CREDIT ASSESSMENT PROCESS AND REPAYMENT OF LOANS INMRICOFINANCE INSTITUTIONS IN KENYA
BY
BEATRICE NJENGAD61/XXXXXX/20XX
A RESAERCH PROPOSAL SUBMITTED IN PARTIAL FUFILLMENTOF THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTER OF BUSINESS ADMINISTARTION, SCHOOOL OF BUSINESS UNIVERSITY OF NAIROBI
JUNE 2014
CHAPTER ONE
INTRODUCTION
The process of lending is guided by credit policies which
are guidelines and procedures put in place to ensure smooth
lending operations. If lending is not properly assessed,
involves the risk that the borrower will not be able or
willing to honor their obligations (Feder & Just 1980). In
order to lend, financial institutions accept deposits from
the public against which they provide loans and other form
of advances. Since they bear. A cost for carrying these
deposits, banks undertake lending activities in order to
generate revenue. The major sources of revenue comprise
margins, interests, fees and commissions (Odongo, 2004).
Beyond the urge to extend credit and generate revenue, most
financial institutions have to recover the principal amount
in order to ensure safety of depositors' fund and avoid
capital erosion. During Lending one has to consider interest
income, cost of funds, statutory requirements, depositor’s
needs and risks associated with loan proposals. For these
reasons banks have overtime developed credit policies and
procedures which stipulate the lending process. This process
includes among others the credit appraisals, documentations,
disbursement, monitoring and recovery processes lending.
Bank lending is also based on established international
standards.
REFERENCES
1.1.1 Credit Assessment Process
More specifically, Credit assessment improves current credit
scoring from following three Perspectives: Credit assessment
ensures inclusion of primary predictive factors that cover
the full spectrum of relevant qualification criteria and
both determines and reveals how they combine to produce
outcomes. Credit scoring, which relies on historical data,
does not have this capability, nor does it possess a
feedback mechanism to adjust factor weightings over time as
experience accumulates.
Credit assessment process determines which risk factors
pertain to the lending decision within the context of each
borrower’s situation and the loan product parameters, then
appropriately adjusts the factor weightings to produce the
right outcome. This is in stark contrast to credit scoring,
which has a fixed number of factors that have a constant set
of point weightings that are automatically applied to every
credit applicant regardless of their qualifications.
Furthermore, credit assessment uses a forward-looking
approach and simulates future economic conditions, and its
adaptive nature makes it more predictive over time, unlike
credit scoring models.
Credit assessment process integrates judgmental components
and proper context into the modeling process in a complete
and transparent manner. Credit scoring systems lack context
because they rely purely on the available data to determine
what factors are considered. Credit scoring systems lack
transparency because two individuals with identical credit
scores can be vastly different in their overall
qualifications, the credit score itself is not readily
interpretable, and industry credit scoring models are
maintained as proprietary, as are their development
processes.
REFERENCES
1.1.2 Repayment of Loans
Default on borrowed funds could arise from unfavorable
circumstances that may affect the ability of the borrower to
repay as pointed out by Stigliz and Weiss (1981). The most
common reasons for the existence of defaults are the
following: if the financial institution is not serious on
loan repayment, the borrowers are not willing to repay their
loan; the financial institutions staffs are not responsible
to shareholders to make a profit; clients lives are often
full of unpredictable crises, such as illness or death in
the family; if loans are too large for the cash needs of the
business, extra funds may go toward personal use; and if
loans are given without the proper evaluation of the
business Norell (2001).Wakuloba(2005) in her study on the
causes of default in Government micro credit programs
identified the main causes of default as poor business
performance, diversion of funds and domestic problems.
Breth (1999) argued that there are many socio-economic and
institutional factors influencing loan repayment rates. The
main factors from the lender side are high-frequency of
collections, tight controls, a good management of
information system, loan officer incentives and good follow
ups. In addition, the size and maturity of loan, interest
rate charged by the lender and timing of loan disbursement
have also an impact on the repayment rates (Okorie al.,
2007). The main factors from the borrower side include socio
economic characteristics such as, gender, educational level,
marital status and household income level and peer pressure
in group based schemes.
REFERENCES
Breth, S.A., (1999).Microfinance in Africa, Mexico City: Sasakawa Africa Association.
