Impact of Credit Risk on Profitability of Commercial Banks of Nepal

Abstract

Credit risk management is crucial for banks to avoid financial difficulties and enhance profitability. Strong financial performance incentivizes stakeholders like shareholders and employees to invest and contribute more effectively. This study investigates how factors like Total Investment to Total Deposit Ratio (TITD), Non-Performing Loan Ratio (NPLR), Credit Deposit Ratio (CDR), Capital Adequacy Ratio (CAR) and Loan Loss Provision Ratio (LLPR) influence the profitability of commercial banks in Nepal. The analysis also explores the relationships between these ratios and performance metrics like Return on Equity (ROE) and Return on Assets (ROA) for commercial banks in Nepal. Standard financial analysis techniques and statistical methods were applied to evaluate secondary data obtained from published annual reports of sample commercial banks namely Nepal Bank Ltd. (NBL), Everest Bank Ltd. (EBL) and Himalayan Bank Limited (HBL) from fiscal years 2013/14 to 2022/23. Multiple regression analysis was employed to assess the impact of credit risk on the profitability of Nepalese commercial banks. The results reveal a significant negative impact of TITD, NPLR, CDR and CAR on ROE. The analysis confirms a negative correlation of TITD, NPLR and CDR on ROA. This indicates that a higher proportion of non-performing loans leads to a decrease in profitability. The coefficient of determination (R-squared) for the ROE model is 0.666, implying that 66.60% of the variation in ROE can be explained by the independent variables considered. To improve financial performance and mitigate future risks associated with non-performing loans, banks are recommended to closely monitor loan performance and meticulously evaluate borrowers' creditworthiness and repayment capacity before loan approvals. Additionally, continuous improvement in asset utilization, liquidity management, and cost control practices are crucial. Further research is encouraged to explore the influence of loans on banks' financial performance using a broader range of independent variables and longer study periods (e.g., 15-20 years) to achieve greater precision. This research offers valuable insights for financial analysts, investors, regulators, economists, and other stakeholders involved in making critical decisions within the financial sector.