. However, before discussing about credit risk, it is very important to define the
meaning of risk. According to (Williams A, 1998), risk is a potential variation in outcomes
and the exposure to a potential loss. In general, it can be defined as a probability or
uncertainty about economic losses due to the occurrence of an event.

The risk surrounding a potential loss creates significant economic burdens for businesses,
governments, and individuals. Billions of dollars are spent each year on strategies for
financing potential losses. But when losses are not planned for in advance, they may cost even
more. Businesses as well as individuals may try either to avoid risk as much as possible or to
reduce its negative consequences. Overall, an entity’s cost of risk is the sum of outlays to
reduce risk, the opportunity cost of activities forgone due to risk considerations, expenses of
strategies to finance potential losses and the cost of unreimbursed losses (Giapoutzi, 2010).

Credit risk is inherent in all business activities and is an element in virtually every products
and services that is provided. Typically the risk of credit related losses refers to the type of
business transaction that is contracted for and can occur from variety of credit loss scenarios.
Credit loss can also occur from failing to honor or repay reciprocal financial agreement that
still have some economic value such as a credit derivative contact. Credit risk can also occur
from decline in borrowers’ credit quality that results in loss to the value of a debt obligation
(Yang, 2013).

1.2. BACKGRAUND OF THE COMAPANY

United Bank was incorporated as a Share Company on 10 September 1998 in accordance with
the Commercial Code of Ethiopia of 1960 and the Licensing and Supervision of Banking
Business Proclamation No. 84/1994. The Bank obtained a banking services license from the
National Bank of Ethiopia. Over the years united Bank built itself into a progressive and
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modern banking institution, endowed with a strong financial structure and strong
management, as well as a large and ever-increasing customers and correspondent base. Today,
United Bank is a full service Bank that offers its customers a wide range of commercial
banking services with a network of 145 Branches and 27 sub-Branches, and a number of
additional outlets on the pipeline. United Bank's priority in the coming years is to strengthen
its capital base, maximizing its return on equity and benefiting from the latest technology in
order to keep abreast with the latest developments in the local and international financial
services industry (UB, 2016).

On June 30, 2016 the Bank has 3,213 employees in the capacity of different managerial,
clerical and non-clerical. At the same date, the total capital of United Bank stood at Birr 2.07
Billion.

1.3. STATEMENT OF THE PROBLEM

Banks are the dominant financial institution in most economies and play a critical role to
emerging economies where most borrowers have no access to capital market. The traditional
role of a bank is collecting money from depositors and lending loans which make up the bulk
of their asset. It is obvious that well-functioning banks accelerate the economic growth of
country

While poorly functioning banks are impediments to economic progress (Barth, 2001). About
85 percent of banks’ income is earned from interest on loans which contributes significantly
to the overall income of banks.

Thus lending is not an easy task for banks because it creates a big problem in the form of
non-performing loans. Due to the nature of their business, banks expose themselves to the risk
of default from borrowers.

It is widely accepted that the quantity or percentage of non-performing loans (NPLs) is often
associated with bank failures and financial crises in both developing and developed countries.
In fact, there is abundant evidence that the financial/banking crises in East Asia and Sub-
Saharan African countries were preceded by high non-performing loans. The 2008/09 global
financial crises, which originated in the US, was also attributed to the rapid default of sub-

2
prime loans/mortgages. In view of this reality it is therefore understandable why much
emphasis is placed on non-performing loans when examining financial vulnerabilities.
(Charles, 2013).

As cited by (Arega, 2016) lenient lending, excessive lending and high interest rate are major
factors determining NPL in Banks. Hence, credit approving that has not properly considered
the credit terms would potentially lead to occurrence of loan default. As per the study by
(Jimenze, 2005) on the Spanish banking sector from 1984 to 2003 NPLs are determined by
lenient credit terms. The authors indicated that the causes for the leniency were attributed to
disaster myopia, group behavior, moral hazard and agency problems that may entice bank
managers to take risk and lend excessively during boom periods.

On the other hand, banks that charge high interest rate would relatively incur a higher default
rate or non-performing loans. In this regard, a study by (J.C, 1992) on large commercial
Banks in US revealed that a high interest rate charged by banks is associated with loan
defaults (Raghavan, 2003). Who used a panel regression analysis indicated that financial
factors like cost of credit have got significant impact on NPLs (Bloem,2001) also indicated
that “bad loans” may substantially rise due to abrupt changes in interest rates.

Recently banks witnessed rising non- performing credit portfolio and this significantly
contributed to financial distress in the banking sector (Hossain, 2011). Banks collect deposits
and lend to customers but when customers fail to meet their obligations problems, non-
performing loans arise. Non-performing loans (NPLs) began to rise as deteriorating finances
of distressed borrowers and soaring interest rates impaired borrowers’ ability to service loan.
In addition, the collapse of financial and property asset values substantially reduce the value
of the collateral for many bank loans. As a result, most financial institutions experienced
erosion in profit. The financial institutions’ capital base was affected by increased losses from
loan default, requiring them to seek re-capitalization. The biggest problem facing banking and
financial intermediaries is the risk of customers or counter party defaults(Stephen, 2002).

A report from UB’s Credit Analysis and Approval Department showed that NPL rate has
shown an increasing trend for the past three consecutive years revealing increase the credit
risk. Thus, this research assesses and analyses the challenges and credit risk management

3
practice of United Bank and came up with the possible recommendation to manage the credit
risk and non performing loan of United Bank.

1.4. BASIC RESEARCH QUESTIONS

 What are the factors causing credit risk in United Bank?

 What are the credit risk management practices in United Bank?
 What measures have been taken to minimize (avoid) the rate of Non-Performing Loans
by United Bank?
 What are the challenges of the credit risk on the performance of United Bank?

1.5. OBJECTIVES OF THE STUDY

1.5.1. GENERAL OBJECTIVE

The general objective of the study is to assess the practice of Credit Risk Management and
identify the root causes of Credit Risk and its effects on the performance of United Bank S.C.

1.5.2. SPECIFIC OBJECTIVES

 To identify the major causes of credit risk.

 To assess credit risk management practice in the Bank.
 To assess the challenge and impact of the credit risk on the performance of the Bank.
 To examine the possible measurement to be taken to solve the problem.

