Kisala_The Effect of Credit Risk Management Practices on Loan Performance in Microfinance Institutions

7/26/2019 Kisala_The Effect of Credit Risk Management Practices on Loan Performance in Microfinance Institutions

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THE EFFECT OF CREDIT RISK MANAGEMENT PRACTICES ON LOAN

PERFORMANCE IN MICROFINANCE INSTITUTIONS IN NAIROBI, KENYA

PETERSON MBAYA KISALA

D61/63838/2011

A RESEARCH PROJECT PRESENTED IN PARTIAL FULFILLMENT OF THE

REQUIREMENTS OF THE DEGREE OF MASTER OF BUSINESS

ADMINISTRATION

UNIERSITY OF NAIROBI

OCTOBER, 201!


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ii

DECLARATION

This research project is my original work and has not been submitted for a degree in any

other University.

Signed ------------------------------------------- Date -----------------------------------

PETERSON MBAYA KISALA

D61/63838/2011

This research project has been submitted for examination with my approval as the University

Supervisor.

Signed ------------------------------------------- Date -----------------------------------

DR" JOSEPHAT LISHENGA


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ACKNO#LEDGEMENT

The successful completion of this research would not have been possible without the support

guidance and assistance of many people amongst others. Special thanks go to my supervisor

Dr. !osephat"ishenga for his intellectual support throughout the course of this study.

# am also highly indebted to my entire family for their moral support and encouragement.

$ay %od bless you abundantly.


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DEDICATION

# dedicate this work to my family for their moral support& and encouragement during the

undertaking of this work. To the almighty %od # will be forever grateful for 'is blessings

without which it would be impossible to accomplish anything.


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TABLE OF CONTENTS

D()"*+*T#, ........................................................................................................................... ii

*),/"(D%($(T ............................................................................................................iii

D(D#)*T#, .............................................................................................................................. iv

LIST OF TABLES ...................................................................................................................... ix

"#ST ,0 *11+(2#*T#,S ........................................................................................................ x

*1ST+*)T .................................................................................................................................. xi

)'*3T(+ ,( ............................................................................................................................ 4

#T+,DU)T#,.......................................................................................................................... 4

4.41ackground of the Study........................................................................................................... 4

4.4.4 )redit +isk $anagement 3ractices ..................................................................................

4.4.5 "oan 3erformance in $icrofinance.................................................................................. 6

4.4. (ffects of credit +isk management practice on "oan 3erformance ................................. 7

4.4.8 $icrofinance #nstitutions in enya.................................................................................. 9

4.5 +esearch 3roblem..................................................................................................................... :

4. ,bjective of the Study............................................................................................................ 44

4.8 2alue of the Study.................................................................................................................. 44

)'*3T(+ T/, ......................................................................................................................... 4

"#T(+*TU+( +(2#(/............................................................................................................. 4

5.4 #ntroduction ............................................................................................................................4


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5.5 Theoretical +eview ................................................................................................................ 4

5.5.4 *gency Theory............................................................................ .................................. 4

5.5.5 Transaction )ost Theory ............................................................................................. 48

5.5. 3ortfolio theory. ............................................................................................................ 46

5.5.8 )apital *sset 3ricing Theory... ...................................................................................... 47

5.Determinants of "oan 3erformance ........................................................................................ 49

5..4 #nterest +ate in )redit $anagement............................................................................... 49

5..5 "oan si;e in )redit $anagement ................................................................................... 4 ................................................................................................. 5& ),)"US#,S *D +(),$$(D*T#,S ................................................ :

6.= #ntroduction ....................................................................................................................... :

6.4 Summary ........................................................................................................................... :

6.5. )onclusion........................................................................................................................ :

6.. +ecommendationsfor3olicy ............................................................................................. 8=

6.8. "imitationsoftheStudy ...................................................................................................... 84

6.6. +ecommendations for 0urther +esearch .......................................................................... 84

+(0(+()(S........................................................................................................................ 8

APPENDICES ............................................................................................................................ 6=

A$$%&'() I* Q+%-(.&&(% ........................................................................................................ 6=


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:

LIST OF TABLES

Table8.4?DescriptiveStatisticsTable 88

Table8.5?)oefficientSummaryTable>ear5==9 86

Table 8.?$odelSummaryTable>ear5==9 89

Table8.8?*,2*Table>ear5==9 89

Table8.6?)oefficientSummaryTable>ear5==


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LIST OF ABBREIATIONS

*T$ *utomated Teller $achine

*T$#* *T$ #ndustry *ssociation

)1 )entral 1ank of enya

)D,@s )ollaterali;ed Debt ,bligations

+,* +eturn on *ssets

US* United States of *merica

*$0# *ssociation of $icro 0inance #nstitutions of enya

)1As )ommunity 1anks

$0# $icro 0inance #nstitutions

3*+ 3ortfolio *t +isk

)*3$ )apital *sset 3ricing $odel

UD3 United ations Development 3rogramme

)+$ )redit +isk $anagement


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ABSTRACT

)redit risk has always been a concern not only to bankers but to the entire business world

because the risks of a borrower not fulfilling his obligations in full on due date can seriously

jeopardi;e the performance of a financial institution. This study sought to review the effect of

credit risk management on the loan performance of microfinance institutions in enya. The

research design used in this study was descriptive research design as it involved an in depth

study of credit risk management and its relationship with loan performance in micro finance

institutions. 3rimary data was collected through Buestionnaires while Secondary data collected

from the micro finance institutions annual reports C5==9-5=44 was used. The study populations

were the : micro finance institutions licensed by the )entral bank of enyaE however data was

obtained from 6 micro finance institutions. The data collected from the annual reports of the

micro finance institutions was analy;ed using multiple regression analysis. #n the model

return on eBuity was used as the profitability indicator while non-performing loans ratio and

capital adeBuacy ratio as credit risk management indicators. This study showed that there is

significant relationship between loan performance and credit risk management.

