IMPLEMENTATION OF CREDIT RATING A SURVEY OF COMMERCIAL BANKS IN KENYA

BY AMOLLO ERIC REG

TABLE OF CONTENTS
CHAPTER ONE: INTRODUCTION..........................................................................................1 1.0 Background............................................................................................................................1 Credit Rating................................................................................................................................2
1.1.1 Credit Rating Agencies............................................................................................3 1.1.2 The Banking Industry in Kenya................................................................................5

Statement of the Problem.............................................................................................................6 1.3 Objectives of the study...........................................................................................................7

1.3.1 General Objective....................................................................................................7 1.3.2 Specific Objectives..................................................................................................7

1.4 Research Questions................................................................................................................7 1.5 Significance of the Study.......................................................................................................8 CHAPTER TWO: LITERATURE REVIEW.............................................................................9 2.0 Introduction............................................................................................................................9 2.1 History of credit rating in Kenya...........................................................................................9 2.2 The Credit Rating Process....................................................................................................11 2.3 Credit Risk Management Strategies.....................................................................................13 2.4 Effects of Credit Rating.......................................................................................................14 2.5 Empirical Studies.................................................................................................................16 CHAPTER THREE: RESEARCH METHODOLOGY..........................................................18 3.0 Introduction..........................................................................................................................18 3.1 Research Design...................................................................................................................18 3.2 Study Population..................................................................................................................18 3.3 Data Collection....................................................................................................................19 3.4 Data Analysis.......................................................................................................................19 REFERENCES............................................................................................................................20 APPENDICES..............................................................................................................................23 Appendix 1: Questionnaire........................................................................................................23 Appendix 2: List of Banks .......................................................................................................24

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CHAPTER ONE: INTRODUCTION 1.0 Background

The concept of credit is one that existed and was in use almost as long as there has been civilization. It predates, by a considerable length of time the use of money, and written references to it appear as far back as in the code of Hammurabi, established around 1750 B.C. From its beginnings, credit has been used as a selling tool, to bind customers to a particular vendor and allow them to acquire more substantial goods for which they do not have the necessary capital (Mandell, 1994). The power theory of credit emphasizes that financial institutions would be more willing to extend credit if, in case of default, they could easily enforce contracts by forcing repayment or seizing collateral. The amount of credit in a country would then depend to some extent on the existence of legislation that protects the creditor rights on the quality procedures that lead to repayment. Credit ratings have become a widely accepted measure of firms creditworthiness in financial markets. Despite the significant growth of rating agencies, with a continuous reliance on credit ratings by regulators, investors and firms, prior academic literature generally tends to underestimate the relevance of credit ratings in firms financial decision-making. Credit rating has been defined in different ways: Admin (2008) defines it as the degree of credit worthiness assigned to an individual based on the credit history and financial status. Credit rating also assesses the credit worthiness of a country and corporation. A credit rating is a simple number which many lenders use to determine whether or not they will give a loan or line of credit to an individual. One's credit rating is impacted by a number of factors, some of which are controllable, others of which are not. It helps lenders or investors to know if the subject will be able to pay back a loan and can also be used to adjust the insurance premium, to determine employment eligibility and establish the amount of utility or leasing deposit. There are different ways in which the financial institutions can get information about an individual who wants a loan which include application form which gives information on an individuals salary, family size, reasons for loan and also past dealings

with the bank, the credit references agency files helps the bank to obtain information such as the court records, financial data, fines, medical history, any default in payments more than six years ago. The effects of credit ratings can be felt in almost every aspect of life. From jobs to purchases, your
ability to obtain the job or goods that you want may be thwarted if your credit rating is too low. With a good credit rating, you have more access to savings, financing and job opportunities.

High credit scores help you secure your future financial stability. With a high credit score, you are able to pay less for insurance, housing and many purchases that require financing. This extra money can be invested at a higher rate than people with low credit scores. Between the savings and the increased savings rate, you are able to build your retirement nest egg faster and can save more to use for future expenses and emergencies.

Credit Rating
Credit rating in Kenya is done by financial institutions and Banks as they give credit to customers through loans or credit cards. The banking industry in Kenya uses the credit reference bureau results as one of the rating parameter. There are two main ways that credit rating in Kenya is done; the individual judgement method and credit scoring or rating method. Under the individual judgement method the bank relies on the staffs who are rating the application for the loan to use their good judgement. Credit rating staffs are aided in arriving at their decision by a list with checks and balances. The pros are weighted against the cons on the check list and the staffs make decisions. The staffs also consider the risks of having the applicant as a customer of their institution. The staff may compare an application against another application of the same category to assist him or her arrive at a decision. The credit scoring or rating method does not rely a lot on the staff judgement as it is a statistical method. The applicant submits their application to the financial institution for review. The credit rating staffs use manual or automated systems which score the application. The rating form is something that is agreed in the financial institution and risk unit has to be involved. The banks try to address as many risk issues as they can in the rating sheet. The applicant is rated on where they work, their marital status, age, whether they own the home where they live and salary they

