Page 1 of 14

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 03

April 2015

125

Available online: http://internationaljournalofresearch.org/ P a g e | 125

Commercial Banks’ Performance and Credit Risk in

Sierra Leone: Panel Evidence

Kargbo

H

Zhuwei

1School of Finance and Economics, Dalian University of Technology, 116023, China,

mohamedkay17@yahoo.com

2School of Finance and Economics, Dalian University of Technology, 116023, China,

anhui@dlut.edu.cn

3School of Finance and Economics, Dalian University of Technology, 116023, China,

zwli@dlut.edu.cn

Abstract

The performance of the banking sector for

most Sub-Saharan African Countries in the

1990s was mixed and witnessed low level of

capital for investment, leading to severe

constraints on resources used for development

of the sector. This scenario was the case for

Sierra Leone, the performance of the banking

sector in the 1990s and mid 2000s was

relatively poor and partly blamed to

inadequate banking supervision, poor

coordination, inadequate payment

infrastructure and subjective assessments of

credit creation across banks leading to high

volume of non-performing loans and liquidity

problem. Given the devastating effects of

credit risk of default on banks’ performance

and growth, we investigate banking

performance and credit risk in Sierra Leone

from 1997-2011, using Panel Least Square

regression approach. This study reveals that

non-performing loans, loan loss provision and

the quality of total loans were contributing

factors for the poor performance of banks in

Sierra Leone. However, bank size and interest

rates spread impact positively at a very small

margin on profitability with an average Return

on Assets (ROA) of 0.025% far below the 2%

Return on Assets for Sub-Saharan Africa. The

hypothesis that positive correlation exists

between banks performance and prudent

credit risk management is supported. The

result also shows that banks performance and

effect on credit risk are similar across banks in

Sierra Leone (cross- section invariant). This

study contributes to current literature by

providing an econometric understanding of

relationship between banking sector

performance and credit risk in Sub-Saharan

Africa. This understanding is important for

academics and policy makers in shaping the

future stability of the banking sector.

Keywords: Credit Risk, Banks’ Performance,

Correlation, Panel Evidence Regression and

Sierra Leone.

1. Introduction

Banking sector performance and its

implication on credit risk is a controversial

topic because we are most concern about

poor banking performance that can lead to

bank failure and crisis in the financial sector

and thus have a negative effect on the

economic growth. This research does not

undermine banking failure and the

devastation it may cause on the financial

sector and the overall growth climate. We

Page 2 of 14

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 03

April 2015

126

Available online: http://internationaljournalofresearch.org/ P a g e | 126

have seen recently the world witnessed one

of the most devastating financial meltdowns

of 2007-2009 since the great depression of

the 1930s. The most affected sector was the

financial services industry, particularly the

banking sector and became a regular target

for tougher regulation, public anger and

academic critics, and one factor that

received considerable attention is risk

management discourse.

However, among the risks faced by banks

credit risk plays a crucial role on banks

performance since huge amount of banks

revenue are from credit as a result of interest

charged on credit. It is important to note that,

interest rate charged is directly correlated

with credit risk; high interest rate may

increase the chances of credit default.

However, studies on banks performance and

its implications on credit risk in the financial

sector are rare; examples of some of the

studies include the financial turmoil of

2007-2009, the economic and financial crisis

of Vietnam and the banking and financial

crises in Asia largely on account of

non-performing loans and forced several

banks in Indonesia and Thailand to close

operation (Ahmed and Ariff (2007). The

performance of the banking sector can be

affected by internal and external factors,

characterized by bank specific factors

(management, board and ownership etc) and

macroeconomic factors (Inflation, Real

Gross Domestic Product etc). Banks play a

pivotal role as depositories and often

provide the main financial instrument for

household wealth and are the major financial

intermediaries in developing countries.

(Gelb, 1989). This implies that maintaining

confidence in the banking sector is

important for avoiding a disruption of the

financial sector and hence economic growth.