The results of the analysis states that both non-performing loans ratio and capital adeBuacy ratio

have negative and relatively significant effect on return on eBuity with 3"+ having higher

significant effect on +,( in comparison to )*+. 'ence& the regression as whole is significantE

this means that 3"+ and )*+ reliably predict +,(. 'aving established a relationship

between credit risk management and the financial performance of micro finance institution& the

research suggests that all micro finance institutions should adopt accredit risk grading system.


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4

CHAPTER ONE

INTRODUCTION

1"1B5.+&' . -7% S-+'

The overall aim of a credit analyst is to reach a judgment about extending credit to a

customer using information that is relevant to the principles of good credit management.

/hile 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& 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

bankAs counterparties. This experience is common in both %-4= and non-%-4= countries

1asel& C5===.

+isk is central to the banking business and can be defined as the chance or possibility of

danger& loss& or injury 3arry& C4::9. /hile this study will primarily concern itself with credit

risk& it is worth noting that financial institutions are faced with a variety of risks which they

must identify& measure and manage. These include but are not limited to operational risk&

legal or documentary risk& liBuidity risk& hedging risk& sovereign risk& credit risk& market risk&

delivery risk& position risk& and provisional risk 1anks& C4:: /hile risk has affected many

of the institutions active in todayAs markets& regulators have also been reBuired to make

changes to enforce oversight of products and institutions in their respective areas 1anks&

C4::.


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The world over& credit risk has proved to be the most critical of all risks faced by a banking

institution. * study of bank failures in ew (ngland found that& of 75 banks in existence

before 4:


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institutions must develop a credit policy to govern their credit management

operations3andey& C5==


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information problems and in reducing the level of loan losses& thus the long-term success of

any banking organi;ation. )redit risk management is essential in optimi;ing the performance

of financial institutions 1aselC 5=4=.

*ccording to %reuning and 1ratanovic C5== the basis of a sound credit risk management

system include guidelines that clearly outline the scope and allocation of bank credit facilities

and the manner in which the credit portfolio is managed that is how loans are originated&

appraised& supervised and collected. Derban& 1inner and $ullineux C5==6 recommended that

borrowers should be screened especially by banking institutions in form of credit assessment.

)ollection of reliable information from prospective borrowers becomes critical in

accomplishing effective screening as indicated by symmetric information theory. Fualitative

and Buantitative techniBues can be used in assessing the borrowers although one major

challenge of using Bualitative models is their subjective nature.

'owever according to Derban& 1inner and $ullineux C5==6& borrowers attributes assessed

through Bualitative models can be assigned numbers with the sum of the values compared to

a threshold. This techniBue minimi;es processing costs& reduces subjective judgments and

possible biases. The rating systems will be important if it indicates changes in expected level

of credit loan loss. 1rown 1ridge C4::


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1"1"2 L.& P%.4&% (& M(.(&&%

* performing loan is loan which is not in default& or is not about to be& with a reasonable

expectation that the loan will not enter default even though it has not technically defaulted yet

is a performing loan. *s a general rule& banks and other financial institutions like to avoid

non-performing loans& because there is a risk that they will not be able to recover the

principal left on the loan& let alone the interest which has accrued.

"oan performance refers to rate of profitability or rate of return of an investment in various

loan products .thus broadly& it looks at the number of clients applying for loans& how much

they are borrowing& timely payment of installments& security pledged against the borrowed

funds& rate of arrears recovery and the number of loan products on the chain. "oan portfolio

refers to the total amount of money given out as loans in different loan products& to the

different types of borrowers. These loan products may comprise ofE Salary loans& %roup

guaranteed loans& #ndividual loans and corporate loans 3uxty et al.& C4::4.#t looks at the

number of clients with loans and the total amount in loans. /ester 3aul& C4::.

"oan portfolio is the $icrofinance institutions most important asset hence& portfolio Buality

reflects the risk of loan delinBuency and determines future revenues and an institutions ability

to increase outreach and serve existing customers. 3ortfolio Buality is measured as portfolio

at risk over = days. 'ow best a loan portfolio is performing is looked at in terms of

profitability and or rate of return on the different loan products& this is a function of the

number of the loans and the cost of administering these loans #ndjeikein& C4::9.


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1"1"3 E%- . %'(- R(5 4&%4%&- $-(% .& L.& P%.4&%

)redit risk management in $icrofinanceAs functioning influence the efficiency of

microfinanceAs risk management is and expected to significantly influence its loan

performance 'arker and Satvros& C4::


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foreign currency values. 0atemi and %laum C5=== outline the steps that may be taken

without regard for the repercussions of these decisions for shareholdersA value.

#t therefore follows that regardless of whether shareholder value maximi;ation or managerial

risk aversion is the driving force& engagement in risk management practices is to be observed.

,ne of the most important practices involves management of credit risk& particularly for

banks and other firms in the financial services industry. The increasing variety in the types of

counterparties from individuals to sovereign governments and the ever-expanding variety in

the form of obligations from auto loans to complex derivatives transactions have meant that

credit risk management has jumped to the forefront of risk management activities carried out

by firms in the financial services industrySmith& C4::


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time. Some of these institutions concentrate only on providing credit& others are engaged in

providing both deposit and credit facilities& and some are involved only in deposit collection.

