Risk Management in Banks: It’s Relationship with the Financial Performance of Commercial Banks in Bangladesh

Abstract

Risk management is an essential element of bank and financial intermediation. Failure to effectively evaluating and managing the risks factors may lead to losses that threaten the health of the bank and the sustainability of the entire financial system. Most of Bangladesh’s commercial banks have their own guidelines and procedures for managing the core risk areas i.e. Credit Risks, Market Risks, Operation Risk and Liquidity Risk to ensure the bank’s sustainable development and manages all risks factors.

This study analyzes the impact of risk management factors on the financial performance of commercial banks operating in Bangladesh both in the short run and long run considering internal and external control factors. This study also review the existing risk management related policies, guidelines and practices in commercial banks operating in Bangladesh. After reviewing risk management related theories, Bangladesh Bank policies and guidelines related to risk management and empirical literatures, this study identify dependent variables as return of asset (ROA) and return on equity (ROE) as proxy of financial performance and independent variables including log of non-performing loan ratio (LnNPLR) as proxy of credit risk, log of net interest margin (LnNIM) as proxy of interest rate risk, log of foreign exchange gain/ losses (LnFexGL) as proxy of foreign exchange risk (both are component of market risk of the banks), loan to deposit ratio (LDR) as proxy of liquidity risk and log of cost to income ratio (LnCIR) as proxy of operational risk. This study include proxy variable related to type of banking operations in Bangladesh like Islamic banking or Conventional banking in to the econometric models. Gradually, it does include Herfindahl–Hirschman Index (HHI) as proxy of within banking industry concentration control variable and GDP Growth Rate & Inflation Rate as proxy of macro-economic variables into the econometric models. The econometric models have been developed to examine both long run and short run effect of the independent variables on the dependent variables to establish the research questions.

The secondary data has been accumulated from the annual reports of all the commercial banks operating in Bangladesh during the study period, i.e. from 2014 to 2019. After panel data set validation, this study used STATA – 12 version to test long term and short term impact of dependent variables on the independent variables to check the impact of risk factors on the financial performance of local commercial banks operating in Bangladesh during the period. To check the long run effect of the dependent variables on the independent variables, this study examine the output of both random effect GLS regression model and fixed effect regression model for all the econometric models. Hausman Test result has been used to determine the appropriate model for analyzing long run effect of the econometric models. Two step system GMM model has been used to check the short run impact of the dependent variables on the independent variables for all the econometric models.

The empirical output of first econometric models shows that, the bank specific risk factors, credit risk and operational risk has negative impact of both the dependent variables, i.e. financial performance of commercial banks operating in Bangladesh during the study periods, both in the long run and short run, considering bank specific control factors only, which is also in line with the statistical assumption of this study. The other risk factor, market risk (including both interest rate risk and foreign exchange risk) has positive impact of both the dependent variables, i.e. financial performance of commercial banks operating in Bangladesh during the study periods, both in the long run and short run, considering bank specific control factors only, which is also in line with the statistical assumption of this study. But, the other risk factor, liquidity risk showed different behaviors in different part of this study. Liquidity risk has negative correlation with both the dependent variables, i.e. ROA & ROE in the long run while have positive correlation with ROA and negative correlation with ROE in the short run. When this study included within banking industry concentration control proxy variable ―HHI‖ in to the second econometric model, the liquidity risk behaves differently, i.e. liquidity risk showed positive correlation with both the dependent variables, i.e. ROA & ROE, both in the long run and short run, which is also in line with the statistical assumption of this study.

However, when this study included macro-economic control variables ―GDP Growth rate‖ and ―Inflation rate‖ into the third econometric model along-with within banking industry concentration control proxy variable ―HHI‖ and bank specific control variable ―Bank Size‖, foreign exchange risk showed negative correlation with ROA but have positive correlation with ROE in the long run while has positive correlation with both ROA & ROE, i.e. financial performance of commercial banks operating in Bangladesh in the short run. The foreign exchange risk behaves differently in the long run with two dependent variables, i.e. ROA and ROE due to different types of dividend payout policies and capital management policies of the commercial banks operating in Bangladesh, which may have influence on the ROE ratio calculation techniques for the Banks. The correlation between other risk factors and profitability of the banks are in line with the statistical assumption of this study considering all the internal and external control factors into the model.

After reviewing all the outputs of the econometric models, it has been observed that, Banks’ can manage their credit risk and operational risk efficiently through implementation of prudent policies, guidelines and ensure proper monitoring, compliances to minimize losses as well as improve their financial performance. But there may have influence of some external factors on the liquidity risk and market risk of the banks. Which has been analyzed and empirically tested through examined econometric models of this study, i.e. bank should analyzed other external factors like banking industry concentration and macro-economic variables like GDP Growth Rate and Inflation Rate carefully while managing the liquidity risk and market risk in addition to all the bank specific risk factors for commercial banks operating in Bangladesh during the study period. Based on the findings, this study made some recommendation for the stake holders of the commercial Banks operating in Bangladesh, which will be effective to manage its risk factors as well as financial performances.