ISSN 2349-7807
International Journal of Recent Research in Commerce Economics and Management (IJRRCEM)
Vol. 6, Issue 4, pp: (158-169), Month: October - December 2019, Available at: www.paperpublications.org
EFFECT OF CREDIT RISK MANAGEMENT
ON LOAN PERFORMANCE OF DEPOSIT
TAKING MICROFINACE INSTITUTIONS
IN NAIROBI COUNTY, KENYA
1
KANGETHE ELIZABETH, 2DR. OLUOCH OLUOCH, 3DR. SAMSON NYANGAU
Abstract: The success of MFIs in Kenya largely depends on the effectiveness of their credit management systems
because these institutions generate most of their income from interest earned on loans extended to small and
medium entrepreneurs. This study investigated on the effect of credit risk management on loan performance of
deposit taking Microfinance institutions in Nairobi County, Kenya. Modern portfolio theory, agency theory and
asymmetric information theory were used to inform the study. The study adopted a descriptive research design
and all 13 deposit-taking microfinance institutions in Nairobi were the targeted population. A sample of 118
microfinance staffs derived from Krejcie and Morgan (1970) strategy. Both secondary and primary information
was gathered. Primary information was gathered by use of structured questionnaires addressing the independent
variables while the secondary information was assembled from the financial reports of the Microfinance
institutions on loan performance for five years (2014 - 2018). The data gathered was analyzed using descriptive
and inferential statistics. Multiple linear regressions was used to show the relationship between the variables. The
study established that microfinance institutions in Nairobi asks for collateral when giving loans and they also
consider the past track record of repayment of the client. Regression results revealed that a change in credit
appraisals processes holding all the other factors constant leads to positive change on loans performance of
microfinance institutions. The study also revealed that credit risk control has significance and positive influence on
loan performance of microfinance institutions. Further it was revealed that most micro finance have accredit
committee and a lender approval limit for loans. Prediction by regression model revealed that credit terms has a
significance influence on loan performance of microfinance institutions. Finally the study established that a change
in credit approvals while holding all the other factors constant would affect loans performance of microfinance
institutions. Grounded on the study findings, it is recommended that micro-finance institutions need to enhance
their methodologies of identifying risk from credit, analysis and assessment of risk arising from credits, proper
monitoring of credit offered to clients and credit approval to improve on their loan portfolio. Owing to the current
study findings the researcher proposes further studies on an examination of the relationship between credit risk
management and loans performance in the banking industry as whole so as to compare the results and a study on
the strategic credit risk management practices by banking institutions on loan performance.
Keywords: credit appraisals, credit risk control, credit terms and credit approvals.
1. INTRODUCTION
Credit creation is the main income generating activity for the banks. But this activity involves huge risks to both the
lender and the borrower. When financial institutions issue loans, there is a risk of borrower default. According to Casu
(2012), when banks collect deposits and on-lend them to other clients, they put clients’ savings at risk. The risk of a
trading partner not fulfilling his or her obligation as per the contract on due date or anytime thereafter can greatly
jeopardize the smooth functioning of a bank’s business. The default of small number of borrowers may result to large
Page | 158
Paper Publications
, ISSN 2349-7807
International Journal of Recent Research in Commerce Economics and Management (IJRRCEM)
Vol. 6, Issue 4, pp: (158-169), Month: October - December 2019, Available at: www.paperpublications.org
losses for a financial institution which can lead to massive financial distress affecting the whole economy (Bessis, 2013).
Credit Risk is the potential that a credit borrower/counter party fails to meet the obligations on agreed terms. There is
always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of
credit risk by the financial institution. These losses could take the form of outright default or alternatively, losses from
changes in portfolio value arising from actual or perceived deterioration in credit quality (Achou & Tenguh, 2011).
Statement of the Problem
Controlling non-performance of advances is extremely basic for both the performance of an individual Microfinance
foundation and the economy's financial environment. With the rise in bankruptcy rates, the probability of incurring losses
due to loans non-performance has risen. Scheufler (2012), indicated that credits policies, standards and appraisal
procedures enable the firm to earn financial returns. Credit management provides a leading indicator of the quality of
deposit MFIs credit portfolio.
The success of MFIs in Kenya largely depends on the effectiveness of their credit management systems because these
institutions generate most of their income from interest earned on loans extended to small and medium entrepreneurs. The
Central Bank Annual Supervision Report, 2013 indicated high incidence of credit risk reflected in the rising levels of non-
performing loans by the MFI’s in the last 10 years, a situation that has adversely impacted on their profitability (CBK,
2013). This trend not only threatens the viability and sustainability of the MFI’s but also hinders the achievement of the
goals for which they were intended which are to provide credit to the rural unbanked population and bridge the financing
gap in the mainstream financial sector.