earn. These rating criteria are dependent on the financial institution. There are many more criteria on which to base credit rating in Kenya. After the staffs have completed inputting the information from the application form to the rating sheet form, a rate is given. The rating method has less individual errors and biases. There is also increased and enhanced precision in credit rating. The method is sometimes thought to be rigid. To overcome this problem, the credit rating staffs have over-ride rights to the rating system and the decision can be over-ruled. This over ride has to be approved by a supervisor. The credit scores range from 200 to 900 with mid-point at 400; while a score of 200 is considered poor, that of 900 is considered excellent. The importance of credit rating and scoring of each application that is received in a bank cannot be ignored. In some countries, there are companies that do the credit rating and one can pay to get their rating for credit cards or loans. Credit scoring and Credit rating in Kenya is still developing and the score sheets keep changing (Campbell, 2007).

1.1.1 Credit Rating Agencies

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness and affects the interest rate applied to the particular security being issued. In contrast to CRAs, a company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency. The Capital Markets Authority Act (Cap 485), which was passed in 1989, recently released guidelines for the establishment of credit rating agencies in Kenya to provide an independent assessment of the credit risk of issuers of securities and financial instruments. All issuers of commercial paper and corporate bonds must now be rated on the basis of an objective and independent opinion on the general creditworthiness of an issuer of a debt instrument and its
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ability to meet its obligations in a timely manner over the life of the financial instrument, based on relevant risk factors including the ability of the issuer to generate cash in the future. At present the authority has licensed only one credit rating agency and is interested in further applications. The following names have been specifically referred to in the guidelines as being the kind of agencies the authority is interested in: Standard and Poor, Moody's, Thomson Bank Watch and Fitch IBCA. CBK awarded the first license to Nairobi-based Credit Reference Bureau-Africa (CRB-Africa), which operates in 12 African countries. This opened a new chapter in the way loans are structured and priced in the country. Two more licenses will be issued to Metropol East Africa and South Africas Compuscan. The bureau collects information on borrowing and paying habits of institutions or individuals, and supplies it to financial institutions. The information is essential in determining the level of interest rate to charge a borrower based their credit history. Such information will allow banks to reward faithful customers those who have a history of paying their debts on time-by competitively pricing their interest rates and reducing the premium risk which is associated with not knowing their credit history. This information enables financial institutions to competitively price loans and lend to individuals who do not have collateral in the form of property. For borrowers, the new trend will see them access low-priced loans as banks move away from the current trend where security in the form of property is the order of the day to when costing of loans is based on past repayment habits. With information on the repayment habits, banks will also be able to include small and medium enterprises seeking loans for business expansion, but which have not been able to access credit due to obsession with collateral in the form of property. Financial institutions will willingly lend to the low income earners, who have traditionally been viewed as risky due to absence of information on their credit worthiness and a loan repayment habits. Credit experts say the development, however, spell doom for serial loan defaulters who normally access loans from banks, without providing their credit history, because banks will have already known who they are dealing with, but for faithful borrowers, their credit history will make it easy for banks to lend to them. It will be now mandatory for all financial institutions to report all
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cases reference bureaus raising the questions of possibility of data espionage as banks normally holds such in information in great secrecy.

1.1.2 The Banking Industry in Kenya

The banking sector in Kenya is governed by the companys Act, the Banking Act and the Central bank Act and the various prudential guidelines issued by Central Bank of Kenya. The Central Bank of Kenya is responsible for formulating and implementing monetary policy directed to achieving stability in the general level of prices and fosters the liquidity, solvency and proper functioning of a stable market based financial system while supporting the economic policy of the Government (Central Bank of Kenya, 2011). As at 31st December 2011, the banking sector comprised of the Central Bank of Kenya, as the regulatory authority, 44 banking institutions (43 Commercial banks and 1 Mortgage finance company), 2 representative offices of foreign banks, 5 Deposit-Taking Microfinance Institutions and 126 Forex Bureaus. 31 of the banking institutions are locally owned while 13 are foreign owned. The locally owned financial institutions comprise of 3 banks with public shareholding, 27 privately owned commercial banks, 1 mortgage finance company while 5 Deposit-Taking Microfinance Institutions and 126 forex bureaus are privately owned (Central Bank of Kenya, 2011). The foreign owned financial institutions comprise of nine locally incorporated foreign banks and four branches of foreign incorporated banks. The sector was dominated by local private institutions with 27 institutions accounting for 58 percent of the industrys total assets and 64 percent of total financial institutions. The foreign owned financial institutions were 13 and accounted for 37 percent of the industrys total assets as at 31st December 2011 and 36 percent of total number of financial institutions. Multinational banks play an important role of intermediation in the economy which is vital for the smooth and efficient running of the economy (Central Bank of Kenya, 2011). Commercial banks in Kenya have continued to embrace the use of the internet as a remote delivery channel for banking services. The most common online services include; viewing of accounts, inquiries and requests, salary payments, clearing cheques status query, instant alerts of account status and transfer of funds. The microfinance industry in Kenya is also experiencing positive growth and change. Microfinance has over the years evolved from charity based social and financial empowerment programmes to fully operational financial institutions, which
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continue to contribute towards bridging the gap of financial inclusion. Further, the microfinance sector is witnessing increased interest from commercial banks (Central Bank of Kenya,2011).

