Credit Risk, Liquidity Risk and Profitability in Nepalese Commercial Banks
Credit Risk, Liquidity Risk and Profitability in Nepalese Commercial Banks
Credit Risk, Liquidity Risk and Profitability in Nepalese Commercial Banks
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Abstract
The main purpose of the study is to measure the effect of credit and liquidity risk on the profitability of commercial banks in
Nepal. The panel least squares regression model was used to analyze the balance data of ten commercial banks for the years
2012–2021, with 100 observations. Non-performing loan ratio (NPLR), capital adequacy ratio (CAR), investment ratio (IR),
capital ratio(CR), liquid assets to total assets (LTA and liquid assets to total deposits(LTD) are independent variables, and
return on Equity (ROA) is a dependent variable. The necessary data are collected from the annual report of sample banks,
banking and financial statistics, and the bank supervision report published by the Central Bank of Nepal. This study has used a
descriptive and causal comparative research design. Similarly, Eviews-12 computer software has been employed for diagnosis,
model fit, and analysis of data. Likewise, descriptive statistics, Pearson's correlation analysis, and multiple regression models
have been used in the study. The random effect model was taken as fitted models after the model diagnosis using Eviews-12
computer software. The regression model revealed that CAR has a positive and statistically significant effect on ROE, whereas
IR has a negative and statistically significant effect on ROE. However, CR has a negative and statistically significant effects
on ROE, at the same time, capital adequacy ratio, investment ratio, and capital ratio also have significant impact on ROE. So, a
strong credit and Liquidity performance and a wide non-performing loan decrease the profitability of the bank.
Keywords: return on equity, non-performing loan ratio, capital adequacy ratio, and investment ratio, capital ratio, liquid assets
to total assets and liquid assets to total deposits
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Theoretical and empirical review from India). The research used a generalized method of
Theoretical review moment (GMM) for the estimation to overcome the effects
Credit risk collects immobilized money in the form of of some endogenous variables. The findings of the study
deposits from all over the country. This will provide capital showed that CAR and ALR have significantly positively
for the development of the industry, trade, and business related to the financial performance, while NPLs, CER and
sectors, as well as other resource-depleted sectors. A sound LR have significantly negatively related to the financial
banking system is required for a healthy economy and the performance of the Asian commercial banks.
formulation of economic policies. As the country moves Bandara et al. (2021) [4] employed panel data regression
toward a free market economy, an efficient banking system analysis to measure the effect of credit risk on the
becomes a top priority, allowing private sector savings to be profitability of the banking sector in Sri Lanka for the
retained in the country for the promotion of investment observation period from 2010 to 2017 i.e. eight years of
needed for growth. As a result, commercial banks have thirteen banks. ROA is used to measure the profitability of
evolved into the financial system's beati (Shekher, 2014) [46]. banks while non-performing loan ratio (NPLR), loan-to-
Credit risk is one of the most significant risks that banks deposit ratio (LDR), net charge-off ratio (NCOR), and
face, as credit is one of the primary sources of income for capital adequacy ratio (CAR) are used as credit risk
commercial banks. As a result, the management of the risk indicators to quantify the measure. Descriptive and
associated with that credit has an impact on the banks' inferential statistics are employed to analyses the data. This
profitability. The significance of credit risk management in study is based on the quantitative design of research. This
banks stems from its ability to influence financial study employed panel data analysis the estimate the
performance, existence, and growth. Bank credit is observed relationship between the variable by two different
to be dependent on economic activity in an economy. Bank specification models, the Fixed Effect Model and the
credit increases as the economy grows, while slowing Random Effect Model. The study concludes that credit risk
growth or a decline in economic activity causes a decrease is important determinant of profitability of banks.
in bank credit (Dash & Kabra, 2010). Furthermore, non-performing loans have a negative and
According to Berger (1995), the quick ratio, liquid assets to significant ROA while the loan-to-deposit ratio is not an
deposits, total loan to deposits, and current ratio all had a important variable to expand the bank's profit. On the other
positive impact on the ROA and ROE of US banks from hand, the capital adequacy ratio positively impacts
1983 to 1989, but a negative impact from 1989 to 1992. profitability.
