DESIGN AND IMPLEMENTATION OF A COMPUTERIZED LOAN MANAGEMENT SYSTEM FOR REJECTING OR APPROVING LOAN REQUEST USING CREDIT RISK AND EVALUATION MODELS
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
The chapter reviews literature from other scholars on the aspect of credit risk and portfolio allocation. It specifically looks at theoretical literature in section 2.2 Credit risk management in 2.3 Empirical literature in 2.4 and lastly the chapter summary in 2.5.
2.2 Review of Theories
2.2.1 Liquidity Theory of Credit
This theory, first suggested by Emery (1984), proposes that credit rationed firms use more trade credit than those with normal access to financial institutions. The central point of this idea is that when a firm is financially constrained the offer of trade credit can make up for the reduction of the credit offer from financial institutions. In accordance with this view, those firms presenting good liquidity or better access to capital markets can finance those that are credit rationed. Several approaches have tried to obtain empirical evidence in order to support this assumption. For example, Nielsen (2002), using small firms as a proxy for credit rationed firms, finds that when there is a monetary contraction, small firms react by increasing the amount of trade credit accepted. As financially unconstrained firms are less likely to demand trade credit and more prone to offer it, a negative relation between a buyer’s access to other sources of financing and trade credit use is expected. Petersen and Rajan (1997) obtained evidence supporting this negative relation.
2.2.2 Portfolio Theory
Portfolio theory of investment which tries to maximize portfolio expected return for a given amount of portfolio risk or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although portfolio theory is widely used in practice in the finance industry and several of its creators won a Nobel prize for the theory, inrecent years the basic portfolio theory have been widely challenged by fields such as behavioral economics(Markowitz 1952).
Portfolio theory was developed in 1950’sthrough the early 1970’s and was considered an important advance in the mathematical modeling of finance. Since then ,many theoretical and practical critisms have been developed against it.This include the fact that financial returns do not follow a Gaussian distribution or indeed any symmetric distribution, and those correlations between asset classes(Micheal,Sproul 1998).
2.2.3 Tax Theory of Credit
The decision whether or not to accept a trade credit depends on the ability to access other sources of funds. A buyer should compare different financing alternatives to find out which choice is the best. In trade between a seller and a buyer a post payment may be offered, but it is not free, there is an implicit interest rate which is included in the final price. Therefore, to find the best source of financing, the buyer should check out the real borrowing cost in other sources of funds.
Brick and Fung (1984) suggest that the tax effect should be considered in order to compare the cost of trade credit with the cost of other financing alternatives. The main reason for this is that if buyers and sellers are in different tax brackets, they have different borrowing costs, since interests are tax deductible. The authors’ hypothesis is that firms in a high tax bracket tend to offer more trade credit than those in low tax brackets. Consequently, only buyers in a lower tax bracket than the seller will accept credit, since those in a higher tax bracket could borrow more cheaply directly from a financial institution. Another conclusion is that firms allocated to a given industry and placed in a tax bracket below the industry average cannot profit from offering trade credit. Therefore, Brick and Fung (1984) suggest that firms cannot both use and offer trade credit.
2.2.4 Credit Risk Theory
Although people have been facing credit risk ever since early ages, credit risk has not been widely studied until recent 30 years. Early literature(before 1974) on credit uses traditional actuarial methods of credit risk ,whose major difficulty lies in their complete dependence on historical data.Upto now ,there are three quantitative approaches of analyzing credit risk:
structural approach, reduced form appraisal and incomplete information approach (crosbie et al,2003).Melton 1974 introduced the credit risk theory otherwise called the structural theory which is said the default event derives from a firm’s asset evolution modeled by a diffusion process with constant parameters. Such models are commonly defined “structural model “and based on variables related a specific issuer. An evolution of this category is represented by asset of models where the loss conditional on default is exogenously specific. In these models, the default can happen throughout all the life of a corporate bond and not only in maturity (Longstaff and Schwartz.1995).
