THESIS TOPIC:ANALYSIS OF CREDIT RISK MANAGEMENT AND ITS IMPACT ON THE PROFITABILITYOF BANKS AND LENDING TO THE EMERGING OIL AND GAS SECTOR IN GHANACHAPTER ONEINTRODUCTION1.1 BACKGROUND OF THE STUDYSincethe divulgence of oil and gas in the Western district of Ghana, mostaccomplices essentially family unit, have come into conclusion and of the viewthat, most Ghanaians would enhance themselves in the briefest possible timeneglecting the perils related with the freshly discovered business and genuineplayers. We have seen genuine troubles and money related risks thatoil-conveying countries like Nigeria have looked consistently.
In Ghana,political affiliations including the organization and other criticalaccomplices have quite recently checked their benefits without forming thewants of the all-inclusive community. Banks,the major and key stakeholder(s) in both the upstream and downstream oil andgas expect the principle part in managing their investors’ values and thedangers related with the exploration and production of oil and gas. Banksfinancing part in the oil and gas industry at all levels makes them exposed tocredit risk in their day-to-day business. Ghana, for a couple of years, hasquite recently been a net buyer of oil and other oil-related merchandise howeverwith the disclosure and creation of oil in commercial quantities goes with itsown particular advantages and threats to players related with the “blackgold”. Thiswork twists up evidently essential to reveal the potential credit risk to thebanks as around 85% of banks in Ghana now trade oil and oil-related activitiesas part or whole business line as their inside business operations. I am alongthese lines persuaded that various banks without much introduction in the oiland gas trading activities in the developing sector may be caught by seeing financialbooms and face troubles if the idea of credit risk and management related withthe sector are not identified and well understood and the necessary strategiesadapted to mitigate against such happenings in order to prevent losses. Theconsequences of not alleviating and overseeing dangers are enormousmisfortunes, for example, the end result for Barings Bank Plc in 1995. BaringsBank Plc collapsed because of its inability to meet the gigantic exchangingcommitments that a staff uncovered for the benefit of the bank.
Myprimary objective is to identify appropriate credit risk management practices andits effect on banks profitability and be able to show how these effects affectsuch an emerging and young market. In achieving this objective, I will aim attackling the following issues;The nature of credit risks in the oil and gas industry and banking sector.Risk management practices and its effect on banks profitability.Relationship between the credit risk to banks and lending to the emerging oil and gas sector. Iplan to examine the current risk and its effect on the profitability of banksand also credit risk impact on lending to the oil and gas sector in Ghana andfurthermore able to recognize proper procedure or rules as build up guide onexisting credit risk policies for managers and bank staffs for smooth operationalflow.
The guidelines shall be consistent with sound and prudent bankingpractices applicable on the global front. 1.2 PROBLEM OFSTATEMENT:Oilis clearly the most significant commodity on the planet, it can be upbraid orblessing to nations if not properly oversaw, at any rate, and the ‘Dutchdisease’ is still new in literature.
The ‘black gold’ on the planet is withouta doubt the biggest source of energy presently. It is situated among the mostflighty non-horticultural items, particularly lately. Over the span of the lastfive (5) years, oil prices dropped from 110 USD/barrel in April 2014 to 64USD/barrel in June 2015 and furthermore dropped to 50 USD/barrel in August2016.
The present oil value remains at 56.63 USD/barrel (47.66 EUR/barrel) asat September 2017.
This evident example shows how unpredictable oil price canbe. In spite of the way that the oil price is an imperative source of instabilityon the global economy, it isn’t a measure of credit risk, fear or a check offuture financial wellbeing in the oil production and exploration areas, relatedsectors, for instance, the natural gas, utility, chemicals and auto sectors, orthe security markets. Credit Default Swaps (CDS) for these oil and oil-relatedsectors measure expected credit risk, fear and the future fiscal quality ofthese areas, which is noteworthy information that the oil price may quantify.Risk management practices impact banks profit and increase firm’s value and maydiminish financial distress.
