THE IMPACT OF CREDIT POLICY ON LOAN PORTFOLIO PERFORMANCE IN MICROFINANCE INSTITUTIONS. A CASE STUDY OF OPPORTUNITY BANK KAMWOKYA BRANCH, KAMPALA

ABSTRACT

The study was conducted in opportunity bank in Kamwokya on Kira road just 3 kilometers from the city center Kampala with the purpose of examining the impact of credit policy on loan portfolio performance of opportunity bank. The research objectives included; to evaluate the effects of credit standards on loan recovery in opportunity bank, to examine the effects of credit variables on loan repayment in opportunity bank and to determine the effects of credit rationing on the loan recovery in opportunity bank.

The study employed a cross chapteral research design where both quantitative and qualitative approaches of data collection were employed to collect data from 50 respondents. The participants were selected using two sampling techniques; purposive and simple random sampling. The data was collected using questionnaire and interview guide which was then analyzed descriptively.

Most of the MFIs lack the efficient risk management mechanism that will help eradicate or sieve out serial defaulters. To effectively lock out these serial defaulters, MFIs requires referencing solution that will enable them submit and share data whilst processing their customers’ credit application.

The study revealed that all the institution that participated in the study have a loan risk management policy that is in operation. The stakeholders who are involved in credit policy formulation to a great extent are the members of these organizations and the regulator while the employees and the directors are involved in the credit formulation process only to a moderate extent. The study confirmed that the existing credit policy of the organization forms the basis for developing a new credit policy that is used by the organization. The institution has set up well funded risk management functions, with enhanced risk awareness among lenders, risk strategies are followed in disbursement of credit, the institution conducts thorough risk assessment on the potentials clients and it has also set up fund to cater for the risks that the institution may incur in its transactions. The other factors that directly/indirectly affect loan performance include adequacy of staff members, staff monitoring roles, credit skill knowledge, credit approval procedure, loans software in place, access to clients’ information, monitoring of accounts, interest rates, competition, character, capacity and collateral of the borrower,

CHAPTER ONE

INTRODUCTION

1.0 Introduction

This chapter covers the background of the study, statement of the problem, purpose of the study, objectives of the study, research questions, scope of the study and the significance/ justification of the study.

1.1 Background of the Study

The background of the study included historical, conceptual and contextual background to the study as explained below;

1.1.1 Historical Background to the Study

Micro finance institutions belong to a wider group of financial institutions regarded as semi formal financial institutions. These are institutions which are registered as non-government organizations performing financial functions of lending and taking deposits (Microfinance Act 2012).

A credit policy is the blue print used by a business in making its decision to extend credit to a customer. Thus, the main goal of a credit policy is to avoid extending credit to customers who are unable to pay their accounts. Credit policy for some larger businesses can be quite formal; involving specific documented guide lines, credit checks and customer credit applications, the policy for small businesses tends to be quite informal and lacks the items found in the formal credit policy of larger businesses. Many small business owners rely on their business instincts as their credit policy (Blair, 2011). Credit policy has direct effects on the cash How of any business. Hence, a credit policy that is too strict will turn away potential customers, reduce sales and finally lead to a decrease in the amount of cash inflows to the business. On the other hand, a credit policy that is too liberal will attract slow paying (even non-paying) customers .increase in the business average collection period for accounts receivables .and eventually lead to cash inflow problems in opportunity bank. A good credit policy should help management to attract and retain customers, without having negative impact on cash flow.

The importance of a credit policy is to maximize the value of a firm. (Puxty and Dodds, 2011). An optimum credit policy is achieved through proper adjustment of credit standards. Credit terms and collection efforts. These are the controllable decision variable that should be considered in accounts receivable. Credit policy is a guide to successful credit administration and benefits must be weighed against the cost to ensure the benefits are worth the effort of administering the credit. Benefits like increase in market share, retention of existing customers, acquisition of new ones, must be weighed against cost s like selling and production costs, administration costs incurred during assessment, supervision and collection of credit and bad debts losses (Pandey. 2010)

1.1.2 Conceptual Background to the Study

A credit policy is an institutional method for analyzing credit requests and its decision criteria for accepting or rejecting applications (Girnf 2010).A credit policy is important in the management of accounts receivables. A firm has time flexibility of shaping credit policy within the confines of its practices. It is therefore a means of reducing high default risk implying that the firm should be discretionary in granting loans (Pandey. 2010).