1.6. SIGNIFICANCE OF THE STUDY

This research paper provides information about the credit risk management challenge and
practice of the Bank to interested parties and United Bank policy maker and high level
management group to examine the current problem and take necessary action. It will also be
used as a reference for other researchers who would like to study on the same topic in the
Ethiopian Banking. In addition it gives the researchers the opportunity to gain practical
knowledge on how to undertake a research.

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1.7. SCOPE OF THE STUDY

The focus of the research is assessment of credit risk management practice of United Bank of
Ethiopia and the research mainly focuses on credit administration and related area at head
office level, in order to gather relevant information about the study.

Therefore, the study is limited to the credit activity and risk management area of United Bank
of Ethiopia on head office.

1.8. LIMITATION OF THE STUDY

The Study had encountered problems in finding related literatures on the subject during
secondary data collection for this research paper and we also faced problems while collecting
data from employees in which most of the time they were not willing to fill the questionnaires
due to various reasons.

In addition, we faced a problem in time of collecting data through questionnaires and

interview from three different work unites. Which is found in the head office and Main
Branch of the Bank, because of time constraint, unwillingness and bureaucracy to make such
inquiry.

1.9. RESEARCH DESIGN AND METHODOLOGY

1.9.1. Research Design

As the objective of this research paper is to assess the practice and challenges of credit risk in
United Bank, descriptive research design will be employed for the study. This method enables to
answer the research question and attain specific objective. A descriptive study is one in which
information is collected without changing the environment. A descriptive study can provide
information about the naturally occurring health status, behavior, attitudes or other characteristics
of a particular group. Descriptive studies are also conducted to demonstrate associations or
relationships between things in the world around you.

Descriptive studies are usually the best methods for collecting information that will
demonstrate and describe the world as it exists. These types of studies are often done before
an experiment to know what specific things to manipulate and include in an experiment.
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Descriptive studies are more formalized and typically structured with clearly stated
hypotheses or investigative questions. It serves a variety of research objective such as
descriptions of phenomenon or characteristics associated with a subject population, estimates
of proportions of a population that have these characteristics and discovery of associations
among different variables (Negechu, 2002).

1.9.2. Population

The targeted population of this study will be employees of United Bank S.C. who has a direct
relationship with loan activities. Hence, employees working in Credit Analysis and Appraisal
Department, Risk Management and Compliance Department, and the main Branch Credit
Division employees will be used as a unit of study. Accordingly, in the three work units there are
a total of 23 employees that could be used as a target population (i.e 11 employees at Credit
Analysis Department, 6 employees at Risk Management and Compliance Department and 6
employees at the Bank’s Main Branch.)

Since the population size is very small to sample, the researchers decided to employ census
method and take all the 23 employees as a respondent to the research questionnaires and hence
no sample is made.

1.9.3. Data Type and sources

For this research, the researchers will use both primary and secondary source of data. As a result,
company annual report, Credit Department and branch’s reports regarding NPL will be assessed.
Moreover, primary data will be collected from employees, and the management staff of the Bank.

1.9.4. Method of Data Collection

The methodology to be used for data collection in this study is largely dependent on the type and
source of data. A well designed comprehensive questionnaire will be prepared and distributed to
employees in the two departments and selected branch working on the area of credit to collect
primary data moreover personal interview will be conducted with two department Staff; Credit
Analysis and Appraisal Department and Staff of Credit Risk Management, which will help the
study to be developed with first hand information. Additionally, policy manuals, procedures,
annual reports, and publications will be used as means of collecting second hand information.
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1.9.5. Method of data analysis

Data collected from respondents through questionnaires and interviews will be coded, tabulated,
carefully analyzed and interpreted using descriptive analytical techniques. Hence tables, graphs
and charts will be used to present raw data collected from data sources and analysis and
interpretation of same will be made following each data presentation.

1.10. ORGANIZTION OF THE RESEARCH REPORT

The study paper is organized in four chapters. The first chapter consists of introductory part
which includes background of the study, statement of the problem, basic research questions,
objective of the study, definition of terms, scope of the study, research design and
methodology and organization of the study. The second chapter deals with review of related
literature. The third chapter consists of data presentation, analysis and interpretations. Finally,
the forth chapter presents summary of major finding, conclusion and recommendations.

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 CHAPTER TWO

REVIEW OF RELATED LITERATURE

2.1. THEORETICAL REVIEW

2.1.1. Risk

There is no single definition of Risk. Economists, behavioral scientists, risk theorists,

statisticians, and actuaries each have their own concept of risk. Therefore the researcher
will try to give different authors view and definitions for the word risk.

According to (Williams A, 1998) Risk is a potential variation in outcomes and the exposure to
a potential loss. It can also be defined as uncertainty about economic losses due to the
occurrence of an event. Economic losses are caused by perils such as crimes, fire and
accidents. It is the possibility of an adverse deviation from a desired outcome that is expected.

On the other hand risk can be defined as “the variability of the actual return from the expected
returns associated with a given asset or investment” (Khan, 2004). (Ehrhardt, 2011) also
defined risk as “the chance that some unfavorable event (Both financially as well as
physically will occur)”

2.1.2. Credit Risk

Credit in bank is a contractual agreement in which a borrower receives something of value

now and agrees to repay the lender at some later date. However Credit risk is defined as the
probability that some of a bank‘s assets, especially its loans, will decline in value and possibly
become worthless. It arises from non-performance by a borrower, either an inability or an
unwillingness to perform in the pre-committed contracted manner (Raghavan,2003). Credit
Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed
terms.

There is always scope for the borrower to default from his commitments for one or the other
reason resulting in crystallization of credit risk to the bank.

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According (A., 2011), credit risk is delay of one’s own obligation in accordance with stetted
contractual financial obligation within the deadline of payment by counter party. Credit risk is
the possibility that debtors or borrowers incapability of paying its obligation in a way that
predetermined contractual agreement made during credit approval process which adversely
affect the working environment of the lender.

The (Basel, 2001), defines credit risk as a chance when borrowers fail to repay their loan
partially or fully due to different circumstances. It also state that the extent to which the bank
exposed to higher credit risk will lead to unexpected financial crises and lower credit risk will
minimize the probability of the crises because large amount of profit will be generated from
this department of the bank

2.1.3. RISK MANAGEMENT

Management in the simplest understood definition can be defined as the act of planning,
directing, controlling, monitoring and testing for desired results to be obtained. Or it is simply
the act, manner, or practice of managing; handling, supervision, or control (Stephen, 2012).
Risk on the other hand can be defined as the possibility that something unpleasant or
dangerous might happen.

