Credit

risk

management

in

the

case

of

commercial bank of Ethiopia Bahirdar branch

Group Members

Belayneh Ketema
Belhu H/meskel
Berhanu Tewodros
Biniyam Fikadu

Advisor; Dereje Assefa

Chapter one: Introduction

1.1 Background of the study
Banks are useful to economic development through the financial services they
provide. Their intermediation role can be said to be a catalyst for economic growth.

The efficient and effective performance of the banking industry over time is an
index of financial stability in any nation. The extent to which a bank extends credit
to the public for productive activities accelerates the pace of a nations
economic growth and its long -term sustainability.
The credit function of banks enhances the ability of investors to exploit
desired profitable ventures. Credit creation is the main income generating activity
of banks (Kargi, 2011). However, it exposes the banks to credit risk. The Basel
Committee on Banking Supervision (2001) defined credit risk as the possibility of
losing the outstanding loan partially or totally, due to credit events (default risk).
Credit risk is an internal determinant of bank performance. The higher the
exposure of a bank to credit risk, the higher the tendency of the banks to
experience financial crisis and vice-versa.
Among other risks faced by banks, credit risk plays an important role on banks
profitability since a large chunk of banks revenue accrues from loans from
which interest is derived. However, interest rate risk is directly linked to credit
risk implying that high or increment in interest rate increases the chances of loan
default. Credit risk and interest rate risk are intrinsically related to each other
and not separable (Drehman, Sorensen, and Stringa, 2008).Increasing amount
of non-performing loans in the credit portfolio is inimical to banks in
achieving their objectives. Non-performing loan is the percentage of loan values
that are not serviced for three months and above (Ahmad and Ariff, 2007).
Due to the increasing spate of non-performing loans, the Basel II Accord emphasized
on credit risk management practices. Compliance with the Accord means a sound
approach to tackling credit risk has been taken and this ultimately improves bank
performance. Through the effective management of credit risk exposure, banks not
only support the viability and profitability of their own business, they also contribute
to systemic stability and to an efficient allocation of capital in the economy (Psillaki,
Tsolas, and Margaritis, 2010).
For most banks, loans are the largest and most obvious source of credit risk;
however, other sources of credit risk exist throughout the activities of a bank,
including in the banking book and in the trading book, and both on and off the
balance sheet. Banks are increasingly facing credit risk (or counterparty risk) in
various financial instruments other than loans, including acceptances, interbank
transactions, trade financing, foreign exchange transactions, financial futures,
swaps, bonds, equities, options, and in the extension of commitments and
guarantees, and the settlement of transactions.
Since exposure to credit risk continues to be the leading source of problems in
banks world-wide, banks and their supervisors should be able to draw useful lessons
from past experiences. Banks should now have a keen awareness of the need to
identify, measure, monitor and control credit risk as well as to determine that they

hold adequate capital against these risks and that they are adequately
compensated for risks incurred. The Basel Committee is issuing this document in
order to encourage banking supervisors globally to promote sound practices for
managing credit risk. Although the principles contained in this paper are most
clearly applicable to the business of lending, they should be applied to all activities
where credit risk is present.
To this end, this study assesses the credit risk management practice of Commercial
Bank of Ethiopias branches in Bahirdar in the following areas: (i) establishing an
appropriate credit risk environment; (ii) operating under a sound credit granting
process; (iii) maintaining an appropriate credit administration, measurement and
monitoring process; and (iv) ensuring adequate controls over credit risk.

