CHAPTER ONE

INTRODUCTION

1.1. Background of the Study

The operations of individual banks (how they acquire, use, and manage funds to make a profit)

are roughly similar throughout the world. In all countries, banks are financial intermediaries in the
business of earning profits. The main banking business is accepting the deposits and utilizing it for
lending to industry. Lending business is generally encouraged because it has the effect of funds
being transferred from the system to productive purposes which results into economic growth.
The debtor take the funds from the bank in the form of credit and they have to pay back the principal
amount with the interest to the bank as a result, the bank gets the profit in the form of interest and
again this profit is reinvested leading to the growth of the economy. Because banking plays such
a major role in channeling funds to borrowers with productive investment opportunities, this
financial activity is important in ensuring that the financial system and the economy run smoothly
and efficiently Mishkin F. and Stanly G (2012).

A healthy and vibrant economy requires a financial system that moves funds from people who save
to people who have productive investment opportunities. I.e. Banks are financial institutions that
accept deposits and make loans. Included under the term banks are firms such as commercial banks,
savings and loan associations, mutual savings banks, and credit unions (Mishkin, F 2012) However,
lending carries credit risk, which arises from the failure of borrower to fulfill its contractual
obligations either during the course of a transaction or on a future obligation. Due to the nature of
their business, commercial banks expose themselves to the risks of default from borrowers.

The issue of non-performing loans (NPLs) has gained increasing attentions in the last few decades. The
immediate consequence of large amount of NPLs in the banking system is bank failure. Many
researches on the cause of bank failures (e.g. Demirguc-Kunt 1989, Barr and Siems 1994) found out
that asset quality is a statistically significant predictor of insolvency, and that failing banking
institutions always have high level of NPLs prior to failure. According to the International Monetary
Fund (IMF, 2009), NPL is any loan in which interest and principal payments are overdue for 90 days

1
or more. On the other hand, the Basel Committee1 (2001) puts NPLs as loans left unpaid for a period of
90 days. Therefore, NPLs refer to those as financial assets from which banks no longer receive interest
or installment payments as scheduled.

A financial intermediary is an institution that acts as an intermediary by matching supply and demand
of funds (Beck, 2001). Heffernan (1996) defines banks as intermediaries between depositors and
borrowers in an economy which are distinguished from other types of financial firms by offering
deposit and loan products. Bossone (2001) also argues banks are special intermediaries because of their
unique capacity to finance production by lending their own debt to agents willing to accept it and to
use it as money.

Commercial banks are the dominant financial institutions in most economies (Rose, 1997). Greuning
and Bratanovic (2003), argue that commercial banks play a critical role to emerging economies where
most borrowers have no access to capital markets. Well functioning commercial banks accelerate
economic growth, while poorly functioning commercial banks are an impediment to economic
progress and aggravate poverty (Barth [Link], 2001; Khan and Senhadji, 2001, as cited in Richard,
2011).

There are two main ways through which NPLs could affect economic recovery. Firstly, banks
burdened with NPLs may be ill-placed to extend fresh credit. Secondly, overextended borrowers face
reduced incentives to invest and assets remain under their control rather than being reallocated
to more productive users (IMF, 2009).

Why borrowers became defaulter? What causes loan to be non-performing loan? The study aims to
evaluate the determinants of non-performing loans in the commercial banks in Ethiopian by looking
at bank-level data and macroeconomic indicators

2
As such, it will contribute to the existing literature by providing evidence on the causes of bad loans
in Ethiopia. The study employed firm-level data which are rarely used by researchers who study non-
performing loans. Therefore, the paper extends the literature on non-performing loans and utilized
both macroeconomic and bank specific variables. Apart from contributing to the literature, the
paper may also have important practical implications for commercial bankers and bank regulators in
the Ethiopian banking system. For instance, the findings may be used to develop a framework for
measuring and assessing credit risk an important element of study for the financial stability unit of a
central bank.

1.2. Statement of the Problem

As mentioned above, the main banking business is accepting deposits and utilizing it for lending to
industry. Lending business is generally encouraged because it has the effect of funds being
transferred from the system to productive purposes which results into economic growth. The
debtor take the funds from the bank in the form of credit and they have to pay back the principal
amount with the interest to the bank as a result the bank gets profit in the form of interest and again
this profit is reinvested leading to the growth of the economy.

The sustainability of financial institutions depends largely on their ability to collect their loans as
efficiently and effectively as possible. In other words to be financially viable or sustainable,
financial institutions must ensure high portfolio quality based on uninterrupted repayment. Financial
stability is considered as vital of sustained and rapid economic progress. Among various
indicators of financial stability, banks‘non-performing loan assumes critical importance since it
reflects on the asset quality, credit risk and efficiency in the allocation of resources to productive
sectors. A common perspective is that the problem of banks‘non-performing loans is ascribed to
political, economic, social, technological, legal and environmental factors across countries (Das
and Ghosh (2003)). Therefore, if the financial system does not work properly, their problems have
3
a great impact on the whole economy. For this reason, policymakers, regulators, academics and
practitioners pay close attention to the soundness and stability of this sector in every country.

Loan portfolio constitutes the largest operating assets and source of revenue of most banks in
Ethiopia. However, some of the loans given out become non-performing and adversely affect the
profitability and overall financial performance of the lending institutions. The economic and
financial costs of these impaired loans are significant. Potentially, these loans may negatively
affect the level of private investment, increase deposit liabilities and constrain the scope of bank
credit to the private sector through a reduction of banks‘ capital, accumulation of losses and
related increased provisions to compensate for these losses.

Non-performing loans are dangerous not only for the economy of one country but also for the
whole world as we have seen the financial crisis created by these loans in East Asian countries,
America and Sub-Saharan Africa (Wan Yusoff, & Dahalan, 2011). Ethiopia has not been
exempted from the problem of non- performing loans which had negative effects both to the
lending institutions and the economy as a whole. In Ethiopian financial regulation system, all
banks in the country are required to keep the non performing loan ratio below 5 % (NBE, 2008). This
legally required limit is very important to make the country‘s financial institution more stable and
safe.

However many lending institutions in Ethiopia are confronted with the challenge of rising non-

performing loan despite efforts are employed to keep at minimum as much as possible. For
example the ratio of nonperforming loans of Zemen Bank (8%) on June 30, 2014, Cooperative bank
of Oromia (5.6%) on June 30, 2016, Bank of Abyssina (5.37%) as of June 2015, Buna Bank(5.9)
on June 30, 2016, Lion Bank (5.3%) on June 30, 2014 are some of the private financial
institutions with NPLs problem in their loan portfolio in recent years (Bank‘s annual report 2014/15
and 2015/16).

4
To address the problem, researches have been undertaken in Ethiopia on problem of non-
performing loan on Ethiopian commercial banks. For example, Habtamu (2015) factors
affecting NPL in Ethiopian Private Banks‖ find out that weak credit analysis, poor credit
monitoring, inadequate risk management, lenient credit policy, bank size and loan diversion
determine NPLs in private banks, Wondimagegn (2012) ―bank specific determinants of NPL in
Ethiopian banks‖ concluded that poor credit assessment, credit monitoring, unfair competition
between bank as determinants of NPLs in banks in Ethiopia, and Tihitina (2009) on the legal aspect
of recovering after the occurrence of NPL‖, all are indicated the presence of NPL in Banks and
came up with more similarly bank specific factors as determinants of NPLs in banks in Ethiopia . But
still the problem of Non-performing Loans in Commercial Banks in Ethiopia is the major issue.
However, Anisa (2015) Determinants of Non-performing loan propose ROA, ROE, Unemployment,
and Exchange rate as future research direction.