Risk Management is “a course of action planned to reduce the risk of an event occurring
and/or to minimize or contain the consequential effects should that event occur” (Keith,
1992). This course of action linked, gives rise to a Risk Management process which involved
a number of stages. Risk management is very important and forms a main part of any
organization’s activities because its main aim is to help all other management activities to
reach the organization’s aims directly and efficiently since it is a continuous process that
depends directly on the changes of the internal and external environment of the organization
(Tchankova, 2002).

According to (Singh, 2013) credit risk management includes all management function such as
identification, measurement, monitoring and control of the credit risk exposure. The writer
further indicated that for long term achievement of banking sector effective credit risk
management practice is a vital issue in the current business environment and poor credit risk
management policy will create serious source of crisis in the banking industry.
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2.1.4. LIFE CYCLE OF CREDIT RISK MANAGEMENT

Whether the institution is to bankrupts or profitability depends on the level of credit risk
management strategy and proper implementation credit process in each credit risk
management life cycle. (George, 2008), put four levels of credit risk management life cycle:

1. Collect obligor (borrower) and loan data: Parties needed her is borrower, loan and
external data. The key task and challenges of this stage is interpretation of financial
information, system integration, getting the borrower and loan data, data quality and getting
external rating data.

2. Compute credit risk: In this stage credit risk will be calculated in the form of risk rating of
meaningful differential risk among different firms and exposure. The main task and
challenges her is developing rating model, calculating the probability of default, rating
approach, comprehensiveness of data, comprehensiveness of model, calculating loss given
default(LGD), exposure at default(EAD) and expected loss(EL) are the major one.
3. Monitoring and managing risk rating: This stage is a stage of monitoring and managing
the risk rating system. The main activity and challenges her is interface with internal
collection, perform back testing of rating, reduction of manual dependency feedback and
alert, develop workflow to manage approval of rating and ensure notification on external
rating change.

4. Managing portfolio and allocation of capital: This level of credit risk management
lifecycle is the most difficult and challenging in the financial world today. The most important
activities and challenges of this stage is compute and monitor portfolio risk, allow transfer of
risk, reporting on risk, stress testing /scenario analysis and stress testing/back testing
challenge are the most important activity expected to be performed at this level.

2.1.5. OPERATING UNDER A CREDIT GARANTIG PROCESS

Each bank has its analytical tools which it uses to minimize losses of money when giving out
loans to customers. The bank always find itself in a situation where they can give a loan to a
customer who will not be able to pay back or refuses to give to a customer who is good and
has the potentials of meeting up with the repayment. To go about a good analysis of potential
customers, the five C‟s of credit have been introduced as a guide for bankers of what criteria
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to use. This includes the gathering of both quantitative and qualitative information to assist
the bankers in their screening process of bad and potential creditors. This information is
gotten using the five Cs of credit as the standards tools. The five Cs include; character,
capacity, capital, conditions and collateral (Dev, 2009).

Character of a company refers to the distinct capabilities about the company which the
lenders see that inspires them with confidence that the loan will be repaid. This includes
things like the business plan, cash flow, history, management, etc.

Capacity of the company incorporates words like sufficiency, adequacy and perseverance.
This means what the company as a customer has as assets and the value of those assets which
shows that it can be able to repay its loans.

Capital of the company means how much adequate funds it has to make the business operate
efficiently in generating cash flow and efficiently within its competitive business
environment. The equity contribution of owners and its ratio to debt (leverage). These are
viewed as good predictors of bankruptcy probability. High leverage suggests a greater
probability of bankruptcy.

Condition of the company describes the economic and environmental influences on the
company’s financial condition and performance. It is the state of the business cycle and is an
important element in determining credit risk exposure, especially for cycle dependent
industries.

Collateral refers to what the company is able to present to the lender which serves as the final
source of repayment and protection against loan loss. In the event of default, a banker has
claims on the collateral pledged by the borrower. The greater the priority of this claim and the
greater the market value of the underlying collateral, the lower the exposure risk of the loan.

The bank incorporates the five C ́ s (character, capacity, capital, conditions and collateral) in
their loan granting process of screening bad from potential creditors. When the loan officers
receive the information (quantitative and qualitative) about the customer, they do their
analysis not in isolation of each element but in relationship amongst the categories. This is
because a customer could as well show a good capacity, have enough capital, have a good

11
economic / environmental influences on its financial condition and performance and have a
good collateral but, if it has a bad character, it will not still act as an inspiration for the bank to
grant the loan.

On the other hand, if the character (business plan, cash flow, history, management, etc)
showed by the customer in question is good, it will go ahead to assure them of the customer’s
repayment capability more. This will thus help the bank whether to grant the loan or not or
and to determine the credit limit. This is because a customer’s character shows how their
previous loan transactions were handled. If after the decision has been taken, whatever may
arise in the future, the bank will always recall the decisions taken in the past given the
structure they used for their analysis to see if they took the right decision or not.

2.1.6. CREDIT RISK MANAGEMENT IN BANK

Although the effects of all risk types can cause negative consequences to the bank, credit risk
has been pinpointed or identified as the key risk associated with negative consequences in
terms of its influence on bank performance (Sinkey,1992). This means if credit risk is not
well managed, it can lead to failure. Thus, for any bank to succeed, its Credit Risk
Management (CRM) must be handled with a lot of seriousness. This is because should a loss
occur, the bank will have to “extend its hands” to get funds from other means to meet up or
cover the losses.

A clear reason why a correct management of credit risk is very important is because banks
have a limited capacity to absorb loan losses and this loses can be covered only by using
income generated by other profitable loans or by bank capital (G.N, 1995). If the income is
used from these two sources to meet up for a loan that has not been paid, this action will go a
long way to affect the capital adequacy of the bank, its liquidity and even its profitability.

Looking at the consequences or effects of credit risk, it is important that before a bank gives
out a loan, it should try as much as possible to have a concrete view of the borrower.
(Greuning, 2003) says “Because of the potentially dire effects of credit risk, it is important to
perform a comprehensive evaluation of a bank’s capacity to assess, administer, supervise,
enforce and recover loans, advances, guarantees, and other credit instruments”.