They range from non-governmental organi;ations& savings and credit cooperatives&

commercial $icrofinance #nstitutions and regulated speciali;ed providers !orion& C4::9.

#n 4:::& the *ssociation of $icrofinance #nstitutions C*$0# was registered under the

Societies *ct as an umbrella organi;ation to represent the microfinance institutions operating

in enya. The *$0#As activities are aimed at supporting the growth and development of

$0#s& by promoting sustainable& efficient& and effective delivery of microfinance services.

*$0# has been playing a vital role in promoting the growth of microfinance in enya in

addition to supporting $0#s to build capacity in order to overcome some of the challenges

facing the sector. *$0# was instrumental in drafting and preparing the $icrofinance 1ill&

which was passed and enacted into law in 5==7 CUS*#DGenya& 5==./hile enya has

more than 56= organi;ations that practice some form of microfinance business& only 5=-

practice pure microfinance& of which are deposit-taking and 49 are credit only. The

remaining 5= $0#s combine microfinance with social welfare activities. *ccording to the

$icrofinance *ct& $0#s in enya are classified into three different tiers& with the first tier

being deposit-taking institutions such as $icrofinance #nstitutions& the second tier being

credit only facilities& and the third tier being informal organi;ations supervised by an external

agency other than the government .These distinct classifications have led to some of the

$icro 0inance #nstitutions speciali;ing in certain niche markets& which have contributed to

their growth and sustainability in delivering microfinance services C*ssociation of

$icrofinance #nstitutions of enya& 5==9


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1"2 R%%7 P.9%4

The success of $0#s largely depend on the effectiveness of their credit management systems

because these institutions generate most of their income from interest earned on loans

extended to small and medium entrepreneurs. The )entral 1ank *nnual Supervision +eport&

5=4= indicated high incidence of credit risk reflected in the rising levels of non-performing

loans by the $0#As in the last 4= years& a situation that has adversely impacted on their

profitability. This trend not only threatens the viability and sustainability of the $0#As but

also hinders the achievement of the goals for which they were intended which are to provide

credit to the rural unbanked population and bridge the financing gap in the mainstream

financial sector. /hile many researchers have carried out general studies on causes of poor

loan performance and their effects on the worldwide banking crises in (urope& *sia and parts

of *frica& there have not been specific studies on the relationship between )redit risk

management and loan performance on microfinance industry.

"oan performance result mostly from ineffective management of credit risks 'ippolyte&

C5==6. Successful $0#s have managed to maintain high levels of loan recovery rates&

generally over :6H. These remarkably high loan recovery ratios triggered the initial wave of

funds from funding agencies and the subseBuent inflow from a variety of social investors

which they could use to expand their operations.

/hile many successful $0#s continue to contain credit risks within desired levels& they face

greater challenges than before as indicated by the increased volatility of their portfolio at- risk

C3*+ ratios. The sources of these challenges include increased competition in the market&


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addition of new credit products with longer-term structures& shift to individual lending&

increased scale of operations& and geographical expansion and efforts to deepen the outreach.

)redit risk management practices help $0#s reduce their exposure to credit risks& and

enhance their ability to compete in the market with other well established financial

institutions like banks #Bbal and $irakhor& C5==9. The micro finance institutions adopt

various credit risks management practices in managing credit. #n1angladesh a microfinance

institution called %rameen 1ank has managed credit risk and at the end of 5=== reported 5.8

million members& where :6 percent of them are women& with I556 million outstanding loan.

#n Thailand also has reported impressive outreach 6 through agricultural lending by the 1ank

for *griculture and *gricultural )ooperative $eyer C5==5. #n general& a lot number of

microfinance institutions have registered impressive outreach in several developing

economies including #ndia& )ambodia& and others which result to improved performance of

the institution $eyer C5==5. The wide variety of performance in microfinance institutions is

reali;ed due to credit risk management adopted by the organi;ation. "arge-sample studies of

the industry have documented the existence of profits and a positive link between $0#

performance and good macroeconomic conditions *ltman and arayanan& C4::


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management in microfinance institutions in enya. To the researcher knowledge there is no

known study done on impact of credit risk management practices on performance of

microfinance institutions in enya& much of the work done relating to credit risk management

practices on financial performance of microfinance institutions has been conducted in the

developed world. This study seeks to fill this gap of knowledge by investigating the

relationship between credit risk management practices and financial performance of

microfinance situations in enya& which is a developing country.

1"3 O9:%-(;% . -7% S-+'

The objective of the study is to determine effects of credit risk management practices on loan

performance in $icrofinance #nstitution in airobi&enya.

1"! +% . -7% S-+'

The study will be significant to the management of $icrofinance #nstitution in enya as they

will be able to uncover the effects of credits risk management practices on loan performance

and adopt appropriate credit risk management practices in reducing level of nonperforming

loans and enhance loan performance. The study will provide an insight on the best credit risk

management approaches micro finance institutions should adopt in order to effectively

manage and enhance profitability. $anagers in microfinance industry will find this study

significant as it will provide an insight on the best credit risk management practices that

should be taken to reduce occurrence of nonperforming loans and improvement of loan

portfolio performance.


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The study will be useful to the government in policy making regarding the loan

reBuirements and also for the supervision of $icrofinance institution.The policy makers will

obtain knowledge on the best mechanisns that should be adopted to curb the poor loan

perfomance and the responses that are appropriate should they occur. This study will

therefore act as a guide in adopting effective credit risk management practices by $0#s in

preventing the occurence defaults in $icrofinance institutions.

