CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The growing competition arising from capitalisation, financial liberalisation and globalisation, alongside the efforts of Nigerian banks to expand their operations into other markets, may have influenced the efficiency and credit risk levels of banking institutions in the country. Over the years, the Nigerian banking sector has experienced several financial liberalisation reforms, creating a dynamic and increasingly complex environment for deposit money banks (Bolarinwa & Akinlo, 2022). One major concern arising from these developments is the need for banks to reduce operational costs and manage their available resources effectively to remain competitive. Another concern relates to the limited knowledge that newly established or expanding banks may have about unfamiliar markets, as well as their possible willingness to accept higher risks in an attempt to increase their market share in particular sectors or geographical areas. Although these issues are important, previous studies on banking efficiency have often examined them separately rather than considering their combined effects.

Risk-based examination has become an important approach to banking supervision because it allows regulatory authorities to direct their attention towards areas with higher operational and business risks. The development of skills in risk-based supervision is also encouraged through continuous training and exposure of bank examiners to relevant practices. This approach helps create awareness among banks, particularly commercial banks, about the importance of establishing formal and properly documented risk management frameworks. Generally, more complex forms of risk require more specialised, focused and closely monitored management strategies (Seppala, 2000; Matz & Neu, 1998; Ramos, 2000).

Financial institutions face several categories of risk, including interest rate risk, foreign exchange risk, political risk, market risk, liquidity risk, operational risk and credit risk. Nigerian banks continue to experience challenges in effectively managing and reporting credit and liquidity risks, which can affect their financial performance and the confidence of shareholders (Olawale & Obinna, 2023). In some situations, commercial banks and other financial institutions have made lending decisions without adequate assessment and approval procedures. These practices have contributed to loan defaults, rising non-performing loans, excessive credit expansion and directed lending.

Credit risk refers to the possibility that the actual return from an investment or loan may differ from the expected return (Conford, 2000). According to Coyle (2000), it represents the potential loss that occurs when customers fail or are unable to repay their credit obligations completely and within the agreed period. In the Nigerian banking sector, credit risk also covers issues such as non-performing loans, loan loss provisions, loans and advances ratios, and capital adequacy, which collectively provide an indication of the quality of a bank's credit portfolio (Tomomewo et al., 2023).

Several factors contribute to credit risk in the banking industry. These include inadequate institutional capacity, weak credit policies, unstable interest rates, poor management, inappropriate legal frameworks, insufficient capital and liquidity, excessive bank licensing, directed lending, poor loan underwriting, reckless lending, weak credit assessment procedures, government interference and inadequate supervision by the Central Bank. Reducing these risks requires a well-capitalised banking system, effective customer service, proper sharing of borrowers' credit information, stable interest rates, lower levels of non-performing loans, increased deposits and responsible lending practices. It is also important to reduce loan defaults and improve the overall quality of bank credit portfolios (Basel Committee on Banking Supervision, 2006). In response to these challenges, the Central Bank of Nigeria (CBN) has introduced stricter regulatory measures and supported the establishment of the Asset Management Corporation of Nigeria (AMCON) to address non-performing loans, strengthen banks and improve the quality of their assets (CBN, 2023).

Commercial banks adopt different credit risk management policies depending on factors such as ownership structure, whether the institution is privately owned, foreign-owned, government-influenced or locally owned, its internal credit policies, credit scoring systems, regulatory environment and the quality of its management (Nworji, Olagunju & Adeyanju, 2011). However, having effective credit management policies does not automatically guarantee high profitability. The performance of an individual bank may also be influenced by wider economic and financial conditions. For example, the market may be more understanding of a bank's poor performance when the entire banking sector is experiencing an economic shock or financial crisis. Furthermore, banks may adjust their lending policies to follow the practices of other institutions, a situation commonly described as herding behaviour (Altman, 2008). Bolarinwa and Akinlo (2022) found that reduced competition increased non-performing loans in the Nigerian banking industry. They also established that bank size and capitalisation influenced competition in ways that could further increase non-performing loans. This highlights the importance of market structure in determining credit risk outcomes.

