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ABSTRACT
This dissertation aims to identify the factors that affect non-performing loans (NPLs) in the banking sector of Sri Lanka, using the National Savings Bank (NSB) as a case study. The NSB is a 100% state-owned bank in Sri Lanka that operates under the purview of the Ministry of Finance. The research methodology involves a qualitative analysis including both primary and secondary data. The findings indicate that the factors affecting NPLs in the NSB are both internal and external. Internal factors include inadequate credit risk management practices, weak internal controls, insufficient loan recovery mechanisms, and inadequate human resources management. External factors include the macroeconomic environment, political instability, and regulatory changes. The study highlights that the NSB needs to improve its credit risk management practices and internal controls to reduce NPLs. Additionally, the bank needs to invest in loan recovery mechanisms, such as debt restructuring and legal action, to minimize the impact of NPLs on its financial performance. Moreover, the study highlights the importance of macroeconomic stability, political stability, and regulatory predictability in reducing NPLs in the banking sector. The findings suggest that the government should create a stable economic and political environment to reduce the risk of default by borrowers. Furthermore, regulators should provide clear guidelines and enforce regulations to ensure banks comply with sound lending practices and maintain adequate loan loss provisions. Overall, the study contributes to the existing literature by providing insights into the factors that affect NPLs in the banking sector of Sri Lanka. The findings provide useful information to policymakers, regulators, and bank managers in developing strategies to minimize NPLs and improve the financial stability of banks.
Keywords: Non-performing Loans, National Savings Bank, Credit Risk Management, Loan Recovery, Human Resources, Debt Restructuring, Macroeconomics stability, Political Stability




Table of Contents
ABSTRACT    2
01. CHAPTER ONE - INTRODUCTION    4
01.1. Introduction    4
01.2. Background and overview of the research topic    5
01.3. Research focus    6
01.4. Research Aim and Objectives    6
01.4.1. Research Aim    6
01.4.2. Research Objectives    7
01.5. Dissertation Overview    7
02. CHAPTER TWO - LITERATURE REVIEW    8
02.1. Introduction    8
02.2. Banking Sector in Sri Lanka    10
02.3. Non-Performing Loans    10
02.4. Non-Performing loans and Bank Lending    12
02.5. International Empirical Review    13
02.6. Empirical Studies Based on Sri Lanka    14
02.7. Credit Risk and Credit Risk Management    15
02.8. Credit Management Policies    16
02.9. Conclusion    20
03. CHAPTER THREE - RESEARCH METHODOLOGY    20
03.1. Introduction    20
03.2. Research Philosophy    20
03.3. Research Design    20
03.4. Data Type and Sources    21
03.5. Sampling Method    22
03.5. Data processing and analysis method    23
03.6. Ethical Considerations    24
04. CHAPTER FOUR - FINDINGS    25
04.1. Introduction    25
04.2. Critical Review of selected articles and identification of themes    25
04.3. Findings based on Survey    30
04.4. Conclusion    32
05. CHAPTER FIVE - DISCUSSION    33
05.1. Introduction    33
05.2. Interpretations    34
05.3. Implications    36
05.4. Discussion based on Literature Review    37
05.5. Discussion based on Survey    39
06. CHAPTER SIX - CONCLUSION    42
06.1. Introduction    42
06.2. Research Objectives    42
06.3. Practitioners Contribution    43
06.4. Theoretical Contribution    44
06.5. Research Limitations    45
06.6. Possible Areas for Future Research    46
06.7. Conclusion    46
REFERENCES    47
Reference    53
APPENDIXES    55
Appendix 01: Questionnaire    55
01. CHAPTER ONE - INTRODUCTION
01.1. Introduction
The banking sector is a critical part of the economy of Sri Lanka, and it plays a significant role in promoting economic growth and development in the country. However, in recent years, this sector has faced a challenge of rising Non-Performing Loans (NPLs), which have become a significant concern for policymakers and stakeholders in the banking industry. NPLs are loans that are not repaid by the borrower within the stipulated time frame or when the borrower has defaulted on payments (Ekanayake and Azeez, 2015). The high level of NPLs in the banking sector of Sri Lanka has adverse effects on the stability of the financial system, credit availability, and economic growth.
