EFFECT OF BORROWERS INFORMATION ON CREDIT RISK MANAGEMENT: A CASE OF MICROFINANCE INSTITUTIONS IN NAKURU TOWN

ABSTRACT 
Throughout the developing world, the growing availability of consumer credit and the heightened competition between microfinance institutions have made the necessity of borrower information all the more apparent. However, the extent and efficiency of borrower information vary greatly. Borrowers have often used the underlying challenge of information asymmetry to create multiple bad debts in MFIs in Kenya. The purpose of this study therefore was to establish the effect of borrowers‟ information on credit risk management in MFIs in Nakuru Town, Kenya. The study specifically looked at the effect of information on borrower‟s capacity, borrower‟s capital, borrower‟s collateral, borrower‟s conditions and borrower‟s character on credit risk management. The study employed a descriptive research design and targeted managers and finance related employees in 18 MFIs in Nakuru Town, Kenya who totaled 198. From this population, statistical formula was employed to establish a sample size of 67. The sample was allocated proportionately and later simple random sampling was used to collect data. The study used a closed ended questionnaire which was piloted to ensure validity and reliability. The data collected was then coded and analyzed using SPSS Version 21 and presented in tables. For purposes of testing the hypothesis of the study, a regression analysis was carried out. It was established that the coefficient of correlation (R) for the relationship between the independent variables and the dependent variable was 0.433. The value therefore indicated a strong and positive correlation. The R2 value of 0.188 implies that 18.8% of the variations in credit risk management of MFIs in Nakuru Town can be explained by the variations in independent variables in the study, that is, information on the 5Cs of applicants had an effect on credit risk management.

CHAPTER ONE 
INTRODUCTION 
Background of the Study 
Credit risk management in an organization encompasses a number of processes both within and outside the firm all aimed at creating the best strategies to minimize the adverse effects of credit risk and improve on cash inflows to enhance liquidity. It is basic to start with the constitution of a credit control department formed from a team of finance professionals bestowed with the responsibility of managing a firm‟s credit portfolio. This defines clearly their responsibilities and defines a logical manner in which they are supposed to interact with the other interrelated departments within the organization such as the sales or marketing team as well as treasury or the cash management arm of finance department. This ensures that conflicts are minimized and the overall organization objective is maintained. 

The functional responsibility of credit control department starts with formulation of a sound credit policy which stipulates acceptable credit standards and desired credit terms to be extended to the customers. Credit terms can be described in terms of factors like credit period, collection policy, allowable cash discounts and discounts period all which are incentives in credit management. All these credit parameters in the credit policy must be designed in such a manner that they conform to the overall organizational policy and goal of profit maximization (Fabozzi et al, 2002). 

Before an organization extends any credit to its customers a policy or a list of rules must be established to prevent any potential credit risks. According to Pike and Neale (1999), credit management entails a design process starting all the way from a credit sale to the very end when the payment relating to that sale is fully collected. Many organizations have gotten into pitfalls of credit such as cash flow problems or constrained working capital because they have not established good systems to be able to collect debts in a pace consistent with the way sales are made. This has led to inevitable financing of accounts receivables and at times costly borrowing to be able to meet short term working capital requirements. 

Organizations can avoid cash flow problems if they administer and manage credit with financial prudence by ensuring that all goods and services rendered are promptly paid for (Grover, 2002). Accounts receivables account for a big proportion of assets in businesses averaging 15% to 20% of the total assets of a typical business. To control credit sales it is necessary to specify clear responsibilities for the credit department in its credit management functions. This function should be instilled with specific goals and objectives (Knox, 2004). This corroborates the fact that no matter the size of any business operation the focus should be on managing and collecting accounts receivables efficiently and effectively to maximize essential cash inflows. 

Credit management is a complex process (Armstrong, 2000). It requires sophistication on the part of the lender and credibility in the borrower. However, inefficiencies in some markets – particularly information irregularities from both lender and borrower 

- limit the level to which they contribute to financial inclusion. In the absence of comprehensive information about a borrower, credit decisions are often less than optimal. As a result, the incidence of non-performing loans soars; interest rates increase and collateral requirements become more stringent, as lenders make efforts to mitigate the lack of transparency between them and their borrowers. 

