ASSESSMENT OF LENDING PRACTICES AND CREDIT RISK
MANAGEMENT IN CENTENARY BANK KASESE BRANCH
CHAPTER ONE
INRODUCTION
Introduction
In this chapter presents the background of the study, statement of the problem,
research questions, and objectives of the study, significance of the study, scope of the study,
limitation of the study, theoretical frame work, conceptual framework and operational
definition of the terms.
Background of the study
Profitable bank lending is based not on making loans but on minimizing the risk in
collecting them. In this respect then, the major business of the bank therefore is the
administration of risk in profitable ways. The continued and profitable operation of banks is
dependent is how it presently manages its credit risk. Banking institutions carries risk
associated with private sector lending more so when some of the loanees don’t honor their
payments obligations. Whatever the degree of risk is taken; loan losses can be minimized by
organizing and managing the lending function in a highly professional manner that is credit
risk management. Credit risk, according to Basel (2000), is the potential that a bank borrower
or counterparty will fail to meet its obligations in accordance with agreed terms. It is a risk of
borrower default, which occurs when counterparty defaults on repayment. The reasons for
loan default / loan delinquency are when the obligor is in a financially stressed situation
(GESTEL; BAESENS, 2008).
Inadequate financial analysis, inadequate loan support according to (SHEILA, 2011)
are the causes of loan default. Credit risk management is the identification, measurement,
monitoring and control of risk arising from the possibility of default from loan repayment
(EARLY, 1966; COYLE, 2000).
Ditcher (2003) observes that banks in USA gave credit to customers with high interest rate
which discouraged borrowing. As a result, the concept of credit did not become popular until
the economic boom in USA in 1885 when banks had access to liquidity and wanted to lend
excess cash.
Available statistics from the Bank of Uganda annual supervision report, 2015
indicates high incidence of credit risk reflected by increasing non-performing loans (NPLs)
by MDI’s.
The situation has adversely impacted on their profitability and overall asset quality has
deteriorated.
The NPL ratio (NPLs to total gross loans) increased from 3.2% in December 2011 to
5.3% December 2012 it decreased marginally in December 2013 to 3.4% and again rose to
4.2% in December 2014 and then rose to 6.6% in December 2015. This trend not only
threatens the viability and sustainability of MDI’s but also hinders the goals for which they
were intended to achieve that is provision of micro finance services mainly to small and
medium enterprises
(MFPED, 2001). Failure to control credit could result in insolvency as success of MDI’s
largely depends on the effectiveness of their credit risk management practices (ALFRED,
2011).
Credit Risk Management practices
Credit risk management practices are the apperception, evaluation, auditing and
management of risk arising from the likelihood of loan non repayment. Management of credit
risk is at the heart of survival of most financial institutions. Credit risk management is at the
core of survival for the big majority of commercial banks. Kithinji (2010) defined credit risk
management has been defined as implementation of policies to limit insider lending and large
exposures to related parties this is in addition to controlling risks stemming out of chances
that a client may not repay the loan. Inadequate credit risk management practices and absence
of care to variations in economy can be named as causes for poor financial performance by
banking institutions (Tefera, 2011). The objective of credit risk management in banks is to
achieve maximum risk-adjusted rate of return by retaining credit risk exposure within
satisfactory limits (Wang, 2013). Indicatively credit risk management may be spell out
methodical appliance of management strategies, processes and practices to the tasks of
pinpointing, evaluating, gauging, treating and monitoring risk. Earnings due to banks will be
exposed to risks of variations in returns and hence fluctuate if the financial institutions are not
aware of the percentage of loans that will become delinquent.
Loans extended to bank's clients might have risks associated with non-repayment in
circumstances the bank assumes that the loanees will faithfully pay back amounts borrowed.
A few of the clients ordinarily don’t make the repayments resulting to decreased profits due
to the need for provisioning and writing of the loans (Karugu & Ntoiti, 2015). Essentially, the
credit risk of a bank is the likelihood of cost arising from non-repayment of interest and the
initial loaned amount, or both, or failure to sell of securities pledged on the loan (Kithinji,
2010). Credit risks faced by commercial banks are not only a threat to its financial
performance but also to the financial market (Eder, Fecht, & Pausch, 2014).
