DIRE DAWA UNIVERSITY

COLLEGE OF ACCOUNTING AND FINANCE

DEPARTMENT OF ACCOUNTING

DETERMINANTS OF BANKS’ LENDING BEHAVIOR IN

ETHIOPIA

(A case of Ethiopian commercial bank)

Thesis Proposal Submitted in Partial Fulfillment of the Requirements for

the Masters of Business Administration (MBA)

By: - Samuel Assefa Wondim ID 1300620

Advisor:-

Dire Dawa, Ethiopia

March, 2022
 List of figures
Figure 2.1 Conceptual frameworks of the dependent variable and explanatory variable .................. 14
 List of tables
Table 3.1 List of sample Ethiopian commercial banks included in the study……………..16

Table 3.2 Definition of variables, measurement and the expected sign.................................... 21

3
List of abbreviation
CBE: Commercial Bank of Ethiopia
CEE - Central and East European countries
GDP - Gross Domestic Product
NPL - Non Performing Loans
OLS - Ordinary Least Square
US - United States of America
VIF - Variance Inflation Factor

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 ABSTRACT
The research study will be conducted on Determinants of Lending Behavior in Ethiopia. It tested
and confirmed the impact of internal and external factors on Ethiopian commercial banks’ lending
behavior. The main objective of the study was to investigate the factors that affect lending behavior
of banks in 8 commercial banks. The researcher will be uses secondary sources of data. The
secondary source of data will be collected from financial statements, books, manuals and internet.
The researcher will be using quantitative type of data which is collected from the 8 banks. The
study considered bank loans and advances as outcome variable and bank specific factors (liquidity
ratio, volume of deposit, credit risk and bank capital) as internal explanatory variables, and
monetary policy instruments (cash reserve requirement and lending rate) and macroeconomic
factors (GDP and annual foreign exchange rate of birr to USD) as an external explanatory variables.

Key words: Ethiopia, lending behavior, credit risk, loan and advance, volume of deposit,
liquidity ratio

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 1. INTRODUCTION
1.1 Background of the Study

Lending is a major service rendered by banks which contribute immensely to their revenue
generation. The loans can either be short term, medium or long term depending on the type of
need being addressed. Lending is therefore a major driver in aiding the economic activities of
households, firms and governments which in turn influences the growth and development of any
nation’s economy. Lending activities of banks influences the growth of an economy through
provision of resources for investments. This has led to liberalization of financial institutions by
many economies. It must be realized that the financial intermediation role that commercial banks
play make them to be in a position to determine financing of various economic sectors based on
available opportunities and the risks associated with each sector. However, economists still remain
divided in their opinion on determinants of lending behavior despite well-known liberalization
policies.

The Ethiopian financial sector is characterized by highly regulated, closed from foreign
competition, rapid growing economy with shallow and low coverage financial service also the
financial soundness indicators shows that Ethiopian commercial banks are profitable and stable
(Zewdu,2014). The banking industry play the most crucial role in facilitating capital accumulation
and economic processes for developing countries since they are one of the critical component of
the financial system (J. Ladime, E. Kumankuma & K. Osei, 2013); and (Kassie, 2014). Banks are
dominant in Ethiopian financial system which constitutes 95 percent share of assets, 97 percent of
deposits, 94 percent loans and advances and 77 percent equity of the financial sector on average
(Kassie, 2014). Nowadays there are about 19 banks which constitute one development bank and the
remaining 18 are commercial banks.

Commercial banks are an important phenomenon in economic growth and development. In order
for them to perform these roles, it must be realized that banks have the potential, scope and
prospects of financial intermediation. As a result commercial bank plays a great role for the growth
of the economy by maintaining three main operating guiding principles, which are profitability,
liquidity and solvency. (Osei, 2013) (Nwankwo, 2000) (as cited in (Olokoyo, 2011)) stated that
credit is the main source of single-income asset for most commercial banks. This is why every bank

6
should pay deposit interest for depositors in lieu of using their money. Hence they charge loan rate
from borrowers as expense of using their money. For generating interest income banks grant loans
and advances for individuals, government and private firms by assuring profitability, liquidness
and creditworthiness or solvency. The lending behavior of commercial banks is influenced by
different factors which can be included as endogenous (bank specific) and exogenous (industry
specific or monetary policy and macroeconomic) factors.