2.3 Credit Risk Management Practices
2.3.1 Loan Portfolio
Loan portfolio constitutes loans that have been made or bought and are being held for repayment. Loan portfolios are the major asset of Loan Applications and the lending institution. The value of the loan portfolio depends not only on the interest rates earned on loans but also on the likelihood that interest and principal will be paid (jasson, 2002). Lending is the principal business activity for most commercial banks, the loan portfolio is typically the largest asset and the predominate source of revenue. As such, it is one of the greatest sources of risk to a financial institution’s safety and soundness. Whether due to lax credit standards, poor portfolio risk management, or weakness in the economy, loan portfolio problems have historically been the major cause of losses and failures. Effective management of the loan portfolio and the credit function is fundamental to a Sacco’s safety and soundness. Loan portfolio management (LPM) is the process by which risks that are inherent in the credit process are managed and controlled. Because review of the LPM process is so important, it is a primary supervisory activity (Koch 2000).
Assessing LPM involves evaluating the steps the management takes to identify and control risk throughout the credit process. The assessment focuses on what management does to identify issues before they become problems. The identification and management of risk among groups of loans may be at least as important as the risk inherent in individual loans. For decades, good loan portfolio managers have concentrated most of their effort on prudently approving loans and carefully monitoring loan performance. Although these activities continue to be mainstaysof
loan portfolio management, analysis of past credit problems, such as those associated with oil and gas lending, agricultural lending, and commercial real estate lending in the 1980s, has made it clear that portfolio managers should do more. Traditional practices rely too much on trailing indicators of credit quality such as delinquency, nonaccrual, and risk rating trends. (Richardson 2002).
Effective loan portfolio management begins with oversight of the risk in individual loans. Prudent risk selection is vital to maintaining favorable loan quality. Therefore, the historical emphasis on controlling the quality of individual loan approvals and managing the performance of loans continues to be essential. But better technology and information systems have opened the door to better management methods. A portfolio manager can now obtain early indications of increasing risk by taking a more comprehensive view of the loan portfolio (Koch 2000).
To manage their portfolios, bankers must understand not only the risk posed by each credit but also how the risks of individual loans and portfolios are interrelated. These interrelationships can multiply risk many times beyond what it would be if the risks were not related. Until recently, few banks used modern portfolio management concepts to control credit risk. Now, many banks view the loan portfolio in its segments and as a whole and consider the relationships among portfolio segments as well as among loans. These practices provide management with a more complete picture of the bank’s credit risk profile and with more tools to analyze and control the risk. (Sinkey, 1992)
2.3.2 Credit Risk Management
When a Sacco grants credit to its customers, it incurs the risk of nonpayment. Credit risk management refers to the systems, procedures and controls which a Sacco puts in place to ensure the efficient collection of customer payments and minimize the risk of non-payment (Naceour and Goaied 2003) Credit risk management forms a key part of a company’s overall risk management strategy. Weak credit risk management is a primary cause of many business failures. Many small businesses have neither the resources nor the expertise to operate a sound credit management system (Richardson, 2002).
