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

CHAPTER ONE

1.0 Introduction

This chapter covers the background of the study, statement of the problem, purpose of the stud), 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 will include 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 \\a\ 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 is 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 will be 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 will be;

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 will be 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 will focus on credit policies in opportunity bank, how well the portfolio is performing and the relationship between credit policy and loan portfolio performance.

1.6.2 Geographical scope

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

1.6.3 Time scope

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

1.7 Significance / justification of the study

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

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

The study will 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.

CHAPTER TWO

LITERATURE REVIEW

2.0 Introduction

This chapter summarizes the information from the available literature in the same field of study. It will review theories of credit management as well as empirical studies on credit management and financial performance in Kenya and in other countries.

2.1 Theoretical literature review

It is significant to note that changes have been taking place in the credit industry and this is backed up by the recent scenario where most lending institutions have developed sustainable credit appraisal standards that help them when it comes to credit appraisal and risk management (CBK 2011 annual report). Theories have been developed by different scholars that have positively affected rather have a relation to the lending activities and organization of this lending corporations. Discussed below are theories or models related to governance, operation and management of the lending institutions.

2.1.1 Contingency Theory

Contingency theory was developed by Fred Fiedler, 1967, but several contingency approaches were also developed concurrently in the late 1960s. Contingency theory is a class of behavioral theory that claims that there is no best way to organize a corporation, to lead a company, or to make decisions. Instead, the optimal course of action is contingent upon the internal and external situation of the corporation. As far as appraisal systems are concerned, different borrowers come with different scenarios on their ratings. The lending institutions have to scrutinize every individual and view what should be done, who is to be advanced credit with and how much is appropriate at a particular time. The lending institutions too also looks at its position as far as how much they are allowed to give out as credit to strike a balance between their loan portfolio and current deposits. There sometimes is no best mechanism of appraising but looking at the situations currently prevailing.

2.2 The effects of Credit Standards on loan recovery

Credit standards according to Mehta (2010), in advancing loans, credit standard must be emphasized such that the credit supplier gains an acceptable level of confidence to attain the maximum amount of credit at the lowest as possible cost. Credit standards can be tight or loose (Van Home. 2010). Tight credit standards make a firm lose a big number of customers and when credit are loose the firm gets an increased number of clients but at a risk of loss through bad debts. A loose credit policy may not necessarily mean an increase in profitability because the increased number of customers may lead to increased costs in terms of loan administration and bad debts recovery.

In agreement with other scholars Van Home (2010), advocated for an optimum credit policy, which would help to cut through weaknesses of both tight and loose credit standards so, the firm can make profits. This is a criteria used to decide the type of client to whom loans should be extended. Kakuru (2010) noted that it’s important that credit standards be basing on the individual credit application by considering character assessment, capacity condition collateral and security capital.

Character it refers to the willingness of a customer to settle his obligations (Kakuru, 2010) it mainly involves assessment of the moral factors. Social collateral group members can guarantee the loan members known the character of each client; if they doubt the character then the client is likely to default. Saving habit involves analyzing how consistent the client is in realizing own funds, saving promotes loan sustainability of the enterprise once the loan is paid. Other source should be identified so as to enable him serve the loan in time. This helps micro finance institutions not to only limit loans to short term projects such qualities have an impact on the repayment commitment of the borrowers it should be noted that there should be a firm evidence of this information that point to the borrowers character (Katende, 2010).

According to Campsey and Brigham (2010) the evaluation of an individual should involve: gathering of relevant information on the applicant, analyzing the information to determine credit worthiness and making the decision to extend credit and to what tune. They suggested the use of the 5Cs of lending. The 5Cs of lending are Capacity, Character, Collateral, Condition and Capital. Capacity refers to the customer’s ability to fulfill his/her financial obligations. Capacity, this is subjective judgment of a customer’s ability to pay. It may be assessed using a customer’s ability to pay. It may be assessed using the customer’s past records, which may be supplemented by physical or observation.