From the above research studies in Ethiopia on NPLs, none of the them have talked about the
effect of bank‘s performance indicators variables like ROA, ROE, and Macroeconomic factor like
Exchange rate between birr and US dollar which cause changes to the level of NPL‘s in
commercial banks in Ethiopia like other variables; interest rate, growth in GDP, inflation in the
economy. Thus, the researcher aimed to determine the root causes of Non-Performing loans in
Commercial Banks in Ethiopia. So the researcher wanted to see the determinants of Non-Performing
loans, by incorporating macroeconomic variables and bank specific variables by using quantitative
type research.

1.3. Objectives of the Study

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1.3.1. General objective

The general objective of the study is to investigate the determinants of nonperforming loan in

Commercial Banks in Ethiopia.

1.3.2. Specific objectives

Specifically, the objectives of the study included the following;

1. To examine the major institutional or bank-specific factors affecting non-performing loans (NPLs)
in commercial banks in Ethiopia.

2. To analyse the major macroeconomic factors contributing for non-performing loans (NPLs) in
commercial banks in Ethiopia.

1.4. Research Questions

The study attempted to address the following specific questions:

What are the major institutional or bank-specific factors affecting non-performing loans (NPLs) in
commercial banks in Ethiopia?

What are the major macroeconomic factors contributing for non-performing loans (NPLs) in
commercial banks in Ethiopia?

1.5. Significance of the Study

6
The loan portfolios of the lending institutions are major assets that generate a significant amount

of interest income. It plays a critical role in determining the financial performance of commercial
banks and it can therefore be said that the healthier the loan of the commercial banks, the better its
financial performance will be. In the light of the importance of the health of the loan portfolio, it is
essential that a study be conducted to identify the determinants of nonperforming loans in the
commercial banks in Ethiopia. The outcome of this project firstly would enable commercial banks
adopt workable strategies to control the problem of a growing non-performing loan portfolio in
the institution and thereby improve its financial performance and profitability.

Secondly, the project would be of benefit to the Ethiopian banking and non-banking financial

Sectors as a whole since the financial institutions in the country operate within the same
environment and deal with customers of similar characteristics. Thirdly, the project could serve as a
source of reference for other related research works in the future. Thus, the study would
Contribute immensely to the improvement of NPL of commercial banks which play a significant role
in the economy.

1.6. Scope of the Study

The study focuses on the non- performing loans in the Financial Institution in Ethiopia with

Particular focus on eight Commercial Banks in Ethiopia. Thus, the research seeks to establish the
causes of poor loan repayment performance by the customers of these commercial banks. The
reason for limiting the scope to eight Commercial Banks is that they possesses all the unique
characteristics of all Banks, engages in almost all the activities undertaken by the other banks in the
country and also they are located in almost all the regions in Ethiopia. Additionally, banks credit

7
activities of Commercial Banks in Ethiopia covers several sub- sectors of the economy and could be
studied and the findings reasonably generalized as what exist in all banks in Ethiopia.

Generally, this research work looks at the various categories of bad loans, the possible causes of bad
loans, the impact of bad loans on the operations of Banks in Ethiopia and the economy as a whole.
The period of assessment has also been limited to 2007-2016; this is because of most of the private
commercial banks in Ethiopia established & started after 2007 and only ten private commercial
banks has published data for ten years. Additionally, the last ten years are characterized by
high figure of NPLs in the banks. Therefore, this is to ensure that the result reflects the current
trend of NPL in the operations of Commercial Banks in Ethiopia.

1.7. Limitations of the Study

All the necessary data may not be collected due to the wide distribution of outlying bank

branches, confidentiality of data because most financial institutions will not readily disclose
information to researchers for fear of breach of Secrecy and unwillingness to provide the right
information by respondents in the process of collecting the relevant data.

In addition, respondents delay in giving the required data, and a few respondents fail to respond to
requests which may affect the quality and generalization of this survey. Even though the banks in the
country share common characteristics and face similar challenges, there is still the possibility
that some aspects regarding the topic may not be discussed if those aspects are peculiar with the
commercial banks that are not covered in the study.

A sample and not the entire population of commercial banks in Ethiopia were dealt with by
relying on published annual reports and financial statements.

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1.8. Organization of the Research Paper

The study was organized in a way of constituting five sections. The first section is an

Introductory part of the survey which includes: background of the study, the statement of the
problem, the research questions and objectives of the study, the significance of the study, scope and
limitation of the study and the organization of the research paper. The second section
constituted review of literatures on the Evolution of Financial institution in Ethiopia, Loan
classification, definitions and causes of NPLs, and the trends of NPL and the challenges facing
commercial banks in Ethiopia. This section discussed briefly about the determinants of NPLs,
which can be broadly defined as factors pertaining to bank-specific and macroeconomic and
policy-related conditions. These variables are by no means exhaustive, but they sufficient to
provide a useful framework for analyzing the dynamics of NPLs in the Ethiopian banking sector.
Accordingly, the expected impacts of these variables were described. The third section comprised the
methodology of the study i.e. the target population, the sample size and sampling technique, the
research instrument and data collection procedures are outlined.

9
CHAPTER TWO

LITERATURE REVIEW

2.1. Theoretical and Conceptual literature review

2.1.1. Loans Classification and Provisioning Practice of Ethiopian Banks

The current classification and provisioning practice of Ethiopian banks has been framed by the

National Bank of Ethiopia‘s directives. For loans with fixed repayment terms, the NBE‘s
directive and the current practice of the banks are based on an objective indicator of
collectability i.e. the period that payments of interest and principal are past due.

The NBE Directive No SBB/43/2008 laid down the framework for the loan classification
system for all banks operating in the Ethiopian banking industry. The directive is applied to all
banks irrespective of their ownership and purpose of establishment (i.e. development and
commercial banks as well as government and private banks).

The NBE‘s guideline utilized a 5-grade (pass, special mention, substandard, doubtful and loss) loan
classification framework to classify loan accounts. In addition, it highly relied on
delinquencies (measured as the numbers of days or month‘s loan repayment are past due) as main
benchmark to classify loans. Thus, loans with pre-established repayment programs are classified
as non-performing loans when principal and/or interest is unpaid for 90 days or more. In addition, for
loans without repayment terms when the account remain outstanding, exceeded its limit, interest due
uncollectible and inactive for 90 consecutive days or more. Besides, the directive has established
criteria to classify overdraft facilities based on their lowest debit performance. This can give an
10
indication that the regulator directive has set objective criteria for classifying loans providing the
discretion of\ subjective judgment to its on-site examiners. The directives have also established a
framework for the treatment of renegotiated loans and advances and multiple loans and advances
despite ambiguities on some of the standards.

 Pass: An asset is classified as Pass‘ if there are no outstanding arrears and the obligor is
expected to continue to comply with all terms of the loan contract; there being no reason to believe
that the entity will be, subject to risk of loss. Loans or advances in this category are fully protected
by the current financial and paying capacity of the borrower and are not subject to criticism.

11
 Special Mention: An asset is classified as Special Mention ‘if potential weaknesses exist in
the obligor‘s financial position and/or the collateral pledged. Loans or advances with pre-
established repayment programs past due 30 days or more, but less than 90 days.

 Substandard: An asset should be classified as Substandard ‘ i f it has one or more well-

defined weaknesses that make the full collection of the principal and interest questionable,
especially when the obligor‘s financial condition, including net worth and/or repayment capacity,
is unfavorable and is deteriorating; the pledged collateral, if any, is insufficient or is deteriorating;
and/or if an actual breach of contract has occurred. Loans or advances with pre-established
repayment programs past due 90 days or more, but less than 180 days.