This study will contribute to academia by showing how credit risk management C)+$

practices can affect the loan performance in $0#s #nstitution. #t will add to the body of

literature on )+$ practice that has shown the effects of )+$ on the management of the

lending portfolio of $icro finance institutions. The study will also be significant to research

who may find this study valuable to form a foundation to identify research gap and carry a

further research.


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CHAPTER T#O

LITERATURE REIE#

2"1 I&-.'+-(.&

This chapter is concerned with the review of literature related to the study& the theoretical

review& determinant of loan performance in microfinance& empirical review and the

conceptual framework. #n the literature& it reviews other authorsA works on credit risk

management practices and loan performance. The last section is the summary of the literature

which points out the research gaps on the empirical studies done.

2"2 T7%.%-( R%;(% E4$(( S-+'(%

,lomola C5==5 found that repayment performance is significantly affected by borrowerAs

characteristics& lenders characteristics and loan characteristics. +epayment problems can be in

form of loan delinBuency and default. /hatever the form however& the borrowers alone

cannot be held responsible wherever problems ariseE it is important to examine the extent to

which both borrowers and lenders comply with the loan contract as well as the nature and

duties& responsibilities and obligations of both parties as reflected in the design of the credit

programme rather than heaping blames only on the borrowers.

"inbo C5==8 examined efficiency versus risk in large domestic US* banks. 'e found that


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profit efficiency is sensitive to credit risk and insolvency risk but not to liBuidity risk or to the

mix of loan products. 'arker and Satvros C4::


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tailoring and urban agriculture were important in influencing loan repayment performance of

the borrower. #n addition& sex and business experience of the respondents were found to be

significant determinants of loan repayment rate. *ddis microfinance institution has a number

of internal and external problems like shortage of loanable funds for further expansion&

competition& and improper interference of third party in the decision of loan approval.

%estel and 1aesens C5==: risk management is primarily concerned with reducing earnings

volatility and avoiding large losses. #n a proper risk management process& one needs to

identify the risk& measure and Buantify the risk and develop strategies to manage the risk. The

highest concern in risk management is the most risky products. The prior concern for the risk

management is those products that can cause the highest losses? high exposures with high

default risk.

orieet al C5=45 carried out a study on determinants of loan repayment of $icrofinance

#nstitutions in Southeast States of igeria The objective of the study was to analy;e the loan

repayment performance& institutional factors& and factors affecting repayment rate of

microfinance institutions C$0#s in the South-east states of igeria. #t was carried out in three

states namelyE (boni& (nugu and #mo& out of the five southeast states. Using a cross-sectional

data a multi-stage sampling techniBue was employed in selecting a total of 7 $0#s from the

three states& that is& 45 $0#s per state. The three states were purposively selected based on the

performance index of United ations Development 3rogramme in the selection of $icro start

3rojects& which made the final list in the Southeast states of igeria. 0or the sample si;e& four

$0#s were chosen each from formal Ccommercial and development banks& semi-formal


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C%,-$0#s and community banks C)1s and informal C+otating Savings and )redit

*ssociations C+,S)*S. +esults from the study& affirmed that the formal segment was more

organi;ed& better eBuipped with higher Buality and well-motivated staff than the semi-formal

and informal segments. The informal sector presented the best repayment picture of the three

segments& followed by the semi-formal institutions. ,utstanding among the determinants of

loan repayment of microfinance institutions were outreach& shocks& training duration& loan

si;e and credit officerAs experience.

orir C5=44 study was to investigate the impact of credit risk management practices on the

financial performance of Deposit Taking $icrofinance institutions in enya. The study used

a descriptive survey approach in collecting data from the respondents. The number of the

respondents was 7 staff working in all licensed Deposit taking microfinance institutions in

enya. 0rom the findings the study concludes that Deposit taking microfinance institutions in

enya adopted credit risk management practices to counter credit risks they are exposed to

and it also concluded that Deposit taking microfinance institutions adopt various approaches

in screening and analy;ing risk before awarding credit to clients to minimi;e on loan loss.

This included establishing capacityGcompetition and conditions and use of collateralGsecurity

and character of borrower were used in screening and risk analysis in attempt to reduce

manages credit risks. The study further concludes that there was a positive relationship

between credit risk management practices and the financial performance of Deposit taking

microfinance institutions.

/arue C5=45 investigated empirical analysis of external factors affecting loan delinBuency


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performance in $0#s in enya. The study used primary data. The study target population

comprised 8: $0#s registered by *ssociation of $icrofinance #nstitutions of enya

C*$0#. * survey research design was used and a census of the 8: $0#s was taken. The

data was collected through a self-developed structured Buestionnaire and administered to

$0#s loan officers for response. $ultiple regression analysis was used to establish

relationship between loan delinBuency and microfinance institutions& self-help groups and

external factors in $0#s in enya. The estimated regression coefficients and t-values were

interpreted. The study found evidence on external factor was found positive and significantly

CNO 5.68:& t-value 5.=7: related to loan delinBuency performance in microfinance

institutions in enya.

