CHAPTER ONE

INTRODUCTION 

Introduction

The history of microfinance is closely linked with poverty reduction. Although the beginning of cooperative savings and credit activities can be traced back as far as in 1849 with the foundation in Rhineland of the first cooperative society of saving and credit by Raiffeisen, it is truly with Yunus in 1976 with the creation of the Gramen Bank that one can situate the birth of “modern microfinance” (Blondeau, 2006).

Microfinance was originally conceived as an alternative to banks, which in most developing countries serve only 5 to 20% of the population (Gallardo et al., 2003), and informal moneylenders. With the passage of time, the microfinance sector has evolved. Microfinance institutions now have more than 100 million clients and achieve remarkable repayment rates on loans (Cull et al, 2009).

Background of the Study

The lending system was originated in Ancient Greece and Rome 3000 years ago. One of the oldest methods of lending was followed by the pawnbrokers. Pawnbrokers lend by collecting collaterals from the borrower to reduce the risk of the lender. This system was followed by the exchange of goods at an initial stage. For example, people get the money from the lender and in return, they gave the equivalent amount of goods to him. In Zamindar system, the people get the money from zamindars and then work for him to repay the amount. For farmers, the mill owners lend the amount to farm the grains and purchased the grains from them.

The new era of lending was evolved in the early 1800s. The building society and savings fund society was started during this era. The concept of credit can be traced back in history and it was not appreciated until and after the Second World War when it was largely appreciated in Europe and later to Africa (Kiiru, 2004). Banks in USA gave credit to customers with high interest rates which sometimes discouraged borrowers hence the concept of credit didn’t become popular until the economic boom in USA in 1885 when the banks had excess liquidity and wanted to lend the excess cash (Ditcher, 2003).

In Africa the concept of credit was largely appreciated in the 50’s when most banks started opening the credit sections and departments to give loans to white settlers. Microfinance institutions fill a needed gap within the financial services industry by offering small loans, or micro-loans, to people unable to access conventional loan services.

Microfinance institutions vary in size and function with some organizations focusing entirely on micro financing, while others work as extensions of large investment banks. People living in under-developed areas such as Latin America, Kosovo and countries within the Sub-Saharan region can access needed financial resources through the services provided by microfinance institutions. (Role of MFI by Jacquelyn Jeanty).

The concept of loan can be traced back in history and it was not appreciated until and after the Second World War when it was largely appreciated in Europe and later to Africa. Bank in USA give loans to customer with high interest rate which sometime discourage borrower hence the concept of loan didn’t become popular until the economic boom in USA in I885 when the bank had excess liquidity and wanted to lend excess cash (Ditcher, 2003).

In Africa the concept of loan was in the 5O’s when most banks started opening the credit section or department to give loan to white settler. In Kenya loan was not popular to the poor. In I990’s loan given to customers who were not credible enough called for an intervention. Most suggestion Were for the evaluation of customer’s ability to repay the, but this did work as loan default continued (Modurch, 1999). The concept of loan management became widely appreciated by Microfinance Institutions (MFI) in the 9O’s, but again this did not stop loan default to this date (Modurch, 1999). Loan is one of the major sources of fund for investment, it is the major source of earning of financial institution most especially for microfinance institution and thus loan management is one of the most important activities in every financial institution and cannot be overlooked.

Nzotta (2004) said that loan management greatly influence the success of failure of commercial banks arid other financial institutions. This is because the failure of deposit bank is influence to a large extent by the quality of loan decision. He further notes that loan management provides a leading indicator for the quality of deposit banks credit portfolio. Stoltenberg and Anderson (1995) assert that performances are measured by how efficient the enterprise uses its resource in achieving it objective. It was believed that many firms low performance is as a result of poor performance.

A key requirement for effective loan management is the ability to intelligently and efficiently manage customer ability to pay back loans. In order to minimize exposure to bad debt and bankruptcies, companies must have greater insight into customer financial strength, credit score history and changing payment patterns. Loan management start with the grants and does not stop until the full and final payment has been received. It may be difficult to establish an optimal loan policy as the best combination of the variables of loan policy is quite difficult to obtain (Pandey, 2008).

The success of lending out loan depend on the methodology applied to evaluate and to award the loan (Ditcher, 2003) and therefore the loan decision should be based on a thorough evaluation of the risk condition of lending and the characteristic of the borrower. Numerous approaches have been developed in client appraisal process by financial institution (Horn, 2007).

Many lending decisions by Microfinance institution frequently base on their subjective felling about the risk in relation to expected repayment by the borrower. Microfinance institutions commonly use this approach because it is both simple and inexpensive. While other company would have its own method to determining risk and quality of the client depending on the target group the following evaluation concept are useful for most occasions. These concepts are referred to as the 5C’s of credit appraisal (Edward, 1997); these elements are Character, Capacity, Collateral, Capital and Condition (Edward, 1997).

Loan policies should be well documented so that the loan officer will be able to know the area of prohibition and the area where they can operate. Also, such policies should be subjected to periodic review to make the credit union kept abreast with dynamic and innovation nature of the economy as well as competing with other changing sector (Fernando, 2006). Some risk can be measured with historical and projected  financial  data, while other such as those  associated with the borrower’s character and willingness to repay a loan are not directly measured (Butteworth. 1990).