Statement of the Problem

Banks that have adopted credit rating have realized significant increases in small business and micro business loans in the total lending portfolio. The use of credit rating is not universal with about 47 percent of banks surveyed using some form of credit scoring for small business lending (Cowan et al., 2006). Small firms have experienced shrinking of credit availability with the use of credit rating (Andrew, 2005). However, small businesses in the US are not necessarily disadvantaged in accessing credit due to the use of credit rating (Berger et al., 2005). Credit rating therefore has the potential to offer a number of benefits which can improve access to credit for both firms and individuals. Reichert et al (1983) is not convinced of the predictive ability of credit scoring approaches and finds that the benefit received from credit rating may merely relate to the objective and efficient manner in which predictions are made. He does not believe that the scoring methods have much superiority by their own in predicting the probability of default. According to Beattie (2008) credit rating is a major effect in a persons life when you want a loan and he goes ahead and gives an example of credit rating agency used in the USA that has a score of 300-500 and that the average score of an American is 650-750. He mainly concentrates with the developed countries banks and other financial institutions. Information on the extent of use of credit rating practices by commercial banks is nonexistent. Mutie (2006) conducted a study to establish the relationship between credit rating practices by Kenyan banks and the level of non-performing loans. Cowan et al (2006), conducted a survey of several SMEs who were bank customers in downtown Nairobi. They found that effectively developed and managed credit scoring would help meet their needs in a variety of ways. Some of the ways that credit scoring would meet their needs included: the reduction of reliance on collateral, risk-based pricing that may lower their interest rates and greater credit availability for higher-risk customers, who, without risk-based pricing, would simply be denied loans. In addition, turn-around times from application to approval and funding would likely decrease. Finally, as lenders become more confident in scorings accuracy, risk-adjusted approval rates may increase.

This study would be different from the ones mentioned above in that it seeks to establish the extent to which commercial banks in Kenya have implemented the credit rating system. The study will also seek to determine the impact credit rating has had on the performance of the commercial banks. This will be measured in terms of improved credit management and reducing the default levels and risk of non-performing loans.

1.3 Objectives of the study

1.3.1 General Objective
To establish the extent to which commercial banks in Kenya have implemented credit rating systems.

1.3.2 Specific Objectives

i.

To determine the credit rating systems used by the Kenyan commercial banks to approve loans to individuals

ii.

To determine how credit rating affects loan approval of an individual by the Kenyan commercial banks

iii.

To establish the impact of credit rating on the performance of commercial banks in Kenya

1.4 Research Questions

The following are the research questions for this study:
1. What credit rating system do the Kenyan commercial banks use?

2. How does credit rating affect an individuals loan approval by the banks in Kenya?
3. What impact does credit rating have on the performance of commercial banks in Kenya?

1.5 Significance of the Study

The findings of this study will be of great value to the banks management in understanding the effectiveness of the credit rating system that they are currently using. The study will shed more light on whether the credit rating system being applied has had a positive impact in reducing loan approval time, reducing credit risk and default levels. The banks management will also be able to use the study to consider whether to revamp the credit rating system or complement it with other information sources. To the individual borrower, the study will help in understanding how banks assess their creditworthiness. The borrowers will also know what type of information banks look for to determine whether or not they should be loaned and even how much and for how long they should be loaned. This will help them manage their credit history so as to avoid problems in future of when borrowing from banks. This study may also be useful to credit rating agencies who are engaged in collecting processing credit information for both individual and corporate borrowers. The agencies will understand how banks are rating their customers and take advantage of the loopholes and weaknesses to boost their business. The study also aims at contributing to this body of knowledge which is still under researched in Kenya. For the scholars and researchers the study will provide a base on which
future studies can be conducted on a similar concept but on a different context.

CHAPTER TWO: LITERATURE REVIEW 2.0 Introduction

This chapter considers literature relevant to the subject under study. The main issues under review are; the history of credit rating in Kenya, credit rating process, the credit rating models and the effects of credit rating. This section also looks at empirical studies done on the topic of credit rating in order to find the gaps which this study will fill.

