CHAPTER ONE

INTRODUCTION

1.1 Organization of The Study

Chapter one provides the background details of parts model on loan default in microfinance institutions in Fako division. The chapter exposes the statement of the research problem which is the core issue of this research, the objectives of the study which is derived from the statement of research problem, research hypothesis which are the conditional statement to be investigated, significant of the study and scope and period of the study. Chapter two explains the different concept of credit risk, related literature and empirical, conceptual and theoretical literatures of credit risk written by different authors. Chapter three explains the various ways in which data will be collected in this chapter and also the method of data presentation and analysis (research methodology). Chapter four will be talking on how the various data collected will be presented and analyzed bringing out various facts. Chapter five will be the summary of the work, conclusion and then recommendation.

1.2 Background of Study 

The economic crisis that occurred in 2007 and 2008 along with the credit crunch placed credit risk management into the regulatory focus. Subsequently, supervisory bodies instigated more transparency. This called for financial institutions in the lending business to have comprehensive knowledge of their borrowers (customers) and their associated credit risk (Lybeck, 2011). The new Basel III policies conveyed by BCBS present a superior regulatory burden for banks. The proposed Basel (IV) standards for capital reserves for banks will assist in the mitigation of risk in the occurrence of a financial crisis. It is probable to follow the third Basel accords and more rigorous capital requirements and superior financial disclosure will be required. These Basel accords impose certain minimum capital ratios as a guarantee that banks have a sturdy capital position to guard their solvency in the occurrence of a deep recession. The capital strength ensures that the banks carry on lending even in the depression stage of the business cycle.

To act in accordance with the most rigorous regulatory requirements, and take up the elevated capital costs of credit risk, as illustrated by Lybeck (2011) many financial institutions such as banks are refitting their approach to credit risk management. Nevertheless, banks with a perception that this is solely a conformity exercise are being shortsighted. Therefore, a superior credit risk analysis and management presents an opportunity for banks to improve the overall financial stability, and performance to retain a competitive advantage.

Based on existing literature, credit risk exposure continues to be a significant basis of problems for the lending institutions. This issue is even more imperative with reference to microfinance institutions in Cameroon. As defined by Kairu(2009) microfinance is the process of providing monetary services to the unbanked or low-income earners. It also refers to the sustainable practice of offering those services. These institutions lend to low income earners, a group that is believed to be very risky in terms of exposure to credit risk. Therefore, credit risk can be defined as the likelihood of loss owing to a borrower’s failure to meet his obligation (loan, line of credit) (HKIB, 2012).

Stability and profitability of a financial institution depends solely on the credit management practices in that institution while poor performance is attributed to weakening credit quality. The management of credit risk can play down operational risk while locking in realistic income. The first step to managing credit risk is ensuring that the lending staff complies with the laid down industry lending standards and policies.  Secondly, the financial institutions should ensure that their credit policies manage other areas of credit risk such as syndicated loans, evergreen loans just to name a few and there is minimal individual lending. An institution’s board and management should ensure that there are set targets in terms of loan portfolio mix included in the yearly planning. Thus, the monitoring of a loan portfolio should be on a continual basis in order to establish that the current performance matches up to the projected expectations, and the intensity of risk stays within tolerable confines.

As defined by Gregory (2010) credit risk occurs when counterparty is not in a position or is unwilling to meet his or her obligation. It may be distinguished in terms of an actual default or declining of counterparty’s credit quality. Owing to the fact that credit risk exposure goes on as the foremost basis of tribulations in financial institutions globally, these institutions draw constructive lessons from these past occurrences. Financial institutions as an overview should have a keen responsiveness of the need to recognize, determine, observe and manage credit risk. Furthermore, these institutions should ensure that their capital is sufficient to counter these risks as well as ensure superior compensation for the risks incurred. The Basel Committee on Banking Supervision present the basis that financial institutions worldwide can uphold sound practices for the management of credit risk. Though most of the principles in the Basel accords are applicable in business of lending, it is advisable that they are utilized in all activities where credit risk is present.

