Abstract

Credit risk has always been a concern not only to micro finance institutions but to entire business world because the risks of a borrower not fulfilling his obligation on due date can seriously jeopardize the performance of a financial institution.  The study sort to review the effect of credit risk control on loan performance of micro finance institutions in Buea.

The research design used in this study was the descriptive research design and as it involved in depth study of credit risk control and its relationship with loan performance in micro finance institutions. Secondary data was collected from the micro finance institution annual report. The data collected from the annual report of the micro finance institution was analysed using regression analysis. In the model, ROE was used as the profitability indicator while non-performing loans and capital adequacy ratio as credit risk control indicator.

This study showed that there is a significant relationship between loan performance and credit risk control. The results of the analysis states that both non-performing loan ratio and capital adequacy ratio have negative and relatively significant effect on the return on equity with NPLR having higher significant effect on ROE in comparison to capital adequacy ratio.

Hence, the regression as whole is significant to NPLR and CAR. Having established a relationship between credit risk control and loan performance of micro finance institution, the research suggests that all micro finance institution should adopt a credit risk grading system.

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Credit risk control forms a key part of a company’s overall risk management strategy. Weak Credit risk control is a primary cause of many business failures. Many small businesses, for example, have neither the resources nor the expertise to operate a sound Credit risk control system (Mc Menamin, 1999). When a company grants credit to its customers it incurs the risk of non-payment. Credit management, or more precisely Credit risk control, refers to the systems, procedures and controls, which a company has in place to ensure the efficient collection of customer payments thereby minimizing the risk of non-payment (Mokogi, 2003).

World Bank defines Micro Finance Institutions (MFIs) as institutions that engage in relatively small financial transactions using various methodologies to serve low income households, micro enterprises, small scale farmers, and others who lack access to traditional banking services CBS (1999). Financial intermediation is of great importance in any economy (Dondo and Ongila 2006).

According to Camerooon’s Poverty Reduction Strategy Paper (PRSP) and vision 2035, the financial sector is expected to play a catalytic role in facilitating economic growth through SMEs. Access to formal credit by small-scale business persons has been quite poor particularly among the low-income category. This is largely as a result of the credit policies associated with loans provided by the formal sector (Ringeera, 2003). According to Mokogi (2003), even if granting credit may accrue benefits of increasing sales to the institution, there are high default risks that may adversely affect its future. Financial institutions therefore have to come up with appropriate credit management policies that will yield the maximum benefits and reduce the risk of defaults. Credit policies vary from one institution to another; a firm’s unique operating conditions dictate the kind of credit policy to adopt.

Myer and Brealey (2003) noted that if services are offered on credit, the profit is not actually earned unless the account is collected. Financial institutions take into consideration a number of factors before setting the credit standards. They include financial stability of the customer, the nature of credit risk on the basis of prior record of payment among others. In establishing credit terms, the institution should consider the use of cash discount. An increase in the average collection period of an institution may be the result of a predetermined plan to extend credit terms or the consequence of poor credit administration (Block and Hirt, 1992).

In recent years, a growing number of developing countries, including Cameroon, have embarked on reforming and deregulating their financial systems, transforming their financial institutions into effective intermediaries and extending viable financial services on a sustainable basis to all segments of the population (Seibel, 1996). By gradually increasing the outreach of their financial institutions, some developing countries have substantially elevated poverty lending, institutional strategies and financial systems approaches.  In the process, a new world of finance has emerged, which is demand-led and savings driven and conforms to sound criteria of effective financial intermediation.

As a result of the successful integration of microfinance strategies into micro policies, this makes banking in the micro economy and the poor both viable and sustainable. Throughout 1980s and 1990s, the financial institutions, which were mainly Non-Governmental Organizational-based credit programs, improved on the original methodologies and reviewed their policies about financing the poor.  During this period it was demonstrated that poor people, especially women, repayed their loans with near-perfect repayment rates, unheard of in the formal financial sectors of most developing countries, were common among the better credit programs.  The poor were also willing and able to pay interest rates that allowed MFIs to cover their costs. As a result of these two features, i.e. high repayment and cost-covering interest rates, enabled some MFIs to achieve long-term sustainability while reaching large numbers of clients.  The promise of microfinance as a strategy that combines massive outreach, far reaching impact and financial sustainability makes it unique among development interventions.