Policies save time by ensuring that the same issue is not discussed over and over again each time a decision is to be made. This ensures that decisions are consistent and fair and that people in the same circumstance get treated in the same manner (Khandkar and Khan, 2010). According to McNaughton (2010), credit policy provides a frame work for the entire management practices.

Most financial institutions have written credit policies which are the cornerstone of sound credit management, they set objectives, standards and parameters to guide micro finance officers who grant loans and manage loan portfolio. The main importance of policies is to ensure operation’s consistency and adherence to uniform sound practices. Policies should always be the same for all and is the general rule designed to guide each decision, simplifying and listening to each decision making process. A good credit policy involves effective initiation analysis, credit monitoring and evaluation.

Credit policies are set of objectives, standards and parameters to guide bank officers who grant loans and manage the loan portfolio. Thus, they are procedures, guidelines and rules designed to minimize costs associated with credit while maximizing the benefit from it (Ahimbishwe. 2011). The main objective of credit policy is to have an optimal investment in debtors that minimizes costs while maximizing benefits hence ensuring profitability and sustainability of microfinance institutions as commercial institutions. The credit policy of an organization may be stringent or lenient depending on the manager’s regulation of variables. There are three main variables namely credit terms .credit standards and credit procedures (Hulmes.l992).Managers use these variables to evaluate clients credit worthiness .repayment period and interest on loan collection methods and procedures to take in case of loan default. A stringent credit policy gives credit to customers on a highly selective basis. Only customers who have proven creditworthiness and strong financial base are given loans, the main target of a stringent credit policy is to minimize the cost of collection, bad debts and unnecessary legal costs (Pandey. 2011).

1.1.3 Contextual Background to the Study

A credit policy is the blue print used by a business in making its decision to extend credit to a customer. Thus, the main goal of a credit policy is to avoid extending credit to customers who are unable to pay their accounts. Credit policy for some larger businesses can be quite formal: involving specific documented guide lines, credit checks and customer credit applications, the policy for small businesses tends to be quite informal and lacks the items found in the formal credit policy of larger businesses. Many small business owners rely on their business instincts as their credit policy (Blair. 2011).

Credit policy has direct effects on the cash flow of any business. Hence, a credit policy that is too strict will turn away potential customers, reduce sales and finally lead to a decrease in the amount of cash inflows to the business. On the other hand, accredit policy that is too liberal will attract slow paying (even non-paying)customers .increase in the business average collection period for accounts receivables and eventually lead to cash inflow problems in Uganda Finance Trust. A good credit policy should help management to attract and retain customers, without having negative impact on cash flow.

On the other hand, loan portfolio refers to the total amount of money given out in different loan products, to the different types of borrowers, this may be comprised of; salary loans .group guaranteed loans .individual loans and corporate loans (Puxty et al, 2011). It looks at the number of clients with loans and the total amount in loans (Wester.2012). Survival of most financial institutions depends entirely on any successful lending program that revolves on funds and loan repayments made to them by the clients (Oregon, 1986). This therefore requires a restrictive credit control system to be put in place so as to restrain from unnecessary lending thus, improving on profitability of micro finance institutions. (K.akuru.2010). Credit management is the executive responsibility of determining customer’s credit ratings as part of the credit control function (Terry, 2010).

Increased demand for high working capital and cash for expansion has made most institutions and enterprises having to resort to borrowing of fund from financial institutions like banks, microfinance institutions and other lending agencies like insurance companies and mortgages.

Opportunity bank is one of the active institutions in loan extension to the entire community. On the contrary loan portfolio in opportunity bank has greatly affected the entire performance of the organization through increased arrears rates, high costs in loan recovery, constant bad debts written off, and high costs of administering loans that result from small scale and week) loan repayment.

