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Chapter 2

Literature review

Theoretical Literature:

Several theories exist in the literature that explain the credit and liquidity risk

management.one of the theory of liquidity risk management is Anticipated Income Theory

This theory argue that a bank’s liquidity can be managed through the right phasing and

structuring of the loan commitments made by a bank to the customers. The liquidity can be

planned if the scheduled loan payments by a customer are based on the future of the borrower.

According to Nzotta (1997) theory emphasizes the earning potential and therefor the credit

worthiness of a borrower because the ultimate guarantee for ensuring adequate liquidity.

Nwankwo (1991) suggests that the theory points to the movement towards self-liquidating

commitments by banks……… one of the other theory of liquidity risk management is The

Shift Ability Theory This theory is based on the proposition that the assets that the banks
hold may be sold to other lenders or investors or shifted to central bank, which is ready to buy the

assets offered for sale……..

Several factors explain by literature which become the reasons of credit risk in banking system.

Leverage (LEV) is one of the reason of credit risk. In banking and finance, leverage is defined as a

technique concerning the use of borrowed funds in the purchase of an asset, with the

anticipation that the after-tax income from the asset and asset price appreciation will exceed

the borrowing cost.

Management efficiency (MGT) is another factor this efficiency ratio measures a company's

ability to use its assets to generate income. Some common efficiency ratios are accounts
receivable turnover, fixed asset turnover, sales to inventory, sales to net working capital,

accounts payable to sales and stock turnover ratio.

Risk-weighted assets (RWA) are a bank's assets or off-balance-sheet exposures, weighted

according to risk. This sort of asset calculation is used in determining the capital requirement or

capital adequacy ratio for a financial institution. Therefore, above mentioned elements are

reliant on credit risk.

Empirical literature:

Imran Khan;Mehreen Khan and Muhammad Tahir (2017) did a study in Pakistan. He selected 5

Islamic and 19 conventional banks and data collected from 2007 – 2014. He uses sample t-test

and logistic regression to determine the impact of risk on profit. The result show that Islamic

banks are better at profitability, efficiency, and liquidity management. On the other hand,

conventional banks are higher in asset quality………

Saeed and Zahid (2016) conducted a study in UK. He selected 5 conventional banks and

data collected from 2007 to 2015. He uses correlation model and see the impact of CR on

profitability of the commercial banks. Study conclude that credit have influence on bank

profitability, and all factors including non-performing loans, growth, leverage and bank

size are +ve correlated with ROA. Credit risk also +ve correlated with ROE………

Dr. Mahmood Ali (2018) This study investigated the profitability of Islamic and Conventional

banks in Pakistan for the period 2008 – 2012, using a cross-sectional time-series (panel data).

The sample contains 17 conventional and 5 Islamic banks. The Liquidity does not play a

significant role to account profitability for both types of banks. The results were insignificant for

all the variables and for all the type of banks. Credit Risk is more significant for Conventional

banks than Islamic Banks.

Nevine Sobhy Abdel Megeid (2017) this study aims to analyze and compare the

effectiveness of liquidity risk management of Islamic and conventional banking in Egypt

to determine which of the two banking systems are performing better. A sample of 6

conventional banks (CBs) and 2 Islamic banks (IBs) in Egypt was selected. Using the

liquidity ratios, the investigation involves analyzing the financial statements for the period

of 2004-2011. The study have found that in Egypt, CBs perform better with respect to

liquidity risk management than IBs ……..

Oluwatobi Fagboyo; Abayomi Adedeji and Anjola Adeniran (2018) this research seeks to study

the impact of liquidity management on profitability within the Nigerian deposit money banks.

This will include a ten-year period (2007-2016). Five banks have been selected to represent the

number of people of the twenty-four deposit money banks in Nigeria. The liquidity indicators

square measure quick ratio, cash ratio, current ratio and liquidity coverage ratio, while return on

equity (ROE) and return on assets (ROA) were uses for profitability. The Regression analysis was

used to test the hypothesis. Findings show that liquidity management has a significant impact on

the performance of deposit money banks The empirical results also shows that a rise within the

quick ratio of accessible funds results in a rise within the profitability, where a rise within the

cash ratio and the liquidity coverage ratio results in reduction within the profitability of the

deposit cash banks in Nigeria……….

Tanveer Bagh; Sadaf Razzaq; Tahir Azad; Idrees Liaqat and Muhammad Asif Khan (2017)

conducted a study of banks in Pakistan and data collected from 2006 – 2016. The secondary

financial data obtained from audited annual financial reports were analyzed using descriptive

and inferential statistics. Return on assets (ROA) and Return on equity (ROE) are used as

measures of bank’s profitability whereas, Current Ratio (CR) advances to deposit ratio (ADR),

Cash deposit ratio (CDR) and Deposit Assets Ratio (DAR) are used to measure liquidity
management. The result shows that ADR, CDR and DAR have positive and significant impact on

ROA, while negative and significant impact on ROA. CR, ADR, CDR and DAR have positive and

significant impact on ROE………

Kabir; Md Nurul; Worthington; Andrew; Gupta and Rakesh (2015) In this paper, we look at credit

risk levels in Islamic banks and conventional banks globally. One problem with existing studies is

that the use of accounting information alone to assess credit risk, and this will be especially

misleading for Islamic banks. Using a market-based credit risk , Merton’s distance-to-default

(DD) model, we examined the credit risk of 156 conventional banks and 37 Islamic banks across

13 countries between 2000 and 2012. We also calculate the accounting information-based Z-

score and nonperforming loan (NPL) ratio for the aim of comparison. Our results show that

Islamic banks have significantly lower credit risk than conventional banks as support DD. In

contrast, and as predicted, Islamic banks show much higher credit risk using the Z-score and NPL


Independent Variable:

Credit Risk:

 Non-Performing Loan (NPL) ratio as credit risk (Abiola and Olausi, et al 2014;

Akram and Rahman, et al 2018; Fidanoski, Choudhry, Davidovic and Sergi et al


 “In banking studies, the loan is classified as NPL when the payment of interest

and principal are overdue by 90days or more” (Misman, Bhatti, Lou, Samsudin

and Rahman, 2015)

Liquidity Risk:

Liquidity Management Practices is used as an independent variables and to measures

Liquidity Management Practices four ratios i.e. Current Ratio, Advances to deposit ratio

,Cash deposit ratio and Deposit Assets Ratio to be used.

Dependent Variable:

 Profitability as return on equity (ROE) (Abiola and Olausi, et al 2014; Akram and

Rahman, et al2018).


 Ho: There is no impact of credit risk on IB’s Profitability.

 Ho: There is no impact of credit risk on CB’s Profitability.

 Ho: There is no impact of liquidity risk on IB’s Profitability.

 Ho: There is no impact of liquidity risk on CB’s Profitability.

 The performance of CBs is better in comparison with IBs regarding their CRM