Credit extended to borrowers may be at the risk of default such that whereas banks extend credit on the understanding that borrowers will repay their loans, some borrowers usually default and as a result, banks income decrease due to the need to provision for the loans. Every financial institution bears a degree of risk when the institution lends to business and consumers and hence experiences some loan losses when certain borrowers fail to repay their loans as agreed. Such unpaid loans are referred to as non-performing loans (Kithinji, 2010).The standard most widely accepted international measure of portfolio quality (loan performance) in banking is Portfolio at Risk (PAR) beyond a specified number of days.

It shows the portion of the portfolio that is contaminated by arrears and therefore at risk of not being repaid, the older the delinquency, the less likely that the loan will be repaid. Portfolio at Risk (PaR) is calculated by dividing the outstanding balance of all loans with arrears by the outstanding gross portfolio as of a certain date (Stauffenberg, et al., 2003). CBK Prudential Guidelines (2006) defines nonperforming loan as a loan that is no longer generating income. The guidelines state that loans are non-performing when: principal or interest is due and unpaid for 90 days or more; or interest payments for 90 days or more have been re-financed, or rolled-over into a new loan. Nonperforming loans are one of the main reasons that cause insolvency of the financial institutions and ultimately hurt the whole economy (Hou, 2007).

1.2 Statement of the Problem

Granting credit to customers is an important investment option for financial institution which comes with high risk and thus the need for Credit risk control to ensure reduced loan default rate while at the same time advancing credit in a fair and undiscriminating manner. It is estimated that about 18 % of private investment capital in Cameroon is sourced from the MFIs mainly by individual and small business entities towards establishing SMEs, procurement of agricultural land, housing and supporting education among other financial needs.

A number of studies have been done locally and internationally in relation to credit risk management and loan performance. Walsh (2010) carried out an assessment of the credit management process of credit unions. The study found that credit unions are deficient in the credit control department. A study conducted by Ahlberg and Anderson (2012) on credit risk, Credit Assessment, Basel III, Small Business Finance in 95 small and large banks in Sweden found out that most banks had a well-developed credit process where building a mutual trust relationship with the customer is crucial. A study by Iqbal and Mirakhor (2007) found out that strong risk management practices can help MFIs reduce their exposure to credit risk and enhance their ability to compete well in the industry. In his study, Simiyu (2008), established that majority of the institutions used Credit Metrix to measure the credit migration and default risk. The findings showed that the microfinance institutions are faced with the challenge of strict operational regulations from the Central Bank in Yaounde.

According to Mc Menamin (1999), weak credit risk management is a primary cause of many business failures including financial institutions. Hempel et. al (1994) in his study focusing on national banks that failed in the mid-1980s in the U.S.A found that the consistent element in the failures was the inadequacy of the bank’s management system for controlling loan quality. It is strongly recommended that financial institutions should manage their credit risk to avoid exposing their organization to unnecessarily high levels of risk and subsequently a decline in returns. A common approach to customers’ credit selection and analysis is the use of the “six Cs” which usually refers to capacity, capital, character, collateral, conditions and control of credit as an initial screening and risk assessment. A number of studies have been done in both developed and developing countries on Credit risk control mainly focusing on large financial institutions such as banks.  Most studies in MFIs have focused on their financial performance and the performance of their customers mainly the SMEs (Rukwaro (2000), Kitaka (2006) and Mokogi (2003).

These studies among other finding have indicated a high default rates among the MFIs. With the growing interest by SMEs and individuals in borrowing from MFIs, this problem will likely continue to grow especially where appropriate risk management procedures are not applied. This study therefore seeks to analyse Credit risk control practices used by MFIs in Cameroon and Buea in particular and their effect on loan performance of the institutions with a view of providing important information to the institutions in improving their risk management procedures.

 1.3 Research Questions

The main research question of this study is what is the effect of credit risk control on loan performance in Microfinance institutions in Buea?

In line with the main question the specific research questions are going to be,

1. What is the effect of credit risk control on individual customers’ loan performance in Microfinance institutions in Buea?
2. What is the effect of credit risk control on Business customers’ loan performance in Microfinance institutions in Buea?

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