ABSTRACT
The success of individual MFIs in credit risk management is largely reflected in the proportion of delinquency’s loans to gross lending. Factors such as credit policies, loan recovery procedures, and loan appraisal process are viewed as critical drivers of institutional factors leading to loan default; each of these factors significantly affects loan default performance in MFIs in Kenya. The study used primary data. The study target population compromise 48 MFIs registered by Association of Microfinance Institutions of Kenya (AMFIK). A descriptive survey design was used to carry out a census of 48 microfinance institution in Kenya, this is because of the small size population .The data was collected through a structured questionnaire and administered to MFIs loan officers for response. Multiple regression analysis was used to establish relationship between loan delinquency and credit policies, loan recovery procedures, and initial loan appraisal in MFIs in Kenya. A total of 48 questionnaires were administered of which 45 were adequately respondent to and considered for analysis, this formed 94% response rate. The findings indicated that all the three factors tested had a significant impact on the loan default rate, thus the micro-finance institutions have a cause to worry if they have to reduce the loan default rates by considering the three factors under the study It is recommended that the management of micro-finance institutions should take keen interest in the three institutional factors if they have to reduce their loan default portfolio in microfinance institutions. It is suggested that a similar study be undertaken targeting the banking sector to establish the factors that contribute to loan default in the banking sector in Kenya.
CHAPTER ONE
INTRODUCTION
Background to the Study
The major goal of microfinance is the provision of micro loans to the low-income and the poor households. The chance that a microfinance institution (MFI) may not receive its money back from borrowers (plus interest) is the most common and often the most serious vulnerability in a microfinance institution. Since most microloans are unsecured, delinquency can quickly spread from a handful of loans to a significant portion of the portfolio. This contagious effect is exacerbated by the fact that microfinance portfolios often have a high concentration in certain business sectors. International organizations are coming 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 CGAP, (1999).
Lending to the poor or lower income group raises many debates among practitioners and academicians. The poor are usually excluded from credit facilities because of many reasons. These include insufficient collateral to support their loans, high transaction costs, unstable income, lower literacy and high monitoring costs. Usually they survive through involvement in micro business activities or informal activities that comprises food processing and sales, small scale agriculture, services, crafts and petty trading. However, these activities actually contribute a number of total employment and gross domestic product (GDP) to the country. Micro and small enterprises (MEs) have been recognized as a major source of employment and income in many countries of the Third World Modurch, (1999).
In 1990s micro loans given to customers did not perform which called for an intervention. Most suggestions were for the evaluation of customer’s ability to repay the loan, but this didn’t work as loan defaults continued The concept of credit management became widely appreciated by Microfinance Institutions (MFI’s) in the late 90s, but again this did not stop loan defaults to this date Modurch, (1999).A key requirement for effective credit management is the ability to intelligently and efficiently manage customer credit lines. In order to minimize exposure to bad debt, over-reserving and bankruptcies, companies must have greater insight into customer
financial strength, credit score history and changing payment patterns. The ability to penetrate new markets and customers hinges on the ability to quickly and easily make well-informed credit decisions and set appropriate lines of credit. Credit management starts with the sale and does not stop until the full and final payment has been received. It is as important as part of the deal as closing the sale. In fact, a sale is technically not a sale until the money has been collected. It may be difficult to establish an optimal credit policy as the best combination of the variables of credit policy is quite difficult to obtain. A firm will change one or two variables at a time and observe the effect. It should be noted that the firm’s credit policy is greatly influenced by economic conditions (Pandey, 2008). As economic conditions change, the credit policy of the firm may also change.
Microfinance Institutions and other finance institutions must develop a credit policy to govern their credit management operations Pandey, (2008) and since microfinance institutions generate their revenue from credit extended to low income individuals in the form of interest charged on the funds granted (Central Bank Annual Report, 2010) the loan repayments may be uncertain. The success of lending out credit depends on the methodology applied to evaluate and to award the credit Ditcher, (2003) and therefore the credit decision should be based on a thorough evaluation of the risk conditions of the lending and the characteristics of the borrower. Numerous approaches have been developed in client appraisal process by financial institutions. They range from relatively simple methods, such as the use of subjective or informal approaches, to fairly complex ones, such as the use of computerized simulation models Horne, (2007). Many lending decisions by Microfinance institutions are frequently based on their subjective feelings 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 each company would have its own method of determining risk and quality of its clients, depending on the target group, the following client evaluation concepts are useful for most occasions. These concepts are referred to as the 5C’s of credit appraisal Joana, (2000). These elements are Character, Capacity, Collateral, Capital and Condition .
According to Schreiner, (2003), 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, 13.6 per 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 resources through credit can contribute towards poverty alleviation. Bystrom, (2007) 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.
Micro-financial institution that offers savings and credit services is facing realities of market competition due to the liberalization of the economy, excess liquidity in big commercial banks, inadequate financial resources resulting to low liquidity in lending institutions among other factors Dinos et al, (2010). The microfinance institutions have now become a household-name as millions of Kenyans rely on them, almost entirely for their basic needs of food, shelter and clothing and even school fees and medical expenses. They exist as viable and credible alternatives to formal banking institutions which to a large extent are beyond the reach of ordinary Kenyans. They provide the financial support and advantage which lies in the strong structure and shared values of trust mutual and development. They have mobilized funds over kshs.150 billion making them one of the major contributors to national economy. The Micro financial Act 2008 required that loans policy and procedures manual specifying the criteria and procedures applicable in the evaluation, processing, approval, documentation and release of loan or credit facilities are put in writing by every licensed society. Loans must be disbursed according to the established credit policy and procedures as given by Schreiner, (2003).
