Abstract:
Purpose: This paper focuses on analyzing the impact of credit risks on the profitability of
six major licensed commercial banks in Sri Lanka which account for around 53% of the
market share from 2017 to 2021.
Design/Methodology/Approach: Return on Equity (ROE) was considered to measure the
profitability while measuring the credit risks and it was carried out through Non-
Performing Loan ratio (NPL), Capital Adequacy Ratio (CAL), Total Loan to Assets ratio
(LTA), and Total Loan to Deposit ratio (LTD). STATA is used to analyze the data. To test
the hypothesis, Pooled OLS, random, and fixed effect models are employed, and the most
suitable model is picked through the Breusch and Pagan LM test and Hausman tests.
Based on the results pooled OLS is selected for the interpretation with an Adjusted R2 of
74%.
Findings: The study reveals a significant negative impact of NPL on profitability,
suggesting that increased NPL proportions heighten credit risk, potentially leading to
losses and reduced profitability. Conversely, the LTD shows a negative relationship,
potentially exposing banks to higher default risks despite boosting interest income.
However, LTA demonstrates a positive relationship with ROE within a certain limit,
suggesting enhanced interest income without significant default risk escalation. CAR,
however, does not directly impact profitability, emphasizing its role in ensuring capital
adequacy and regulatory compliance.
Originality: This study only focuses on the systematically important licensed commercial
banks as they represent more than 50% of the market share and have a significant
influence on the Sri Lankan economy. Hence, managing their credit risk exposures is
significantly important for the country significantly important for the country.