Empirical scrutiny of previous studies outcome on effect of credit risk management on loan performance has provided
inconclusive findings. Previous studies have reported mixed outcomes on the effects of credit risk management on loan
performance. Kargi (2011), studied Impact of credit risk management on performance of shares and profit of Nigerian
Listed Banks. Results showed that loans and advances, interest income, bank size and equity capital exert significant
positive impact on performance of shares. In line with prior studies, the study also revealed a significant negative effect of
loan loss provision and an insignificant positive influence on shares performance.
In a similar context, Smith (2014), examined the impact of credit risk management on performance of deposit money
banks in Nigeria over the period,2005 to 2011 using panel regression model. The study revealed that credit risk
management has a significant impact on profitability of deposit money banks in Nigeria. Alshatti (2015), examined the
effect of credit risk management on financial performance of Jordanian commercial banks. The empirical findings show
positive effect of non-performing loans/gross loans ratio, a negative effect of leverage ratio and an insignificant effect of
capital adequacy ratio and credit interest/credit facilities ratio on ROE and ROA.
Ndegwa (2016), studied the effect of credit risk on the financial performance of commercial banks listed at the Nairobi
securities exchange. Capital adequacy ratio (CAR) was found to have positive and weak association with ROA and ROE.
On the other hand, Gatuhu (2014), investigated the effect of credit risk management on financial performance of MFIs
and commercial banks. While these studies handle credit risk management and financial performance, they don’t address
the recent adjustments of interest rate capping in commercial banks and credit rating on credit risks. Essendi (2013),
aimed at establishing the effect of credit risk management on loans portfolio among Saccos in Kenya. Results indicated
that formulation of the credit policy is largely done by members of the organization and regulation with moderate
involvement of employees and the directors.
Since most studies have related credit risk management and financial performance of banks, the study identified
methodological, conceptual, contextual and theoretical gaps. Therefore, this study sought to fill the gap and empirically
add to the existing literature by specifically looking at credit appraisals, credit risk control, credit terms and credit
approvals, as the independent variables and loan performance as the dependent variable. The study also aimed at using
more recent data and a different study period. The use of loan performance, rather than the financial performance was a
strength for this study as it broadens the empirical literature in this area. The study answered the question: What is the
effect of credit risk management on loan performance of deposit taking Microfinace institutions in Nairobi County,
Kenya?
Page | 159
Paper Publications
International Journal of Recent Research in Commerce Economics and Management (IJRRCEM)
Vol. 6, Issue 4, pp: (158-169), Month: October - December 2019, Available at: www.paperpublications.org
EFFECT OF CREDIT RISK MANAGEMENT
ON LOAN PERFORMANCE OF DEPOSIT
TAKING MICROFINACE INSTITUTIONS
IN NAIROBI COUNTY, KENYA
1
KANGETHE ELIZABETH, 2DR. OLUOCH OLUOCH, 3DR. SAMSON NYANGAU
Abstract: The success of MFIs in Kenya largely depends on the effectiveness of their credit management systems
because these institutions generate most of their income from interest earned on loans extended to small and
medium entrepreneurs. This study investigated on the effect of credit risk management on loan performance of
deposit taking Microfinance institutions in Nairobi County, Kenya. Modern portfolio theory, agency theory and
asymmetric information theory were used to inform the study. The study adopted a descriptive research design
and all 13 deposit-taking microfinance institutions in Nairobi were the targeted population. A sample of 118
microfinance staffs derived from Krejcie and Morgan (1970) strategy. Both secondary and primary information
was gathered. Primary information was gathered by use of structured questionnaires addressing the independent
variables while the secondary information was assembled from the financial reports of the Microfinance
institutions on loan performance for five years (2014 - 2018). The data gathered was analyzed using descriptive
and inferential statistics. Multiple linear regressions was used to show the relationship between the variables. The
study established that microfinance institutions in Nairobi asks for collateral when giving loans and they also
consider the past track record of repayment of the client. Regression results revealed that a change in credit
appraisals processes holding all the other factors constant leads to positive change on loans performance of
microfinance institutions. The study also revealed that credit risk control has significance and positive influence on
loan performance of microfinance institutions. Further it was revealed that most micro finance have accredit
committee and a lender approval limit for loans. Prediction by regression model revealed that credit terms has a
significance influence on loan performance of microfinance institutions. Finally the study established that a change
in credit approvals while holding all the other factors constant would affect loans performance of microfinance
institutions. Grounded on the study findings, it is recommended that micro-finance institutions need to enhance
their methodologies of identifying risk from credit, analysis and assessment of risk arising from credits, proper
monitoring of credit offered to clients and credit approval to improve on their loan portfolio. Owing to the current
study findings the researcher proposes further studies on an examination of the relationship between credit risk
management and loans performance in the banking industry as whole so as to compare the results and a study on
the strategic credit risk management practices by banking institutions on loan performance.