Based on these findings, Berger asserted that the Chhetri (2021) [7] investigated the effect of credit risk on the
relationship between liquidity and profitability ratios is financial performance of commercial banks in Nepal using
dependent on the specific conditions present during the time panel data of 17 commercial banks for the periods of 2015
periods studied. According to the study's findings, a high to 2020. ROA was used as a dependent variable to measure
current ratio has a positive impact on profitability when the profitability of commercial banks. On the other hand,
banks' financial conditions are deemed precarious, but a Capital adequacy ratio, asset quality, liquidity, management
negative impact on profitability when liquidity is available quality ratio, bank size and non-performing loan ratio were
from alternative sources. The most common measures of taken as independent variables under the study. Similarly,
liquidity, according to Vishnani and Shah (2007), are descriptive statistics, panel regression model and correlation
current ratio and return on investment for profitability. A matrix were run for analyzing the data. This investigation
higher current ratio indicates a greater investment in current has adopted a descriptive and causal-comparative research
assets, implying that the firm's rate of return on investment design. For choosing sample banks, the convenience
is low, as excess investment in current assets will not yield a sampling method was used for the study. The regression
sufficient return. A low current ratio indicates that the firm model revealed that non – performing loan (NPLR) has a
is investing less in current assets, resulting in a high rate of negative and statistically significant impact on ROA.
return on investment because there is no unused investment Capital adequacy ratio and bank size have negative and
in current assets. A low current ratio, on the other hand, may statistically insignificant impacts on ROA. CDR has a
indicate production and sales disruption due to frequent positive but no significant relationship with the ROA.
stock outs, as well as an inability to pay creditors on time The LAD ratio is a ratio that measures a bank's ability to
due to the restrictive policy. repay depositors' deposits using the bank's most liquid
assets. Banks can avoid liquidity risk, according to Davis
Empirical review (2008) in Hua Shen et al (2009), by holding a sufficient
Siddique et al. (2021) [47] investigated the issue of high non- proportion of liquid assets that can be used to meet
performing loans in Asian banks which contributed to 60% immediate or pre-due needs. There are currently many
of world growth. The major goal of the study is to measure instruments available that can be used by banking to meet
the impact of credit risk management and bank-specific the funding needs of customers who want to withdraw their
factors on the financial performance in scenarios of South funds in the form of cash and other immediate needs
Asian commercial banks. NPLs and capital adequacy ratio (Antariksa, 2005) [1], including sharia banking, although
(CAR) were used to measure credit risk. Similarly, cost- financial instruments used to meet the needs of limited
efficiency ratio (CER), average lending rate (ALR) and liquidity because it must meet sharia requirements.
liquidity ratio (LR) were used as bank-specific factors. On Therefore, liquidity is a problem that many faced by sharia
the other hand, return on assets (ROA) and return on equity banking (Noraini, 2012). However, the excess of liquid
(ROE) were used as proxy variables to measure the financial assets indicates that the bank is inefficient in exploiting its
performance of the banks. The study was based on funds so that it can affect the profit gain and adversely affect
secondary data collected from 19 commercial banks (10 profitability. Thus, the higher the LAD the lower the
commercial banks from Pakistan and 9 commercial banks profitability, meaning that LAD has a negative effect on
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profitability. The results of research on banking on the performing loan, capital assets ratio and the loan loss
influence of liquidity risk to profitability conducted Hua provision ratio have a negative impact on ROE, while the
Shen et al (2009) showed that the ratio of LAD has a capital adequacy ratio makes a positive contribution to
significant negative effect on profitability. ROE. Thus, credit risk management has a significant impact
The LTA ratio is one measure of liquidity risk that is used to on profitability. (Bhattarai (2014)the findings of the study
determine how much of a bank's total assets are made up of showed that negative effect of nonperforming loan ratio on
existing liquid assets (Antariksa, 2005) [1]. The high LTA bank performance and the positive effect of cost per loan
ratio indicates the greater availability of assets ready to be assets on bank performance. Capital adequacy ratio and cash
converted into cash and demonstrates fairly good bank reserve have no influence on bank performance. Since there
liquidity. However, the more cash that is idle in the bank is a significant relationship between credit risk and bank
because it is not used for operational purposes, the more performance.
