CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

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.

In 1990s 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  delinquency and delinquencys  continued  (Morduch, 1999). The concept of credit management became widely appreciated by Microfinance Institutions (MFI’s) in the late 90s, but again this did not stop loan delinquency to this date (Morduch, 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 (Edward, 1997). These elements are Character, Capacity, Collateral, Capital and Condition (Edward, 1997).It is widely recognized that the exclusion of the poorest people, particularly in the rural areas, from  the  tradition  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 to them became very risky and very costly. There is little controversy in the literature about the fact that 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 et. al., 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, microfinance  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 to improving the lot of the poor in developing countries, MFIs provide to them the much needed credit  loans  of  small  amount  to  finance  their entrepreneurship  projects, to  finance  theirconsumption,  to  cope to  illness  or  for  the  education  of  their  children  without  any  collateral requirement (Baklouti et. al., 2013).

It has been proven that microfinance 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 a microcredit schemes increases the number of small enterprises, which in turn creates employment opportunities for the poorest and stimulates therefore economic development and social inclusion (Babu and Singh, 2007).

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 meaning that the MFI should be  self-sufficient; that is be  able  to  cover  all  its  present  costs  and  make  profits  on  services  that  they offer. In order to become a permanent and maximize their sustainability, MFIs must apply high interest rate, largely higher than market rates. This can be at 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  amongmicrofinance academics and practitioners. To face such a dilemma, it is vital for MFI’ 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 (Babu and Singh, 2007).

Loan granting is the main income generating function of every savings and credit co-operativesociety. Credit management activity facilitates efficient management and administration ofthe credit union loan portfolio in order to ensure equitable distribution of available funds and to encourageliquidity planning. In order to achieve prudence and accepted best practice, credit managementshould always be guided by clearly spelt out laid down laws and procedures as found in the loan policy of credit unions. Essentially credit unions have three main functions vis-à-vis their members namely; accept savings provide credit facilities and financial counseling. 

The board of directors and the credit committee of the credit union are responsible for formulation, reviewing and amending the loan policy. The supervisory committee is responsible for ensuring that the loan policy is adequately carried out and that it achieves the goals it was created. The committees determine if the policy is being complied with by periodically reviewing a sample of loans granted and denied. The policy is expected to establish a fair loan granting system, establish efficient credit assessment procedures, assist in proper recovery of loan funds and finally to guide staff and board members on the loan granting process.

Loan appraisal is an application for funds, evaluated by financial institution. The aspects to be focused in appraisal includes: purpose of the client, need genuineness, repayment capacity of the borrower, quantum of loan and security. Loan appraisal plays important role to keep the loan losses to minimum level, hence if those officers appointed for loan appraisal are incompetent then there would be high chances of lending money to non‑deserving members (Boldizzoni, 2008). Collection procedure is a systematic way required to recover the past due amount from clients within the lawful jurisdiction. The collection aspects may vary from institution but those should be complaint to existing laws such as third party collection agencies may involve in a collection process. It does not just involve in collection procedure details provided by the institution but also the procedure in which the lawful collection takes place (Latifee, 2006). Well administered collection is needed for better performance of the loan. If financial institutions do not follow well administered collection procedures, this would results in loan delinquencys (Boldizzoni, 2008). Previous studies indicate that micro finance institutions (MFIs) need to have strong and effective credit risk management policies for ensuring consistent recoveries from clients (Frank et al., 2014).

According to Basel Committee on Banking Supervision (1999), credit risk is most simply defined as the potential that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Chijoriga (1997) stated that credit risk is the most expensive risk in financial institutions and its effect is more significant as compared to other risks as it directly threatens the solvency of financial institutions. While financial institutions in Cameroon have faced difficulties over the years the major cause of their failures has been mostly attributed to poor credit standards for borrowers and counterparties, poor portfolio risk management. 

Loan granting is the main income generating activity of CUs and interest charged on loans comprises more than 90% of its income. However, other sources of credit risk exist throughout the activities of a financial institution including in the banking book and the trading book, and both on and off the balance sheet. The goal of credit risk management is to minimise a CU’s risk by maintaining credit risk exposure within acceptable parameters. Sinkey (1992) pointed out that credit risk management should be inherent to the entire portfolio as well to individuals comprising that loan portfolio.

The success and failure of credit management is mainly determined by the level of risk management in place, procedures, policies, professionalism and governance. If there is good risk management system that is well thought out and elaborated by professionals, it will mean that the leaders allow policies and procedures put in place to be operated without interruption except in cases of identified fraud or bias.

Zeller (2001) pointed out that minimising bad loan has benefits to all parties involved especially the lenders. It will help in the identification of potential credit risks related to loan restructuring, underwriting and documentation, in gathering information required to monitor borrower relationships for changes in risks including determining the appropriate level of monitoring and identifying information required for both the lender and borrower, in evaluation of changes in credit management that require action including assessing internal and external factors and recognising and evaluating warning signals, in selecting appropriate solutions to solve emerging credit problems by using strategies that optimises the outcome for the institution. Also, it will assist in recognition of lending institutions that entail exposure to lender liability and lastly it will help in identification of the potential impact of bad loans to the institution.

