Credit Risk Management and Profitability of Commercial Banks in Kenya

1. 1 Background The risk focused examination process has been adopted to direct the inspection process to the more risk areas of both operations and business. Skills in risk-focused supervision are continually being developed by exposing examiners to relevant training. By adopting this approach, the banking industry, and specifically the small banks are sensitized on the need to have formal and documented risk management frameworks (De Juan, 1991). Notably, the more complex a risk type is, the more specialized, concentrated and controlled its management must be (Seppala, 2000; M atz and Neu, 1998; Ramos, 2000).

Risk management is defined as the process that a bank puts in place to control its financial exposures. The process of risk management comprises the fundamental steps of risk identification, risk analysis and assessment, risk audit monitoring, and risk treatment or control (Bikker and M etzmakers, 2005; Buttimer, 2001). Whereas a risk in simple terms can be measured using standard deviation, some risks may be difficult to measure requiring more complex methods of risk measurement.

Good risk management is not only a defensive mechanism, but also an offensive weapon for commercial banks and this is heavily dependent on the quality of leadership and governance. Jorion (2009) notes that a recognized risk is less “risky” than the unidentified risk. Risk is highly multifaceted, complex and often interlinked making it necessary to manage, rather than fear. While not avoidable, risk is manageable – as a matter of fact most banks live reasonably well by incurring risks, especially “intelligent risks” (Payle, 1997; Greuning and Bratanovic, 1999)).

Financial institutions are exposed to a variety of risks among them; interest rate risk, foreign exchange risk, political risk, market risk, liquidity risk, operational risk and credit risk (Yusuf, 2003; Cooperman, Gardener and M ills, 2000). In some instances, commercial banks and other financial institutions have approved decisions that are not vetted, there has been cases of loan defaults and nonperforming loans, massive extension of credit and directed lending.

Policies to minimize on the negative effects have focused on mergers in banks and NBFIs, better banking practices but stringent lending, review of laws to be in line with the global standards, well capitalized banks which are expected to be profitable, liquid banks that are able to meet the demands of their depositors, and maintenance of required cash levels with the central bank which 1 means less cash is available for lending (Central Bank Annual Report, 2004).

This has led to reduced interest income for the commercial banks and other financial institutions and by extension reduction in profits (De Young and Roland, 2001; Dziobek, 1998; Uyemura and Van Deventer, 1992). Credit risk is the possibility that the actual return on an investment or loan extended will deviate from that, which was expected (Conford, 2000). Coyle (2000) defines credit risk as losses from the refusal or inability of credit customers to pay what is owed in full and on time.

The main sources of credit risk include, limited institutional capacity, inappropriate credit policies, volatile interest rates, poor management, inappropriate laws, low capital and liquidity levels, directed lending, massive licensing of banks, poor loan underwriting, reckless lending, poor credit assessment. , no non-executive directors, poor loan underwriting, laxity in credit assessment, poor lending practices, government interference and inadequate supervision by the central bank.

To minimize these risks, it is necessary for the financial system to have; well-capitalized banks, service to a wide range of customers, sharing of information about borrowers, stabilization of interest rates, reduction in non-performing loans, increased bank deposits and increased credit extended to borrowers. Loan defaults and nonperforming loans need to be reduced (Bank Supervision Annual Report, 2006; Laker, 2007; Sandstorm, 2009).

The key principles in credit risk management are; firstly, establishment of a clear structure, allocation of responsibility and accountability, processes have to be prioritized and disciplined, responsibilities should be clearly communicated and accountability assigned thereto (Lindergren, 1987). According to the Demirguc-Khunt and Huzinga (1999), the overwhelming concern on bank credit risk management is two-fold. First, the Newtonian reaction against bank losses, a realization that after the losses have occurred that the losses are unbearable.

Secondly, recent development in the field of financing commercial paper, securitization, and other non-bank competition have pushed banks to find viable loan borrowers. This has seen large and stable companies shifting to open market sources of finance like bond market. Organizing and managing the lending function in a highly professional manner and doing so pro-actively can minimize whatever the degree of risk assumed losses.

Banks can tap increasingly sophisticated measuring techniques in approaching risk management issues (Gill, 1989). 2 Technological developments, particularly the increasing availability of low cost computing power and communications, have played an important supporting role in facilitating the adoption of more rigorous credit risk, implementation of some of these new approaches still has a long way to go for the bulk of banks.

The likely acceleration of change in credit risk management in banks is viewed as an inevitable response to an environment where competition in the provision of financial services is increasing and, thus, need for banks and financial institutions to identify new and profitable business opportunities and properly measure the associated risks, is growing (Lardy, 1998; Roels et. al. 1990). Inevitably, as banks improve their ability to assess risk and return associated with their various activities, the nature and relative sizes of the implicit internal subsidies will become more transparent.

Brown and M anassee (2004) observe that credit risk arose before financing of business ventures. The bible is hostile to credit by stating that one should not let the sun go down on an unpaid wage. Banks and other intermediaries can transfer the payment delays and the credit risk among producers, or between producers and outside investors (Demirguc-kunt and Huzinga, 2000). While the commercial banks have faced difficulties over the years for a multitude of reasons, the major cause of serious financial problems

continues to be directly related to credit standards for borrowers, poor portfolio risk management or lack of attention to changes in the economic circumstances and competitive climate (Central Bank Annual Supervision Report, 2000). The credit decision should be based on a thorough evaluation of the risk conditions of the lending and the characteristics of the borrower. Numerous approaches have been developed for incorporating risk into decision-making process by lending organizations.