Basel Committee on Banking Supervision, (2006) encouraged the use of “know your
customer” principal as a strategy to minimizing credit risk. Nonobjective decisions made by
banks executives may result to insider leading or lending to personal friends, persons without
superior financial knowledge or to meet personal agenda (Kithinji, 2010). An answer to the
problem would be the usage of verified loaning systems and chiefly the measurable ones
which are more objective (Karugu & Ntoiti, 2015). Changes in credit risks may mirror
changes in the health of a bank’s loan portfolio which may in turn affect the bank’s
performance (Weersainghe & Perera, 2013). Weersainghe & Perera, (2013) were of the view
that varying profitability levels could be traced back to variations in credit risk as increased
exposure to the risk is associated with declining organization profitability. According to
Karugu & Ntoiti, (2015) empirical evidence supported the view of the presence of an inverse
connection existing between credit risk and performance of financial institutions suggesting
that the more these institutions are exposed to high risk loans, the higher the poor performing
assets the poor the performance.
In banking institutions, policies of managing credit risk essentially comprise of its
policies of managing and diminishing the risk exposure and occurrence (Dam, 2010). As
issuance of loans is a core business of banking institutions products and services, managing
risk is crucial to profit generation of financial institutions.
Lending Practice
Bank customers with loans and the total amount loaned out relates to various lending
products used (Kurui & Kalio, 2014). Loan portfolio encompasses salary loans, group bonded
loans, individual loans and company loans (Murugu, 2010). It is important to note that the
type and number of loans a bank will make as well as to whom it will grant credit and what
conditions and circumstances requires a sound policy decision.
The lending decision like any other investment decision involves enormous amount of
risk. Therefore, adequate case must be taken in the process of arriving at such decisions. Thus
a meaningful periodic appraisal of lending and credit Administration can only be based on
qualitative policies of the lending institution with respect to extension of credits.
According to Kurui & Kalio (2014), continued existence of most financial institutions
depends entirely on successful lending program that revolves on funds and loan repayments
made to them by the clients. This means a restrictive credit control policy should be adopted
to act as a deterrent to unnecessary lending and in the process improve on profitability of the
financial institutions (Kipchumba, 2015). As a result the formulation and execution of sound
lending policies constitute part of the most vital responsibilities of bank management. As
earlier mentioned it is the screening device through which the appraisal techniques are
weighed. Grosse (1963) opined that well-conceived lending policies and careful credit
practices are essential for a bank if is to perform it credit-creating functions effectively and
efficiently and at the same time minimise or eliminate the risk inherent in any extension, of
credit.
Problem statement
Banks are useful to economic development by through the provision on financial
services and intermediation of lenders with savings to borrowers who need the money
(Kolapo,
Ayeni, &Oke, 2012). The pace of a country’s economic growth and long term sustainability
is accelerated by the extent to which banks extend credit to the general public. Credit
creation, being the main income generating activity of the banking institutions, exposes them
to credit risk. These risks have a huge influence on the bank’s financial performance hence
calling for prudent credit risk management practices (Kolapo, Ayeni, & Oke, 2012). There
have been a number of studies on credit risk management and lending practices both in
developed and developing countries (see for example, OTIENO et al, 2016; ALSHATTI,
2015, and Akoth, 2016). There is no study, to my knowledge, that has examined the
relationship between credit risk management and lending techniques of Centenary banks in
Kasese Manucipality. As a result, this study intends to close the empirical literature gap.
Objective of the Study
To assess lending practices and credit risk management in Centenary Bank Kasese branch.
Specific Objectives
1. To identify the various lending practices used by Centenery bank.
2. To establish the level of credit risk management by the bank.
3. To establish the relationship between lending practices and credit risk management.
Research questions
1. What are the lending practices used by Centenary bank?
2. What is the level of credit risk management of the bank?
3. Is there any relationship between lending practices and credit risk management?
Justification of the study
1. This research work is apparently going to be useful to top level managers who may find
the recommendation and suggested strategies useful in managing credit portfolios. In a
similar manner, branch and credit managers will be guided on loan disbursement to
ensure strict adherence to lending guidelines and economic analysis of environment.
2. The research will help the researchers to acquire academic knowledge. The study will
further enrich existing knowledge on the relationship between credit risk management
techniques and lending practices of Centenary bank
3. In addition to the above, other researchers will find this piece of my work useful in their
academic pursuits in the related topic.
Scope of the study
Content Scope
The research will focus on lending practices and credit risk management in the bank.
Time scope
The study will be carried out in the month of March 2020
Geographical scope
The assessment will be conducted on Credit officers and Managers of Centenary Bank in
Kasese town of Kasese Municipality.