During appraisal emphasis is laid on: intended purpose of the member, need genuineness, repayment capacity of the borrower, quantum of loan and security. Loan appraisal plays important role to keep the loan delinquency to minimum level, it therefore follows that if the loan officers appointed for  appraisal are incompetent then there would be high chances of lending money to non‑deserving customers (Boldizzoni, 2008). Collection procedure is a systematic way required to recover the past due amount from clients within the lawful jurisdiction. The collection aspects may vary from institution but those should be complaint to existing laws such as third party collection agencies may involve in a collection process. It does not just involve in collection procedure details provided by the institution but also the procedure in which the lawful collection takes place (Latifee, 2006). Well administered collection is needed for better performance of the loan. If financial institutions do not follow well administered collection procedures, this would results in loan delinquencys (Boldizzoni, 2008). Previous studies indicate that MFIs need to have strong and effective credit risk management policies for ensuring consistent recoveries from clients (Frank et al., 2014).

The recent instabilities in the financial sector related to subprime mortgage lending crisis in U.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 microcredit markets, the increasing over-indebtedness among micro-entrepreneurs and the current financial difficulties increase the credit risk and therefore lead to a growing need to estimate the risk of failure of microfinance 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.

1.2 Statement of the Research Problem

Loan delinquency has been the major cause of bank failures both in developed and developing economies. The global financial crisis that originated in the USA around 2008 and spread through the European Union and even spilled over to some African countries leading to closure of some Banks and companies in USA was as a result of the credit crunch. The credit crunch came as a result of the early 2000s housing bubble in the USA which led to too much liquidity in banks causing them to go on sub-prime mortgages and poorly appraised loans. The failures to meet the mortgage terms and difficulties in recovering the outstanding loans led to the financial crisis that was felt almost the world between 2008-2010 (IMF Report 2010).

Since BamCCUL just as other MFIs provide financial services to the low and medium income earners especially those in the rural areas who quite often lack collateral securities and credit history to ensure credit worthiness, they face a lot of problems in relation to achieving the desired level of performance in terms of raising enough interest on their loans that can help cover their expenses and also compensate members for their shares and savings. Evident is the fact in 2017 even though the amount of realized recovery increased by 1.1% compared to the budgeted amount, the realized interest on savings fell by 14% compared to the budgeted. In the same year, even though total realized loan portfolio increased by 3.9% compared to the budgeted, the realized interest on loan instead fell by 18% compared to the budgeted meaning there was a problem with loan repayment since loan delinquency rate stood at 23% (BamCCUL Annual Report, 2013).

With measures put in place to strengthen the credit risk management of BamCCUL such as opening up of new branches to facilitate loan repayment for example the Kumba branch, there was no significant improvement in 2016. In 2016, although members’ savings increased by 12% from 2013, interest on saving fell by 8.3%. Also, in the same year, total loan portfolio increased by 7.8% from 2016 to 2017 and the delinquency rate also increased from 23% in 2013 to 25% in 201 (BamCCUL Annual Report, 2018).

In 2015, saving increased by about 5% from 2018, interest on saving increased by about 11% showing an improvement in performance. Loan portfolio on its part increased by 14.9% in 2018 compared to 2017 and the delinquency rate dropped from 25% in 2017 to 22% in 2018 (BamCCUL Annual Report 2018). From the above counts, it is clear that despite the numerous efforts put in place to propel profitability and hence the performance of BamCCUL, the desired level of profitability is not realized and the above analysis clearly indicates that loan delinquency rate can be a major determinant of the performance of BamCCUL. This study therefore seeks to provide answer to the proceeding research questions.

1.3 Research Questions

1.3.1 Main Research Question

What are the effects of loan delinquency on the profitability of Bambili Cooperative Credit Union (BAMCCUL)?

1.3.2 Specific Research Questions

This research will be aimed at providing answers to the following specific questions:

• To what extent does loan delinquency affect the Profitability of Bambili Cooperative Credit Union?
• What are the measures to improve on the profitability of Bambili Cooperative Credit Union?
• What are the major problems associated with profitability in Bambili Cooperative Credit Union?

1.4 Objectives of the Study

1.4.1 Main Objective of the Study

The main objective of this study is to investigate the effect of loan delinquency on the profitability of BAMCCUL.

1.4.2 Specific Research Objectives

To achieve the main objective, the following specific objectives are necessary;

• Outsourcing the major problems associated with profitability in BAMCCUL
• Investigating the effects of loan delinquency on the profitability of BAMCCUL
• Making necessary recommendations for policy implementation