Therefore, it is crucial to identify the factors that contribute to the high level of NPLs in the banking sector of Sri Lanka. This dissertation aims to provide insights into the internal and external factors that affect NPLs in the banking sector of Sri Lanka. The internal factors include bank-specific factors such as credit risk management, loan classification and provisioning, and capital adequacy, while external factors include macroeconomic factors such as GDP growth, inflation, and interest rates. The research will examine the relationship between these factors and NPLs in the banking sector of Sri Lanka, and provide recommendations to policymakers and bank managers on strategies to mitigate the impact of NPLs on the economy.
01.2. Background and overview of the research topic
The banking sector in Sri Lanka has witnessed a significant growth over the years, with the number of banks and financial institutions operating in the country increasing rapidly. The sector is a crucial component of the country's economy, as it provides critical financial intermediation services to individuals, businesses, and the government. However, in recent years, the sector has been grappling with the issue of rising Non-Performing Loans (NPLs), which have become a significant concern for policymakers and stakeholders in the banking industry.
Non-Performing Loans are loans that have not been repaid by the borrower within the stipulated time frame or when the borrower has defaulted on payments (Ekanayake and Azeez, 2015). The high level of NPLs in the banking sector of Sri Lanka has adverse effects on the stability of the financial system, credit availability, and economic growth. NPLs reduce the banks' capacity to lend, leading to a decline in credit availability, which could negatively affect economic growth. Additionally, high levels of NPLs can erode banks' capital, leading to a reduction in their ability to absorb losses and potentially increasing the risk of bank failures.
Therefore, it is crucial to identify the factors that contribute to the high level of NPLs in the banking sector of Sri Lanka. These factors can be classified into two categories: internal and external factors. Internal factors are bank-specific factors, which include credit risk management, loan classification and provisioning, capital adequacy, and corporate governance. External factors, on the other hand, are macroeconomic factors that affect the banking industry, including the country's Gross Domestic Product (GDP) growth rate, inflation, interest rates, and political stability.
In recent years, the banking sector of Sri Lanka has faced several challenges, including the high level of NPLs. The issue of NPLs is not unique to Sri Lanka, as many countries have also faced similar challenges. Therefore, it is essential to understand the factors contributing to this problem and develop strategies to mitigate their impact on the economy. Several studies have been conducted on this topic, and they have identified various factors that affect the level of NPLs in the banking sector of Sri Lanka (Ekanayake, 2018). However, more research is needed to provide a comprehensive understanding of the problem and to develop effective solutions.
This dissertation aims to contribute to the existing literature by identifying the internal and external factors that affect NPLs in the banking sector of Sri Lanka. The research will examine the relationship between these factors and NPLs in the banking sector of Sri Lanka, and provide recommendations to policymakers and bank managers on strategies to mitigate the impact of NPLs on the economy.
01.3. Research focus
The research focus of this dissertation is to identify the factors that affect the Non-Performing Loans (NPLs) in the banking sector of Sri Lanka. NPLs are loans that have not been repaid by the borrower within the stipulated time frame or when the borrower has defaulted on payments. High levels of NPLs can have adverse effects on the stability of the financial system, credit availability, and economic growth. The research will use both primary and secondary data to analyze the factors that affect NPLs in the banking sector of Sri Lanka. The secondary data will obtain using financial statements of banks, statistical data, and reports from the Central Bank of Sri Lanka (Balagobei, 2019). The primary data will obtain by interviewing bank managers, lending officers, and banks staffs to gain an in-depth understanding of the factors that contribute to high levels of NPLs in the banking sector of Sri Lanka.
The research focus is important because it will provide insights into the factors that contribute to the high levels of NPLs in the banking sector of Sri Lanka. The findings of this research will be useful to policymakers, regulators, and bank managers in developing strategies to mitigate the impact of NPLs on the economy (Anjom and Karim, 2016). The research will also contribute to the existing literature on the topic, providing a comprehensive understanding of the problem and potential solutions.
