Chapter 1 Introduction The Rationale of the Study Commercial banks play an important role in the economy and their stability is relevant and critical for the financial system

Chapter 1
Introduction
The Rationale of the Study
Commercial banks play an important role in the economy and their stability is relevant and critical for the financial system. To maintain a stable financial intermediary function, banks should be profitable (Bollard & Hunt, 2011). Beyond the function of intermediation, the financial performance of banks has a significant impact on country’s economic growth. Good financial performance of the bank rewards the shareholders for their investment and stimulates additional investment which will bring further economic growth (Abdul, 2017). On the other hand, the poor performance of banks may lead to their failure and appearance of the financial crisis which will have negative consequences on economic growth (Bektashi, Hoti ; Nuhui, 2017).
The banking industry is a very important sector because the developments of finance, and particularly the banking system, promote economic growth (Lipunga, 2014). The banking system plays a major role in transferring funds from the saving units to the investing units (Nshimiyimana ; Zubeda, 2017). Banks are important for the economy and organizations at the time of economic recession and money-related crisis. If the banking industry does not perform well the economy could be affected broadly. Thus, banks are a critical part of the financial system, which plays a pivotal role in contributing to country’s economic development (Rasidah & Mohd, 2011).

Banking is a business of risk-taking. Banks generally perform the intermediation role by accepting deposits from the savers and lending the money to borrowers (Abel, 2013). In doing so, they are exposed to various risks, which directly and/or indirectly influence their profitability (Olweny & Shipho, 2011). Banks are vital to economic growth because the overall financial systems of most economies in the world are influenced by the banking system (Ali, Akhtar & Ahmed, 2011). Largely, a sound and profitable banking system are in a better position to endure negative distress and contribute more significantly to the growth of the financial system (Aburime, 2009). Likewise, failures of individual banks adversely affect the economy and the society at large (Kolapo, Ayeni, Kolade & Ojo, 2012).
A risk is inherent in our daily life in general and in financial sectors, due to a regulated environment. Banking industries could not afford to take this risk (Nguyen, 2016). Nonetheless, banks are exposed to the same struggle and hence they encounter various types of financial and non-financial risk (Eveline, 2010). Risk and uncertainties form a vital part of banking which by nature entails taking a risk (Raghavan, 2003). When discussing the effect of credit risk by Commercial Banks, it is important to have a consistent definition of the term – risk. For Kupper (1999), a risk is defined as the instability of a corporation’s market value. This is particularly true for credit risk, where the benefit consists on only a small return, and the disadvantage consists of a loss that could lower bank’s value and worst bankruptcy. Because of this downside risk, banks tend to focus their attention on understanding and managing risk to mitigate it to avoid financial loss (Cruz & Cotas, 2013).
In the study conducted by Kolapo et al. (2012) in Nigeria, they found out that credit risk management is positively related to the profitability of banks in Nigeria. Kargi (2014) stated that the credit operations of commercial banks increase the ability of investors to achieve desired profitable ventures. Credit creation is the main income generating activity of commercial banks. However, it exposes the commercial banks to credit risk. Credit risk is a determinant of commercial bank performance (Kolapo et al., 2012). Moreover, Akuma, Doku and Awer (2017) mentioned that the higher the commercial banks’ exposure to credit risk, the higher the tendency of the commercial banks to experience financial crisis and vice-versa. Of all the risks that baking institution faced, credit risk gives affects more on commercial banks’ profitability since a large amount of commercial banks’ revenue accrues from loans from which interest is derived (Drehman, Sorensen ; Stringa, 2008).
In the Philippines, the banking sector is reported to be the single largest component of the financial system and it is likely to continue being the main source of finance to the private sector (Albert ; Hee Ng, 2012). The ability to mitigate and manage risk is an important element in ensuring the competitiveness of the Philippine banking sector (Cruz ; Cotas, 2013). Furthermore, they mentioned that banks with good risk management are most likely lead to being more profitable. The more profitable financial institution, the more they will be able to offer new products and services.
Several researchers globally study the effect of credit risk on profitability but came up with deferent conclusions. Ara, Bakaeva and Sun (2009) found out a positive relationship between credit risk and profitability of Commercial Banks in their study conducted in Sweden. Kolapo et al. (2012) showed that credit risk management is positively related to the profitability of banks in Nigeria. In contrary, Kithinji (2010) assessed the effect of credit risk management on the profitability of Commercial Banks in Kenya and found that banks’ profitability is not affected by credit risk management. Ruziqa (2013) come up with the same conclusion as Kithinji (2010). The results illustrated that credit risk was negatively related to profitability.
Given the information mentioned, the researchers found out that there was no exact conclusion that can be drawn that credit risk will affect the profitability of Commercial Banks in the Philippines. And for such reason, the researchers intend to fill that gap. The researchers believed that the knowledge of credit risk management must be given importance and thus makes this area worth studying.

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Objectives of the Study
This study determines the significant relationship between credit risk and profitability of Commercial Banks in the Philippines. Specifically, this study sought to attain the following objectives:
1. To determine the credit risk of Commercial Banks in the Philippines in terms of:
1.1 Non-performing Loan Ratio (NPLR)
1.2 Capital Adequacy Ratio (CAR)
1.3 Loan to Total Asset Ratio (LTAR)
2. To determine the profitability of Commercial Banks in the Philippines in terms of:
2.1 Return of Capital
2.2 Net Profit
3. To determine the significant relationship of credit risk to the profitability of Commercial Banks in the Philippines.

Statement of Hypothesis
Ho1: There is no significant relationship between credit risk and profitability of Commercial Banks in the Philippines.

The Significance of the Study
This study will provide benefits to the following parties:
Government. This research benefits the government in developing policy papers, policy-making regarding taxation and other regulatory requirements of banks in the country and any other services offered by the banking industry. The policy maker will gain insight on how well they can take part in the mitigation of credit risks for the Commercial Banks to achieved high financial gains.
Banking Industry. This study provides insights on the management and directors in these companies to monitor and develop techniques in mitigating credit risk and its influence on profitability.

