Abstract

The major objective of the study was to identify the factors responsible for loan default by clients of microfinance institutions, to examine the credit methodologies used in loan default management and to identify the relationship between loan default and MFI operations. Questionnaires were used collect data for the study.

It was a combination of descriptive and analytical research of results from self-administered questions, interviews and record inspection. The researcher analyzed the data and also constructed some tables to show comparisons. Responses were edited for completeness and accuracy; percentages were employed where respondents’ attitude were sought. Tables were also used for data analysis.

From the study, the findings indicated that there is a negative relationship between the study variables meaning that an increase in Loan defaults reduces the performance of microfinance institutions.

It was established that loan defaults are Marjory caused by poor sales from the clients and disappointments from the creditors .It was further revealed that institutional factors mostly cause loan defaults.

The study critically recommended that, the institutions should educate people on how to invest money is it was revealed that loan defaults are caused by poor sales. Hence stakeholders should ensure that borrowers invest in activities that they consider productive and that Institutions should improve on their terms of loan collection and repayment as it was revealed that institutional factors greatly cause loan defaults.

The most recommended area for further research were: loan default management in big formal institutions.

CHAPTER ONE

INTRODUCTION

1.1 Background to the study

Microfinance as pioneered in Bangladesh by Mohammed Yunus was to assist low-income women and men through micro-enterprises for their economic development. Growing concerns about poverty stands out in political agendas all over the world, as the stubbornness of poverty even in the richest nations is being met with increasing impatience (Mwangi et al,1998). Governments and international aid donors have been subsidizing credit to small farmers in rural areas of many developing countries. These subsidized credit from donor Non-Governmental Organizations (NGOs) made it possible for large numbers of low-income people to have access to financial services.

Most of the finances available to the rural areas in Africa are through Microfinance, this method was known as traditional savings in most of the communities across the continent. According to Aghion and Morduch, 2009, the African experience suggests that MFIs have built on pre-existing informal sector mechanisms (among the many examples are Pride micro financed to create viable channels for capltal infusions from formal sector banks, donors, and governments. As a result, deposit taken MFIs, informal microfinance institutions and credit only MFIs have all developed increasingly close ties with full-fledged commercial banks and other non-bank financial institutions in the formal sector. Banks and MFIs complement each other well by servicing substantially different client bases. Banks lend and collect deposits mostly from a limited formal private sector in Africa and to the government, while MFIs service poor and rural households, and small entrepreneurs ofien in the informal sector.

In Uganda micro finance industry started thriving in the early 1990s after the closure of failed commercial banks and co-operative banks, due to the gap that existed in the provision of financial services in the rural and urban areas, lack of industrial coordination and other challenges. This forced the micro finance practitioners to come together under the guidance of the Ministry of finance, planning and economic development to form micro finance committee in 1997. This committee was later named the Micro Finance Forum (MFF). Broadly, the committee aims at enhancing effective coordination, and mechanism to the professionalization of micro finance institution in Uganda (MFPED; 2004).

Micro finance institutions in Uganda currently work under a joint vision to develop the industry and this was defined in 2000 general meeting where micro finance stakeholder met to discuss strategies to develop the industry. Their vision has three main aspects and these relate to: Users (‘the demand community’), providers of services (‘the supply community’) and the environment.

International organizations are Goming to the realization that MFIs are veritable and effective channels to ensure programme implementation effectiveness, particularly in poverty alleviation projects and firsthand knowledge of the needs and interest of the poor (Chakravarty & Shahriario; 2010.). According to Chossudovsky (1998), the World Bank Sustainable Banking with the Poor project (SBP) in mid-1996 estimated that there were more than 1,000 microfinance institutions in over 100 countries, each having a minimum of 1,000 members and with 3 years of experience. In a survey of 2006 of such institutions, 73 per cent were NGOs, 13.6per cent credit unions, 7.8 per cent banks and the rest savings unions. An overwhelming majority of the world’s poor live in the third world countries. Various approaches have been employed in alleviating poverty of which provision of credit that targets the poor is one. Many are now of the opinion that allowing the poor to have command over resourGes through credit can contribute towards poverty alleviation. Schrader (2009) argues that the best way to do something about poverty is to let the people do their own thing.

