Abstract

Credit risk management in microfinance institutions has become more important in microfinance literature. Since granting credit is one of the main sources of income in credit Unions, the management of the risk related to that credit affects the profitability of the credit unions. This study seeks to investigate the effect of credit risk management on the performance of MFIs in the Fako chapter of credit Unions.

The study specifically investigates the effects of client appraisal, credit risk control, and collection policy on the performance of credit unions in the Fako chapter. Data was collected using questionnaires which were designed and administered to staff and Board members of the credit unions, 84 respondents were selected using purposive sampling technique, analysis was performed in the Statistical Package for Social Sciences(SPSSv21) using descriptive and inferential statistics (correlation and regression analysis).

Our findings revealed that there was a positive relationship between client appraisal, credit risk control, and the performance of credit unions while collection policy negatively affected performance. It was therefore recommended that MFIs should have stringent credit appraisal techniques if they are to ensure that their performance is not adversely affected resulting from the poor screening of debtors, MFIs should enhance their client appraisal techniques so as to improve their financial performance. Through client appraisal techniques, the MFIs will be able to know credit-worthy clients and thus reduce their non-performing loans.

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

In today’s environment of intense competitive pressures, volatile economic conditions, rising default rates, and increasing levels of consumer and commercial debt, an organization’s ability to effectively monitor and manage its credit risk could mean the difference between success and survival (Altman, 2002). The past decade has seen dramatic losses in the banking industry.

Firms that had been performing well suddenly announced large losses due to credit exposures that turned sour, interest rate positions are taken, or derivative exposures that may or may not have been assumed to hedge balance sheet risk (Santomero, 1997).

In response to this, commercial banks have almost universally embarked upon an upgrading of their risk management and control systems. Due to the nature of their business, commercial banks expose themselves to the risks of default from borrowers. Prudent credit risk assessment and the creation of adequate provisions for bad and doubtful debts can cushion the bank’s risk (Aduda & Gitonga, 2011).

The main aim of every financial institution is to operate profitably in order to maintain its stability and improve in growth and expansion. In the last twenty years, the banking sector has faced various challenges that include non-performing loans (NPL), political interference, and fluctuations of interest rate among others, which have threatened the bank’s stability.

According to Shubhasis, (2005), risk management is important to bank management because banks are “risk machines” that take risks; they transform them and embed them in banking products and services. Risks are uncertainties resulting in adverse variations of profitability or in losses. Various risks faced by commercial institutions include credit risk, market risk, interest rates risk, liquidity risk, and operational risk.

Management of trade between risks and returns is important for the sustainable profitability of microfinance and other financial institutions. Amongst risks in microfinance operation, credit risk which is related to a substantial amount of income-generating assets is found to be a determinant of microfinance performance. Hence credit risk management capability of microfinance institutions remains a paramount academic discourse in finance and economics (Gizaw, Kebede, & Selvaraj, 2014).

It is widely recognized that the exclusion of the poorest lenders, particularly in the rural areas, from the traditional financial banking system is one of the main obstacles to sustainable development and poverty reduction. Indeed, it is almost impossible for rural poor people who live in riskier environments and who lack assets collateral, formal wage job, and limited credit history loans to obtain credit from the traditional banking system because lending to them became very risky and very costly.

There is little controversy in the literature about the fact that the formal financial sector has little incentives to provide financial services to poor clients. Generally, and according to economic theory, the exclusion of poor people from traditional banks can be explained by the high level of asymmetric information such as adverse selection and moral hazard, which raises problems of screening, monitoring, and enforcement (Baklouti & Abdelfettah, 2013).

Excluded from formal financial institutions, poor people generally have to rely on loans from informal moneylenders, who are more likely to exploit the poor by providing loans on enormously high-interest rates. To make the world a better place and to enhance international development, the United Nations Organization (UNO) announced in 2000 the millennium development goals, aimed to reduce poverty by half by the year 2015. In this regard, microfinance has recently attracted growing attention and has proven worldwide to be a promising tool to alleviate poverty.

These Microfinance institutions (MFIs) have the function of providing financial services to the low-income households who have long been deemed ‘unbankable”, including the self-employed and customers without collateral assets. Dedicated to improving the lot of the poor in developing countries, MFIs provide to them the much-needed credit loans of a small amount to finance their entrepreneurship projects, to finance their consumption, to cope with illness, or the education of their children without any collateral requirement.

It has been proven that microfinance programs have a great contribution to reducing poverty. More importantly, it has been proven that Microfinance can be viewed as a development strategic tool by enabling poor entrepreneurs to initiate their own business, teaching them how to protect the capital they have, deal with risk, and expand the circle of their economic activities.

The availability of microcredit schemes increases the number of small enterprises, which in turn creates employment opportunities for the poorest and stimulates therefore economic development and social inclusion. Apart from their social mission success, MFIs have appeared to be a potentially viable and profitable business and have unregistered a well-known success of some third-world programs in generating impressive repayment rates.

Achieving self-sustainability means that the MFI should be self-sufficient, be able to cover all its present costs, and make profits on services that they offer. In order to become permanent and maximize their sustainability, MFIs must apply high interest rates, largely higher than market rates. This can be at expense of social aims because the high interest rate can exclude poor people particularly those living in rural or marginal areas.

These dual objectives in serving poor clients with relatively small loans and achieving self-sustainability even profit represents one of the most widely discussed dilemmas among microfinance academics and practitioners. To face such a dilemma, it is vital for MFI’s stability to find the best practice, improve the efficiency of their portfolio risk management as well as apply accurate pricing policy, which allows for finding a better equilibrium between sustainability and outreach.