Collateral is the property, fixed assets, chattels, pledged as security by clients. Collateral security, This is what customers offer as saving so that failure to honor his obligation the creditor can sell it to recover the loan. It is also a form of security which the client offers as form of guarantee to acquire loans and surrender in case of failure to pay; if borrowers do not fulfill their obligations the creditor may seize their asset (Girma, 201 0).

According to Chan and Thakor (2010), security should be safe and easily marketable securities apart from land building keep on losing value as to globalization where new technology keeps on developing therefore lender should put more emphasis on it. Capital portends the financial strength, more so in respect of net worth and working capital, evaluation of capital may be by way of analyzing the balance sheet using the financial ratios. Condition relates to the general economic climate and its influence on the client’s ability to pay. Condition, this is the impact of the present economic trends on the business conditions which affects the firm’s ability to recover its money. It includes the assessment of prevailing economic and other factors which may affect the client ability to pay (Kakuru, 2010).

Good credit management provide the institution with a reasonable and adequate return on loans and capital employed primarily through improvement in operations efficiency this generates adequate internal resources to finance the institution’s growth (Pandey, 2010). The institution may have tight credit standards that it may extend loan to the most reliance and financially strong customers such standards will result in no bad debt losses and less cost of credit administration (Pandey. 2010).

Pandey (2010) stressed that credit standards are criteria for selecting customers for credit; the fund may have higher credit standards that is extending loans to selected customers with good reputation or record. On the other hand customers have to be evaluated to see if they meet the standards set by the management before loans are extended to them. However, (Van Home. 2010) states that when an institution extends loan to only strongest customers, it will never have bad losses and will incur fewer administration expenses.

2.3 Credit variables on loan repayment

A Credit term is a contractual stipulation under which a firm grants credit to customers (Wamasembe, 2011); furthermore these terms give the credit period and the credit limit. The firm should make terms more attractive to act as an incentive to clients without incurring unnecessary high levels of bad debts and increasing organizations risk. Credit terms normally stipulate the credit period, interest rate, method of calculating interest and frequency of loan installments.

Kakuru (2010) explains the significance of discounts in credit terms. Discounts are offered to induce clients to pay up within the stipulated period or before the end of the credit period .This discount is normally expressed as a percentage of the loan. Discounts are meant to accelerate timely collection to cut back on the amount of doubtful debts and associated costs.

Ringtho (2010) observes that credit terms are normally looked at as the credit period terms of discount and the amount of credit and choice of instrument used to evidence credit. Credit terms may include; Length of time to approve loans, this is the time taken from applicants to the loan disbursement or receipt. It is evaluated by the position of the client as indicated by the ratio analysis, trends in cash flow and looking at capital position. Maturity of a loan, this is the time period it takes loan to mature with the interest there on. Cost of loan. This is interest charged on loans, different micro finance institutions charge differently basing on what their competitors are charging. The chartered institute of bankers and lending text (2012) advises lending institutions to consider amount given to borrowers. Robinson MS (2010) pointed out that the maximum loan amount per cycle are determined basing on the purpose of the loan and the ability of the client to repay (including guarantee).

SECTION THREE

RESEARCH METHODOLOGY

3.1 Introduction

This section discusses the research design, data type and sources, sample size and selection, data collection tools/methods, data presentation and analysis, data collection procedure and limitation of the study.

3.2 Research Design

A descriptive in nature research design will be used because it is flexible in both quantitative and qualitative data collection. Descriptive research design will also be used because it is effective to analyse non-quantified topics and issues, the possibility to observe the phenomenon in a completely natural and unchanged natural environment and the opportunity to integrate the qualitative and quantitative methods of data collection which other designs do not provide.

3.3 Data type and sources

Data will be collected from both primary and secondary source.

Primary data will be collected by use of questionnaires and interview guide. Secondary data will be collected from published journals, reports, text books, and company records.