profit the bank loses, and the condition will eventually Reported from the bank-specific variables that return on
affect the low level of profitability (Machmud and assets (ROA) is significantly positively impacted by bank
Rukmana, 2010) [39]. As a result, it can be deduced that the size and debt-to-assets ratio. Whereas, the deposit-to-assets
higher the LTA ratio, the lower the profitability. Research ratio and loan-to-deposit ratio are a significant and negative
on sharia banking about the influence of liquidity risk to impact on bank profitability. This study used panel data
profitability done by Antariksa (2005) [1] and Machmud and from 2010 to 2021 of 40 private south Asian commercial
Rukmana (2010) [39] shows that LTA ratio negatively affect banks i.e. 20 sample banks taken from India and 20
profitability. commercial banks taken from Bangladesh using a random
Hakuduwal (2021) examined the bank-specific factors' sampling method. The fit of the model test and data analysis
effect on the financial performance of Nepalese commercial were done by using E-views econometric software.
banks. Total assets, total deposit, total loan and advance and Breusch–Pagan Lagrange Multiplier (LM) Test is employed
total equity were taken as independent variables and return to test whether the model is appropriate or not.
on assets was taken as a dependent variable. The panel data
from 2012 to 2018 was taken for the study and 16 Methodology
commercial banks were taken as samples. The purposive This study examines the effect credit and liquidity risk on
sampling method was employed to select the sample banks. profitability of commercial banks in Nepal over the periods
Regression, F-test and t-test were used for analysis based on of 2012 to 2021 of 10 commercial banks pooled data
pooled least square method. This study revealed that the regression. The necessary data include time series and cross
total assets and total loan and advance have a positive sectional datawere taken from the annual reports of sample
significant impact on profitability. Likewise, total equity has banks and NRB website. Similarly, various mathematical
no significant impact and the total deposit has a negative and statistical tools were used under the study. Descriptive
significant impact on the profitability of commercial banks and causal comparative research designs are employed. This
in Nepal. The study suggests to Nepalese commercial banks study was used purposive sampling technique to select the
policy makers to utilize their assets, loans, deposits properly sample banks. These selected banks for the study are:
and equity for sound profitability of the bank. Similarly,
Bank-specific factors including bank size, assets quality, The model
capital adequacy, liquidity, operating efficiency, deposits, The econometric model used in the study for the purpose of
leverage, and assets management significant impacts on estimate the effect of independent variables on dependent
profitability (Al-Homaidi et al., 2002). On the other hand, variable is given as:
bank size is not significantly affected by bank profitability
Y=
(Neupane, 2020) [41].
Khan and Ali (2016) investigated the relationship between Where, Y is the dependent variable, β0 = Constant, β =
commercial banks' liquidity and profitability in Pakistan. Coefficient of explanatory variables, Xit = Vector of
Correlation and regression are used to determine the nature explanatory variables, and εit = Error term
and extent of the relationship between dependent and By adopting the above model, the effect of credit and
independent variables. Secondary data was used for liquidity risk on profitability has been estimated by the
analysis, which was extracted from Habib Bank Limited's following regression equation:
annual accounts for the previous five years (2008-2014).