 Doubtful: An asset is classified as ‗Doubtful‘ when weaknesses exists which make

collection or repayment in full highly questionable and improbable based upon currently existing
circumstances, conditions, and the estimated recoverable amount of the pledged collateral, if any.
Loans or advances with pre-established repayment programs past due 180 days or more, but less than
360 days

 Loss: At the time of classification, the asset is deemed Loss if it is uncollectible and of such
little value that it should not be included on the books of account and financial statements of the
licensed institution. Loans or advances with pre-established repayment programs past due 360 days.

2.1.2. Non-Performing Loans

Loans constitute the primary source of income of banks. As any business establishment a bank also
seek to maximize its profit. Since loans are more profitable than any other assets, a bank is willing to
lend as much of its funds as possible. But banks have to be careful about the safety of such advances.
Bankers naturally try to balance the issue of maximizing profit by lending and at the same time
manage risk of loan default as it would impair profit and thereby the very capital. Thus a bank needs
to be cautious in advancing loans as there is a greater risk which follows it in a situation where the
loan is defaulted. In other words loan loss or defaulted loans puts a bank in a difficult situation
especially when they are in greatest amount. Despite the fact that banks hold security for the loans
they grant they cannot be fully be certain as to whether they are paid or not. It is when such risks
materialize that loans turn to be non- performing. The concept of non-

12
performing loans has been defined in different literatures. According to Patersson and Wadman
(2004), non- performing loans are defined as defaulted loans which banks are unable to profit from.
They are loans which cannot be recovered within stipulated time that is governed by the laws of a
country. According to the International Monetary Fund (IMF, 2009), a non- performing loan is any
loan in which interest and principal payments are more than 90 days overdue; or more than 90
days’ worth of interest has been refinanced. Non-performing loans generally refer to loans which for
a relatively long period of time do not generate income; that is the principal and/or interest on
these loans has been left unpaid for at least 90 days (Fofac, 2009). Non-performing loans are
further defined as loans whose cash flows stream is so uncertain that the bank does not recognize
income until cash is received, and loans those whose interest rate has been lowered on the
maturity increase because of problem with the borrower (Machiraju, Undated). HR Machiraju
expresses non-performing loans as a leading indicator of credit quality. Generally, in developing
and underdeveloped countries, the reasons for default have a multidimensional aspect.
Various researchers have concluded various reasons for loan default. Literature categorizes
determinants of NPL to macroeconomic and bank specific factors. The paragraphs that follow
discuss macroeconomic determinants of nonperforming loans.

Knowledge of NPLs is important because it affect the financial intermediation role of

commercial banks which constitutes the banks‘ main source of their income, and ultimately, the
financial stability of an economy (Klein, 2013). For this reason, NPLs have increasingly attracted
attention recognizing that a consequence of large amount of NPLs in the banking system is bank
failure as well as a symptom of economic slowdown (Lata, 2014).

This is largely because the financial performance of any commercial bank is measured in terms of
profitability and NPLs have a direct adverse impact on the bottom line due to the provisions which
the banks are forced to make on account of the NPLs (Balasubramaniam, 2013).

Other researchers have commented that an increase in NPLs rate is a reflection of the failure of
credit policy (Saba, Kouser and Azeem, 2012). Khemraj and Pasha (2012) explain that high
percentages NPLs are often associated with performance problems of banks and financial crises in
both developing and developed countries. Fofack (2005) associates the occurrence of banking crises
with a massive accumulation of NPLs and further observes that the NPLs account for a significant
portion of total assets of insolvent banks and financial institutions.

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2.1.3. Direct Consequences of Non-Performing Loans

Economic development will always be in its infancy if sufficient capital cannot be formed.

Capital formation is basically the function of thrift organizations, like banks and other financial
institutions, to motivate the households to save from their earnings. These savings should be
utilized in economic processes.

Economists have identified at least three broad reasons for saving; life cycle saving: Saving to meet
long -term objectives such as retirement, college attendance, or for the purposes of a home;
precautionary saving: savings for protecting against unexpected setbacks such as the loss of a job or a
medical emergency; bequest saving: Saving done for the purpose of leaving an inheritance. Along
with household savings, there is another form of saving investment that basically comes from
corporation.

Savings can be held in different forms as: financial assets, stores of value, as well as informal
financial assets such as savings in informal financial institutions. Getting the small savings from the
households, financial institutions form large capital so that it can be invested in the
development of various sectors like industry, business, development and others. When saving gets
invested rightly it works for the economic development. But if money is wasted wrongly, then it
does not work for economic development. So investments have both positive and negative
consequences. If the invested funds can be captured timely, it can again form new capital
creating a good option of reinvestment or consumption.

Both these reinvestments and consumption functions create a positive impact on the economy,
because economy gets some value added jobs to do. Apparently, it may seem that it‘s good so far as
economic development is concerned, as the money remains invested in the economic process. But the
reality is that the funds may fail to achieve its ultimate target, it may be unutilized or underutilized
or even in extreme case, the funds may flow out of the economy for example due to non-performing
loans. Then the loss will be a total loss both to the investing authority and to the society as well.

14
Thus it will lead the economy to be stagnant for the time being, and if not checked, forever. It
will also accelerate the path of being and remaining poor for the time being.

15
2.1.4. NPL Theories

Agency Theory

Agency theory has its origins in the 1960s and 1970s by Stephen Ross and Barry Mitnick, who were
responsible for economic and institutional theory of agency respectively (Ross, 1973). Agency
theory extends the analysis of the firm to include separation of ownership and control, and
managerial motivation (Eisenhardt, 1989). In the field of corporate risk management agency issues
have been shown to influence managerial attitudes toward risk taking and hedging, (Smith and Stulz,
1985). Theory also explains a possible mismatch of interest between shareholders, management
and debt holders due to asymmetries in earning distribution, which can result in the firm taking too
much risk or not engaging in positive net value projects, (Mayers and Smith, 1987). Consequently,
agency theory implies that defined hedging policies can have important influence on firm value
(Fite and Pfleiderer, 1995). The latter hypotheses are associated with financing structure, and give
predictions similar to financial theory.

 Deflation Theory

The first is deflation theory (Fisher, 1933), which suggests that when the debt bubble bursts the
following sequence of events occurs; debt liquidation leading to distress selling and contraction of
deposit currency, as bank loans are paid off. This contraction of deposits cause a fall in the level of
prices, which leads to greater fall in the net worth of business, hence precipitating bankruptcies
which leads the concerns running at a loss to make a reduction in output, in trade and in
employment of labour. The cycles cause complicated disturbances in the rates of interest and a fall in
the money value. The complicated disturbances described above can be summed as both external
and internal forces (macro and micro factors) influencing state of over-indebtedness
existing between, debtors or creditors or both which can compound to loan defaults.

16
 Ownership Structure Theory

The third theory, ownership structure theory was pioneered by Jensen (1976) integrated the
elements of theory of property rights, Ronald (1937), the theory of agency, Ross(1973) and
Mitnick (1974) and the theory of finance, Minsky (1974). The theory explains why highly
regulated industries such as public utilities or banks have higher debt-equity ratios for equivalent

12

17
levels of risk that the average non-regulated firm. Jensen (1976) argues that, ―ownership
structure‖ rather than ―capital structure‖ is the crucial variables to be determined, not just the
relative amounts of debt and equity but also the fraction of the equity held by the manager.
Relating to this study, the Kenya banking industry is composed of various categories of banks
based on different ownership structure with different percentage in shareholdings. Ownership
structure theory is appropriate for this study in that NPL levels are investigated on basis of bank
ownership structure dependence.