2.1 History of credit rating in Kenya

In the mid 90s there was a wakeup call as major banks struggled with non performing loans which were greatly affecting their bottom line. The government of Kenya had to bailout some banks where it was the major shareholder to prevent obvious closure. This resulted in a great debate in Parliament and some defaulters ended up being mentioned in Public. So when the suggestion to have a Credit Rating Bureau was made many welcomed the idea. The banking system remained relatively stable in 1999 compared to 1998 when five commercial banks were placed under statutory management by the Central Bank. Measures put in place by the Central Bank to rescue the banks under statutory management continued successfully. As a result, one bank previously under statutory management was reopened for business. The depositors formed committees to assist the liquidation agents in restructuring the remaining banks under statutory management.

Personal Credit rating in Kenya compiles and maintains an individuals credit history and aims at evaluating the ability of the potential borrower to repay a loan. It is a recognized evaluation of an individuals repayment ability based on financial transactions carried on in the past, that is, credit worthiness of an individual. This credit worthiness is essentially determined through statistical analysis of the available credit data.

With introduction of products by the banks such as unsecured personal loans, mortgages, and unsecured overdrafts, it was important for banks to have good credit rating system. Personal Credit rating in Kenya is still not yet fully functional because most data is still being collected. Banks are still using their own Credit Scoring models. An individuals credit score affects his or her ability to borrow money through the banks. To further strengthen the banking system and enhance surveillance in the industry, the Central Bank took the following actions:
i)

Bank Supervision Department was strengthened to enhance closer surveillance aimed at detecting banking problems early enough so as to take preventive action. Guidelines for risk classification of loans were revised and issued to facilitate better credit risk assessment. The Bank continued to encourage formation of credit reference and credit rating agencies in order to enhance credit risk assessment. The first credit reference bureau was launched in February 1999 and a credit rating agency has also started operations. A circular in respect of borrowing by directors of banking institutions requiring their loans to be at commercial rates was issued.

ii)

iii)

iv)

A system of vetting directors and chief executives of banks prior to being appointed was implemented. The disclosure of the financial performance was enhanced as a way of ensuring better market discipline. The banks are now required to publish non-performing loans as well as facilities to directors.

v)

The Banking Act was amended further in 1999 so as to be in tandem with the regional and international banking regulations as follows:
i)

A capital requirement was adopted in order to be in line with the Basle Committee Accord and International Supervisory practice. Restrict advances, credit and guarantees to or in form of an insider or associate in excess of 20% of core capital of the banking institutions. Central Bank may prescribe limits on the preparation of core capital that may be invested in purchase or acquisition of land.
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ii)

iii)

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Institutions to disclose to the Central Bank the full particulars of the individuals who hold shares in the banking institutions.

2.2 The Credit Rating Process

Every bank before granting credit should assess the creditworthiness of the borrower. It means a persons ability to repay instalments in a specific amount. The result of the test is to determine the maximum monthly instalment, which the candidate is able to pay. Bank evaluates the creditworthiness, taking into account two main factors: - Fixed monthly income; - Monthly maintenance costs - the costs incurred on a monthly basis to ensure normal operation (rent, electricity, water, telephone, etc.). In addition, the creditworthiness may be affected by a variety of other factors, such as residence, place of work, property ownership, number of persons in the household, etc. The notion "creditworthiness" can be defined as a presumed ability to meet agreed deadlines related to repaying the credit and the interest accrued without affecting the vitality of the borrower, i.e. the repayment process should be based on the income received in the process of the borrower's usual activity, without affecting adversely his financial situation, his financial results as well as other business entities. An important point in conducting the credit activity is the thorough analysis of the business activity and the income received in this business activity is taken as a fulcrum. It is necessary that a number of conditions be observed, namely:
i) ii)

The credit extended as an absolute value should meet the real needs of the borrower; The credit period should correspond exactly to the circulation speed of the resources for the securing of which it has been extended; The profitability of the borrower's business activity should entirely cover the credit amount, the interest rate, the charges and the risks, calculated in the credit analysis.

iii)

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The analysis of the creditworthiness involves preliminary study of the factors and prerequisites which can affect adversely the duly repayment of the credit1. It is of high importance that bank specialists demonstrate competence and conscientiousness. Banks have at their disposal various ways for choosing suitable borrowers to be financed and for exercising control over the special purpose of the credit resources and their expedient and efficient spending. The in-depth study of the financial situation of the loan applicant does not harm the good relations between him and the bank. Establishing firm grounds for the credit relations is seen as an inherent characteristic element of the credit activity. The study of the financial situation, which is carried out by qualified and experienced bank experts, may disclose a number of shortcomings which until that moment have been unknown to the administrative and managerial staff and in this way the study can turn out to be extremely useful for the loan applicant too. If the commercial bank does not have staff that is well qualified and capable of carrying out a comprehensive and systematic economic analysis of the financial stability and creditworthiness of the potential borrowers, it is advisable that they use the services of a specialized company. This conclusion stems from the significance of the analysis of the creditworthiness, which is of utmost importance in taking decisions concerning the credit that has been applied for and is of great importance to the credit institution (Stoyanov, 2008).

