The Impact of Credit Risk on the Profitability of Commercial Banks in Sri Lanka
Financial institutions facilitate economic growth and development through financial intermediation. Among financial institutions, commercial banks are the biggest, performing a major share of financial intermediation and serving as the core of the financial system. Moreover, commercial banks are the foundation of payment systems in many economies particularly in developing countries by playing an intermediary role between depositors and borrowers (Felix Ayadi et al. 2008) The intermediary role of commercial banks explain the core function of commercial banks which fall within the concept of traditional banking. However, lending by itself generates risk when the borrower fails to meet his obligations. The risks associated with lending is called credit risk that is recognised as the most important among risks relating to liquidity, operations, and markets (Perera et al. 2014,Yusuf,2003) Credit creation is an important determinant of bank performance since it is generated through financial intermediation which is the main income generating activity of commercial banks. According to the Kargi (2011) creation of credit is the main income generating activity for banks but this involves huge risks to both lender and the borrower. If the banks fail to manage credit risk, they may pay high costs in the shape of bankruptcy since the banks that are highly exposed to credit risk face a reduction in profitability (Arif, A. et al 2012) Uncertainty and the global financial crisis has created pressure on credit risk and ultimately caused profitability of commercial banks (Bayyoud Sayyad, 2015) Most studies generally confirm that risk management is vital for any organisation to achieve its objectives in fair manner in the current business environment, (Smith et al. 1990. Fatemi and Fooladi, 2006) Risks are inherent to all aspects of commercial bank operations. Therefore, banking in the modern economy is all about risk management (Thiagarajan and Ramachandran, 2011) Managing risk is important to any type of bank regardless of nature, size or location. Moreover, recent studies in this area reveal that poor asset quality, excessive credit expansion, and inappropriate risk management are the main reasons for the financial crisis.The importance of managing credit risk is highlighted by the Basel committee on banking supervision and in its recent accord, Basel III identified the responsibility of managing credit risks in financial crisis (Jayadev, 2013)