Assessment of non-performing loan

Management System of Oromia International

Bank In Case Of Wolkite Branch

A Research Paper Submitted to Accounting

Department in the Partial Fulfillment for the
requirement Bachelor of Arts in Accounting

Prepared by………………….Tsegaye Birhanu

ID………………..ACC/111/06
Advisor………..Lakech E. (msc)

Wolkite University college of Business & Economics

Department of Accounting & Finance

JUNE 28

2016

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 Table of contents
Contents Page

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List of table contents……………………………………………………………………………………………………………i
Declaration of originality of the work.................................................................................................iii
List of tables.........................................................................................................................................v
Graph...................................................................................................................................................v
ACKNOWLEDGEMENT.........................................................................................................................vi
List of Abbreviation............................................................................................................................vii
Abstract.............................................................................................................................................viii
Chapter One........................................................................................................................................1
1. Introduction.....................................................................................................................................1
1.1. Background of the study...............................................................................................................1
1.2. Back ground of the organization...................................................................................................3
1.3. Statement of the problem............................................................................................................4
1.4. Research Questions....................................................................................................................5
1.5. Objectives of the study.................................................................................................................5
1.5.1 General objectives of the study..................................................................................................5
1.5.2. Specific objective of the study...................................................................................................6
1.6. Scope of the study........................................................................................................................6
1.7. Limitation of the study..................................................................................................................6
1.8. Significance of the study...............................................................................................................6
1.9. Organization of the paper.............................................................................................................6
Chapter Two........................................................................................................................................7
2. Literature review.............................................................................................................................7
2.1. Theoretical literature review........................................................................................................7
2.1.1. Banking......................................................................................................................................7
2.1.2. Role of Banks.............................................................................................................................7

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2.1.3 Overview of banking industry in Ethiopia...................................................................................8
2.1.4. Risks in Banks.............................................................................................................................9
2.1.5. Definitions and concepts of non-performing loans..................................................................10
2.1.6. Sources of non-performing loans.............................................................................................11
2.1.7. Classification of Non- performing loan....................................................................................11
2.1.8. Assessment of non-performing loan........................................................................................12
2.1.9 Non-performing loan management system of banks...............................................................13
2.1.10. Impacts of non-performing loans on bank system management..........................................14
2.1.11 Lending process in banks........................................................................................................14
2.1.13. Performance measure in banks.............................................................................................17
2.3. Research knowledge gap............................................................................................................19
Chapter three....................................................................................................................................20
3. Research Methodology..................................................................................................................20
3.1 Research Design...........................................................................................................................20
3.2 Sampling techniques....................................................................................................................20
3.3 Sample Size Determination..........................................................................................................20
3.4 Types and Source of Data............................................................................................................21
3.5 Method of Data Collection...........................................................................................................21
3.6 Method of Data Analysis..............................................................................................................21
Appendix............................................................................................................................................26
Reference...........................................................................................................................................30

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List of Abbreviation

NIM Net Interest Margin

NBE National Bank of Ethiopia

NPL Non-Performing Loan

OIB Oromia International Bank

ROA Return on Asset

ROE Return on Equity

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 Chapter One
1. Introduction

1.1. Background of the study

Banking sectors play a key role in the development of an economy. The development role
undertaken by banking sector determines the step for development of economy. Hence, the
stability of banking sector is a key for the development of an economy. The primary function of
bank is mobilizing deposits from surplus units to deficit units in the form of loan and advances to
various sectors such as agricultural, industry, personal and governments. However, in recent
times, the banks have become very cautious in extending loans due to non-performing assets
(Sontakke and Tiwari, 2013).

According to Rawlinset al.(2012), the principal aim of any business is to make profits. That is
why any asset created in conduction of business should generate income for the business. Since
this issue is applicable for the banking sector business, banks should give due consideration on
the management of loans because lending is the main business of commercial banks and loan is
normally the main assets and vital source of revenue for the commercial banks (Daniel and
Wandera, 2013). Deposits in banks are offset by higher margins from creation of credits as loans.
However, if such assets do not generate any income, the banks` ability to repay the deposit
amount on the due date would be in question. Therefore, the banks with such asset would
become weak and such weak banks will lose the faith and confidence of the customers.
Ultimately, unrecoverable amounts of loans are written off as non-performing loan (Maliket al.,
2010).

Deterioration in asset quality is much more serious problem of bank unless the mechanism exists
to ensure the timely recognition of the problem. It is a common cause of bank failure. Poor asset
Quality leads nonperforming loan that can seriously damage a banks’ financial position having
an adverse effect on banks operation (Lafuente, 2012).