2.1.5. Global Perspective of NPLs

A major problem being observed all over the world in the banking sector is problem of bad
loans. First step of building a stable and strong financial system is to minimize non-performing
loans. According to World Bank (2014), non-performing loans as proportion of total loans is 24..6
% for Ireland, 31.3 % for Greece, 9.5 % for Egypt, 6% for Russia, 3.6% for South Africa, 3.2% for
USA, 2.9 % for Brazil and 1% for China. Non-performing loans have been huge concern for all
the nations across the globe.

A review of the global perspective on the effect of NPLs reveals a consistent pattern of NPL

trend, especially, in light of the pre and post global financial crisis. Evidence from Asia indicates that
there was more than threefold increase in the volume of NPLs in Indonesian banks in the period
leading up to the financial crisis (Cortavarria et al, 2000) and over sixty banks collapsed during the
crisis. Karim, Chan, Hassan, 2010, indicate that in both Malaysia and Singapore, growth and
innovation was constrained by banks which faced the accumulation of NPLs which eroded their
capital.

In the Middle East, according to Espinoza and Prasad (2010), the global crisis exposed the

18
vulnerabilities of the banks in the Gulf Cooperation Council to varying degrees. Gulf
Cooperation Council countries are experienced significant banking credit between 2003 and
2008. The favorable macroeconomic environment preceding the global crisis had been conducive to
favorable credit conditions and lower NPLs. In 2009, the NPLs rose sharply and credit
stagnated, causing worries that economic recovery could be stagnated by credit constraints.

NPL levels increase as the economic situation deteriorates and interest payments rise.
Conversely, deterioration in banks‘ balance sheets may feed back into the economy because

19
banks will tighten credit conditions, especially if there remains uncertainty in the valuation of
projects and of assets.

Krueger and Tornell (1999) attribute the credit crunch in Mexico after the 1995 crisis partially to
NPLs. They point out that banks were burdened with credits of negative real value, thereby
reducing the capacity of the banks in providing fresh fund for new projects. In Asia, both Malaysia and
Singapore, growth and innovation has been constrained by banks which faced the accumulation of
NPLs which eroded their capital (Karim et al, 2010).

In South America, Argentina experienced domestic credit growth of 36.14 percent during the
second quarter of 2012, while Brazil saw domestic credit growing by 13.36 percent during the third
quarter of 2012. These growth rates were not accompanied by significant increases in NPLs at least
not for Argentina, Brazil and Mexico. Bréard, Blancas, Correa and Arbe (2014) comment that asset
quality metrics in South America pointed towards a record-low level of NPLs which reached 3.0
percent of total loans.

The Mexican banking sector was well capitalized; however, the NPL ratio increased to 3.4

percent in December, 2013, above the 2.5 percent registered a year earlier, due to financial
problems among major home builders. In Colombia, the NPL ratio rose modestly, reaching 2.1
percent in October, 2013 from 1.9 percent from previous year. In Venezuela, the local credit
context remained stable. Based on official data, credit growth (only in the banking system)
accelerated whilst the NPL ratio decreased to 0.6 percent in July, 2013 from 0.9 percent the
previous year.

2.1.6. Determinants of Nonperforming Loans

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Literature identifies two sets of factors to explain the evolution of NPLs over time. One group

focuses on external events such as the overall macroeconomic conditions, which are likely to
affect the borrowers‘ capacity to repay their loans, while the second group, which looks more at the
variability of NPLs across banks, attributes the level of non-performing loans to bank-level factors.
Empirical evidence, however, finds support for both sets of factors.

This section discusses briefly about the determinants of NPLs, which can be broadly defined as
factors pertaining to bank-specific as well as macroeconomic and policy-related conditions.

21
These variables are by no means exhaustive, but they suffice to provide a useful framework for
analyzing the dynamics of NPLs in the Ethiopian banking sector. Accordingly, the expected
impact of these variables can be described as follows:

Macroeconomic Determinants of Nonperforming Loans

Several papers in the banking literature examine the relationship between macroeconomic
environment and loan quality. In this line of research, it has been hypothesized that an
expansionary phase of the economy features relatively low NPLs, as both consumers and firms face
a sufficient stream of income and revenues to service their debts. As the booming period continues,
however, credit is extended to lower-quality debtors and subsequently, when recession sets in, NPLs
increase. Indeed, Carey (1998) argues that ‗‗the state of the economy is the single most important
systematic factor influencing diversified debt portfolio loss rates‘‘. It focuses on external events such
as the overall macroeconomic conditions, which are likely to affect the borrowers‘ capacity to
repay their loans.

The macroeconomic determinants of the quality of banks‘ loans have been area of various
researchers during the past two decades. The literature on the major economies has confirmed that
macroeconomic conditions matter for credit risk. These literatures among others have
investigated the linkage between macroeconomic factors like GDP, inflation, real interest rates,
unemployment etc. and loan performance. The paragraphs that follow critically review the
existing literature on the major macroeconomic factors that have bearing on Nonperforming loans

[Link].[Link] in Gross Domestic Product (GDP)

Basel (2013) using estimation technique method and panel data of 75 countries over ten year
period from 2005 to 2010 studied the macroeconomic determinants of non-performing loans. The
Analysis presented that real GDP growth was the main driver of non- performing loan ratio. There is
a significant empirical evidence of negative association between growth in gross domestic
product and non-performing loans (Salas and Suarina, 2002; Fofack, 2005). If we look into the
explanation of this negative relationship provided by the literature we find that growth in the gross
22
domestic product usually increases the income which ultimately enhances the loan payment
capacity of the borrower which in turn contributes to lower bad loan and vice versa (Khemraj and
Pasha, 2009).

23
[Link].[Link]

Kiayai (2003) argue that the poor fiscal policy had resulted to high inflation rates and that this
could be one of the contributors of NPLs. Inflationary expectation is a factor that is embedded in the
interest rate. Interest will remain high if investors believe that the government will introduce inflation
in future by adding money in circulation through extended credit form the central bank. There is an
empirical evidence of positive relationship between the inflation in the economy and non-performing
loans (Khemraj and Pasha, 2009, Fofack 2005). While Nkusu, (2011) has explained that this
relationship can be positive or negative according to the author inflation affects loan payment
capacity of borrowers positively or negatively, higher inflation can enhance the loan payment capacity
of borrower by reducing the real value of outstanding debt; moreover increased inflation can also
weaken the loan payment capacity of the borrowers by reducing the real income when salaries/wages
are sticky, moreover by highlighting the role of inflation in the presence of variable interest rate.

Nkusu further explains that in this scenario inflation reduces the debt servicing capacity of the

loan holders as lenders adjust the lending interest rates to adjust their real return. So according to
literature relationship between inflation and non-performing loans can be positive or negative
depending on the economy of operations.

[Link].3. Exchange Rate

As far as relationship of the exchange rate is concerned literature provides mixed reviews.
According to Khemraj and Pasha (2009) there is a positive relationship between real effective
exchange rate and non-performing loans. An appreciation in exchange rates may have different
implications i.e. it can adversely affect the loan payment capacity of export oriented firms
(Fofack, 2005) on the other hand it can positively affect the loan payment capacity of those
borrowers who borrow in foreign currency, the relationship between nominal effective exchange rate
(includes inflation) and non-performing loans is indeterminate. Macro and banking stability are

24
closely linked, so that what happens in one affects the other. The evidence for most countries suggests
that, except where the banks are state owned or heavily state controlled, instability generally
starts in the macro economy and spills over into the banking sector. The resulting

25
Banking instability, in turn, feeds back and amplifies the macro instability. Thus, to enhance
overall stability in the economy, it is necessary both to pursue successful contra cyclical
macroeconomic policy and to reduce the fragility of banking relative to the magnitude of macro
shocks that may be expected in the particular economy (Tandon Committee, 1998). Summing up, the
existing empirical evidence shows, quite convincingly, that favorable macroeconomic
conditions, such as sustained economic growth, low unemployment and interest rates, tend to be
associated with a better quality of bank loans; under favorable economic circumstances,
borrowers receive sufficient streams of income and meet their debt obligations more easily.
Furthermore, these results are robust to different empirical methodologies and hold across
countries.