A written loan policy statement is beneficial as it communicated to employees in the loan department what procedures they must follow and what their responsibilities were. Therefore it helped the organization to move towards a loan portfolio, controlling its risk exposure and satisfying regulatory requirements Joana, (2000). Any exceptions to the policy should be fully documented and reasons for it listed. While any written policy must be flexible due to continuing changes in economic conditions and regulations, violation of loan policy should be infrequent events. Loans department should consider all such changes and periodically review all loans until more quickly and acted as a continuing check on whether loans policy was adhered to by loan officers. The commercial banks reviewed loans more efficiently such that they were able to top up loans-faster using modern technology unlike institutions Craig, (2006). According to Beatriz (2007), it was revealed that the study underscored the need to formulate a prudent credit policy for individual manufacturing firms as well as the need for a conducive macro and micro environment in order to synchronize benefits of using credit facilities to facilitate financial mobilization of firms which can be likened to institutions also. Therefore formulation of a prudent credit policy for institution is important to avoid loss of its market to its rivals and improve performance in terms of development.
According to Fofack ,( 2005), the types of loan offered by institutions are mainly short-term and long-term loans. The short-term loans are those repayable within a year and are usually meant for school fees and other emergency expenses. The amounts are generally small is guaranteed by government and did not help farmers to increase their overall earning capacity. Long-term or development loans arc for larger amounts and had a longer term effects. They helped farmers to increase their earning capacity through success of projects financed by these loans. Repayment period was usually for more than one year, No collaterals are given by members in form of property pledged except the secured guarantors and thus management should consider securing them in that manner. There was evidence that repayment of institutions loans was not being taken seriously by members due to low interest rate charged, lack of suitable guarantors and poor management systems for loan collection. As a result most of them were caught up in serious cash flow problem. The situation was complicated further by overdrafts whereby institutions negotiated with commercial banks at higher interest rates are loaned to members at lower interest rates Pamoja, (2010).
The borrower’s credit worthiness is the ability of a customer to pay out the credit as and when due with a comfortable margin of error. This usually involves a detailed study of five aspects of loan application: character, capacity, cash, collaterals and conditions. Character refers to customer’s responsibility, truthfulness, serious purpose and intention to repay loan. If the customer is insincerely promising to use borrowed funds as planned and in repaying as agreed, the loan should not be made to avoid a credit problem. The loan officer must be convinced that a customer has a well defined purpose for requesting a credit and has a serious intention to repay. Capacity to borrow money refers to the authority to request a loan and the legal standing to sign a binding loan agreement by a customer. Thus the borrower must not be a minor and supportive documents must be provided for example a copy of resolution of borrowing company or pay-slip of an employee. According to Srinivasan, R. (2007) capacity refers to the income available to make repayment. Having a substantial income, holding the same job for several years and having few other debt payments suggest a strong financial capacity to repay.
Credit risk management should include strict delinquency monitoring, loan-loss provision and collection procedures. Credit risk is measured most accurately when loans are approved and processed on the basis of "five Cs"-character. Loans must be disbursed according to established credit policies and procedures. Loan analysis should therefore be guided by the formula: purpose, repayment schedule, amount applied for, collaterals, and terms of loan agreement, interest rate chargeable, applicant's character and experience that a member or loanee has to fulfill the purpose of loan. Craig, (2006) describes non-performing loan as that loan that is in default or close to default. Many loans become non-performing after being in default for three months, but depend on the contract terms. A loan is non-performing when payments of interest are past due by 90 days or more or at least 90 days of interest payments have been refinanced or delayed by agreement or payments are less than 90 days overdue but there are other good reasons to doubt that payments was not be made in full.
Credit is major form of external finance used by households, firms and governments in economy (Peeters, 2003). Credit finance encompasses any financing which requires unconditional payment or settlement in the future. In Kenya, credit continues to play an important role in the country's economy. The Central Bank of Kenya has estimated that the total domestic credit as at 30th June 2009 was reckoned Kshs. 408billion (CBK, 2007). When borrower approaches a financial institution for a loan facility the intention is to use it to finance a planned project and eventually repay the loan. Customers borrow funds for various reasons. The most common objectives for borrowing are for acquisition of assets like house, land or cars. As for business people, the need for funds would be to increase stock -in- trade, capital level or meet some current expenditure .In addition to the above primary needs the borrowers do sometimes approach financial institutions for bridging finance to take care of short-term needs.
Statement of the Problem
Competition among MFIs has not only brought benefits such as better access and lower interest- rates, but has also introduced problems Saloner,(2007). These adverse effects fall back not only on the MFIs, which are struggling to maintain their performance level, but also on the clients. Borrowers are facing serious problems from paying back their loans. According to Peeters, (2003), 25% of borrowers in microfinance institutions take loans from six or more different financial institutions which eventually lead to repayment crisis in the microfinance industry. Repayment crisis subsequently lead to liquidity problems which negatively influence the operational performance of microfinance institutions. Despite its importance due to the increasing competition in the microfinance industry in Kenya, there is no record available to this study on the factors contributing to loan defaulting in MFI’s in Kenya.
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