The study of Skarica (2013) on the non-performing loans in Central and Eastern European
Countries through fixed effect model was also found as Gross Domestic Product growth rate,
unemployment rate and inflation had negative and significant impact on non-performing loans.
Similarly, Carlos (2012) based on ordinary least square model estimators found as non-

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performing loans have negative association with gross domestic product growth rate whereas a
positive association with unemployment rate. Similar to the Western and other African countries,
in Ethiopia also Wondimagegnehu(2012) Conducted a study on nonperforming loans and found
as poor credit assessment, failed loan monitoring, underdeveloped credit culture, lenient credit
terms and conditions, aggressive lending, compromised integrity, weak institutional capacity,
unfair competition among banks, and fund diversion for unexpected purposes and overdue
financing had an effect on the occurrence of non-performing loans.

Credit risk refers to the likely wood that potential borrowers will default on their financial
obligation with lending institutions. Credit risk management in the lending institution is primary
line of defense to protect itself against customers who fail to meet term of loan or other credit
that extend to them .Which financial institutions have faced difficulties over the year of a
multiple reasons? The major cause for the serious banking problem continuously to be directly
related to the lack of credit risk standard for borrower and counterpart ideas (John, 1991).            

The goals of credit risk management is to be maximal a banks rise adjusted rate of return by
making credit exposures with acceptable permanents, bank need to manage the credit risk
inherent in the fire part folio as well as risks in the individual credit or transaction the effective
approach to risk management and essential the long term success of any banking organizations.
Since exposures to credit risk management continuously to be the lending source of problems
able to draw usefulness from past experience. Credit risk management is responsible for the
implementation of actions that limit bankruptcy and control the daily operations and also
establish risk management. Credit risk management plays an important role in the development
of one country to bring sustainable development as well as to build the strong managing system
(Mishkin, 1992).

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1.2. Back ground of the organization
The present day banking was developed in Greece and Italy in the 15th century. The word ‘’Bank
‘’ is derived from the Italian word Banco, which means bench of country of place of business on
which the money charger of lender (the early bankers) used to sit in market places to advance
money(Belay,1987)
The modern banking began in Ethiopian 1905, when the bank of Abyssinia was established in
Addis Ababa under 50-year franchise agreement with the British owned national bank of Egypt.
Then it was substituted by the bank of Ethiopia, which was a purely Ethiopian institution or the
first indigenous in Africa on July 1931. The bank of Ethiopia divided into national bank of
Ethiopia and commercial bank in 1963. Oromia International Bank S.C was established in
accordance with pertinent law regulation and 1960 commercial code of Ethiopia by monitory and
banking proclamation No.83/19948 by licensing and supervision of banking proclamation No.
592/2008. The Oromia International bank has about 170 branches, which one of these is found in
Wolkite and the rest of the branches are in different part of the country. The Oromia
International Bank the first bank in Ethiopia that start give interest free banking[Sharia-
compliant banking] services. The Oromia International Bank gives all service which other banks
give for public (www: Oromia International Bank.com).

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1.3. Statement of the problem
Bank exists to provide in financi1al intermediation service while at the same time endeavor to
maximize profit and shareholders value. Lending will consider the most important function for
utilization commercial bank as major portion of income will earn from loan and advances
(Radha, 1980).The primary and fundamental operation of bank accepting deposits from the
economic surplus units and facilitating credit to the economic deficit units. Their major source of
income will from extending credit. They more the bank is granting credit, the higher will be its
profit and the more will be the risk of uncollectible which may lead the bank to problem of
liquidity.
Issues of Nonperforming Loans (NPLs) gained increasing attentions in the past few decades.
Poor loan management will contribute to NPLs. It will critical issue for every bank to manage
bad loans. Many countries could suffering from Non-performing Loans (NPLs) in which banks
could be unable to get profit out of loans (Peterson and Wadman, 2004).If the loan is well
managed; it will increase the bank’s profitability and sustainability in the future. However, if
failed to do so, it will be the major threat to their survival (MacDonald, 2006).
Non-performing loans affect the bank`s liquidity and profitability which could be the main
components for the overall efficiency of the bank. An increase in non-performing loans provision
diminishes income. Again, mismatch of maturities between asset and liability create liquidity
risk for the banks that deteriorate bank’s overall credit rating including its image. Therefore, the
determinants of non-performing loans should be given a due consideration because of its adverse
effect on survival of banks (Badar and Yasmin 2013)

Despite the fact that loan is major source of banks income and constitute their major asset, it will
risk area of the industry. That will be also way credit risk management will one of the most
critical risk management activity carried out by firms in the financial service industry. In fact of
all the risks banks face, credit risk will consider as the most lethal as bad debts would impair
banks profit, it would be noted that credit risk arises from uncertainty in a given counterpart’s
ability to meet its obligation. If the uncertainty materializes they would lead to deterioration of
loan quality. Deterioration in banks loan quality would be one of the major causes of financial
fragility. Past experience shows that a rapid build –up of bad loans plays crucial role in banking
crises (Hermosillo, 1999).

