CHAPTER ONE

INTRODUCTION

This initial chapter introduces the entire research paper. It presents a background to the study, statement of the problem, research questions, objectives, and hypotheses, the relevance of the study, and the scope.

1.1 Background of the Study

The power of financial institutions especially microfinance to create money is of great importance in business operations. Microfinance is the major financial intermediaries in any economy and they are the major providers of credits to the household and corporate sector and operate the payment mechanism. They deal with both retail and corporate customers, have well-diversified deposit and lending books,s and generally offer a full range of financial services.

The policy of microfinance to make money results in the elastic credit system that is necessary for economic progress at a relatively steady rate of growth. Particularly, microfinance makes profits by selling liabilities with one set of characteristics (a particular combination of liquidity risk and return) and using the proceeds to buy assets with a different set of characteristics i.e. asset transformation.

Modern financial management defines the business of the financial system as measuring, managing, and accepting the risks. Under the definitions, the most important and uncertain banks and financial institutions must measure, monitor, and manage their credit risk. This hazard which is called the default risk is the danger that the counterparty will default or not perform. With increased pressure on the financial institutions to improve shareholders’ return, banks have had to assume higher risk and at the same time, manage these risks to avoid losses.

Recent changes in the banking environment (globalization, deregulation, conglomeration, etc.) have posed serious risk challenges for banks and have offered productive opportunities (Saunders and Marcia, 2007).

Generally, the aim of risk management is not simply to reduce or even to eliminate risk it is also viewed as the process of recognition, measurement, and control of risk that an investor faces.  Indeed, this may not be possible given various difficulties of measuring risk and the limitations of the instruments for controlling risks.

Risk management must be of the continuous process the composition of an investor’s portfolio and the risk of the assets therein, as well as the objectives and constraints of the investor change over time. However, the need for risk management has increased sharply in the past three decades.

Risk management has the purpose and the scope of Risk management to ensure that the risk-taking part of investing is being carried out in a controlled and understood manner. It is a continuous process change of the composition of the investor‘s portfolio, the risk of the asset in the portfolio, and the objectives and constraints of investors (Haim and Thierry, 2005).

The goal of credit risk management is to maximize the risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Microfinance needs to manage the credit risk inherent in the entire portfolio as well as the risk in individual credit risk and other risks.

The effective management of credit risk is a critical component of a comprehensive approach to risk management and is essential to the long-term success of any microfinance organization. The fundamental dilemma in managing credit risk is overcoming the agency or incentive problems between lenders as outsiders and borrowers as insiders.

Microfinance institutions that managed to successfully perform their credit risk management finally have a positive impact on their financial performance what is a reverse in the opposite case (Haim and Thierry, 2005).

The five C’s of credit is a system used by lenders to gauge the creditworthiness of potential borrowers. The system weighs five characteristics of the borrower and conditions of the loan, attempting to estimate the chance of default.

The five C’s of credit are character, capacity, capital, collateral, and conditions. Credit Risk Management is inherent in microfinance and is unavoidable. The basic function of microfinance management is risk management.

The business of banking is credit and credit is the primary basis on which a bank’s quality and performance are adjusted. Credit risk is composed of default risk and credit mitigation risk.

Default risk is the risk that the counterparty will default on its obligations to the investor. In this risk, the credit quality deteriorates (or default risk increases).

Credit risk is more difficult to measure because data on both default and recovery rates are not extensive, credit returns are highly skewed and fat-tailed, and longer-term time horizons and higher confidence levels are used in measuring credit risks.

These are problems in measuring credit risk that has inspired the development of several sophisticated models and commercial software products for measuring portfolio credit risk (Haim and Thierry, 2005).

Due to increasing attention from international bodies, donors and policymakers, microfinance the world over has entered into a principal phase of development. Practitioners of microfinance have referred to it as the last hope for the poor and are currently divided between those who favor profitability and the second camp combining profitability and social dimension.

Other major players within the financial system, such as commercial banks until recently looked at microfinance as a market niche. Attitudes continue to evolve as developing countries strife at incorporating microfinance into the mainstream financial system.

In the phase of this global evolution, top-performing Microfinance Institutions (MFIs), are being restructured, their income stream widened, and are no longer dependent on subsidies to strife. Many have become profit-making institutions as a result of transparent and access to different sources of financing.

In Cameroon, microfinance services are no longer reserved for the social Non-Governmental Organizations (NGOs) as the boundary between microfinance and commercial banking activities is becoming blurred.

In its traditional microfinance form, the route of formal microfinance activities can be traced back to 1963 following the creation of the first cooperative savings and loans institution (Credit Union), at Njinikom in the North West region of Cameroon by a Roman Catholic clergy.

The development of microfinance institutions and their activities remain blurred until the early 1990s when President Paul Biya in order to incorporate the elites and various interest groups into his New Deal Policy passed the remarkable law No. 90/053 of 19 December 1990 relating to freedom of associations, and Law No. 92/006 of 14th August 1992 relating to cooperatives, companies, and common initiative groups.