Academe. This study furnishes with relevant information regarding the effect of credit risk on profitability in banking institutions. The study will add to the body of empirical literature on credit risk exposure of Commercial Banks and form a basis for further research.
The University of Mindanao. Data and information from this study can be used as baseline data for future studies and research of the students.
Students. The result provides the students with some knowledge on the connection of credit risk to the profitability of companies.
Future Researchers. The result of the study provides necessary information which can be used as a research tool to help provide the upcoming researches aiming to conduct similar studies regarding credit risk and profitability of Commercial Banks in the Philippines.

Definition of Terms
The following operational definitions of terms were used in this study:
Commercial Banks. It is an institution that provides financial services, including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creating of credit.
Credit Risk. It is defined as the risk of default on a debt that may arise from a counterparty (borrower) failing to make required payments or failure to meet the terms of any contract with the financial institution.
Non-performing Loans (NPL). These are credits which the banks perceive as possible losses of funds due to loan default.
Non-performing Loan Ratio (NPLR). It is the ratio of the amount of nonperforming loans in a bank’s loan portfolio to the total amount of outstanding loans the bank holds. The NPL ratio measures the effectiveness of a bank in receiving repayments on its loans
Capital Adequacy Ratio (CAR). It is mostly used as a measure of the financial strength of a bank or any financial institution. The higher the CAR of the bank the more it can create loans and absorbs losses (Adeusi, Aluko, and Kolapo, 2014).
Loan to Total Asset Ratio (LTAR). It is a ratio that measures the exposure level of the Bank to credit risk known as loan match. Banks with higher loan to total asset ratio have high exposure to credit risk.
Profitability. It is used to assess a business’s ability to generate earnings compared to its expenses and other relevant costs incurred during a specific period of time.
Return on Capital. Or return on invested capital (ROIC), is a ratio used in finance¬¬, valuation and accounting, as a measure of the profitability and value-creating potential of companies after considering the amount of initial capital invested.
Net Profit. It is a financial metric used to assess a company’s financial health and business model by revealing the proportion of money left over from revenues after accounting for the expenditures.

Chapter 2
Review of Related Literature
Presented in this chapter are the facts and principles that are related to the present study. This chapter discusses the relevant related literature obtained from local and foreign sources aimed to clarify and help familiarize information by the utilization of theoretical frameworks as presented below.
Credit risk
Risk sounds negative in every area it is inclined however the risk is an essential part of life, it has its pros and cons. For example, in business, Lanza (2017) pointed out that risk implies future uncertainty about deviation from expected earnings or expected outcome. On the brighter side, Davis (2018) stated that risk can uncover new markets, new audiences, and new capabilities. With these new discoveries, risk management is a must for every company.
Li and Zou (2014) cited that credit risk is one of the most significant risks that banks face, considering that granting credit is one of the main sources of income in commercial banks. Therefore, the management of the risk related to that credit affects the profitability of the banks. Furthermore, Gestel and Baesens (2008) define credit risk as the risk that a borrower defaults and does not honor its obligation to service debt. It can occur when the counterpart is unable to pay or cannot pay on time. They also mentioned that these defaults may result to the accumulation of non-performing loan which may affect the profitability of the banks.
According to Margaritis, Psillaki and Tsolas (2010), credit risk is one of the significant risks of banks by the nature of their activities. Through effective management of the exposure of the banks to credit risk, they do not only support the viability and profitability of their own business, but they also contribute to the systemic stability and to an efficient allocation of capital in the economy (Alshatti, 2015). Moreover, Gestel and Baesens (2008) said that the default of a small number of customers may result in a very large loss for the bank. Nevertheless, Gizaw, Kebede and Selvaraj, (2015) said that a good risk management could avoid the high exposure on credit risk.
As credit risk is generally linked with lending, which is the major activity of banking business; therefore it is a dangerous threat to the profitability of commercial banks (Kaaya ; Pastory, 2013). Credit risk is generally found in all of the activities in which success based on issuer, borrower or counterparty performance. When bank funds are invested extended or remains uncovered by authentic or implied contractual agreements, during such time credit risk management can take place any time (Abiola ; Olausi, 2014).
As stated by Rajagopal (2002), a good credit risk management is a good banking, which will ultimately result in a profitable survival of the institution. A proper approach in determining the risk, measurement and control will protect the interest of banking institution in a long run. Moreover, Bagchi (2003) mentioned that a proper credit risk planning, credit rating system, policies and framework of credit risk management, control and monitoring contributes to achieving an effective credit risk management system.
Khan (2008) explains that credit risk is the one of the most vital risks for any Commercial Bank. Non-performance by the borrower will arise to credit risk. Non-performance by the borrower may arise from either a failure or an unwillingness to perform the terms of the contracts (Ndwiga, 2010). Also, Ghenimi, Chaibi and Omri (2017) mentioned that the real risk from credit is when the portfolio performance deviates from its expected value. The credit risk of a bank also affects the book value of a bank. The more credit is in risk, the more probability of a bank to be insolvent. Furthermore, Abdullah, Khan and Nazir (2012) asserted Credit Risk is a kind of misfortune because of the default of loan of the bank.
Rose (2001) mentioned that loans are the main and most obvious source of credit risk for most banks. However, there are other sources of credit risk exist in the activities of a bank; these include banking book, trading book, and both on and off the balance sheet (Aaron, Armstrong ; Zelmer, 2012). Banks, especially commercial banks, are gradually facing credit risk in several financial instruments other than loans, these include acceptances, foreign exchange transactions, trade financing, financial futures, interbank transactions, bonds, swaps, options, equities, and in the extension of commitments and guarantees, and the settlement of transactions (Tobias ; Themba, 2011).
According to Banejee and Cerda (2012), the purposes of credit risk management are to maximize the performing asset, minimize the non-performing asset, and ensuring the optimum point of loan, advances and the efficiency and effectivity of the management. Additionally, Muninarayanappa and Nirmala (2004) state that the success of an effective credit risk management needs to have a proper maintenance of suitable credit risk environment and proper credit strategy and policies. Thus, the ultimate goal should be to protect and improve the loan quality.
Non-performing Loan Ratio (NPLR)
Non-performing loan (NPL) refers to loans or advances whose credit quality has declined such as collection principal and/or interest of the loans or advances that are due and uncollected for 90 (ninety) consecutive days or more away from the scheduled payment date or maturity with contractual repayment conditions (Adhikary, 2006). They are called as non-performing for the very reason that the loan ceases to perform or generate income for the banks. Siamat (2005) also states that NPL is defined as a difficulty in repaying the loan due to deliberate action or as a result of external factors beyond the control of the debtor.
Commercial banks showed themselves to the risk of default or delay in payment of borrower of loans. The core activity of commercial banks is to generate loans (Li ; Zou, 2014). Banks generate money from a series of activities of deposit and borrowing. NPL is considered losses when happens. Higher NPLR means higher losses, which adversely influence the banks’ available capital and assets for further borrowing. Hence, the efficiency of banks’ investment is affected, further influencing the profitability (Adam, 2014). In contrast, a lower NPLR is linked with the lower risk and deposit rate, meaning a positive impact on banks’ operations. Similarly, higher NPLR led toward negativity in profitability of financial institution (Iftikhar, 2016).
According to Anjom and Karim (2016), NPL of banks was critically important since it reflects on the asset quality, credit risk and efficiency in the distribution of resources to productive areas. In recent times, NPL becomes a concerning issue for banking sectors. Basu (2003) mentioned that non-performing loan can enhance the insolvency of banks leading to bank failure. He further states that non-performing Loans are one of the major causes of the economic stagnation problems in every economy. Furthermore, Parven (2011) states that NPL in the financial sector is viewed as the cause of a poor unprofitable enterprise and it is the reflection of problems in the banking and corporate sectors. NPL also create a negative effect on the income statement due to provision for loan losses (Bouvatier & Lepetit, 2012). In the worst scenario, a high level of non-performing loans in a banking industry will raise a risk of insolvency and invite a panic to run on deposits. Moreover, Kargi (2014) cited that the most profound impact of high nonperforming loans in bank portfolio is the reduction in profitability.
Greenidge and Grosvenor (2010) mentioned that the initiation and progression of financial and banking crises is the result of a high level of NPLs. Guy and Lowe (2011) also mentioned that NPLs have been used widely by lending institutions as a measurement for asset quality and is often associated with failures and financial crises in both the developed and developing world. Thus, Banks should improve their way in receiving repayments of their granted loans since they are the critical part of the financial system, which plays a pivotal role in contributing to country’s economic development (Rasidah ; Mohd, 2011).