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The main factors that cause the risk of uncollectable of default of the risk of being non-
performing loan could be absence of sound credit policy and strategy, weak follow- up and poor
control after granting credit, poor collection efforts, excessive use of loan as a competition tool
in banking industry and their existence of poor management of non-performing loan and
advances is sign of weakness in loan administration or lack of good credit risk management, and
it will result in loss of profit and good will administration of acquired properly, opportunity costs
and other miscellaneous expense. The strength of banks portfolio depends on the health of its
borrower. In many countries, failed business enterprises bring down the banking system (Alemu,
2001). High level of non-performing loan would be link with banks failures and financial crisis.
Failure in one bank might lead to run on (stop) bank which in turn as contiguous impact affecting
the whole banking industry as has recently been experienced in USA other parts of the world.
Therefore, this study tries to assess non-performing loan management system in Oromia
International Bank.

1.3.1 Research Questions

Based on the above clarification, the study will raise the following basic research questions that
should be answered in this area of study.
 What measurement should take by the bank in order to reduce the NPL problem?
 What is the problem encountered by the bank in credit collection?
 How the banks evaluate the credit worthiness of customers?

1.5. Objectives of the study

1.5.1 General objectives of the study

The general objective of the study is to assess Non- Performing Loan Management System in
Oromia International Bank,Wolkite branch.

1.5.2. Specific objective of the study

 To investigate the measures that the bank should be take to minimize non-performing
loans.
 To identify problems encounter (faced) by the bank in credit collection.
 To evaluate credit worthiness of the customers.

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1.6. Scope of the study
The scope of the study is limited to discuss the assessment of non-performing loan management
system in Oromia International Bank, Wolkite Branch due to more financial and time
requirement, all over OIB branch is hardly possible. Besides, the study is restricted to one
branch.

1.8. Significance of the study

The study assist the bank to reassess (review, check, reevaluate, reexamine) and go through its
non-performing loan-management and whether or not the bank have sound credit policy,
procedures and strategy to manage its non-performing loans that the branch could beneficiary
from its customers and to maintain health loans and increases its effort in minimizing the
percentage of non-performing loan and other researcher can use as a reference regarding NPL.

1.9. Organization of the paper

This paper is organized into three chapters. The first chapter starts with presenting background of
the study, background of the organization, statement of problem, research question, and
objectives of the study, scope of the study,and significance of the study. The second chapter
focuses on theoretical, empirical review of related literature and research knowledge gap. The
third chapter deals with the research methodology.

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 Chapter Two
2. Literature review
The purpose of this chapter is to review the evidence on non- performing loan management
system of firms. Hence, the chapter is arranged into three sections, the first section presents the
theoretical review while the second section reviews the empirical evidence pertaining to Non-
Performing Loan Management System. The third section is the research gap that researchers will
fill.

2.1. Theoretical literature review

2.1.1. Banking
A bank is a financial intermediary that offers loan and deposits, and payment services. Nowadays
banks also offer a wide range of additional services, but it is these functions that constitute banks
distinguishing features. Because, banks play such an important role in channeling funds from
savers to borrowers. To understand how banks’ work, it is necessary to understand the role of
financial intermediaries in an economy. Financial intermediaries and financial markets’ main
role is to provide a mechanism by which funds are transferred and allocated to their most
productive opportunities. A bank is a financial intermediary whose core activity is to provide
loan to borrowers and to collect deposit from savers CasuGirardone (2006).

2.1.2. Role of Banks

According to CasuGirardone (2006) to understand the advantages of the intermediation process,
it is necessary to analyze what banks do and how they do it. The main function of bank is to
collect fund or deposits from units in surplus and lend funds or loans to units in deficit. Deposits
typically have the characteristics of being small size, low risk and high liquidity. Loans are of
larger size, higher risk and illiquid. Banks bridge the gap between the needs of lenders and
borrowers by performing transformation function.

Size transformation

Generally, savers or depositors are willing to lend smaller amounts of money than the amounts
required by borrowers. Banks collect funds from savers in the form of small size deposits and
repackage them in to larger size loans. Banks perform this size transformation function

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exploiting economies of scale associated with the lending or borrowing function, because they
have access to a larger number of depositors than any individual borrower (Agyeman, 1987).

Risk transformation
Individual borrowers carry a risk of default (known as credit risk) that is the risk that they might
not be able to repay the amount of money they borrowed. Savers, on the other hand, wish to
minimize risk and prefer their money to be safe. Banks are able to minimize the risk of
individual loans by diversifying their investments, pooling risks, screening and monitoring
borrowers and holding capital and reserves as a better for unexpected loses(Akapo, 1994).