Stiglitz J.E., Weiss A. (1981) Credit Rationing in Markets with Imperfect Information, The American Economic Review, 71 :( 3)
Wakuloba R.A.B (2005).Causes of Default in Government Micro-
CreditProgramme: A Case Study of Uasin Gishu District Trade
Development Joint Loan Board, Nairobi
Okorie A., Andrew C. I. (1992), Agricultural Loan Recovery
Strategies in a Developing
Economy: A Case Study of Imo State, Nigeria, African Review of
Money, Finance and Banking, 2
Norell, D., (2001). How to Reduce Arrears In Microfinance Institutions, Journal of Microfinance, (3)1.
1.1.3 Credit Assessment Process and Repayment of Loans
Effective credit risk assessment and loan accounting
practices should be performed in a systematic way and in
accordance with established policies and procedures. To be
able to prudently value loans and to determine appropriate
loan provisions, it is particularly important that banks
have a system in place to reliably classify loans on the
basis of credit risk. Larger loans should be classified on
the basis of a credit risk grading system. Other, smaller
loans, may be classified on the basis of either a credit
risk grading system or payment delinquency status. Both
accounting frameworks and Basel II recognise
loanclassification systems as tools in accuratelyassessing
the full range of credit risk. Further,Basel II and
accounting frameworks both recognise
that all credit classifications, not only
those reflecting severe credit deterioration, should be
considered in assessing probability of
default and loan impairment.
13. A well-structured loan grading system is an important
tool in differentiating the
degree of credit risk in the various credit exposures of a
bank. This allows a more accurate
determination of the overall characteristics of the loan
portfolio, probability of default and
ultimately the adequacy of provisions for loan lo
sses. In describing a loan grading system, a
bank should address the definitions of each loan grade and
the delineation of responsibilities
for the design, implementation, operation
and performance of a loan grading system.
14. Credit risk grading processes typically take into
account a borrower’s current
financial condition and paying capacity, the current value
and realisability of collateral andother borrower and
facility specific characteristics that affect the prospects
for collection of principal and interest. Because these
characteristics are not used solely for one purpose
(e.g. credit risk or financial reporting), a bank may assign
a single credit risk grade to a loan regardless of the
purpose for which the grading is used. Both Basel II and
accounting edit risk assessment and loan provisioning may
involve risk measurement modelsand assumption-based
estimates. Models may be used in various aspects of the
credit risk assessment process including credit scoring,
estimating or measuring credit risk at both theindividual
transaction and overall portfolio levels, portfolio
administration, stress testing loans
or portfolios and capital allocation. Credit risk assessment
models often consider the impactof changes to borrower and
loan-related variables such as the probability of default,
loss given default, exposure amounts, collateral values,
rating migration probabilities and internal borrower
ratings. As credit risk assessment models involve extensive
judgment, effective model validation procedures are crucial.
Banks should periodically employ stress testing and back
testing in evaluating the quality of their credit risk
assessment models and establish internal tolerance limits
for differences between expected and actual outcomes and
processes for updating limits as conditions warrant. Banks
should have policies that require remedial actions be taken
when policy tolerances are exceeded. Banks should also
document their validation process and results with regular
reporting of the results to the appropriate levels of bank
management. Additionally, the validation of internal credit
risk assessment models should be subject to periodic review
by qualified, independent individuals (e.g., internal and
external auditors)
1.1.4 Microfinance Institutions
1.2 Research Problem
Income from lending constitutes on average 75-80% of the
total bank income. Credit policies and procedures are
designed to guide lending and ensure prudent lending
operations. Despite rigorous credit assessment process
Barclays uses that includes among others proof that customer
does not have other credit obligation, analysis of their
account performance, sustainability of their income levels,
security and ability to pay (International Credit Manual,
2003), Barclays is faced with poor management of its loan
portfolio as noted in Credit reference Bureau Report
2005.This led to poor quality loan portfolios which had to
be provided for fully. The financial records showed that
Barclay's provisions and bad debts written off increased
from Shs1.9billion in 2002 to UgShs 6.8billion in 2004.
1.3 Objective of the Study
The objective of this study is to determine the effect of
credit assessment process on repayment of loans in
microfinance institutions in Kenya.
1.4 Value of the Study
This study will provide empirical data for policy makers in
formulating appropriate policy environment for the
operations of microfinance institutions in Kenya.
The findings of this study will provide recommendations on
how to assess and recover the loans given to customers.
The study will also be of significance to future researchers
as literature review, and further provoked research in the
area of lending and portfolio management.
CHAPTER TWO
LITERATURE REVIEW
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
This section summarizes the literature that is available
regarding credit assessment process and loan repayment that
is most used by credit officers in most microfinance
institutions to determine whether their customers are credit
worthy or not.