[Link].4. Real Interest Rate

Lending rates/interest rates are one of the primary economic determinant of non-performing

loans/bad loans. An increase in interest rate weakens loan payment capacity of the borrower
therefore non-performing loans and bad loans are positively correlated with the interest rates
(Nkusu, 2011). As far as interest rate policy is concerned it plays very important role in NPLs
growth rate in a country/economy, Hoque and Hossain (2008) examined this issue and according to
them non-performing loans are highly correlated with the high interest rates which enhances the debt
burden of the borrowers and causes loan defaults.

Financial institutions facilitate mobilization of savings, diversification and pooling of risks and
allocation of resources (Collins et al., 2011). However, since the receipts for deposits and loans are
not harmonized, intermediaries like banks incur certain costs (Ngugi, 2001). They charge a price for
the intermediation services offered under uncertainty and set the interest rate levels for deposits and
loans. The disparity between the gross costs of borrowing and the net return on lending defines
the intermediary costs which include information costs, transaction costs, administration, default
costs and operational costs (Rhyne, 2002). Interest rate spread is well-defined by market
microstructure characteristics of the banking sector and the policy environment (Ngugi,
2001). Nkusu (2011) listed several reasons for high interest rate spread which included: lack of
26
sufficient competition, diseconomies of scale due to small size of markets, high operating and
fixed costs, high transportation cost of funds due to expensive telecommunications, existence of
regulatory controls and perceived market risks.

27
Espinoza and Prasad (2010) examined the macroeconomic determinants of non-performing loans in
the GCC banking system according to them high interest rates increases loan defaults but they did not
find statistically significant relationship. Bloem and Gorter (2001) studied causes and treatment of
NPLs, according to them frequent changes in the interest rate policy causes an increase in the
bad loans. Asari, et al. (2011) also found significant relationship between loan defaults and interest
rates they also found that an increase in loan defaults also causes asset corrosion of banks and
subsequently capital erosion. According to Dash and Kabra (2010) the banks with aggressive
lending policies charging high interest rates from the borrowers incur greater non-performing
loans. Collins and Wanjau (2011) also found interest rate as a primary factor boosting non-
performing loans.

Various researchers have given a variety of findings about this relationship between Interest rate

and NPLs in banks. According to some researchers high interest rate has a significant and
positive relationship with Non- Performing Loans. They are of the view that when banks
increase interest rate, there is an additional payment burden on borrowers resulting in increased
defaults (Stiglitz and Weiss, 1981; Reddy, 2002; Boyd and Nicolo, 2005; Keeton and Morris,
1987; Fofack, 2005; Collin- Dufresne & Goldstein, 2001; Asari et al, 2011). Some of studies have
also shown a weaker or insignificant relationship between interest rate and Non-Performing Loans
(Kaplin et al, 2009; Patnaik and Shah, 2004; Epinoza and Prasad, 2010). The study of Sinkey
(2002) shows that increase in interest rate negatively impacts the loan defaults. Similarly the study of
Rajan and Dhal (2003) indicates a significant association of high cost of borrowing and Non-
Performing Loans (NPLs).

[Link].Bank Specific Determinants

There are factors which look more at the variability of NPLs across banks, attribute the level of non-
performing loans to bank-level factors. The literature identifies two sets of factors to explain the

28
evolution of NPLs over time. One group focuses on external events such as the overall
macroeconomic conditions, which are likely to affect the borrowers‘ capacity to repay their
loans, while the second group, which looks more at the variability of NPLs across banks,
attributes the level of non-performing loans to bank-level factors. Empirical evidence, however, finds
support for both sets of factors.

29
[Link].1. Loan Growth Rate

Keeton (1999) used data from 1982-1996 and a vector auto regression model to analyze the

impact of credit growth and loan delinquencies in the US. It reported evidence of a strong
relationship between credit growth and impaired assets. Keeton (1999) showed that rapid credit
growth, which was associated with lower credit standards, contributed to higher loan losses in
certain states in the US. In this study loan delinquency was defined as loans which are overdue for
more than 90 days or does not accrue interest.

[Link].2. Bad Management

Berger and DeYoung (1997), who studied the links between NPLs, cost efficiency and

capitalization in the US commercial banks for the period 1985–94, found a two-way causality
between cost efficiency to NPLs. While they explained the causality from NPLs to cost
efficiency as ―bad luck,‖ driven mainly by deterioration in macroeconomic conditions, they
explained this causality from cost efficiency to NPLs through the hypothesis of ―bad
management.‖ In particular, this hypothesis argues that low cost efficiency is a signal of poor
management practices, thus implying that as a result of poor loan underwriting, monitoring and
control, NPLs are likely to increase. Williams (2004) who focused on the relationship between loan
quality and cost efficiency among European savings banks from 1990–1998, Podpiera and Weil
(2008), who analyzed the Czech banks between 1994–2005, and Louzis, Vouldis and Metaxas (2010),
who examined the determinants of NPLs in the Greek banking sector, found support for this
hypothesis.

[Link].[Link] Selection and Moral Hazard

30
The theory of asymmetric information tells us that it may be difficult to distinguish good from bad
borrowers (Auronen, 2003), which may result into adverse selection and moral hazards problems.
The theory explains that in the market, the party that possesses more information on specific item to
be transacted (in this case the borrower) is in a position to negotiate optimal terms for the
transaction than the other party (in this case, the lender) (Auronen, 2003). The party that knows less
about the same specific item to be transacted is therefore in a position of making either right or wrong
decision concerning the transaction. Adverse selection and moral hazards

31
have led to substantial accumulation of nonperforming assets in banks (Bester, 1994; Bofondi and
Gobbi, 2003). The very existence of banks however, is often interpreted in terms of its superior
ability to overcome t basic problems of information asymmetry.

The idea underlying this model is that borrowers do not always provide all the information
required. Even if they do, not all information will be correct (Changeta, 2007). Borrowers
generally have private (internal) information about their projects that is more accurate than the
information possessed by lenders. As a consequence, a lender could still be uncertain about the
default risk of a loan contract and have difficulties in assessing and controlling the nature and
behavior of the borrower. The adverse selection problem occurs if lenders try to protect
themselves against default risk by setting their contractual terms in a manner appropriate for the
expected average quality of their loan applicants.

The ―moral hazard‖ hypothesis, which was discussed by Keeton and Morris (1987), argues that

banks with relatively low capital respond to moral hazard incentives by increasing the riskiness of
their loan portfolio, which in turn results in higher non-performing loans on average in the future.
Keeton and Morris (1987) indeed showed that excess loss rates were prominent among banks that
had relatively low equity-to-assets ratio. The negative link between the capital ratio and NPLs was
also found in Berger and DeYoung (1997), and Salas and Saurina (2002). More generally, Keeton
and Morris (1987) argued that banks that tend to take more risks, including in the form of excess
lending eventually absorbed higher losses. Their finding was supported by Salas and Saurina (2002)
and Jimenez and Saurina (2005).