01.4. Research Aim and Objectives
01.4.1. Research Aim
The research aim is to identify the factors that affect the Non-Performing Loans (NPLs) in the banking sector of Sri Lanka and provide recommendations to policymakers and bank managers on strategies to mitigate the impact of NPLs on the economy.
01.4.2. Research Objectives
The research objectives are:
1. A critical examination of the academic literature on Non-Performing Loans in the Banking Sector of Sri Lanka.
2. Justify and explain the key research methodology, including research philosophy, data collection method, sampling strategy, and data analysis method.
3. Present and critically analyse the findings of both primary and secondary data of the research and identify the relationship between literature and research findings.
4. Make conclusions and recommendations regarding the factors that affect the Non-Performing Loans in the Banking Sector of Sri Lanka.
The research objectives are important because they will provide a comprehensive understanding of the factors that contribute to high levels of NPLs in the banking sector of Sri Lanka. The research objectives will also provide policymakers, regulators, and bank managers with insights into potential strategies to mitigate the impact of NPLs on the economy. By achieving these research objectives, this dissertation will make a significant contribution to the existing literature on the topic and provide a basis for further research on this important issue.
01.5. Dissertation Overview
This dissertation will focus on identifying the factors that affect the Non-Performing Loans (NPLs) in the banking sector of Sri Lanka. The study will explore both internal and external factors that contribute to high levels of NPLs in the banking sector. Internal factors will include credit risk management, loan classification and provisioning, capital adequacy, and corporate governance. External factors will include the country's GDP growth rate, inflation, interest rates, and political stability. The research will adopt a qualitative data analysis method. The study will use secondary data obtained from the annual reports of banks, the Central Bank of Sri Lanka, and other relevant sources (Khan, Siddique and Sarwar, 2020). The study will also conduct interviews with bank managers and policymakers to gain insights into their perspectives on the factors that affect NPLs in the banking sector.
The dissertation consists of six chapters. Chapter 1 provides an introduction to the research topic, background, research focus, research aim, and research objectives. Chapter 2 provides a literature review of the factors that affect NPLs in the banking sector of Sri Lanka. Chapter 3 outlines the research methodology, including research design, data collection, and data analysis techniques. Chapter 4 presents the findings of the study, including the relationship between credit risk management, loan classification and provisioning, capital adequacy, and macroeconomic factors on NPLs in the banking sector of Sri Lanka. Chapter 5 discusses the implications of the findings and provides recommendations for policymakers and bank managers on strategies to mitigate the impact of NPLs on the economy. Finally, Chapter 6 provides a conclusion to the dissertation, summarizes the key findings, and offers suggestions for future research.
02. CHAPTER TWO - LITERATURE REVIEW
02.1. Introduction
The International Monetary Fund (IMF) defined loans as non-performing when the installment of the loan is overdue by more than 90 days. Financial institutions' creditworthiness is evaluated based on their Non-Performing Loans (NPLs). Thus, NPLs are one of the key metrics used to assess the stability of a nation's financial system. Financial institutions in many developing nations, including Sri Lanka, take significant risks to increase an industry's market share. Risks are inevitably going to be high when a financial institution seeks to increase its profits because these risks are closely related to its lending portfolio, which can be determined by the amount of NPLs (Barseghyan, 2010; Zeng, 2012). Therefore, NPL should be properly addressed with regard to its determinant aspects as it is the main problem for every country in the world. Investigating the factors that influence credit risk is a challenge since it is crucial for regulatory agencies that are concerned with financial stability and the administration of the banking sector. The risk of Credit is a significant issue in the financial sector, and it results from NPLs. NPLs may signal the beginning of a financial crisis. Numerous research that used macroeconomic or industry-specific variables to examine the determinants of NPLs discovered a substantial correlation between the variables (Fajar, 2017; Zheng, Bhowmilk & Sarker 2019; Foglia, 2022). In order to examine how macroeconomic and bank-related factors affected non-performing loans (NPLs) in licensed commercial banks (LCBs) in Sri Lanka, Ekanayake (2018) employed panel data methodologies. In contrast to the return on assets, which has a strong negative impact on NPLs, the data showed a favorable relationship between non-interest income and NPLs. The size of the bank, return on capital employed, Real GDP growth, net interest margin, high inflation, asset returns, and interbank loans are additional factors that have a significant impact on a bank's nonperforming loans (Warue, 2013; Salas & Saurina, 2002; Fofack, 2005). Sri Lanka faced two financial crises in 1988 and 2008 as a result of the system's high level of non-performing loans (NPLs) and the worsening of all macroeconomic indices as well as industry-specific variables. By attracting deposits, directing resources to the most efficient uses, and investing in the real estate market, the financial sector helps any nation's economic growth.