12
This monitoring is very important because with the uncertainty in the future, any potential
event that can cause a borrower to default payment can be fast identified or, a mechanism can
be put in place on time to reduce the frequency and /or intensity of a loss should it occur.
Early identification of borrowers at risk is good because it enables service providers to
adequately staff collections departments, determine the most cost-effective type of customer
outreach, and initiate repayment plans before a borrower’s financial situation worsens to the
point at which foreclosure is unavoidable (Focardi,2009).

It is very clear that banks make profit from the spread between the interest rate they charge to
borrowers and the interest rate they pay to depositors. Lending has always been the primary
functions of banks, and accurately assessing a borrower‘s credit worthiness has always been
the only method of lending successfully (Andrew,2004). To insure reasonable profit, banks
attempt to make loans that will be fully repaid with interest on due date. Therefore, banks are
directly concerned about borrowers repaying their loans on a timely basis so that the value of
the banks can be maximized. If banks don‘t manage credit risk effectively, they won‘t be
profitable and won‘t be in business very long. Banks can reduce their exposure to credit risk
on different loans by applying major credit risk management principles. (as identified by
(Fredrick,2004). These are:

 Screening and monitoring: Adverse selection in loan market requires the lenders
screen out the bad credit from the good ones so that loans are profitable to them. Once
a loan has been made, the bank‘s has to monitor or follow up the borrowers ‘activities.
 Long - term Customer Relationship: if the borrower has borrowed previously from
the bank, the bank has a record of the loan payments. This reduces the costs of
information collection and makes it easier to screen out bad credit risks. Long-term
relationship enables banks to deal with even unanticipated moral hazard contingencies.
 Collateral Requirements: is an important credit risk management tool. Collateral,
which is properly promised to the lender as compensation if the borrower defaults, it
lesser the lender‘s losses in the case of a loan default.
 Credit Rationing: is one way of credit risk management that refers refusing to make
loans even though borrowers are willing to pay the stated interest rate or even a higher
rate (Frederick,2004).

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2.1.7. RELATIONSHIP BETWEEN CREDIT RISK MANAGEMENT AND BANK
PERFORMANCE

The advantages of implementing better risk management lead banks to better performance.
Better bank performance increases their reputation and image from public or market point of
view. The bank also gets more opportunities to increase the productive assets, leading to
higher bank profitability, liquidity, and solvency (Tandelilin, 2007). Therefore, Effective
credit risk management should be a critical component of a bank’s overall risk management
strategy and is essential to the long-term success of any banking organization. It becomes
more and more significant in order to ensure sustainable profits in banks.

As per different researchers and authors, Credit risk is the most significant of all risks in terms
of size of potential losses. As the extension of credit has always been at the core of banking
operation, the focus of banks risk management has been credit risk management. When banks
manage their risk in a better way, they will get advantage to increase their performance.

Better risk management indicates that banks operate their activities at relatively lower risk and
lower conflict of interests between parties (Anthony, 1997).

2.2. EMPERICAL REVIEW

Credit risk is a serious threat of banks; therefore various researchers have examined the
impact of credit risk on banks in varying dimensions (Richard, 2008). Conduct research on
the Credit risk management system of Tanzanian commercial banks and found that checklist
with the help of 5C (Character, Capacity, Condition, Credit history, and Collaterals) was used
to assess borrowers Creditworthiness. Researcher also found that the quantitative Credit
scoring model was not used as a result of poor record keeping and lack of effective data base
system in different sectors with in the country.

(Ahmed, 1998) in their study found that loan loss provision has a significant positive
influence on non-performing loans. Therefore, an increase in loan loss provision indicates an
increase in credit risk and deterioration in the quality of loans consequently affecting bank
performance adversely.

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In relation to credit risk and banks performance the study conducted by (Girma,2011), on
Credit Risk management and its impact on performance in Ethiopian Commercial Banks with
the aim of better understanding of credit risk management and its impact on performance
(return on asset). The result of the study revealed that the most common way of
communicating effectively to reduce risk is developing understanding between management
team and employees. The study also reveals banks with higher profit potentials can better
absorb credit losses whenever they crop up and therefore record better performances.
Furthermore, the study shows that there is a direct but inverse relationship between return on
asset (ROA) and the ratio of non-performing loans to total loan (NPL\TL) and loan provision
to total loan.

Finally the study concludes that, banks with good credit risk management policies have a
lower loan default rate and relatively higher return on asset.

(Bourke’s,1989) reports on the effect of credit risk on profitability appear clearly negative in
Europe, North America and Australia. This result may be explained by taking into account the
fact that the more financial institutions are exposed to high risk loans, the higher is the
accumulation of unpaid loans, implying that these loan losses have produced lower returns to
many commercial Banks in U.S.A. (Miller,1997). The findings of Felix and Claudine (2008)
also shows that return on equity ROE and return on asset ROA all indicating profitability were
negatively related to the ratio of non-performing loan to total loan (NPL/TL) of financial
institutions therefore decreases profitability

Credit risk is the most obvious risk in the banking and possibly the most important in terms of
potential losses. The default of a small number of key customers could generate very large
losses and in an extreme case could lead to a bank becoming insolvent. This risk relates to the
possibility that loans will not be paid or that investments will deteriorate in quality or go in to
default with consequent loss to the bank. Credit risk is not confined to the risk that borrowers
are unable to pay; it also includes the risk of payments being delayed, which can also cause
problems for the bank (Tibebu,2011).

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 2.3. KNOWLEDGE GAP

There are a few researches on Credit Risk Management that we can access. Some of those
researches gave examples of Credit Management principles used as creating value explicitly
addressing uncertainty, basing on the best available information and taking into human
account. They also cited the five C’s of Credit Management, which include Character, Capital,
Capacity, Collateral and Conditions. We are also cited on our research these five C’s on the
other hand there are also research papers, associates Credit Risk with Liquidity Risk, Foreign
Exchange Risk, Operational Risk and Interest Risk. Here, there exist a great knowledge gap
amongst ourselves and the later group of researches in that we can only consider interest rate
risk to our researches.

However, we believe that this research gap would not affect our findings and conclusion. So
that, we highly focus on that of the five C’s and interest rate risk as a major factors or risk
exposure affecting the Bank’s Credit Risk Management practice.

