CHAPTER ONE

GENERAL INTRODUCTION

1.1: Background of the Study

Modern credit union history dates from 1852, when Franz Hermann Schulze Delitzsch consolidated the learning from two pilot projects one in Ellensburg and the other in Delitzch in the kingdom of Saxony into what is generally recognized as the first credit union in the world. He went onto develop a highly successful urban credit union system. In 1864 Friedrich Withelm Raiffersen founded the first rural credit union in Heddesdolf (now part of Neuwied) in Germany.By the time of Raiffessen’s death in 1888 Credit unions had spread to ltaly, France, the Netherlands, England, Austria and other nations.

The first credit union in North America, the Caisse Populaire de Lavis in Quebec, Canada began Operating on January 23, 1901 with a 10-cent deposit. Founder Alphonse Desjardins a reporter in Canadian parliament was moved to take up his mission in 1897 when he learned of a Montrealer who had been ordered by the count to pay nearly C $5,000 in interest on a loan of Drom a money lender. Drawing extensively on European Precedents, Desjardins developed a unique parish based model for Quebec (the Caisse Populaire).

In the United States, ST. Mary’s bank credit union of Manchester, New Hampshire was the first Credit union. Assisted by a personal visit from Desjardins, St. Mary’s was founded by French- Speaking immigrants to Manchester from Quebec on November 24, 1908. America’s credit union Museum now occupies the location of the home from which St. Mary’s bank credit union first operated. On November 1910, the women’s educational and industrial union set up the industrial credit union, modeled on the Desjardins credit unions it was the first non-faith-based community credit union serving all people in the greater Boston area. The St. Mary’s credit union serves any resident of Massachusetts.

After being promoted by the Catholic Church in the 1940s to assists the poor in Latin America, credit unions expanded rapidly during the 1950s and 1960s especially in Bolivia, Costa Rice, the Dominican Republic, Honduras and Peru. The regional confederation of Latin America credit unions (COLAC) was formed and with funding by the inter-American development bank credit union 1n the regions grew rapidly throughout the 1970s and into the early 1980s. In 1988, COLAC represented 4 million members across 17 countries with a lean portfolio or circa half a billion dollars. However, from the late 1970s onwards many Latin American credit unions Struggled with inflation, stagnating membership and serious loan recovery problems, In the 1980s donor agencies attempted to rehabilitate Latin America credit unions by providing technical assistance and focusing credit unions efforts on mobilizing deposits from the local Population. In 1987, the regional financial crisis caused a run on credit unions significant Withdrawals and high default rates caused liquidity management plays an important part in the performance of micro financial institutions, It is therefore pertinent there should be effectiveliquidity management to avoid the problems that may come as a result of poor liquidity management.

Credit risk has pervasive effects on credit unions’ profits and safety (Koehn and Santomero 1980; Kim and Santomero 1988, and Anthanasoglou et al. 2005) since a greater proportion of MFI’s Income emanates from granting loans (Gieseche 2004) and it is the subject of strict regulatory oversight and policy debate (Bank for International Settlement 2001). Furthermore, Credit risk has contributed to the insolveney of many MFI’s (Bessis 2002) and MFI’s protitability is coming on its ability to foresee, avoid and monitor risks (Bobakovia 2005). According to Padmanabham (1988) and Agu (1998), loan default reduces the reserve base of a MFI’s, weakens its capacity for further credit creation, reduces staff moral and affects borrowers confidence. Because of the perverse effects of credit risk on MFI’s ‘ profitability, several Credit risk management strategies have been adopted by MFIs. We have credit manuals, credit derivatives, banking regulation and supervision and credit risk models.

The contemporary business environment has become very complex and dynamic changing the risk profiles of bank MFIs (Financial Service Roundtable 1999). Basel (2001) and Gastineau (1992) sees credit risk as the possibility of losing the outstanding loan partially or totally due to credit events such as bankruptcy, failure to pay a due obligation, moratorium or credit rating change and restructure. However, Basel (1999) observes that even though loans are the most obvious source of credit risks, we have other sources like financial instruments and acceptances. Credit risks arise because not all the loans granted to clients is reimbursed in accordance with the terms of the loan agreement. The Credit facilities end up either as performing loans (serviced in accordance with the terms of the agreement) (Ajayi 1997) or non-performing loans (not well serviced bycustomers) (Graham 2007).

Effective credit risk management is of strategic necessity and must be a core competence of any financial institution” (Financial Services Roundtable 2009). Credit crisis has forced MFI’s to re-examine their extant risk management procedures and to adopt holistic management approaches (KPMG 2009). Thus, a MFI’s ability to manage credit risks constitutes a source of competitive advantage (Marrison 2002).

1.2. Statement of the Problem

many microfinance institutions today are at the risk of going into liquidation due to the poor management of the credits of the financial institution. Understanding the implication of such mismanagement, the necessity to analyze how successful MFI’s such as BamCCUL, AziCCUL, NtaCCUL and many more manage their credits so as not to go into credit risk which is one of the common risks that MFI’s face arose. Credit proposition, assessment and approval are concepts that cannot be separated from each other. As stipulated by Urs B. et al (2007) from the  Judgments of evaluation of credit officers in the management of credit in MFI’s in their thesis, they concluded that credit officers are embedded into a rigid and highly standardize risk assessment process consisting of formal conditions and quantitative and qualitative analyses.

Profitability of credit unions refers to their ability to generate revenue that exceeds their operational costs. Athanasoglou, Brissimis and Delis (2005) cited that an excellent and profitable financial sector can endure depressing economic shocks and facilitate the stability of the banking sector. Studies conducted on financial performance and credit risk of credit unions offer contradictory findings. Some state that credit unions with high control mechanisms on credit can increase their financial performance as they are perceived as safer by the management of the MFI’s for instance, Bourke (1989) finds some indication ofa positive connection between credit risk management and banking performance while Molyneux and Thornton (1992) found a negative correlation between financial performance and credit risk management.

The relevance of this study therefore will be to clearly establish the challenges to efficient credit management in financial institutions.

1.3: Research Questions

1.3.1: General Research Question of the Study

What are the effects of credit risk management on Micro Finance Institutions profitability?

1.3.2: Specific Research Questions[

• How does capital adequacy ratio affect Microfinance’s profitability?
• How does cash reserve affect Microfinance’s profitability?
• How does Non-Performing Loans affect Microfinance’s profitability?

1.4: Objectives of the Study

We have the following main research objectives and three specific research objectives:

1.4.1: General Objective

The main objective of the study is to examine the effect of the credit risk management on MFI’s profitability

1.4.2: Specific Objectives

• To evaluate the effect of capital adequacy ratio (CAR) on Microfinance’s profitability
• To examine the effect of  cash reserve (CR) on Micro finance’s profitability
• To assess the effect of non-performing loan ratio (NPR) on Microfinance’s profitability