2.2 Theoretical Review`
It is argued that failure to assess whether customers are
credit worthy highly contributes to poor financial
performance of firms when these customers are unable to
repay the loans. Credit officers should minimize risks
through ensuring that they give loans to customers who is
credit worthy. Recent studies have focused on the links
between Credit policy and loan repayment the legal
institutions that can facilitate credit contracts, exploring
the nature of those contracts based on the power theory of
credit, information theories of credit, and the legal origin
of institutions.
2.2.2 Credit Metrics Model
Credit Metrics is a statistical model developed by Morgan
(1995), the investment bank for internal use, but now it’s
being used all around the world by hundreds of banks. This
model works on the statistical concepts like probability,
means, and standard deviation, correlation, and
concentrations. According to Gupton (1997) the model was
developed with three objectives which include to develop a
Value at Risk (VAR) framework applicable to all the
institutions worldwide those carry the credit risks in the
course of their businesses, develop a portfolio view showing
the credit event correlation which can identify the costs of
concentrations and the benefits of diversification in a mark
to market framework and to apply it in making investment
decisions and risk mitigating actions i.e determining the
risk based credit limits across the portfolio, and rational
risk based capital allocations.
Credit Metrics is a tool for assessing portfolio risk due to
changes in debt value caused by changes in obligor credit
quality. This model includes the changes in value caused not
only by possible default events, but also by upgrades and
down grades in credit quality, because the value of a
particular credit varies with the corresponding credit
quality according to Bhatia (1997). In the case of default a
recovery rate is taken as the portfolio value. This
distribution gives us two measures of credit risk which are
standard deviation and percentile level. Credit Metrics has
various applications which are to reduce the portfolio risk
by reevaluate obligors having the largest absolute size
arguing that a single default among these would have the
greatest impact, reevaluate obligors having the highest
percentage level of risk arguing that these are the most
likely to contribute to portfolio losses, reevaluate
obligors contributing the largest absolute amount of risk
arguing that these are the single largest contributors to
portfolio risk.
The last categories are the "fallen angels" whose large
exposures were created when their credit ratings were
better, but who now have much higher percentage risk due to
recent downgrades. Its other application is to limit setting
of course, what types of risk measure to use for limits, as
well as what type of policy to take with regard to the
limits are management decisions.
Finger (1997), notes that a user might use the credit
metrics for two different purposes namely what type of limit
to set, which risk measure to use for the limits and what
policy to employ with regard to the limits. These limits
could be set in terms of percentage risk, exposure size and
absolute risk. Identifying the correlations across the
portfolio so that the potential concentration may be reduced
and the portfolio is adequately diversified across the
uncorrelated constituents. This model helps the financial
institution think about how the various credit policies
should be modified to be able to issue good loans and
minimize credit risk.
2.2.3 The 5 C’s Model of Client Appraisal
Microfinance Institutions use the 5Cs model of credit to
evaluate a customer as a potential borrower (Abedi, 2000).
The 5Cs help MFIs to increase credit performance, as they
get to know their customers better. These 5Cs include
character, capacity, collateral, capital and condition.
Character basically is a tool that provides weighting values
for various characteristics of a credit applicant and the
total weighted score of the applicant is used to estimate
his credit worthiness (Myers and Forgy, 2005). This is the
personal impression the client makes on the potential
lender. The factors that influence a client can be
categorized into personal, cultural, social and economic
factors (Ouma, 1996). The psychological factor is based on a
man’s inner worth rather than on his tangible evidences of
accomplishment. MFI’s consider this factor by observing and
learning about the individual. In most cases it is not
considered on first application of credit by an applicant
but from the second time. Under social factors, lifestyle is
the way a person lives. This includes patterns of social
relations (membership groups), consumption and
entertainment.
A lifestyle typically also reflects an individual's
attitudes, values or worldview. Reference groups in most
cases have indirect influence on a person’s credibility.
MFI’s try to identify the reference groups of their target
as they influence a client’s credibility. Personal factors
include age, life cycle stage, occupation, income or
economic situation, personality and self concept. Under life
cycle stage for example older families with mature children
are not likely to default since it’s easier to attach
collateral on their assets since they are settled unlike the
unsettled young couples. The MFI’s will consider the cash
flow from the business, the timing of the repayment, and the
successful repayment of the loan. Anthony (2006) defines
cash flow as the cash a borrower has to pay his debt.
Cash flow helps the MFI’s to determine if the borrower has
the ability to repay the debt. The analysis of cash flow can
be very technical. It may include more than simply comparing
income and expenses. MFI’s determines cash flow by examining
existing cash flow statements (if available) and reasonable
projections for the future (ratios Orlando (1990) posits
that lenders review the borrower’s business plan and
financial statements, they have a checklist of items to look
at one of the being the number of financial ratios that the
financial statements reveal.