Sindani C5=45 carried out a study on effectiveness of credit management system on "oan

3erformance& (mpirical evidence from $icro 0inance Sector in $eru& enya.The overall

objective of the study was to assess the effectiveness of credit management systems on loan

performance in microfinance institutions.The study adopted a descriptive survey design. This

design investigates the current status and nature of the phenomena. * census survey of all the

9= credit officers in 48 microfinance institutions in $eru town was conducted. Specifically

the study sought to establish the effect of credit terms& client appraisal& credit risk control

measures and credit collection policies on loan performance. The respondents were the credit

officers of the $0#s in $eru town. )ollection policy was found to have a higher effect on

loan repayment.

dwiga C5=44 investigated the relationship between credit risk management practices and


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financial performance of microfinance situations in enya. The objective of the study was to

examine the effects of credit risk management practices on financial performance of

$icrofinance #nstitutions in enya. (xploratory research design was chosen because it

enabled the researcher to generalise the findings to a larger population. The population of this

study comprised of all licensed $icrofinance institutions in enya. The population of this

study comprised all the 8 licensed $icrofinance institutions in enya. #nferential statistic

was be sued to establish the relationship between credit risk management practices and the

financial performance of $0#s& performance of $0#s will be measured by their profitability .

0rom the findings the study concludes that microfinance institutions in enya have adopted

various the credit risk management practices which are credit risk management& risk

monitoring& risk identification and +isk *nalysis and *ssessment.The study concluded that

there is positive relationship between credit risk management practices and financial

performance of $icrofinance #nstitutions in enya.

osgei& C5=45 investigated effects of lending methodology on performance of loan portfolio

in microfinance institution in enya .The purpose of the study was to assess the effect of

lending methodology on the performance of gross loan portfolioGassets in micro-finance

institutions. The specific objectives were to establish the effect of group and individual

lending on performance of loan portfolio in $icro-finance institutions& and to establish the

effect of moderating factors on performance of gross loan portfolio. Secondary data was used

in the study of < out of 67 microfinance institutions under umbrella *ssociation of

$icrofinance #nstitutions of enya C*$0#. This was motivated by availability of data. 3anel

data analysis was applied to test hypothesis that there is no relationship between group


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lending on performance of loan portfolio. *fter running a regression in which loan portfolio

performance is the dependent variable& the study found a positive significant coefficient of

=.9: and CpO=.85 on group lending without moderating factors. /hen moderating factors

were included the coefficient becomes =.< and CpO=.4:. The null hypothesis is therefore

rejected. There is no significant relationship of individual lending on performance of loan

portfolio in the regression despite finding a positive coefficient of =.84 and CpO=.59.

Therefore there is no effect on individual lending on performance

2"6 S+44 . L(-%-+% R%;(%O N= P NMit P Qit ...............................................................eBuation #

/here& > is the dependent variable C"oan performance& N= is constant& N is the coefficient of

the explanatory variables Ccredit risk management practices& Mit is the explanatory variable

and Qit is the error term assumed to have ;ero mean and independent across time period.

A&-( M.'%

* linear regression model will be applied to establish the relationship between credit risks

management practices and the level of loan performance. The responses credit risks

management practices will be measured by computing indices based on the responses derived

from the "ikert-Scaled Buestions. The relationship eBuation represented in the linear eBuation

below.

> O R P N4M4 P N5M5P NMP N8M8P

/here

>O "oan 3erformance measured as a percentage of loan repaid to the total amount

of loan advanced to clients.


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O (rror term? captures variables that were not included in the model.

R O )onstant Term? The average loan performance holding the explanatory variables constant

N4O 1eta coefficients measures the changes in dependent variable attributed to the changes in

explanatory variables.

M4O )redit risk measured using risk coverage ratio measured as loan loss reserve divided by

portfolio at risk

M5O #nterest rate spread calculated as Cinterest rate on gross ,utstanding "oan 3ortfolio-

Cinterest rate paid on gross outstanding funding liabilities which will be sourced from the

financial statements

MO %D3 growth rate measured as a percentage change of %D3 from the previous year.

M8Ointerest rate measured as the interest rate charged on the loan advanced to consumers


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CHAPTER FOUR

DATA ANALYSIS, RESULTS AND DISCUSSION"

!"1 I&-.'+-(.&

This chapter is a presentation of results and findings obtained from field data& both

descriptive and inferential statistics have been employed specifically using regression and

*,2* to establish the significance of the model and also to establish the link between

credit risk management practices and microfinance institutions in airobi enya.

!"2 R%$.&% R-%

The targeted population si;e was nine C: $0#s licensed under the central bank of enya.

The study used a census study whereby the entire population was studied as opposed to

selecting a sample thereby making a response rate of 4==H. *ccording to $ugenda and

$ugenda C4:::& a response rate of 6=H is adeBuate for analysis and reportingE a rate of 7=H

is good and a response rate of 9=H and over is excellent. This means that the response rate

for this study was excellent and therefore enough for data analysis and interpretation.

This high response rate can be attributed to the data collection procedures& where the

researcher pre-notified the potential participants and applied the census method where

secondary data was obtained from financial reports of the association of microfinance

institutions in enya.


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!"3 D%($-(;% --(-(

Table 8.4 presents the descriptive statistics for the data set. 0ive variables namely "oan

performance& credit risk& interest rate spread& %D3 rate and interest rate of the : $0#s with 6

observations each were used in the analysis

T9% !"1? Descriptive Statistics table

(9% O9 M%& S-'"D%;" M(& M)

"oan performance 6 =.4=


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!"! C.%-(.& M-()

The study sought to determine effect of credit risk management on loan performance of

deposit taking microfinance institutions in enya. 3earson )orrelation analysis was used to

achieve this end at ::H& :6H and :=H confidence levels. The correlation analysis enabled

the testing of studyAs hypothesis that credit risk has a significant effect on loan performance

of $0#s. Table 8.5 shows the correlation matrix between the dependent and independent

variables.