According to (Olokoyo, 2011) and (S. Olusanya, A.O. Oyebo and E.C. Ohadebere, 2012) volume
of deposit, investment portfolio, interest (lending) rate, cash reserve requirement ratio, liquidity
ratio, annual foreign exchange rate to US dollar and GDP at current market price are the main
factors that affect the lending behavior of commercial banks in Nigeria. (Malede, 2014)
investigated the determinants of commercial banks’ lending behavior in Ethiopian case by adding
bank size on the above explanatory variables but foreign exchange rate was not included. Besides,
(Assefa, 2014) examined short and long-run impact of bank-specific, monetary policy and
macroeconomic variables on bank credit to private sector in Ethiopia; using supply-side approach
over the period 1978/79-2010/11. (Ladime et, 2013) also examined and categorized these
variables into bank characteristic, industry characteristic and macro-economic indicator.

Therefore, this paper proposal will be investigate most determinants of Ethiopian commercial
banks’ lending behavior either private sector or government by incorporating the additional two
variables (bank capital and foreign exchange rate).

1.2 Statement of the Problem

Lending is the principal business activity for most commercial banks, makes the loan portfolio is
typically the largest asset and the predominate source of revenue for commercial banks. Thus, the
major portion of gross profit of the banking industry is earned from loans in the form of interest
income and contributes the lion share of commercial banks earnings (Vong et, 2009). But, on the
other hand, it is also one of the greatest sources of risk to a financial institutions safety and
soundness. Whether due to lax credit standards, poor portfolio risk management, or weakness in
the economy, historically loan portfolio problems have been the major cause of losses and failures
for commercial banks (Vong et, 2009).

The lending function of commercial banks is influenced by different internal and external factors.
According to (E. Richard and V. Okoye, 2014) internal factors of lending behavior of banks are

7
established by their directors while external factors arise from the regulatory actions of national
(central) banks, other regulatory authorities in the financial sector of the economy and from the
general macroeconomic event. Scrutinizing these major factors that affect the lending behaviors of
commercial banks is the critical task of different parties. In different countries of the world,
several studies were conducted to inspect the determinants of lending behavior of commercial
banks. For instance, (Olokoyo, 2011); (Olusanya et, 2012);(Ladime et, 2013);(Tomak, 2013)and
Richard and Okoye(2014) investigate factors that are classified as internal and external. On the other
hand, some scholars try to address and emphasis in examining macro-economic factors of loans
and advances. Some researchers examine single explanatory variables in depth rather than
scrutinize all in one; (L. Gambacorta and P. Mistrulli, 2003) studied the influence of bank
capitalization on banks channeling in Italy case.

The finding of (Olokoyo, 2011) and (Olusanya et, 2012) shows there is a positive relationship
between loans and advances and annual average exchange rate in Nigeria. In addition, (R. Kishan
and T. Opiela, 2000) confirm a bank capital have a great impact on their lending behavior. These
three papers shows that bank capital and annual foreign exchange rate are explain the loan and
advances of commercial banks.

Therefore, the main purpose of this study will be examine determinants of lending behavior of
Ethiopian commercial banks. Based on the previous discussion this study fills the gap first by
incorporate bank capital and annual foreign exchange rate as an independent variable and second
it examine lending’s made for private and non- private sectors beside it covered a ten year latest
data from 2012 to 2021 G.C.
1.3 Objectives of the Study
1.3.1 General Objective
The main objective of the study will be to investigate the factors that affect lending behavior of
banks in Ethiopia.
1.3.2 Specific Objectives
The study will be addressed the following specific objectives:
 To examine the impact of endogenous factors on commercial banks’ lending behavior.
 To examine the impact of industry specific factors on commercial banks’ lending behavior.
 To examine the impact of macroeconomic factors on commercial banks’ lending behavior.