Moral hazard in the banking sector context refers to the adverse incentives created by the
prospects of implicit coverage of banks losses by governments. It can be particularly high when
banks‘ capitalization is low; in such cases, it often leads to adoption of imprudent lending
strategies with direct implications for banks‘ loans portfolios which tend to be heavily skewed

32
toward high risk projects. When these projects are owned by investors and entrepreneurs directly or
indirectly connected with the lenders, the financial transaction is termed as insider lending.

33
[Link].[Link] Principal -Agent problem

The idea underlying this model is that organization decision – taking authority lies in the hands

of managers. Shareholders as owners of a company are the principals and managers are their
agents. Thus there is a principal –agent relationship between shareholders and managers. In
theory managers should act in the best interests of shareholders, that is, their actions and
decisions should lead to shareholders wealth maximization. But in practice, managers may not
necessarily act in the best interest of shareholders and they may pursue their own personal goals. This
problem arises because managers are motivated by self-interest. The root causes of this self –interest
is jealousy. Managers work hard to make sure that companies become successful and make huge
profit. But due to managers hard work only the shareholders become rich and not managers. Thus,
the existence of Principal-Agent type of leadership can contribute to the increase of NPL.

[Link].[Link] Premium

The model which is recommended by Ewert, Schenk, (2000), proposes that financial decisions incur
different degrees of risk. The ―perceived credit risk‖ depends on a person‘s judgment. Risk and
expected return move in tandem; the greater the risk, the greater the expected return.

An investor assuming risk from his/her investment requires a risk premium above the risk –free rate.
Risk –free rate is a compensation for time and risk premium for risk. The higher the risk of an action,
the higher will be the risk of premium leading to higher required return on that action. So according to
this theory, the corresponding risk should affect interest rate, that is, the higher the failure risk of the
borrower, the higher the interest rate (Ewert, Schenk,Szczesny, 2000).

34
[Link].6. Profitability Indicators (ROA and ROE)

Profitability is another important bank-specific determinant of NPLs. Accordingly, profitability

measures such as return on assets (net profits to total assets), return on equity (net profits to total
shareholders‘ equity) or net interest margin (net interest income to total assets) are assumed to be
inversely related to the NPL ratio. In this regard, Godlewski (2005) shows that the profitability of a
bank has a negative impact on NPLs. Klein (2013) and Louzis et al. (2012) also find NPLs

35
to be adversely related to profitability. However, García-Marco and Robles-Fernandez (2008)
expect that profit maximizing policies will be accompanied with higher levels of risk, which may
induce greater NPLs.

2.2. Empirical Literature Review

First of all we focused on the previous literature on the determinants of non-performing loans

and specifically on the studies conducted on the non-performing loans of Ethiopian banking
sector. We attempted to highlight the determinants of non-performing loans in general and those that
can be functional in case of Ethiopia. Non-performing loans are dangerous not only for the economy
of one country but also for the whole world as we have seen the financial crisis created by these loans
in East Asian countries, America and Sub-Saharan Africa, so this is the need of the era to identify
the factors responsible for non-performing loans; as researchers believe that once we identify these
factors then we can make policies to prevent any future happenings of these loans (Adebola, Wan
Yusoff, & Dahalan, 2011).

According to IMF Working Paper Prepared by Nir Klein (March 2013)on non-performing loans

(NPLs) in Central, Eastern and South- Eastern Europe ,the level of NPLs tends to increase when
unemployment rises, exchange rate depreciates, and inflation is high. The paper also finds that
NPLs are sensitive to bank-level factors. Higher quality of the bank‘s management, as measured by
the previous period‘s profitability, leads to lower NPLs, while moral hazard incentives, such as low
equity, tend to worsen NPLs. In addition, excessive risk taking (measured by loans-to-assets ratio
and the growth rate of bank‘s loans) was found to contribute to higher NPLs in the subsequent
periods.

36
Keeton and Morris (1987) conducted a research in America to identify the factors which are
causing non-performing loans in the banking sector, according to them bad performance of
agriculture and energy sectors along with poor economic conditions are the main factors causing non-
performing loans. Sinkey and Greenwalt (1991) conducted another research in the same country
and identify the causes of non-performing loans as high level of interest rate, unnecessary
lending along with unpredictable funds are the factors which have positive relationship with
the non-performing loans in the banking sector of America.

37
Ewert, Schenk and Szczesny (2000) studied banks‘ lending performance in Germany. Their study
found evidence that high interest rate, and inadequate collateral had significant positive
relationship on the banks poor lending performance.

Das and Ghosh (2007) examined the factors affecting problem loans of Indian state owned banks for
the period 1994-2005, considering dependent lagged variable, macro and bank specific variables
influencing NPAs. They found that GDP growth rate at macro level and loan growth rate, operating
expenses and bank size at bank level play an important role in influencing problem loans.

Thiagarajan et al (2011), carried out a study to predict the determinants of the credit risk in the
Indian commercial banking sector by using an econometric model by utilizing a panel data at bank
level for 22 public sector banks and 15 private sector banks. They have shown that the lagged
non-performing assets had a strong and statistically significant positive influence on the current non-
performing assets.

Salas and Saurina (2006) conducted a research in Spain to identify the factors which explains the
variation in non-performing loans from 1984-2003 according to the authors high interest rates, GDP
growth and soft credit conditions determine the non-performing loans.

Kalirai and Scheicher (2002) found lending rate, production of industry, stock market return and
business confidence index are the factors which determine the level of loan quality in Australia
while conducting a research taking data from 1990-2001. Bofondi and Ropele (2011) found that non-
performing loans are positively associated with the unemployment rates, lending rates and
negatively associated with the growth domestic product rate; they conducted their study in Italy by
taking the quarterly data over the period of 1990-2010.

Siddiqui, Malik, & Shah (2012) conducted a research in Pakistan covering a period 1996Q to
2011Q3 by applying garch model according to the authors non-performing loans are affected by
volatility on interest rates.

Keeton and Morris (1987) argue that banks venturing into excess lending may end up with
higher impaired loans.

Sinkey and Greenwalt (1991) assert that banks with greater risk appetite may endure higher
NPLs. Salas and Saurina (2002) and Jiménez and Saurina (2006) report higher NPLs for
increased bank lending. Klein (2013) also finds positive relation between NPLs and lending.

38
Berger and DeYoung (1997)21 argue that inefficiency leads to higher NPLs due to poor loan
underwriting, monitoring and cost control. Williams (2004), Espinoza and Prasad (2010),
Podpiera and Weil (2008) and Louzis et al. (2012) also find support for this hypothesis.

Hu et al.(2004) and Ranjan and Dhal (2003) report that larger banks have a better chance to
evaluate loans. Salas and Saurina (2002) also find a negative relation between bank size and
NPLs and argue that bigger size allows for more diversification opportunities.

Hippolyte Fofack (2005) explores the leading causes of nonperforming loans in Sub-Saharan
Africa in the 1990s, using causality and pseudo-panel models. The results show a dramatic
increase in nonperforming loans and heightened credit risks which reflect the rapid accumulation of
impaired loans, and are largely driven by macroeconomic volatility and terms of trade
deterioration. They are particularly high in the agricultural sector and illustrate the extremely high
vulnerability of African economies which, in the absence of diversification, remain heavily exposed
to macroeconomic and exogenous shocks.

Aballey (2009) studied the causes of bad loans portfolio at African Development Bank. He found
evidence that non-performing loans are positively correlated to ineffective monitoring of loans and
poor credit appraisal.

