Effect Of Credit Risk Management Practices On Loan Portfolio Performance

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1.1 Background to the Problem

Credit risk refers to the risk that a borrower will default on any type of debt by failing to make required payments. The risk is primarily to the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances. Risk management framework is important for commercial banks. The theory of asymmetric information argues that it may be impossible to distinguish good borrowers from bad borrowers (Auronen, 2010) which may result in adverse selection and moral hazards problems. Adverse selection and moral hazards have led to substantial accumulation of non-performing accounts in the commercial banks (Bofondi and Gobbi, 2009).

Banks are important to economic development through the financial services they provide. Their intermediation role can be said to be a catalyst for economic growth. The efficient and effective performance of the banking industry over time is an index of financial stability in any nation. The extent to which a bank extends credit to the public for productive activities accelerates the pace of a nation’s economic growth and its long-term sustainability. Further, credit extension enhances the ability of investors to exploit desired profitable ventures and is an avenue through which banks create credit (Kargi, 2011). However, this exposes banks to credit risk which in turn could eventually lead to a financial crisis.

Credit extended to borrowers may be at the risk of default such that whereas banks extend credit on the understanding that borrowers will repay their loans, some borrowers usually default and as a result, banks income decrease due to the need to provision for the loans. Where commercial banks do not have an indication of what proportion of their borrowers will default, earnings will vary thus exposing the banks to an additional risk of variability of their profits. Every financial institution bears a degree of risk when the institution lends to business and consumers and hence experiences some loan losses when certain borrowers fail to repay their loans as agreed. Principally, the credit risk of a bank is the possibility of loss arising from non-repayment of interest and the principle, or both, or non-realization of securities on the loans (Kithinji, 2010).

Credit risk management is a critical component of a comprehensive approach to risk management as whole and essential to long-term success of a banking organization. It helps reduce bank losses. Credit risk management is very important to banks as it is an integral part of the loan process. It minimizes bank risks, adjusted risk rate of return by maintaining credit risk exposure with view of shielding the bank from adverse effects of credit risk. Bank are successful when the risks they take are reasonable, controlled and within their financial resources and competence (Machiraju, 2010).

1.1.1 Credit Risk Management Practices

Credit risk can be monitored by looking at the total loan/total assets, non-performing loans/total loans, loan losses/total loans, loan losses reserves/total assets (Mwangi, 2012). Other ways for measuring credit risk would involve qualitative and quantitative models, that is checking on borrower’s specific factors such as; reputation, leverage, volatility of earnings and collateral. Market specific facts such as the business cycle, level of interest rates can also be used as qualitative measures of credit risk. Quantitative measures such as credit scoring models and probability of default can be used to measure credit risk.

BCBS (2012) hold that risk management processes, require supervisors to be satisfied that the banks and their banking groups have in place a comprehensive risk management process. This would include the Board of senior management to identify, evaluate, monitor and control or mitigate all material risks and to assess their overall capital adequacy in relation to their risk profile. In addition, as suggested by Al-Tamimi (2012) in managing risk, commercial banks can follow comprehensive risk management process which includes eight steps: exposure identification; data gathering and risk quantification; management objectives; product and control guidelines; risk management evaluation; strategy development; implementation; and performance evaluation

Different measures or models are employed in credit risk management like the quantitative method to check the client’s ability to repay the loan as well as credit worthiness, terms of payment and interest to be charged, consequences in case of default, customer’s character, deposit and collateral. The researchers recommends that credit risk management should be implemented in the Kenyan commercial banks as its useful in helping reduce the risk that is involved while lending to the customers. These policies associated with the credit risks have been very helpful in recovering what might not be recovered through the collateral securities or high rates hence minimizing the possibilities of a bank to fail (Nzuve (2013),

1.1.2 Loan Portfolio Performance

Loan portfolio refers to the total amount of money given out in different loan products to different types of borrowers. This may be comprised of salary loans, group guaranteed loans, individual loans and corporate loans. Loan portfolio looks at the number of clients with loans and the total amount in loans (Wester, 2010). Owojori et al (2011) highlighted that available statistics from liquidated banks in Nigeria clearly showed that inability to collect loans and advances extended to customers was a major contributor to the distress of liquidated banks.

Loan portfolio constitutes loans that have been made or bought and are being held for repayment. Loan portfolios are the major asset of banks and the lending institution. The value of the loan portfolio depends not only on the interest rates earned on loans but also on the likelihood that interest and principal will be paid (Jasson, 2012). Lending is the principal business activity for most commercial banks, the loan portfolio is typically the largest asset and the predominate source of revenue. As such, it is one of the greatest sources of risk to a financial institution’s safety and soundness. Whether due to lax credit standards, poor portfolio risk management, or weakness in the economy, loan portfolio problems have historically been the major cause of losses and failures,

1.1.3 The National Bank of Kenya

National Bank of Kenya is one of the leading banks in Kenya. The bank has an asset base of Kenya Shillings 226 Billion and a loan portfolio of Kenya shillings 126 Billion. This has resulted to the bank being classified as tier one bank by the regulatory authority. The bank has operated in Kenya for over 100 years with different profit centers such as individual retail, business banking, treasury and credit card unit supporting local big to emerging business. National Bank of Kenya financial strength coupled with extensive local and international resources have positioned National Bank of Kenya as the top provider of financial services in the market for the past several years. National Bank of Kenya has had consistent financial performance has built confidence as a leading retail and corporate bank in Kenya (National Bank of Kenya, 2013).