These ratios are guidelines to assist lenders determine
whether the borrower will be able to service current
expenses plus pay for the additional expense of a new loan.
Collateral is any asset that customers have to pledge
against debt (Lawrence & Charles, 1995). Collateral
represents assets that the company pledges as alternative
repayment source of loan. Most collateral is in form of hard
assets such as real estate and office or manufacturing
equipment. Alternatively accounts receivable and inventory
can be pledged as collateral. Lenders of short term funds
prefer collateral that has duration closely matched to the
short term loan
According to Weston and Eugene (1966), Capital is measured
by the general financial position of the borrower as
indicated by a financial ratio analysis, with special
emphasis on tangible net worth of the borrower’s business.
Thus, capital is the money a borrower has personally
invested in the business and is an indication of how much
the borrower has at risk should the business fail. Condition
refers to the borrower’s sensitivity to external forces such
as interest rates, inflation rates, business cycles as well
as competitive pressures. The conditions focus on the
borrower’s vulnerability.
2.3 Variables of Credit Policy.
Pandey, (2000) observers that credit policy refers to a
combination of three decision variables. These decision
variables determine who qualifies for the loan. They
include, credit standards, credit terms and collection
efforts on which the financial manager has influence.
2.3.1 Credit Standards
Credit standards according to Mehta (1972), in advancing
loans, credit standard must be emphasized such that the
credit supplier gains an acceptable level of confidence to
attain the maximum amount of credit at the lowest as
possible cost. Credit standards can be tight or loose (Van
Horne, 1994).Tight credit standards make a firm lose a big
number of customers and when credit are loose the firm gets
an increased number of clients but at a risk of loss through
bad debts. A loose credit policy may not necessarily mean an
increase in profitability because the increased number of
customers may lead to increased costs in terms of loan
administration and bad debts recovery. In agreement with
other scholars Van Horne, (1994), advocated for an optimum
credit policy, which would help to cut through weaknesses of
both tight and loose credit standards so, the firm can make
profits. This is a criteria used to decide the type of
client to whom loans should be extended. Kakuru (1998) noted
that it’s important that credit standards be basing on the
individual credit application by considering character
assessment, capacity condition collateral and security
capital.
Character it refers to the willingness of a customer to
settle his obligations (Kakuru, 2000) it mainly involves
assessment of the moral factors. Social collateral group
members can guarantee the loan members known the character
of each client; if they doubt the character then the client
is likely to default. Saving habit involves analyzing how
consistent the client is in realizing own funds, saving
promotes loan sustainability of the enterprise once the loan
is paid. Other source should be identified so as to enable
him serve the loan in time. This helps micro finance
institutions not to only limit loans to short term projects
such qualities have an impact on the repayment commitment of
the borrowers it should be noted that there should be a firm
evidence of this information that point to the borrowers
character (Katende, 1998).
According to Campsey and Brigham (1995) the evaluation of an
individual should involve; gathering of relevant information
on the applicant, analyzing the information to determine
credit worthiness and making the decision to extend credit
and to what tune. They suggested the use of the 5Cs of
lending. The 5Cs of lending are Capacity, Character,
Collateral, Condition and Capital. Capacity refers to the
customer’s ability to fulfill his/her financial obligations.
Capacity, this is subjective judgment of a customer’s
ability to pay. It may be assessed using a customer’s
ability to pay. It may be assessed using the customer’s past
records, which may be supplemented by physical or
observation. Collateral is the property, fixed assets,
chattels, pledged as security by clients. Collateral
security, This is what customers offer as saving so that
failure to honor his obligation the creditor can sell it to
recover the loan. It is also a form of security which the
client offers as form of guarantee to acquire loans and
surrender in case of failure to pay; if borrowers do not
fulfill their obligations the creditor may seize their asset
(Girma, 1996). According to Chan and Thakor (1987), security
should be safe and easily marketable securities apart from
land building keep on losing value as to globalization where
new technology keeps on developing therefore lender should
put more emphasis on it. Capital portends the financial
strength, more so in respect of net
worth and working capital, evaluation of capital may be by
way of analyzing the balance sheet using the financial
ratios. Condition relates to the general economic climate
and its influence on the client’s ability to pay. Condition,
this is the impact of the present economic trends on the
business conditions which affects the firm’s ability to
recover its money. It includes the assessment of prevailing
economic and other factors which may affect the client
ability to pay (Kakuru, 2000).
