Credit Risk Management and the Effects on the Profitability of Micro-Financial Institutions: Case of CCC Plc
Department: Banking and Finance
No of Pages: 50
Project Code: BFN10
References: Yes
Cost: 5,000XAF Cameroonian
: $15 for International students
CHAPTER ONE
INTRODUCTION
This
initial chapter introduces the entire research paper. It presents a background
to the study, statement of the problem, research questions, objectives, and
hypotheses, relevance of the study and the scope.
1.1
Background of the Study
The
power of financial institutions especially micro finance to create money is of
great importance in business operations. Micro finance is the major financial
intermediaries in any economy and they are the major providers of credits to
the household and corporate sector and operate the payment mechanism.
They
deal with both retail and corporate customers, have well diversified deposit
and lending book and generally offer a full range of financial services. The
policy of micro finance to make money results in the elastic credit system that
is necessary for economic progress at relatively steady rate of growth.
Particularly,
micro finance make profits by selling liabilities with one set of
characteristics (a particular combination of liquidity risk and return) and
using the proceeds to buy assets with different set of characteristics i.e.
asset transformation.
A
modern financial management defines the business of financial system as the
measuring, managing and accepting of the risks. Under the definitions, the most
important and uncertainty banks and financial institution must measure, monitor
and manage its credit risk.
This
hazard which is called the default risk is the danger that the counter party
will default or not perform. With increased pressure on financial institution
to improve shareholders return, banks have had to assume higher risk and at the
same time, manage these risks to avoid losses.
Recent
changes in the banking environment (globalization, deregulation,
conglomeration, etc.) have posed serious risk challenges for banks and have
offered productive opportunities (Saunders and Marcia, 2007).
Generally,
the aim of risk management is not simply to reduce or even to eliminate risk it
is also viewed as the process of recognition, measurement and control of risk
that an investor faces. Indeed this may
not be possible given various difficulties of measuring risk and the
limitations of the instruments for controlling risks.
Risk
management must be of continuous process the composition of investor’s
portfolio and the risk of the assets therein, as well as the objectives and
constraints of the investor change overtime. However the need for risk
management has increased sharply in the past three decades.
The
risk management has the purpose and the scope of Risk management to ensure that
the risk-taking part of investing is being carried out in a controlled and
understood manner. It is a continuous process change of the composition of the
investor‘s portfolio, the risk of the asset in the portfolio and the objectives
and constraints of investors (Haim and Thierry, 2005).
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
micro finance organizations. The fundamental dilemma in managing credit risk is
overcoming the agency or incentive problems between lenders as outsiders and
borrowers as insiders.
Micro
finance institutions that managed to successfully perform its credit risk
management finally have a positive impact on their financial performance what
is a reverse in the opposite case (Haim and Thierry, 2005).
Credit
Risk Management is inherent in micro finance and is unavoidable. The basic
function of micro finance management is risk management. The business of
banking is credit and credit is the primary basis on which a bank’s quality and
performance are adjusted.
Credit
risk is composed of default risk and credit mitigation risk. Default risk is
the risk that the counterparty will default on its obligations to the investor.
In this risk, the credit quality deteriorates (or default risk increases).
Credit
risk is more difficult to measure because data on both default and recovery
rates are not extensive, credit returns are highly skewed and fat tailed and
longer term time horizon and higher confidence levels are used in measuring
credit risks.
These
are problems in measuring credit risk that have inspired the development of
several sophisticated models and commercial software products for measuring
portfolio credit risk (Haim and Thierry, 2005).
Due
to increasing attention from international bodies, donors and policy makers,
microfinance the world over has entered into a principal phase of development.
Practitioners of microfinance have referred to it as the last hope for the poor
and are currently divided between those who favour profitability and the second
camp combining profitability and social dimension.
Other
major players within the financial system, such as commercial banks until
recently looked at microfinance as a market niche. Attitudes continue to evolve
as developing countries strife at incorporating microfinance into the
mainstream financial system.
In the phase of this global evolution, top performing Microfinance Institutions (MFIs), are being restructured, their income stream widened and are no longer dependent on subsidies to strife. Many have become profit making institutions as a result of transparent and access to different sources of financing.
In
Cameroon microfinance services are no longer reserved for the social
Non-Governmental Organizations (NGOs) as the boundary between microfinance and
commercial banking activities are becoming blurred.
Development
of microfinance institutions and their activities remain blurred until the
early 1990s when President Paul Biya in order to incorporate the elites and
various interest groups into his New Deal Policy passed the remarkable law No.