Much of the existing literature on banks

profitability and its implication on credit risk

management attribute greater importance to

the rate of physical capital accumulation in

the process of economic growth; the rate of

capital accumulation in the banking sector

depends upon the control of quality, quantity

and efficiency of its credit risk management.

Therefore the very nature of banking

business is so sensitive because credit

creation process exposes banks to high

default risk and thereby affecting its

liquidity and general operation that might

lead to financial distress including

bankruptcy (Saunders and Cornett, 2006).

Credit risk is the exposure faced by banks

when a borrower (customer) default in

honoring debt obligations on due date at

maturity (Coyle, 2000). To this end, the need

for credit risk management in the banking

sector is inherent in the nature of banking

business.

It is important to note that the instability of

the banking sector offer important

theoretical insights and policy

recommendation that are particularly

valuable in areas of the world suffering from

banking and financial crisis and low level of

domestic mobilization of capital for

investment and economic growth. Consistent

with this notion, conventional wisdom

suggest that no region in the world requires

insights on building a safe, sound and

banking system and promote financial sector

development and economic growth more

than Sub-Saharan African Countries that

have witnessed low level of capital

accumulation due to limited level of capital

inflows, declining export receipt due to

deteriorating terms of trade and mounting

Page 3 of 14

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 03

April 2015

127

Available online: http://internationaljournalofresearch.org/ P a g e | 127

external debt leading to severe constraints on

resources used for development of the

banking sector and suffered tremendously

from difficulty of maintaining financial

system stability and economic growth.

However, in the last decade studies have

shown that commercial banks in

Sub-Saharan Africa (SSA) are more

profitable than the rest of the world with an

average Return on Assets (ROA) of 2%

(Flamimi, et. al, 2009), one of the major

reasons behind the high return in the region

was that SSA banks are few compared to the

demand for services as a result there is less

competition and banks charge high interest

rate on loan and gives out low interest rate

on deposits, and therefore high interest rate

spread. However, this situation is incredibly

a risky venture and should be taken with

caution.

These scenarios were the case for Sierra

Leone, the performance of Sierra Leone’s

banking sector in the 1990s and mid 2000s

was poor and partly blamed to inadequate

bank supervision, weak coordination among

banks, inadequate payment system

infrastructure and the subjective assessments

of credit creation not consistent across banks

and leading to high volume of

non-performing loans and liquidity problem

and impacts negatively on the banking

industry, it is the case that Pro-Credit Bank-a

foreign owned bank ceased operations in

2010 due to high volume of non-performing

loans and consequently faced with liquidity

problem. (Financial Sector Development

Plan, 2009).

To address these problems, the Bank of

Sierra Leone and the Banking Acts were

revised in 2010, to provide sound legal

framework for the banking system consistent

with a more Independent Central Bank and

effective banking supervision adhering to

prudential soundness financial indicators.

These measures resulted to good overall

financial performance of the banking

industry in the country. Despite the progress

made thus far in the sector, there are couples

of banks that reported losses; the sector is

still faced with systematic and institutional

inefficiencies, these have contributed to the

high cost of financial intermediation, the

unavailability of financing productive

investment especially for small and medium

enterprises, the high volume of

non-performing loans, inappropriate loan

loss provisioning, cash and overall liquidity

deficiency, inadequate judicial procedures

for loan recovery and inadequate credit risk

management evaluation mechanism for bank

clients. (Bank of Sierra Leone Annual

Report, 2011)

Now that growth promotion in the banking

sector is being actively supported by the

International Monetary Fund (IMF), the

World Bank and other International

Financial Institutions (IFS) including the

Government, all these efforts requires

research to find out the link between banks

performance and credit risk in Sierra Leone.

The Sierra Leone Banking industry provides

good laboratory test as its has fraught with

high volume of non-performing loans,

insufficiently risk management mechanisms,

high interest rate spread and institutional

inefficiency for a very long time.

In general, research thus far have looked at

the nexus between financial sector

development and economic growth in other

developing countries, but have not looked

specifically, on how banks performance and

implication on credit risk impacts on the