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2.3 Credit Risk Management Strategies

The credit risk management strategies are measures employed by banks to avoid or minimize the adverse effect of credit risk. A sound credit risk management framework is crucial for banks so as to enhance profitability guarantee survival. According to Lindergren (1987), the key principles in credit risk management process are sequenced as follows; establishment of a clear structure, allocation of responsibility, processes have to be prioritized and disciplined, responsibilities should be clearly communicated and accountability assigned. The strategies for hedging credit risk include but not limited to these; i. Credit Derivatives: This provides banks with an approach which does not require them to adjust their loan portfolio. Credit derivatives provide banks with a new source of fee income and offer banks the opportunity to reduce their regulatory capital (Shao and Yeager, 2007). The commonest type of credit derivative is credit default swap whereby a seller agrees to shift the credit risk of a loan to the protection buyer. Frank Partnoy and David Skeel in Financial Times of 17 July, 2006 said that credit derivatives encourage banks to lend more than they would, at lower rates, to riskier borrowers. Recent innovations in credit derivatives markets have improved lenders abilities to transfer credit risk to other institutions while maintaining relationship with borrowers (Marsh, 2008). ii. Credit Securitization: It is the transfer of credit risk to a factor or insurance firm and this relieves the bank from monitoring the borrower and fear of the hazardous effect of classified assets. This approach insures the lending activity of banks. The growing popularity of credit risk securitization can be put down to the fact that banks typically use the instrument of securitization to diversify concentrated credit risk exposures and to explore an alternative source of funding by realizing regulatory arbitrage and liquidity improvements when selling securitization transactions (Michalak and Uhde,2009). A cash collateralized loan obligation is a form of securitization in which assets (bank loans) are removed from a banks balance sheet and packaged (tranched) into marketable securities that are sold on to investors via a special purpose vehicle (SPV) (Marsh,2008). iii. Compliance to Basel Accord: The Basel Accord are international principles and regulations guiding the operations of banks to ensure soundness and stability. The Accord was introduced in 1988 in Switzerland. Compliance with the Accord means being able to identify, generate, track and report on risk-related data in an integrated manner, with full auditability and transparency
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and creates the opportunity to improve the risk management processes of banks. The New Basel Capital Accord places explicitly the onus on banks to adopt sound internal credit risk management practices to assess their capital adequacy requirements (Chen and Pan,2012). iv. Adoption of a sound internal lending policy: The lending policy guides banks in disbursing loans to customers. Strict adherence to the lending policy is by far the cheapest and easiest method of credit risk management. 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 conditions of the country and the prevailing economic climate (Kithinji,2010). v. Credit Bureau: This is an institution which compiles information and sells this information to banks as regards the lending profile of a borrower. The bureau awards credit score called statistical odd to the borrower which makes it easy for banks to make instantaneous lending decision. Example of a credit bureau is the Credit Risk Management System (CRMS) of the Central Bank of Nigeria (CBN).

2.4 Effects of Credit Rating

The risks that are most applicable to banks risk are: credit risk, interest rate risk, liquidity risk, market risk, foreign exchange risk and solvency risk. Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources (Appa, 1996) whereas credit risk is the risk of loss due to debtors non-payment of a loan or other line of credit (either the principal or interest or both) (Campbell, 2007). Default rate is the possibility that a borrower will default, by failing to repay principal and interest in a timely manner. A bank is a commercial or state institution that provides financial services, including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creating of credit (Campbell, 2007). Credit rating is very important to banks as it is an integral part of the loan process. It maximizes bank risk, adjusted risk rate of return by maintaining credit risk exposure with view to shielding the bank from the adverse effects of credit risk. Bank is investing a lot of funds in credit risk management modeling. Prior to financial sector deregulation, banks were highly motivated to grant credit facility to clients who could easily express their creditworthiness (Bryant, 1999). Deregulation offered the opportunity
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to meet the demands for credit across a wide range of borrowers. Large amount of bad credit, as a result of boom-time advances in the 1980s, caused the banks to be too cautions in extending credit (Boyd, 1993; Bryant, 1999). Credit rating processes enforce the banks to establish a clear process for approving new credit as well as for the extension to existing credit. These processes also follow monitoring with particular care, and other appropriate steps are taken to control or mitigate the risk of connected lending (Basel, 1999). Credit granting procedure and control systems are necessary for the assessment of loan application, which then guarantees a banks total loan portfolio as per the banks overall integrity (Boyd, 1993). It is necessary to establish a proper credit risk environment, sound credit granting processes, appropriate credit administration, measurement, monitoring and control over credit risk, policy and strategies that clearly summarize the scope and allocation of bank credit facilities as well as the approach in which a credit portfolio is managed i.e. how loans are originated, appraised, supervised and collected, a basic element for effective credit risk management (Basel, 1999). Credit scoring procedures, assessment of negative events probabilities, and the consequent losses given these negative migrations or default events, are all important factors involved in credit risk management systems (Altman, Caouette, & Narayanan, 1998). Most studies have been inclined to focus on the problems of developing an effective method for the disposal of these bad debts, rather than for the provision of a regulatory and legal framework for their prevention and control (Campbell, 2007).