Keywords: credit appraisals, credit risk control, credit terms and credit approvals.
1. INTRODUCTION
Credit creation is the main income generating activity for the banks. But this activity involves huge risks to both the
lender and the borrower. When financial institutions issue loans, there is a risk of borrower default. According to Casu
(2012), when banks collect deposits and on-lend them to other clients, they put clients’ savings at risk. The risk of a
trading partner not fulfilling his or her obligation as per the contract on due date or anytime thereafter can greatly
jeopardize the smooth functioning of a bank’s business. The default of small number of borrowers may result to large
Page | 158
Paper Publications
, ISSN 2349-7807
International Journal of Recent Research in Commerce Economics and Management (IJRRCEM)
Vol. 6, Issue 4, pp: (158-169), Month: October - December 2019, Available at: www.paperpublications.org
losses for a financial institution which can lead to massive financial distress affecting the whole economy (Bessis, 2013).
Credit Risk is the potential that a credit borrower/counter party fails to meet the obligations on agreed terms. There is
always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of
credit risk by the financial institution. These losses could take the form of outright default or alternatively, losses from
changes in portfolio value arising from actual or perceived deterioration in credit quality (Achou & Tenguh, 2011).
Statement of the Problem
Controlling non-performance of advances is extremely basic for both the performance of an individual Microfinance
foundation and the economy's financial environment. With the rise in bankruptcy rates, the probability of incurring losses
due to loans non-performance has risen. Scheufler (2012), indicated that credits policies, standards and appraisal
procedures enable the firm to earn financial returns. Credit management provides a leading indicator of the quality of
deposit MFIs credit portfolio.
The success of MFIs in Kenya largely depends on the effectiveness of their credit management systems because these
institutions generate most of their income from interest earned on loans extended to small and medium entrepreneurs. The
Central Bank Annual Supervision Report, 2013 indicated high incidence of credit risk reflected in the rising levels of non-
performing loans by the MFI’s in the last 10 years, a situation that has adversely impacted on their profitability (CBK,
2013). This trend not only threatens the viability and sustainability of the MFI’s but also hinders the achievement of the
goals for which they were intended which are to provide credit to the rural unbanked population and bridge the financing
gap in the mainstream financial sector.
Empirical scrutiny of previous studies outcome on effect of credit risk management on loan performance has provided
inconclusive findings. Previous studies have reported mixed outcomes on the effects of credit risk management on loan
performance. Kargi (2011), studied Impact of credit risk management on performance of shares and profit of Nigerian
Listed Banks. Results showed that loans and advances, interest income, bank size and equity capital exert significant
positive impact on performance of shares. In line with prior studies, the study also revealed a significant negative effect of
loan loss provision and an insignificant positive influence on shares performance.
In a similar context, Smith (2014), examined the impact of credit risk management on performance of deposit money
banks in Nigeria over the period,2005 to 2011 using panel regression model. The study revealed that credit risk
management has a significant impact on profitability of deposit money banks in Nigeria. Alshatti (2015), examined the
effect of credit risk management on financial performance of Jordanian commercial banks. The empirical findings show
positive effect of non-performing loans/gross loans ratio, a negative effect of leverage ratio and an insignificant effect of
capital adequacy ratio and credit interest/credit facilities ratio on ROE and ROA.
Ndegwa (2016), studied the effect of credit risk on the financial performance of commercial banks listed at the Nairobi
securities exchange. Capital adequacy ratio (CAR) was found to have positive and weak association with ROA and ROE.
On the other hand, Gatuhu (2014), investigated the effect of credit risk management on financial performance of MFIs
and commercial banks. While these studies handle credit risk management and financial performance, they don’t address
the recent adjustments of interest rate capping in commercial banks and credit rating on credit risks. Essendi (2013),
aimed at establishing the effect of credit risk management on loans portfolio among Saccos in Kenya. Results indicated
that formulation of the credit policy is largely done by members of the organization and regulation with moderate
involvement of employees and the directors.
Since most studies have related credit risk management and financial performance of banks, the study identified
methodological, conceptual, contextual and theoretical gaps. Therefore, this study sought to fill the gap and empirically
add to the existing literature by specifically looking at credit appraisals, credit risk control, credit terms and credit
approvals, as the independent variables and loan performance as the dependent variable. The study also aimed at using
more recent data and a different study period. The use of loan performance, rather than the financial performance was a
strength for this study as it broadens the empirical literature in this area. The study answered the question: What is the
effect of credit risk management on loan performance of deposit taking Microfinace institutions in Nairobi County,
Kenya?
Page | 159
Paper Publications