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1.4 Scope of the Study
The research will be limited to examine the determinants of lending behaviors of Ethiopian
commercial banks. To include full year data the study exclude newly established banks in the study
period and it will focused on all commercial banks that were established before year 2012. This
paper will not investigate the lending behavior of Development Bank of Ethiopia because as
indicated before on the topic, the research stands to study the lending behavior of commercial banks
only.
1.5 Significance of the Study
This study will have significance on:-

 Provide empirical evidence on the factors of lending behavior of Ethiopian commercial

banks,
 benefit government bodies to have a better understanding of the effect of determinants of
commercial bank lending and also to adjust different policies and regulations (i.e. related to
cash reserve requirement, capital requirement, sometimes exchange rate determination and
interest rate) and to caring on the modification process of policies,
 creating awareness to the society about banks’ lending behavior,
 serving as a base for future research as a reference by providing information,
 giving important suggestion that will help the banks for appropriate and practical factors
that affect lending,
 Indicating that the issue is yet potentially a research area and also use as a reference for
further studies, getting experience and knowing how the problem can be solved in the
scientific research method
1.6 Limitation of the study
In Ethiopia huge amount of loan is processed through government’s policy bank, Development
Bank of Ethiopia (DBE) however, the study will not include this bank in examining determinants
of lending behavior of Ethiopian banks.
1.7 Organization of the Paper
The study will include five main chapters. The first chapter presents background of the study,
statement of the problem, objective of the study, research questions, hypothesis test, significance
of the study, scope and limitation of the study and organization of the paper. The second chapter
summarizes the literature review, which are theoretical literature review & empirical literature

9
review. The third chapter presents research design, source of data and type, data collection,
sampling design and method of data analysis and presentation. In the fourth chapter of the study
analysis, discussion and interpretation of the result would take place and the fifth chapter provides
conclusion and recommendation of the study.
1.8 Definition of Key words
 Behavior: - the way in which one acts or conducts oneself, especially towards others.
 Credit Risk: - a measure of the credit worthiness of a borrower.
 Deposit: - a financial term that means money held at a bank.
 Lending:- occurs when someone allows another person to borrow something
 Loan: - a thing that is borrowed, especially a sum of money that is expected to be paid back with
interest.

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 2. LITERATURE REVIEW
This chapter deals with the theoretical literature written by different scholars and empirical
literature of different researcher’s findings on the title of the paper.
2.1 Modern Banking History in Ethiopia

The first bank established in Ethiopia was the Bank of Abyssinia in 1905.It was owned and
managed by the British- owned National Bank of Egypt (Harvey, 1996). It was given a banking
monopoly for fifty years, including the right to issue notes and coins. However, three other banks
were established in the next ten years. In 1931, the Bank of Abyssinia was replaced by the Bank of
Ethiopia which was wholly owned by the government and members of the Ethiopian aristocracy,
becoming the first 100% African-owned bank on the continent; it was also authorized to issue notes
and coins and to act as the government’s bank. It operated for only a few years, being closed after the
Italian invasion. During the Italian occupation, several Italian banks opened branches in Ethiopia
(Harvey, 1996).

After the liberation the Ethiopian government established the ‘State Bank of Ethiopia’ in
1943andoperatesthe banking activity by 43 employees in two branches. The bank was act as both a
central bank and a commercial bank of the country.

In1963 a new banking law split the functions of the State Bank of Ethiopia in to central and
commercial banking as the National Bank of Ethiopia and the Commercial Bank of Ethiopia
respectively, both were government-owned. The 1963 banking law was allowed for other
commercial banks (foreigners) to operate (Harvey, 1996).

After the fall of the imperial government in 1974, these led to a major change in economic policy.
The nationalization of all large corporations was one the instrument for establishing centralized
control (Harvey, 1996). Ownership of financial institutions was main concern and for this reason
private sector commercial banks were nationalized and concentrated into the Commercial Bank of
Ethiopia (CBE). The new Ethiopian government merely shifted, therefore, from owning most of
the banking system to owning it completely.

After the fall of socialist government, the private sector involvement in the banking industry
started with the virtue of the monetary and banking proclamation No. 83/1994. Currently there are

11
19 licensed banks which operate in Ethiopia. Out of this 3 banks are owned by the central
government namely Development Bank of Ethiopia (DBE), Commercial Bank of Ethiopia (CBE)
and Construction and Business Bank (CBB) which carry out commercial activity like private
banks. The remaining 16 banks are privately owned commercial banks. All the banks are now
regulated by the National Bank of Ethiopia. The National bank of Ethiopia plays the most
influential role in the country’s economic and financial development. It acts as a banker and
financial advisor to the government as the nation’s monetary authority and is responsible to the
government for promoting monetary stability in the country.
2.1 Theoretical Literature Review

