- BACKGROUND OF THE STUDY
Risk is the possibility of loss or the chances of loss resulting from unfortunate occurrence or event. Risk is always at the center of our life. This means that for every human endeavor, there is risk as a result of our different economic pursuit. Risk management is the process of identifying risks, assessing their implications, deciding on a course of action, and evaluating the results. It is at the core of lending in the banking industry. Risk management introduces the idea that the likelihood of an event happening can be reduced, or its consequences minimized. Effective risk management seeks to maximize the benefits of a risky situation while minimizing the negative effect of the risk. According to Njogo (2012), risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events. Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary. Risk management ensures that an organization identifies and understands the risks to which it is exposed.
In one of his speeches, the former CBN Governor, Soludo (2004) made it known that Nigerian banking system today is fragile and marginal. Deposit money banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks, (Anthony ,2010). Adequately managing credit risk in financial institutions is critical for the survival and growth of the financial institutions. Abdullahi (2013) posits that, in the case of banks, the issue of credit risk is even of greater concern because of the higher level of perceived risks resulting from some of the characteristics of clients and business conditions that they find themselves in.
According to Dwayne (2004), banks originate for the main purpose of providing a safe storage of customer’s cash. He argued that since this money received from the customers was always available to the bank, they later put it to use by investing in assets that are profit earning. Thus, the practice of advancing credits. Banks are in the business of safeguarding money and other valuables for their clients. They also provide loans, credit and payment services such as checking accounts. The intermediating roles of the money-deposit banks places them in a position of “trustee” of the savings of the widely dispersed surplus economic units as well as the determinant of the rate and the shape of economic development. The techniques employed by banks in this intermediary function should provide them with perfect knowledge of the outcomes of lending such that funds will be allocated to investments in which the probability of full payment is certain.
Unarguably, financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counter parties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counter parties. Therefore, credit risk management needs to be a robust process that enables Financial Institutions to proactively manage facility portfolios in order to minimize losses and earn an acceptable level of return for shareholders Dandago (2006).
Lending is the principal business activity for most deposit money banks. The loan portfolio is typically the largest asset and the predominate sources of revenue. As such, it is one of the greatest source of risk to a bank’s safety and soundness. Effective management of the loan portfolio’s credit risk requires that the board and management understand and control the bank’s risk profile and its credit culture. To accomplish this, they must have a thorough knowledge of the portfolio’s composition and its inherent risks. They must understand the portfolio’s product mix, industry and geographic concentrations, average risk ratings, and other aggregate characteristics. They must be sure that the policies, processes, and practices implemented to control the risks of individual loans and portfolio segments are sound and that lending personnel adhere to them (Imeokpararia, 2013).
Risk is an essential part of business because firms cannot operate without taking risks. Risk is commonly associated with uncertainty, as the event may or may not occur. Risk implies exposure to uncertainty or threat (Kannan and Thangavel, 2008). Olajide, (2013) explains that recent economic volatility gives risk management a new focus and eminence. Successful firms are able and willing to effectively integrate risk management at all levels of management process.
Traditionally, risk has been viewed as negative consequences and unfavorable events. The consideration of risk from the negative perspective is restrictive and misleading for two main reasons. First, uncertainty may manifest in either negative (threat) or positive (opportunity) form, or both; and second, the way a risk is perceived influences the manner in which it is handled (Hillson, 2002). Managing risks from negative perspective may result to complete omission of opportunities (benefits/gains) in the event being considered. However, perspectives on risk differ, as the risk definition depends on and is affected by the risk observer (Kelman, 2003). Moreover, risk sometimes entails some economic benefits, as firms may derive considerable gains by taking risk. Business grows through greater risk taking (Drucker, 1977). Risk is, therefore, integral to opportunities and threats which may adversely affect an action or expected outcome (Kaye, 2009; Lowe, 2010). Getting rid of risk undermines the source of value creation; which truncates potential opportunities. Hillson and Murray-Webster, (2011) write that, in essence, to business enterprise, risks are ‘uncertainty that matter’.