THE EFFECT OF CREDIT RISK MANAGEMENT ON THE PERFORMANCE OF MICROFINANCE INSTITUTIONS
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Credit risk management is one of the most important activities in any company and cannot be overlooked by any micro financial institution since it is their primary source of income and basis for their long term survival. Sound credit management is a prerequisite for a financial institution stability and continuing profitability, while deteriorating credit quality is the most frequent cause of poor financial performance and condition. As with any financial institution the biggest risk in microfinance is lending money and not getting it back. The study sought to determine the effect of credit management on the financial performance of micro financial institutions in FAKO. The study adopted a descriptive survey design. The population consist of micro finances in fako while the sample size is 84 consistent of 12 sample micro finances with 7 correspondent each. Primary data was collected using questionnaires where all the issues on the questionnaires where address . Descriptive statistics were used to analyzed data. Furthermore descriptions were made base on the result of the tables. The study found that credit risk appraisal, credit risk control and credit risk identification had an effect on the financial performance of MFIs in Fako. The study established that the was a strong relationship between financial performance and credit risk identification, credit risk appraisal and credit risk control as this variable significantly affect financial performance.
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 “modem 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 aI., 2003), and informal money lender. With the passage of time, the micro finance sector has evolved. Microfinance institutions now have more than 100 million clients and achieve remarkable repayment rates on loans (Cull etaI, 2009). The rapid growth of micro finance has brought increasing calls for regulation, but complying with prudential regulations and the associated supervision can be especially costly for microfinance institutions (Cull and aI., 2009). Since regulation remains a precondition for deposit taking in many countries, more MFls seek to transform into regulated entities to access cheap and local currency deposits. Regulation also opens the door to a variety of funding opportunities and helps to reduce the overreliance on subsidies. Donors and microfinance practitioners are well aware that micro lenders need to prepare for the day when subsidies disappear (AghionOrduch, 2005). Just like many other African countries, the micro finance sector’s springboard in Cameroon was the banking system restructuring engaged by the Ministry of Finance (MINFI) and the Banking Commission for Central Africa (COBAC). The expansion of MFls III Cameroon during the 1980s can highly be explained by the gap left by the restructuring of the banking sector in almost developing countries, which was characterized by the restraining or rationing of credit opportunities. Cameroon was not an exception. In Cameroon, the history of micro finance dates back to more than one century in its traditional form popularly known as “Njangi or Tontine”. The introduction of “modem” micro finance in Cameroon started in 1963 by a Catholic priest Father Alfred Jansen, in Njinikom in the North-West Region of Cameroon (Creusot, 2006). This idea of Credit Unionism spread all over the North- West and South- West regions of Cameroon and by 1968, 34 credit unions that were already in existence joined together to form the Cameroon Cooperative Credit Union League CamCCUL) Limited. CamCCUL is therefore the umbrella organization of cooperative credit unions and the largest MFI in Cameroon and the CommunauteEconomique des Etats de l’ AfriqueCentrale (CEMAC) sub-region (www.camccul.org).
Credit is one of the many factors that can be used by a firm to influence demand
for its products. According to Home and Wachowicz (1998), firms can only
benefit from credit if the profitability generated from increased sales exceeds the added costs of receivables. Myers and Brealey (2003) define credit as a process whereby possession of goods or services is allowed without spot payment upon a contractual agreement for later payment.
Micro- finance concept has operated for centuries in different parts of the world for example, “susus” in Ghana, “tandas” in Mexico, “tontines” in West Africa and “pasanaku” in Bolivia. One of the earliest and longest serving micro-credit
organization providing small loans to rural poor dwellers with no collateral is the Irish loan Fund system initiated in the early 1700″s by Jonathan swift. His idea began slowly in 1840s and became a widespread institution of about 300 branches all over Ireland in less than one decade. The principal purpose was to advance small loans with interest for short periods. However, the pioneering of modern microfinance is often credited to Dr. Mohammad Yunus, who began experimenting with lending to poor women in the village of Jobra, Bangladesh during his tenure as a professor of economics at Chittagong University in the 1970s. Microfinance is the supply of loans, savings, and other basic financial services to the poor.” As these financial services usually involve small amounts of money – small loans, small savings, the term “microfinance” helps to differentiate these services from those that formal banks provide. Microfinance institutions provide a reliable source of financial support and assistance compared to other sources for financing Myers and Brealey (2003). Sources for examples loans operating outside the micro finance industry typically form informal relationships with borrowers and have no real legal or substantial ties with their customers. As a result, loan terms tend to carry high costs with no guarantee that lenders will remain in one place for any length. In contrast, micro finance institutions typically work alongside government organizations and have ties with larger global organizations.
As with any financial institution, the biggest risk in micro finance is lending
money and not getting it back. Credit risk is a particular concern for MFIs because most micro lending is unsecured (i.e., traditional collateral is not often used to secure microloans Churchill and Coster (2001). 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 credit risk management practices that entails the identification of existing and potential risks inherent in lending activities. Timely identification of potential credit default is important as high default rates lead to decreased cash flows, lower liquidity levels and financial distress. In contrast, lower credit exposure means an optimal debtors” level with reduced chances of bad debts and therefore financial health. According to Scheufler (2002), in today’s business environment risk management and improvement of cash flows are very challenging.
