Credit Risk Management and Profitability of Rural Banks in the Brong Ahafo Region of Ghana

Abstract

Credit risk management in rural and community banks has become more important not only because of the financial crisis that the world is experiencing currently, but also as a crucial concept which determines banks’ survival, growth and profitability. Because credit granting is one of the key sources of income generating activity in rural banks, the management of the risk related to credit affects the profitability of the banks.

This study examines the impact of credit risk management on the profitability of rural and community banks in the Brong Ahafo Region of Ghana. We used the annual financial statements of ten rural banks from the period of 2006 to 2010 (five years) for our analysis. The panel regression model was employed for the estimation. In the model, definition of Return on Equity (ROE) and Return on Asset (ROA) were used as profitability indicators while Non-Performing Loans (NLP) and Capital Adequacy Ratio (CAR) as credit risk management indicators.

The findings indicate a significant positive relationship between non-performing loans and rural banks’ profitability revealing that, there are higher loan losses but banks still earn profit. This indicates that, rural banks do not have sound and effective credit risk management practices.  Theoretically, non-performing loans reduce the profit levels of rural banks but in a situation where non-performing loans are increasing proportionately to profitability, then it means that rural banks do not have effective institutional measures to deal with credit risk management. What the banks do is that they shift the cost on loan default to other customers in the form of higher interest rate on loans.

Higher interest margin charged on loan by rural banks due to weak credit risk management practices prevent microenterprises from accessing loans. Such a situation prevents business expansion and rural industrialization which are essential for poverty reduction.

Most studies in this area tend to focus on the big commercial banks, thus this study with its focus on rural banks, contributes a lot to literature concerning credit risk management in small banks such as rural and community banks.

In terms of policy directions, the Bank of Ghana will have to tighten its control mechanisms of on rural banks to stop this unfortunate trend in the rural banking industry.

Key Words: Rural Banks, Credit Risk, Profitability, Ghana