The banks very frequently suffer from poor lending practice (Koford & Tschoegl, 1999). Monitoring, and other appropriate steps, are necessary to control or mitigate the risk of connected lending when it goes to companies or individuals (Basel, 1999). Therefore, the Nepal Rastra Bank (NRB) i.e. central bank, has issued guidelines which attention to general principles that are prepared for governing the implementation of more detailed lending procedures and practices within the banks. The NRB has issued some criteria, such as the credit assessment of borrowers (macro-economic factors and firm specific analysis), the purpose of credit, track records, repayment capacity, liquidity status of collateral for new credit, as well as the renewal and expansion of existing credit (NRB, 2010). It is mandatory for a bank to prepare Credit Policies Guidelines (CPG) for making investment and lending decisions and which reflect a bank tolerance for credit risk. Prior to consent to a credit

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facility, the bank should make an assessment of risk profile of its customers, such as of their business, and which can be done through the credit procedure (NRB, 2010).

2.5 Empirical Studies

Credit risk is a serious threat to the performance of banks; therefore various researchers have examined the impact of credit risk on banks in varying dimensions. Kargi (2011) evaluated the impact of credit risk on the profitability of Nigerian banks. Financial ratios as measures of bank performance and credit risk were collected from the annual reports and accounts of sampled banks from 2004-2008 and analyzed using descriptive, correlation and regression techniques. The findings revealed that credit risk management has a significant impact on the profitability of Nigerian banks. It concluded that banks profitability is inversely influenced by the levels of loans and advances, non-performing loans and deposits thereby exposing them to great risk of illiquidity and distress. Epure and Lafuente (2012) examined bank performance in the presence of risk for Costa-Rican banking industry during 1998-2007. The results showed that performance improvements follow regulatory changes and that risk explains differences in banks and nonperforming loans negatively affect efficiency and return on assets while the capital adequacy ratio has a positive impact on the net interest margin. Kithinji (2010) assessed the effect of credit risk management on the profitability of commercial banks in Kenya. Data on the amount of credit, level of non-performing loans and profits were collected for the period 2004 to 2008. The findings revealed that the bulk of the profits of commercial banks are not influenced by the amount of credit and non-performing loans, therefore suggesting that other variables other than credit and non-performing loans impact on profits. Chen and Pan (2012) examined the credit risk efficiency of 34 Taiwanese commercial banks over the period 2005-2008. Their study used financial ratio to assess the credit risk and was analyzed using Data Envelopment Analysis (DEA). The credit risk parameters were credit risk technical efficiency (CR-TE), credit risk allocative efficiency (CR-AE), and credit risk cost efficiency (CR-CE). The results indicated that only one bank is efficient in all types of efficiencies over the evaluated periods.

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Overall, the DEA results show relatively low average efficiency levels in CR-TE, CR-AE and CR-CE in 2008. Felix and Claudine (2008) investigated the relationship between bank performance and credit risk management. It could be inferred from their findings that return on equity (ROE) and return on assets (ROA) both measuring profitability were inversely related to the ratio of non-performing loan to total loan of financial institutions thereby leading to a decline in profitability. Ahmad and Ariff (2007) examined the key determinants of credit risk of commercial banks on emerging economy banking systems compared with the developed economies. The study found that regulation is important for banking systems that offer multi-products and services; management quality is critical in the cases of loan-dominant banks in emerging economies. An increase in loan loss provision is also considered to be a significant determinant of potential credit risk. The study further highlighted that credit risk in emerging economy banks is higher than that in developed economies. Al-Khouri (2011) assessed the impact of banks specific risk characteristics, and the overall banking environment on the performance of 43 commercial banks operating in 6 of the Gulf Cooperation Council (GCC) countries over the period 1998-2008. Using fixed effect regression analysis, results showed that credit risk, liquidity risk and capital risk are the major factors that affect bank performance when profitability is measured by return on assets while the only risk that affects profitability when measured by return on equity is liquidity risk. Ben-Naceur and Omran (2008) in attempt to examine the influence of bank regulations, concentration, financial and institutional development on commercial banks margin and profitability in Middle East and North Africa (MENA) countries from 1989-2005 found that bank capitalization and credit risk have positive and significant impact on banks net interest margin, cost efficiency and profitability. Ahmed, Takeda and Shawn (1998) in their study found that loan loss provision has a significant positive influence on non-performing loans. Therefore, an increase in loan loss provision indicates an increase in credit risk and deterioration in the quality of loans consequently affecting bank performance adversely.
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CHAPTER THREE: RESEARCH METHODOLOGY 3.0 Introduction

This chapter describes how data will be collected, study population, methods of data analysis so as to help establish solutions to the research questions and research objectives. Four areas will be looked at, research design, population and sampling, data collection and data analysis.