In extension, credit risk management is an important aspect of credit management. Credit risk is most simply defined as the potential that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximize a financial institution's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Financial Institutions need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. They should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any financial organization. Microfinance institutions therefore need to effectively manage their credit risks if they are to meet the financial obligations. 

The Kenyan financial sector was in the 80‟s and 90‟s weighed down with a momentous nonperforming assets portfolio. This habitually led to the collapse of financial institutions. One of the promoters in this situation was serial defaulters, who borrowed from a range of institutions with no purpose of repaying the loans. Certainly, these defaulters thrived in the “information asymmetry” environment that prevailed due to lack of a borrower information mechanism. Information asymmetry refers to a situation where business owners or managers know more about the scenario, for and risk facing, their business than do lenders. Information asymmetry describes the condition in which relevant information is not known to all parties involved in an undertaking (Ekumah and Essel, 2003). 

Lending is a risky enterprise because repayment of loans can seldom be fully guaranteed. According to Brown et al., (2004), implicit contracts between lenders and borrowers, thus, banking relationships can motivate high effort and timely repayments. Fehr & Zehnder, (2005) also confirm that long-term relationships are a powerful disciplinary device. They posit that in credit markets dominated by short- term interactions, borrowers may only be motivated to repay if they know that, due to loan reporting, their current character is observable by other lenders. The work of Fehr & Zehnder, (2005) indicates that the impact of credit reporting on repayment character on credit market performance is highly dependent on the potential for relationship banking. Therefore, when bilateral relationships are not feasible, the credit market essentially collapses in the absence of acceptable borrower character. 

As repayments are not third-party enforceable, many borrowers default and lenders cannot profitably offer credit contracts (Brown, Falk, & Fehr, 2004). The availability of information on past repayment character allows lenders to condition their offers on the borrowers' reputation. As borrowers with a good track record receive better credit offers, all borrowers have a strong incentive to sustain their reputation by repaying their debt (Orebiyi, 2002). Therefore, by repeatedly interacting with the same borrower, lenders establish long-term relationships that enable them to condition their credit terms on the past repayments of their borrower. As only a good reputation leads to attractive credit offers from the incumbent lender, borrowers have strong incentives to repay. 

Concept of 5Cs of Credit 
There are various methods of assessing credit worthiness of borrowers including the 5C‟s, 5P‟s, financial analysis and previous experience methods among others. The 5C's, according to Peavler (2013), is an approach of assessing credit worthiness which is defined as follows: Capacity refers to borrower's ability to meet the loan payments of interest and principal. Capital is the money invested in the business and is an indicator of how much is at risk should the business fail. Collateral is a form of security for the lender. Banks usually require collateral as a type of insurance in case the borrower cannot repay the loan. Conditions refer to the economic and political conditions of the country. Character is the obligation that a borrower feels to repay the loan. Since there is not an accurate way to judge character, the lender will decide subjectively whether or not the borrower is sufficiently trustworthy to repay the loan. Abrahams et al, (2008) argue that comprehensive credit assessment framework offers a comprehensive rating system that enables lenders to classify credit risk using the Five Cs of credit. 

Concept of Microfinance 
The concept of microfinance arose out of the need to provide to the low-income earners who were left out by formal financial institutions. The practice of microfinance dates back to as early as 1700 and can be traced to Irish Loan Fund System which provided small loans to rural poor with no collateral. Over the years, the concept of microfinance spread to Latin America, then to Asia and later to Africa. Microfinance has its roots in the 1970s when organizations, such as Grameen Bank of Bangladesh were starting and shaping the modern industry of microfinance (Mwangi, 2011). In Kenya, microfinance movement gained momentum in the late 1980s as a result of exclusion of large proportion of the population from the formal financial institution mainly banks. Microfinance emerged with the aim of filling the gap left by banks in providing credit to individuals, micro, small and medium enterprises which were on the rise during this period (Ogindo, 2006). Among the pioneer microfinance institutions (MFIs) in Kenya are Equity Building Society (currently Equity Bank), Family Building Society (currently Family Bank), Faulu Kenya and KRep (Mwangi, 2011).

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Item Type: Kenyan Postgraduate Material  |  Attribute: 81 pages  |  Chapters: 1-5
Format: MS Word  |  Price: KSh900  |  Delivery: Within 30Mins.
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