Further, Kangimba (2010) studied determinants of non- performing loans in Standard Charted
Bank. He argued that long duration granted for repayment of loans, unwillingness of borrowers to
pay back the loan, cheating in declaration of collateral, poor management, lack of business skills,
and high competition are the reasons for non-performing loans.

Kwayu (2011) analyzed factors for non- repayment of bank loans at NBC Dodoma region. She
argued that interest rate does not affect repayment of loans, but costs incurred during loans
application are high. The attitudes of borrowers contributed to non-repayment of loans. Other
reasons for poor repayment of loans were bad economic condition and high competition.

During the military rule in Ethiopia, the banking sector was riddled with non-performing loans as a
consequence of weak lending practices. For instance, the non-performing loans of the
Commercial Bank of Ethiopia amounted to ETB 5.8 billion, equivalent to 59 percent of its total
annual loan portfolio at the end of June, 2002. Similarly, the non- performing loans of the
Development Bank of Ethiopia reached 94 percent in 2003 (Banking Sector Review 2010).

39
The factors that led these two banks to accumulate massive amounts of non-performing loans and
eventually to their insolvency were mismanagement, ineffective supervision and political

40
Interference. All of these factors were at play in Ethiopia during the early years of the current
administration (Admassu Bezabeh, April 2014)

2.3. Current Situation of Banking Sector in Ethiopia

In 2015/16 the number of banks declined to 18 from 19 due to the merger of Construction&

Business Bank with Commercial Bank of Ethiopia. Of the 18 banks 16 were private and 2 public
Banks opened 494 new branches in 2015/16 (of which 363 were private) raising the total branch
network to reach 3,187 from 2,693 last year. About 34.4 percent of bank branches were situated in
Addis Ababa. The total capital of the banking system rose 39.8 percent to Birr 43.0 billion by end
June of 2016 (NBE 2015/16 Annual Report)

Total resources mobilized by the banking system (deposit, loan collection and borrowing) rose by
8.0 percent and reached Birr 149.6 billion by end 2015/16. As commercial banks expanded their
branch network, their deposit liabilities increased to Birr 438.1 billion showing a 19.3 percent
annual growth. Saving deposits grew by 24.2 percent followed by time deposits (18.6 percent), and
demand deposits (13.7 percent). The share of private banks in deposit mobilization increased to 33.6
percent from 32.2 percent last year due to the opening of 363 new branches. Commercial bank of
Ethiopia alone mobilized 66.1 percent of the total deposits banking system owing to its large branch
network (NBE 2015/16 Annual Report)

Consequently, total outstanding borrowing of the banking system stood at Birr 32.9 billion
slightly higher than Birr 31.2 billion a year ago. Of the total borrowing, domestic sources
accounted for 89.1 percent and foreign sources the remaining balance of Birr 77.2 billion
collected during the review fiscal year was up by 28.6 percent of which, 56.3 percent was the share
of private banks (NBE 2015/16 Annual Report)

Banks, including Development Bank of Ethiopia (DBE) disbursed fresh loans to the tune of Birr 88.0
billion in 2015/16 which was a 16.6 percent higher than a year ago. Of the total new loans, about
43.6 percent was made by private banks, and the rest by public banks. About 29.0 percent of the loans
went to industry followed by domestic trade (17.1 percent), housing and construction (15.5 percent),
41
agriculture (15.2 percent) and international trade (10.8 percent) and others (12.4 percent) (NBE
2015/16 Annual Report)

Total outstanding credit of the banking system expanded by 20.4 percent and reached Birr 280.3
billion at the end of June 2016. Specifically, outstanding claims on private sector rose by 23.8

42
percent, on public enterprises 21.2 percent and on the central government 6.2 percent.
Outstanding credit to industry accounted trade (18.5 percent), domestic trade (10.2 percent),
housing and construction (10 percent) and agriculture (7.3 percent). The share of private sector
(including cooperatives) in outstanding credit was Birr 179.2 billion (or 63.9percent) depicting a 21.5
percent annual growth (NBE 2015/16 Annual Report)

2.4. Research Hypotheses

A hypothesis is a specific and testable statement of prediction about what you expect to happen
between variables in your study. It is a tentative statement about the relationship between two or more
variables (Kendra Cherry (2016). This research study is sought to explain the significance of growth
in GDP, inflation rate, exchange rate, real interest rate, ROA, ROE, and loan growth rate on the
level of Non-Performing Loans in commercial banks in Ethiopia hence it is a cause-effect
investigation.

Therefore, the researcher formulated the following hypothesis:

H1: ROA has negative relationship with NPLs in commercial banks in Ethiopia. H2: ROE has negative
relationship with NPLs in commercial banks in Ethiopia.

H3: GDP growth has negative relationship with NPLs in commercial banks in Ethiopia H4: Inflation
has considerable relationship with NPLs in commercial banks in Ethiopia.

H5: Loan growth rate has positive relationship with NPLs in commercial banks in Ethiopia. H6:
Exchange rate has considerable relationship with NPLs in commercial banks in Ethiopia. H7: Real
Interest rate has positive relationship with NPLs in commercial banks in Ethiopia.

2.5. Conceptual Frame Work

The aim of this study is to identify the determinants of nonperforming loan in commercial banks
43
in Ethiopia which can be divided in to bank specific and macroeconomics determinant.
Accordingly, based on the objective of the study, the following conceptual model has been
framed. Nonperforming loans are affected by macroeconomics factor and banks specific factors. The
macroeconomics factors included real GDP growth, inflation rate, exchange rate and real interest
rate. Loan growth rate, ROA and ROE are bank specific factors determine the NPL.

44
Figure: 2.1: Conceptual framework of the study

Macroeconomics Determinants  Real GDP growth rate

 Inflation rate  Exchange rate

 Real interest rate

Nonperforming Loan

Determine
Bank specific Determinants  Return on asset

 Return on equity  Loan growth rate

Source: Researcher own formulation.

45
 CHAPTER THREE

RESEARCH METHODOLOGY

3.1 Description of the Study Area

Like other business activities, banks strive to make profit and grow. Presently headquarters of all
private commercial banks and state-owned banks are located at the capital city, Addis Ababa. The
Department that is responsible for provision of loans and advances to individuals and projects is
contained at the Head Offices of the banks. Therefore, the study will be conducted in consultation with
staff involved in credit operations at head offices level using survey design with structured self-
administered questionnaires.

3.2. Research Design

In order to achieve the objectives of the study, the research undertakes descriptive approach, using both
qualitative and quantitative data. In doing so, the study intends to describe, compare, contrast and
interpret the existing facts and puts the status of NPL in relation to various variables which will help to
understand the issue and lead to causal analysis. Further the research utilizes a survey as a research
method.

3.3 Sample Size Determination and Sampling Techniques

The study will limited to employees that are directly involving in administration of loans at all head
offices level as a sampling frame. Such professionals including, loan officers, credit analysts, credit
directors, relationship managers and recovery & monitoring officers etc. In order to simplify the study,
convenience sampling will be employed followed by multistage cluster sampling using preexisting
clusters as a sampling frame. Accordingly, the commercial banks will be classified into two clusters as
private owned and stated owned banks. Further all positions and respective tasks were listed involving
credit processing, loan provisioning, monitoring and follow- ups. Furthermore, professionals will be
classified based on positions held in the structure of credit department. In doing so each position will
be considered strata to carryout proportional sampling to avoid the likelihood of sampling biases.

