Impacts of non-performing loan on financial performance of commercial banks in Ethiopia

Abstract

Banks while making profits, encounter several risks. Nowadays, one of the most important risks is default risk, which leads to increase in non-performing loans (NPLs). As the lending process affects not only the banking activity, but also the development process, risks should be avoided as much as possible. Hence, addressing NPLs is essential for fostering a healthy lending environment and supporting sustainable economic development. This study was conducted to examine the impact of Non-Performing Loans on financial performance of ten sampled Commercial banks of Ethiopia, based on panel data analysis from the time period of 2008 to 2022. The secondary data were collected from National Bank of Ethiopia (NBE) and World Bank World Development Indicators. To achieve the intended objective this study employed descriptive and econometrics techniques. The empirical investigation uses the accounting measure of Return on Assets (ROA) which is the dependent variable used to represent Banks’ performance, while bank specific and macroeconomic factors as an independent variables. Furthermore, based on the diagnostic test conducted fixed effect model (FEM) was appropriate to examine the determinants of financial performance of commercial banks. Based on the research findings, the results of balanced fixed effect panel data regression analysis showed that Non-performing loans and Gross Domestic product (GDP) had a negative regression coefficient and statistically insignificant impact on financial performance of commercial banks in Ethiopia. While, lending interest rate had negative and statistically significant impact on financial performance of commercial banks in Ethiopia. On the other hand, the study result shows that firm size, liquidity and deposit rate had positive and statistically significant impact on financial performance of Commercial banks in Ethiopia. The positive and significant effects of bank size, liquidity & deposit rate suggest that larger banks with ample liquidity and attractive deposit rates tend to exhibit stronger financial performance. These findings emphasize the importance of scale, liquidity management and deposit mobilization strategies in bolstering profitability and stability within the banking industry. Commercial banks in Ethiopia are encouraged to adopt a holistic approach that addresses both internal and external factors affecting financial performance. This includes optimizing operational efficiency, diversifying revenue streams, enhancing credit risk management practices and engaging with policymakers to advocate for conducive regulatory environments.