The recent instabilities in the financial sector related to the subprime mortgage lending crisis in the U.S provide an example of the dangers in providing an increasing array of higher-risk loans to higher-risk borrowers. The rapidly growing supply of funds for micro-loans, the increasing competition in microcredit markets, the increasing over-indebtedness among micro-entrepreneurs, and the current financial crisis increase the credit risk and therefore lead to a growing need to estimate the risk of failure of microfinance borrowers.

In order to improve both social outreach and financial sustainability in an increasingly constrained environment, developing powerful credit risk management tools in MFI becomes more than ever crucial (Baklouti & Abdelfettah, 2013).

Microfinance institutions are exposed to credit or default risk whenever they make commercial or personal loans. Inherent in the loan process is the ever-present problems of asymmetric information, adverse selection, and moral hazard. Typically, in lending and borrowing, the potential borrowers know more about the risk and return of an investment project and the likelihood of a loan being repaid than does the lender.

The balance of information between the borrower and the lender is not equal or symmetric. Instead, borrowers have the best knowledge about the project they are funding and will put the best possible spin on any credit report or project shortcomings (Maureen, Reynold, & Bruce, 2015).

The existence of information asymmetry, therefore, give lenders a hard time differentiating between good credit risks and bad credit risks and demand a blanket premium over and above the existing rates as compensation for the risk arising out of the inability to determine who indeed should be lent to (Munene, 2012).

This causes the good firms to shy away from borrowing from such a lender since the high-interest rates have devalued their strong credit history while the bad firms become very eager to borrow from such a lender since they know that judging by the strength of their cash-flows, they should be charged an even higher interest rate. As a result, lenders end up with a loan portfolio comprising almost entirely of bad credit risks.

An effective system that ensures repayment of loans by borrowers is critical in dealing with asymmetric information problems and in reducing the level of loan losses, thus the long-term success of any financial organization. Considerations that form the basis for a sound credit risk management system include policy and strategies (guidelines) that clearly outline the scope and allocation of bank credit facilities and the manner in which a credit portfolio is managed, that is how loans are originated, appraised, supervised and collected (Greuning and Bratanovic, 2003).

The recommendation has been widely put to use in the banking sector in the form of the credit assessment. According to the asymmetric information theory, a collection of reliable information from prospective borrowers becomes critical in accomplishing effective screening. Therefore, the study intends to through more light on the issue of credit risk management by microfinance institutions within the Buea municipality.

1.2 Statement of the Problem

Microfinance institutions (MFIs) often known as banks for the poor, make funds accessible to the small and medium scale enterprises who may not qualify for loans from traditional banks due to their high-risk nature. If Microfinance institutions are taking up this high credit risk responsibility, how do they manage the credit risk they are exposed to in order to make profits and stay in business? What credit risk policies are adopted to reduce the credit risks they are exposed to and the effect of the credit risk policies on their clients?

Credit risk challenges are implicit in financial institutions’ activities because credit risk events are typically uncertain (Laurentis, 2009).  In Fako therefore, as Nancy (2001) has noted an effective credit risk management process is required to help MFI establish rules to prevent operating losses due to human error, employee carelessness, technological malfunction, or fraud. However, MFIs may put into place internal controls and procedures as well as periodic internal audit reviews to ensure that employees comply with the rules when performing duties in credit management.

Empirical studies have focused on the different challenges that affect the performance of MFIs (Achou & Tengoh, 2008). In addition, prior studies regarding credit risk management tried to examine the possible methods to manage credit risk including the use of credit risk rating and the effect of borrower’s financial positions on credit risk management, and the effect of the relation of borrower and lender on credit risk management.

Although there has been a number of studies on credit risk management and related issues both in developed and developing countries, it is difficult to believe that these studies exhaustively examined the effect of credit risk management on the performance of microfinance institutions, particularly in Cameroon.

Granting credit to the microfinance institution members is an important activity and therefore it is important to manage credit risks facing the microfinance institutions, coupled with taking necessary measures to reduce loan defaulters while at the same time advancing credit in a fair and undiscriminating manner so as to continue offering services to members.

Weak credit risk management is a primary cause of many business failures. Most National Credit Unions that failed in the mid-1980s in the U.S.A were because of a consistent element of the inadequacy of the bank’s management system for controlling loan quality (Parrenas, 2005).

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 and counterparties, poor portfolio risk management, or lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counterparties (Gil-Diaz, 2008).

In unstable economic environments, interest rates charged by financial institutions are fast overtaken by inflation and borrowers find it difficult to repay loans as real incomes fall, insider loans increase, and over-concentration in certain portfolios increases giving a rise to credit risk..

Sound credit management is a prerequisite for a financial institution’s stability and continuing profitability while deteriorating credit quality is the most frequent cause of poor financial performance. It is for this reason that the current study has sought to through more light on the issue of credit risk management particularly in the Fako chapter of Credit Unions.

1.3 Research Questions

The discussed background and problem formulation lead us to the following research question. The main objective of this study is to examine the effect of credit risk management on the performance of microfinance institutions in the Fako chapter of Credit Unions the study specifically seeks to;

To what extent does credit risk management affects the performance of the Fako chapter of Credit Union.

With the following specific questions

1. What is the effect of client appraisal on the performance of microfinance institutions in the Fako chapter of Credit Unions?
2. To what extent does credit risk control affect the performance of microfinance institutions in the Fako chapter of Credit Unions?
3. How does collection policy affect the performance of microfinance institutions in the Fako chapter of Credit Unions?

Further Readings

THE EFFECT OF CREDIT RISK MANAGEMENT ON THE FINANCIAL PERFORMANCE OF COMMERCIAL BANKS IN CAMEROON: CASE STUDY NFC BANK BAMENDA