T9% !"2*)orrelation coefficients of credit risk and corporate liBuidity variables

#ntereste

4.====

Table 8.5 shows that credit risk and %D3 growth rate had a positive relationship with the loan

performance of $0#s while interest spread and interest rate charged had a negative

relationship with the loan performance of $0#s. )redit risk showed strong and positive

C+O=.9


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clients hence easy loan repayment. 0inally& interest rate charged on loan advanced increase

reported a negative but strong relationship with loan performance C+O-=.9:44. #ncrease on

interest charged by $0#s increase the total amount of loan charged which eats into clients

disposable income. This would increase the default rate thereby negatively affecting loan

performance of the $0#s.

!"> R%%(.& &("

+egression analysis was used to determine determinant of coefficients C$odel summary&

analysis of variance C*,2* and regression coefficients. Determinant of coefficient C+

sBuare is important in indicating the percentage of the proportion of the total variation in

loan performance of $0#s that is attributed to the changes in credit risk management and the

control variables. *nalysis of variance is useful in determining if the model is fit for

estimation and if the sample mean is drawn from the same population. +egression coefficient

indicates the significance of coefficient estimates for each independent variable.

!">"1A&( . (&%

Table 8. gives an analysis of variance. This is established if there is significance difference

between the means of the variable and under study and also to examine the overall

significance of the model. ,verall significance of the model is important in establishing

whether the model is fit to giving true estimate of the variables. Since the p value C=.===4 is

below =.=6& it can be concluded that the regression models was significant in giving true

estimate of the variables. #t also implies that the means of the variable are not significantly

related.


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T9% !"3*ANOA

$odel

+egression

4 +esidual

Total

Sum of SBuares Df $ean SBuare 0 Sig.

.56= 8

:

4

.=69

.==59

54.4444 .===4

.=


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toward 8 indicates negative autocorrelation. Since the D/ value of 4.


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!"6 D(+(.& . (&'(&"

0rom the regression result above& all the explanatory variables are statistically significant C3

Y =.=6 at 6H in causing the variation loan performance. ,n average $0#s will report loan

performance of =.8< units if the explanatory variables were excluded in the estimation model.

This depicts that there are other control variables that affect loan performance of $0#S which

were never considered in the study.)redit risk management is positively related with the loan

performance as indicated with a positive coefficient. )redit risk is statistically

significantCtO=.8=96& p O =.=59& pY=.=6 in explaining the variation in loan performances and

other factors held constantCinterest spread& %D3 rate and interest rate. )redit risk

management& therefore& directly influences the level of loan performance in $0#s.

* unit increase in credit risk management will lead to .9


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CHAPTERFIE

SUMMARY, CONCLUSIONS AND RECOMMENDATIONS

>"0 I&-.'+-(.&

This chapter presents the summary and description of findings derived from the study.

The chapter also provides findings& conclusions and recommendations for policy as well

as recommendations for further research.

>"1 S+44

The main objective of this study was to determine the effect of credit risk management on

loan performance in $0#s. 0rom the findings& there is evidence that suggests that

several $0#s specific factors Ccredit risk& interest rate margins or spread& %D3 growth rate&

interest are important determinants of loan performance. This study only considers

four $0#s specific variables owing to data availability. The study established the following

eBuation?

> O =.8< P .9


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variation on loan performance of microfinance as results of change in %D3 growth rate& the

study further revealed that there was a negative relationship between loan performance of

$0#s& interest spread and interest rate charged on loans. $odeling in full the way spreads

between interest rates on three-month Treasury bills and rates for the alternative instruments

widen and narrow over time would reBuire an almost limitless set of determining factors.

The study found that the key indicator of financial performance and efficiency of $0#s is the

spread between lending and deposit rates. #f this spread is large& it works as an impediment to

the expansion and development of loan repayment. This is because it discourages potential

savers due to low returns on deposits and thus limits financing for potential borrowers. This

has the economy-wide effect of reducing feasible investment opportunities and thus limiting

future growth potential. #t has been observed that large spreads occur in developing countries

due to high operating costs& financial taxation or repression& lack of a competitive financial

sector and macroeconomic instability. That is& risks in the $0#s are high. The study revealed

that the magnitude of interest rate spread varies and itAs inverse to the degree of efficiency of

loan performance& which is an offshoot of a competitive environment. The nature and

efficiency of the financial sectors is found to be the major reasons behind differences in

spread.

>"3" R%.44%&'-(.&.P.(

$0#s should also apply efficient and effective credit risk management that will ensure that

loans are matched with ability to repay& loan defaults are projected accordingly and relevant

measures taken to minimi;e the same. $0#s should also enhance periodic credit risk monitoring

of their loan portfolio to increase the loan performance. This can be achieved by hiring Bualified

debt


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collectors and competent personnel.

#t is recommended that $0#s should use the services provided by )redit +eference 1ureaus for

the purpose of determining the credit worthiness of borrowers as a means of minimi;ing bad

loans. )+1s help lenders make faster and more accurate credit decisions. #t is recommended

that $0#s needs to invest on debt collections and this will entail hiring Bualified and

experienced debt collectors& lawyers so as to increase litigation of defaulters and auctioneers.

#t is recommended that )entral 1ank which is the +egulatory *uthority of $0#s in enya

should apply stringent regulations on interest rates charged by $0#s so as to regulate their

interest rate spread and also they should come up with rigorous policies on loan advances so as

to mitigate moral ha;ards such as insider lending and information asymmetry. #t is

recommended that management should organi;e regular trainings in areas like credit

management& risk management and financial analysis. This would sharpen the knowledge and

skills of credit officers so as to improve on the Buality of credit appraisals.