Risk management is considered as an estimatingtool determining banks failure or success. As commercial banks in Ghana looksfor opportunities to invest their capital and their investor’s value, theenergy sector (oil and gas) turns into an emerging business sector foropportunities and also dangers as they are exposed to credit and counterpartyrisks. This work seeks to bring to limelight, the need for Banks to criticallypay attention to credit risk management practices while achieving profitability.The problem of this study is to identify the potential credit risk to the banksand its effects on banks profitability as about 70%-80% of banks in Ghanacurrently trade in oil and oil related activities as part or wholly businessline as their core business operations. Therehas been a general conviction that the banking sector in Ghana is decentlyenduring with individual banks having great risk profiles and sound riskadministration structures. The banking industry had not experienced any misfortunesin the face of the global financial crisis until recently, the collapse of UTBank Ghana limited and Capital Bank Ghana limited which has subsequently beenacquired by Ghana Commercial Bank. Some financial analyst and experts haveblamed huge outstanding debts owed to the banking sector by various energycompanies such as Tema Oil Refinery (TOR), the Volta River Authority (VRA), theElectricity Company of Ghana (ECG) and the Bulk-oil Distribution Companies(BDCs) as a severe strain on the banking sector of which UT and Capital banksfall a victim. Additionally, the industry throughout the years has seenworsening asset quality in the face of weak macroeconomic factors such asdepreciating of the local currency, high inflation rates and interest ratesresulting in high default rates of major players in the energy sector (oil andgas).
Moreover, there has, however, not been any major test to ascertain theresilience of the banking industry to withstand major shocks until recentpolicies by the Bank of Ghana to increase minimum capital requirements of banks.There is, in like manner, a vacuum between the general conviction on the riskposition of the Ghanaian banking industry and the evidence to back this conviction.It is also experimental that different banks without much introduction in theoil and gas business in the emerging sector might be gotten by seeing financialbooms and face challenges if the nature of credit risks and management relatedwith the sector are not recognized and relieved against such happenings rememberingto avert financial distress. 1.
3 RESEARCHQUESTION:Amongother risks faced by banks, credit risk plays an important role on banks’financial performance since a large chunk of banks’ revenue accrues from loansfrom which interest margin is derived (Kolapo, Ayeni & Oke, 2012, p.31). Isubsequently mean to look at the connection between credit risk management inthe emerging oil and gas industry and its impact on the profitability of banksand also the connection between credit risk to banks and lending to the oil andgas sector.
There has not been an unmistakable research that has possessed thecapacity to set up the connection between credit risk management and banks profitabilityand in addition lending to oil exploration and production (E&P) companies.Tohave the capacity to secure the information of the impact of risk managementpractices on banks profit and look at the connection between credit risk tobanks and lending to E&P companies, I offer the following researchquestions: To what extent are Banks in Ghana exposed to credit risks in the emerging oil and gas industry?What is the relationship between credit risk management and the profitability of commercial banks in Ghana?What is the relationship between credit risk to banks and lending to oil E&P companies?What monitoring tools or actions should be adopted in managing credit risk exposures to banks in the oil and gas industry? 1.4 SIGNIFICANCE OFTHE STUDY:Theresearch topic is vital to the overall awareness and success of commercialbanks in Ghana in the wake of Ghana developing its oil and gas sector and willbring the following to bear on the banking sub-sector. The fundamental reasonis to analyse how credit risk management of the oil and gas industry will impactthe productivity of banks in Ghana and also loaning to the oil and gas E&P companies.In breaking down this impact, it is essential to build up whether there is aconnection between the factors or not.
The real issue is the indicators ofcredit risk management and profitability as well as debt repayment capacity ofE&P companies. I intend to use capital adequacy ratio (CAR) andnon-performing loan ratio (NPLR) as the variables to represent credit riskmanagement and ROE and ROA as variables to measure commercial banks’ profitability.Since credit risk to banks that finance oil E companies arises from theability or inability of the E borrower to repay debt with operating cashflow generated from production and sale of oil and natural gas (source: https://occ.gov), Net operatingcash flow of E companies will be used as the variable to represent repaymentcapacity of E borrowers. After examining the existence of a relationship,I will intend to establish the effects of the relationship. Moreover,the work can become a guide to help improve corporate supervisory roles in banksin-house credit risk management units and an insight to improving riskmanagement practices understanding of other stakeholders and players in the oiland gas industry. The work is also significant in fulfilling the University ofSiena requirement of awarding me MSc Finance degree. 1.
