Evaluation of Credit Management and Its Effect on Performance of Rural Banks in Ghana: A Case Study of Adansi Rural Bank Ltd. Fomena-Ashanti
Chapter One
Objectives of the Study
The aim of the study is to establish the effect of credit risk on the financial performance of Adansi Rural Bank Ltd, Fomena, Ashanti.
Specific Objectives
The following strategically designed objectives guided the study:
- To find out the effectiveness of bank bankers in managing and identifying credit risk. ii. To establish whether thestrategies of managing credit risk have an effect on the financial performance.
- To analyse how the management challenges of credit management affect the financial performance.
- To find out the perception of bank bankers towards controlling and managing credit risk.
CHAPTER TWO
LITERATURE REVIEW
Introduction
This chapter presents the literature review on the credit risk and performance of Adansi Rural Bank Ltd, Fomena, Ashanti. It summarizes the information from other researchers who have carried out their research in the same field of study. The chapter presents theoretical literature, the empirical review, conceptualization and the research gap.
Theoretical Review
The theories in the study include: commercial-loan theory, agency theory, credit risk theory and loan pricing theory.
Credit Risk Theory
Credit risk is the most common risk to microfinance and other financial institutions by the nature of its activity. It is typically the largest type of risk when we figure them on the basis of potential losses. According to Bessis (2003), the default of a small number of members may result in a very large loss for the microfinance. It is simply defined as the potential that a borrower or counterpart fail to meet its obligations in accordance with agreed terms. It can occur when the member in microfinance is unable to pay or cannot pay on time. There can be many reasons for default. In most cases, the obligor is in a financially stressed situation and may be facing a bankruptcy procedure. One can also refuse to comply with the debt service obligation, for example in the case of a fraud or a legal dispute.
Credit risk is the potential change in net asset value due to changes in the perceived ability of Counter-parties to meet their contractual obligations. It occurs when a borrower does not pay back the loan. According to Mwirigi (2006), most financial institutions as early as one-month late repayment, a loanee was considered as a defaulter and thus collections efforts were intensified and this explains why micro finance institutions commend low default rates. Those who didn’t pay on time, their property was sold to recover the money, followed by write off of the balance and others would consider writing off the balance and allow defaulters to repay the principal only.
There are three key quantitative approaches to analyzing credit risk: structural approach, reduced form approach and incomplete information approach. Merton (1974) came up with a model based on the capital structure of the firm which became the basis of the structural approach. In his approach, the company defaults at the loan repayment time T if its value falls below some fixed barrier at time T. Thus the default time becomes a discrete random variable which picks T if the company defaults and infinity if the company does not default. As a result, the equity of the firm becomes a contingent claim of the assets of the firm’s assets value. This theory is relevant to the study as credit risk is the main variable of the study. The theory describes how the bank bankers understand he credit risk concept, how the loan defaulters fail to pay their loan leading to risk and thus the bank bankers should find strategies to recover the loans.
The Commercial-Loan Theory
The commercial-loan theory, also known as real bills doctrine, argues that banks have a problem described as liquidity-earnings dilemma. It states that if a bank wants to be a safe haven for all its depositors’ funds, it would simply hold all those funds in its safe as perfectly liquid assets; then whenever a depositor requested cash from the rural bank, the banker would simply open the safe and give the money back to the client. This would ensure that there is no credit risk. However, this presents the problem that no earnings would be generated for the bank (Woolcock, 1999).
According to the theory, the bankers can take a position at the other extreme in order to earn some profit other than being only cash keepers for its clients. Credit risk bankers can employ all the funds deposited to the rural bank to make a loan to finance a high-risk venture. Such a loan might have a high earnings potential for the bank, but the loan probably will not be liquid. It would be difficult to liquidate to obtain cash when depositors want to make withdrawals. To resolve the liquidity-earnings problems, bankers must recognize the advantage of making self-liquidating loans (real bills). A loan is considered self-liquidating if it is secured by assets which can be resold to repay the loan which helps to mitigate credit risks. Loans of this type could ensure the banks continues liquidity and earn profits. Thus, liquidity and earnings are simultaneously gained by the bank.
Loan Pricing Theory
Loan pricing theory by (Stieglitz and Weiss, 1981) states that if rural banks set interest rates too high, they may induce adverse selection problems because high-risk borrowers are willing to accept these high rates. Rural banks tend to always set high interest rates while trying to earn maximum interest income. Once borrowers of these high interest loans receive the loans, they may develop moral hazard behavior or so called borrower moral hazard since they are likely to take on highly risky projects or investments (Chodechai, 2004). To mitigate this risk therefore rural banks will be forced to moderate their rates of interest.
CHAPTER THREE
RESEARCH METHODOLOGY
Introduction
This chapter explains the research design and methodology that have been used to carry out the research. It contains the research design, the population, sample size and sampling procedure, data collection and analysis.
Research Design
The research design used in this study was descriptive research design. Descriptive research seeks to establish factors associated with certain occurrences, outcomes, conditions or types of behavior. Research design is the outline plan or scheme that is used to generate answers to the research problems, (Mugenda and Mugenda, 1999). The design was appropriate because the study involved an in depth study of credit risk and the relationship between the two variables, that is, credit risk and the performance of bank was described extensively.