2.1.1 Signaling Argument

Better companies offer more collateral to signal themselves to the bank a best borrower and in turn to
be charged by the bank a lower interest rate because a good firms know they will not suffer
severely from offering more collateral ever since, the chance of conditions are violated (R. Ewert &
G. Schenk, 1998). (Chodachai, 2004) states that low risk borrowers, prefer contracts with high
level of collateral. In other expression, the low-risk firms offer more collateral to give a signal to the
lending banks that their business is very promising i.e. the collateral is not likely to be repossessed
because default is highly unlikely to occur. Therefore, according to the theory, since more collateral
pledged firms seen as a better, they are charged lower interest rates by banks (Chodachai, 2004).
2.1.2 Credit Market Theory
Model of neoclassical credit market suggests that the terms of credits clear the market. If collateral
and other restrictions (covenants) remain constant, the interest rate is the only price mechanism of
credit with an increasing demand for credit and a given customer supply, the interest rate rises,
and vise-versa (R.Ewert , A. Szczesmy & G.Schenk, 2000).
2.1.3 Loan Pricing Theory
Interest rate premium is set based on the risks. If firms are riskier they would require paying
higher interest rates. However, setting higher interest rate will draw riskier applicants (adverse
selection problem) and/or initiate borrower firms to spend in riskier projects to charge a higher
interest rates to compensate the earlier concessions (moral hazard problem) (Petersen, 1999).
Hence the bank’s expected losses may no longer cover by the higher interest rate and this lead
banks choose not to lend( (Stiglitz & Weiss, 1981); (Petersen, 1999)).

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2.1.4 Theory of multiple lending
It is found in literature that banks should be less inclined to share lending (loan syndicate in the
presence of well-developed equity markets and after a process consolidation. Both outside equity;
and mergers and acquisition increases banks’ lending capacity, thus reducing that need of greater
diversification and monitoring through share lending. ((Carletti et, 2006); (Ongene & Smith,
2000); (Karet et, 2004); (Dgreyse et, 2004)
2.2 Empirical Review
The evolution of bank lending theoretically results from the interaction between demand and
supply factors. However, the variables that help to explain the dynamics of the loans sometimes
affect both demand for and supply of credit, and it is not always, accordingly, possible to
empirically identify the two channels. Hence, to identify the factors of commercial banks
literatures are found in two sides (demand factors and supply factors) in different countries. There
are usually variables of scale, variables related to financing conditions, variables related to the
position of households and corporations and factors related to structural changes in the banking
sector and other variables. Even though, there are many factors in both sides of credit the focus of
the paper is in examining supply side factors.

Many literatures suggest that the bank lending is a function of different determinants emanated
from internal and external environment of banks. Internal factors are bank specific whereas
external factors are originated from monetary policy, economic situations and legal environment
in which their impact is to the whole economy and industry.

(R. Ewert & G. Schenk, 1998) observed big companies that provide more collateral sends some
signals to convince banks that they are less risky customers, with the hope type of securing lower
interest rates. This is not the case with high risky companies that are required to comply with
provision of collaterals and restrictive covenants, and yet are still charged higher interest rates on
loan facilities. The shortcomings in this study include; consideration of interest rate as the only
factor affecting bank lending behavior, and the fact that the study is based on German economy.
2.3 Conceptual framework
Figure 2.1 below illustrates the relation between commercial banks’ loans and advances and the
explanatory variables. Loans and advances of commercial banks is a function of internal and
external factors. Internal factors which included as bank specific determinants are liquidity ratio,

13
credit risk, volume of deposit and bank capital. These factors are originated from each bank and its
impact is for its own. On the other hand the other two box arrows illustrate external factors of loans
and advances in which they are grouped as industry specific determinants (monetary policy
instruments) and macroeconomic factors. Thereby, all of the three box arrows demonstrate the
relation between the dependent variable of the paper and its explanatory variables in different
category. This conceptual framework illustrates the lending behavior of commercial banks which is
measured by net loans and advance of banks is a function of both internal and external factors.

Figure 2. 1 Conceptual framework of the dependent variable and explanatory variable

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 3. RESEARCH METHODOLOGY
The third chapter deals with the research design, data source and type, data collection method,
sampling design and method of data analysis and presentation.