2.3.2 Credit Terms
A Credit term is a contractual stipulation under which a
firm grants credit to customers (Wamasembe, 2002);
furthermore these terms give the credit period and the
credit limit. The firm should make terms more attractive to
act as an incentive to clients without incurring unnecessary
high levels of bad debts and increasing organizations risk.
Credit terms normally stipulate the credit period, interest
rate, method of calculating interest and frequency of loan
installments. Kakuru (1998) explains the significance of
discounts in credit terms. Discounts are offered to induce
clients to pay up within the stipulated period or before the
end of the credit period .This discount is normally
expressed as a percentage of the loan. Discounts are meant
to accelerate timely collection to cut back on the amount of
doubtful debts and associated costs.
Ringtho (1998) observes that credit terms are normally
looked at as the credit period terms of discount and the
amount of credit and choice of instrument used to evidence
credit. Credit terms may include; Length of time to approve
loans, this is the time taken from applicants to the loan
disbursement or receipt. It is evaluated by the position of
the client as indicated by the ratio analysis, trends in
cash flow and looking at capital position. Maturity of a
loan, this is the time period it takes loan to mature with
the interest there on. Cost of loan. This is interest
charged on loans, different micro finance institutions
charge differently basing on what their competitors are
charging. The chartered institute of bankers and lending
text (1993) advises lending institutions to consider amount
given to borrowers. Robinson M.S (1994) pointed out that the
maximum loan amount per cycle are determined basing on the
purpose of the loan and the ability of the client to repay
(including guarantee).
2.3.3 Collection Efforts
McNaughton (1996) defines a collection effort as the
procedure an institution follows to collect past due
account. Collection policy refers to the procedures micro
finance institutions use to collect due accounts. The
collection process can be rather expensive in terms of both
product expenditure and lost good will (Brighan, 1997).
Collection efforts may include attaching mandatory savings
forcing guarantors to pay, attaching collateral assets,
courts litigation (Myers, 1998). Methods used by Micro
finance institutions could include letters, demand letters,
telephone calls, visits by the firm’s officials for face to
face reminders to pay and legal enforcements.
Dickerson et al., (1995) asserts that collection policy is a
guide that ensures prompt payment and regular collections.
The rationale is that not all clients meet their
obligations, some just take it for granted, others simply
forget while others just don’t have a culture of paying
until persuaded to do so. According to Myers (1998) many
micro finance institutions may send a letter to such
individuals (borrowers) when say ten days elapse or phone
calls and if payment is not received with in thirty days, it
may turn over the account to a collection agency.
Collection procedure is required because some clients do not
pay the loan in time some are slower while others never pay.
Thus collection efforts aim at accelerating collections from
slower payers to avoid bad debts. Prompt payments are aimed
at increasing turn over while keeping low and bad debts
within limits (Pandey, 1995). However, caution should be
taken against stringent steps especially on permanent
clients because harsh measures may cause them to shift to
competitors (Van Horn 1995). Ssemukono, (1996) states that
collection efforts are directed at accelerating recovery
from slow payers and decreases bad debts losses .This
therefore calls for vigorous collection efforts .The
yardstick to measurement of the effectiveness of the
collection policy is its slackness in arousing slow paying
customers.
REFERENCES
Pyle D.H. (1971),“On the Theory of Financial
Intermediation”, Journal of Finance, 26
Rajan R. (1995), “The Effect of Credit Market Competition on
Lending Relationships”,
TheQuarterly Journal of Economics
Rajedom, R. (2010), The lending policy and customer
defection in finance organization
Journalof finance and marketing Vol 1 No 15 pp 11.
Riach,M(2010), Credit risk management and policy
implications for microfinance
institutions,Reserch Paper.
2.2.3 Information Sharing Theory
Research on information sharing is relatively recent and
growing. Earlier papers analyze the effect of information
sharing in a market with asymmetric information, either
moral hazard or adverse selection (Gehrig and Stenbacka,
2005). In moral hazard setups, information sharing may
provide borrowers with higher incentives to perform: because
information becomes available to competitor banks, borrowers
are happy to perform better because they no longer fear
being held- up by the lender-monopolist (Padilla and
Pagano (1997). Second, borrowers do not want to
(strategically) default, because this will be publicly
known: when default in- formation is shared, borrowers will
face an increase interest rates and a decrease in access to
finance not only by the current bank, but by the rest of
banks in the market - the so called disciplinary effect
(Padilla and Pagano, 2000) hazard or adverse selection
(Gehrig and Stenbacka, 2005). In moral hazard setups,
information sharing may provide borrowers with higher
incentives to perform: because information becomes available
to competitor banks, borrowers are happy to perform better
because they no longer fear being held- up by the lender-
monopolist (Padilla and Pagano (1997). Second, borrowers do
not want to (strategically) default, because this will be
publicly known: when default in- formation is shared,
borrowers will face an increase interest rates and a
decrease in access to finance not only by the current bank,
but by the rest of banks in the market - the so called
disciplinary effect (Padilla and Pagano, 2000)
known to other banks, second-period competition will be
higher and first-period interest rates will have to go up.