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 CHAPTER THREE

DATA PRESENTATION, ANALYSIS & INTERPRETATION

3.1. Overview

This study, aimed at assessing the credit risk management practice of United Bank S.C. Data
were collected from Credit Analysis Department, Risk Management & Compliance
Department & Main Branch of the Bank through self administered questionnaires. Therefore,
the data collected from the target population of the study through these instruments were
presented and discussed in this chapter using tables. Besides, information obtained from
interview presented using narration.

The research employed both primary and secondary source of data. Primary data were
collected using self administered questionnaire and interviews. A total of 23 questionnaires
were designed and distributed to those individuals working at the Bank’s Credit Analysis
Department, Risk Management & Compliance Department as well as Main Branch.

Regarding the performance of data collection all the distributed questionnaires were dully
filled and returned to us timely. However, we had challenges to undertake interviews to those
concerned staff of the Bank. Concerning secondary data, we have assessed the Bank’s Annual
Report and other performance and periodic reports of the concerned work units.

17
3.2. Data Presentation & Analysis
3.2.1. Demographic Data Analysis
Table 1: Characteristics of the Respondents

Variables Variables Categories Frequencies Percentage

Female 8 35%
Gender Male 15 65%
Total 23 100%
20-29 Years 12 52%
30-39 Years 7 30%
Age 40-49 Years 4 17%
Above 50 0 0%
Total 23 100%
Diploma 0 0%
Educational Back ground Degree 19 83%
Masters and Above 4 17%
Total 23 100%
Clerical 0 0%
Current Position Professional 20 87%
Managerial 3 13%
Total 23 100%
0-5 Years 11 48%
Experience 6-10 Years 9 39%
Above 11 Years 3 13%
Total 23 100%

Source: Questionnaires, 2017

It can be observed in the above table that from the total 23 respondents, 15(65%) respondents
were male and 8 (35%) respondents were female. Thus, we can say that in the studied area
(credit and risk) major respondents were male.

With regard to the age group of our respondents, it can be observed from the same table that
12 (52%) of the respondents fall under the age category of 20 to 29 which is relatively
younger group, 7 (30%) fall under 30 to 39 and the remaining 4(17%) fall at the age category
of 40 to 49.

The above table also shows that majority of our respondents 19 (83%) have possessed their
first degree, while 4(17%) have Masters Degree and above.

18
The other demographic factors we have considered were respondents’ current position and
experience in the Bank. Accordingly; out of the 23 respondents, 20 (87%) have been serving
the Bank at different professional capacities and 3(13%) respondents served at different
managerial position. With regard to their working experience, 11 (48%) served the Bank for
up to 5 years, 9(39%) served from 6 to 10 years and the remaining 3(13%) served the Bank
for over 10 years.

3.2.2. Analysis of findings

Table 1.

Employees’ awareness Response Frequency Percentage

Not Much 13 57%
about Credit Risk
Very much 6 26%
Management practice Not at all 4 17%
of United Bank S.C. Total 23 100 %

Source: Questionnaires, 2017

In order to tackle the challenges and problems associated with Credit Risk, employees should
have the required knowledge about Credit Risk Management. Hence, we were requested
employees of United Bank to assure whether they are aware of the concept of Credit Risk
Management or not. Accordingly; 13 respondents that constitute 57% of the response were
not that much aware about the concept of Credit Risk Management while 6 respondents which
constitute 26% of the total respondent were very much aware of it. However, 4 respondents
which is accountable to 17% of the total respondents were not totally unaware of the concept
of Credit Risk Management.

Table 2.

Response Frequency Percentage

Yes Definitely 14 61%
Assessment of Customers’
Yes to some extent 6 26%
financial history Not at all 0 0%
19
 I am not quite aware of it 3 13%
Total 23 100%

Source: Questionnaires, 2017

Credit risks may stem from poor/lack of assessment of the customers’ financial history.
Banks, before advancing loans to their customers should assess the details of financial history
of their customers which help them as a means to decide on. As a matter of facts, United Bank
employees were requested whether there exist the practice of assessing the customers’
financial history or not before granting the required loan.

Accordingly, as depicted in the above table, though the degree of their response varied, 14
(61%) & 6 (26%) of the respondents assured that the Bank assessed the financial history of its
customers before approval have been granted to the requested loans. However, here also
3(13%) of respondents were not quite sure about the practice of evaluating the customers
financial history before advancing the loans by the Bank.

Response Frequency Percentage

Very good 4 17%
Performances of loan follow
Good 11 48%
up mechanisms Neutral 5 22%
Bad 3 13%
Total 23 100%

Table 3. `

20
Source: Questionnaires, 2017

Banks may employ different types of mechanisms to follow-up their granted loans that may
help them to ensure the loans are used for the intended purpose. United Bank employees were
requested to rate the follow-up mechanisms employed by the Bank. Their response, as
depicted in table 4 above showed that the follow-up mechanism employed by United Bank is
rated as very good only by 4(17%), good by 11 (48%) of the respondents. To the contrary the
Bank’s credit follow up mechanisms have been rated as bad by 3(13%) of the respondents
while 5 (22%) of the respondents remained neutral in rating the Bank’s loan follow up
mechanism effectiveness.

Table 4.

Response Frequency Percentage

Reduce financial loss 10 43%
Expectation from
Improve communication with 5 22%
Effective Credit Risk
the stakeholders
Management Improve decision making 3 13%
Improve resource allocation 5 22%
Total 23 100%

Source: Questionnaires, 2017

This question was asked the respondents to indicate their expectations of credit risk
management in their Bank. The result showed that 43% of the respondents expect effective
credit risk management practice shall reduce financial loss, 22% expect improvement of
communication with stakeholders and resource allocation. The remaining 13% of the
respondents expect improvement on decision making process shall prevail due to the practice
of effective Credit Risk Management.

Table 5.