1.2 Statement of the Problem

Credit risk management is essential to optimizing the performance of financial institutions. Credit risk management is very important to banks as it is an integral part of the loan process. It maximizes bank risk, adjusted risk rate of return by maintaining credit risk exposure with view to shielding the bank from the adverse effects of credit risk. Bank is investing a lot of funds in credit risk management modeling. Commercial banks adopt various credit risks management practices in managing credit.

Evidence from the CBK annual report 2014, show a rise in the level of national Bank of Kenya NPA’S over recent years. The years 2013, 2012, 2011, 2010, 2009 saw NPAs ratio change from 4.11, 3.44, 3.42, 5.4 & 7.5 respectively. Despite employing credit risk management strategies responsible for managing risks related to lending, the bank is still experiencing a sharp rise in the level of NPA’S in its books. If the nonperforming assets are not brought into control, they have a potential of eroding the asset book and eventually affecting the profitability and general performance of the bank. (Tetteh, 2012) states that despite innovations in the financial services sector over the years, credit risk is still the major single cause of bank failures, for the reason that “more than 80 percent of a bank’s balance sheet generally relates to this aspect of risk management.

According to Kithinji (2010) the National Bank of Kenya has faced difficulties on loan portfolio performance over the years for a multitude of reasons, the major cause of serious banking problems onloan portfolio performance continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counterparties. In unstable economic environments, interest rates charged by banks are fast over taken by inflation and borrowers find it difficult to repay loans as real incomes fall, insider loans increase and over concentration in certain portfolios increases giving a rise to credit risk.

Several studies have analyzed the effect of credit risk management practices on profitability. Gisemba (2010) studied the relationship between credit risk management practices and financial performance of SACCOs in Kenya while Ndwiga (2010) and Chege (2010) both surveyed the relationship between credit risk management practices and the financial performance of microfinance institutions in Kenya. Gizycki (2001) Kithinji (2010) and Musyoki and Kadubo (2011) analyzed the impact of credit risk management on the financial performance of Banks in Kenya for the period 2000 – 2006 however, these studies failed to address the effect of credit risk management practices on loan portfolio performance. Despite studies having been done on credit risk management, none has been done at National Bank hence knowledge gap exists. The study sought to establish the effect of credit risk management on loan performance of commercial banks in Kenya, with a key focus on National Bank of Kenya, Eldoret branch.

1.3 Research Questions

  1. How does hedging affect loan portfolio performance of National Bank of Kenya?
  2. What is the effect of credit risk insurance on loan portfolio performance of National Bank of Kenya?
  3. To what extent has risk diversification affected loan portfolio performance of National Bank of Kenya?
  4. What role does the CRB play in loan portfolio performance of National Bank of Kenya?
  5. How does the five Cs principles affect loan portfolio performance of National Bank of Kenya?
  6. How effective are the risk management practices on the loan portfolio performance of national bank of Kenya?

1.4 Significance of the Study

The study will create a foundation in this important subject upon which related studies or in-depth analysis can be undertaken. This study will also help the government policy makers to pursue reforms that will influence growth of the banking sector and in this regard economic growth is likely to be stimulated.

It will highlight the impact of credit risk management on financial performance of commercial banks in Kenya which the finance/bank managers can use for the early identification of the riskiness of their institutions and also help in formulating their risk management techniques. To other stakeholders in the economy, it will also highlight the key factors that industry players should analyze when assessing the riskiness of their institutions.

1.5 Scope and Delimitations of the Study

This study sought to determine the effects of risk management practices on loan portfolio performance of National Bank, Eldoret Branch and was carried out in Eldoret townin the month of June and August 2017.

1.6 Theoretical Framework

Liquidity Theory of Credit formed the basis of this study. This theory, first suggested by Emery (1984), proposes that credit rationed firms use more trade credit than those with normal access to financial institutions. The central point of this idea is that when a firm is financially constrained the offer of trade credit can make up for the reduction of the credit offer from financial institutions. In accordance with this view, those firms presenting good liquidity or better access to capital markets can finance those that are credit rationed. Several approaches have tried to obtain empirical evidence in order to support this assumption. For example, Nielsen (2002), using small firms as a proxy for credit rationed firms, finds that when there is a monetary contraction, small firms react by increasing the amount of trade credit accepted. As financially unconstrained firms are less likely to demand trade credit and more prone to offer it, a negative relation between a buyer’s access to other sources of financing and trade credit use is expected. Petersen and Rajan (1997) obtained evidence supporting this negative relation.

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