Understanding the Factors Affecting the Success of Credit Risk in Kuwait Finance House Research Paper

Introduction

The banking business sector is enormously impacted by the perceptive and imperceptive factors in an intensely competitive environment. In recent times, this competition has stiffened all the more with the advancement of globalization. In each regard of their business operations, banks ought to take effective measures in order to diminish risk by pinpointing the prospective causes based on real-world circumstances. Imperatively, the banking sector is deemed to be a significant source of financing for several companies and entrepreneurs. In the past decade, there have been dramatic changes concerning the management of risk in the banking industry. Progressively more financial institutions and managers have augmented the focus on the significance of risk management. In delineation, risk management encompasses the practice of identifying, assessing and listing of risks followed by organized and cost-effective application of resources to curtail, supervise and control the probability and influence of disastrous events or to capitalize in the realization of prospects (Gizaw, Kebede, and Selvaraj, 2015).

The power and supremacy of financial establishments, particularly commercial banks, to generate money is of great significance in business operations. These banks operate as financial intermediaries within any economic setting and they are key providers of financial credit to both the corporate and household sectors. Credit risk is basically the likelihood that a borrower in a financial institution or a counterparty will end up failing to meet its obligations in line with the consented terms and conditions. In general, credit risk is linked to conventional lending activities of banking institutions and it basically delineated as a loan that has not repaid either partly or in full. Nonetheless, credit risk can also emanate from a financial establishment holding bonds and other financial securities. Imperatively, all banking institutions have their personal credit philosophy instituted in an official written loan policy that must be backed and conveyed with a suitable credit philosophy. A credit philosophy is deemed to be effective when all employees within the financial establishment are in alignment with the lending primacies of the management. Credit risks can emanate from ambiguity in financial markets, failures in projects, and legal obligations, credit problems, calamities, natural causes and adversities, in addition to intentional attacks from an opponent. Specifically, credit risk is the by a long way the most significant risk that is faced by banks and the success of their business operations are reliant upon precise measurement and efficacious management of this risk to a greater magnitude as compared to any other kind of financial risk. An increase in credit risk has the effect of increasing the financial institution’s marginal cost of debt and equity, which consequently brings about an increase in the cost of funds for the institution (Tefera, 2011).

Literature Review

Derelioglu and Gurgen (2011) defined credit risk as the prevailing or potential risk to earnings and capital emanating from the failure of an obligor to meet the terms of any agreement with the financial institution or in the event that the obligor otherwise fails to carry out the terms and agreements. Imperatively, credit risk is one of the fundamental risks in commercial risks and the capability to manager it efficaciously is a determining factor of the banking institution’s stability. When implementing financial decisions, banks employ a credit risk assessment instrument that facilitates the estimation of the likelihood that the prospective borrowers will end up defaulting in their loan obligations. In the course of this process, the analysis of credit risk is purpose to curtail the potential loss to the acceptable levels of risk (Derelioglu and Gurgen, 2011).

The fundamental income generating activity for banking institutions is credit creation. Nonetheless, this activity encompasses major risks to the lender as well as the borrower. The risk of a counterparty failing in not fulfilling his or her obligation in accordance to the contract or agreement can significantly endanger the functioning of the bank’s business operations. It is imperative to note that banks that have high credit risk also have high risk of experiencing bankruptcy and this puts the bank depositors in danger (Bhattarai, 2016). To sustain sufficient profit level in this intensely competitive setting, there is a high tendency of banks taking up excessive risks. Nonetheless, this exposes the institutions to credit risk. The greater the level of exposure of the banks to credit risk the greater the inclination of the banks in facing financial disaster and vice versa. Bank loans are the biggest and most apparent source of credit risk and therefore banks have to be prudent in this approach (Gizaw, Kebede, and Selvaraj, 2015; Bhattarai, 2016).

Whereas banking institutions have experience major challenges over the years for a wide range of reasons, the fundamental cause of severe banking issues continues to have a direct relation to the counterparties’ credit standards, inappropriate risk management, or failure to focus on changes in economic or other situations that can result in a worsening in the credit position of a financial institution’s counterparties. Taking into consideration that exposure to credit risk is a prevailing source of issues in banks across the globe, it is pivotal for banks and their managers to take in significant insight from past experiences. Presently, banks ought to have a profound cognizance of the need to ascertain measure, supervise and control fundamental credit risk factors (Asfaw and Veni, 2015).

In relation to existent literature, scholars have determined that the factors affecting the success of credit risk can be categorized into two groups including internal factors (micro-economic) and external factors (macro-economic). In accordance to Garr (2013), the different factors that influence credit risk can be classified into macroeconomic factors, industry-specific factors, and bank institution –specific factors.

Macro-economic Factors

These are factors that have an influence on the economy of a nation as a whole and comprise of different variables including the prevailing interest rates, the rate of inflation in the country, unemployment rates, the level of consumer consumption, and also gross domestic product (GDP). Research conducted by Vazquez et al. (2012) establishes that here is a negative correlation between the GDP of a nation and non-performing or defaulting loans. In contrast, the findings of the study established that there exists a positive correlation between non-performing loans and macro-economic variables including high rate of inflation, the rate of unemployment, and the interest rates. High inclinations of credit risk go in tandem with high rate of inflation, high interest rates, in addition to high unemployment rate. This is largely for the reason that they restrict the capacity of borrowing in addition to increasing the cost of borrowing (Sandada and Kanhukamwe, 2016).

Microeconomic Factors

The basis of micro-economic factors that give rise to credit risk comprise of restricted institutional capability, unsuitable credit policies, unpredictable interest rates, poor institutional management, inadequate rules and regulations, insufficient capital and liquidity levels, inappropriate underwriting of financial loans, negligence in credit evaluation, intrusion by the government, in addition to inadequate monitoring by the national monetary authority (Kithinki, 2010). Research conducted by Das and Ghosh (2007) extensively examined the factors affecting credit risk in the Indian banking sector. The findings of the study established that credit risk was largely impacted by different micro factors including the managerial competencies, institution capacity, institutional risk and also excessive loan growth.

Bank-Specific Factors

Research has indicated that different bank-specific factors have an influence on the success of credit risk within the financial institution. The research study conducted by Garr (2013) identified a number of variables including the ownership structure of the financial establishment, operating costs, proficiency and efficacy of the bank’s management, quality and composition of the bank deposits, quality of the bank assets, size and capital of the bank in addition to the reserve requirement for the bank.

Research conducted by Mwaurah (2013) established that a key determining factor of credit risk success is managerial efficiency. The study indicates that crises experienced by commercial banks come about largely owing to inadequate management competencies and that know-how and management responsibility play a pivotal role in ascertaining the risk appetite of a financial establishment. Furthermore, the author points out that poor credit management policy give rise to poor lending practices, which bring about a ballooned portfolio of defaulted and unpaid loans. Furthermore, a study conducted by Bashir (2000) makes the argument that the ownership structure of a financial institution is a key determining factor of credit risk. The study outcomes demonstrated that foreign-owned banking institutions are profitable and effective in managing credit risk as compared to their domestic rivals amongst Islamic banks.

Problem Definition

In the contemporary, banks in Kuwait are experiencing numerous challenges that have a likelihood of influencing their capacity to grow and develop in addition to operating within a more competitive business setting. Presently, the economy of the country…