The success of MFIs largely depends on the effectiveness of their credit management system because these institutions generate most of their income from interest earned on loan extended to small and medium entrepreneurs. The Central Bank Annual Supervision Report (20l0) indicated high incidence of credit risk reflected in the rising level of non- performing loan by the MFIs in the last 10 years, a situation that has adversely impacted on their profitability. This trend not only threatens the viability and sustainability of the MFIs but also hinder the achievement of the goal for which they were intended which are to provide credit to the rural unbanked population and bridge the financing gap in the mainstream financial sector.

Micro-finance concept has operated for centuries in different part of the world for example susus in Ghana, tandas in Mexico, tontines in West Africa and pasanku in Bolivia. One of the earliest and longest serving micro-credit organization providing small loan to rural poor dwellers with no collateral is the Irish Loan Fund initiated in the early l700s by Jonathan swift. His ideas began slowly in 1840’s and became a widespread institution of about 300 branches all over Ireland in less than one decade. The principal purpose was to advance small loan with interest for short periods. However, the pioneering of modern microfinance is often credited to Mohammad, who began experimenting with lending to poor Women in the village of Jobra. As this financial service usually involve small amount of money small loan, small saving, the term

microfinance helps to differentiate these services form those which formal banks provide. Microfinance institutions provide a reliable source of financial support and assistance compared to other source for financing.

Microfinance was originally conceived as an alternative to banks which in most developing countries serve only 5-20% of the population. It was initially developed by and is today still primarily developed by non- government organization (NGOs) who received donor funds and lend to microfinance clients (often at subsidize rate).

In many cases government also play a critical role in setting policy for the microfinance industry, providing sum grants to NGOs or other microfinance institutes (MIFs) or lending directly to the poor credit unions, cooperatives, commercial banks and small information groups and important players in microfinance. The model of non-market base micro lending has had mixed success in term of financial performance (Amankwah, 2011).

As with any financial institution, the biggest risk in microfinance is lending money and not getting it back. Loan risk is a great concern for MFI’s because most micro lending is unsecured. Many banks do not extend loan to people without securities and guaranties due to the high default risk for repayment of interest and is some case the principal amount itself.

Therefore, these institutions required to design sound loan management that entails the identification of existing and potential risk inherent in lending activities. Timely identification of potential loan default is important as high default rates leads to decrease cash flow, lower liquidity level and financial distress (Butterworth, 1990).

Statement of the Problem

Loan granting procedures play a vital role in the profitability of every microfinance institution with regards to this study there are problems that seek answers. According to Shekhar, 1985, loan granting plays an important role in the lives of many people and in almost all industries that involve monetary investment in some form.

Credit is mainly granted by banks including to several other functions like mobilizing deposits, local and international transfers, and currency exchange service. Some of the problems faced in loan management are poor screening method in knowing unsuitable or bad business ideas, poor method of accessing the borrower’s ability to manage project and failure to document available collateral sources.

What some micro finance institution does concerning loan granting which is not working is that they fail to evaluate fully if the creditor is capable of paying back the loan. For example, they may check if the creditor has collateral for his loan and fail to check the past financial record of the creditor.

Also another thing they fail to do or work on is to identify the loan term that is short term loan or long term loan which is more favourable to them. They do not know which loam term yield more interest to them so as to concentrate on it and this may lead to mismanagement. According to Gitman (1997), the probability of bad debts increases as credit standards are relaxed.

Microfinance institution must therefore ensure that the management of receivables is efficient and effective. Such delays on collecting cash from debtors as they fall due has serious financial problems, increased bad debts and affects customer relations. If payment is made late, then profitability is eroded and if payment is not made at all, then a total loss is incurred. On that basis, it is simply good business to put credit management at the front end by managing it strategically.

As with any financial institution, the biggest risk in microfinance is lending money and not getting it back. Credit risk is a particular concern for MFIs because most micro lending is unsecured. The people covered are those who cannot avail credit from banks and such other financial institutions due to the lack of the ability to provide guarantee or security against the money borrowed.

Many banks do not extend credit to these kinds of people due to the high default risk for repayment of interest and in some cases the principle amount itself. Therefore, these institutions required to design sound loan granting procedure that entails the identification of existing and potential risks inherent in lending activities. (Craig Churchill and Dan Coster, 2001).

Hence, the issue of credit management has a profound implication both at the micro and macro level. When credit is allocated poorly it raises costs to successful borrowers, erodes the fund, and reduces banks flexibility in redirecting towards alternative activities. Moreover, the more the credit, the higher is the risk associated with it.

The problem of loan default, which is resulted from poor loan granting procedure, reduces the lending capacity of a bank. It also denies new applicants’ access to credit as the bank’s cash flow management problems augment in direct proportion to the increasing default problem. In other words, it may disturb the normal inflow and outflow of fund a bank has to keep staying in sustainable credit market. It is based on these backdrops that the researcher seems to investigate more on the effect of loan granting procedure on the profitability of micro finance institution in Cameroon

Objectives of the Study

General objectives of the study

The main objective of the study is to examine the effect of loan granting procedure on the profitability of micro finance institution.

Specific objectives of the study

In line with the main objective the following specific objectives are developed in other to better carry out this study.

1. To evaluate the effect of a prospective customer’s character and sincerity of purpose on the profitability of micro finance institution in Cameroon.
2. To access the influence of evaluating a prospective customer financial condition on the profitability of micro finance institution in Cameroon
3. To ascertain the effect of monitoring compliance with the loan agreement on the profitability of micro finance institution in Cameroon.

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