2.3.2.1 Delinquency Management
A delinquent loan is defined as any loan in which the full payment has not been received per the loan contract. For purposes of managing delinquent loans, Loan Applications should categorize loans and provide for bad debts where the loans should be described as defaulted, performing, watch, substandard, doubtful and bad debts then a specific provision should be set for each category. Loan Applications are expected to submit returns on capital adequacy to Sasra every month and not less 15th of the subsequent month. Inability to do these will attract financial and subsequently administrative sanctions which include suspension of investments, lending, purchase of property and accepting deposits by the Sacco. For delinquency management on loans portfolios’ to be effective loans are classified into five categories which include performing, watch-unpaid unto 30days,substandard –unpaid up to 180 days, Doubtful-unpaid up to 360days and Loss-unpaid for over 360days.(Sassra report)
2.3.3 Risk Identification
Risk identification is vital for effective risk management, for Loan Applications to manage risks facing them effectively they need to know how to identify the credit risks. The first step in risk identification identifying and prioritizing key risks which are reviewed and approved by the management committee. There is also need to determine the degree of risk the Sacco should tolerate and to conduct assessments for each risk of the potential negative impact if it is not controlled. Finally analyze the risk faced by the Sacco in the areas of interest rates risk, liquidity, credit, operations and strategic risks (CBK Sacco)
2.3.4 Risk analysis and Assessment
(Fatemi, 2000).Atypical risk analysis process consists of two components; financial analysis (quantitative analysis) and qualitative analysis. Financial analysis consists of analysis of financial; data available for the credit applicant, the analysis of annual financial statements has a central position in this context. Mostly financial analysis is carried out by credit analysts, there should be a general guideline stipulating that the analysis is confirmed by the person in charge of the organizational unit supplying the module for credit analysis when this module is handed over to the credit officer managing the exposure. (Eldelshain 2005)
2.3.5 Credit Approval
Clear established processes of approving new creditors and extending the existing credits has been observed to be very important while managing credit risks in Loan Applications. Credit unions must have in place written guidelines on credit approval processes and approval authorities .The board of directors should always monitor loans, approval authorities will cover new credit approvals, renewal of existing credit changes in terms and conditions of previously approved credits particularly credit restructuring which should be fully documented and recorded. Prudent credit practice requires that persons empowered with the credit approval authority should have customer relationship responsibility. Approval authorities of individuals should be commensurate to their positions within the management ranks as well as their expertise (Mwisho, 2001)
2.3.6 Credit Risk Control and Monitoring
The importance of monitoring risks is to make sure that they can be managed after identification. The Loan Applications play an increasingly important role in local financial economies where competition for customers and resources with Micro Finance Institutions and other commercial banks is high therefore they require effective and efficient risk control and monitoring systems.
The risk management feedback loop will involve the management and senior staff in the risk identification and must assess, process, as well as to create sound operational policies, procedures and systems. Implementation and designing of policies, procedures and systems will integrate line staff into the internal control processes, thus providing feedback on the Sacco’s
ability to manage risk without causing operational difficulties. The committee and the manager should receive and evaluate the results on an ongoing basis. Most risk management guidelines in Loan Applications will be contained in the policy manuals eg the credit manual. (CBK, 2010)
2.3.6 Credit Risk Management Measurement
Operating and financial ratios have long been considered as tools for determining the condition and the performance of afirm.Modern warnings models for financial institutions gained popularity when Sinkey(1975) utilized discriminant analysis for identifying and distinguishing problem banks and Altman (1977) examined the saving and loan industry. The procedures to identify financial institutions approaching financial distress vary from country to country, they are designed to generate financial soundness ratings and are commonly referred to as the CAMEL rating system (Gasbarro et al.2002).In Nigeria the central bank applies the CAMEL rating system to assess the soundness of financial institutions which is an acronym for Capital Adequacy, Asset Quality, Management Quality, Earnings and Liquidity (CBK, 2010).
According to Sasra, CAMEL as an offsite evaluation tool has been adopted to identify Loan Applications that are financially vulnerable and therefore need increased supervisory attention. The rating scale is from 1 to 5 with 1 being the strongest and 5 being the weakest. Loan Applications with rating of 1 are considered more stable, those with 2and 3 are considered average and those with rating of 4or 5 are considered below average and are monitored to ensure their viability.
2.4 Empirical Studies
According to WOCCU the financial discipline of provisioning for loan losses has not been part of the SACCO development since Loan Applications have relied on the check-off system for decades. Loan Applications therefore end up having extremely low net institutional capital and fail to meet the WOCCU prudential standard of excellence of a minimum of 10% net institutional capital. Institutional capital is a critical second line of defense after loan loss provisions from losses incurred by the credit union related to increasing delinquency and defaults.
Silikhe (2008) on credit risk management in microfinance institutions in Nigeria found out that despite the fact that MFI’s have put in place strict measures to credit risk management, normal
loan recovery is still a challenge to majority of the institutions. This explains the reasons why most financial institutions are either not growing or about to close down.
Dhakal (2011) on risk management in Loan Applications found out that risk management is not imbedded into the Loan Applications institutional cultures and its value is not shared by all employees. He also noted that given the capacity, introduction of sophisticated systems and technical tools risk management does not work in Loan Applications and therefore they lack the capacity required for risk management.