Liquidity, profitability, current ratio, quick ratio, gross profit ROE = β0 + β1NPL+ β2CAR+ β3IR+ β4CR+ β5LAD+
margin, and net profit margin are used to assess the
β6LTA+ ..............
relationship. The study has found that there as significant
positive relationship between liquidity with profitability of Where,
the banks. None of the variable shows negative relation with ROE= Return on Equity
all the ratios of liquidity. Hence that research indicated that β0 = Constant
liquidity has positive relationship with profitability. β1, β2, β3, β4, β5, β6 = Beta Coefficient of independent
Shrestha (2011) Found that return on assets has positive and variables
significant relationship with capital adequacy and negative NPLR=Non-Performing Loan Ratio
and significant relationship with default rate. Similarly, the CAR=Capital adequacy Ratio
study found negative relation with cost per loan assets. IR=Investment Ratio
Poudel (2012) Return on equity was significantly influenced CR =Capital Ratio
by capital adequacy ratio, interest expenses to total loan, LAD= Liquid assets to total assets
while capital adequacy ratio had considerable effect on LAT= Liquid Asset to total deposit
return on equity. Nelson (2020) The study shows that non- = Estimation of error term
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Table 1: Descriptive statistics of ROE, NPLR, CAR, IR, CR,LTA and LTD
Variables N Minimum Maximum Mean SD CV
Return on equity 100 -6.06 44.96 15.80 0.0682 0.433
Capital adequacy ratio 100 -5.82 19.09 12.66 0.0304 0.240
Non-performing loan 100 0.08 5.83 1.49 0.0115 0.777
investment ratio 100 49.56 95.58 79.35 0.0951 0.119
capital ratio 100 -4.96 17.21 9.75 0.0309 0.317
Liquid to total deposit 100 8.87 25.09 15.14 0.0335 0.221
Liquid assets to assets 100 5.11 25.33 13.22 0.0382 0.289
Note: Annual report of sample banks and NRB, results are drawn from EVIEWS-12.
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Table 4.1 shows that the average return on equity is 15.80%, average capital ratio over a study period that demonstrates a
ranging from -6.06% to 44.96%, with a standard deviation consistent growth of financial performance of capital ratio.
of 0.068% and a coefficient of variation of 0.43. As a result, The average liquid assets to total deposit ratio is 15.14%,
banks have an average return on equity over a study period ranging from 8.87% to 25.09%, with a standard deviation of
that demonstrates consistent growth financial performance 0.033% and a coefficient of variation of 0.221. As a result,
of return on equity banks have an average liquid asset to total deposit ratio over
The average capital adequacy ratio is 12.66%, ranging from a study period, indicating a consistent growth in the
-5.82% to 19.09%, with a standard deviation of 0.03% and a financial performance of liquid assets to total deposits.
coefficient of variation of 0.24. As a result, banks have an The banks have an average liquid asset to total assets ratio
average capital adequacy ratio over a study period that of 13.22%, which ranges from 5.11% to 25.33% with a
demonstrates the minimum requirement of financial standard deviation of 0.038% and a coefficient of variation
performance of capital adequacy ratio. of 0.2. This means that the banks have an average liquid
The average non-performing loan is 1.49%, ranging from asset to total assets over a study period, indicating a
0.08% to 5.83%, with a standard deviation of 0.011% and a consistent growth of financial performance of liquid assets
coefficient of variation of 0.77. As a result, banks have an to total deposit.
average non-performing loan over a study period,
demonstrating the minimum requirement of non-performing Inferential statistics
loan financial performance. Correlation analysis
The average investment ratio is 79.35%, ranging from Correlation analysis is a statistical tool to measure the
49.56% to 95.58%, with a standard deviation of 0.095% and strength of linear association between two or more than two
a coefficient of variation of 0.1119. As a result, banks have variables. The value of correlation coefficient always lies
an average investment ratio over a study period that between -1 to +1. Correlation coefficient +1 means there is
demonstrates a higher growth in financial performance of strongly positively association between the variables while
investment ratio. correlation coefficient -1 means there is strongly negatively
The average capital ratio is 9.75%, ranging from -4.96% to association between the variables. Similarly, correlation
17.21%, with a standard deviation of 0.030% and a coefficient 0 means there is no association between the
coefficient of variation of 0.31. As a result, banks have an variables.