3.1 Research Design

This section presents the methodologies that have been employed to achieve study objectives as
well as to test the hypothesis by large, the study employed explanatory research design. The major
objective of this study is to investigate the determinants of commercial banks’ lending or loan and
advances .The research problem tend to be explanatory which seeks to explain the relationship
between lending or loan and advances and bank level, macroeconomic as well as regulatory
factors.
3.2 Research Approach
To attain the objectives of the study and to test the formulated hypothesis the study will be employed
quantitative research approach since the paper aims to examine the impact of independent variables
on the commercial banks loan supply. This is believed appropriate because the study will be
involved in studying the effect of internal and external factors on banks’ lending behavior. Annual
financial report of 8 commercial banks, covering the period from 2010 to 2019 and other
macroeconomic data will be uses for the study. The data are panel and the reason of using it is
panel data have an advantage of giving more informative data since it comprises both cross
sectional, which captures individual variability, and time series information(Abebe, 2014).Ordinary
Least Square(OLS) of method of estimation of a multiple regression model will be chosen to
undertake the study.
3.3 Data Type and Data Source
The researcher will be used secondary type of data because of easy accessibility of the data and
also in order to control the cost effectively. The data will be also cleaned and stored in an
electronic format. The selected banks are included in the study have been operating for the last 10
years, from the year 2012 up to 2021. For this regard, 10 years (2012-2021) financial statement of
the selected banks will be using in the analysis and all the financial statements are consolidated
each year. Regarding the industry and macroeconomic variables, the data will be collected from
National Bank of Ethiopia (NBE), which regulates the financial sector of the country. Besides,
related books, journals articles, internet and various literatures also will be used as sources of data.

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 3.4 Population and sample Size
3.4.1 Sample Size
The target population for this study will be all commercial banks carry out their operation in
Ethiopia which is 18 in number. Out of the total, Commercial Bank of Ethiopia is state owned
and the remaining’s privately owned.

3.4.2 Sampling technique

The sample frame for the study will be determined based on long year banking operation
experience and the availability of each bank data from the year 2012 -2021.The selection of the
sample period will be based on the intention to increase the degree of freedom and to meet
the requirements of the estimation procedure. The sample consist eight (8) commercial banks that
were registered before 2007 from 18 commercial banks operating in the country. The period 2012-
2021 will be chosen just to examine the determinants of bank lending using recent data and very
recently established banks will not considered avoiding new entrant bias. Out of 18 commercial
banks the researcher will took all banks established and operated in the study period to undertake
this investigation. Thus, banks established and started their operation after the starting time frame
of the study i.e.2007 will not include on the study.

Table 3.1 List of sample Ethiopian commercial banks included in the study.
No. Private Commercial Bank Year of est.

1 Commercial Bank of Ethiopia 1963

2. Awash International Bank 1994
3. Dashen Bank 1995
4. Abyssinia Bank 1996
5. Wegagen Bank 1997
6. United Bank 1998
7. Nib International Bank 1999

8. Lion International Bank 2006

Source: www.nbe.gov.et

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 3.5 Model Specification
To test the hypotheses of the study multiple regression model will be formulated. The model will be
modified from (Olokoyo, 2011); (Olusanya et, 2012); and (Malede, 2014). As it is explained
previously, the dependent variable of the study is loans and advances of banks and the explanatory
variables i.e. credit risk, liquidity ratio, cash reserve ratio, gross domestic product, average lending
rate, average annual exchange rate of Birr to US Dollar, volume of deposits and bank capital. The
study will be used Ordinary Least Square (OLS) method of estimation to estimate the parameters
or regression coefficients.

LOA=f (Cr, Lr, Crr, Gdp, Alr, Fx, Vd, Bc, Є) .............................................................. (1)

To represent some omitted variables, measurement error and sampling error of the empirical
model were included in the disturbance (error) term Є which represent other variables which will
not explained by the independent variables included in the model.
The multiple regression equation of the above model (1) is extended as follows:
𝐋𝐎𝐀𝐢𝐭 = 𝛂 + 𝛃𝟏𝐂𝐫𝐢𝐭 + 𝛃𝟐𝐋𝐫𝐢𝐭 + 𝛃𝟑𝐂𝐫𝐫𝐢𝐭 + 𝛃𝟒𝐆𝐝𝐩𝐢𝐭 + 𝛃𝟓𝐀𝐥𝐫𝐢𝐭 + 𝛃𝟔𝐅𝐱𝐢𝐭 + 𝛃𝟕𝐕𝐝𝐢𝐭 + 𝛃𝟖𝐁𝐜𝐢𝐭 +𝛆𝐢𝐭
…………………………………………………..……………………….. (2)