90/053 of 19 December 1990 relating to freedom of associations, and Law No.
92/006 of 14th August 1992 relating to cooperatives, companies and common
initiative groups.
Another
major contributing factor to the growth and development of microfinance
activities in Cameroon can be linked to the banking crisis in the late 1980s
that resulted to the closure of branches of commercial and developmental banks
in rural areas and some cities.
Many
top executives lost their jobs, some were dismissed. Some of these executives
and employees formed cooperative credit unions that function like mini banks.
As microfinance activities gained heavy weight in the financial system of the
country, the roles of different stakeholders became clearly defined as the supervisory
authorities configured MFIs within the national territory.
Network
of MFIs: Made up of institutions developed endogenously such as MC2, CAMCCUL
(Cameroon Cooperative Credit Union League), The Self Directed village Savings
and Credit (CVECA) supported through the decentralized rural credit project of
the Ministry of Agriculture and Rural Development with the support of BICEC and
two other French institutions.
Two
independent MFIs created by individuals and located mostly in urban areas,
three NGOs with development projects, agro industrial activities and credit
component. The case of Cotton Development Company (SODECOTON), and South West
Development Authority.
With
growing interest in the sector in the absence of effective governance
mechanism, the monetary authority in other words the Ministry of Finance took
over control of the microfinance sector initially placed under the ministry of
Agriculture.
This
led to a series of texts relating to sub regional integration, supervision and
control of microfinance activities. These texts were adopted unanimously by a
council of Finance Ministers from the Economic and Monetary Community of
Central Africa (CEMAC) by 2005.
Consequently,
the new regulation which became effective as from April 14, 2005, organizes the
sector and classify MFIs into three categories. First category includes MFIs
accepting savings and credits just from their members. Second category includes
MFIs accepting credit and savings from members and non-members and the third
category, MFIs granting just credits to the general public. They extend credit
to third parties without collecting savings.
Since
after the classification, commercial banks involvement in microfinance in
Cameroon has increasingly become visible. Starting with, Afriland First Bank-
created Mutual Community Credit (MC2), the microfinance brand in 1992, while
from the opposite direction Cameroon Cooperative credit Union League (CAMCCUL)
network created Union Bank of Cameroon (UBC) a commercial bank that out rightly
failed to take advantage of the pool of competitive advantage offered by
CAMCCUL.
New
players in the sector include SGBC that introduced the advanced microcredit
brand and Ecobank which is one of the latest player in the market in 2009. Many
scholars use the Return of Assets (ROA) or Return on Equity (ROE) as a measure
of MFIs or banks’ profitability (Rosenberg 2009; Ogboi and Unuafe 2013; Aemiro
and Mekonnen 2012; Naveen et al 2012) and as of 2015 there are 418 licensed
micro finance in Cameroon.
1.2 Problem Statement
The
aim of every micro finance institution is to operate profitably in order to
maintain its stability and improve in growth and expansion. For most people in
micro finance, lending represents the heart of the industry.
Loans
are the dominant asset at most micro finance, generate the largest share of
operating income, and represent their greatest risk exposure. Micro finance
sector in Cameroon has faced various challenges that include non-performing
loans and fluctuations of interest rate among others, which have threatened
their stability.
According
to Bessis (2005) Credit Risk Management is important to micro finance
management because there are ‘risk machines’ they take risks; they transform
them and embed them in banking products and services.
Risks
are uncertainties resulting in adverse variations of profitability which shows
the Financial Performance or in losses that show their failure. While various
previous studies provide valuable insights on credit risk management, they have
not entirely made clear their effects on profitability of micro financial
institutions.
Some
challenges faced by MFI in Cameroon such as non-performing loans and
fluctuation of interest rate, it is important to conduct the study about credit
risk management as it is essential that MFIs manage credit risks so as to
reduce losses and ensure continued existence in the long term.
It
is from this background that this study sought to assess the effect of Credit
risk management on the profitability of microfinance institution with the
specific case of micro financial institutions in Buea.
1.3 Objectives of the
Study
The
main objective of this study is to find out the effect of credit risk
management on the profitability of micro financial institutions in Cameroon
with the specific case of MFIs in Buea. Consequently, the specific objectives
derived are:
- To evaluate the effect of credit worthiness of a borrower on the profitability of MFIs in Buea
- To assess the measures of mitigating default risk and improving profitability of MFIs in Buea
- To determine the extent to which the lending portfolio management affects the profitability of MFIs in Buea
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