With the rise in bankruptcy rates, the probability of incurring losses has risen. Economic pressures and business practices are forcing organizations to slow payments while on the other hand resources for credit management are reduced despite the higher expectations.
Therefore, it is a necessity for credit professionals to search for opportunities to implement proven best practices. By upgrading your practices, five common pitfalls can be avoided. Scheufler (2002) summarizes these pitfalls as failure to recognize potential frauds, underestimation of the contribution of current customers to bad debts, getting caught off guard by bankruptcies, failure to take full advantage of technology, and spending too much time and resources on credit evaluations that are not related to reduction of credit defaults.
It is widely recognized that the exclusion of the poorest lenders, particularly in the rural areas, from the traditional financial banking system is one of the main
obstacles for sustainable development and poverty reduction. Indeed, it is almost impossible for rural poor people who live in riskier environments and who lack assets collateral, formal wage job and limited credit history loans to obtain credit from traditional banking system because lending them has become very riskyand very costly. There is little controversy in the literature about the fact that, the formal financial sector has little incentives to provide financial services to poor clients. Generally, and according to economic theory, the exclusion of poor people from traditional bank can be explained by the high level of asymmetric information such as adverse selection and moral hazard, which raises problems of screening, monitoring and enforcement (Baklouti&Abdelfettah, 2013).
Excluded from formal financial institutions, poor people generally have to rely on loans from informal moneylenders, who are more likely to exploit the poor by providing loans on enormously high interest rates. To make the world a better place and to enhance international development, the United Nations Organization (UNO) announced in 2000 the millennium development goals, aimed to reduce poverty by half by the year 2015. In this regard, micro finance has recently attracted growing attention and has proven worldwide to be a promising tool to alleviate poverty. These Microfinance institutions (MFIs) have the function of providing financial services to the low-income households who have long been deemed ‘unbankable”, including the self-employed and customers without collateral assets. Dedicated in improving lots of poor people in developing countries, MFIs provide to them the much needed credit loans of small amount to finance their entrepreneurship projects, to finance their consumption, to cope with illness or the education of their children with little or no collateral requirement.
It has been proven that micro finance programs have a great contribution In reducing poverty. More importantly, it has been proven that Microfinance can be viewed as a development strategy tool by enabling poor entrepreneurs to initiate their own business, teaching them how to protect the capital they have, to deal with risk, and to expand the circle of their economic activities. Availability of microcredit schemes Increases the number of small enterprises, which in turn creates employment opportunities for the poorest and stimulates economic development and social inclusion.
Apart from their social mission success, MFIs have appeared to be a potentially viable and profitable business and have registered a well-known success of some third-world programs in generating impressive repayment rates. Achieving self-sustainability means that the MFI should be self-sufficient, be able to cover all its present costs and make profits on services that they offer. In order to become permanent and maximize their sustainability, MFIs must apply high interest rate, largely higher than market rates.
This can be at the expense of social aims, because high interest rate can exclude poor people particularly those living in rural or marginal areas. These dual objectives in serving poor clients with relatively small loans and achieving self-sustainability even profit represent one of the most widely discussed dilemmas among micro finance academics and practitioners. To face such a dilemma, it is vital for MFI’s stability to find the best practice, improve the efficiency of their portfolio risk management as well as apply accurate pricing policy, which allow for finding a better equilibrium between sustainability and outreach.
The recent instabilities in the financial sector related to subprime mortgage lending crisis in D.S provides an example of the dangers in providing an increasing array of higher-risk loans to higher-risk borrowers. The rapidly growing supply of funds for micro-loans, the increasing competition in micro credit markets, the increasing over-indebtedness among micro-entrepreneurs and the current financial crisis increase the credit risk and therefore leads to agrowing need to estimate the risk of failure of micro finance borrowers. In order to improve both social outreach and financial sustainability in an increasingly constrained environment, developing powerful credit risk management tools in MFI becomes more than ever crucial (Baklouti&Abdelfettah, 2013).
Microfinance institutions are exposed to credit or default risk whenever they make commercial or personal loans. Inherent in the loan process are the ever-present problems of asymmetric information, adverse selection and moral hazard.
Typically, in lending and borrowing, the potential borrowers know more about the risk and return of an investment project and the likelihood of a loan being repaid than does the lender. The balance of information between the borrower and the lender is not equal or symmetric. Instead borrowers have the best knowledge about the project they are funding and will put the best possible spin on any credit report or project short-comings (Maureen, Reynold, & Bruce, 2015).
The existence of information asymmetry therefore gives lenders a hard time differentiating between good credit risks and bad credit risks, and demands a blanket premium over and above the existing rates as compensation for the risk arising out of the inability to determine who lend to (Munene, 2012). This causes the good firms to shy away from borrowing from such a lender since the high interest rates have devalued their strong credit history while the bad firms become very eager to borrow from such a lender since they know that judging by the strength of their cash-flows, they should be charged an even higher interest rate. As a result, lenders end up with a loan portfolio comprising almost entirely of bad credit risks.