Licensed Banks (LBs) give credit to many borrower categories for a wide range of objectives, whether for personal, business, or corporate clients, and are the first and largest source of debt capital in the financial sector (Saunders & Cornett, 2003). Additionally, the financial sector's function has significantly increased and is no longer restricted to accepting deposits and extending credit (Fourie et al. 1998; Valdez, 2000). Businesses in the financial sector operate in a highly competitive environment, therefore poor LBs performance has a direct impact on the sector as a whole. Variations in financial performance will result from this, and the industry will become fearful. When loan quality declines, systemic risk is automatically created, which then influences the system's financial intermediation structure by causing clients to withdraw more money or make smaller deposits. This will have a direct impact on the economy's decline. As a result, NPLs are crucial to any financial institution in the globe, and when they are greater in LBs, they contribute to an economy's overall poor performance (Demirgüç-Kunt, 1998; GonzálezHermosillo, 1999). NPLs are referred to as "financial pollution" because of the harm they do as they are continually improved (Demirgüç-Kunt, 1998; González-Hermosillo, 1999). Regulators should keep the underlining factor of NPLs in mind when they adopt various laws and regulations pertaining to the financial sector's performance with the idea of safeguarding the stability of the system of finance. As per Mugahed & Rasidah (2021), non-performing Loans have been affected by the real growth of GDP, unemployment rate, public debt, and the rates of lending.
02.2. Banking Sector in Sri Lanka
There are 32 Licensed Banks (LBs) in Sri Lanka which can be allocated into the 26 Licensed Commercial Banks (LCBs) and 6 Licensed Special Banks (LSBs) (Annual Report CBSL, 2019). By the end of 2019, 62.1% of the 12 trillion dollars in financial sector assets in Sri Lanka came from the country's entire banking sector (Annual Report CBSL, 2019). Every LB in Sri Lanka have categorize loans and advances as "non-performing" when the principal and/or payments of interest have been late for three months or longer. These LBs must also set aside money for loans and advances that have been designated as nonperforming, with the amount of this money being at least equal to the sum of 50% of all loans and advances that have been delinquent for at least six months but no longer than 12 months and loans and advances that have been overdue for at least twelve months (Annual Report CBSL, 2019).
LBs in Sri Lanka carry some risks because of the structure of their corporate strategy, lending habits, and target markets. In a climate of muted economic activity over the recent era, the banking sector's performance has fluctuated. The banking industry maintained its resilience despite the additional strain brought on by the unfavorable business environment that existed before April 2019 and before 2009 owing to unfavorable weather conditions, a financial crisis, political unpredictability, and terrorist attacks. The NPLs in LBs fluctuate as a result of macroeconomic and industry-specific factors in Sri Lanka. Therefore, this study focused on spans the years 2000 to 2019 and examines macroeconomic and industry-specific factors which could potentially have an effect on the NPLs.
