ASSESSING THE IMPACT OF CREDIT RISK MANAGEMENT ON FINANCIAL PERFORMANCE OF COMMERCIAL BANKS: A CASE STUDY OF UGANDA’S BANKING SECTOR

NOELINE KIRONDE NAKALEMBE

kironde@gmail.com

+256 776756540/782626785

AN ABSTRACT ABOUT “ASSESSING THE IMPACT OF CREDIT RISK MANAGEMENT ON FINANCIAL PERFORMANCE OF COMMERCIAL BANKS: A CASE STUDY OF UGANDA’S BANKING SECTOR”

Introduction 

The banking sector has a very important role it plays while contributing to the country’s economic transpiration and social development through enhancing and rendering financial assistance services, risk management, and payment systems. Particularly, commercial banks, tend to be financial brokers, diverting cash from money savers to money borrowers, whereby they enhance capital formation and investment (Freixas & Rochet, 2021). However, this sector is exposed to tremendous challenges and high risks, which basically include, but not limited to; credit risk, that is majorly from the chances of money borrowers defaulting on their standard loan obligations and principles. Most times, the outcomes of credit risk can be severely comprehended, resulting to instability in the financial management, bank failures, and also systemic crises (Bessis, 2020). Therefore, for commercial banks therein the banking sector, to regulate these risks and ensure sustainability and stability of money borrowers, effective credit risk management should be exercised. This study aims to assess the impact of credit risk management on the financial performance of commercial banks in Uganda’s banking sector, focusing on the role of loan portfolio diversification and the credit scoring models while reducing credit risks. 

Problem Statement

Despite the important role of credit risk management, many commercial banks in Uganda’s banking sector continue facing a very significant challenge in effectively managing credit risks. The levels of non-performing loans (NPLs) in the banking sector are very high and this stands as a testament to this challenge. According to the Bank of Uganda, the NPL ratio for commercial banks in Uganda stood at 4.4% in 2022, which is comparably higher than the recommended threshold that should be 3% (Bank of Uganda, 2022). This high NPL ratio erodes the profitability of banks and also undermines their capital adequacy and stability. In addition, the COVID-19 pandemic magnified the credit risk challenge facing commercial banks in Uganda, as many borrowers are still struggling to servicing their outstanding loans due to their economic disruptions caused by the pandemic (World Bank, 2022). Therefore, this study aims at addressing the following research questions:

1. What is the impact of credit risk management on the financial performance of commercial banks in Uganda?

2. To what extent do loan portfolio diversification and credit scoring models contribute to the reduction of credit risk in commercial banks?

3. What are the challenges faced by commercial banks in Uganda in managing credit risk, and how can these challenges be addressed?

Experimental Methods

This study was conducted by use of mixed-methods approach, where both quantitative and qualitative methods were employed to collect and analyze data.

Quantitative Method

The quantitative method was majorly employed while gathering the essential secondary data from the financial statements of commercial banks in Uganda, and also from the Bank of Uganda’s recent and past publications. The data selected covered a precisely a period of seven years, from 2018 to 2024 and the variables of interest included but not limited to;

Credit risk management variables that include; credit scoring models, non-performing loans (NPLs) ratio, and loan portfolio diversification.

Financial performance variables that include; return on equity (ROE), net interest margin (NIM), and return on assets (ROA).

The obtained data was critically analyzed using regression analysis, correlation analysis, and descriptive statistics. 

Qualitative Method

The qualitative method was employed while conducting semi-structured interviews with different senior managers and credit officers of the selected commercial banks in Uganda. These interviews aided in gather information on the viable challenges that are faced by commercial banks especially in managing credit risk, and also the possible strategies used while mitigating credit risk. The interviews were steadily recorded, interpreted, and critically analyzed using content analysis.

Sampling Technique

The study employed a purposive sampling technique while selecting the commercial banks that participated in the study. Their selection considered the banks’ asset size, profitability margin, and geographical location. And a total of five (5) commercial banks were selected for the study.

