The impact of credit risk on the financial performance of commercial banks in Lesotho

Abstract

Commercial banks play a crucial role in economic development by allocating financial resources from surplus to deficit units, thereby creating value through credit extension. Therefore, the financial performance of commercial banks across the globe is of utmost importance to all the stakeholders. This study therefore determines the impact of credit risk on the financial performance of commercial banks in Lesotho. The measurement of the study variables includes the use of Return on Equity (ROE) for bank’s financial performance and Capital to Risk-Weighted Assets Ratio (CRWAR), Asset Quality Ratio (AQR), Loan Loss Provision Ratio (LLPR), and Loans and Advances Ratio (LAR) for credit risk assessment. The study adopts a quantitative research design to analyze panel data collected from the audited financial statements of four commercial banks in Lesotho spanning for 2012-2021 using the panel least squares regression model. The results from the fixed effects estimation technique revealed an inverse relationship between the two credit risk measures: CRWAR and LAR with bank performance (ROE), emphasizing the importance of prudent credit risk management practices. Conversely, LLPR had a positive relationship with bank performance (ROE), highlighting the role of adequate loan loss provisions in enhancing bank profitability. Based on these findings, recommendations are proposed for the effective management of credit risk in commercial banks in Lesotho. First, emphasis is placed on improving LLPR to enhance ROE, emphasizing the need for prudent credit risk assessment, portfolio diversification, and effective collateral policies. Lastly, attention is drawn to liquidity management, considering the observed negative impact of LAR on ROE. Banks are urged to prioritize liquidity risk management, maintaining adequate liquidity buffers, and implementing strategies to address liquidity shortfalls.