Abstract

This study sought to investigate the effects of credit risk management on the financial performance of microfinance institutions in Fako. Data was obtained with the help of a structured questionnaire and was analysed using ordinary least square method. It was derived from the regression analysis there was a positive and significant effect of liquidity ratio on financial performance of Micro financial institutions in Fako.

Also, it was revealed that capital adequacy had a positive coefficient and significant effect on the financial performance of Micro financial institutions in Fako.  The rate of default was also found to have a positive effect on Micro financial institutions in Fako.

It is recommended that management of the Microfinance institutions in Fako should carefully consider systematic defaulter follow-up and defaulter reports, Microfinance institutions in Fako should ensure that there exists favourable liquidity ratio and capital adequacy, the government and other stakeholders should ensure that there is favourable liquidity ratio for Microfinance institutions in Fako.

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The economic crisis that occurred in 2007 and 2008 along with the credit crunch placed credit risk management into the regulatory focus. Subsequently, supervisory bodies instigated more transparency. This called for financial institutions in the lending business to have comprehensive knowledge of their borrowers (customers) and their associated credit risk (Lybeck, 2011).

The new Basel III policies conveyed by BCBS present a superior regulatory burden for banks. The proposed Basel (IV) standards for capital reserves for banks will assist in the mitigation of risk in the occurrence of a financial crisis. It is probable to follow the third Basel accords and more rigorous capital requirements and superior financial disclosure will be required.

These  Basel accords impose certain minimum capital ratios as a guarantee that banks have a sturdy capital position  to  guard  their solvency  in  the  occurrence  of a  deep  recession.  The capital strength ensures that the banks carry on lending even in the depression stage of the business cycle.

To act in accordance with the most rigorous regulatory requirements, and take up the elevated  capital  costs of credit  risk, as  illustrated  by  Lybeck (2011)  many  financial institutions such as banks are refitting their approach to credit risk management. Nevertheless, banks with a perception that this is solely a conformity exercise are being short-sighted. Therefore, a superior credit risk analysis and management presents an opportunity for banks to improve the overall financial stability, and performance to retain a competitive advantage.

Based on existing literature, credit risk exposure continues to be a significant basis of problems for the lending institutions. This issue is even more imperative with reference to microfinance institutions in Kenya.  As defined by Kairu (2009) microfinance is the process of providing monetary services to the unbanked or low-income earners. It also refers to the sustainable practice of offering those services.

These institutions lend to low-income earners, a group that is believed to be very risky in terms of exposure to credit risk. Therefore, credit risk can be defined as the likelihood of loss owing to a borrower’s failure to meet his obligation [loan, line of credit] (HKIB, 2012).

In Cameroon in general, like in many other less developed countries the microfinance sector is extremely essential in most developing countries, Cameroon not being an exception due to its ability to reach out to the less privileged in society. Before the creation of Microfinance Institutions (MFI), bank loans were unavailable for poor people, and money lenders exploited many of the under banked (Silva, 2007) especially in developing countries.

Today, microfinance facilitates financial inclusion and linkage and expands financing channels for vulnerable groups such as the members of the base of the pyramid (Ashta, 2009; Karmakar, 2008). Hence microfinance can be called economic innovation that has the goal to fight poverty (Jonker, 2009). Notes should however be taking that these institutions also need to make profits for their shareholders thus have to retrieve their loans with interest. A failure to retrieve these loans could spark failure not only for the financial institution but for the national economy since a majority of poor and middle income save their funds in these institutions.

In November 2006 the official Microfinance Information Exchange, Inc. released some thought-provoking statistics from the leading microfinance institutions. The most profitable microfinance institution in 2006 was in Africa, with an average of 30.90% return on assets, followed by another in Asia with an average of 30.2% return on assets.

This indicates that microfinance institutions especially in Africa in a way highly performance. This is despite the quality of their loan portfolio which in most cases is made up of small and medium sized businesses. This high return on asset is indicative of the fact that despite the client financial standing there is they are still able to pay their loans. However, with the 2008 collapse of the Douala based microfinance, COFINEST having a deposit value of 5 billion francs CFA and debtors’ value of over 9 billion (Numkam, 2011), there is a great deal of skepticism pertaining to the performance of the microfinance sector in Cameroon.