Capital Adequacy Ratio (CAR)
Commercial banking in virtually all countries has been subject to a lot of regulations. One of the regulations is the minimum capital commercial banks must keep absorbing the loss if unexpected things happen (Hull, 2012). Thus, Basel Accord (1998) recommended Capital Adequacy Ratio (CAR) for judgment of asset quality and appropriate Credit Risk Management. It is the ratio of total capital to risk-adjusted assets of the bank. The higher the ratio is the sign of better assets quality and bank Capital Adequacy and low credit risk (Mostafa, Eldomiaty ; Abdou, 2011)
Gaiya (2016) states that capital adequacy ratio is important because it becomes the bases to make sure that the banks have enough resources and capital to absorb a reasonable amount of losses before these losses result to their insolvency and consequently lose the funds of its depositors. Additionally, Posner (2014) mentioned that CAR ensures the efficiency and stability of the financial system of the nation by lowering the risk of banks in becoming insolvent. Furthermore, Mendoza and Rivera (2017) cited that the insolvency of the banks will shake the confidence of financial systems and unsettles the entire financial market system. They further mentioned that capital adequacy is the key to maintain the stability of the monetary and banking system. Thus, Abiola and Olausi (2014) state that commercial banks with higher capital adequacy ratio can create more loans and absorb any future credit losses and therefore record better profitability.
According to the study of Morgan (1984), the importance of capital adequacy has high importance for commercial banks. He further stated that commercial banks have a legal responsibility to retain the sufficient capital adequacy ratio. In addition, Benczur, Cannas, Cariboni, Girolamo, Maccaferri and Giudici (2017) cited that the major task of the bank is to make available sufficient funds required to absorb potential future losses because it shows financial strength of the financial institution.
Capital adequacy ratio (CAR) is defined as the ratio of capital to the risk-weighted sum of bank’s assets. It measures the amount of a bank’s capital relative to the amount of its risk-weighted credit exposures (Gorajek ; Turner, 2010). Capital-based regulation has become a major issue in the banking industry. To keep the minimum capital adequacy ratio and secure against underlying losses, capital-constrained banks began to collect outstanding loans or became reluctant to grant new lending (Hyun ; Rhee, 2011). In addition, minimum capital adequacy ratio has been established to ensure banks can absorb a reasonable level of losses before the insolvency and before depositor funds lost (Yunisa ; Umah, 2013). Hence, minimum CAR aims to protect depositors and promote the efficiency and stability of the financial system of the banks and provides safety against sudden financial losses that may occur (Greuning, 2003).
Olalekan and Adeyinka (2013) have studied the effect of capital adequacy on the profitability of deposit-taking banks in Nigeria and assessed the effect of capital adequacy of both foreign and domestic banks in Nigeria on their profitability. The research showed a positive and significant relationship between capital adequacy and bank profitability. This implies that capital adequacy plays an important role in the determination of bank profitability for deposit-taking banks. Furthermore, Mehta and Bhavani (2017), in their research about the impact of various variables on banks’ profitability in the domestic commercial banking sector of the UAE, clearly indicated that the cost efficiency, maintaining a high capital adequacy ratio, and improving asset quality were the most significant variables that could impact the profitability of banks for all measures of profits.
Iloska (2014) specified that the strength and quality of capital influence and affect the profitability of the banks. Clearly, lower capital ratios imply higher leverage and risk leading to higher borrowing costs. Additionally, Flamini, McDonald and Schumacher (2009) said that capital is an important variable in determining the profitability of the banks and a well-capitalized bank could offer a signal to the market that a better-than-average performance could be expected from them. Indeed, well-capitalized banks are less risky and generate lower profits as they are perceived to be safer (Bikker & Vervliet, 2017).
Loan to Total Asset Ratio (LTAR)
According to Abiola and Olausi (2014), banks’ loan to asset ratio (LTAR) should be used in assessing the impact of loan activities on bank risk. The reason to do so is that bank loans are relatively illiquid and subject to a higher default risk other than the assets of the banks (Elliott, 2014). This will imply a positive relationship between LTAR and the risk measures. In contrast, Altunbas (2005) stated that a relative progress in banks’ credit risk management strategies might result that loan to total asset ratio is negatively related to its risk measure.
Total loans to total assets ratio (LTAR) is considered an indicator of liquidity and liquidity is very important in explaining bank profitability and loans are the main source of income and are estimated to have a positive impact on bank performance (Yao, Haris & Tariq, 2018). Much literature found a positive relationship between liquidity and profitability as a bank which holds a reasonably high quantity of liquid assets will probably obtain high profits (Menicucci & Paolucci, 2016).
Kithinji (2010) analyzed the effect of credit risk measured by the ratio of loans on total assets in Kenyan banks from 2004 to 2008. He found out that the bulk of the profits of commercial banks are not influenced by the amount of loan.
Profitability
