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THE INFLUENCE OF CREDIT RISK ON THE FINANCIAL PERFORMANCE OF MICROFINANCE INSTITUTIONS IN UGANDA,

A Case Study of Pride Microfinance Nakawa Branch

CHAPTER ONE

INTRODUCTION

1.0 Introduction

This chapter covered the background of the study, statement of the problem, purpose of the study, objectives of the study, research questions, and scope of the study, significance of the study, conceptual framework and definition of terms.

1.1 Background to the Study

The financial indicators of financial performance are: sales growth, return on investment (ROI), return on sales (ROS), return on equity (ROE), and earnings per share. The popular ratios that measure organizational performance can be summarized as profitability and growth: return on asset (ROA), return on investment (ROI), return on equity (ROE), return on sale (ROS), revenue growth, market shares, stock price, sales growth, liquidity and operational efficiency. Banks that charge lower interest rates have a bigger consumer base compared to those that charge high inters rates leading to an increased financial performance. Interest represents the average interest rate on all new public and publicly guaranteed loans contracted during the year. Competitive interest rates on deposits encourage customers of banks to deposit more (Crane, 2010).

The outcomes are not universal in nature but largely depend on the organizational context hence selection of the measures that represent performance of a particular organization is done based upon the circumstances of the organization being rated. It is important to remember that interest rates are not the only factors affecting a firm’s financial performance rather measuring a group performance is more important than focusing on only one or two measures at the exclusion of others (Parasuram, 2019).

Credit risk 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 guidelines, 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 risk management 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, 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 microfinance bank. A good credit risk management should help management to attract and retain customers, without having negative impact on cash flow.

Credit portfolio performance continues to attract attention of scholars and policy-makers due to the long reputable need for credible Microfinance institutions (MFIs) like PRIDE microfinance. Some empirical evidence has shown that in most developing economies, MFIs have brought millions of citizens into cohesive financial institutions which are succeeding very well in providing financial services to its members for improving their standard of living (Collier, Katchova, & Skees, 2011; Kumar & Golait, 2009; Moti et al., 2012). In continuing with this service, Biekpe and Kiweu (2009) point out that Credit portfolio performance of MFIs is critical. With issues of over-indebtedness emerging among microfinance customers.

Microfinance institutions aim at maximizing the return to portfolio while keeping the risk within acceptable bound (Van der Maas, 2006). This maximization requires a balancing of high repayment rates, low arrear rates, low default rates as well as low portfolio at risk. Unfortunately for Ugandan case, MFIs suffer from poor credit allocation strategies and weak risk management practices according to Association of Microfinance Institutions Uganda (AMFIU report (2014). Credit portfolios are the major asset of MFIs and various studies have been undertaken as regards to, for example, Credit portfolio performance (González-Vega, 2003; Kropp & Katchova, 2011; Qinlan & Izumida, 2013).With respect to PRIDE microfinance, the major problem facing the bank has been identified as failure to manage Credit default (PRIDE microfinance Annual Reports, 2005, 2006, 2007). The management of the bank depends on incentives to repay on time; instant arrears information and delinquency tracking; immediate action to enforce repayment; and rigorous recovery in case of default to achieve Credit repayment (Annual Report, 2005). Out of the 28 operational branches of PRIDE microfinance Bank, micro lending performance indicates that the total portfolio for the headquarter branch is approximately UGX. 14.1 billion of which UGX. 3.7 billion is in individual micro Credit with a total arrears rate of 3.7% for the year 2007. For the years 2006 and 2005, the bank closed with arrear rates of 3.6% and 5.46% respectively. In addition, the bank’s micro lending performance for the last three years reveals that it has continued to record average arrear rates of 4.24% and Non-Performing Assets (NPA) rates of individual micro Credit of 1.4% where the acceptable rate by Bank of Uganda is 1%. The above weaknesses may be responsible for the high default rate. It is upon this background that the study seeks to investigate the influence of credit risk on the performance of microfinance institutions in Uganda.

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1.2 Statement of the Problem

Credit risk management is beneficial to a financial institution as effective Credit risk management helps a financial institution in increasing its liquidity, and also enables it to pay back debts, workers, and increase its capital base among many other benefits of Credit management (Orebiyi, 2002).

However despite of the adoption of credit management policies by PRIDE microfinance banks, the bank is faced with numerous performance challenges including, poor levels of recovery rates of Credit from borrowers, low profitability margins, poor performance as compared to its other similar  financial institutions such as commercial banks, village banks and above all increased complaints by bank top management about the low levels of the institutions performance (PRIDE microfinance Bank Annual Reports, 2005, 2006). This study therefore sought to examine the influence of credit risk on the performance of microfinance institutions in Uganda, with specific reference to PRIDE Microfinance Nakawa Branch.

1.3 Purpose of the Study

The study sought to examine the influence of credit risk on the performance of Microfinance institutions in Uganda, with specific reference to PRIDE Microfinance Nakawa Branch.

1.4 Objectives of the Study

1. To examine the influence of transactional risk on microfinance performance.
2. To determine the effects of portfolio risk on performance of microfinance.

• To establish the relationship between credit risk management and the performance of microfinance institutions.

1.5 Research Questions

1. What are the influence of transactional risk on microfinance performance?
2. What are the effects of portfolio risk on performance of microfinance?

• What is the relationship between credit risk management and the performance of microfinance institution?

1.6 Scope of the Study

1.6.1 Study Scope

The study specifically concentrated on influence of transactional risk on microfinance performance, the effects of portfolio risk on performance of microfinance and the relationship between credit risk management and the performance of microfinance institution.

1.6.2 Geographical Scope

The study was carried out at PRIDE microfinance Nakawa Branch.

1.6.3 Time scope

The period of data to be considered in the organization was from 2012-2019 and period of body of knowledge in reviewing literature was from 2010-2020

1.7 Significance of the Study

The study is expected to provide guidance to the Central Bank (Bank of Uganda) and other regulators in the credit risk management policy formulation.

The study will add to the already existing literature on determinants of micro finance institution performance.

The study is expected to stimulate further research into the area of lending policy formulation and performance of Credit.

The study is expected to enable commercial banks identify the Credit management policies that are critical in the lending business.

The study will help the government in formulation of policies regarding microfinance institutions in the country.

1.8 Operational definition of key terms

Credit

Credit is generally defined as a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at a later date generally with interest.

Risk

Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.

Microfinance

Microfinance refers to an array of financial services, including loans, savings, and insurance, available to poor entrepreneurs and small business owners who have no collateral and wouldn’t otherwise qualify for a standard bank loan.

Microfinance is a broad term to define financial services for people with low incomes or those who do not have access to traditional banking services.

Financial performance

Carton (2018) also defines financial performance of an organization as the measure of the change of the financial state of an organization or the financial outcomes that results from management decisions and the execution of those decisions by members of the organization.