Impact of Non-Performing Loans on Profitability in Liberian Commercial Banking

Banking activities in Liberia commenced in 1954 which led to the establishment of the Bank of Liberia and later the National Bank of Liberia, now the Central Bank of Liberia. Today, there are nine (9) commercial banks operating in Liberia with 90 branches and windows in 2018. The banking sector in 2017 recorded a growth in key balance sheet indicators which include liquidity, capital position and shareholder’s worth. Historically there is no domestic financial instrument to place liquidity. The banking industry is the largest sub-sector of the financial sector, accounting for at least 85% of the sector’s total assets (CBL Annual Report, 2018).

The Over years financial institutions have been confronted with several challenges particularly non-performing (NPL).

Non-performing is defines as borrowed money on which debtors have not made payment of interest and principal for at least 90 days and above. Credit default result to provision expense that reduces the earning of the banks. Profitability is the ability of the organization to generate income in excess of expenses from its normal course of business or operation.

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Provisional results for 2006 indicate the industry has made a loss of US$2.52m after making its first post-conflict profit in 2005. The loss was largely on account of huge provisioning for loan losses (Pan African Capital Group LLC, 2006). Liberia Bank for Development and Investment (LBDI) has the most extensive retail distribution network in Liberia. The bank has for many years been the most profitable bank in Liberia. However, provisional results for 2006 sourced from the Central Bank shows a loss of US$1.28M mainly due to huge provisions made for non-performing Loan.

Loans Non Performing Loans (NPLs) are also referred to as Non-Performing Assets (NPAs). A Nonperforming Loan/ Asset is a credit facility of which interest and or principal amount has not paid in line with schedule for certain period of time. A loan is one of key assets of the bank as the interest payments and the repayment of the principal create a stream of cash flows ( KIRU, 2013). The interest payments is source of determinants banks’ profitability. Banks regularly classified assets as nonperforming if it is not serviced per the schedule. If payments are late for a short time, a loan is classified as past due and once a payment becomes really late (usually 90 days), the loan is classified as non-performing. A high level of non-performing assets, compared to similar lenders, may be a sign of problems. ( KIRU, 2013), stated that the best indicator for the health of the banking industry in a country is its level of Nonperforming assets (NPAs).

Nonperforming loans reflects the performance of banks. Decline in the ratio of Nonperforming loans indicates improvement in the asset quality of public sector banks and private sector banks. Increase in the ratio of nonperforming loans to total loans on the other hand should worry commercial banks. The decline in gross NPAs to gross advances indicates the improvement in the credit portfolios of both the sector banks. Gross NPAs to total assets has direct bearing on return on assets as well as liquidity-risk management of the bank. Non-performing Assets are threatening the stability and demolishing bank’s profitability through a loss of interest income, write-off of the principal loan amount itself. Non- performing loans are also commonly described as loans in arrears for at least ninety days ( KIRU, 2013).

The NPL does not only affect the bank’s profitability, it also affects the economy as whole. NPL abort economy development in that non repayment of interest and principles credit facilities shutdown the expansion of other sectors to access financing. Customer failure to repay principal amounts decreases the asset base of banks, the principal amount is written off as expenses on income statement, hence reduces bank profit. Similarly, customer failure to pay interest on loans as expected reduces bank income, which also decreases the level of profits to the bank. This finding supports information asymmetry theory and bad management hypothesis which argue that increase in NPL is a result of adverse selection, and is linked to management inability to control operating efficiency which in the long run lead to decrease in profitability.

Quality of assets in lending technologies is normally measured by the quantum of non-performing loans and has been found a direct and interlinked relationship between both (Guy 2011). Michael et al. (2006) emphasized that NPL in loan portfolio affect operational efficiency which in turn affects profitability, liquidity and solvency position of banks. Batra (2003) noted that in addition to the influence on profitability, liquidity and competitive functioning, NPL also affect the psychology of bankers in respect of their disposition of funds towards credit delivery and credit expansion. According to Kroszner (2002), non-performing loans are closely associated with banking crises.