2.1.3 Overview of banking industry in Ethiopia

Bank of Abyssinia was the first bank established in Ethiopia based on the agreement between
Ethiopian government and National bank of Egypt in 1905 with a capital of 1 million shillings.
However, bank of Abyssinia was closed at in 1932 by Ethiopian government under Emperor
Haile Selassie and replaced by Bank of Ethiopia with a capital of pound sterling
750,000.Following the Italian occupation between1936-1941, the operation of bank of Ethiopia
ceased whereas the departure of Italian and restoration of Emperor Haile Selassie’s government
established the state bank of Ethiopia in 1943.However, State bank of Ethiopia was separate
dinto National bank of Ethiopia and commercial bank of Ethiopia S.C. to separate the
responsibility of national bank from commercial banks in 1963. Then, on December 16, 1963 as
per proclamation No.207/1955 of October 1963 commercial bank of Ethiopia control all
Commercial banking activities (Fasil and Merhatbeb, 2009).
Following the declaration of socialism in 1974, the government extends the extent of its control
over the whole economy and nationalized all large corporations. Accordingly, Addis bank and
Commercial bank of Ethiopia Share Company were merged by proclamation No.84 0f August 2,
1980 to form single commercial bank in the country until the establishment of private
Commercial banks in 1994.To this end, financial sector were left with three major banks namely;
National bank of Ethiopia, commercial bank of Ethiopia and Agricultural and development bank
during the socialist government. However, following the departure of Dergue regime, Monetary
and banking proclamation of 1994 established the National bank of Ethiopia as a legal entity.
Following this, monetary and Banking proclamation No.84/1994 and the Licensing and
Supervision of banking business proclamation No.84/1994 laid down the legal basis for

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investment in banking sectors (Habtamu, 2012).Currently, banking sectors in Ethiopia are
showing progressive developments in terms of number of branches, total assets, human resource
utilization and the like relative to other African developing countries. This indicates as Ethiopia
categorized under banked country with limited Outreach (Tseganesh, 2012).

2.1.4. Risks in Banks

Credit risk:

According to Basle committee on banking supervision (2000) credit risk is defined as ‘the
potential that a bank borrower or counter party will fail to meet its obligations in accordance with
agreed terms. Generally credit risk is associated with the traditional lending activity of banks and
it is simply described as the risk of a loan not being repaid in part or in full.
Interest Rate risk:
According to Hempel and Simonson,1999,pointed out interest rate risk for bank is the exposure
that is the risk associated with unexpected changes in interest rates, has grown sharply in recent
years as a result of the increased volatility in market interest rates especially at the international
level.
Refinancing Risk and Reinvestment Risk:
Saunders and Cornett (2003) define refinancing risk as: the risk that the cost of rolling over or re-
borrowing funds will rise above returns being earned on asset investment. Also they define
reinvestment risk as: ‘the risk that the returns on funds to be reinvested will fall below the cost of
funds’.
Liquidity (or funding) Risk:
Liquidity risk is generated in the balance sheet by mismatch between the size and maturity of
assets and liabilities. It is the risk that the bank is holding insufficient liquid assets on its balance
sheet and thus is unable to meet requirements without impairment to its financial or reputational
capital. Liquidity risk can also occur when the duration of the balance sheet is mismatched:
consider the situation if some of the loans funded by deposits were to default. If loan defaults
were so large as to leave insufficient liquidity for the bank to satisfy depositor’s demands to
withdraw these deposits, then the bank would need to find new deposits to fund the withdrawals
(CasuGirardone 2006).
Operational Risk:

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Another important risk in banking is operational risk. The risk management group of the Basle
committee on banking supervision (2001) defines operational risk as the risk of loss resulting
from inadequate or failed to internal processes, people and systems, or from external events.
Financial Risk:
Financial risks are subject to complex interferences that may significantly increase banks overall
risk profile. According to (Anteneh,2006), financial risks companies of two types;
1. Speculative risks are based on financial arbitrage and can result in profile, if the
arbitrage is corrected or loss if it is incorrect.
2. Pure risk includes liquidity, credit and saving risks which can result in a loss for
bank if they are not properly managed.

2.1.5. Definitions and concepts of non-performing loans

Non-performing loans are loans on which debtors have failed to make contractual payments for a
pre-determined time. It should be noted that a loan classified as a non- performing doesn’t
necessarily lead to losses. If there is adequate collateral, losses might not occur. Conversely
loans may be lost even though they were never classified as non- performing. Not all countries
use the same definitions for non-performing loans, and there may even different definitions in
within a single county depending on the sector involved (financial institutions, quoted
corporations, small enterprises, government entities and so forth(Rawlinetal,2012)
At international level, the definition provided by the paragraph 4.84 of the International
Monetary Fund’s compilation guide on financial soundness indicators reads, summarized, as
follows’ loan is non performing when payments of interest and principal are past due by 90-days
or more, or at least 90-days of interest payments have been capitalized, financed or delayed by
agreement, or payments are less than 90-days overdue, but there are other good reasons to doubt
that payments will made in full (International Monetary Fund,2004).