3.3 Sample Size and Sampling Procedure 3.3.1 Sample Size

The researcher will use a sample size of 40 respondents and these will be categorized in the following manner, 1 from the senior management level. 3 from the human resource department.4 customer care attendants. 6 banking officers, 14 credit officers and 5 research and development officers. This number will be determined using the following derived from the following formula according to Kish (1965). The results are tabulated below;

Table 3:1 showing the Sample Size of respondents

Source: Primary Data

3.3.2 Sampling Procedure

The researcher will use a purposive sampling technique where managers, credit officers who have long experience in credit policy and loan portfolio performance in microfinance institutions in order to get reliable and consistent information in a broad perspective and group using a simple random technique.

3.4 Data Collection Tools and Methods

This section reveals the nature of data collection tools and methods as explained below:

3.4.1 Questionnaire

These are a pile of pre-set questions with allocations of simple and precise responses from the respondent. This method will be used due to its wider coverage, convenience on both the researcher and the respondents, and also given its undoubtable mode of time saving and in

addition it permits the comparison and generalization of findings in a cross section of the study area. Questionnaires will be chosen because of their ability to reduce any bias and the collection of authentic data important for data analysis. The researcher will use both closed ended and open-ended questionnaires aimed at examining the impact of credit policy on loan portfolio performance in microfinance institutions using opportunity bank Kamwokya branch. Kampala. However one of the limitations to this study will be that since the study is self-administered, the researcher will note inconsistencies in answering and returning the questionnaires. The researcher will further note (during the editing process) that most respondents expressed high levels of bias according to their departments.

3.4.2 Interview Guide

Face to face in depth interviews will be conducted to collect data from opportunity bank officials and other respondents. Structured questions and open ended statements will be used by the researcher in trying to interview senior managers, employees from the loans department, employees from accounts section, Credit department under opportunity bank Kampala.

3.5 Data Collection Procedure

A letter of introduction will be obtained from the research coordinator, Economics and Statistics, Kyambogo University seeking permission to conduct the study. It will be presented to the officials of opportunity ban seeking permission to carrying out the stud}’ in the division. After being granted the permission, the researcher will proceed to make appointments with the selected respondents. Thereafter, the researcher will administer questionnaires and the required data will be collected. The researcher personally will administer questionnaires to the respondents in order to avoid delay, to avoid collecting wrong data, ensure completeness and accuracy and confidentiality of the data collected will be strictly adhered to.

3.6 Data Processing and Analysis

Completed questionnaire will be edited for completeness and consistency. The questionnaire will be coded to allow for statistical analysis. According to Mugenda (2010).data must be cleaned, coded and properly analyzed in order to obtain a meaningful report. The Statistical Package for Social Science (SPSS) version 12 will be used to analyze and interpret the collected data where appropriate. The percentage frequencies will be posted to excel worksheets to generate graphical summaries that will also be used to indicate the direction of respondents, fables and charts will be used to summarize responses for further analysis and facilitate comparison.

3.7 Anticipated limitation of the study

Cost. The researcher will experience a problem of limited finances during the study which will include transport, printing and photocopying of relevant materials. However, the researcher will borrow some money from relatives, friends and use it sparingly so as to overcome the cost constraint.

Time. The researcher will experience time constraint in data collection, analyzing of data and in final presentation of the report. However, the researcher will overcome this problem by putting the time element into consideration while fulfilling all appointments with respondents and fully meeting them.

Non and late responses. The researcher also will experience a problem of late responses or no responses at all from some respondents who will be given the questionnaires to fill. However, the researcher will assure the respondents that any information given will be treated with maximum confidentiality.

CHAPTER FOUR

PRESENTATION, ANALYSIS AND INTERPRETATION OF FINDINGS

4.0 Introduction

This chapter consists of the presentation, discussion and analysis of the findings from the study. It provides results which were analyzed from raw data collected in the field. It is in two categories; the first one represents the demographic characteristics of the respondents while the other category represents the responses of the questions that were asked concerning research objectives. The analysis was done and data is represented in form of tables, graphs and pie-charts.

4.1 Overview of the Study

The study was carried out at opportunity bank. Questionnaires and interview guides were designed to obtain data from a sample size of 40 was selected. The findings of the study were presented in accordance to the study objectives.