3.1 Research Design

Kothari (2004) defines research design as the management of conditions for collection and analysis of data in a manner that aims to combine relevance to the purpose with the economy in procedure. It constitutes the blueprint for collection, measurement and data analysis and answers the questions what, where, when and by what means the research was conducted. The design used will be quantitative design. This is because in quantitative research the aim is to determine the relationship between one thing (an independent variable) and other (dependent or outcome variable) in population. Such designs are either descriptive study which establishes any association between variables or experimental which establishes causalities. Descriptive study involves collection of data in order to test hypothesis or answering research questions concerning the status of the subject in the study. Descriptive study design also helps in thinking systematically about aspects or factors in a given situation and offers ideas for further probing and further research.

3.2 Study Population

The population of this study will consist of all the commercial banks in Kenya. According to Central Bank of Kenya (CBK 2012), there are 43 licensed commercial banks and 1 mortgage finance company (see appendix 3 for full list). A census survey study is recommended so as to cover the entire population of commercial banks in Kenya.

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3.3 Data Collection

Primary data will be collected through questionnaires which will be dropped to the finance departments of various commercial banks to be filled in by the staff and collected later once completed. The study will also make use of secondary data to gather more information from past researches, commercial banks magazines, journals and the internet. Each bank will be given one questionnaire. An introduction and explanation letter will also be attached to the questionnaire to explain to the respondents the purpose of the study as well as assuring them of confidentiality of information provided. Due to likelihood of a poor questionnaire return rate, the researcher will also follow up the respondents through telephone and assist them to fill the questionnaire where there are clarifications needed.

3.4 Data Analysis

This is where the collected data will be managed and examined so as to address the research questions. It will involve verifying the completeness of the collected data, its accuracy and if it is related to topic in question. Then a summary of presentation of the result and interpretation of the findings will be done to finally come up with conclusions. The data collected will then be analyzed through quantitative technique of percentages after editing and coding so as to make it simple for data interpretation. This will also facilitate content analysis to analyze the data collected from the research. This will be done by looking at the different responses from the questionnaires and drawing relevant conclusions about the research questions according to the realized percentages.

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Andrew, J. (2005). Corporate Credit and the End of Relationship Lending, Journal of Credit Control, 24-28 Ahmed, A.S., Takeda, C. and Shawn, T. (1998). Bank Loan Loss Provision: A Reexamination of Capital Management and Signaling Effects, Working Paper, Department of Accounting, Syracuse University, 1-37. Admin, 2008, credit rating: what is credit rating, http://www.mysmp.com/bonds/creditrating.html Ahmad, N.H. and Ariff, M. (2007).Multi-country Study of Bank Credit Risk Determinants, International Journal of Banking and Finance, 5(1), 135-152. Al-Khouri, R. (2011). Assessing the Risk and Performance of the GCC Banking Sector, International Journal of Finance and Economics, ISBN 1450-2887, Issue65, 72-8. Altman, E., Caouette, J., & Narayanan, P. (1998). Credit-risk Measurement and Management: the ironic challenge in the next decade. Financial Analysts Journal, 54(1), 7-11. Appa, R. (1996). The Monetary and Financial System. London Bonkers Books Ltd. 3rd Edition