Profitability also termed as financial performance. It is a measure of companies’ policies and operations in monetary terms (Verma, 2017). In fact, it is a general measure of a firm’s overall operation health over a given period of time and can be used to compare similar firms across the same industry or to compare industries or sectors in aggregation (Buvaneswari & Venkatesh, 2013). Basically, there are many ways to measure a companies’ financial performance. According to Ndung’U (2013), this may then be reflected in the firm’s return on investment, return on assets, value-added, among others and is a subjective measure of how a firm can use assets from its main mode of business and create revenues.
Abel and Le Roux (2016) examined the determinants of banking sectors’ profitability in Zimbabwe for the period 2009– 2014 and found out that the profitability of banking sectors is dependent on how effective they could manage their risks. Moreover, it has been shown that bank performance is not only influenced by bank-specific factors in their internal operations but also external factors such as the nature of the macroeconomic environment (Ayanda, Christopher & Mudashiru, 2013). They further state that profitability of the banks is influenced by the effective mitigation of the banking sectors in exposure to credit risk.
Buyinza (2010) pointed out that high profitability of the banks was linked with well-capitalized banks with well-organized management and the size of the bank. Banks’ profitability is the ability of a bank to generate revenue more than cost, in relation to the capital base of the bank. Furthermore, Athanasoglou, Brissimis and Delis (2005) stated that a competitive and profitable banking sector can withstand adverse situations and contribute to the firmness and stability of the financial system.
Moreover, Mishkin (2007) detailed that most of the financial industry, like other industries qre in business to earn profits by marketing its products. Besides, to maximize well the profits, according to Rajapathirana and Hui (2018), financial institutions must develop new products that would satisfy the needs of their own and those of the customers; in other words, innovation, which can be extremely helpful to the economy, is driven by the desire to get or stay rich.
The strength of the banking industry is an important prerequisite to ensure the stability and growth of the economy. Consequently, a better assessment of the financial condition of the banks is a fundamental goal for regulators (Halling ; Hayden, 2006). Besides, Tabari, Ahmadi and Emami (2013) have mentioned that the safety of banking system is depending on the profitability and capital adequacy of banks. Moreover, profitability is a determinant which shows the management of how competitive they are and in what positions the bank in market-based banking. This parameter helps the banks to tolerate some level of risk and support them against short-term problems (Sufian, 2009).
This view of the innovation course leads to the following simple analysis: A change in the financial environment will stimulate a search by firms for innovations that are likely to be profitable (Hofstrand, 2009). Companies are finding that many of the old ways of doing business were no longer profitable; the products and services they had been offering to the market were no longer selling (McNamee ; Selim, 1999). Indeed, to survive in the new economic environment, Banks must research and develop new strategies and ways that would mitigate credit risks and improve profitability (Li ; Zou, 2014).
Return on Capital
Return on capital (ROC) refers to as the profit on an investment and on how effective the management in receiving a return on their capital investment in relation to how much was invested (Heinzl, 2011). It is also known as return on invested capital or return on total capital. It is also a ratio used in accounting, finance and valuation that shows how effective a company has been at turning capital into profits (Hossan ; Habib, 2010). Furthermore, return on capital is a useful measure for comparing the relative profitability of businesses after factoring in how much capital was used and this allows the long-term investor to look for companies at a fair price (Damodaran, 2007).
Hosna, Manzura and Juanjuan (2009) asserted a statement about the credit risk management effects on performance which is generally measured through Return on Equity, which is majorly used for performance measurement; they also recognized the indicators of non-performing advances. Moreover, according to Stockton (2016), measuring return on capital is essential to an understanding, direction, and evaluation of the business. Furthermore, lack of understanding of these principles on applications can ruin a management.
Net Profit
According to Bragg (2017), Net Profit displays how much a firm has left in their revenue after deducting all the expenditures. Net profit helps people like managers budget gross profit levels into their prediction of profitability, not only that but also, according to Gibson (2009), its measures are used by auditors and the Internal Revenue Service to judge the accuracy of accounting systems. Moreover, it can also be used to estimate inventory involved in insured losses.
In practice, Net profit ratios are calculated by dividing net profit by revenue, thus having Net Profit / Revenue. There are two key ways to improve the net profit margin; first, increase the prices; second, decrease the costs to produce the goods (Merritt, 2018). Moreover, Net profit ratios determine how well or effective an institution in producing a profit in their operations. Indeed, one must always observe that the higher the net profit margin, the better and it must always be noted that there should be consistency on the high net profit margin to be able to say that that companies earning is stable (Vieira, 2010).

