Credit is the provision of resources (such as granting a loan) by one party to another party where that second party does not reimburse the first party immediately, thereby generating a debt, and instead arranges either to repay or return those resources (or material(s) of equal value) at a later date. It is any form of deferred payment. The first party is called a creditor, also known as a lender, while the second party is called a debtor, also known as a borrower (Sullivan, et al 2003). It is therefore a representation of an amount of money that will be paid in the future for benefits received earlier such as goods purchased or loans obtained. Credit risks (CRs) exist because a future payment of an amount borrowed may not occur. CR can be defined as the potential that a borrower or counterparty will not be able to meet its responsibilities in conformity with agreed terms. Hence, it is a form of counterparty risk. This can also be expressed as the failure to deliver goods and services, a failure to provide an agreed loan facilities or refusal to pay an amount indebted to in full and at a scheduled or due date. It is also the risk that a financial institution will incur losses from the decline of the value of assets due to the financial conditions of an entity to which credit is provided.
The world has experienced remarkable numbers of financial crises during the last thirty years. Caprio and Klingebiel (1997) have identified 112 systemic banking crises1 in 93 countries since the late 1970s (Ibid.). Demirguc-Kunt and Detragiache (1998) have identified 30 major banking crises that are encountered from early 1980s and onwards. Interestingly, the majority of the crises coincided with the deregulatory measures that led to excessively rapid credit extension. In the long run, continuous increases in asset prices created bubbles. At some point, the bubble burst and the asset markets experienced a dramatic fall in asset prices coupled with disruption. Finally, widespread bankruptcies accompanied by non-performing loans, credit losses and acute banking crises were observed.
Very recently, the US subprime mortgage sector has observed one of the worst financial crises in 2007-2008. Subsequently, the global financial market is going through a turbulent situation. This has necessitated a close examination of the numerous issues related to the operation of financial markets to identify the root of the problem. Various issues such as the capital adequacy levels in the banking system, the role of rating agencies in financial regulation and the fair-value assessment of banking assets are the most debated ones. In response to the banking crises, significant reformations have been carried out in the banking regulatory system. The most important ones are Basel Accord(s), Basel I and II, which refer to the banking supervision accords issued by Basel Committee on Banking Supervision (BCBS).
Basel I, also known as 1988 Basel Accord, implemented a framework for a minimum capital standard of 8% for banks. This was enforced by law in the G 104 countries in 1992. Basel I with focus on credit risk considers the minimum capital requirement as the main tool to prevent banks from taking excessive risk. The main reason was the belief that a well-designed structure of incentives is more effective than structural controls. Basel I contributed to the financial stability by creating conditions for equal competitions amongst banks across borders. However, several issues such as lack of risk sensitive measures of the creditworthiness and weak incentives for banks to strengthen risk management system emerged as shortcomings. These stimulated significant opportunities for regulatory arbitrage such as the increase of off balance-sheet exposure. It was revealed that Basel I was unable to provide an adequate response to the changing global context.
The prime function of Micro Finance Institutions (MFIs) have always been lending to small businesses and households. With this situation, the appropriate method of assessing a borrower's credit worthiness has been the only way to ensure a successful lending. (Fight, 2004)
Microfinance institutions play an increasingly important role in local financial. Taking credit risk is part and parcel of financial intermediation. Yet, the effective management of credit risk by Microfinance institutions is critical to their viability and sustained growth. Failure to control risks, especially credit risk, can lead to insolvency (Wenner et al, 2007). Like all financial institutions, microfinance institutions (MFIs) face risks that they must manage efficiently and effectively. MFIs which do not manage its risks well are likely to fail in their social and financial objectives. When poorly managed risks begin to result in financial losses, donors, investors, lenders, borrowers and savers tend to lose confidence in the organization and funds begin to dry up. When funds dry up, an MFI is not able to meet its social objective of providing services to the poor and quickly goes out of business. Risk management must therefore be a high priority to Microfinance institutions. However, it is deranging to come to the realization that risk management is still not widely defused in the microfinance industry as expected. Exclude a few microfinance institutions (MFIs), which make up the core of the industry, most MFIs do not pay enough attention to CR.
Credit risk management has debatably existed from the beginning of providing financial assistance to households and other small businesses. Credit risk management is risk assessment that comes in as an investment. Risk often comes in investing and in the allocation of capital. The fundamental rationale of lending is risk mitigation. Ascertaining a borrower's strength and tendency to repay is a necessity to productive lending. As banking and finance have developed, so has CRM. Credit risk management encompasses identification, measurement, matching mitigations, supervising and control of the CR exposures.
MFIs have increasingly grown in the last decade in breadth, depth, and range of outreach. Astonishingly, many MFIs appear to regard even the basic CRM which aided MFIs to achieve high growth rate. Managing CR in MFIs is critical for their survival and growth. It is of greater concern because of the higher level of anticipated risk from debtors. As a result, microfinance institutions that are active in giving out loans are likely to face an elevated level of risk and need to manage it well.