Response Frequency Percentage

Board Members 3 13%
The Authority to Establish
Policy Development 11 48%
Credit Risk Management
Committee
Policy Executive Management 6 26%
Other 3 13%
21
 Total 25 100%

Source: Questionnaires, 2017

Establishing effective Credit Risk Management Policy requires a careful analysis about the
industry in which the organization operates, the competition, the human and other resources
and other legal and formal requirements from the regulating organ. Hence, it should be
prepared by those who can have adequate knowledge and information about the various
factors that could possibly affect the outcome of the policy. Minding this point, we have
requested the respondents to disclose us who prepared the Bank’s Credit Risk Management
Policy so far. Accordingly as it is shown in the above table, 13% of the respondents have said
that the Bank’s Credit Risk Management Policy has been developed by the Board Members,
48% have said that the policy has been developed by the Policy Development Committee,
26% have said that the policy has been developed by the Bank’s Executive Management and
the remaining 13% have said that the policy has been developed by the Bank’s Risk
Management Department and endorsed by the Executive Management of the Bank.

However, from the interview we have had with two of the Bank’s Credit Analysis and
Appraisal Department Managers, the Bank’s Credit Risk Management Policy has been
developed by the Bank’s Risk Management and Compliance Department, reviewed by the
Bank’s Policy Development Committee and approved by the Board Chairman.

Table 6.

Response Frequency Percentage

Agricultural Loan 23 100%
Export Loan 23 100%
Manufacturing Loan 23 100%
Import loan 23 100%
Type of loan the bank gives Building & Construction
23 100%
more emphasis on loan
Domestic trade and service
23 100%
loan

Source: Questionnaires, 2017

22
We have also requested our respondents to tell us the Bank has given more emphasis to which
sector. Accordingly, as can be seen from the above table, all (100%) of the respondents have
stated that United Bank has been granted loans to the agricultural sector, international trades
such as import and export trade, Manufacturing sector, construction sector as well as domestic
trades.

Table 7.

Response Frequency Percentage

1-5 days 0 0%
Duration of period to
One Week 2 9%
process a loan from United One Month 7 30%
Bank More than a month 14 61%
Total 23 100%

Source: Questionnaires 2017

It is evident that customers expect quick response and approval for their loan request from any
Bank. The more they get quick approval the more they become happy and strengthen their
relationship with the Bank. However, when we see the loan processing period of United Bank,
only 2 respondents, which represent 9% of the total respondents said it lasts a week to get a
loan from United Bank while 7(30%) said it takes a month. The remaining 14 (61%) of
respondents however said that it takes more than a month to get a loan from United Bank
which is by far unsatisfactory.

Table 8.

Response Frequency Percentage

Comparison between Improved a lot 4 17%
Previous and current loan Not Improved 14 61%
No Comment 5 22%
service of United Bank
Total 23 100%

Source: Questionnaires, 2017

Respondents were requested to compare and justify their past experience in providing loan
services by United Bank against their current experience. Accordingly, 14 (61%) of responses
have shown that the current loan service of United Bank is not improved while only 4 (17%)

23
of them believed the service has shown improvement. The remaining 5 (22%) however, have
no comments.

Table 9.

Availability of Credit Response Frequency Percentage

Yes 23 100%
Risk Guideline and
No 0 0%
Policy. Total 23 100

Source: Questionnaires, 2017

We have also forwarded our question to the respondents to assure us whether the Bank has
Credit Risk Guide line or not. As their response shown in the above table 10, the Bank has a
documented Credit Risk Management Guideline which is responded by 100% of the
respondents.

Table 10.

Activities Frequency Percentage

Creating clear and trustworthy 2 9%
information
Develop understanding between 5 22%
management team and
employee
Efforts made by United Fast and sharp communication 1 4%
Bank to reduce Credit Risk between management team and
stakeholders
Regularly communicating 3 13%
among management and staff
Creating and maintaining a clear 0 0%
communication
All answers 12 52%
Total 23 100%

Source: Questionnaires, 2017

24
There were efforts put in place to minimize the vulnerability of granted loans to risk.
Accordingly the Management of United Bank S.C. has put efforts to minimize credit risk to
the expected level. Hence, as we have seen from employees response in this regard, the Bank
has Developed understanding between management and employees which is stated by 22% of
the respondents; creates clear and trust worthy information regarding Credit Risk which is
stated by 13% of the respondents, Regularly communicates the guide lines and policy to staff
which is stated by 13% of the respondents and providing fast and sharp communication
among stakeholders which is stated by 4% of the respondents. Besides, 52% of the
respondents have stated all the alternatives have been employed by the Bank.

Table 11:

Variable Response Frequency Percent

Diversion of borrowed Strongly Disagree 0 0

fund to other purpose Disagree 0 0

Neutral 4 17
Agree 4 17
Strongly agree 15 66
Total 23 100

Insufficient credit Strongly Disagree 1 4

Disagree 2 9
awareness contributes to
Neutral 1 4
Credit Risk Agree 12 52
Strongly agree 7 30
Total 23 100

Unwilling customer to Strongly Disagree 6 26

Potential Causes of
Disagree 6 26
NPL disclose the information
Neutral 2 9
required Agree 4 17
Strongly agree 5 21
Total 23 100

Lack of proper credit Strongly Disagree 9 39

Disagree 5 22
follow up contribute to
Neutral 1 4
Credit Risk Agree 1 4
Strongly agree 7 30
Total 23 100

25
 Willful default Neutral 1 4
Agree 10 43
/unwillingness to pay back
Strongly agree 12 52
Total 23 100

Source: Questionnaires, 2017

There are a number of possible causes for Non Performing Loans. However, as in the case of
United Bank; unwillingness of customers to pay back, insufficient credit awareness and
diversion of borrowed fund to other purpose are the major causes of NPL each having an
aggregate 95%, 83% and 82% responses respectively. Whereas, Lack of proper credit follow
up and customers unwillingness to disclose the required information are the least causes of
NPL at United Bank having an aggregate 34% and 38% responses respectively.