02.3. Non-Performing Loans
A loan becomes non performing when the person neglected to pay the installment or the interest of the amount of the loan for a specific period and different countries use different criteria to classify loans under NPLs (Kuzucu & Kuzucu, 2019). According to the International Monetary Fund (IMF), loans stop performing when an installment is more than 90 days past due. Non -performing Loans, known as bad loans or bad debt, are burdens to the bank itself and the whole economy (Kuzucu & Kuzucu, 2019)
A debt that is in default or exhibits default-like characteristics is referred to as "non-performing." When a loan does not make the agreed-upon principal or interest payments and has no intention of doing so in the future, it is said to be in default (Pilbeam, 1998). Although this can vary based on the conditions of the contract, loan servicing normally terminates three months following a default. A loan is considered nonperforming if interest and principal payments are 90 days or more past due, at least 90 days' worth of interest payments have been capitalized, refinanced, or agreed-upon postponed, or if payments are 90 days past due but there are other compelling reasons to believe they won't be made in full. According to Vigano (1993), non-performing loans as those made by lenders to borrowers from which they do not profit, particularly mortgages. In other words, the borrower cannot repay the loan in full or even just enough to generate a profit for the bank. A new payment process can then be agreed upon, or the bank can choose to prevent the collateral the borrower pledged in lieu of that. Lenders typically prefer to stay away from non-performing loans because both choices are expensive for the bank. According to Timothy (1994), when loans are placed on nonaccrual status or when the conditions are drastically altered during a restructuring, they are judged to be in default. The financial practice of withdrawing all reported but unpaid interest from loans is known as non-accrual. When loan payments were more than 90 days late, banks frequently ceased adding interest.
However, the criteria used to determine when debts were deemed past due varied greatly. When loans were fewer than 90 days past due at the conclusion of the reporting period, many banks did not put them on nonaccrual status. Non-performing loans and advances include those that are (I) not generating income, (II) whose full repayment is no longer anticipated, and payments are over 90 days past due, (III) whose total credits to the accounts are insufficient to pay interest over a three-month period, or (IV) whose maturity date has passed but no payment has been made (Eastern Caribbean Central Bank, 2009). According to Asari's definition from 2011, non-performing loans are defaulted loans from which banks cannot benefit.
In general, if interest is not paid after 90 days, the loan defaults; however, there may be variations depending on the country. The long-term relationship made it very evident how much interest rates influence non-performing loans. However, there isn't much of a correlation between inflation rates and loan default rates. Both interest rates and inflation, according to Asari (2011), won't have an immediate impact on non-performing loans.
NPLs are an issue for banks. When loans are performing, it gives an interest income to the bank. This enables to have more new loans. Banks should provide greater capital upon the presumption that the loans they have been provided will not be repaid. This limits the capacity to make new loans and affects the banks’ performance. In order to succeed in the long term, banks must keep the number of bad loans to a minimum. When Banks have non-performing loans, the balance sheet is suffering because they are not getting enough money to execute the operations.
As per Economic Review done by Ekanyake (2015), it shows NPLs could be affected by bank-level and macro-economic factors. According to the study conducted by Sinkey & Greewalt (1991), commercial banks that charged high-interest rates end up with loan defaults. A study done by Rajiv & Dhal (2003) shows that non-performing loans have affected by the cost of credit. As per the study done by Bloem and Gorter (2001), non-performing loans could arise because of changes happened in interest rates suddenly. Higher interest rates have been linked to more non-performing loans, according to a study by Espinoza and Prasad (2010), however, this correlation is not statistically significant. This was validated by research conducted by Keeton (1999). The researcher's method of choice was a vector auto-regression model. It demonstrated a connection between credit expansions quickly and default.
02.4. Non-Performing loans and Bank Lending
The variables such as bank lending, monitoring practices, and capacity constraints have had an impact on the rapid increase in the non-performing loan ratio (Ekanayake, 2015). Higher rates of non-performing loans, which are reported in the financial situation statement, could have a detrimental influence on the soundness of the banking system and its capacity to fund the real economy. There is a contradiction about whether the competition between banks make the financial system more stable or less stable (Beck & Schepens, 2013, Goetz, 2018). The ability of borrowers to repay loans denominated in foreign currencies is demonstrated to be strengthened by enhanced economic conditions, increased inflation, and lower interest rates; but, for unhedged borrowers, exchange rate depreciations are found to raise the debt load of such loans (Anastasiou & Tsionas, 2016; Jiménez & Saurina, 2006; Louzis, Vouldis, & Metaxas, 2012). Balgova & Plekhanov (2016), for instance, assessed the (positive) effects of policy-induced decreases in NPLs on the actual economy using data for a global sample of 100 nations. The authors claim that the progress that is lost as a result of the excess of NPLs can be sizable. Accornero, Alessandri, Carpinelli, and Sorrentino (2017) combined borrower-based data for non-financial firms and bank-level data for Italy to investigate how NPLs affect the availability of bank credit. They conclude that rather than the level of NPL ratios, what causally affects bank lending is the external accumulation of new NPLs and the consequent rise in provisions. Studies on the causes of non-performing loans as well as their consequences on bank lending and the real economy have regressed non-performing loans (NPLs) or macroeconomic factors against one another and other control variables. As a result of simulating the dynamics of each variable separately, these studies ignore the dynamic relationship and responses between changes in non-performing loans, banking, and macroeconomic determinants.