A microfinance institution's risks must be identified before they can be measured and managed. Credit risk management needs to be a robust process that enables MFIs to proactively manage facility portfolios in order to minimize losses and earn an acceptable level of return for shareholders. Whilst particular CRM practices may differ among MFIs depending upon the quality and composite nature of their credit activities, an intensive credit risk management plan will cover the four areas stated above. These patterns should also be enforced in alignment with sound practices associated with the assessment of asset quality, the sufficiency of provisions and reserves, and the exposure of CR, as covered in other recent Basel Committee documents. If deployed correctly and effectively, credit risk management can be a value-enhancing activity that goes beyond regulatory compliance and can provide a competitive advantage to MFIs that execute it appropriately.
The aim of CRM in an MFI's operations is to maximize FI's risk adjusted rate of return by maintaining the CR exposure within acceptable boundary. MFIs need to manage the CR inherent in an entire loan portfolio as well as the risk in individual credit or transaction. MFIs should also take into consideration the relationship between credit, liquidity and interest rate risk. The efficient management of CR vital part of the overall risk management system and it is crucial to each MFI bottom line and eventually the survival of all FI establishments. It is therefore important that credit decisions are made by sound analysis of risks involved to avoid harms to MFIs profitability. On the other hand, MFIs profits are directly related to the amount of loans granted but on the other, tighter credit standards are needed to prevent losses and lower CR. MFIs will weigh and balance these two options in order not to impair its overall prosperity.
The advent of the Financial Services Modernization Act of 1999 was embraced with a lot of excitement by all in the banking sector. The current possibility for FIs to branch out into a more liberal range of services and products make life really cool for MFI entrepreneurs and managers. But this diversification advantage is a once in a life time opportunity that should be consumed with some caution and prudence as this involves a great deal of risk. This is in direct line with the saying that the higher you go, the colder life becomes.
The very nature of the MFI business is so sensitive because much of their liability is lending to small businesses from depositors. MFIs use these deposits to generate credit for their borrowers, which in fact is a revenue generating activity for most MFIs. This credit creation process exposes the MFI to high default risk which might lead to financial distress including bankruptcy. All the same, beside other services, MFIs must create credit for their clients to make some money, grow and survive stiff competition at the market place. This paper is to provide a preliminary investigation of the current CRM practices of MFIs in the metropolis so that further criteria can be suggested by regulators to reduce broad MFI risks.
- Why is Credit Risk Management important to micro finance institutions?
- What are some of the causes of CR in MFIs?
- How effective is CRM in MFIs
- What are some of the measures put in place to curb CR in micro finance institutions?
- How current are the MFIs in terms of CRM practices
Objectives of the study
The main objective of the study is to look into the resent practices of CRM by micro finance institutions. With regards to the growing mixture in the types of counterparties and the variety in the forms of responsibilities, credit risk management has moved to the forefront of risk management activities fulfilled by FIs. The purpose of this research is to provide an investigation of current CRM practices of MFIs so that further criteria can be suggested by regulators to reduce broad MFI risks. This paper also seeks to investigate the popular CRM strategies implemented by MFIs in the Kumasi metropolis.
The study is planned to throw more light on the current patterns of MFIs. Thus attention is geared towards:
- This paper also wishes to investigate the popular CRM strategies implemented by FIs in the metropolis.
- How MFIs use credit risk evaluation and assessment tools to mitigate their credit risk exposure.
- Ascertain the scope to which resourceful credit risk management can perk up MFI performance.
- To identify and prioritize potential risk events in the operations of micro finance institutions.
Significance of the study
The main purpose of this survey is to assess credit risk management applications and to determine shortcomings. This research is to evaluate credit risk management applications and to determine it shortcomings. The study will serve as a guide to financial institutions on risk management practices and the way to curb it. It will enable microfinance firms to establish a genuine credit risk environment. It will also give MFIs to operate under a sound credit-granting process to preserve an appropriate credit administration, assessment and monitoring procedure. Furthermore, the significance of the study is to ensure adequate controls over credit risk in financial institutions.
This study will make use of the multiple embedded strategies which will use both primary and secondary data sources in the forms of structured and unstructured questionnaire and personal interviews of microfinance companies in the Kumasi Metropolis.
Various credit risk analysis method such as credit scoring, loans default analysis, credit predictive modeling, credit risk modeling, credit scoring from the various MFIs will be collected and analyzed.
These will be put into graphical demonstrations for the purpose of assessing microfinance institutions and possibly grading them based on their risk management practices. Also, calculations of percentages and simple proportions will be demonstrated.
Limitations of the work
A lot of constraints were encountered in this project work. First of all, microfinance companies' are less transparent with information. The success of getting the needed information will also depend highly on the goodwill of the officials involved and the level of confidence they will have in the researcher that, information divulged would not be disclosed to their competitors. Time constraint was another factor as a lot of time was used in search for the gathered information as they were completely scattered.
Organization of the study
The main body of the dissertation will be structured as follows: Chapter 1 will introduce the study by getting the problem, objectives and give a background of credit risk management in microfinance institutions. Chapter II will review literature on credit risk management in financial institutions. Chapter III will focus on the research methodology.
Chapter IV will analyze the data collected on credit risk management practices in microfinance companies in the Kumasi Metropolis. Chapter V will discuss conclusions and recommendations