Table 12:

Variable Response Frequency Percent

Capacity (how capable Very Unimportant 0 0

is the customer in Unimportant 0 0

Moderate 3 13
repaying his/her debt) Important 5 22
Very Important 15 65
Total 23 100

Character (Customers 0 0
Very Unimportant
0 0
financial history and Unimportant
Moderate 1 4
his/her personal Important 18 78
integrity) Very Important 4 17
Importance of the 5Cs Total 23 100

Collaterals ( Assets 0 0
Very Unimportant
0 0
provided by customers Unimportant
Moderate 0 0
as security for the loan) Important 0 0
Very Important 23 100
Total 23 100

Condition (Overall 5 22
Very Unimportant
15 65
environment that the Unimportant
Moderate 0 0
customer is operating) Important 3 13
Very Important 0 0

26
 Total 23 100

Capital (how much 1 4

Very Unimportant
1 4
adequate funds the Unimportant
Moderate 1 4
customer has to make Very Important 20 88
the business operate Total 23 100

efficiently)

Source: Questionnaire, 2017

Most financial institutions consider the 5Cs (Capacity Character, Collaterals, Condition and
Capital) as factors when they evaluate loan requests. Some of these factors may have more
importance while others considered as less important by Bank’s. As in the case of United
Bank S.C., our data, which is depicted in table 13 above, Collaterals, are considered as very
important factors among the other Cs which is stated by 100% of the respondents. On the
other hand 88% of respondents and 4% of respondents said that Capital adequacy is important
and moderately important factor. Capacity is stated as a third important factor rated by 65% as
very important and by 22% as moderately important followed by Character which is said to be
very important by 17% and important by 78% of the respondents. Whereas, condition
considered as the least important factor by United Bank employees in granting Loan with a
response of 65% unimportant, 22% very unimportant and only with 13% important.

3.3. ANALYSIS ON FINDINGS OF THE INTERVIEW

Finally, as part of our means to gather primary data we have made an interview with two
senior management staff of United Bank. Interview had been made with the heads of two
Credit Department Divisions and the result obtained from the interview is summarized and
presented under here while some of the findings obtained from the interview are discussed
with the findings obtained using questionnaires.

Major Functions of Credit Department

According to the interview responses from the two division heads, United Bank’s Credit
Department performs the following major functions:

 Documentation,

27
  Credit Disbursement,
 Credit monitoring and follow up of proper execution,
 Loan Repayment follow up,
 Maintenance of Credit Files and customers profile,
 Maintaining collateral and security documentation,
 Consulting the Bank’s credit customers,
 Treatment of sick loans,

From our interview we have learned that, the Bank’s Credit Department is well organized to
undertake all the credit activities effectively and efficiently. However, it is also noted that the
Department should undertake the activities of Credit Risk Management in consultation with
the Bank’s Risk Management Office.

Objectives of Credit Risk Management in United Bank

In general the objective of credit risk management in United Bank is to minimize or avoid any
risks that are associated with credit or loan disbursement and repayments thereof.

In order to achieve these objectives, United Bank Crafted and implemented Credit Risk
Management System as a means to avoid or at least minimize risks associated with credit.

The function of the Credit Risk Management in United Bank encompasses:-

 Establishing Credit Policies and Procedures of the Bank,

 Develop risk assessment and measurement systems,
 Develop risk tolerance limits for Senior Management and Board approval;
 Conducting Credit Analysis and review,
 Measuring and Monitoring of Credit Risk exposure,
 Identifying current and emerging risks;
 Report results of risk monitoring to Senior Management and the Board.

From the interview we have also noted that the main purpose of the Bank’s Credit Risk
Management System is to properly manage the potential credit risks. Accordingly the
following measures are taken to minimize the credit risks.

 Evaluating current financial condition of the borrower,

 Ensuring that collateral security is adequate and enforceable relative to borrowers’
current circumstances,
 Ensuring that credits are in compliance with their promise and margins,

28
  Providing early identification, classification of potential problem credits to protect the
investment and ensure repayment of the loan before it becomes a complete loss,
 Providing essential information to determine the adequacy of the provision for loan
losses,
 Providing senior management and the board with an objective and timely assessment
of the overall quality of the loan and investment portfolio, and
 Ensuring that proper accounting is maintained for all types of credits,

Both interviewees were also assured that credit risks can be minimized if the Bank can
effectively implements its credit risk management system.

Furthermore,

 Credit concentrations in a single borrower or organization or in group,

 Individual factors such as corruption and other unethical practices either by the
employees or by the customers or both,
 Unfair and unmatched competition in the industry, especially from the government
owned Commercial Bank of Ethiopia,
 Inappropriate estimation of collaterals and securities by the Bank’s staff, are basic
threats of credit risks in United Bank that need the attention of the board and top
management.

Finally, the interviewees were requested that how United Bank evaluate and select among its
loan applicants and what procedures are to be followed. Hence, from their response we have
learned that, the applicants are selected based on their proposal strengths and their collateral
and security value they present. Moreover, their relationship with the Bank, financial history,
past records on loan repayments, and feasibility of their project are other factors considered
before granting the loans.

29
 CHAPTER FOUR
SUMMARY, CONCLUSION AND RECOMMENDATIONS

4.1. SUMMARY OF FINDINGS AND CONCLUSION

Credit Risk Management help prevent losses and protect company investments. Unless
Bank’s can monitor their credit service, they no longer survive and stay profitable. Credit
policies and procedures, credit analysis and credit review help to prevent poor lending
decisions and protect the Bank from financial loss United Bank S.C has its own Credit Risk
Management System; however the Bank has its own limitations in the practices of CRM.

 First and Foremost Most of its employees are not aware of the Bank’s Credit Risk
Management System.
 Only few of them have sufficient knowledge of credit risk management system of the
bank, Due to this the amount of Non Performing Loans become increasing from time
to time.
 The financial history of the borrowers is well documented and known; however there
are also trends of lack of assessing the financial history of customers to some degree.
 The performance and follow up of loan is relatively very good.
 Reducing financial loss and improving resource allocation are the major expectations
from the Bank’s effective credit risk management system.
 United bank has a documented credit risk management policy and procedure.
 The practice of developing and reviewing the Bank’s Credit Risk Management policy
by the concerned organization is a good trend.
 United bank grants all kinds of loans such as Agricultural loan, Export loan,
Manufacturing loan, Import loan, Domestic trade and service loan and etc…
 On the other hand, the loan processing of United Bank S.C takes relatively longer
period of time which provides its part to the dissatisfaction of customers.

30
  The Bank’s customers believed that recent years United Bank S.C credit service is not
improved compared with previous time.