Theoretical framework
This study was premised on the risk-bearing theory of profit developed by Hawley (1900). It argues that the essential function of an entrepreneur is to take risks, a function that cannot be delegated to anybody else. It contends that profit is a reward for risk bearing. The theory further theorizes that some risks are inherent in every business enterprise in view of the speculative nature of business. Thus, in the business of banking, the management has to bear the risk in order to get profit being the reward for the risk-taking. As Hawley (1900) pointed out, the degree of risk varies in different businesses, yet there is a positive relationship between risk and profit.
This study also adapts the theory of Multiple Lending. In this theory, deposit-money banks can be less inclined to share lending which is in other word referred to as loan syndication. The theory can operate where there is a well-developed equity market and after a process consolidation. It is also noted that, both outside equity and mergers and/or acquisition enhances lending capacity of banks, thus minimizing the need for greater diversification and monitoring through share lending. The theory is highly applicable in commercial banks because their primary job is lending. In line with the theory of multiple lending, it is fundamental for commercial banks to assess their lending capacity prior to advancing any credit to prospective borrowers.

Conceptual framework

Figure 1. Conceptual Framework of the Study

The study aimed at determining the relationship of credit risk to the profitability of Commercial Banks in the Philippines. There are 2 variables presented, variable X and Y. In Figure 1, the credit risk as an independent variable, variable X, and Profitability as a dependent variable, variable Y. Credit risk comprises of non-performing loan ratio, capital adequacy ratio, and loan to total asset ratio. On the other hand, profitability comprises return on capital, and gross profit rate.

Chapter 3
Method
Presented in this chapter are the methods and procedures used to carry out this research work. Moreover, the necessary details on the instrument used in pursuing this study, the procedures performed in gathering the data, the research design used, the sample size used, and the statistical tool used for the analysis and interpretation of data are presented.
Research Design
A research design is of utmost importance when conducting research (Gorard, 2013). Appropriate research designs must be utilized to come up with appropriate results and conclusions. As for this study, the researchers utilized a correlational analysis research design, for this is deemed as the most proper method in determining the relationship between credit risk and profitability of Commercial Banks in the Philippines.
National Center for Biotechnology Information NCBI (2016) states that correlational research can be used to determine the relationships among variables. Thus, it is appropriate for the researchers to used correlation analysis since this design will help them determine that the relationship does or does not exist between different variables (Crossman, 2017).
Research Respondents
According to Polit and Hungler (1999), a population is a totality of all the objects, subjects or members that conform to a set of specifications. The target population is the entire group a researcher is interested in or the group about which the researcher desires to draw conclusions (Mugenda ; Mugenda, 2009). The population of this study includes all Commercial Banks operating in the Philippines before or during the year 2013 to the present. There are only twenty-two (22) registered commercial banks in the Philippines listed in the Bangko Sentral ng Pilipinas (BSP) for the year 2018, and only fifteen (15) of these registered banks started their operation before the year 2013. Hence, the remaining seven (7) Commercial Banks that started their operation later than 2013 will not be included in the population. For this reason, the researchers used total population sampling technique since this is deemed the most appropriate technique to use in analyzing small population. According to Crossman (2018), using the total population sampling technique will give more accurate and reliable findings and results. This means that the respondents were selected without bias and the statistical conclusion that can be drawn from the analysis of the sample is valid.
Research Instrument
Consistent with study of Sufian and Chong (2008); Ayanda et al. (2013); and Ongore and Kusa (2013), this study used secondary data from the published quarterly financial statements of the fifteen (15) commercial banks in the Philippines for the period 2013–2017 to estimate the relevant ratios and coefficients.
The researchers used research checklist to obtain secondary data necessary to conduct the research. The checklist contains the necessary data that is needed to compute the financial ratios to determine the relationship of credit risk to profitability of commercial banks in the Philippines. To ensure the validity and reliability of the research instrument, the checklist has been validated by the panel of experts.
Data Interpretation
This study used financial ratios to determine the relationship of credit risk to the profitability of commercial banks in the Philippines. The greatest advantage for using ratio for measuring banks’ performance is that it compensates bank disparities created by bank size (Samad, 2004).
The following formulas were used:
Non-performing loan ratio (NPLR).
NPLR = Non-performing Loans / Total Loan
Capital Adequacy Ratio (CAR).
CAR = Total Capital / Total Asset
Loan to Total Asset Ratio (LTAR).
LTAR = Total Loan / Total Asset
Return on Capital (ROC).
ROC = Net Profit / (Beginning Capital + Ending Capital) / 2
Net Profit.
Net profit = Gross Profit – Expenditures

Research method
To conduct a systematic study, the following steps were executed accordingly.
1. Permission to conduct the study. The researchers asked an approval, through a formal letter presented to the Dean of College of Accounting Education, to conduct the study.
2. List of commercial banks. After the necessary approval, the researchers got the list of commercial banks listed in the Bangko Sentral ng Pilipinas (BSP).
3. Obtain financial statement. After obtaining the list, the researchers collected financial statements of the commercial banks in the Philippines, from the published financial statements in BSP website, to obtain the necessary data for the study.
4. Validation of research instrument. The research instrument, checklist, has been validated by the panel of experts to ensure its validity and reliability.
5. Collection of data. This study used quantitative techniques in analyzing the data. After obtaining the financial statements from the BSP, the necessary data were extracted, tabulated and analyzed. Tables and charts were used for further representation for easy understanding and analysis.