One of the major assets of a MFI is the loan portfolio and its quality is a reflection of loan delinquency, establishes projected income and its capacity to augment its outreach, and services to existing customers (Ledgerwood, Earne & Nelson, 2013). Portfolio at risk over 30 days and Non-Performing loans ratio (NPLR) are the key measures of portfolio quality. The performance of a loan portfolio is assessed in terms of the returns generated from the different loan products; which is a factor of the loans financed and the outlay of advancing them, most of the loans advanced by MFIs are deemed high risk for the fact that they do not have collateral and are frequently advanced to a more susceptible and low income individuals. Regardless of this fact, the repayment rate on MFI loans has in the past proven strong.

Therefore, non-performing loan ratios are subjective measures of how MFIs manage to generate revenue from their assets. As illustrated by Ledgerwood et al, (2013) these variables should generally be employed in the evaluation of the general financial performance, steadiness, as well as health of MFIs over a period, in addition to comparing similar institutions in the same industry.

1.3 Statement of The Problem

The asset quality formerly known as portfolio quality (Ledgerwood et al., 2013) is still a key measure of financial performance and stability for Microfinance institutions. Currently, MFIs continue to increase their products in terms of deposits provision, insurance just to mention a few. Therefore, the loan portfolio is still viewed as a key element of a MFI asset base. For that reason, the quality of the assets continues to be a major gauge of a microfinance financial feasibility. The effectiveness of credit risk management of MFIs largely dictates their success because these institutions generate their earnings from interest achieved on loans advanced. The Central Bank Annual Supervision Report (2014) highlighted a soaring rate of credit risk because of the increasing rate of NPLs in MFI’s. This kind of a drift threatens the stability, viability, and sustainability of the MFIs. Whilst many studies that have been carried out by researchers on the causes of poor loan performance and their effects on the wide-reaching banking crises in Europe, Asia and some parts in Africa, there have not been detailed studies on the outcome of credit risk management on the Microfinance industry’s financial performance.

Poor credit-risk rating, analysis and modeling result in financial instability. Most of the financially stable MFIs have maintained far above the ground levels of loan recovery rates. These recovery ratios are because of donor funding and funding agencies used in the expansion of their operations (Ledgerwood et al., 2013). Regardless of the fact that these financially stable MFIs maintain their credit risks within preferred levels, volatility of their portfolio at- risk ratios create bigger challenges. The sources of these challenges include increased competition in the market, product diversification of longterm structures, increased operations, move to individual lending, expansion and efforts to intensify the outreach. Parts model practices help MFIs reduce their exposure to credit risks, and enhance their ability to compete in the market with other well-established financial institutions like banks.

1.4 Research Question 

Does the purpose of the loan affect loan default in microfinance institution in fako division?

How does loan repayment affect the purpose of the loan in microfinance institution in fako division?

How does the term of the loan affect loan default in microfinance institution in fako division?

1.5 Objectives of The Study

The objective of this study will be divided into two parts; main and specific objectives.

1.5.1 Main Objective

The main objective of this study is to determine the effect of parts model on loan default of microfinance institutions.

1.5.2 Specific Objectives

To determine the effect purpose of the loan on loan default of microfinance institution.

To determine if the repayment of the loan will affect loan  default in microfinance institution in fako division.

To examine the term of the loan and if it affect loan default in microfinance institution in fako division.

1.6 Hypothesis of The Study

One hypothesis will be formulated and tested in this research;

1^st H₀: Credit analysis and credit management does not significantly have an effect on the loan default on microfinance in Fako Division.

2^ndH0: The purpose of the loan does not significantly affect loan default in microfinance in Fako Division.

3^rdH0: The amount of the loan does not always affect loan default in microfinance in Fako Division.

4^thH0: The repayment of the loan does not significantly affect the loan default of microfinance in fako division.

5^thH0: The term of loan does not have an effect on loan default in microfinance in fako division.

6^thH0: The security of the loan does not significantly affect loan default in fako division.