However, the quality of the trade accounts accepted the length of the credit period, the cash discount for an easy payment and the collection procedures have not been effective in loan recovery. This in turn becomes costly to the institution on lop of affecting the volume of sales .Such decreases in the percentage of a loan recovery could be attributed to inappropriate credit policies that are not effective .therefore this instigates that there appears to be a problem in paying back the loans got from the microfinance institutions by their clients and this can be partly attributed to credit policy employed.

1.2 Statement of the problem

Opportunity bank was established to improve the living standards of the local population moreover, initially it was a non-profit making organization, and however it has been diverted to a micro deposit taking institution (MDI), which is a profit maximizing institution. However Opportunity bank just like any other financial institution, has credit policies as a way of administering loans. The policies have objectives of maximizing profits to the benefit of the shareholders as well. Since 2010, the institution has laced hardships in loan recovery, portfolio at risk despite all the efforts of attaching assets to secure loans, building up equality loan portfolios and keeping the rate of deficit under control. The branch manager cited that problem is as a result of inadequate application of the tools of credit policy management (refer to the New vision Monday 23rd July 2012) locking it into a large and increasing proportion of nonperforming loans. According to Mugisa (2010) bad quality assets (loans) not only erode the institution’s ability to recycle its financial resources but also threaten their survival and deprive the economy of a continuous flow of capital. It’s was against this background that the researcher has felt concerned and decided to go ahead and carry out the study to examine what impact credit policy would have on loan portfolio performance using opportunity bank Kamwokya branch, as the a case study.

1.3 Purpose of the Study

The main purpose of the study was to examine the impact of credit policy on loan portfolio performance of opportunity bank.

1.4 Objectives of the Study

The objectives of the study were;

1. To evaluate the effects of credit standards on loan recovery in opportunity bank.
2. To examine the effects of credit variables on loan repayment in opportunity bank
3. To determine the effects of credit rationing on the loan recovery in opportunity bank

1.5 Research Questions

The study was guided by the following research questions:

1. What are the effects of credit standards on loan recovery in opportunity bank?
2. What are the effects of credit variables on loan repayment in opportunity bank?
3. What are the effects of credit rationing on the loan recovery in opportunity bank?

1.6 Scope of the Study

1.6.1 Content Scope

The study focused on the impact of credit policy on loan portfolio performance of opportunity bank. Specifically, the study evaluated the effects of credit standards on loan recovery, the effects of credit variables on loan repayment and the effects of credit rationing on the loan recovery.

1.6.2 Geographical scope

The study was conducted in opportunity bank in Kamwokya on Kira road just 3 kilometers from the city center Kampala.

1.6.3 Time scope

The study focused on material facts about credit policy and loan portfolio performance in microfinance institutions which covered a period of 5 years , that is from 201 1-2016 but Period of body of knowledge was longitudinal in nature from 2011-2016. Therefore, this research was conducted from January 2017 to May 2017.

1.7 Significance / justification of the study

The study would help identify weaknesses in credit management policies of opportunity bank. This would help management to find means of strengthening their operations and other necessary remedial actions.

The study would help to enhance the researcher’s knowledge and understanding of the study variables

The study would add to the body of existing literature and provide a basis for future studies and references for future researchers.

1.8 Conceptual Framework

The impact of credit policy on loan portfolio performance in microfinance institutions

Independent variable                                                Dependent variable

Intervening variable

Source: Self developed from Literature of, Kareta (2009),

The conceptual framework shows (two independent variables credit policy and loan portfolio performance. Outreach is a moderating variable whereas customer retention is a dependent variable. Zeller & Lapen notes that microfinance lending is associated with default risk which compels management to formulate and implement credit policies which are used by managers to influence credit accessibility inform of outreach. Once credit is accessed by customers, manager play a big role with staff in retaining customers which is achieved on the assumption that managers are competent enough to make financial decisions which facilitates the achievement of corporate.