Where:
LOAit: Loans and Advances of Bank i at time t
Crit: Credit Risk of Bank i at time t
Lrit: Liquidity Ratio of Bank i at time t
Crrit: Cash Reserve Ratio of bank i at time t
Gdpit: Gross Domestic Product of Bank i at time t
ALrit: Average lending Rate of Bank i at time t
Fxit: Annual Foreign Exchange rate of Birr to USD of Bank I at time t
Vdit: Volume of Deposits of Bank i at time t
Bcit: Bank Capital of bank i at time t
Є: error term of the model
α: Intercept of the regression line
β (1-8) parameters or coefficients to be estimated

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3.6 Explanation and measurement of variables
3.6.1 Dependent Variables
Loans and advances is the main source of single income asset (Nwankwo, 2000) (cited in (Olokoyo,
2011)) and primary functions of commercial or deposit banks. On the other hand, loan is crucial for
investment and long term economic growth of a given country. Despite its importance to the bank
and to the economy, the credit decision is influenced by different bank specific and macro-
economic factors. So many researches were conducted to identify the determinants and their effect
on loans and advances of banks by several scholars. The degree of influence is different from
country to country. The study will took net loans and advances of banks as a dependent variable to
conduct the study( (Olokoyo, 2011);(Olusanya et, 2012); and (Malede, 2014)).
3.6.2 Independent Variables
Based on literatures and by considering the prevailing banking system in Ethiopian, eight
explanatory variables will be selected for the purpose of examining lending behavior of
commercial banks.

Credit Risk

Credit risk is the potential of a particular borrower or a counterparty default or failure to meet its
obligation in accordance with contracts. Loans and advances are the main source of credit risk for
commercial banks(I. Kaaya & D. Pastroy). Credit risk is not the only but the major important
factor which affects the bank lending behavior among various risks (credit risk, liquidity risk,
market risk, foreign exchange risk, etc.) Credit risk is measured by evaluating the probability of
default by a particular borrower after taking into account various risk diversification and hedging
arrangements. Banks should critically approve the risk premium charged from the borrower before
granting the loan. Commonly the loan granting is dependent on the size of the premium which can
be calculated by considering different factors. Most finance literatures show that credit risk is
proxied by Non- Performing Loans (NPLs). For the purpose of this study credit risk will be
commonly measured by using provision for loan loss (Non-performing loan) to the gross loan amount
(Tehulu & Olana, 2013); and (Bologna, 2011). It will be expected a negative relation with loan and
advance of banks.

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Liquidity Ratio
Commercial banks are required by central (national) banks to be always liquid to meet the demands
of depositors. Thus, maintaining a certain level of liquid asset is essential for each bank before
entering to lending activity. Liquidity ratios are explained by various balance sheet ratios used to
identify the liquidity trend of that particular bank. These ratios can be used to measure the
liquidity risk of the bank. The ratio of liquid asset to total deposits will be used for this study as a
measure of liquidity ratio. A positive or negative relation will be expected depending on the state
of the policy.
Cash Required Reserve
Cash reserve requirement is a monetary policy tool for central banks of nations that is used to
balance the circulated currency and to correct various issues of the economy. Every bank is
required by the central bank of the country to maintain certain percentage of its deposit liabilities
held in the form of demand (current) deposits, saving deposits and time deposits.
These parts of deposits are prohibited to provide private credit or to buy securities (Glocker and
Towbin, 2011). This amount or ratio of required reserve set by the central (federal) bank of a
country have an impact on the volume of deposit which then used for lending. If the reserve
requirement ratio increases, the amount of deposit held by banks for granting loan decreases, and
vice versa. Statutory reserve requirement to total asset of the specific bank is used for the purpose
of this study. It will be expected that it have positive/negative relation with the dependent variable
(Malede, 2014).
Gross Domestic Product (GDP)
Situations have an effect on lending activity of commercial banks. GDP growth is one element of
macroeconomic factors which is used to measure the economic growth of a country and used to
control changes in a loan demand (Djiogap & Ngomsi, 2012). In the determination of GDP growth
from one year to another, real GDP give a more accurate view of the economy (Murumba, 2013)
since real GDP is the sum of the value added in the economy during a given period or the sum of
incomes in the economy during a given period adjusted for the effect of increasing prices
(Daferighe & Aje). Therefore, the study uses real GDP as a determinant rather than using the
nominal GDP because nominal GDP has the following limitations. The one is the production of
most goods increases overtime and the second is that the birr price of most goods increases
overtime. When a country is in boom, the real GDP growth raises, the investors can run their