02.5. International Empirical Review
High-interest-rate banks have a greater rate of non-performing loans or defaults. Sinkey & Greenwalt's (1991) study of prominent US commercial banks looked into the connection between high-interest rates imposed by banks and loan defaults as a result. Through the use of a panel regression analysis, Rajiv, and Dhal (2003) demonstrated that monetary policies like the cost of credit had a large impact on NPLs. According to Bloem and Gorter (2001), unexpected fluctuations in interest rates may lead to an increase in "bad loans". The authors undertook in-depth research on numerous worldwide standards and practises for discovering, analyzing, and managing non-performing loans after they have been found in order to approach the issue from the angle of control, management, and reduction strategies.
Espinoza & Prasad's (2010) study looked into the macroeconomic and bank-specific factors affecting NPLs and how they affected the GCC Banking System. Higher interest rates did, in fact, result in a decrease in nonperforming loans, although the connection was not statistically significant. Sinkey and Greenwalt (1991) and other research found a link between loan delinquencies and brisk credit expansion. And a researcher discovered that the loan loss rate is explained by excessive lending. This has been verified by (Keeton W., 1999). They used data from American commercial banks between 1982 and 1996 to create a vector auto-regression model, which revealed a link between credit expansion and default.
However, credit expansion is connected to non-performing loans, Salas & Sauruna (2002) found in their study on Spanish banks. Additionally, asset expansion has an effect on NPLs, according to a 2002 study by Bercoff et al. The reasons for NPLs in countries in Central and Eastern Europe were also the subject of a study (Skarica, 2013). The study identified market interest rates, real GDP growth rates, loan growth rates, unemployment rates, and inflation rates as predictors of non-performing loans (NPLs) between the years 2007 and 2012. It made use of seven countries from Central and Eastern Europe using the fixed effect model. The results show a statistically significant inverse association between GDP growth rate, unemployment rate, and non-performing loans, with the relationship deteriorating during expansions and growth and accelerating during recessions. This implies that financial stability is significantly impacted by economic trends. With the premise that inflation may affect borrowers' ability to service their debt, the outcome likewise revealed that inflation had a favorable impact on NPLs.
02.6. Empirical Studies Based on Sri Lanka
Kumarasinghe (2017) found that macroeconomic conditions in Sri Lanka's banking sector had an impact on the quality of their loans by analyzing secondary data covering the years 1998 to 2014. The findings indicate that, of the six indicators, the GDP growth rate and export growth have the most effects on the volume of non-performing loans in Sri Lanka's banking sector. It was determined that there was a correlation between the GDP and the NPL. In the study by Ekanayake and Azeez (2015), which examined the variables that affect ex-post credit risk in Sri Lanka's commercial banking industry, non-performing loans (NPLs) were employed as a proxy variable. The study looked at a sample of nine licensed commercial banks from 1999 to 2012.