5 RESEARCH GAPAND CONTRIBUTION:Asproven, banks’ strength plays a vital role in the stability and growth of aneconomy. Ghana’s oil and gas sector willreceive boost and develop with the strength of banks. And the stability ofbanks depends on the profitability and capital adequacy (Tabari et al., 2013,p.
1624). Studies relating to banks profitability have made us mindful of thelacking conclusion of relationship between credit risk management and banksprofitability. Most researchers concentrate on the more extensive components ofrisk management practices and shows diverse outcomes. Researchers have notpossessed the capacity to set up the impacts of risk management practices inthe emerging oil and gas industry on banks profitability in Ghana. In this way,there is the need to fill this exploration hole.Inprinciple, the study will cover the research gap on the impact of credit riskmanagement in the energy sector on the productivity of banks. Banks are using diversifiedderivatives (futures, options, and swaps) to hedge counterparty default risks (Jones& Pérignon, 2013, p. 373).
I plan to give more extensive knowledge toreaders. Additionally, the work will give the premise to different researcherswho wish to advance on the topic.Froma down to earth viewpoint, the data used in this work will offer a” mirror” forbank administrators, investors, E companies and bank supervisors,contingent upon the result. Bank directors could give careful consideration toenhance banks’ execution by dealing with the credit risk banks confront dealingin the oil and gas industry. Banks along these lines can better orchestrate anddistribute their resources in regards to the position of credit risks.
Moreover, private financial specialists can have a more far reaching viewpointof how profitability will be influenced. By assessing the risk management fromthe risk report that banks give, they may have more resources on basicleadership as indicated by the observational outcome. Finally, bank supervisorswill be given more confirmation to the effect of credit risk management and toexplore on the off chance that it is important to deregulate or impose furtherregulation.
In the event that the outcome shows that no relationship exists,the commitment could be that there is no requirement for different researcherto endeavour into this zone or more compelling elements ought to be consideredto create more critical relationship.1.6 LIMITATIONS:Iintend to focus on 10 largest commercial banks in Ghana between the periods2012 to 2016 which directly and indirectly finance major players in the oil andgas industry (upstream and downstream) and also five (5) major oil and gasexploration and production companies.
Moreover, huge banks could have blendedactivities from banking and investment banking, e.g. the fundamental risks confrontedby banks and investment banks are not normally indistinguishable.
For example, creditrisk is the biggest risks for banks while market risk and credit risk areimperative to investment banks.Also,in order to gather enough data to make generalization, I have chosen the timehorizon from 2012 to 2016, which covers the year of Ghana’s oil discovery andcommercialization in 2012. In this case, I do not take into account the impactof oil discovery in 2007 could have on the result of the study, which mightcause bias to the estimates. 1.
7 DELIMITATIONDespitethe fact that, there are different banks and non-bank financial institutionsauthorized with the mandate to do business in the emerging oil and gas industryin Ghana, this study will focus on thebiggest 10 licensed banks both household and universal as indicated by theircurrent size (Total assets 2015-2016) for a much better observation andanalysis. I am additionally aware of the time allotment as a constraining variable;consequently steady interaction and review with my supervisor through e-mailswill be adopted. 1.8 OVERVIEW OF THEGHANAIAN BANKING INDUSTRYEventhough banking is as primitive as human society, it has gone through changes inmany ways world-wide throughout the years. Most banks today offer a wide rangeof products and services than ever before, and their central functions ofputting the community’s surplus funds (deposits and investment) to work bylending to people remain unchanged as it has always been. These changes came asa result of government policies, globalization, economic deregulation andinformation, communication technology (Mohammed and Robert, 2006).InGhana, the banking industry has not only increased in products and services,but also increased in terms of numbers.