Data Collection Instruments

The study considered and used the following data collection instruments;

1. Secondary data that was from financial statements and Bank of Uganda publications.

2. Semi-structured interview guides for the qualitative interviews.

The experimental methods used in this study were designed to provide a comprehensive understanding of the impact of credit risk management on the financial performance of commercial banks in Uganda. The mixed-methods approach allowed for the collection of both quantitative and qualitative data, providing a more nuanced understanding of the research questions.

Areas of Finance

The study clearly intersects with different fields of finance, and each offers a very unique ideas and perspectives between the shared relationships among regulatory frameworks, financial performance, and credit risk. The study distinguished different forms of finance, that include:

Corporate Finance

This is majorly used by corporations in the financial management, which include financial planning, cost of capital and capital budgeting. In relation to this study, corporate finance is essential while understanding how commercial banks ensures top management of their credit risk and make clear and identified financial decisions. This study assessed the potential impacts of credit risk management on the financial performance of commercial banks, which is a key aspect of corporate finance.

Financial Markets and Institutions

This provides the fundamental framework for the generation and exchange of financial assets. In this study, the banking sector was critically examined as one of the key financial institutions that enhances financial intermediation services. This study investigated the impact of credit risk management on the financial performance of commercial banks, which is critical for maintaining financial stability and sustainability while preventing systemic crises.

Investments

Investment involves strategic allocation of capital to assets while expecting to generate returns. In the context of this study, investments are important in understanding how commercial banks manage their loan portfolios and determine their investment decisions. The study examined the impact of loan portfolio diversification on credit risk, which is fundamental to investment management.

Financial Management

This involves critical planning, proper organizing, and steady control of financial resources. This study, is guided the understanding of how commercial banks tend to manage their credit risk and make proper financial decisions. The study assessed the impacts of credit risk management on the financial performance of commercial banks, which is vital for maintaining financial stability, sustainability and preventing systemic crises.

Risk Management

This contains the clear identification, designed assessment, and defined mitigation of risks. In relation to the study, risk management is essential for interpreting how commercial banks manage their credit risk. The study found out the impact of credit risk management on the financial performance of commercial banks, which is very important for risk management.

Financial Regulation and Supervision

This involves the supervision of financial institutions to guarantee their safety and soundness. The study found out that financial regulation and supervision are essential while understanding how commercial banks are regulated and supervised to effectively manage their credit risk. The study assessed the impacts of credit risk management on the financial performance of commercial banks, which is vital for maintaining financial stability and preventing systemic crises.

Findings

The study investigated the strategic impact of credit risk management on the financial performance on the banking sector and in commercial banks in Uganda. The study findings discovered that credit risk management has an outstanding impact on the financial performance of commercial banks. Conspicuously, the study found that the two most effective strategies improving financial performance and strategically reduce on the credit risks are; loan portfolio diversification and credit scoring models. The study also identified; inadequate training of credit officers, insufficient credit information, and inadequate credit risk management frameworks, as the most challenges faced by commercial banks in Uganda in managing credit risk.

Recommendations

The findings have vital suggestions and recommendations to bank managers, regulators, and policymakers. Firstly, commercial banks need to effectively prioritize credit risk management as a fundamental component of their overall risk management strategy. Secondly, the study provides for the importance of loan portfolio diversification and credit scoring models as the reducing factors for credit risk and improving financial performance. Lastly, regulators and policymakers are recommended to provide the necessary guidance and support to banks in order to effectively implement credit risk management strategies.

Conclusion

This study contributes to the available literature on credit risk management and financial performance, and provides deep perspective for bank managers, regulators, and policymakers. The study discovered vital underscores for aiding to maintain the financial stability while preventing systemic crises in Uganda’s banking sector. Further related studies could cover and explore the very impacts of credit risk management on financial stability and systemic risk, and also the roles of credit risk management while promoting financial inclusion and easy access to credits.

References.

1. Bank of Uganda. (2022). Annual Report.

2. Bessis, J. (2020). Risk Management in Banking. John Wiley & Sons.

3. Freixas, X., & Rochet, J. C. (2021). Microeconomics of Banking. MIT Press.

4. World Bank. (2022). Global Economic Prospects. World Bank Publications.