Target Population
This is a survey of all the staff of Adansi Rural Bank Ltd, Fomena, Ashanti and therefore, the target population of this study is the staff of Adansi Rural Bank Ltd, Fomena, Ashanti.
Sampling Frame
According to Upagande and Shende (2012), sampling frame is a definite plan for obtaining sample from a given population upon which data is collected from. It is the list of units in the survey population. Sampling frame determines how well the target population is covered and affects the choice of data collection method. Therefore, sampling frame is simply a list of the study population. The sample size of the study was obtained from financial department, loan/credit officers. The choice was because of the management of the credit risk is concerned by the credit/loan officers, financial bankers and the branch bankers is the top banker responsible of all the activities in rural banks branches.
CHAPTER FOUR
RESEARCH FINDINGS
Introduction
The preceding chapter described the methodology applied for this study. This chapter presents the results of the study. It presents and discusses the findings. The findings are organized in terms of the research objectives. The reporting of the findings is done in form of a narrative discussion where the findings are first described and then analyzed followed by the discussions. The study was set to find out the extent to which credit risk and strategies used by bankers to compete in the banking industry effect the performance of bank.
CHAPTER FIVE
SUMMARY OF THE FINDINGS, CONCLUSIONS AND RECOMMENDATIONS
Introduction
This chapter presents the summary of the findings, the conclusions and the recommendations to the study. From the recommendation the study will present the areas for further studies.
Summary
The study indicated that rural banks have to ensure that credit management is effective to prevent it from failing in its obligation and meeting its objectives. The study indicated that it is crucial for rural banks to manage credit risk so as to maximize on its return on assets (performance). The study indicated that rural banks need effective credit management techniques to minimize loan defaulters, cash loss and ensures the organization performs better increasing the returns thereby portraying a stable financial performance.
The study established that there are approaches that are used by the bank in screening and risk analysis before awarding credit to clients to minimize on loan loss. From the findings, the competition and conditions are the approaches mostly used in screening and in risk analysis before awarding credit to clients.
It was also found that most of the respondent agreed to a moderate extent that collateral and character of borrower were used in screening and risk analysis. Credit management is important since it leads to optimizing the financial performance and that sound credit management practices were built on good quality portfolio management, credit union adopted credit documentation as a ways of managing credit risk and the use of collateral enhances risk management in rural banks.
The study also reached to a conclusion that rural banks adopt various strategies in analyzing and screening of risk before awarding credit to clients to minimize on loan loss. This included establishing competition and conditions and use of collateral and character of borrower were used in screening and risk analysis in attempt to reduce credit risk.
Conclusion
From the findings, the study concludes that there is a relationship between credit management and performance such that credit management affects performance. When asked about the application of the credit management principles in the banking institutions, the secondary data indicated that credit management principles were widely used in the banking and even microfinance institutions. Credit management principles were applicable in their banking institutions. They gave examples of credit management principles used as creating value, explicitly addressing uncertainty, basing on the best available information and taking into account human factors. They also cited on the six Cs of credit management which include character, capability, context, credibility, collateral and conditions. In conclusion, there was an inverse relationship between credit risk and performance (return on assets) in rural banks.
Recommendations to the Study
The study recommends that rural banks should put consideration on non-performing loans which increases credit risks thus decreasing the bank’s performance, they should have effective techniques of measuring and intimidating credit risk such as the use of ratios like non-performing loans ratios, liquidity and operational cost efficiency ratios, they should have effective and efficient strategies to manage credit risks which might increase the performance in rural banks.
Suggestions for Further Research
Since this study focuses on credit risk, the researcher recommends further research on other risks such as financial risks, interest rate risks and market risks. The researcher also suggests that the study could further be developed by including more independent variables to the study and increasing the sample size. The variables would help improve the results of the study since it would include all the other factors that affect the performance of the banks. The increased sample size would give a better representation of the banking sector.
REFERENCES
- Aghion, G.S. and Morduch, A.M. (2000), “Risk Management in Financial Institutions”, Sloan Management Review, Vol. 39 No. 1, pp. 33-46.
- Basel (2010) “Principles of management of credit risk” Consultative paper issued by the Basel committee on banking supervision, Basel (April 2010).
- Buttit (2010) the relationship between credit risk and performance of micro finance institutions in Ghana. Unpublished MBA project at the University of Ashanti.
- Central Bank of Ghana, (2005), Risk Management Survey report, Ashanti. Construction Law.
- Fischer and Myron Scholes (1972). The Capital Asset Pricing Model: Some Empirical Tests, 79– 121
- Gill, P. (1989) “Change in Product Liability Reform”, AuconstrlawNlr48, Australian
- IFSB, (2005). Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering only Financial Services, Financial Services Board.
- Jensen and Meckling, (1976), Theory of the Firm: Bankerial Behavior, Agency Costs
- Kamau P. (2010) adoption of risk management by rural banks in Ghana. Unpublished MBA project University of Ashanti.