The study concluded that the amount of non-performing loans can be explained by both macroeconomic factors and unique bank features. It was found that NPLs typically increase when bank efficiency diminishes. A positive correlation exists between the loan-to-asset ratio and NPLs. Banks that had rapid lending expansion were related to a lower level of non-performing loans. Compared to smaller banks, larger banks experience fewer loan defaults. NPLs altered favorably with the prime lending rate and negatively with the rates of GDP and inflation growth in terms of macroeconomic considerations. Karthikasan did an analysis of the bank-specific factors affecting the non-performing loans in commercial banks in Sri Lanka (2016). A sample of 10 and 100 employees from each of the 25 licensed commercial banks that made up the target population was chosen using stratified simple random selection. The information was gathered through a self-created questionnaire distributed to the executives, loan officers, and credit managers. Participants in the survey were primarily private bank workers. According to the research, there is no connection between commercial banks' ownership of banks and their non-performing loan portfolios. High-interest rates are positively and significantly correlated with non-performing loans. In commercial banks, rapid loan growth and nonperforming loans are positively connected. Credit assessment and nonperforming loans have a bad association with commercial banks.
According to employees of the nation's commercial banks, strict credit monitoring improves loan performance. Credit monitoring and non-performing loans have a negative correlation. In commercial banks, there is a negative link between collateral security and nonperforming loans. In commercial banks, there is no correlation between lending terms and nonperforming loans. In commercial banks, there have been observed positive correlations between credit size and nonperforming loans. Negative risk assessment and non-performing loans are positively associated with commercial banks. Poor risk assessment was strongly correlated with non-performing loans.
02.7. Credit Risk and Credit Risk Management
Credit Risk is defined as the potential loss due to non-payment or late payment by bank borrowers or counterparties (Vaidyanathan, 2013). This happens when counterparties failed to meet their obligations. Credit risk is more common and crucial for banks as lending is their core business activity (Ekanayake, 2018). Therefore, credit risk is linked with Non-Performing Loans, and the volume of NPLs reflected by it (Ekanayake, 2018). “The Eastern Caribbean Central Bank (2009)” defined, credit risk management as the practice of reducing the impact of credit risk-related incidents on the financial organization. Prior to employing the proper countermeasures to reduce the financial institution's risk of suffering a loss, it entails identifying, analyzing, and assessing the extent of the potential loss. In order to sustain successful credit risk management, the lending institution should develop and put into practice effective credit risk management strategies in accordance with its credit risk strategy. The institution's risk tolerance as well as the desired degree of profitability for accepting different credit risks should be considered in the credit risk strategy. The identification and measurement of the risks associated in a bank's loans and investment activities can be aided by the implementation of clear credit regulations and processes. This is part of a comprehensive credit risk management plan. The board of directors must expressly establish in writing the company's credit policy, which must define the guidelines for managing credit risk. By lowering a bank's credit risk exposure to a tolerable level, credit risk, management aims to raise the threat rate of return. Both the inherent credit risk of the entire portfolio and the credit risk related to specific transactions or credits must be managed by banks. The connections between credit risk and other risks should be considered by banks. The effective management of credit risk, a key component of a comprehensive risk management plan, is crucial to the long-term success of any bank. For most institutions, loans are often the biggest and most evident source of credit risk (Basel Committee, 1999). For most institutions, loans are often the biggest and most evident source of credit risk (Basel Committee, 1999). Vigano (1993) contends that in order to determine the likelihood that a loan will be repaid on time, it is essential to carefully review the borrower's background information. The likelihood of timely repayment is affected by a variety of objective aspects of the consumer's corporate environment, the consumer's attitude toward existing debt, and the bank's capacity to evaluate these aspects using the information at its disposal and to handle various contractual provisions related to credit risk. According to Vigano (1993), the ability and willingness of the borrower to pay, the presence of beneficial external conditions, the legitimacy of the information, and the bank's capacity to verify the borrower's intent to pay are the primary criteria that define credit risk.