In Nigeria, commercial banks contribute significantly to economic development by mobilising financial resources and providing credit to businesses, investors and individuals. Lending is a major activity in the banking industry, while loans and advances constitute a significant portion of bank assets and generate a substantial share of operating income. However, lending also exposes banks to considerable financial risks. The collapse of several banks in Nigeria during the late 1990s and the subsequent restructuring of the banking sector have been associated with poor management of credit facilities and high levels of non-performing loans.

Using panel data from listed deposit money banks, Chukwu et al. (2024) established that non-performing loans have a significant negative effect on the financial performance of Nigerian commercial banks. Their findings showed that increases in non-performing loan ratios consistently reduce return on assets (ROA) and weaken the overall stability of banks. Similarly, Ogunwale and Isibor (2024) found that non-performing credits and capital adequacy ratios significantly influence the equity returns of major Nigerian deposit money banks, including First Bank, Zenith Bank, Access Bank, GTBank and UBA, over a ten-year period.

Despite the growing attention given to credit risk management by commercial banks, its contribution to financial performance has not been fully examined. This creates a need for further investigation into the relationship between credit risk management and the performance of commercial banks in Nigeria. Consequently, this study examines how credit risk management influences the financial performance of commercial banks, with particular attention to the role of non-performing loans and other relevant credit risk indicators.

1.2 Statement of the Problem

The stability of the financial system is essential to the economic development of any country because weaknesses or failures within the system can negatively affect economic activities and growth (Das & Ghosh, 2007). The financial performance of an organisation reflects its ability to generate resources through its daily operations over a particular period. It is commonly assessed using indicators such as net income and cash generated from operating activities. In the banking industry, performance can be evaluated through traditional accounting measures and market-based indicators (Aktan & Bulut, 2008). Since the early 1990s, banking risk management practices have continued to develop to address major risks, including credit risk, interest rate risk, liquidity risk, market risk, foreign exchange risk and solvency risk.

Appa (1996) explains risk management as a process involving the identification of risks, assessment of their possible effects, development of appropriate management strategies and the use of available resources to reduce their impact. Credit risk, in particular, refers to the possibility of financial loss resulting from a borrower's failure to repay a loan or other credit obligation, including the principal amount, interest or both (Campbell, 2007).

Recent empirical studies in Nigeria have continued to highlight the relationship between banking risks and financial performance. Okwuosa et al. (2023), using panel corrected standard error regression on twelve listed deposit money banks covering the period from 2013 to 2022, found that liquidity risk and operational risk had positive and significant relationships with profitability measured by return on assets. Their findings also indicated that increased credit risk could weaken bank returns. Similarly, Uche and Obinna (2022) reported that higher non-performing loan levels were associated with lower financial performance, particularly when measured using return on assets. Kelvin and Odebode (2024) also found that non-performing loans negatively affected the return on equity of selected commercial banks, while bank size had a positive effect.

The importance of credit risk management in banking cannot be overstated because it is a major part of the lending process. Effective credit risk management helps banks maximise risk-adjusted returns by ensuring that their exposure to credit risk remains within acceptable limits. It also protects financial institutions against the negative consequences of borrowers' inability or unwillingness to repay their loans.

The Central Bank of Nigeria reported that the banking industry's Capital Adequacy Ratio (CAR) declined from 13.8 per cent in 2022 to 11.2 per cent at the end of June 2023. This reduction was attributed to foreign exchange market reforms, which led to the revaluation of risk assets denominated in foreign currencies. During the same period, the non-performing loan ratio was 4.1 per cent, remaining within the prudential limit of 5.0 per cent (CBN, 2023).

These developments raise important questions about the relationship between credit risk indicators and the financial performance of commercial banks in Nigeria. In particular, there is a need to determine whether non-performing loans are significantly related to bank performance, measured through return on assets (ROA) and return on equity (ROE). It is also necessary to establish whether the capital adequacy ratio has a significant relationship with these performance indicators. Therefore, this study investigates the relationship between credit risk management and the financial performance of commercial banks in Nigeria, with particular attention to the effect of non-performing loans on profitability.