Operational terms
(i) Lending: A process by which a Bank customer is temporarily given money for a specified
purpose and specified period of time with a promise to repay the amount borrowed.
ii) Credit: This involves giving (receiving) goods or purchasing power now in return for a
promise to receive or re-pay the goods or purchasing power later. It is the sale of goods,
services or money claims in the present in exchange for promise to pay (usually money) in
the future
(iii) Bad and doubtful debt. This may be defined as a loan or debt, which has become
irrecoverable at date of maturity. A loan may be termed bad or doubtful on event of
borrower’s failure to repay the loans in accordance with terms and conditions of the
agreement.
iv) Securities: This may be defined as something that provides safety, freedom, from danger
or anxiety, something valuable for example a life insurance policy given as pledge for the
repayment of a loan or fulfillment of a promise or undertaking.
vii) Guarantee; A guarantee is an under taking in writing to be liable for the debt of a
customer to a third party on default.
viii) Credit risk management practices have been defined as the identification,
measurement, monitoring and control of risk arising from the possibility of non-payment of
loans advanced to various clients.
CHAPTER TWO
LITERATURE REVIEW
Introduction
This chapter reviews the work of the previous researchers related to this study.
Literature was reviewed in relation to the research objectives.
Banks lending practices
The lending practices and policies of commercial banking system change relatively
slowly. Frequent modification of lending practices is not needed since the financing needs of
business and industry change slowly. Some change is, however, discernible, some successful
lending practices have been adopted to meet the new financing needs of industry and
commerce. In some cases, new techniques of lending have been devised in order to extend
credit to finance new types of business. The terms and conditions under which new loans can
be made altered by federal or state legislation. Changing tax policy followed by Treasury
Department has also influenced trends in lending practices. It is, therefore, impossible to
discuss contemporary trends in lending practices without referring to the policies followed by
the central banking system. In addition, to show what the lending activities of commercial
banking system have been, it is necessary to examine trends in the various kind of loans.
George W, 1952
Sound lending procedures in financial institutions involve identifying high-risk loan
applicants, modifying lending conditions such as security requirements and monitoring
repayments. Until in recent years, lending has been the essence of commercial banking and in
fact now colossal part of banks assets are in credit grant. As a result, the formulation and
execution of sound lending policies constitute part of the most vital responsibilities of bank
management. As earlier mentioned it is the screening device through which the appraisal
techniques are weighed. (Report on banking in Uganda, 2018)
Relaxed lending standards and complacency, unguaranteed credits, cultural influence,
partisan politics, man know man and carelessness in enforcing compliance are some practices
given for why loans granted for which repayment is expected plus interest go bad. Most of
the banks that are now neck deep in bad debts found themselves in that situation through
mismanagement of their loan lending portfolio. Considering the ratio of defaulters in Banks
with Government equity and those that are one hundred percent private one may tend to agree
that partisan politics in its rotten form has some influence in granting and administering
loans. Anthony Ononye believed there is what he called political lending (Banking and
Finance Digest Vol. 5 pg. 13). Mr. Ayo a chartered Accountant also opined that tribal and
sentimental lending is eating deep into lending and credit administrations of commercial
banks.
Bankers should not relax on the qualitative lending policies of their banks because
even the best policies need periodic review in the light of ever changing environmental
condition. The starting point of a sound lending and credit policy begins with knowledge of
the legitimate credit need of the customer. It is important to recognize that loans should not
be given simply because of personal interest or favoritism. Legitimate credit is one that will
further the growth and stability of the community and the economic well-being of its
inhabitants including the customer. In addition, the Banker must have a clear concept of how
much credit and what variety of loans the community needs, in order to effectively appraise
his own willingness and ability to meet the credit demand of the customer. The limiting factor
in this case ought to be the customer’s genuine needs for credit and the banks’ ability to meet
those needs rather than any arbitrary pre-conceived ideas or average statistical and personal
relationship.
The need for a sound policy to regulate bank lending arises from the fact that
uncontrolled monetary expansion can in addition to the unavoidable risks involved
accelerated inflationary pressures in the economy. This indeed is a negation of the objectives
of promoting monetary stability and the achievement of a sound financial structure. Similarly,
poor lending policies of a commercial bank can lead to a high loan to deposit ratio and this
can result to liquidity crisis for the bank (Intellectual reserve, 2019)
Another important aspect of lending policies and guidelines is in respect of payment.
Credit is commonly believed to be the lifeblood of the economy. If this assertion is correct,
any credit, which ceases to flow, becomes stagnant. It should therefore be a basic policy of
commercial bank lending that any money loaned in whatever form and to whoever should
flow back to the bank in form of repayments. That is the terms of repayment should be related
to the form and nature of the transactions being financed and a definite repayment program
should be established with respect to every loan no matter how well secured or how sound. A
sound loan should be collectable from the anticipated income or profit of the borrower rather
from liquidation of any collateral that may be pledged. Stanbic bank lending policies and
regulation report (2018).
Credit Culture