Basel Committee on Banking Supervision,(2001). Risk Management Practices and Regulatory Capital: Cross-Sectional Comparison (available at www.bis.org) Basel. (1999). Principles for the management of credit risk. Consultative paper issued by Basel Committee on Banking Supervision, Basel. Beattie, 2008, Credit rating, last modified 25 February 2009, http://en.wikipedia.org Beattie, 2008, Understanding your credit rating: Learn how bad debt habits affect loan
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Benedict, G., Ian, M., Judit, V. C., & Wolf, W. (2007). Bank Behaviour with access to credit risk transfer markets. Research Discussion Papers, 4, Bank of Finland. Ben-Naceur, S. and Omran, M. (2008). The Effects of Bank Regulations, Competition and Financial Reforms on MENA Banks Profitability, Economic Research Forum Working Paper No. 44. Bernanke, B. (1993). Credit in the Macroeconomy. Quarterly Review - Federal Reserve Bank of New York,18, 50-50. BGL Banking Report (2010). Getting Banks to Lend Again The Bankers Magazine of July 2012, publication of The Financial Times Ltd., London. Boyd, A. (1993). How the industry has changed since deregulation. Personal Investment, 11(8), 85-86. Bryant, K. (1999). The Integration of Qualitative Factors into Expert System for Evaluating Agricultural Loans Paper presented at the Australasian Conference on Information System. Cowan D.C. and Cowan M. A (2006). A survey based assessment of Financial Institution use of Credit Scoring for Small Business Lending. SBA Advocacy No. 283 Campbell, A. (2007). Bank insolvency and the problem of nonperforming loans. Journal of Banking Regulation, 9(1), 25-45. Chen, K. and Pan, C. (2012). An Empirical Study of Credit Risk Efficiency of Banking Industry in Taiwan, Web Journal of Chinese Management Review, 15(1), 1-16. Coyle, B. (2000). Framework for Credit Risk Management, Chartered Institute of Bankers, United Kingdom Demirguc-Kunt, A. and Huzinga, H. (1999). Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence, The World Bank Economic Review, 13(2), 37940. Drehman, M., Sorensen, S. & Stringa, M. (2008). The Integrated Impact of Credit and Interest Rate Risk on Banks: An Economic Value and Capital Adequacy Perspective, Bank of England Working Paper No.339 Epure, M. and Lafuente, I. (2012). Monitoring Bank Performance in the Presence of Risk, Barcelona GSE Working Paper Series No.61. Felix, A.T and Claudine, T.N (2008). Bank Performance and Credit Risk Management, Unpublished Masters Dissertation in Finance, University of Skovde.
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Kargi, H.S. (2011). Credit Risk and the Performance of Nigerian Banks, AhmaduBello University, Zaria. Kimeu T.M. (2008). A Survey of Credit Risk Management Techniques of Unsecured Bank Loans of Commercial Banks in Kenya. MBA Project; University of Nairobi. Kithinji, A.M. (2010). Credit Risk Management and Profitability of Commercial Banks in Kenya, School of Business, University of Nairobi, Nairobi. Lindgren, H. (1987). Banks, Investment Company, Banking Firms, Stockholm Enskilda Bank (1924-1945), Institute for Research in Economic History, Stockholm School of Economics, Stockholm. Mandell L., (1994). The Credit Card Industry: A History, Boston, Twayne Publishers. Marsh, I.W. (2008). The Effect of Lenders Credit Risk Transfer Activities on Borrowing Firms Equity Returns, Cass Business School, London and Bank of Finland. Michalak, T. and Uhde, A. (2009). Credit Risk Securitization and Banking Stability: Evidence from the Micro-Level for Europe, Draft, University of Bochum, Bochum. Mutie, C.M. (2006), Credit Scoring Practices & Non-Performing Loans in The Kenyan Commercial Banks. MBA Project, University of Nairobi. NRB (2010). Risk Management Guidelines. Bank Supervision Deparment, Nepal Rastra Bank, Baluwatar, Kathmandu Nepal. Partnoy, F. and Skeel, D. (2006). Financial Times of 17 July, 2000. Psillaki, M., Tsolas, I.E. and Margaritis, D. (2010). Evaluation of Credit Risk Based on Firm Performance, European Journal of Operational Research, 201(3), 873-888. Shao, Y. and Yeager, T.J. (2007). The Effects of Credit Derivatives on U.S. Bank Risk and Return, Capital and Lending Structure, Draft, Sam M. Walton College of Business, Arkansas. Reichert, A.K., Choo, C.C. and Wagner, G.M., (1983). An Examination of conceptual Issues Involved in Developing Credit Scoring Models; Journal in Business Economics and Statistics, Vol 1, Pg 98-116

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APPENDICES Appendix 1: Questionnaire

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Appendix 2: List of Banks

Commercial Banks 1.
2. 3. 4. 5. 6.

African Banking Corporation Bank Bank of Africa Bank of Baroda Bank of India Barclays Bank CFC Stanbic Bank Charterhouse bank (under statutory management) Chase Bank (Kenya) Citibank Commercial Bank of Africa Consolidated Bank of Kenya Cooperative Bank of Kenya Credit Bank Development Bank of Kenya Diamond Trust Bank Dubai Bank Kenya Ecobank Equatorial Commercial Bank Equity Bank Family Bank Fidelity Commercial Bank Limited Fina Bank First Community Bank Giro Commercial Bank Guardian Bank Gulf African Bank Habib Bank Habib Bank AG Zurich I&M Bank
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7.
8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29.

30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43.

Imperial Bank Kenya Jamii Bora Bank Kenya Commercial Bank K-Rep Bank Middle East Bank Kenya National Bank of Kenya NIC Bank Oriental Commercial Bank Paramount Universal Bank Prime Bank (Kenya) Standard Chartered Kenya Trans National Bank Kenya United Bank for Africa Victoria Commercial Bank

Mortgage Finance Companies 44. Housing Finance ltd

Source: Central Bank of Kenya - 2012

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