02.8. Credit Management Policies
The theoretical knowledge of how credit markets operate has made significant strides in recent decades. These developments have come about as a result of a paradigm that emphasizes issues with incomplete knowledge and enforcement. Mbano (2022), emphasized the risk associated with a project may be accessed by lenders and borrowers to differing degrees, and their estimates of that risk may vary. The information asymmetry in the loan market is effectively illustrated by the fact that the lender only knows the projected return and risk of the borrower's project, while the borrower only knows the anticipated risk and return of the average project in the economy (Blanchard, O. et al. (2016). Adverse selection is the process of determining how risky a potential borrower is, ensuring the borrower will use the loan responsibly once it has been granted so that s/he will be able to repay it, evaluating how the project actually performed in case the borrower claims his inability to repay, and figuring out how to make the borrower pay are all steps in the process of ensuring the borrower will be able to pay (enforcement) (Blanchard, O. et al. (2016). Due to the problems with enforcement and inadequate information, the credit market is inefficient, which leads to default. Mensha (1999) emphasized the importance of managing credit by asserting that it merits special attention since effective credit management has a significant impact on the success or failure of financial organizations. Understanding how a bank manages its credit risk can help determine in large part the quality of the bank's loan portfolio. Therefore, strong portfolio management, efficient credit management, and most importantly personnel that is trained to use the system are necessary for effective credit management. To function properly and offer loans to investors, financial institutions must respect fundamental credit standards. Aside from other technical credentials, the officer in charge must satisfy a number of conditions, including having a comprehensive understanding of the borrower's operations, an appropriate debt-to-equity ratio, the marketability and feasibility of the investment project, and other similar matters. Before determining whether the borrower and the project are creditworthy, the officer frequently needs to undertake a credit study.
The primary causes of non-performing loans, according to Skarica (2014), are the unemployment rate, inflation, and a fall in GDP (NPLs). In a larger sense, the relationship between macroeconomic determinants and unsystematic or sector-specific variables has been conceptualized and tested (Cebenoyan & Strahan, 2004; Warue, 2013; Waqas et al., 2017). Bad loans are a problem that affects both the banking (LBs) and nonbanking sectors, with a stock component that is not performing and a flow component that may become non-performing (licensed finance companies and leasing firms).
NPLs have a detrimental impact on borrowers, the banking system, and ultimately the economy (Zheng et al. 2019). The amount of NPLs a bank has is essentially a measure of its wealth (Faiar, 2017). NPL mostly contributed to slowing the global economy (Louziz et al. 2012; Abid et al. 2014). Global conditions have an impact on macroeconomics, whereas the rise in non-performing loans was thought to have an impact on microeconomic conditions (Faiar, 2017). Additionally, this study showed that this scenario is caused by falling demand and commodity prices from an external standpoint. As a result, the implication increased default rates and placed restrictions on the soundness of the financial system. Due to the failure to receive loan repayments on schedule, banks are having trouble managing their cash flow to fulfil the liquidity needs of both depositors and other borrowers. Bad loans have the potential to lead to financial instability, which could lead to project failure and have a negative impact on a nation's economy.
Financial intermediation theory and agent theory (Diamond, 1984; Jensen & Meckling, 1976) both have significant theoretical implications for dealing with the financial industry. An intermediary role is played by financial institutions in a nation's financial activities. They then act as an agent in an economy by gathering data or transferring assets/funds and investing those assets on the client's behalf (Saunders & Cornet, 2008). When a bank works as an intermediary, it immediately functions as an agent, which is one of the main roles played by a bank, and the clients of the agents receive services from the work performed by banks. Investigating the elements that affect the principal is therefore a topical and significant topic because the majority of agents are actively involved in the process that a bank has put in place. Following a thorough examination of the literature, two key sources of factors that affect NPL in the financial sector and are applicable to LBs in Sri Lanka were identified. Macroeconomic indicators including the real interest rate, GDP, inflation, and unemployment are listed first (Makri, Tsagkanos, and Bellas, 2014). 2005; Messai and Joini 2013; Foacck). The second source is industry-specific traits, which may have an impact on the ability to repay loans. Examples include management performance (Podpiera and Weill 2008; Messai and Joini 2013; Louzis et al., 2012; and Berger, 1997) and the scale of the financial institution (Louzis et al., 2012). Some researchers discovered a connection between macroeconomic factors and the crucial quality of the loans.
One key driver of the strength of the financial system, loan quality, has been linked by some scholars to macroeconomic issues. According to several research findings, bad loans decline when the economy grows because borrowers have enough money to pay back loans according to the specified repayment schedules (Fajar, 2017; Zheng, Bhowmilk & Sarker 2019; Foglia, 2022).
Managers are approving loans to boost an economy's growth regardless of the borrower’s creditworthiness, and as...