Besides contingencies at the borrowers’ level;

 Diversion of borrowed funds to other purpose and lack of proper business plan during
loan approval are the major causes of nonperforming loans in United Bank S.C.
 Due to customers’ lack of interest to repay loans in time, business shut down and
shortage of funds to repay the loan and other cases most of United Bank S.C loan
customers fail to repay their loan in time which is a big threat of risk to the bank.
 In loan granting process United Bank S.C. uses the five C’s such as Capacity,
Character, Collateral, condition and Capital as major criteria’s for loan granting
procedures. However, it gives more emphases to collateral, capital adequacy and
character factors.
All in all the credit risk management process used by United Bank is relatively good despite
the fact that it takes long time and there are non performing loans that will not be repaid
within the stated period which implicates that the procedure and credit risk management
system should be revised and the borrowers history and good follow up mechanism should be
created.

4.2. RECOMMENDATION
The researchers forward the following possible recommendation to United Bank S.C. The
recommendations believed to alleviate or at least minimize the problems associated with
Credit Risk Management practices in United Bank S.C. Therefore, We strongly advise the
management of United Bank S.C to give due attention and consideration of the
recommendations.
 Train all of its employees who are assigned at Credit Activities with the Bank’s credit
Risk Management System,
 Revise its Credit Risk Management System and policy and procedure timely by
considering the international, legal and competitive factors,

31
 Properly review the loan requests of customers, ensure collaterals and securities are
adequate and enforceable before approving the loans, besides give more emphasis to
all the 5c’s factors.
 Properly evaluate current financial condition, records in loan repayment and
accounting practices of its customers while reviewing the loan request,
 Create awareness on credit facilities to its customers during the loan request,
 Communicate the bank’s credit risk management system policy and procedure timely
and accurately to employees and other stakeholders.
 Identifying the key factors in the loan granting process by analyzing the five C’s.
 Have an effective follow up mechanism to ensure borrowed funds are used for the
intended purpose only, pay regular visit of the customers facilities,
 Providing early identification and classification of potential problem credits to protect
the investment and ensure repayment of the loan before it becomes a complete loss,
 Try to shorten the loan processing time up to the customer expectation..
 Minimize non performing loans and build the reputation of the bank.

32
 References

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Capital Management and Signaling Effects, Working Paper, Department of
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 Charles, Okaro Kenneth. 2013. Impact of Credit Risk Management and Capital
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 Focardi C. 2009. “The Mortgage Crisis: How are credit risk managers responding?”
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35
 Annex I

ST.MARY’S UNIVERSITY
FACULTY OF ACCOUNTING AND FINANCE

Questionnaires to be filled by staff of United Bank

Dear Sir/Madam;

This questionnaire is developed by prospective graduates of St.Marry’s University to gather

<<
pertinent data for a study entitled on Credit Risk Management Practice a case study on

36
United Bank S.c >> for the requirements of the partial fulfillment of B.A Degree in Accounting
and Finance.
Since none of your response is forwarded to any 3 rd party and is kept confidential, please
answer each question with no fear of repercussion. Moreover, the success or failure of this
case study entirely depends on your responses; hence please respond each question as
appropriately as possible.

General Instruction
 No need of writing your name.
 Please put a tick() mark on the space provided

Thank you in advance for your utmost cooperation!

Part1. Background of the respondents

1. Sex Female Male
2. Age group 20-29 30-39
40-49 Above 50
3. Highest Educational Level Obtained
Diploma Degree Masters and Above
4. Current Position
Clerical Professional Managerial
5. Experience in current position
0-5 Years 6-10 Years Above 11 Years
Part II. Research related questions
1. How much do you know about Credit Risk Management System adopted by United
Bank?
Not Much Very Much Not at all
2. Does United Bank assess borrowers’ financial history before extending the loans?
Yes Definitely Yes to some extent
Not at all I am not quit aware of it
37
3. How do you rate the loan follow up mechanism of United Bank after granting a loan?
Very Good Good Neutral Bad
4. What is your expectation from effective credit risk management in your organization?
Reduce financial loss Improve communication with the stakeholders
Improve decision making Improve resource allocation
Other (Please Specify)
5. Who has the authority to establish risk management policy in your organization?
Board Members Policy Development committee
Executive Management/VPs and President/
Other (Please Specify)
6. Which type of loans granted to its Customers does the Bank usually give more
emphasis?
Agricultural Loan Export Loan Manufacturing loan
Import loan Building and Construction loan
Domestic trade and Service loan
7. How long does it take to get a loan from United Bank?
1-5 days One Week One Month More than a month
8. How do you evaluate the current and previous loan service of United Bank?
Improved a lot Not Improved No Comment
9. Does your organization have a documented credit risk management policy and
procedure?
Yes No
10. How much does the Bank put to reduce Credit Risk?
Creating clear and trustworthy information
Developing understanding between management team and employee
Fast and sharp communication between management team and stakeholders
Regularly communicating among management and staff
Creating and maintaining a clear communication
Other (Please Specify)
11. Please provide your level of agreement using the following rates(Where 1= Strongly Dis Agree, 2= Dis
Agree, 3= Neutral, 4= Agree, 5= Strongly Agree)

1 2 3 4 5
Diversion of borrowed fund to other purpose contributes
to Credit risk
Insufficient Credit awareness contributes to Credit Risk
Unwilling customer to disclose the information required
Lack of proper Credit Follow contributes to Credit Risk
Willful default /unwillingness to pay back contributes to
Credit Risk

38
12. How important do you consider the following factors in your credit granting process.
Please rate in order of importance, where; 1= Very Unimportant, 2= unimportant,
3= Moderate, 4= Important, 5= Very Important)
1 2 3 4 5
Capacity/how capable is the customer in repaying the debt/
Character/Customers financial history, but also their personal
integrity/
Collateral/assets provided by customer as the security for the
loan/
Condition/Overall environment that customer is operating in/
Capital/how much adequate funds the customer has to make the
business operate efficiently/

Annex II

Interview Questions

39
These interview questions are developed by St.Mary University for research paper to
be done for partial fulfillment of the academic requirements of B.A degree in
<<
Accounting and Finance in order to Assess Credit Risk Management>> a case study
on United Bank S.C.
1. What are the major functions of United Bank’s Credit Department performs?
2. What are the main measurements of the Banks’ to minimize Credit Risk
Management System?
3. What challenges you face in Credit Risk Management?
4. Does your organization offer training for employees? With regard to Credit Risk
Management?
5. How well the Bank’s Credit Risk Management policy and procedure is
communicated to employees and other stakeholder?

40