6. Tabulation and Analysis. The data collected were thoroughly examined and checked for completeness and comprehensibility. The data were summarized and tabulated. Statistical tools were used to establish the relationship of credit risk to the profitability of Commercial Banks in the Philippines.
Statistical Tools
The following are the statistical tools to be used in the analysis and interpretation of the data.
Mean. This was used to describe the level of credit risk and profitability of Commercial Banks in the Philippines.
Min-Max. This is used to determine the highest and lowest level of credit risk and profitability of Commercial Banks in the Philippines.
Pearson’s R. This was used in determining the significant relationship in credit and profitability of Commercial Banks in the Philippines.

Chapter 4
Results and Discussion
This chapter contains the analysis and interpretation of the data gathered for this study. The primary objective of this study is to know the significant relationship between credit risk and profitability of Commercial Banks in the Philippines. To elaborate on the said objective, the researchers have provided tables and discussions that summarize the gathered data to fully understand and know the relationship between credit risk and profitability.
Table 1
Credit Risk of Commercial Banks in the Philippines
Credit Risk Min Max Mean
Non-Performing Loan Ratio 0.00 9.80 2.20
Capital Adequacy Ratio 3.04 30.36 12.88
Loan to Total Asset Ratio
18.35 88.45 50.53

Table 1 shows the level of credit risk of commercial banks in the Philippines and the analysis of the independent variables, Non-performing loan ratio; capital adequacy ratio; and loan to total asset ratio, or variable X of this study.
Non-Performing Loan Ratio (NPLR)
It shows that some commercial banks in the Philippines are very effective in terms of receiving repayments of the loans. This is indicated, for the last five years, by the minimum result of NPLR which zero. NPLR which is 6 percent and below are deemed healthy, but generally speaking, anything above 6 percent non-performing loan is undesirable (Ruziqa, 2013). This indicates that a maximum result of 9.80 NPLR means that some banks are not effective in receiving repayments of the loans. Nevertheless, Non-performing loan ratio of commercial banks in the Philippines is highly desirable because of an average of 2.2 percent NPLR.
This result implies that Commercial banks in the Philippines should focus on how they can effectively receive repayments of their granted loans to avoid accumulation of non-performing loan since making loans are the main service offered by the commercial banks which is where they derive their income (Li ; Zou, 2014). Besides, Adam (2014) mentions that NPL is considered losses when happens. This means that higher NPLR means higher losses. Thus, Anjom and Karim (2016) said that a good management of NPL where banks can effectively receive repayments of the granted loan would positively result in a better financial performance.
Capital Adequacy Ratio (CAR)
The risk-based capital adequacy ratio (CAR) of commercial banks, expressed as a percentage of qualifying capital to risk-weighted assets, shall not be less than ten percent (Bangko Sentral ng Pilipinas, 2015).
Table 1 indicates that some banks do not conform to the standards. This means that some commercial banks with low CAR have the difficulty in coping up with their losses which explains why there are some quarters that some banks have negative profit margin. Nonetheless, commercial banks reach the average of 12.88 percent of CAR which means most of them to conform to the standard.
Thus, commercial banks should have an adequate capital which is at least 10 percent since capital adequacy ratio has a positive relationship to profitability (Flamini et al., 2009). Conforming to the requirements set by the Banko Sentral ng Pilipinas would help the commercial banks to avoid bankruptcy. As Posner (2014) said, CAR ensures the efficiency and stability of financial system of the nation by lowering the risk of banks in becoming insolvent. Also, CAR does not only measures the adequacy of the banks to absorb future losses but it also guarantees that, according to Abiola and Olausi (2014), a higher capital adequacy ratio means that banks can create more loans and therefore record better profitability.
Loan to Total Asset Ratio (LTAR)
Banks with higher loan to total asset ratio have high exposure to credit risk (Ghenimi et al., 2017). The table shows that the maximum of LTAR of commercial banks is 88.45 percent this indicates that most of the commercial banks in the Philippines are more expose to credit risk. The same conclusion can be drawn in the average LTAR.
This infers that LTAR could be the cause of higher NPL of commercial banks since commercial banks are more expose to credit risk the risk of having non-performing loan is not that far. In fact, Abiola and Olausi (2014) cited that banks’ loan to asset ratio are positively related to the risk measure of banks. The more risky the bank the more profitable it can be Hawley (1900). In contrast, Kithinji (2010) found out that the bulk of the profits of commercial banks are not influenced by the amount of loan and exposure to credit risk. This means that commercial banks should assess when to take risk and when to avoid it. Commercial banks should learn how to manage their risk, more specifically credit risk. Thus, Stulz (2014) mentioned that the role of risk management in a bank is not to reduce the bank’s total risk per se. It is to identify and measure the risks that the bank is taking; aggregate these risks to measure the total risk. This would enable the bank to eliminate, mitigate and avoid bad risks, and ensure that its level of risk is consistent with its desired risk.
Figure 2. Credit Risk of Commercial Banks
Figure 2 depicts the level of credit risk of commercial banks from the year 2013-2017 as displayed from the data above. From this, it can be observed that the trend of the various indicators of variable X illustrates different movements. For non-performing loan ratio, it can be observed that there was almost no movement showing whether its level of credit risks keeps increasing or decreasing. Not like capital adequacy ratio wherein from the year 2013, its level of credit risks soars high until the year of 2015 where it suddenly declined until the latest year of 2017. In contrast with capital adequacy ratio trend of soaring to declining, loan to total asset ratio displayed reversed trend. From the year 2013, its level of credit risks falls down yet eventually increased without backing off up until the year of 2017.
The trends or movements of level of credit risks is a proof of how desirable the performance of the commercial banks is depending on its various indicators as the variables X. Though there was no benchmark regarding how desirable credit risk is being observed by the commercials banks, it is believed that if non-performing loan ratio is within 6 percent or below, it is considered desirable. Thus, clearly from the ratios above, for 5 consecutive years, commercial banks are highly effective in terms of receiving repayments for loans or its level of credit risk is desirable. The same from non-performing loan ratio, capital adequacy ratio is in conjunction with the prescribe limit from the Bangko Sentral ng Pilipinas (BSP) which states that it’s desirable to have a capital adequacy ratio of not less than 10 percent.
Thus, looking for its trends of ratios, it is safe to say that the commercial banks were also observing favorable level of credit risk under capital adequacy ratios. In contrast with non-performing loan ratio and capital adequacy ratio, loan to total asset ratio depicts that from the years 2013 to 2015, the level of credit risk of commercial banks is favorable but as the year goes on, it can be observed that from 2016 onwards the commercial banks are more exposed to credit risk as indicated by their LTAR of more than 50 percent.
This means that the three ratios are connected with each other. This implies that commercial banks should give their attention to NPLR, CAR and LTAR, since these ratios are related to the risk measure of the bank specifically credit risk. Besides, Siamat (2005), Gaiya (2016) and Menicucci and Paolucci (2016) mentioned that these three ratios indicates the risk of the banks of having a default in loans and positively related to profitability.