As a result, information sharing can lead to welfare losses.
However, they assume that all characteristics about true
types can be revealed to the outside bank. In contrast, we
distinguish between information that can be shared (hard)
and information that cannot (soft), relationship specific
information. Hauswald and Marquez (2003) show that
information processing, providing the screening bank with
more informational advantage, will safeguard it from
competition allowing to earn rents.
Advances in the screening technology, therefore, will
increase returns from screening. Access to that same
information, on the other hand, levels the playing field for
banks and erodes their rents due to increased competition.
Thus, technological progress that allows for easier access
to the incumbent's information will decrease the returns to
investing in such information.
Information theories of credit refer to the amount of credit
to firms and individuals would be larger if financial
institutions could better predict the probability of
repayment by their potential customers. Therefore, more
banks know about the credit history of prospective
borrowers, the deeper credit markets would be. Public or
private credit registries that collect and provide broad
information to financial institutions on the repayment
history of potential clients are crucial for deepening
credit markets.
The information that each party to a credit transaction
brings to the exchange will have important implications for
the nature of credit contracts; the ability of credit
markets to match borrowers and lenders efficiently and the
role played by the rate of interest in allocating credit
among borrowers. The nature of credit markets can lead to
distinct roles for different types of lenders and different
types of borrowers (Walsh, 2003). When lenders know more
about borrowers, their credit history, or other lenders to
the firm, they are not as concerned about the “lemons”
problem of financing non-viable projects,
and therefore extend more credit (Stiglitz et al 1981).
Legal origin also has implications for financial
developments. Beck et al (2004) identified a political and
an adaptability channel through which legal origin affects
credit markets. The political channel depends on the balance
between state power and private property rights. For
example, civil law that promotes institutions that favor
state power over private property rights would tend to have
adverse implications for the growth of credit markets. The
adaptability channel recognizes that legal traditions differ
in their ability to evolve efficiently because judges
respond case by case to changing conditions. Both channels
imply that countries whose law is French in origin should
have on average slower financial development than British
common law countries. Risk is the possibility that the
actual return on an investment will be different from the
expected return on that investment. Credit risk has been
defined as the distribution of financial losses due to
unexpected changes in the credit quality of a counter party
in a financial agreement. Madison (1974) posits that the
oldest Mercantile.
Agency opened its doors in New York in 1841; it offered a
new kind of service to businessmen. Earlier, in both Europe
and America, businessmen seeking credit information had
occasionally hired agents or organized in local associations
to share information and protect themselves from credit
losses. But the Mercantile Agency was the first organized
effort to provide all who wished to subscribe to its service
with detailed credit information about businessmen across a
broad expanse of territory.
The credit granting process leads to a choice between two
actions; to give the new applicant credit or to refuse.
Credit scoring tries to assist this decision by finding what
would have been the best rule to apply on a sample of
previous applicants. This is the basis of credit scoring
approach where a decision to accept or reject an application
is made (Thomas et.al, 2002). It allows for case by case
risk management assessment when appraising a loan
application.
It therefore refers to the use of statistical models to
transform relevant data into numerical measures that guide
credit decisions. It is therefore referred to as the
industrialization of trust (Anderson, 2007). Credit scoring
has been championed worldwide to be a better means of
evaluating a credit worthy borrower as compared to the
traditional methods of risk assessment. The development of
technology over the years has seen many banks adopt credit
scoring models as part of their evaluation of a creditworthy
borrower. Steven (2006) posits that Credit scoring attempts
to simplify the task of estimating the probability of
default and calculate the loss given default from a range of
complicated possible scenarios.
REFERENCES
Padilla, A. J. and M. Pagano (2000). Sharing default
information as a borrower discipline
device, European Economic Review.
Anderson D.R., Williams T.A., and Sweeney D.J., (2009).
