EFFECT OF LOAN PORTFOLIO MANAGEMENT ON THE PROFITABILITY OF DEPOSIT TAKING MICROFINANCE INSTITUTIONS IN NAIROBI COUNTY, KENYA

ABSTRACT 
Loan portfolios are the major assets of the lending institutions, therefore they should be managed well to yield the desired profitability. Loan portfolio management is one of the most important activities in financial institutions and cannot be overlooked. Sound loan portfolio management is a prerequisite for microfinance institutions’ stability and continuing profitability. As with any financial institution, the biggest risk in microfinance is lending money and not getting it back. The study sought to assess the effect of loan portfolio management on the profitability of Deposit Taking Microfinance Institutions in Nairobi, Kenya. Many studies have been done on loan portfolio management and the performance of microfinance institutions but none of them focused on the aforementioned study, instead they recommended more studies to be done on the microfinance institutions’ profitability. The main objective of this study was to assess the effect of loan portfolio management on the profitability of Deposit Taking MFIs. The independent variables examined in order to determine MFIs’ profitability are loan portfolio planning, client screening and loan portfolio monitoring. The study used a descriptive survey design. The population of the study was made up of all the Deposit Taking Microfinance Institutions operating in Nairobi County. A census was used to carry out the study. The study used primary data which was collected using questionnaires. The data collected was then tabulated and analysed using the Statistical Package for the Social Sciences. Multi regression was used to determine the effect of the independent variables on dependent variable. The results were presented in tables and graphs. The study found out that loan portfolio planning, client screening and loan portfolio control had significant influence on the profitability of Deposit Taking Microfinance Institutions. Planning is a significant factor, predicting up to 69.2% of the profitability, Client screening predicted up to 25% decrease in profitability, however, it is effectively carried out in most of the Deposit Taking Microfinance Institutions. The findings also showed that loan portfolio control was established as significant predictor of up to 51% of the profitability. The study concluded that loan portfolio management has a significant effect on the profitability of the Deposit Taking Microfinance Institutions in Nairobi County at 55.2%. The study recommended that Deposit Taking Microfinance Institutions should improve their loan portfolio control and client screening as this will help them reduce their portfolio risk, hence increase profitability.

CHAPTER ONE 
INTRODUCTION 
Background of the Study 
Loan portfolio constitutes loans that have been made or bought and are being held for repayment. Loan portfolios are the major assets of the lending institutions. 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. Lending is the principal business activity for most commercial banks. The loan portfolio is typically the largest asset and the predominant source of revenue. As such, it is one of the greatest sources of risk to a bank’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 bank losses and failures. Effective management of the loan portfolio is fundamental to a microfinance institution safety and soundness (Janson, 2002) 

According to Koch and Wall (2000), loan portfolio management (LPM) is the process by which risks that are inherent in the credit process are managed and controlled. Because review of the LPM process is so important, it is a primary supervisory activity. Effective loan portfolio management begins with oversight of the risk in individual loans. Prudent risk selection is vital to maintaining favourable loan quality. Therefore, the historical emphasis on controlling the quality of individual loan approvals and managing the performance of loans continues to be essential. But, better technology and information systems have opened the door to better management methods. A portfolio manager can now obtain early indications of increasing risk by taking a more comprehensive view of the loan portfolio. Assessing LPM involves evaluating the steps the management takes to identify and control risk throughout the credit process. The assessment focuses on what management does to identify issues before they become problems. The identification and management of risk among groups of loans may be at least as important as the risk inherent in individual loans. 

According to Robinson (2003), a microfinance institution (MFI) is a firm that provides financial services to low-income households in developing countries around the world. In the minds of many, microfinance and micro-credit are synonymous. Microfinance refers to all types of financial intermediation services provided to low-income households and enterprises in both urban and rural areas, including employees in the public and private sectors and the self-employed. According to Ejigu (2009), only a small fraction of the world population has access to financial instruments, essentially because commercial banks consider the poor people as un-bankable due to their lack of collateral and information asymmetries. 