>"!" L(4(--(.&.-7%S-+'

#n attaining its objective the study was limited to : $0#s in enya. Secondary data was

collected from the firm financial reports. The study was also limited to the degree of

precision of the data obtained from the secondary source. /hile the data was verifiable since

it came from the )entral 1ank publications& it nonetheless could still be prone to these

shortcomings. The study was based on a five year study period from the year 5==: to 5=4. *

longer duration of the study will have captured periods of various economic significances

such as booms and recessions. This may have probably given a longer time focus hence given

a broader dimension to the problem.

>">" R%.44%&'-(.& . F+-7% R%%7


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The study sought to determine the effect of credit risk management on the loan performance of

$0#s in enya. There is need for a study to be conducted to determine the relationship

between interest spread and loan performance of $0#s as it was found that interest spread

negatively affects the loan performance of $0#s.

0rom the findings and conclusion& the study recommends and in-depth study to be carried out

on the relationship between increase in interest rate and loan performance of $0#s in enya.

#n order to better the effects of credit information sharing on default risk& there is need to a

study to be carried out to determine the impact of credit information sharing on loan

performance in $0#s& this will assist in $0#sincrease loan performance and also reduce the

default risk.

.


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REFERENCES

*ckerberg& *. and %owrisankaran& %. C5==7. Fuantifying eBuilibrium network externalities

in the *)' banking industry&RAND Journal of Economics & 9C&9


55/69

%itonga& T. C5== #nnovation process and the perceived role of the )(, in the banking

#ndustry& Unpublished $1* project University of airobi.

'enderson& 1. !. and 3earson& . D.& C5=44. The dark side of financial innovation? a case

study of the pricing of a retail financial product. Journal of Financial

Economics.

'ouston& ).& !oel& .& )hen& ". and >ue& $.& C5=44. +egulatory arbitrage and international

bank flows.Journal of Finance.

amotho& *. D C5==


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,bay& ". C5===& 0inancial #nnovation in the 1anking #ndustry? The )ase of *sset

Securiti;ation C%arland 3ublishing& ew >ork

,loo& %. C5==8& 1anking SurveyE * comprehensive survey of enyaAs banking sector? $"e

%usiness and financial journal $# #SS oC4=5:-54:6.

3earce& !. and +obison& +. C4::9& Strategic $anagement? Strategy formulation&

implementation and control. #rwin& 7th edition !ohnson and Scholes.

Silber& /. C4:ork

S^rensen& D. and 'ans& (. C5=45&&usiness Development? a market-oriented perspective. !ohn

/iley K Sons.

Sullivan& '. and +ichard& !. C5===& 'ow 'as the *doption of #nternet 1anking *ffected

3erformance and +isk in 1anksZ Financial 'ndustry Perspectives& 0ederal +eserve

1ank of ansas )ity& 4-47.

Thompson&*. and Strickland& *.!. C4::7 Strategic $anagement? )oncepts and cases

+ichard D #rwin& US*.

Tufano& 3. C5==.Financial innovation# The 'andbook of the (conomics of 0inance.

2olume 4& 3art 4. (lsevier. pp. =9-6

Tufano& 3. C5==. 0inancial innovation? the last 5== years and the next. #n $"e (and%ook of

t"e Economics of Finance& edited by %eorge $ )onstantinides& $ilton 'arris and


57/69

+en_ $. Stul;.

/agner& /. C5==9? 0inancial development and the opacity of banks& Economics )etters :9&

7-4=.

$erton& +.& C4::6.Financial 'nnovation and t"e Mana*ement and Re*ulation of Financial

'nstitution# 1(+ /orking 3apers 6=:7& ational 1ureau of (conomic +esearch&

#nc.

$oodyAs #nvestor Service&C4::7. )orporate 1ond Defaults and Default +ates& 4:9=-4::6 &

$oodyAs Special +eport & 4::7.

$orris& S.& C5==4# Coordination Risk and t"e Price of De%t+ 0$% Discussion 3apers

dp9& 0inancial $arkets %roup.

$orsman& (.C4::& )ommercial "oan 3ortfolio $anagement& +obert $orris *ssociates&

3hiladelphia& 4::.

$ugenda& ,.$. and $ugenda& *.%. C5==.Researc" Met"ods, Quantitative a Qualitative

Approac"es. airobi? *cts 3ress.

$utie& )hristopher $. C5==7&The relationship between credit scoring practices in enyan

commercial banks and onperforming "oans.\ $1*& University of airobi

aceur S.1. and %oaied $.& C5==& The Determinants of the Tunisian Deposit 1anksA

3erformance& *pplied 0inancial (conomics& 44

gare (vans $agara C5==


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,da $.& $uranga !. C4::9& ]*ew 0ramework for $easuring the )redit +isk of a

3ortfolio\ 'nstitute for Monetary and Economic !tudies -'ME!.page. 4-86.


59/69

3arrenas& !. ). C5==6& and The +egulatory and 1usiness (nvironment for +isk $anagement

3ractices in the 1anking Sectors of *3() (conomies? Report of a Colla%orative

!urvey /ndertaken %y t"e Pacific Economic Cooperation Council Finance Forum

and t"e Asian &ankers0 Association# 33. 4-48.

3ausenberger and assauer& C5===& %overning the )orporate +isk $anagement 0unction& in

0renkel& $. 'ommel& U. and +udolf& $. 5==6& +isk $anagement? )hallenge and

,pportunity& Springer.