Nobody will have more motivation to change his situation than the sufferer himself/herself.          Alemayehu (2010), defined microfinance as a provision of financial services to low income clients or solidarity lending groups including consumers and the self-employed, who traditionally lack access to banking and related services. According to Grameen’s foundation, Microfinance is sometimes called the ‘banking for the poor’. ‘Microfinance is an amazingly simple approach that has been proven to empower very poor people around the world to pull themselves out of poverty. A key to mlcrofinance is the recycling of loans. As each loan is usually repaid within six months to a year the money is recycled as another loan, thus multiplying the value of each dollar in defeating global poverty, and changing lives of communities (Grameen Trust, 1995). Microfinance helps the poorest people to work their way out of poverty for good. Giving the loan to help empower women to start their own businesses, enabling them to feed their families everyday (Microloan foundation, 2010). Microfinance also known as micro credit, as small loans offered to poor households to foster self-employment and income generation (Faz1e,Hasan & Abed, 2010). Yacob (2010), opines that microfinance is the supply of loans, saving, and other basic financial services to the poor.

Microfinance is a facility that makes it possible for the focused poor people to get a small loan to start a business, pay for school fees, procure housing or receive health care (Microfinance vital to economic growth 2010:15). Such an initiative is instrumental in changing the poverty patterns in view of improved facilities to lessen the challenge posed by startup capital. Microfinance has been changing people’s lives and revitalizing communities since the beginning of trade (United Nations 2010).

Microfinance Institutions emerged as an alternative financing source and a powerful instrument for poverty reduction among relatively poor people through the provision of broad range of financial services such as loan, deposits, payment services, money transfer and insurance services (Robinson, 2003; ADB, 2000). Among the major objective of these institutions was to help poor people who are financial constrained and vulnerable, with financial services to enable them to engage in productive activities or start small businesses (CGAP, 2009).

With a primary objective of social mission through outreach to the poor, Microfinance institutions were originally financed entirely by grants, low-interest loans and donor’s subsidies (Zeller & Mayer, 2002), and offered financial services at low cost to ensure that the poor could access the services. This resulted into highly dependence on subsidies and grants from the donors, governments and other development agents (Armendariz & Morduch, 2005).

With rapid growth of Microfinance sector, they have been a change in the line of thoughts among donors, policy makers and other stakeholders about the profitability and efficiency of these institutions (Cull et at, 2009; Barres et al, 2005), also they have been changes in business environment including, increased competitions, involvement of more commercial banks offering microfinance services and advancement in banking technology which have affected Microfinance institution’s operations and their way of doing business (Rhyne & Otero, 2006). This has led to the increasingly debate on the need for sustainable and efficlent Microfinance institutions, which can cover their operating costs with better allocation of scarce resources (Morduch, 2000; Hermes et at, 2008).

Attention to credit has had a much longer history within both aid agencies and governments. It is seen as crucial to the development of the firms and other micro-enterprises in the third world. That small enterprise may make more efficient use of capital, labour and that their contribution to the economy is far greater than was earlier imagined is now widely recognized (Thea and Oppenooth, 1992). Cooperatives and micro-finance have increased incomes to the rural households as a development program objective. Micro-finance demand can be globally only through the provision of financial service by self-sufficient institutions.

This implies that they must learn to manage loan default. Hence they have to emphasize and        ‘ encourage timely payment of the loans borrowed so that rotation is realized. Specific measures to discourage default can be incorporated in credit schemes, but viable project design and good administration are the most important safe guards (Marguerite, 2001). Two basic tenets of micro-lending are excellent client service and strict default management.

Loan default management therefore is crucial to the institutions because loans are their target assets, generator of income and highest reasons for their existence. Hence defaulted loans determine the quality of portfolio. For instance, cooperatives are sustainable institutions that are financed from local savings and require little external subsidy. They perform an active financial intermediation function particularly mediating flows from urban and semi urban to rural areas and between net savers and net borrowers while ensuring that loan resources remain in the communities from which the savings were mobilized (Otero and Rhyne, 1994).