Kenyan microfinance institutions have for a long time served the unbanked segments of the population despite several obstacles in their quest to access this niche. It is estimated that micro- enterprises contribute about 18 per cent of Kenya’s gross domestic product and 25 per cent of non-agricultural GDP (Mwanza, 2010). As an industry, microfinance is a relatively new phenomenon in Kenya, with a few agencies starting over 20 years ago but the sector has been gaining the status of an industry only in the last 10 years. The Government of Kenya (GoK) has indirectly provided a boost to the microfinance sector. During 1992 to 1994, the GoK implemented a Structural Adjustment Program which has resulted in the liberalization of the economy. The Government of Kenya identified areas and projects needing external donor support, including small scale and microenterprise. Kenya Rural Enterprise Programme (K- REP, now the Sidian bank) can be considered the pioneer of NGO microfinance in Kenya. The experimental and financing activities of K-REP have had far reaching consequences, influencing the outreach of other NGO-MFIs (Ong’ayo, Otto and Musinga, 2002). 

Microfinance institutions in Kenya are regulated under The Microfinance Act, 2006 and the microfinance regulations issued set out the legal, regulatory and supervisory framework. The Microfinance Act became operational with effect from 2nd May 2008. The principal objective of the Microfinance Act is to regulate the establishment, business and operations of microfinance institutions in Kenya through licensing and supervision. The Act enables Deposit Taking Microfinance Institutions licensed by the Central Bank of Kenya to mobilize savings from the general public, thus promoting competition, efficiency and access. It is therefore, expected that the microfinance industry will play a pivotal role in deepening financial markets and enhancing access to financial services and products by majority of the Kenyans (Central Bank of Kenya, 2013). Before the enactment of this bill, the over 200 MFIs operating in Kenya were unregulated unless they optionally entered the Association for Microfinance Institutions (AMFI), based in Nairobi and funded by a USAID grant. According to Mutua (2007) under the new bill, MFIs operating in Kenya are vulnerable to the fines imposed by the CBK that can reach up to Ksh 1 million (equivalent to USD 14,376) for every guideline to which they do not comply. The new regulations were to protect the 60 percent of the Kenyan population who are out of the scope of the formal banking services from bogus MFIs. 

Loan portfolio management involves loan portfolio planning, client screening and portfolio control. In Deposit Taking Microfinance institutions (DTMs), loan portfolio planning deals with coming up with policies by which loans are segmented, priced, and their sizes and associated risks determined. This is carried out in such a way that loans are profitably extended to group- guaranteed, low-income individuals to help them realize their anticipated business or development goals. Client screening focuses on analysing and appraising the creditworthiness of applicants for loans in terms of their ability to service and repay the loans applied for. Loan portfolio control deals with loan disbursement, enforcing loan servicing, monitoring, repayment, and follow up actions (Aleema and Kasekende, 2001). Loan portfolio planning, client screening and portfolio control are all conducted with the sole objective of achieving desired loan portfolio profitability, which, itself is reflected in loan interest payment and loan repayment. Thus, when DTMs’ profitability is not realized, questioning loan portfolio management becomes inevitable (Martin, 1996). In this study, the independent variables are portfolio planning, client screening and portfolio control and the dependent variable is profitability. 

Profitability has been defined as the measure of whether the company is performing satisfactorily (Frank, 1996). Also, according to Pandey (1996) profitability is the measure of overall performance effectiveness of the firm. It is used to measure the performance of management, identifying whether a company may be worthwhile investment and determine the institutions performance relatives to its competitors. On the other hand, the indicators of profitability in the banking service include the profits earned by the bank, the growth and expansion prospects of the bank, the cost of operation that are incurred and the demand of loans. An institution should earn profits to survive and grow over a long period of time. Profits are essential nuts, it would be wrong to assume that every action initiated by management of the company should be maximizing profits irrespective of social consequences. It is a fact that sufficient profits must be earned to sustain the operations of the business to be able to obtain funds from investors for expansion and growth. According to Van Horne (2002) in general terms, profit is defined as the difference between revenue and expenses over a period of time. In economic sense, profits would mean net increase in the wealth; cash flows plus change in the value of the firm’s assets. This definition incorporates the time dimension and therefore implies the discounted value (present value) or the stream of benefits. The accounting definition of profits is based on actual principle and includes non-cash items. It is assumed that items of revenue and expenses are on cash basis still there would be difference between accounting profit and cash profit; the accountant charges depreciation which is a non cash item to computing accounting profits. Profit is the end result of operation of an organization. Profit maximization is taken by the traditional economic as the objective of a firm.

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