Essentials of Contemporary Business Statistics (International Edition). Mason,
South-Western Cengage Learning
Madison J.H., (1974). The Evolution of Commercial Credit
Reporting Agencies in Nineteenth-Century America. The Business
History Review, 48:2 (Summer, 1974), 164-186
Steven, R. (2006): Operational Risk (10th Edition), Securities and
Investment Institute, 24 Monument Street, London
Stiglitz, Joseph, and Weiss A., (1981). Credit Rationing in
Markets with Imperfect Information, American Economic Review 71,
393-410
Stiglitz, Joseph, and Weiss A., (1981). Credit Rationing in
Markets with Imperfect Information, American Economic
Review 71, 393-410
Beck T., Demirguc-Kunt A. Peria M.S.M. (November, 2008).
Bank Financing for SMEs around the world: Drivers,
Obstacles, Business Models and Lending practices.
Washington: The World Bank Development Research
Group
Walsh C.E. (2003).Monetary Theory and Policy, Boston, MIT
Press, International Edition.
2.3 Determinants of Credit Assessment Process
Credit assessment is the first stage in the lending process.
It is the process through which the credit applicant
presents the necessary documentations to the bank in order
to obtain a loan Nsereko (1995). Credit assessment involves:
This is basic stage in the lending process. Anjichi (1994)
describes it as the 'heart' of a high quality portfolio.
This involves gathering, processing and analyzing of quality
information as way of discerning the client's
creditworthiness and reducing the incentive problems between
the lenders as principals and the borrowers as agents.
The bank's credit policy, procedures and directives guide
the credit assessment process. Banks should base their
credit analysis on the basic principles of lending which are
Character, Capacity, Capital, Collateral and Conditions
(Matovu and Okumu, 1996). It is designed to ensure lenders
take actions which facilitate repayment or reduce repayment
likely problems. This information about the riskiness of the
borrower makes the financial institution to take remedial
actions like asking for collateral, shorter duration of
payment, high interest rates and other form of payment
(Stiglitz and Karla, 1990).
When a financial institution does not do it well, its
performance is highly affected. Edminster (1980) stressed
the importance of credit analysis when he observed that its
abandonment often resulted into several banks using credit
card to process. The variable we have, according to Hunte
(1996) included the length of time taken to process
applications, credit experience, proportion of collateral
security to the loan approved. It was found out that long
waiting time reflected a shortage of credible credit
information required to make informed credit decisions. This
in turn leads to greater risk more intense credit rationing
and low repayment rates. Hunte (1996) also observed that
loan experience indicated the ability to manage the business
loans better hence good quality borrowers for the business.
A less experienced borrower has less ability to manage a
business loan and therefore is not credit worthy (Devaney,
1984; Robinson, 1962).
Hunte, 1996). This implies that there are big risks
associated with new borrowers since the loan officer has no
familiarity of recovery from them.
Credit documentation and disbursement is another aspect of
credit assessment process. It encompasses the conduct of key
exposure control measures that ensures securities and
documentation is obtained before funds are disbursed, and
that modification on all credit facilities is approved
within credit policy. It also includes the maintenance of
orderly up dated credit files and the imposition of relevant
fees, updating of records and prompt notification of credit
reviews and renewal dates (McNaughton et al, 1996) Loan
documentation involves the legal drafting, document review,
collateral checks and the waiver of terms.
While the disbursement function involves checking the
validity of notes as well as ensuring that the documentation
for the credit facilities are properly executed. Loan
documentation defines the necessary security and covenant
before the loan is made. It provides risk protection by
providing. Grounds for the bank to take legal action when
borrowers fail to honor their obligations (Day et al, 1996).
Credit documentations clearly states the credit terms which
are the conditions attached to the loan after the borrower's
loan application has been favorably appraised. These include
among others:
2.4 Empirical Studies
REFERENCES
Day, J & Taylor, P (1996); How lazy drafting can lead to
losses, The Chartered Banker, Vol.2, No.7
-Nsereko, J. (1995); Problems of Non-Performing advances III
the Uganda Banker, Vol.3, No.1, Pg.26-35
Harrison, D (1996); Art or Science? The Importance of
Understanding Credit Risk, the
Chartered Banker, Vo1. 1 No.1
Matovu, J & Okumu, L. (1996), Credit Accessibility to the
Rural Poor in Uganda; Economic Policy Research Bulletin,
Vo1.2, No.1 (April) Pg.1-22
Ddumba Sentamu, (1993), The Role of Barclays bank in deposit
mobilization in Uganda, A PHD dissertation, Makerere
University, Kampala, Uganda
Gardner, D. C (1996); Corporate Credit Risk, Fairplace
Financial publishing place, London.