Another major contributing factor to the growth and development of microfinance activities in Cameroon can be linked to the banking crisis in the late 1980s that resulted in the closure of branches of commercial and developmental banks in rural areas and some cities.

Many top executives lost their jobs, some were dismissed. Some of these executives and employees formed cooperative credit unions that function like mini banks.

As microfinance activities gained heavyweight in the financial system of the country, the roles of different stakeholders became clearly defined as the supervisory authorities configured MFIs within the national territory.

Network of MFIs: Made up of institutions developed endogenously such as MC2, CAMCCUL (Cameroon Cooperative Credit Union League), The Self Directed village Savings and Credit (CVECA) supported through the decentralized rural credit project of the Ministry of Agriculture and Rural Development with the support of BICEC and two other French institutions.

Two independent MFIs were created by individuals and located mostly in urban areas, three NGOs with development projects, agro-industrial activities, and credit components. The case of Cotton Development Company (SODECOTON), and South West Development Authority.

With growing interest in the sector in the absence of an effective governance mechanism, the monetary authority in other words the Ministry of Finance took over control of the microfinance sector initially placed under the Ministry of Agriculture.

This led to a series of texts relating to sub-regional integration, supervision, and control of microfinance activities. These texts were adopted unanimously by a council of Finance Ministers from the Economic and Monetary Community of Central Africa (CEMAC) by 2005. Consequently, the new regulation which became effective on April 14, 2005, organizes the sector and classifies MFIs into three categories.

The first category includes MFIs accepting savings and credits just from their members. The second category includes MFIs accepting credit and savings from members and non-members and the third category, MFIs granting just credits to the general public. They extend credit to third parties without collecting savings.

Since the classification, commercial banks’ involvement in microfinance in Cameroon has increasingly become visible. Starting with, Afriland First Bank- created Mutual Community Credit (MC2), the microfinance brand in 1992, while from the opposite direction Cameroon Cooperative Credit Union League (CAMCCUL) network created Union Bank of Cameroon (UBC) a commercial bank that outrightly failed to take advantage of the pool of competitive advantage offered by CAMCCUL.

New players in the sector include SGBC that introduced the advanced microcredit brand and Ecobank which is one of the latest players in the market in 2009.

Many scholars use the Return of Assets (ROA) or Return on Equity (ROE) as a measure of MFIs or banks’ profitability (Rosenberg 2009; Ogboi and Unuafe 2013; Aemiro and Mekonnen 2012; Naveen et al 2012) and as of 2015, there is 418 licensed microfinance in Cameroon.

1.2 Problem Statement

The aim of every microfinance institution is to operate profitably in order to maintain its stability and improve in growth and expansion. For most people in microfinance, lending represents the heart of the industry.

Loans are the dominant asset at most microfinance, generate the largest share of operating income, and represent their greatest risk exposure. The microfinance sector in Cameroon has faced various challenges that include non-performing loans and fluctuations of interest rate among others, which have threatened their stability.

According to Bessis (2005), Credit Risk Management is important to microfinance management because there 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 which shows the Financial Performance or in losses that show their failure. While various previous studies provide valuable insights on credit risk management, they have not entirely made clear their effects on the profitability of micro-financial institutions.

Some challenges faced by MFI in Cameroon such as non-performing loans and fluctuation of interest rate, it is important to conduct the study about credit risk management as it is essential that MFIs manage credit risks so as to reduce losses and ensure continued existence in the long term.

It is from this background that this study sought to assess the effect of Credit risk management on the profitability of microfinance institutions with the specific case of micro-financial institutions in Buea.

Read More: THE IMPACT OF CREDIT RISK MANAGEMENT ON THE PROFITABILITY OF MICROFINANCE UNICS BUEA

1.3 Objectives of the Study 

The main objective of this study is to find out the effect of credit risk management on the profitability of micro-financial institutions in Cameroon with the specific case of MFIs in Buea. Consequently, the specific objectives derived are:

1. To evaluate the effect of creditworthiness of a borrower on the profitability of MFIs in Buea
2. To assess the measures of mitigating default risk and improving the profitability of MFIs in Buea
3. To determine the extent to which the lending portfolio management affects the profitability of MFIs in Buea

1.4 Research Questions.

The main research question of this study is that of knowing whether credit risk management affects the profitability of micro-financial institutions in Cameroon. From this, the following are derived:

1. What is the effect of the creditworthiness of a borrower on the profitability of MFIs in Buea?
2. Do the measures of mitigating default risk improve the improve profitability of MFIs in Buea?
3. To what extent does the management of lending portfolios affect the profitability of MFIs in Buea?

1.5 Hypothesis of the Study

H01: creditworthiness of a borrower has no statistically significant influence on the profitability of MFIs in Buea

H11: creditworthiness of a borrower has a statistically significant influence on the profitability of MFIs in Buea

H02: Measures of mitigating default risk do not significantly improve the profitability of MFIs in Buea

H12 Measures of mitigating default significantly improve the profitability of MFIs in Buea

H03: Lending portfolio management has no significant impact on the profitability of MFIs in Buea.

H13 Lending portfolio management has a significant impact on the profitability of MFIs in Buea.