Pride Uganda is an International NGO dealing specifically in Micro-Finance. It started its operations in Uganda in 1996 as PRIDE AFRICA and later changed to PRIDE UGANDA. Its mission is to create sustainable financial and information servlces Net work for small and medium enterprises to increase incomes and employment of the poor and to stimulate business growth in Uganda. It mainly finances commerce and manufacturing sector of the on- going businesses. It does not finance business start- ups. Pride Africa operate in Kampala, Mbarara, Masaka, Mukono, Jinja, Mbale, Kasese, Rukungiri , Kabale, Kabalore, Hoima, Arua, Lira, Soroti, Iganga, Mpigi, Ishaka,Mayuge, Wakiso, Bugiri, Ntungamo and Bushenyi districts.(Pride Handout).

PML Uganda Ltd as an MDI provides basic financial services for both rural and urban citizens who cannot obtain these services throu% full-banking services. It started in 1996 as a micro finance institution with aims of providing savings and credit to micro and small scale business people, promote growth under poverty eradication programme and also respond to the resource gap in the market. It’s estimated that 10% of the rural population and 5% of the rural poor have access to finanGial services in terms of credit and savings. However, it moved up its registration in November 2004 after having all the requirements needed by bank of Uganda as stated in the Microfinance Deposlt-taking Institution Act (2003).

According to Rosenberg (1999), Micro Finance Institutions (MFIs) are increasingly a central source of credit for the poor in many countries. Weekly collection of repayment installments by bank personnel is one of the key features of micro-finance that is believed to reduce default risk in the absence of collateral and make lending to the poor viable. Some of the factors that lead to loan default include; inadequate or non-monitoring of micro and small enterprises by banks, leading to defaults, delays by banks in processing and disbursement of loans, diversion of funds, over-concentration of decision making, where all loans are required by some banks to be sanctioned by Area/Head Offices.

In Uganda, the major MFIs include Foundation for Inter National Community Assistance (FINCA, U), Uganda Micro-finance Union (UMU), Uganda Womens’ Finance and Credit Trust (UWFCT), Promotion of Rural Initiative Development Enterprises (PRIDE) Micro- Finance Limited, Micro Enterprise Development Network (MEDNET), Commercial Micro- Finance (CMF). These borrowed from Bolivia’s Bancosol, Bank Rakyat Indonesia (BRI) and Grameen Bank in Bangladesh. These banks were the first of the self sufficient MFIs to develop the management, organizational structures, and Information systems along with the commitments to full cost recovery and institutional self —sufficiency that enabled them to provide micro-finance profitably on a large scale (Graham 2000; Marguerite, 2001). The field of microfinance has grown substantially over time wlth MFIs recognizing the need to achieve financial sustainability while offering financial services to the poor through non collateralized loans (credit) in addition to other services that checks poverty in the lives of clients.

1.2. Statement of the problem

It is generally accepted that credit, which is put to productive use, results in good returns. But credit provision is such a risky business that, in addition to other reasons of varied nature, it may involve fraudulent and opportunistic behavior. MFIs should rather depend on loan recovery to have a sustainable financial position in this regard, so that they can meet their objective of alleviating poverty. Whether default is random and influenced by erratic behavior or whether it is influenced by certain factors in a specific situation, therefore, needs an empirical investigation so that the findings can be used by micro financing institutions to manipulate their credit programs for the better performance of microfinance institutions Mwangi et al 2009.

Microfinance Institutions (MFIs) over a couple of decades have moved from the giving of subsidized credit that depends on the benevolence of donors to a self-sustainable financial company that gives credit to its clients at a cost and to be able to recoup all funds that it gives to its clients. The repaid funds are subsequently given to other SMEs and self employed individuals as MFIs seeks to reach as many clients as possible in pursuance to the objective of alleviating poverty in society.

Repayment of loans by clients ensures sustainability of microfinance institutions and therefore default by clients to repay loans (credit) tends to affect the operations of every viable MFI. This loan default had its consequences and implications on the operations of MFIs this fact therefore prompts the researcher to investigate the effect of loan default on the operation of microfinance institutions taking a case study of Pride Micro microfinance Mbarara Branch.

1.3 The purpose of the study

The purpose of this study was to explore the relationship between loan default and operations of microfinance institutions.

1.4 Objectives of the Study

1. To identify the factors responsible for loan default by clients of microfinance institutions
2. To examine the credit methodologies used in loan default management
3. To identify the relationship between loan default and MFI operations

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