Risk Management in Banks : Its Relationship with the Financial Performance of Commercial Banks in Bangladesh considering all Internal and External Factors
Authors: - Md. Rashaduzzaman 
Published: November 2024

Risk management is an essential element of bank and financial intermediation. Failure to effectively evaluating and managing the risks factors may lead to losses that threaten the health of the bank and the sustainability of the entire financial system. Most of Bangladesh’s commercial banks have their own guidelines and procedures for managing the core risk areas i.e. Credit Risk, Market Risk, Operation Risk and Liquidity Risk to ensure the bank’s sustainable development and manages all risks factors.

This study analyzes the impact of risk management factors on the financial performance of commercial banks operating in Bangladesh both in the short run and long run considering internal and external control factors. This study also review the existing risk management related policies, guidelines and practices in commercial banks operating in Bangladesh. After reviewing risk management related theories, Bangladesh Bank policies and guidelines related to risk management and empirical literatures, this study identify dependent variables as return of asset (ROA) and return on equity (ROE) as proxy of financial performance and independent variables including log of non-performing loan ratio (LnNPLR) as proxy of credit risk, log of net interest margin (LnNIM) as proxy of interest rate risk, log of foreign exchange gain/ losses (LnFexGL) as proxy of foreign exchange risk (both are component of market risk of the banks), loan to deposit ratio (LDR) as proxy of liquidity risk and log of cost to income ratio (LnCIR) as proxy of operational risk. This study include proxy variable related to type of banking operations in Bangladesh, i.e. Islamic banking or Conventional banking operation in to the econometric models. This study also includes Herfindahl–Hirschman Index (HHI) as proxy of within banking industry concentration control variable and GDP Growth Rate & Inflation Rate as proxy of macro-economic variables into the econometric models. The econometric models have been developed to examine both long run and short run effect of the independent variables on the dependent variables to establish the research questions.

The secondary data has been accumulated from the annual reports of all the local commercial banks operating in Bangladesh during the study period, i.e. from 2014 to 2019. After panel data set validation, this study used STATA – 12 version to test long term and short term impact of

dependent variables on the independent variables to check the impact of risk factors on the financial performance of local commercial banks operating in Bangladesh during the period. To check the long run effect of the dependent variables on the independent variables, this study examine the output of both random effect GLS regression model and fixed effect regression model for all the econometric models. Hausman Test result has been used to determine the appropriate model for analyzing long run effect of the econometric models. Two step system GMM model has been used to check the short run impact of the dependent variables on the independent variables for all the econometric models.

The empirical output of the econometric models shows that, the credit risk has a negative impact on both the dependent variables, i.e., the financial performance of commercial banks operating in Bangladesh during the study periods both in the long run and short run, which is also consistent with the statistical assumption of this study. So, when the credit risk of a commercial bank operating in Bangladesh increases the financial performance of the banks decreases. Both the long-term and short-term financial performance of commercial banks operating in Bangladesh during the research periods were positively impacted by the interest rate risk, which is also consistent with the study's statistical assumption. The other factor of market risk, i.e. foreign exchange risk showed negative correlation with ROA but positive correlation with ROE in the long run while positive correlation with both the dependent variables, i.e. financial performance of commercial banks operating in Bangladesh during the study periods in the short run means inconsistency with the statistical assumption of this study. So, we can summarized that, foreign exchange risk has negative correlation with ROA but have positive correlation with ROE in the long run while has positive correlation with both ROA & ROE, i.e. the financial performance of commercial banks operating in Bangladesh in the short run considering all the bank specific control factors, banking industry concentration control factors and macro-economic control factors in to the model. The foreign exchange risk behaves differently in the long run with two dependent variables, i.e. ROA and ROE due to different types of dividend payout policies and capital management policies of the commercial banks operating in Bangladesh, which may have influence on the ROE ratio calculation techniques for the Banks. The liquidity risk has positive impact of both the dependent variables, i.e. financial performance of commercial banks operating in Bangladesh during the study periods both in the long run and short run which is also in line with the statistical assumption of this study considering all the bank specific control factors, banking industry concentration control factors and macro-economic control factors in to the model. So, when the liquidity risk of a commercial bank operating in Bangladesh increases the financial performance of the banks also increases. Last but not least, operational risk has a negative effect on both the dependent variables, i.e., the financial performance of commercial banks operating in Bangladesh during the study periods, both in the long run and short run, which is also consistent with the statistical hypothesis of this study considering all the bank specific control factors, banking industry concentration control factors and macro-economic control factors in to the model. So, when the operational risk of a commercial bank operating in Bangladesh increases the financial performance of the banks decreases.