2.1.6. Sources of non-performing loans

According to the research done by Islam, M.S., Shil, Nikhil, C., and Mannan, M.A., (2005),
which the study have comprised the view of the professionals in the respective fields. In the
study, the primary sources of data collection were given priority over the secondary sources. The
responses were accumulated and descriptive statistics were used to draw the conclusions
theoretically. Based to the study, they have identified that there are a few sources of loans being
non-performing:

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a) Reduced attention to borrowers.
b) Moving along the risk curve - meaning that risk increase and are always to some degree
unknown as the low situations become saturated.
c) Increasing loan size increases risk.
d) Lenders lack plans to deal with risk.
e) Borrowers probe a credit operation's weaknesses.
f) Rent-seekers capture the credit program especially when some subsidy is involved.
g) Lenders and project designers have low expectation.
h) The lender is unwilling to collect, arise from a number of factors such as requires soft funds
that the lenders can afford to lose.
i) Lacks of good models, such as lenders are simply unfamiliar with successful examples of
dealing with bad and doubtful debts.
j) Loan sanctioned by corruption.
k) Weak follow up weaken the system.

2.1.7. Classification of Non- performing loan

Non-performing loan means, loan whose credit quality has deteriorated and full collection of
principal and interest in accordance with covenants or terms of loan in question. Distinguishing
loan good or bad differ substantially between countries some use and other quantitative criteria.
According to National Bank of Ethiopia directive number SSB/32/2002, shall classify non-
performing loan, weather such loan have established schedule or not, in to four categories using
the following criteria.
Pass-loan/advance: in this category is fully protected by current financial and paying capacity
of borrowers and it not subjected to criticism. In general any or advance or position there of
which is fully secured, both principal and interest by cash or cash substitute.
Special mention: any clear post due 30 (thirty) days or more but less than 90 (ninety) days
substandard between 90 and 180 days non-performing loan.

Doubtful: non- performing loan or advance past due of 180 days or more but less than 360
(three hundred sixty) days.

Loss: non- performing loan advance past due of 360 (three hundred sixty) days (Skarica, 2013)

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2.1.8. Assessment of non-performing loan
The assessment of the credit worthiness involves the gathering, processing and analyzing of
information on the loan applicant. An important aspect of information is by way of credit
references and credit rating. According to Rose (1999) the question that must be dealt with
before any other is whether or not the customer can service the loan – that is, pay out the credit
when due, with a comfortable margin of interest. The factors underlying the assessment of pre-
lending safeguards, in the opinion of Rose (1999) are; character, capacity, cash, collateral,
conditions and control (i.e. the 6Cs). In another context, Rouse (1989) referred to mnemonics
used as common checklist to review loan application as: CCCPPARTS (Character, Capital,
Capability, Purpose, Person, Amount, Repayment, Terms and Security); PARSER (Person,
Amount, Repayment, Security, Expediency, Remuneration); CAMPARI (Character, Ability,
Margin, Purpose, Amount, Repayment, Insurance/Security).The variation in the mnemonics
relates to the basic principle of assessing the potential of having loans repaid. The dimension of
each of the factors outlined by Rose (ibid) is as follows:
Cash: take-home pay for an individual, the past earnings, dividends, and a less record for a
business firm, adequacy of past and projected cash flow; availability of liquid reserves, turnover
of payables, accounts receivable, and inventory; capital structure and leverage and expense
controls.
Security: Securities for loans and overdrafts are to ensure recovery of the funds lent to the
borrower in the event that the borrower becomes unwilling or incapable of meeting his
commitments.

2.1.9 Non-performing loan management system of banks

It is inevitable that any business owner, big or small, is going to encounter clients that are just
not willing to pay. This is especially prominent in the banking industry, as services are ongoing
processes and not a one-time product purchase. It is no surprise that many small businesses do
not survive the first two years, and the inabilities to collect from nonpaying clients are likely a
large contributor of this failure. Debt collection is endless challenges that must be tackled with
care (Nishimura et al, 2001).The following strategies are recommended:
Monitoring
Monitoring of credit facilities granted to customers is a significant function in ensuring the
success of the project for which repayment is made. Huppi and Feder (1990) revealed that

17
effective monitoring leads to higher recovery of loans by exposing possible dangers (like loan
diversions) and reminding borrowers of their obligations to the lending bank (i.e. calling for
redoubling of efforts towards loan repayments). Monitoring of credit facilities has been
concentrated typically on ensuring repayment when there are signs of defaults for either payment
of interest or principal repayment by installments.
Collateral
The granting of credit facilities is underpinned by the risk of being repaid when due. Williams
and Heins (1985) indicated that risk identification is the process by which a business
systematically and continuously identifies property, liability, and personnel exposures as soon as
or before they emerge. The first step in business risk management in their view is to identify the
various types of potential losses confronting the firm, and secondly, to measure these potential
losses with respect to such matters as their likelihood of occurrence and their probable severity.
This therefore calls for critical assessment of any credit request with reasonable assurance that
repayment would not be of much problem. A bank further covers the uncertainty of the
repayment by demanding collateral
Frequent contact
A lack of continued contact is a common mistake in bank debt recovery. While initial contact
brings the debt to the attention of the delinquent client, without continuous, friendly reminders,
you lose the benefit of the first courtesy call. Frequent contact is the key to assuring successful
bank debt recovery efforts. Many clients will make such promises in an effort to stop collection
calls, while others become so overwhelmed with paying several debts that one can slip through
the cracks unless the bank debt recovery agent follows up as a reminder (Business Blog, 2011).