Table 2: Pearson Correlation Analysis of ROE, NPLR, IR, CR, CAR, LTA, and LTD
ROE (%) CAR (%) NPL (%) IR (%) CR (%) LD (%) LA (%)
ROE (%) 1
CAR (%) 0.024** 1
NPL (%) -0.164 -0.547** 1
IR (%) -0.249* 0.533** -0.374** 1
CR (%) -0.166* 0.860** -0.330** 0.576** 1
LD (%) -0.172 -0.143 0.184 0.014 0.009 1
LA (%) -0.066 -0.212 0.031 -0.098* -0.193 0.509** 1
Note: Results are drawn from EVIEWS-12
**Correlation is significant at the 0.01 level (2-tailed).
*Correlation is significant at the 0.05 level (2-tailed).
Table 4.2 shows the relationship between the dependent and On-performing loans have a -0.163-correlation coefficient
independent variables. This table clearly shows correlations with return on equity. Non-performing loans have a negative
between liquidity and credit variables (such as non- and significant relationship with return on equity.
performing loans, capital adequacy ratios, investment ratios,
capital ratios, liquid assets to total deposit ratios, and liquid
Regression analysis
assets to total assets ratios) and profitability variables (i.e.
Regression analysis is a mathematical tool that uses to
Return on equity). The coefficient of correlation between
estimate or predict the cause-effect relationship between the
capital adequacy and return on equity is 0.024. The
relationship between and capital adequacy ratio and return two or more variables. In this study, a panel data analysis
on equity is positive but significant. The coefficient of model is employed for data analysis. There are three
correlation between capital ratio and return on equity is - estimation models for the panel regression model, i.e.,
0.16. The correlation between capital ratio and return on polled ordinary least square (POLS), random effect model
equity is negative and significant. The coefficient of (REM), and fixed effect model (FEM). To determine the
correlation between investment ratio and return on equity is appropriate model for data analysis, a model diagnostic test
-0.250. The investment ratio has a negative and significant statistic was used. The Hasman Test, Breaush Pagan LM
relationship with return on equity. The coefficient of Test, and Chow Test are employed to select an appropriate
correlation between liquid assets and total assets and return model.
on equity is -0.066. The relationship between liquid assets
and total assets and return on equity is a negative and Table 3: Hausman Test
insignificant one. The coefficient of correlation between
Test Summary Chi-Sq. Stat Chi- Squ. d.f. Prob
liquid assets and total deposits and return on equity is - Cross Section Random 5.470 6 0.485
0.172. The relationship between liquid assets and total Note: Results are drawn from EVIEWS-12
deposits and return on equity is negative and significant.
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H0: Random effect model is appropriate than fixed effect ROE= 29.87-0.204NPL+ 1.44CAR-0.227IR-1.21CR+
model, select RE (p> 0.05). 0.108LAD-0.289LTA+
H1: Fixed effect model is appropriate than random effect
If non-performing loans fall by one percent, return on equity
model, select FE (p <0.05).
falls by 0.204 percent while all other factors remain
The above Table 3 shows the p-value of Hauman Test constant. If the capital adequacy ratio rises by one unit, the
which is more than 0.05 i.e. 0.7303 which means null return on equity rises by 1.44 percent while all other factors
hypothesis i.e. random effect model is accepted. After that, remain constant. If the investment ratio falls by one percent,
Breaush Pagan LM Test is applied to decide whether the return on equity falls by 0.227 percent while all other
random effect or polled ordinary least square model is factors remain constant. If the capital ratio falls by one
appropriate. Null hypothesis suggests for POLS model and percent, the return on equity falls by 1.21 percent while all
alternative hypothesis suggests for random effect model. other factors remain constant. If the ratio of liquid assets to
total deposits increases by one percent, the return on equity
Table 4: Breusch Pagan LM Test for Model increases by 0.108 percent while all other variables remain
Cross-section Test Hypothesis Time Both
constant. If liquid assets to total assets decrease by 1 unit
Breusch- Pagan 13.961 5.066 19.028 than return on equity decrease by 0.289 percent keeping
0.000 0.024 0.000 other factors remains constant.