Table 2
Profitability of Commercial Banks in the Philippines
Profitability Min Max Mean
Return on Capital -3.99 14.42 5.34
Net Profit In Millions of Peso In Millions of Peso In Millions of Peso
(32.198) 1,728.598 356.541

Table 2 depicts the profitability of commercial banks in the Philippines in terms of return on capital and net profit which are both considered dependent variable or variable Y of the study.
Return on Capital
Based on the above data, it indicates that there are commercial banks that are not receiving any return in capital, instead their capital decreases. This is supported by the minimum return of capital which is -3.99 percent. On the other hand, there are commercial banks that are highly effective in terms of receiving return in their capital which is indicated by the maximum ROC of 14.42. But in general, an average of 5.34 ROC indicates that commercial banks are considered effective in receiving returns in their capital.
Return on capital (ROC) refers to as the profit on an investment and on how effective the management in receiving returns in their capital investment in relation to how much was invested (Heinzl, 2011). This implies that commercial banks should focus their attention in having a good return in their capital investments to have a better performance in the industry. Having a good ROC means that banks are using their capital in an efficient manner (Maverick, 2015). Moreover, having a good financial performance in the financing industry would invite more investors to invest (Hummel, 2017).
Net Profit
According to Bragg (2017), Net Profit displays how much a firm has left in their revenue after deducting all the expenditures. Table 2 indicates that some banks are losing while others are doing very well, but in general, commercial banks are doing well because of a positive net profit in an average of 356 million for the past five years.
Net profit determines how well or effective an institution in producing profit in their operations. Moreover, the higher the net profit the better and it must always be noted that there should be consistency on the high net profit margin to be able to say that that company’s earning is stable (Vieira, 2010). This indicates that a bank to be perceived as financially stable, they should have a positive net profit and a better financial performance. Commercial banks should maximize their resources and optimize their operation to arrive in a more profitable environment.

Figure 2.1 Profitability of Commercial Banks by Return on Capital

Figure 2.1 illustrates the profitability of commercial banks from the year 2013 to 2017 in terms of return on capital (ROC). From the data above, it can be observed that return of capital of commercial banks in 2013 is very high with a ratio of 12.02. However, in the year 2014 ROC suddenly decrease to 5.13 and gradually decreasing until 2016. This means that commercial banks are consistently having a diminishing return. Nevertheless, they are still effectively having a good return as indicated by a positive ratio. Moreover, in the year 2017, commercial banks started to increase their ROC to 3.83 which is a good sign of profitability.
This trend implies that commercial banks should assess the causality of the diminishing return they have experienced in order to maintain a good return on capital. Besides, Elliott (2016) mentioned that as a company’s equity grows, it become a challenge to them to maintain a high ROC. He further states that a high ROC may elevate the capability of the company to grant more credits.

Figure 2.2 Profitability of Commercial Banks by Net Profit
Figure 2.2 illustrates the profitability of commercial banks from the year 2013 to 2017 in terms of net profit. From the data above, it can be observed that net profit of commercial banks in 2013 is very high which is above 350 million, an average net profit of commercial banks in the Philippines. However, in the year 2014 net profit suddenly decrease to 236 million and gradually decreasing until 2016. This means that commercial banks are consistently having a declining net profit. Yet, they are still successfully having a good performance as indicated by a positive net profit. Furthermore, in the year 2017, commercial banks started to elevate their net profit above the average which is a good sign of profitability.
Thus, commercial banks should maintain this sound financial performance to become more competitive in the financing industry. Additionally, having a good financial performance in the financing industry would invite more investors to invest (Hummel, 2017); therefore more income could be expected. Moreover, profitability is a key to determine if the company would survive as a corporate entity and grow. Growth is key to be profitable and a long-term success of the entity (Maverick, 2016).

Table 3
Relationship of Credit Risk and Profitability of Commercial Banks
Credit risk Profitability
Net Profit Return on Capital
r-value p-value Interpretation r-value p-value interpretation
Non-Performing Lon Ratio 0.006 0.983 Not Significant 0.139 0.622 Not Significant
Capital Adequacy Ratio 0.279 0.315 Significant 0.015 0.959 Not Significant
Loan to Total Asset Ratio 0.082 0.771 Not Significant 0.134 0.633 Not Significant
Overall 0.148 0.599 Not Significant 0.092 0.745 Not Significant

The independent variables of the study are NPLR, CAR, and LTAR. The value of probability tells about the significant and insignificant results. Based on P-value, the acceptance and rejection of null hypothesis is explained. The significance level for rejection of null hypothesis is, P-value is below than 0.05, but if P-value is above than 0.05, then null hypothesis will be accepted. R-value and P-value of NPLR, CAR, and LTAR with ROC and net profit is shown in Table 3.