2.1.10. Impacts of non-performing loans on bank system management

Loans generate huge interest for banks which contribute immensely to the financial performance
of banks. However, when loans go bad they have some adverse effects on the financial health of
banks. This is because in line with banking regulations, banks make adequate provisions and
charges for bad debts which impact negatively on their performance. Bank of Ghana regulations
on loan provisioning indicate that loans in the non-performing categories that is loans that are at
least ninety days overdue in default of repayment will attract minimum provisions of 25%, 50%
and 100% for substandard, doubtful and loss, respectively (Bank of Ghana Act, 2004).

18
According to Bloem and Gorter(2001), though issues relating to non-performing loans may
affect all sectors, the most serious impact is on financial institutions such as commercial banks
and mortgage financing institutions which tend to have large loan portfolios. Besides, the large
bad loans portfolios will affect the ability of banks to provide credit. Huge non-performing loans
could result in loss of confidence on the part of depositors and foreign investors who may start a
run on banks, leading to liquidity problems.

2.1.11 Lending process in banks

The process of lending begins before the loan is made the boards of director establish a loan
policy and consider risk reduction techniques. The processes and when the loan is repaid or when
it’s determined to be uncollectable at that point it has no longer value. It is removed as an asset
from bank’s balance sheet. Even then the bank still may be able to collect some of the proceeds
(E. Gup, 2005).The key part of lending processes involves the 6C’s of credit scaring model.
Some writers like Stephen Rose et al, 1993 classifies in to 5C’s of credit such as character,
capacity, capital, collateral and condition for our discussion we shall use E. Gup 5C’s
classification.
Character
Bank must ‘’know their customer’’ before they make loan and character is the place to start the
term character means borrower’s honesty, responsibility, integrity and consistency from which
we can determine their willingness to repay loans and settle their obligation within the terms of
contract.

Capacity

Bankers are interested not only on the borrower’s ability to repay but also in his or her legal
capacity to borrow minor has no capacity to sign a contract with banks therefore, they require or
guardian cosign paper.

Capital

Capital is the amount of funds invested by the borrowers in the business to support both fixed
and current asset. Banks generally require prospective borrower’s to submit their financial
statements in order to determine credit worthiness that enable creditor to recover their funds
through sale of assets

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.Collateral

Collateral refers to assets that are pledged for security in credit transaction (E. Gup, 2005). The
review of collateral involves a compressive assessment of quality of overall assets pledged as
security to protect the secured bank lender against loss as per K.C Shekn, 1982 credit is granted
with the expectation that the funds will be repaid as agreed, not that the pledged asset will have
to be sold to provide the funds needs repayment.
Condition
External factors like economic condition that affects the borrower to repay the financial
obligation (E. Gup, 2005). Excesses capacity in commercial real estate in the market the lender
should take in to account change in conditions, such as recession, interest rate shock and assets,
price deflation before granting loan therefore, the loan officer must become an economic
forecaster.
Compliance

The previous C’s concerned the borrower compliance applies to the lender, compliance to court
decision, laws and regulations is important part of lending processes.

2.1.12. Factors Affecting Bank Loan

According to Zewdu (2010), the sources of fund for lending are reserve, deposits and capital. All
these sources may be affected by different factors and would have a direct influence on lending.
In case, since nonperforming loans (NPLs) has a direct reflection of poor asset quality, the
factors that influence banks loans have their own impact on NPLs (Rawlin et al., 2012).

According to Reed and Gill (1989)), the factors that influence bank loans that might have their
own impact on NPLs are:

Capital position: The capital of banks serves as a custom for protection of depositors’ funds.
Profitability: Some banks may emphasize earning more than others. Banks with greater need of
earning might adapt more aggressive lending policies.
Stability of deposits: - The fluctuation and type of deposit must be considered. After adequate
provisions have been made for reserves, bank can then engage in lending.

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Economic conditions: - Stable economy is more conducive to a liberal loan policy than the one
that is subject to seasonal and cyclical movements.
Influence of monetary and fiscal policies: - If monetary and fiscal policies are expansive and
additional, reserves are made available to the commercial banking system; the lending ability of
banks is increased.
Ability and experience of bank personnel:-The expertise of lending personnel is not
insignificant in the establishment of bank loan policy. Credit needs of the area served:- banks
specialized experience on different types of loans e.g. Mortgage real-estate.
Profit is the ultimate goal of commercial banks. All the strategies designed and activities
performed thereof are meant to realize this grand objective. However, this does not mean that
commercial banks have no other goals. Commercial banks could also have additional social and
economic goals. However, the intention of this study is related to the first objective, profitability.
To measure the profitability of commercial banks there are variety of ratios used of which Return
on Asset, Return on Equity and Net Interest Margin are the major ones (Murthy and
Sree,2003;Alexandru et al., 2008).