19
business through debt and this encourage credit service of banks. At the same time the debt
repayment ability of borrowers increases and the opposite is true when economy is depressed
(GDP growth is very low or go down). Real GDP growth rate will uses for the purpose of this
study. GDP growth will be expected to have positive or negative relationship with bank lending (
(Liadroo, 2012) and (Malede, 2014)).
Interest (Lending) Rate
It is a rate set by the lender or the bank to charge the borrowing unit. This rate mostly include the
cost of raising funds through deposit, owner contribution (equity) and/or from financial markets,
risk premium to compensate the additional risk, operating cost and profit margin. The amount or
level of lending rate will have its own effect on lending growth of banks. It is measured by taking
average annual lending rate of banks ( (Bologna, 2011) and (Malede, 2014)). Ceteris paribus, the
rising of lending rate will diminish the demand of loan and vice versa. Thus, it will expected that
it have a positive/negative relation with loans and advances.
Volume of Deposit
Amount of deposit attracted by banks in the form of saving, current or demand and time deposits
have influence on the loans and advances. Deposits are the main source of funding for banks and
are the lowest cost source of liability for granting loans and advances (Alper & Anbar, 2011). (E.
Richard and V. Okoye, 2014) on their study of determinants of lending behavior of deposit money
banks in Nigerian found that lending behavior of Nigerian banks are determined by level of
deposit available and other factors. In the same manner, (A.Araga, 2014)observe that change in
volume of deposit, with other explanatory variables have great changes in volume of banks’ loans
and advance in the economy. Total deposit liability of the bank will uses for the study. Generally,
it was expected that there is a positive relation between volume of deposit and loans and advances
of the banks.
Bank Capital
(Chernykh and Theodossiou, 2011) states that well capitalized and larger banks are better able to
withstand potential credit risks and, therefore, allocate higher percentage of their assets to business
loans. This implies that the amount of capital have its own influence on the lending function of
banks. The finding of (Gambacorta and Mistrulli, 2003) shows that well capitalized banks can be
able to better absorb temporarily financial difficulties on the part of their borrower and preserve
long term lending relationships. Their study also reflects that excess capital is a direct measure of

20
banks capacity to expand credit because it takes into consideration prudential regulation
constraints. In this paper total of shared capital will uses and a positive relation with loan growth
will be expected (Liadroo, 2012) because excess capital contributed by the owners can affect the
bank willingness and ability of to extend credit.
Operationalization of the Study Variables
This part shows the measurement of the variables will be employed in the study. Furthermore, the
expected sign of each explanatory variable will be presented by taking to account their influence
on dependent variable.

Table 3.2 Definition of variables, measurement and the expected sign

Symbol Variables Measurement Expected Relation

Dependent variable

Non-performing loan/Total loans

LOA Loan and advances
and advances

Independent variable

Non-performing Loan/Total Loans

CR Credit risk –
and Advances

LR Liquidity Ratio Liquid assets/Total Deposit –/+

Statutory reserve
CRR Cash Reserve Ratio –/+
requirement/Total asset

Gross domestic
GDP Real GDP growth rate –/+
product

Average Lending Annual bank average lending rate

ALR –/+
Rate

Foreign Exchange Annual exchange rate of Birr to US

FX –/+
Rate Dollar

A sum of all Types of deposits

VD Volume of Deposits +

21
3.7. Methods of Data Analysis
The study will uses secondary data of audited annual financial report of banks, real GDP growth
rate and annual exchange rate of Ethiopian Birr to US Dollar of ten consecutive years which are
all collected from National Bank of Ethiopia. Inferential statistics will be used to draw conclusions
about the reliability and generality of the findings.
The data will be panel from 2012-2021 which contains both a cross sectional and time series.
Different diagnostic tests like model adequacy, hetroscedasticity, multicollinearity, normality,
autocorrelation and cross sectional independency will be carried out for the purpose of the adopted
model and the employed explanatory variables to be satisfactory and free from any statistical
error.
3.8. Ethical Consideration
Ethical consideration must be an integral aspect of any particular study. Dependable ethical
principles will be observed in the course of conducting the research. (Saunders et, 2009) add that
gaining permission and consent to collect data is a very important aspect of any study. All data
collection will be therefore made to contain informed consent form.

22
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