3eters& !.$.& "ewis& 1.".& Dhar& 2. C4:


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Sekaran& Uma C5==& Researc" Met"ods for &usiness, A !kill2%uildin*"""Tatham& +.".& K

1lack& /.). C4::


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APPENDICES

A$$%&'() I* Q+%-(.&&(%

)+(D#T +#S $**%($(T 3+*)T#)(S

I" CREDIT RISK IDENTIFICATION

Please respond to t"e follo1in* statements %y indicatin* t"e e4tent to 1"ic" you a*ree or

disa*ree as per t"e *iven c"oices#

> ! 3 2 1

S-0.&638/60%%

A60%%

U&2%0-/(&

D(,/60%%

S-0.&638'(,/60%%

4 /e analy;e the business plan to identify risk exposure

5 /e consider professionalism in the respective business /e consider capacity of the loan applicants

8 /e look at the long term planning hori;on of every loan

applicant

6 /e look at the conditions ie economic& political before we

finance a project

7 /e consider the net worth of the business

9 /e consider the past track record of repayment< /e look at the character of loan applicants

: /e look at the credit trustworthiness of loan applicants

4= /e periodically monitor projects financed


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II" CREDIT RISK ASSESSMENT


disa*ree as per t"e *iven c"oices

> ! 3 2 1

S-0.&638/60%%

A60%%

U&2%0-/(&

D(,/60%%

S-

0.&638'(,/60%%

4 /e periodically assess funded projects

5 /e have a credit evaluation committee

/e have monthly review of loan performance

8 /e have a loan recovery mechanism

6 /e calculate ratio analysis for profitability&

efficiency& leverage

7 /e analy;e growth in sales of our clientsG

borrowers


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III" PORTFOLIO ASSET QUALITY



> ! 3 2 1

S-0.&638/60%%

A60%%

U&2%0-/(&

D(,/60%%

S-0.&63

8'(,/60%%

4 /e periodically assess credit Buality of our loan portfolio

5 /e invest in different loan products

Decision to diversify our investment is only made by

management

8 The loan portfolio is invested in different sectors of the

economy

6 ,ur loan portfolio is fully insured


64/69

I" CREDIT RATING



> ! 3 2 1

S-0.&638/

60%%

A

60%%

U&2%

0-/(&

D(,/

60%%

S-0.&638'(,/

60%%

SECTION I" CREDIT RATING

4 The micro finance has an internal credit rating

system.

5 /e do credit rating on all for all loans

The micro finance has a loan classification

procedure

8 The micro finance has limits on the amount of

loan one can get

6 The micro finance has a credit committee

7 The micro finance has a lender approval limit for


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loans issued

" CREDIT RISK CONTROL



> ! 3 2 1

S-0.&638/60%%

A60%%

U&2%0-/(&

D(,/60%%

S-0.&638'(,/60%%

4 )lients are vetted before accessing loans

5 'efty penalties are charged on loan defaulters

8 "oans are awarded after signing of a binding contract

6 $anagement report to board of direct directors on non-

performing loans

7 /e participate in loan portfolio hedging against risk

9 ,ur clients are reBuested to provide guarantees


66/69

A$$%&'() II* L(- . M(.(&&% (&-(-+-(.&

S.+%* C%&- 9&5 . K%&

1" F++ K%& DTM L(4(-%'

3hysical *ddress? 0auluenya 'ouse& gong "ane -,ff gong +oad

D-% L(%&%'* 54st $ay 5==:

1ranches? 59

2" K%& #.4%& F(&&% T+- DTM L(4(-%'

3hysical *ddress? *kira 'ouse& iambere +oad& Upper 'ill&

D-% L(%&%'* 4st $arch 5=4=

1ranches? 58

3" SMEP D%$.(- T5(& M(.(&&% L(4(-%'

3hysical *ddress? S$(31uilding - irichwa +oad& ,ff *rgwingsodhek +oad

D-% L(%&%'*48th December 5=4=

1ranches? 7

!" R%4+DTM L(4(-%'

3hysical *ddress? 0inance 'ouse& 48th 0loor& "oita Street

D-% L(%&%'* 4st December 5=4=

1ranches?

>" R(5( D%$.(- T5(& M(.(&&%

3hysical *ddress? ? 5nd 0loor& (l-roi3la;a& Tom $boya Street

D-% L(%&%'* 48th !une 5=44

1ranches?


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6" U#E?O D%$.(- T5(& M(.(&&% L(4(-%'

3hysical *ddress? 3ark3la;a1uilding& %round 0loor& $oktarDaddah Street

D-% L(%&%'* =< ovember 5=4=

1ranches? 5

@" C%&-+ D%$.(- T5(& M(.(&&% L(4(-%'

3hysical *ddress? 3la;a 4st 0loor& ew 3umwani +oad& %ikomba

D-% L(%&%'* 49th September 5=45

1ranches? 4

8" SUMAC DTM L(4(-%'

3hysical *ddress? )onsolidated 1ank 'ouse 5nd 0loor& oinange Street

D-% L(%&%'* 5:th ,ctober 5=45

1ranches? 4

"UI D%$.(- T5(& M(.(&&% L(4(-%'

3hysical *ddress? *sili)omplex1uilding 4st 0loor& +iver +oad

D-% L(%&%'*


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A$$%&'()III? D-C.%-(.&F.4

MICRO FINANCE YEAR ROE NPLR CAR

*2(+*%( 2*"U(S

U/(L, 5==: 55.7= 6.=6 4


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5=44

Documents

Kisala_The Effect of Credit Risk Management Practices on Loan Performance in Microfinance Institutions