2.1.13. Performance measure in banks

Return on Equity (ROE)
ROE is a financial ratio that refers to how much profit a company earned compared to the total
amount of shareholder equity invested or found on the balance sheet. ROE is what the
shareholders look in return for their investment. A business that has a high return on equity is
more likely to be one that is capable of generating cash internally. Thus, the higher the ROE the
better the company is in terms of profit generation. It is further explained by Khrawish (2011)
that ROE is the ratio of Net Income after Taxes divided by Total Equity Capital. It represents the
rate of return earned on the funds invested in the bank by its stockholders. ROE reflect how
effectively a bank management is using shareholders ‘funds. Thus, it can be deduced from the
above statement that the better the ROE the more effective the management in utilizing the
shareholders capital.
Return on Asset (ROA)
ROA is also another major ratio that indicates the profitability of a bank. It is a ratio of Income to
its total asset (Khrawish, 2011). It measures the ability of the bank management to generate
income by utilizing company assets at their disposal. In other words, it shows how efficiently the

21
resources of the company are used to generate the income. It further indicates the efficiency of
the management of accompany in generating net income from all the resources of the institution
(Khrawish, 2011). Wen (2010), state that a higher ROA shows that the company is more efficient
in using its resources.
Net Interest Margin (NIM)
NIM is a measure of the difference between the interest income generated by banks and the
amount of interest paid out to their lenders (for example, deposits), relative to the amount of their
(interest earning) assets. It is usually expressed as a percentage of what the financial institution
earns on loans in a specific time period and other assets minus the interest paid on borrowed
funds divided by the average amount of the assets on which it earned income in that time period
(the average earning assets). The NIM variable is defined as the net interest income divided by
total earnings assets (Gul et al., 2011).Net interest margin measures the gap between the interest
income the bank receives on loans and securities and interest cost of its borrowed funds. It
reflects the cost of bank intermediation services and the efficiency of the bank. The higher the
net interest margin, the higher the bank's profit and the more stable the bank is. Thus, it is one of
the key measures of bank profitability. However, a higher net interest margin could reflect riskier
lending practices associated with substantial loan loss provisions (Khrawish, 2011).
2.2. Empirical Literature Review
Boudriga et al.,(2009) investigated on the title “bank specific determinants and the role of the
business and the institutional environment on Problem loans in the Middle East and North Africa
countries” for2002-2006 periods. The variables included were credit growth rate, Capital
adequacy ratio, real gross domestic product growth rate, return on asset, and the loan loss reserve
to total loan ratio, diversification, private monitoring and independence of supervision authority
on nonperforming loans. The finding revealed that credit growth rate is negatively related to
problem loans. Capital adequacy ratio is positively significant justifying that highly capitalized
banks are not under regulatory pressures to reduce their credit risk and take more risks. Also
return on asset has negative and statistically significant effect on non-performing loans. This
results supports as greater performance measured in terms of return on asset reduces
nonperforming loans since reduced risk taking in banks exhibiting high levels of performance.

22
Louziset al,.(2010) examined the non-performing loans in the Greek financial sector using
dynamic panel data model and found as real gross product growth rate, return on asset and return
on equity had negative whereas lending, unemployment and inflation rate had positive
significant while loan to deposit ratio and capital adequacy ratio had insignificant effect on non-
performing loans

Similarly, Joseph (2011) who conducted study on the title of effects of interest rate spread on the
level of non-performing assets of commercial banks in Kenya was considered interest rate
spread/cost of loan as independent and non-performing loans ratio as dependent variables. The
study applied descriptive research design. Both primary and secondary data were considered
from Commercial banks in 2010. It was analyzed by the help of statistical Package for Social
Science software. The finding indicates that cost of loan/lending rate has a positive significant
effect on the occurrences of non-performing loan

2.3. Research knowledge gap

This chapter presents the theoretical foundation on bank loan and the banking industry in
Ethiopia. In case, Ethiopian current banking system is dominated by the private banks that are
entering to the industry in recent years. The other issues discussed in this chapter is bank
definition and concepts of loan and lending, factors affecting bank loan and sources and
allocations of funds in the banking industry. Further, factors that limit lending such as capital
position, profitability, stability of deposits, economic condition, monetary and fiscal policies that
have their own impact on non-performing loans were discussed. Lastly, Nonperforming loan
issues including its five Cs were discussed. Besides, Empirical studies regarding the non-
performing loan were also discussed. Then, the Knowledge gap is identified and developed by
the researchers. There are a plenty of variables that affect the non-performing loans of banking
sectors. In this study, the researcher focused on bank specific non-performing loans of Oromia
International bank. Besides, most of the related literatures reviewed cover different studies made
both in developing and developed countries’ banking industries. Even if quite numbers of studies
have investigated on the non-performing loans, most of these studies have been done in
developed countries with few being done in developing countries. Thus, as to the knowledge of
the researcher, there is still limited number of literatures in Ethiopian banking industry. This
study therefore, seeks to fill this gap by assessing the non-performing loans and its management

