THE INTERPLAY BETWEEN CREDIT RISK AND FINANCIAL PERFORMANCE OF LICENSED SPECIALIZED BANKS: EVIDENCE FROM A DEVELOPING COUNTRY

Abstract

This paper investigates the influence of credit risk on the financial performance of licensed specialized banks in Sri Lanka from 2006 to 2020, a period marked by economic volatility that added layers of complexity and risk, especially for banks engaged in development lending. Using secondary data from annual reports, the study employs regression analysis to examine this relationship, with the non-performing loan (NPL) ratio as the dependent variable representing credit risk and return on equity (ROE) and return on assets (ROA) as independent variables indicating financial performance. The findings reveal that credit risk significantly impacts the financial performance of these banks, demonstrating a notable negative relationship between ROE and the NPL ratio, as credit risk increases, profitability decreases. These insights are crucial for policymakers to set realistic performance targets and for bank management to allocate capital efficiently and develop strategies to mitigate risk, thereby enhancing financial stability and performance amidst economic uncertainties.