The first bank, the Bank of BritishWest Africa (now StanChart Bank) was established in 1896. Vidal et al., (1999)testified that within a short time the bank was able to acquire the business ofmaintaining the Government accounts and introduced the use of cheques insettlement of Government accounts which helped to educate the public on theusefulness of banking. Vidal et al., (1999) further testified that due tosuccessful operation of the above mentioned bank, another bank, the ColonialBank now Barclays Bank Ghana was also establish in 1918. The largest indigenousfinancial institution in the country, Ghana Commercial Bank was established in1953. TheBank of Ghana which is the central Bank of the Republic of Ghana was formed in1957.The Agricultural Development Bank (ADB) was set up by an Act of Parliament(Act 286) in 1965 to promote and modernize the agricultural sector throughappropriate but profitable financial intermediation.
Its original name then wasthe Agricultural Credit and Co-operative Bank and the establishing Act gave itsmain objective as “to provide credit facilities to agriculturists andpersons for connected purposes” (www.agricbank.com). Essel and Michael (2011)stated that the ADB which was created to service the rural sector began toconcentrate on traditional urban-based banking activities.1.11 Disposition:Chapter 1:introductionInthe section, I have provided a brief introduction to my research topic.
Itincludes the problem backgroundwhich introduces general knowledge according to the research topic and otherresearcher’s for a better understanding to the readers. I have also outlined the research questions andpurpose with the analysis of the contribution, limitation and delimitation. Ihave also given a brief overview of the Ghanaian banking industry, the currentstate of the banking industry and a brief history of oil discovery.Chapter 2: LiteratureReviewTheoretical andEmpirical literatureThischapter will seek to describe and motivate the research process definitions andmethod of collecting and analysing data. My aim is to provide a description forreaders to have critical review and understand the methodological choice.
Abrief summary of theoretical methodology will be provided and a discussion madeon the societal and ethical considerations for this study.Theoretical frameworkThissection involves research made and relevant theories which provide readersdeeper understanding to this thesis. I intend to review theories from threeareas: regulation, profitability and credit risk management of bankingindustries.
Key indicators (ROE, ROA, CAR and NPLR) and theories in theresearch will be defined hence it will be feasible for readers to eliminate theobstacle of reading.Chapter 3: MethodologyInthis chapter, I will provide a practical research methodology in a statisticalmanner. Discussion will be made on how data will be acquired, including thesample, population as well as time horizon. A detailed method of datacollection will be introduced and the hypothesis will be explained according tothe research questions. PracticalMethodologyThissection will present the practical methodology of the work and the variables tobe used in the statistical tests. I intend to describe the population andsample which will justify the study, the time horizon and proxies.Finally,an introduction of the main concepts of statistical tests such as variables,multivariate regression analysis, R square, multicollinearity and heteroscedasticitywill be made.
Chapter 4: Practicalmethodology Findings and AnalysisEmpirical FindingsThischapter will show the result from the last chapter from two perspectives. First, I will present all descriptivestatistics of variables and illustrate the distribution of sample banks accordingto total assets. Then I will present the regression result of all statisticaltests and find the feature of these results.Analysis andDiscussionsInthis part, an explanation of the findings will be made based on the resultsfrom the previous chapter. I will analyse the results from both significant andinsignificant meaning of indicator’s relationships. I will discuss thestability and effect of the relationship established. This analysis will linkto the theoretical framework, previous research and quality criteria.
Chapter 5: Conclusion& Recommendations for further researchThischapter is the conclusion for the entire work. The first part of this chapteris the general review and main results for the whole work. More light will bethrown on the quality of the research from reliability and validityperspectives. I will then present both the theoretical and practicalcontribution of this study and suggestions for further research.References:1. http://poisk-ru.ru/s48417t1.
html2. http://www.nairaland.com/3708303/5-banks-exposure-oil-gas3. https://thismatter.com/money/derivatives/credit-default-swaps.htm4. http://docplayer.
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com/2333-thesis-on-credit-risk.php9. https://www.heritage.org/monetary-policy/report/the-economic-role-government-focus-stability-not-spending10. http://www.asaninst.org/wp-content/cache/essay2017/barings-bank-case-study-summary11.