Gaitho (2010) surveyed on credit risk management practices by Loan Applications in Nairobi, findings revealed that majority of Loan Applications used credit risk management practices to mitigate risks as a basis for objective credit risk appraisal. She also found out that majority of Loan Applications relied heavily on the discretion and ability of portfolio managers for effective credit risk management practices as opposed to a system that standardizes credit and credit risk decisions.
Owusu (2008) on credit practices in rural banks in Ghana found out that the appraisal of credit applications did not adequately assess the inherent credit risk to guide the taking of appropriate credit decision he also found out that the drafted credit policy documents of the two banks lacked basic credit management essentials like credit delivery process, credit portfolio mix, basis of pricing, management of problem loans among others to adequately make them robust. In his recommendations he stated that credit amount should be carefully assessed for identified projects in order to ensure adequate funding. This situation provides the required financial resources to nurture projects to fruition, thus forestalling diversion of funds to other purposes, which may not be economically viable.
Githingi (2010) surveyed on operating efficiency and loan portfolio indicators usage by microfinance institutions found out that most microfinance institutions to a great extend used operating efficiency indicator as a credit risk management practice. Efficiency and productivity ratios are used to determine how well microfinance institutions streamline their credit operations. He also noted that microfinance institutions need to employ a combination of performance indicators such as profitability, operating efficiency and portfolio quality indicators to measure their overall performance.
Asiedu-Mante (2002), has asserted that very low deposits and high default rates have plunged some rural banks into serious liquidity problems, culminating in the erosion of public confidence in these banks. He indicated further that a combination of poor lending practices and ineffective monitoring of credit facilities extended to customers has contributed to high loan delinquency in some banks.
Gisemba (2010) researched on the relationship between risk management practices and financial performance of Loan Applications found out that the Loan Applications adopted various approaches in screening and analyzing risk before awarding credit to client to minimize loan loss. This includes establishing capacity, conditions, use of collateral, borrower screening and use of risk analysis in attempt to reduce and manage credit risks. He concluded that for Loan Applications to manage credit risks effectively they must minimize loan defaulters, cash loss and ensure the organization performs better increasing the return on assets.
Wambugu (2009) on credit management practices in Loan Applications offering front office services found out that risk identification is an important stage in credit risk management and should be applied effectively to identify the current credit risks confronting the organization, provide the likelihood of these risks occurring and reveal the type and amount of loss these risks are meant to cause if they occur. He concluded that the establishment of a review system that provided accurate timely and relevant risk information in a clear, easily understood manner is key to risk monitoring.
Griffin et al (2009) investigated the risk management techniques of twenty eight Islamic banks by examining the perception of senior Islamic banker toward risk. The result reveled that, Islamic banks are typically exposed to the same types of risk in conventional banks with different levels of the risks. Olomola (2002) found that repayment performance is significantly affected by borrower’s characteristics, lenders characteristics and loan characteristics. Repayment problems can be in form of loan delinquency and default. Whatever the form however, the borrowers alone cannot be held responsible wherever problems arise, it is important to examine the extent to which both borrowers and lenders comply with the loan contract as well as the nature and duties, responsibilities and obligations of both parties as reflected in the design of the credit programme rather than heaping blames only on the borrowers.
2.5 Summary
The literature review outlined the need to adopt sound credit risk management practices and portfolio management in order to achieve the ultimate goal of good recovery and to maintain good loan asset quality. This places a SACCO on a pedestal to achieve a sustainable growth and development by deepening financial intermediation as well as maximizing shareholders’ wealth.
Sound credit risk management entails critical assessment of credit risk and control, structured credit delivery process, effective monitoring/supervision regime, institution of oversight mechanism by the Board of Directors in terms of policy measures and supervisory control by the regulator in respect of credit limits, classification and provisioning of credits. The theoretical expositions and practices highlighted in this chapter by various experts and authorities on the basic credit management principles provided pertinent guide for the research.