23
system (bank specific factors or only internal factors such as assessing adequate loan ,loan
monitoring, loan follow up and interest rate) in case of Oromia International Banks in Wolkite
Branch.

24
 Chapter three
3.1 Introduction

3.1 Research Methodology

This section of the study show details of the research design sampling methods, types and source
of data as well as the manner in which the data collected and analyzed of the study.

3.2 Research Design and approach

Research design is the arrangement of conditions for collection and analysis of data in a manner
that aims to combine relevance to the research purpose with economy in procedure. The study
will use mixed method research approach that is qualitative and quantitative method to assess
non-performing loan management system of OIB. This research approach posed the researchers
to challenges the need for the extensive data collection the time intensive nature of analyzing
both text and numeric data and the requirement for researchers to be family with quantitative
form of research. The data was gathered and quantitatively analyzed using statistical tool
percentage.
Qualitative analysis is based on data collected in words than in figures unlike the quantitative
analysis. This type of analysis gives a wider and stronger explanation about a problem, a process,
an event etc.

3.3 Sampling techniques

The study will use non-probability sampling techniques based on purposive sampling techniques,
the researchers sample with a purpose in mind, which the researchers had have one or more
specific predefined groups they are seeking. The study will use this sampling method in order to
include only a sample who can give sufficient data to the study.

3.4 Sample Size Determination

The targeted population of the study is employees of OIB Wolkite branch. Total numbers of
employees working in the organization were 15. Therefore, in this study I will use all of them.

25
3.5 Types and Source of Data
The study will use both primary and secondary data. The primary source was our respondents
and the secondary sources were bank’s documents, book and other materials.

3.6 Method of Data Collection

The study will use both primary and secondary data. The primary data was collected through
structured interview and questionnaires. The questionnaires consist of both closed ended and
open ended questions. Closed ended questions are quicker and easier both for respondents and
researchers. Closed ended questions can be designed as yes or no question. Whereas open ended
questions allow respondents to offer an answer that the researchers didn’t include in the
questions. The primary data also collected through structured interview with manager of Oromia
International bank, because there is greater flexibility under this method other opportunity to
restructure the questions. The secondary data collected from annual report of the bank. This
study conducted on Oromia International Bank Wolkite branch data covering the time period
from 2015 to 2016.

3.7 Method of Data Analysis

The data collected from sample respondents analyzed using descriptive method analysis through
tabulation, percentage, graph, and also data has presented explanation and interpretation

26
 Appendix
Wolkite University
College of Business and Economic
Department of Accounting and Finance
Questionnaires prepared for purposively selected Oromia International Bank in Case of
Wolkite Branch.
Dear respondents; the purpose of these questionnaires are to collect data on the assessment of
non-performing loan management system of Oromia International Bank. The research project is
partially fulfillment of requirement of BA degree of accounting and finance. However, the
success of this study is depending on your cooperation in out and return the questionnaire.
Researchers kindly request your cooperation in fill out and returning the questioners. The data
will be used for academic purpose only.
Thank you in advance for your cooperation!!
Instruction
Part 1
General information about the respondent
1. Male female
2. Age

Below 20 21-25 25-30 31-35

3. Education level

Second degree first degree diploma certificate

4. Qualification

Accounting economics other business fields

5. Position

Branch manager loan officer loan clerk

6. Work experience

27
Less than two years between 2-5 years years above 5

Part 2: Non- performing loan management related questions

7. What are factors made to increase non- performing loan, for instance?

-inadequate loan assessment yes no

-lack of monitoring yes no

-inadequate regulation yes no

-lack of follow up yes no

-high interest rate yes no

-agency problem yes no

-others, please
specify------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------

8. Do you see following factor in loan request?

*collateral yes no

*condition yes no

*capital yes no

*characteristics yes no

*capacity yes no

9. Please write any comment on the credit analysis

28
10. What is the major type of collateral used in lending?

A. Building B Land C. Vehicle

11. Do you study the character of the customer to give loan?

A. Yes B No

Appendix II

Interview Questions

Question 1

Is the bank strictly followed the credit follow up and monitoring procedure?

Question 2

Can you identify borrowers’ back ground granting loan or credit?

Question 3

If your loan default is high, what is its reason?

Question 4

Is the bank being available in all working days?

29
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