Relationship of NPLR to Profitability:
P-value of NPLR is 0.983 with Net Profit and 0.622 with ROC. Its means NPLR result is not significant to profitability but the positivity and negativity of relationship of independent variable NPLR is stated by r-value. The r-value of NPLR is 0.006, (0.6%), for Net Profit and -0.139, (-13.9%) for ROC which means that positive relationship exists among NPLR and Net Profit and negative relationship exist among NPLR and ROC. It states that when NPLR of commercial banks in the Philippines is increased it results in increase in Net Profit and 0.006 means when NPLR is increased by 1 percent; it results in increase in Net profit by 0.6 percent. In contrast, when NPLR of commercial banks in the Philippines is increased it results in decrease in ROC and 0.139 means when NPLR is increased by 1 percent; it results in decrease in ROC by 13.9 percent.
However, the result of the study is similar to previous studies of Epure and Lafuente (2012). Further, In Costa-Rican banking sector, Kargi (2014) conducted study in Nigeria; Ara et al. (2009) in banking sector of Sweden; and study of Iftikhar (2016). These researchers have found a negative relation between Non-Performing loan ratio and Return on Capital. It can be concluded from previous researches NPLR is a financial indicator that demonstrates the quality of bank loans. Commercial banks showed themselves to the risk of default or delay in payment of borrower of loans. The core activity of commercial banks is to generate loans.
Banks generate money from a series of activities of deposit and borrowing. NPL is considered as losses when happens. Higher NPLR means higher losses, which adversely influence the banks’ available capital and assets for further borrowing. Hence, the efficiency of banks’ investment is affected, further influencing the profitability. In contrast lower NPLR is linked with the lower risk and deposit rate, meaning a positive impact on banks’ operations. Similarly, higher NPLR led toward negativity in profitability of financial institution (Gizaw et al., 2015).
Relationship of CAR to Profitability:
P-value of CAR is 0.315 with Net Profit and 0.959 with ROC. Its means Capital Adequacy Ratio result is significant to Net Profit but not significant to ROC. The r-value of CAR is – 0.289, (-27.9%), for Net Profit and -0.015, (-1.5%) for ROC which means that both negative relationship exists among CAR, Net Profit and ROC. It states that when Capital Adequacy Ratio of commercial banks in the Philippines is increased it results in decrease in Net Profit and ROC. This means that when CAR is increased by 1 percent, it results in a decrease in Net Profit of 27.9 percent and 1.5 percent for ROC.
However, the result of this study is similar to the study of Almazari (2013) entitled “Capital Adequacy, Cost Income Ratio and the Performance of Saudi Banks”. His research found negative relationship among CAR and banks profitability. Moreover, there are several studies that have shown the importance of capital in the banking sector.
According to study of Morgan (1984), the importance of capital adequacy has high importance for commercial banks. He further stated that Commercial banks have a legal responsibility to retain the sufficient capital adequacy ratio. In addition, Benczur et al. (2017) cited that the major task of the bank is to make available sufficient funds required to absorb potential future losses because it show financial strength of financial institution. This is predetermined in Basel II Accord, which is implemented on banks that is about how much minimum capital (10%) they need to place aside to show against these kinds of operational and financial risks that they generally face (Gottschalk, 2007).
Relationship of LTAR to Profitability:
P-value of LTAR is 0.771 with Net Profit and 0.633 with ROC. Its means LTAR result is not significant to profitability. The r-value of LTAR is – 0.082, (-8.2%), for Net Profit and 0.134, (13.4%) for ROC which means that a negative relationship exists among LTAR and Net Profit and a positive relationship among LTAR and ROC. This means that when LTAR is increased by 1 percent, it results in a decrease in Net Profit of 8.2 percent and an increase of 13.4 percent for ROC.
LTAR measures the exposure level of the Bank to credit risk. Banks with higher loan to total asset ratio have high exposure to credit risk (Köhler, 2012). This indicates that commercial banks should mitigate their exposure to credit risk to gain more profit but the result indicates LTAR is not significant to profitability the same result to the study conducted by Altunbas (2005); he found out that LTAR is related to the risk measure of the bank but does not affect its performance. Nevertheless, commercial banks should manage their LTAR because somehow its affects its profitability but not in a significant manner.

Relationship of Credit Risk to Profitability:
P-value of credit risk is 0.599 with Net Profit and 0.745 with ROC. Its means credit risk result is not significant to profitability. The r-value of credit risk is -0.148, (-14.8%), for Net Profit and 0.092, (9.2%) for ROC which means that a negative relationship exists among credit risk and Net Profit and a positive relationship among credit risk and ROC. This means that when credit risk is increased by 1 percent, it results in a decrease in Net Profit of 14.8 percent and an increase of 9.2 percent for ROC.
The result indicates that commercial banks should create more loans in order to gain more profit. Besides, Wener, 2014 states that the more loans the banks could make the more interest they can derive from it; in which where they derive their profit. Nevertheless, even though credit risk does not significantly related to profitability it does not mean that commercial banks should just let themselves expose to credit risk. Alshatti (2015) said that through effective management of the exposure of the banks to credit risk, they do not only support the viability and profitability of their own business, but they also contribute to the systemic stability and to an efficient allocation of capital in the economy.
The overall result for credit risk is similar to the study of the following researchers: Adeyefa, Kayode, Obamuyi, and Owoputi (2015); Credit Risk and Bank Performance in Nigeria, Kithinji (2010); Credit Risk Management and Profitability of Commercial Banks in Kenya, and Ruziqa (2013); The Impact of Credit and Liquidity Risk on Bank Financial Performance: The Case of Indonesian Conventional Bank with Total Asset above 10 Trillion Rupiah. They result similarly indicates that credit risk is negatively related to commercial banks’ profitability.
Nevertheless, Kaaya and Pastory (2013) states that performance of banks can be enhanced if there is existing efficient credit risk management. A number of credit risk management strategies should be developed to minimize or completely mitigate the bad impacts which affect the bank performance arises as result of credit risk. However, a good framework for credit risk management is basic necessity for survival of bank and growth of their profits (Kolapo, et al., 2012).