EFFECT OF CREDIT RISK MANAGEMENT ON LOAN PERFORMANCE OF DEPOSIT TAKING MICROFINACE INSTITUTIONS IN NAIROBI COUNTY, KENYA

EFFECT OF CREDIT RISK MANAGEMENT ON LOAN PERFORMANCE OF DEPOSIT TAKING MICROFINACE INSTITUTIONS IN NAIROBI COUNTY, KENYA

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 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 Page | 159 Paper Publications 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 nonperforming 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 direct