1.2 Statement of the problem

While the commercial banks world-wide have faced difficulties over the years
for a multitude of reasons, the major cause of serious financial problems
continues to be directly related to credit standards for borrowers, poor
portfolio risk management or lack of attention to changes in the economic
circumstances and competitive climate. The credit decision should be based
on a thorough evaluation of the risk conditions of the lending and the
characteristics of the borrower. Risks exposed to commercial banks threaten
crises not only in the banks but to the financial market as a whole and credit
risk is one of the threats to soundness of commercial banks (Basel
Committee on Banking Supervision, 2001).
Commercial banks are in the risky business. In the process of providing
financial services, they assume various kinds of financial risks. Over the last
decade our understanding of the place of commercial banks within the
financial sector has improved substantially. These arguments will be neither
reviewed nor enumerated here. Suffice it to say that market participants
seek the services of these financial institutions because of their ability to
provide market knowledge, transaction efficiency and funding capability. In
performing these roles they generally act as a principal in the transaction. As
such, they use their own balance sheet to facilitate the transaction and to
absorb the risks associated with it.
The very nature of the banking business is so sensitive because more than
85% of their liability is deposits from depositors (Saunders, Cornett, 2005).
Banks use these deposits to generate credit for their borrowers, which in fact
is a revenue generating activity for most banks. This credit creation process
exposes the banks to high default risk which might led to financial distress
including bankruptcy. All the same, beside other services, banks must create
credit for their clients to make some money, grow and survive stiff
competition at the market place. Without effective credit risk management

good bank performance or profit will be unthinkable (Jeoitta Colquitt. 2007).

Commercial Bank of Ethiopia (CBE), the largest commercial bank in the
country, is no exception to this. With the current aggressive expansion of
branches for deposit mobilization and provision of loan, the banks risk
exposure is higher than ever before. The study tries to assess the banks
credit risk management practice by answering the following research
questions:
1. Is there an appropriate credit risk environment in CBE?
2. Is the bank operating under a sound credit granting process?
3. Does the bank maintain an appropriate credit administration,
measurement and monitoring process
4. Does the bank ensure adequate controls over credit risk?

1.3 Objective of the study

1.3.1 General objectives
The main objective of the study is to assess the credit risk
management practice of CBE, taking its branches in Bahirdar as a case
study.

1.3.2 Specific objectives

The specific objectives are:
To examine if there is an appropriate credit risk environment in CBE;
To evaluate whether CBE operates under a sound credit granting
process;
To assess if CBE has maintained an appropriate credit administration,
measurement and monitoring process;
To assess whether CBE ensures adequate controls over credit risk; and

1.4 Significance of the study

Risk management is recognized in todays business world as an integral part
of good management practice. In its broadest sense, it entails the systematic

application of management policies, procedures and practices to the tasks of

identifying, analyzing, assessing, treating and monitoring risk.
Financial institutions are exposed to various risks in pursuit of their
business objectives; the nature and complexity of which has changed
rapidly

over

time.

The

failure

to

adequately

manage

these

risks

exposes financial institutions not only hampering the profitability as their

earnings are converting in to bad debts but also increasing interest rate and
causing economic slowdown, ultimately rendered them unsuccessful in
achieving

their strategic

inadequate

risk

business

management

objectives.

may

result

In
in

the

worst

circumstances

case,
so

catastrophic in nature that financial institutions cannot remain in business.

Since the risk management procedures and policies are still in the nascent
stage in Pakistani banking sector, so this study would be a useful
contribution for the industry to better understand risk management and will
provide prolific observations for understanding risk management practices in
an organization and strive seriously to tackle the problem of loan recovery
and

tighten

their

credit

assessment

scrutiny

policy

and

arrange

appropriate monitoring procedure in order to keep an eye on NPLs. It is

a fact that NPLs are steadily causing lesser profitability of banking sector,
as the spread of banks is shrinking due to the lower recovery of
loans and decreasing yield on lending.

1.5 Methodology
1.5.1 Types of research designs
This research uses Quantitative method to address its research question and
to meet its general objectives too. For that datas are collected from
commercial bank of Ethiopia Bahirdar branch. There are also 30 questioners
which will be distributed to credit risk management bodies of the bank in the
study.