1.3 Research Objectives

The main objective of this study is to examine the relationship between credit risk management and the financial performance of commercial banks in Nigeria.

The specific objectives are to:

1. Examine the significance of credit risk management in determining the financial performance of commercial banks in Nigeria.

2. Analyse the financial performance of the selected commercial banks.

3. Determine and evaluate the effect of non-performing loans on the profitability of commercial banks in Nigeria.

1.4 Research Questions

The following research questions will guide the study:

1. What is the significance of credit risk management in determining the financial performance of commercial banks in Nigeria?

2. What is the financial performance of the selected commercial banks?

3. What effects do non-performing loans have on the profitability of commercial banks in Nigeria?

1.5 Research Hypotheses

The following null hypotheses will be tested in the study:

1. Credit risk management has no significant effect on the financial performance of commercial banks in Nigeria.

2. There is no significant relationship between the management of loans and advances by commercial banks and their profitability.

3. Non-performing loans and advances have no significant effect on the financial performance of commercial banks.

1.6 Significance of the Study

The findings of this study are expected to be useful to different stakeholders in the banking industry. These include bankers, financial analysts, bank managers, internal auditors and senior management personnel of commercial banks. The study will provide information on the relationship between different components of credit risk management and the financial performance of commercial banks, using relevant financial ratios for assessment. Such information may assist bank managers and other decision-makers in evaluating credit-related risks and developing appropriate strategies to improve financial performance.

The study is also expected to serve as useful reference material for students, lecturers and researchers interested in banking operations, asset quality, non-performing loans and credit risk management. It will provide additional information that may support further academic investigations into the relationship between credit risk and the performance of commercial banks in Nigeria.

Furthermore, the findings may be useful to regulatory authorities and policymakers in assessing existing credit risk management practices and identifying areas that require improvement. Recent studies, including Tomomewo et al. (2023), Chukwu et al. (2024) and Ogunwale and Isibor (2024), have highlighted continuing concerns about credit risk and bank performance in Nigeria. By providing further evidence on these issues, this study is expected to contribute to discussions on regulatory policies and improved banking practices.

1.7 Limitations of the Study

Certain challenges may affect the smooth completion of this study. These include limited time, inadequate financial and other resources, and difficulties in obtaining the required information. Some respondents may also be unwilling to participate in interviews or provide relevant details. In addition, communication difficulties and the reluctance of some commercial bank employees to disclose important information may create challenges during data collection. These limitations may affect the speed and efficiency of the research process.

1.8 Definition of Terms

Credit Risk: Credit risk refers to the possibility that a borrower may fail to fulfil the repayment obligations attached to a debt. This may result in the lender losing the principal amount or interest, experiencing disruptions in cash flows and incurring additional costs in recovering the outstanding debt. In this study, credit risk is assessed using the non-performing loan ratio, loan loss provision ratio and capital adequacy ratio (Tomomewo et al., 2023).

Commercial Banks: These are financial institutions that provide banking services to individuals, businesses and other organisations. Their major activities include accepting deposits from customers and granting loans to individuals and companies.

Bank Performance: This refers to the ability of a bank to generate financial returns from its operations. In this study, bank performance is measured mainly through return on assets (ROA) and return on equity (ROE), which are commonly used indicators of profitability in Nigerian banking studies (Chukwu et al., 2024; Kelvin & Odebode, 2024).

Non-Performing Loans (NPLs): These are loans for which borrowers have failed to make the agreed principal or interest payments within the required period. Generally, a loan is classified as non-performing when payment has remained overdue for 90 days or more. It may also receive this classification when there are reasonable grounds to doubt full repayment, even where the delay is less than 90 days (Olumide et al., 2024).

Capital Adequacy Ratio (CAR): This is a financial measure that compares a bank's capital with its risk-weighted assets. It indicates the capacity of a bank to absorb potential losses arising from its lending and other financial activities. According to the CBN (2023), the minimum capital adequacy requirement is 15% for banks with international licences and 10% for other banks.

Loan: A loan is an amount of money provided by one party to another for temporary use, with the expectation that it will be repaid under agreed conditions. Repayment may include interest, depending on the terms of the loan agreement.

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