The Effect of Credit Risk Management on the Financial Performance of Commercial Banks: The Case of Selected Private Commercial Banks in Ethiopia

Abstract

Effective credit risk management is fundamental for bank profitability and financial stability. This study investigated the effect of credit risk management practices on financial performance of private commercial banks in Ethiopia. The research examined data from a five-year period (2018- 2022) of five selected private commercial banks in Ethiopia. Secondary data obtained from published audited annual financial reports of the selected banks was used to calculate the CAMEL rating system components (capital adequacy, asset quality, management efficiency, earning quality, and liquidity) which were used as measures of credit risk management, while return on equity (ROE) served as a key indicator of financial performance. Multiple linear regression analysis yielded statistically significant associations between several CAMEL components and ROE. Positive relationships were observed between management efficiency and liquidity with ROE, highlighting the importance of streamlined operations and balanced liquidity management for profitability. A negative association was found between asset quality and ROE, aligning with the notion that higher levels of non-performing loans hinder profit generation. An unexpected finding emerged with capital adequacy and earning quality. Contrary to expectations, the results indicated a negative association between capital adequacy ratio (CAR) and ROE. This might be explained by increased regulatory requirements forcing Ethiopian banks to hold more capital reserves, potentially hindering lending activities. While a positive association was anticipated, the results revealed a negative correlation between earning quality and ROE. This may suggest a potential focus on short-term profit strategies. Based on these findings, the study offers recommendations for Ethiopian banks: optimizing capital adequacy through policy dialogue, enhancing asset quality through stricter lending practices, maintaining liquidity, improving management efficiency, and scrutinizing earning quality metrics to emphasize core business activities