Note: Results are drawn from EVIEWS-12 Level of significance mostly 5% is considered. If prob value
is greater than 5% or 0.05 it means chance of error is high
H0: POLS is better than random effect model, select POLS and we will not consider the regression result of particulars
(p> 0.05). variables. And if chances of error prob value is less than 5%
or 0.05 it means regression results are considerable and
H1: Random effect model is better than POLS, select RE (p variables is significant.
<0.05). The non-performing loan standard error is 0.080, which
indicates that the chance of error is high. The capital
The above Table No.4 shows that the p-value of test is less adequacy ratio standard error is 0.477, and the prob value is
than 0.05 i.e. 0.00 which means null hypothesis is rejected less than 5%, indicating that the regression results are
and suggests to go with random effect model. significant and the variables are significant. The investment
ratio standard error is 0.096 and the prob value is less than
Table 5: Regression results of NPLR, CDR, IRS, CAR, DGR and 5%, indicating that the regression results are significant and
TA on ROA the variables are significant. The capital ratio standard value
Variables Coefficient Std. Error t-Stat Prob. is 0.482 and the prob value is less than 5%, indicating that
C 29.875 8.527 3.503 0.000 the regression results are significant and the variables are
NPL -0.204 0.808 -0.253 0.802 significant. The standard deviation of liquid assets to total
CAR 1.455 0.477 3.043 0.001 assets is 0.245, indicating that the chance of error is high.
IR -0.229 0.096 -2.377 0.011 The liquid assets to total assets std error is 0.239 prob value
CR -1.212 0.482 -2.511 0.012 more than 5% it means chance of error is high.
LTD 0.108 0.245 0.441 0.665
LTA -0.289 0.239 -1.028 0.239 Discussion
R-Square 0.193 The main objective of the study investigates the effect of
Adj-R Square 0.141
credit and liquidity risk on profitability of commercial banks
F-Stat 3.729
in Nepal. Balance panel data of ten commercial banks with
Prob (F-stat) 0.002
DW test 1.326
100 observations for the periods of 2012 to 2021 have been
The regression of ROE and liquidity and credit variables employed for analysis and data analysis done by Eviews-12
Note: Results are drawn from EVIEWS-12 computer software.
The objectives of the study are to point out the current
(i.e’Capital adequacy ratio, non-performing loan, position and trend which is measured by ROE as
investment ratio, capital ratio, liquid assets to total deposit profitability indicators, non-performing loan ratio (NPLR),
and liquid assets to total assets) impact has been analyzed capital adqiuancy ratio (CAR), investment ratio (IR), capital
by defining the ROE changes in terms of liquidity position ratio (CR), Liquid assets to total assets (LTA)and liquid
of selected banks. The regression of ROE on liquidity and assets to total deposits (LTD), of Nepalese commercial
credit indicated in the equation for this regression module is banks. Similarly, it also focuses on identifying the
as follows: prevailing relationship between the dependent and
independent variables and the impact of independent
ROE = β0 + β1NPL+ β2CAR+ β3IR+ β4CR+ β5LAD+ variables on a dependent variable. ROE is employed as
dependent variables and NPLR, CAR, IR, LTA and LTD
β6LTA+ are used as explanatory variables.
The correlation analysis revealed that CAR is positively
How regression is run in eviews and how it is interpret in correlated with ROE and similar findings came in previous
our model ROE id dependent variable and NPL, CAR, IR, research Abdelrahim (2013), Afriyie and Akotey (2012),
CR, LDT and LTA are independent variables. Bhattarai (2014), Kurawa and Garba (2014), and Ogboi and
Unuafe (2013), for example, discovered a significant
ROE= β0 + β1NPL+ β2CAR+ β3IR+ β4CR+ β5LAD+ positive relationship between capital adequacy ratio and
β6LTA+ . bank performance. Alshatti (2015), Zou and Li (2014),
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