46
 3.3.1. Population

Any research work has conclusion inferred from set of premises. The conclusion would be about
groups of people, groups of organizations, employees in an organization, contracts between
organizations, about economic phenomenon, and the like. The broad class of people, objects, or
events that are targeted by the conclusion is known as population or universe. In this study, the
population consisted of commercial banks in Ethiopia licensed by the National Bank of Ethiopia. By
2020, there are 17 commercial banks-one government owned and 16 privates (NBE 2018/19
Annual Report). The target population will all the commercial banks and observation unit from which
data will be collect.

3.3.2. Sampling Technique

Sample is the portion of the study population and used when addressing the total population in the
study is not possible. Different authors show that the need for considering different factors in deciding
on the desired sample size. These factors include the availability of time and resources, homogeneity
of the target population, the accuracy required and the aim of the research (Sarantakos 2005,
sited in Wollela, 2008). The secondary data were collected from 14 years data of purposively
selected target population out of all commercial banks registered by the National Bank of Ethiopia.
Accordingly, from 17 commercial banks in Ethiopia (NBE 2018/19 Annual Report), the
researcher purposively selected 8 commercial banks i.e. Awash Bank, Dashen Bank, Bank of
Abyissina, Wegagen Bank, United Bank, NIB Bank, CBO and Lion International Bank.

3.3.3. Sample Size

Since the study is based on 14 years secondary data of the selected target population out of all.
Commercial banks registered by the National Bank of Ethiopia (NBE 2018/19), limiting time
period based on their year of establishment and data availability is mandatory. Hence, the
selected banks should be in operation on or before the fiscal year 2007. Accordingly, from 17

47
commercial banks registered in the country as of June 2018/19, the researcher has select
purposively 8 commercial banks from which 14years of secondary data will collect for the research
analysis.

3.4. Data Collection Methods

The dependent variable is Commercial bank‘s Non-Performing Loans which is measured in

quantitative terms. Data of the independent variables GDP, Inflation, exchange rate, Real interest rate,
ROA, ROE, Loan growth rate were collected from the sample commercial banks, NBEs data base
and Ministry of economic and finance annual reports. It is always a regulatory requirement for
commercial banks to report their Non-Performing Loans data to the National Bank of Ethiopia
periodically as part of the returns. Therefore, data about the dependent and independent variables
were collected from bank‘s own annual reports, Magazines, internet websites and the NBE using
secondary data collection form. The secondary data are the macro information and, loan growth
rate, ratio of non-performing loans, ROA, and ROE are the bank specific data.

3.5. Data Analysis

To achieve the objective of the study, Data collected using documents, were analyzed.
Quantitatively. The secondary data collected will coded, tabulated, presented and analyzed using
econometrics regression analysis method by using Eviews8 software package. The hypothesis tests
regarding the coefficient estimates are validly conducted and assumptions relating to the classical
linear regression model were tested as required relating to the study. Descriptive statistics,
mean, standard deviation, minimum and maximum values were analyze from the regression
results.

3.6. Model Specification

To implement econometric model for this study, the researcher used both macro-economic and
financial or bank specific variables. Macroeconomic data will collect from NBE annual reports, and
for specific banks data, the researcher used bank‘s annual financial report. In this study, non-
performing loans is explained by four macroeconomic variables and three variables specific to the
banks.

48
NPL i,t = 0+β1GDPt-1+2INFt +β3XRt+β4RIRt +5 ROAi,t+6ROEit +7LGi,t +i,t TL
Where,

NPL/TL i,t: is the ratio of non-performing loans to total loans for bank i in year t. ΔGDP t-1: is the
annual growth in real GDP at period t-1.

INF t: is the annual rate of inflation at period t.

RIRt: is the average annual Real interest rate at year t. XRt: is the annual exchange rate at year t.

RIRt: is the real interest rate at year t.

ROEi,t: is the ratio of Net income from operation to Average equity for bank i at year t. ROAi,t: is the
ratio of Net income from operation to Average asset for bank i at year t.

LG i, t: is represents loan growth rate for the bank i in year t. i,t: error term of bank i at period t.

3.7. Definition, Measurement and Working Hypotheses of Study Variables

For the analyses purpose, nonperforming loan treated as the dependent variable; NPL rate
calculated by using the ratio of impaired loan to total loan, whereas Loan growth rate, return on asset
and return on equity treated as independent variable from bank specific factors and GDP, exchange
rate, Real interest rate and inflation as independent variables of determinants of NPL from
macroeconomic factors.

3.7.1. Dependent Variable:

Non-performing Loan: the ratio of non-performing loans to total loans

3.7.2. Independent Variables:

GDP growth rate: annual growth rate in real GDP of Ethiopia

Inflation rate: the annual rate of inflation of Ethiopia

49
Exchange rate: the annual exchange rate b/n birr and USD

Loan growth rates: represents loan growth rate of bank

Real interest rate: the average annual Real interest rate

Return on Equity (ROE): ratio of Net income from operation to Average equity of bank

Return on Assets (ROA): the ratio of Net income from operation to Average Asset of bank.

Table: 3.1 Summary of variables, their definition and expected sign.

Name of variable Type the Definition of the variables

variables

NPL Dependent the ratio of non-

performing loans to total
loans

GDP growth rate Independent the annual rate of inflation -

of Ethiopia
Inflation rate Independent the annual exchange rate -/+
b/n birr and USD

Exchange rate Independent represents loan growth -/+

rate of bank

Loan growth rates Independent represents loan growth +

rate of bank
Real interest rate Independent the average annual Real +
interest rate

50
ROE Independent ratio of Net income from -
operation to Average
equity of bank
ROA Independent the ratio of Net income -
from operation to Average
Asset of bank

3.8. Diagnostic Statistical Tests

In examining the validity, adequacy and robustness of results obtained from multiple regression
empirical analysis, the present study will employ the following popular and widely used diagnostic and
stability tests.

3.8.1. Normality

A normality test is used to determine whether sample data has been drawn from a normally distributed
population (within some tolerance). A number of statistical tests, such as the Student's t-test and the
one-way and two-way ANOVA, require a normally distributed sample population.

3.8.2. Heteroscedasticity

It is used to test for heteroskedasticity in a linear regression model and assumes that the error terms are
normally distributed

3.8.3 Autocorrelation

utocorrelation analysis measures the relationship of the observations between the different points in
time, and thus seeks a pattern or trend over the time series

51
3.8.4. Multicollinearity

Multicollinearity is a statistical concept where several independent variables in a model are correlated.
Two variables are considered perfectly collinear if their correlation coefficient is +/- 1.0.

52
 [Link] FOUR

TIME AND BUDGET PLAN

4.1Time Schedule

The work plan for research On Determinants of Non-Performing Loans: The Case of the Ethiopian
Commercial Banks will expected to complete as follows:

Responsibl Time schedule by month

List of activities e Nov Dec Jan Feb March Apr May June
Person
Topic selection Researcher 

Proposal Researcher  
development
Securing Researcher 
material and
financial
resources
Data collection Researcher 

Data entry Researcher 

Data analysis Researcher 

Report writing Researcher  

and submission
of first draft
Defense of the Researcher 
research
Dissemination of Researcher 
findings to the
concerned bodies
Monitoring of Researcher        
the research
process
53
33

Budgeting

This research is expected to be completed with the total cost of 12,552.25 birr. The items and cost
allocations for each are shown in the table below.

Sr. Items Unit Unit Total Remarks

No cost(in cost(birr)
Total
birr)

1 Personal cost 5450

Payment for secretary Page 5.00 150 750

Payment for internet month 500 3 1500

services

2 Stationary expense 2500

Pen package 2.5 12 30

Pencil Package .75 3 2.25

Binding expense Page 10 4 40

Printing cost Pages 1.00 500 500

Flash disk 1 280 280

3 Contingencies 1,500

Grand total 12,552.25

54
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