1.5.2 Sample, population, and participants

The researcher uses purposively commercial bank of Ethiopia from the banks
in the country. This is because the researcher wants to see the effects of
credit risk management, by taking datas from 2009 till 2013. Here as one
can easily understand from the research title, it does not allow banks which
have different objectives than profit. Be remained here we have to exclude
banks like development bank Ethiopia .because its main objective is to
create development in the country other than making profit.
Target Population and sample
The focus of this study is to evaluate credit risk management practice of
Commercial Bank f Ethiopias branches in Bahirdar. To this effect all
employees of the branches constitute the population of the study. However,
since the study is interested in credit related matters, credit officers of the
bank are the sample of interest. CBE has a common credit risk management
strategy. Therefore, the study will consider loan and credit officers at the
branches in Bahirdar to elicit responses for analysis.
Sampling Technique
In order to ensure that accurate and reliable information on credit risk
management is obtained, the study will adopt the purposive sampling
technique in deciding on whom to select for the data collection. The choice
of the purposive sampling technique is motivated by the fact that the
information on credit risk management strategies is specific and therefore an
expert with the requisite experience is required in order to achieve data that
is reliable. The participants of this study will be Risk and Compliance
Management Officer of the branch office, Risk management department
officer, and credit analysts (loan officers).
Research Instrument
The study uses primary data sources. The procedure to be employed in this
study is to solicit data through the use of questionnaire. Questionnaire is
made with open-ended statements and a five point likert scale. The

statements address the aspects of the Basel principles for credit risk
management practice, namely: (i) establishing an appropriate credit risk environment;
(ii) operating under a sound credit granting process; (iii) maintaining an appropriate credit
administration, measurement and monitoring process; and (iv) ensuring adequate controls over
credit risk.

1.5.4 Data Analysis

The analysis is carried out after collecting the necessary data from different
sources mentioned above. The researcher use quantitative data analysis
method. Then the outputs of the SPSS were interpreted through charts,
tabular and graphics

1.6 scope of the study

A finding of the study would me more fruitful if it is conducted by including
their similar organization. However, due to the broadness of the title it is
impossible to include all the credit risk management process of the bank.
Therefore, the study focuses on credit risk management process of
commercial bank of Ethiopia in Bahirdar branch.

1.7 Limitation of the study

The researcher tries to accomplish the objective of the study successfully.
But time concern and source of fund will be the main limitation that may
hinder the successful accomplishment of the paper. In addition to the above
two factors data limitation and sample limitation are the other sides to the
limitation part of the study. This limit the researcher not to get data as
required. Some respondents of the interview or questionnaires will be
careless to give appropriate answer for the question.

1.8 Organization of the paper

This section gives a structure of every chapter with in this paper. The paper
consists four chapters. Chapter one introduction, it presents background of
the study, statement of the problem, objective of the study, significance,
methodology and limitation of the study. Chapter two presents literature
review. Chapter three data analysis and interpretation, it reports the result
from the collected. Lastly the paper presents the conclusions of the results
and the recommendations suggested by the researcher in chapter four.

References;
Anthony M. Santomero (1997), Commercial Bank Risk Management: an
Analysis of the
Process, Wharton Financial Institution Center.
Bikker J.A and Metzemakers P.A.J (2005), Bank Provisioning Behavior and
Procyclicality, Journal of International Financial Markets, Institutions and
Money, Elsevier,
Vol 15(2), Pages 141-157
Carey, A. (2001), Effective risk management in financial institutions: the
Turnbull
Approach, Balance Sheet, Vol. 9(3).
Cooper D.R and Schindler P.S. (2003); Business Research Methods, 8 th
Edition, McGraw Hill,
New York
Frederic S. Mishkin., 2004, the economics of money, banking, and financial
markets. 7th ed. Colombia University. Pearson Addison Wesley press.

Grabowski,

M.

and

Roberts,

K.

(1999),

Risk

mitigation

in

virtual

organizations
Organizational Science. Vol. 10(6).
Haslam, and John A., (1968). , A statistical analysis of the relative profitability
of
Commercial banks, Journal of Finance.
Jeoitta Colquitt. , 2007. , Credit Risk Management: How to Avoid Lending
Disasters and Maximize Earning.3rd ed. Mercy College. McGraw-Hill.
Laurent Cleck (2004), Credit risk management and financial stability
Economic Analysis and Research Directorate, Monetary and Financial Policy
Research Division.

Lindgren H. (1987), Bank, Investment Company, Banking Firm. Stockholms

Enskilda 37 Bank [1924-1945]. Stockholm: Institute for Research in Economic
History at the Stockholm School of Economics.

Ross, Westerfield (2008). Modern Financial Management 8th edition. McGraw

Hill.
Saunders and Cornett (2007). Financial Markets and Institutions; an
Introduction to the
Risk Management Approach. McGraw Hill.