They range from relatively simple methods, such as the use of subjective or informal approaches, to fairly complex ones such as the use of computerized simulation models (M ontes-Negret, 1998; CBK Annual Supervision Report, 2000). According to Saunders (1996), banks need to gather adequate information about potential customers to be able to calibrate the credit risk exposure. The information gathered will guide the bank in assessing the probability of borrower default and price the loan accordingly.

M uch of this information is gathered during loan documentation. The bank should however go beyond information provided 3 by the borrower and seek additional information from third parties like credit rating agencies and credit reference bureaus (Simson and Hempel, 1999). Credit risk management is defined as identification, measurement, monitoring and control of risk arising from the possibility of default in loan repayments (Early, 1996; Coyle, 2000).

Credit extended to borrowers may be at the risk of default such that whereas banks extend credit on the understanding that borrowers will repay their loans, some borrowers usually default and as a result, banks income decrease due to the need to provision for the loans. Where commercial banks do not have an indication of what proportion of their borrowers will default, earnings will vary thus exposing the banks to an additional risk of variability of their profits. Every financial institution bears a degree of risk when the institution lends to

business and consumers and hence experiences some loan losses when certain borrowers fail to repay their loans as agreed. Principally, the credit risk of a bank is the possibility of loss arising from non-repayment of interest and the principle, or both, or non-realization of securities on the loans. Risks exposed to commercial banks threaten a crises not only in the banks but to the financial market as a whole and credit risk is one of the threats to soundness of commercial banks. To minimize credit risk, banks are encouraged to use the “know your customer” principle as expounded by the Basel Committee on Banking Supervision.

((Kunt-Demirguc and Detragiache, 1997; Parry, 1999; Kane and Rice, 1998). Subjective decision-making by the management of banks may lead to extending credit to business enterprises they own or with which they are affiliated, to personal friends, to persons with a reputation for non-financial acumen or to meet a personal agenda, such as cultivating special relationship with celebrities or well connected individuals. A solution to this may be the use of tested lending techniques and especially quantitative ones, which filter out subjectivity (Griffith and Persuad, 2002).

Banks have credit policies that guide them in the process of awarding credit. Credit control policy is the general guideline governing the process of giving credit to bank customers. The policy sets the rules on who should access credit, when and why one should obtain the credit including repayment arrangements and necessary collaterals. The method of assessment and evaluation of risk of each prospective applicant are part of a credit control policy (Payle, 1997). 4 A firm’s credit policy may be lenient or stringent.

In the case of a lenient policy, the firm lends liberally even to those whose credit worthiness is questionable. This leads to high amount of borrowing and high profits, assuming full collections of the debts owed. With the stringent credit policy, credit is restricted to carefully determined customers through credit appraisal system. This minimizes costs and losses from bad debts but might reduce revenue earning from loans, profitability and cash flow (Bonin and Huang, 2001). Fisher (1997), Early (1996) and Greuning and Bratanovic

(1999) observe that the lending policy should be in line with the overall bank strategy and the factors considered in designing a lending policy should include; the existing credit policy, industry norms, general economic condition and the prevailing economic climate. The guiding principle in credit appraisal is to ensure that only those borrowers who require credit and are able to meet repayment obligations can access credit. Lenders may refuse to make loans even though borrowers are willing to pay a higher interest rate, or, make loans but restrict the size of loans to less than the borrowers would like to borrow (M ishkin, 1997).

The argument is that credit should be made available according to repayment capability based on current performance. Seppala et. al (2001) and Flannery and Ragan (2002) argue that a sound credit policy would help improve prudential oversight of asset quality, establish a set of minimum standards, and to apply a common language and methodology (assessment of risk, pricing, documentation, securities, authorization, and ethics), for measurement and reporting of non-performing assets, loan classification and provisioning.

The credit policy should set out the bank’s lending philosophy and specific procedures and means of monitoring the lending activity (Polizatto, 1990; Popiel, 1990). According to Simonson et al (1986), sound credit policy would help improve prudential oversight of asset quality, establish a set of minimum standards, and to apply a common language and methodology (assessment of risk, pricing, documentation, securities, authorization, and ethics), for measurement and reporting of non-performing assets, loan classification and provisioning.

The credit policy should set out the bank’s lending philosophy and specific procedures and means of monitoring the lending activity. The guiding principle in credit appraisal is to ensure that only those borrowers who require credit and are able to meet 5 repayment obligations can access credit. Lenders may refuse to make loans even though borrowers are willing to pay a higher interest rate, or, make loans but restrict the size of loans to less than the borrowers would like to borrow (M ishkin, 1997). Financial institutions engage in the second form of credit rationing to reduce their risks.

The lending policy should be in line with the overall bank strategy and the factors considered in designing a lending policy should include; the existing credit policy, industry norms, general economic condition in the country and the prevailing economic climate. According to Simonson et al (1986), sound credit policy would help improve prudential oversight of asset quality, establish a set of minimum standards, and to apply a common language and methodology (assessment of risk, pricing, documentation, securities, authorization, and ethics), for measurement and reporting of non-performing assets, loan classification and provisioning.

The credit policy should set out the bank’s lending philosophy and specific procedures and means of monitoring the lending activity. Credit control policy is the general guideline governing the process of giving credit to bank customers. The policy sets the rules on who should access credit, when and why one should obtain the credit including repayment arrangements and necessary collaterals. The method of assessment and evaluation of risk of each prospective applicant are part of a credit control policy.

The board and management should establish policies and procedures which ensure that the bank has a well documented credit granting process, a strong portfolio management approach, prudent limits, effective credit review and loan classification procedures and an appropriate methodology for dealing with problem exposures. The credit policy should set out the bank’s lending philosophy and specific procedures and means of monitoring the lending activity. Because lending represents the central activity of banks and underpins their profitability, loan pricing tends to be the focal point of both revenues and costs.