4.1.1 Response Rate

A sample of 40 respondents was selected using purposive sampling methods. Questionnaires, and interview guides were administered to them for data collection. Among the 40 respondents, all of them returned the questionnaires, giving a response rate of 100%.

4.2 Demographic Characteristics of the Respondents

The background characteristics compiled show the gender, age, the education level and period of work. This data was analyzed and is presented below;

Figure 4.1: Showing gender of the respondents

Source: Primary Data

From figure 4.1 above, it’s indicated, majority of respondents (53%) were males and the females were only 47% of the total respondents. This implies that men were found to be active in the study under investigation. However, both ideas were relevant for the study. This indicates that the institution employees more males than females in procurement and stores department.

Table 4.1: Age of Respondents                                                                                n=40

Source: Primary Data

Table 4.1 shows that, the majority (40%) of the respondents were predominantly between the ages of 31 and 40 years. A significant percentage (25%) of the respondents was in the age bracket of 41 and 50years. The remaining 20% of the respondents were in the age bracket of 18 and 30years and another 15% of them were in the age group of 50 and above. 31-40years had the highest number because these are the most active age group hence they are actively involved in management in the organizations, therefore they had rich experiences and could also appreciate the importance of the study.

The table above shows that most of the interviewed respondents (55%) were of degree holders, 30% were of Certificate/Diploma and only 15% of the study respondents were of A’ level while none of the respondents had a postgraduate nor of O’ level therefore, provided information based on the academic knowledge, skills and experience they have gain in management. This shows that company employees are qualified and competent to execute their duties and also appreciated the study under investigation.

Findings in figure above, it was revealed that majority (45%) of respondents have worked at organization between 4years and above, followed by 1-3 years  with 30% and less than 1year with (25%). This implies that the majority of the employees are experienced in the activities of the firm and they act as the role models for the newly recruited staff members with regard to study.

4.3 Effect of Credit Standards on Loan Recovery.

To complete the findings for objective one, Respondents were asked some questions. The results were obtained and are presented below;

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QUESTIONNARE FOR MANAGEMENT

Dear respondent,

I am Birungi Sharon, a final year student pursuing a Bachelor’s Degree of Microfinance of Kyambogo University. This questionnaire serves to gather data concerning the “impact of credit policy on loan performance in microfinance institutions. I therefore request to offer a helping hand by either ticking of filling as need be. Data gathered shall be kept with utmost confidentiality for academic purposes and probably the betterment of our education system.

Section A: Background information about the respondent

1. Gender of the respondent

Male                            Female

2. Age bracket of respondent in years

18 –30                         31-40                           41-50                           Over 50

3. Highest level of education attained by respondent

“O” Level                    “A” Level                    Certificate/Diploma                Degree Postgraduate

4. For how long have you been working in this organization?

Less than 1 Year                     1-3 Years                                4 Years and above

SECTION B

EFFECTS OF CREDIT STANDARDS ON LOAN RECOVERY IN OPPORTUNITY BANK, KAMWOKYA – KAMPALA

5. Indicate the extent to which you agree with the following observations on the performance of opportunity bank, Kamwokya branch. Please use the key below to answer the following questions by indicating: (1) for strongly agree, (2) agree, (3) for Not sure. (4) disagree, (5) strongly disagree.

If any other specify

……………………………………………………………………………………………………………………………………………………………………………………………………

SECTION C: EFFECTS OF CREDIT VARIABLES ON LOAN RECOVERY IN OPPORTUNITY BANK KAMWOKYA.

6. In this section, tick the best option by using strongly Agree (SA), agree (A), Not Sure (NS), Disagree (D).

SECTION D: THE EFFECTS OF CREDIT RATIONING ON LOAN RECOVERY IN OPPORTUNITY BANK

7. In this section, tick the best option by using strongly Agree (SA), agree (A), Not Sure (NS), Disagree (D).

THANK YOU FOR YOUR COOPERATION AND PRECIOUS TIME.