NPL generate a vicious effect on banking survival and growth, and if not managed properly leads to banking failures. When banks' amounts of disposal of non-performing loans exceed their profits, it will reduce banks' net worth and lower their risk-taking capacity, making it difficult to invest funds in risky projects and to realize potentially productive businesses. White (2002) links the Japanese financial crisis to non - performing loans. According to White (2002), Japanese banks still suffer under the weight of thousands of billions of yen of bad loans resulting from the collapse in asset prices a decade ago in the country’s financial system.

According to Bloem and Gorter (2001) non-performing loans are mainly caused by an inevitable number of wrong economic decisions by individuals and plain bad luck (inclement weather and unexpected price changes for certain products). Under such circumstances, the holders of loans can make an allowance for a normal share of nonperformance in the form of bad loan provisions, or they may spread the risk by taking out insurance. Nishimura at el (2001) state that one of the underlying causes of Japan’s prolonged economic stagnation is the non - performing or bad loan problem. Non– performing loans can be treated as undesirable outputs or costs to a loaning bank, which decrease the bank’s performance (Chang, 1999). The problem of non-performing loans can put serious adverse effects on the economy; the government has implemented various policy measures for management of non-performing loans and securing confidence in the financial system.

This includes licensing of credit reference Bureaus. Two common measurements for Non Performing Loans/Assets are; Non performing Loans ratio and Non performing Loans coverage ratio. Non performing coverage ratio refers to the ratio of allowance for probable losses on non-performing loans to total nonperforming Loans and its computed as follows; Provisions for Losses on non performing Loans over non performing Loans. NPL ratio refers to the ratio of non-performing loans (NPL) to total loans (gross of allowance for probable losses). It is measured as non performing loans over total loans and advances. In this study non performing loans ratio measured by non performing loans over total loans and advances has been used

The NPL undermines the profitability of banks. If loans and advances are not finance by customers it poses down size risk of liquidity, operational, reputational which has the propensity to liquidate entity. The increase in NPL are one of the main factors for reduction in the earning of LBDI. The study intend to provide answer to the following research questions.

1. What are key factors that result to non-performing loans?

2. How has non-performing loans affected the profitability of the Liberian bank for development investment.

3. How adequate is the bank’s credit policy in mitigating default risk.

The goal of this study is to access the impact of the non-performing loans on profitability of the Liberian bank for development and investment.

The following are key objective that is expected to be achieved.

1. To provide key facts that result to the increased in the NPL of LBDI.

2. To establish the impact of NPL on profitability.

3. To establish relationship between NPL and liquidity.

This study is valuable to the bank’s managers as it will help them to develop credit base policy. This study recommendations will help financial institutions to conduct a sensitivity analysis of their credit profile. The study will also help policy makers in strengthen credit policy at various levels of oversight board, Central Bank of Liberia and Ministry of finance, and researchers.

To test the impact of NPL empirically, proper study methodology will be used. This section explain the variable of the study, data collection, data analysis.

The variable for this study include Real GDP per capita, interest rate, total outstanding loans, NPL rate, financial statements. The study will consider data for five (5) years.

NPL Rate- Dependent

Total loans- independent

Real GDP- independent

Financial statement- independent

Data will be collected from the LBDI website, Central Bank of Liberia and all those data will be factual and reliable.

Data analysis entails examining the data collected and making deduction and references. The data will be analyzed for completeness and analyzed using in ordinary least square.

The significant of NPL to performance of banks profitability, has led to many literatures to review the magnitude. Keenton & Morris (1987). They assume that macroeconomic condition is impact the low payback. (Bank for International Settlement, 2017) assume legal and judicial constrains result to increase in NPL.

This study will be conduct for period of three months from February 16, 2019 to May 16, 209.