An effective system that ensures repayment of loans by borrowers is critical in dealing with asymmetric information problems and in reducing the level of loan losses, thus the long-term success of any financial organization. Considerations that form the basis for sound credit risk management system include: policy and
strategies (guidelines) that clearly outline the scope and allocation of a bank credit facilities and the manner in which a credit portfolio is managed, that is how loans are originated, appraised, supervised and collected (Greuningand Bratanovic, 2003). The recommendation has been widely put to use in the banking sector in the form of credit assessment. According to the asymmetric information theory, a collection of reliable information from prospective borrowers becomes critical in accomplishing effective screening. Therefore, thestudy intends to throw more light on the issue of credit risk management by microfinance institutions within the Fako chapter of credit unions.
Microfinance institutions (MFls) often known as banks for the poor, make funds accessible to small and medium-scale enterprises that may not qualify for loans from traditional banks due to their high-risk nature. If Microfinance institutions are taking up this high credit risk responsibility, how do they manage the credit risk they are exposed to in order to make profits and stay in business? What credit risk policies are adopted to reduce the credit risks they are exposed to and the impact of the credit risk policies on their clients?
This is palpable especially in Cameroon where we witnessed an exponential growth that greeted the micro finance market of Cameroon in 2010, was greatly affected in 2011 following the collapse of some major micro financial institution which affected not just the company itself but loyal customers negatively as the government announced the official closure of COINFINEST, again a situation in which credit risk management and mismanagement were the order of the day, a good number of microfinance have collapse due to poor credit risk management and mismanagement by the shareholders.
Therefore it is incumbent to develop adequate, effective and efficient method of credit risk management, this necessitates the development and implementation of good credit risk management variables like credit risk identification, credit risk appraisal, credit risk control, amongst others
Credit risk challenges are implicit in financial institutions activities because credit risk events are typically uncertain (Laurentis, 2009). Therefore, as Nancy (2001) has noted an effective credit risk management process is required to help MFI establish rules to prevent operating losses due to human error, employee
carelessness, technological malfunction or fraud. However, MFIs may put into place internal controls and procedures as well as periodic internal audit reviews to ensure that employees comply with the rules when performing duties in credit management. Empirical studies have focused on the different challenges that affect the performance of MFIs (Achou & Tengoh, 2008). In addition, prior studies regarding credit risk management tried to examine the possible methods to manage credit risk including the use of credit risk rating and the impact of borrower’s financial positions on credit risk management and the impact of relation of borrower and lender on credit risk management. Although there has been a number of studies on credit risk management and related issues both in developed and developing countries, it is difficult to believe that these studies exhaustively examined the effect of credit risk management on the performance of micro finance institutions particularly in Cameroon.
Granting credit to the micro finance institution members is an important activity and therefore it is important to manage credit risks facing the micro finance institutions, coupled with taking necessary measures to reduce loan defaulters while at the same time advancing credit in a fair and undiscriminating manner so as to continue offering services to members. Weak credit risk management is a primary cause of many business failures. Most National Credit Unions that failed in the mid-1980s in the U.S.A were because of a consistent element of inadequacy of the bank’s management system for controlling loan quality (Parrenas, 2005).
Financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counterparties (Gil-Diaz, 2008).
In unstable economic environments, interest rates charged by financial institutions are fast over taken by inflation and borrowers find it difficult to repay loans as real incomes falls, insider loans increase and over concentration in certain portfolios increases ,giving a rise to credit risk. Sound credit management is a prerequisite for a financial institution’s stability and continuing profitability, while deteriorating credit quality is the most frequent cause of poor financial performance.
It is for this reason that the current study has sought to through more light into the issue of credit risk management in the Fako chapter of credit unions. Poised by the importance of these technics and how detrimental the absence could be for micro finance institutions, the researcher has been inspired solve these above problems by embarking on this piece of research to solve the above problems
The discussed background and problem formulation leads us to the following
research questions. The main research question is thus, “What is the effect of credit risk management on the financial performance of micro-financial insitutions in Fako? And other specific research questions are outlined below:
To what extent does credit risk identification affect the performance of microfinance institutions in the Fako chapter of Credit Unions?
To what extent does credit risk appraisal affect the performance of microfinance institutions in the Fako chapter of Credit Unions?
To what degree does credit risk control affect the performance of microfinance institutions in the Fako chapter of Credit Unions?
The main objective of this study is to examine the effect of credit risk management on the financial performance of microfinance institutions in the Fako chapter of Credit Unions. The study specifically seeks to;
Examine the effect of credit risk identification on the financial performance of microfinance institutions in the Fako chapter of Credit Unions.
Assess the extent to which credit risk appraisal affect the financial performance of microfinance institutions in the Fako chapter of Credit Unions.
Investigate how credit control affects the financial performance of microfinance institutions in the Fako chapter of Credit Unions.