Cofinest’s solvency problems were first revealed in December 2007 when COBAC placed it under provisional administration after audits disclosed a number of irregularities, substantial non-performing and insider loans worth CFA francs 3.9bn (US$8.6m). This poses a serious problem which has up to now has very infinitesimal amount of recognition when it comes to research. There is therefore need to analyse the impact of credit risk management on the performance of microfinance institutions in Cameroon will go a long way to help policy makers come up with better credit risk management policies for the microfinance sector and also help banking institutions manage their risk better.

A loan is delinquent when a payment is late (CGAP, 1999). A delinquent loan changes to a defaulted loan when the chance of recovery becomes minimal. Delinquency is measured because it indicates an increased risk of loss, warnings of operational problems, and may help to predict how much of the portfolio will eventually be lost because it never gets repaid.

There are three broad types of delinquency indicators: collection rates which measures amounts actually paid against amounts that have fallen due; arrears rates measures overdue amounts against total loan amounts; and portfolio at risk rates which measures the outstanding balance of loans that are not being paid on time against the outstanding balance of total loans (CGAP, 1999).

Default occurs when a debtor has not met his or her legal obligations according to the debt contract. For example, a debtor has not made a scheduled payment, or has violated a loan covenant (condition) of the debt contract (Ameyaw-Amankwah, 2011). A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt. A loan default occurs when the borrower does not make required payments or in some other way does not comply with the terms of a loan. (Murray, 2011).

Moreover, Pearson & Greeff (2006) defined default as a risk threshold that describes the point in the borrower’s repayment history where he or she missed at least three installments within a 24 month period. This represents a point in time and indicator of behaviour, wherein there is a demonstrable increase in the risk that the borrower eventually will truly default, by ceasing all repayments.

The definition is consistent with international standards, and was necessary because consistent analysis required a common definition. This definition does not however imply that the borrower had entirely stopped paying the loan and therefore been referred to collection or legal processes; or from an accounting perspective that the loan had been classified as bad or doubtful, or actually written-off. Loan default can be defined as the inability of a borrower to fulfil his or her loan obligation as at when due (Balogun & Alimi, 1990).

Credit risk refers to the probability of loss due to a borrower’s failure to make payments on any type of debt. It is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs.

The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

1.2 Statement of the Problem

The asset quality formerly known as portfolio quality (is still a key measure of financial performance and stability for Microfinance institutions Ledgerwood et al., 2013). Currently, MFIs continue to increase their products in terms of deposits provision, insurance just to mention a few. Therefore, the loan portfolio is still viewed as a key element of a MFI asset base. For that reason, the quality of the assets continues to be a major gauge of a microfinance financial feasibility.

The effectiveness of credit risk management of MFIs largely dictates their success because these institutions generate their earnings from interest achieved on loans advanced. The Central Bank Annual Supervision (Report, 2014)  highlighted  a  soaring  rate  of  credit  risk  because  of  the increasing rate of NPLs (Non-Performing Loans) in MFI’s. This kind of a drift threatens the stability, viability, and sustainability of the MFIs.

While many studies that have been carried out by researchers on the causes of poor loan performance and their effects on the wide-reaching banking crises in Europe, Asia and some parts in Africa, there have not been detailed studies on the outcome of credit risk management on the Microfinance industry’s financial performance.

Poor credit-risk rating, analysis and modelling result in financial instability. Most of the financially stable MFIs have maintained far above the ground levels of loan recovery rates. These recovery ratios are because of donor funding and funding agencies used in the expansion of their operations (Ledgerwood et al., 2013).

Regardless of the fact that these financially stable MFIs maintain their credit risks within preferred levels, volatility of their portfolio at- risk (PAR30) ratios create bigger challenges. The sources of these challenges include increased competition in the market, product diversification of long- term structures, increased operations, move to individual lending, expansion and efforts to intensify the outreach.  Credit risk management practices help MFIs reduce their exposure to credit risks, and enhance their ability to compete in the market with other well-established financial institutions like banks.

1.3 Research Questions

The main research question is: what are the effects of credit risk management on the financial performance of microfinance institutions (MFIs) in Fako?

1.3.1 Specific Research Question

1. What is the effect of the liquidity ratio on the financial performance of microfinance institutions (MFIs) in Fako?
2. What is the effect of the capital adequacy ratio on the financial performance of microfinance institutions (MFIs) in Fako?
3. What is the effect of the rate of loan default on the financial performance of microfinance institutions (MFIs) in Fako?

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