Glen, lD (1996) How Firms in Developing Countries Manage
risk, the World Bank &
International Finance Corporation, Discussion paper 17,
Washington D.C
41 Hanson & Rocha, (1986), High interest rates, Spreads and
the cost of intermediation, World
Bank, industry and Finance series, Vo1.18
-Kagwa, P (2003); Financial Institutions loan portfolio
performance in Uganda. A comparative
study of Barclays bank and microfinance Institutions. An MBA
research dissertation to
Makerere University, Kampala, Uganda
Kakuru, J (2005); Finance Decision and the Business, 2nd
edition
/
Kansiime Eldard, 1996; The role of Barclays bank in the
mobilization and allocation of
resources in Uganda, Uganda Banker, Vo1. 4, No.1 March
pg.23- 28
Kasekende, L & Atieng-ego, (1995) Financial Liberalization
and its Implication for the
Domestic Financial systems; the case of Uganda, A Research
Proposal presented at AERC
workshop in Nairobi, Kenya.
Kim, D & Santomero, A (1993); Forecasting required loan loss
Reserves, Journal of Economics
and Business, August 1993, pg, 315-329
Lanyero, K (2003); Credit Policy and the Utilization of
Development Funds by Barclays bank.
An MBA research dissertation to Makerere University,
Kampala, Uganda
42 Mukasa Muyonga A, (1997); Uganda Barclays bank non-
performing loans: The role of
lending process. An MBA research dissertation to Makerere
University, Kampala, Uganda.
Namara, A (2005); The role of lending policy and the access
to credit by small and micro
enterprises in Uganda. An MBA research dissertation to
Makerere University, Kampala,
Uganda
dongo, W. (2004), The Effects of Credit Policies on the
Performance of loans by Barclays
bank in Uganda, An MBA research dissertation to Makerere
University, Kampala, Uganda
sevume ,G. (2004), The Effects of Credit policies on the
Performance ofloans Officers in
2.4 Empirical Studies
CHAPTER THREE
RESEARCH METHODOLOGY
3.1Intoduction
This chapter presents the design of the research and
procedure that would be taken. The target population under
the study is given including the sample drawn, its design
technique and size. The instruments for data collection and
procedures for the data collection is presented and the data
analysis methods.
3.2 Research Design
Research design refers to how data collection and analysis
are structured in order to meet the research objectives
through empirical evidence economically (Chandran, 2004;
Cooper and Schindler, 2006). (Mugenda & Muganda, 2003)
describes descriptive design as a process of collecting data
in order to answer questions regarding the current status of
the subjects in the study. The research design was
therefore suitable in conducting the study
3.3TargetPopulation
According to Mugenda and Mugenda (2003) a population refers
to an entire group of individuals, events or objects having
a common observable characteristic. The target population of
the project will comprise of six licensed deposit takings
micro finance institutions in Kenya as at 31st June
2013.There are nine deposits taking micro finance
Institution but three of the institutions were licensed in
the late 2012 therefore data wasn’t available. Census was
used in getting information. A census is an attempt to
collect data from every member of the population being
studied rather than choosing a sample. (See appendix 1).
3.4 Data Collection
The data that was collected from secondary sources. The
secondary data on the financial performance of the
institutions was obtained from the financial report of the
institutions. This enabled the researcher to get quantified
data that was helpful to draw conclusions and give
recommendations on the effect of credit policy on the
financial performance of deposit taking micro finance
institutions. Data was collected from the period 2010-2012
because most DTM’s got their license from CBK during this
period.
3.5 Data Analysis
The findings of the research were written down and worked
out, edited and analyzed using comparison and percentage
approaches with the help of SPSS computer program to draw
conclusions and recommendations. Measures of dispersion were
used in assessing the variability of the effect of credit
policy on the financial performance of the deposit taking
micro finance institutions. The significance of the
coefficients range from 0.1 to 0.9 whereby the coefficients
closer to 0.1 indicates less impact and those close to 0.9
indicate greater impact.
3.5.1 Analytical Model
The regression model that was used in analyzing the effects
of credit policy on financial performance of the censured
deposit taking micro finance organizations.
The model of this study is as follows:
Y=α+β1X1+β2X2+β3X3 + ε
Where:
α= Constant Term
Y= Financial Performance
X1= Credit Standards
X2= Credit terms and conditions
X3= Collection efforts
ε = Error term normally distributed about the mean of zero
Whereby Y is the dependant variable (financial performance),
β0 is the regression constant or Y intercept, β1….β3 are the
coefficients of the regression model. The basis of the model
is to help in measuring financial performance by exploring
the contribution of various components. The test of
significance will be the ANOVA test.
