EFFECTS OF CREDIT REFERENCE BUREAU REGULATION ON MITIGATION OF

CREDIT RISKS IN THE DEPOSIT TAKING MICROFINANCE INSTITUTIONS IN

NAIROBI COUNTY

Anne W. Thagishu

Reg. No.:

A Research Project Proposal Submitted in Partial Fulfilment of the Requirement for the
Award of Master of Business Administration at (Name of University)

June 2015

DECLARATION
This research project proposal is my original work and has not been submitted for any award in
any other university.

Signature: .. Date: ...

Annie Thangishu
Reg. No.:

Recommendation
This research project proposal has been submitted for examination with my approval as a
university supervisor.

Signature: .. Date: ...

Names of the Supervisor?????)

Lecturer, School of XXXXXXX
Name of the University

ii
DEDICATION

iii
ACKNOWLEDGEMENT

iv
 LIST OF ABBREVIATIONS
GDP Gross Domestic Product
KATO Kenya Association of Tour Operators
KTB Kenya Tourist Board
KTDC Kenya Tourism Development Corporation
WTO World Tourism Organization

v
 ABSTRACT
Tour and travel industry is about connections, it connects people, places, and culture. It is
involved with facilitating and enhancing tourism. It is an entrepreneurial activity that ensures all
tourism activities are carried out smoothly and efficiently. This study aims at addressing the
effect of terrorism on financial performance of tour and travel operators in Nairobi City County.

vi
 TABLE OF CONTENTS
DECLARATION ii
DEDICATION iii
ACKNOWLEDGEMENT iv
LIST OF ABBREVIATIONS v
ABSTRACT vi
CHAPTER ONE 1
INTRODUCTION 1
1.1 Background of the Study 1
1.2 Research Problem 3
1.3 Purpose of the Study 4
1.4 Research Questions 4
1.5 Significance of the Study 5
1.5.1 The Government 5
1.5.3 Tour and Travel Operators 5
1.5.3 Academicians and Other Researchers 5
1.6 Scope of the Study 6
REFERENCES 7

vii
0
 CHAPTER ONE

INTRODUCTION
1.1 Background of the Study

The provision of credit facilities remains a challenging proposition in any setting particularly in
the developing world with weak legal and judicial enforcement is weak. The situation is
worsened by the fact that in the developing world, information about the ability and willingness
to repay advanced credit by applicants is not readily available (Fiebig et al., 2005). While
borrowers make a lot of effort to repay their loans, they rarely get rewarded for it because this
good repayment history is not available to the bank that they approach for new loans. At the
same time, whenever borrowers fail to repay their loans banks are forced to pass on the cost of
defaults to other customers through increased interest rates and other fees (Hermes et al., 2009).

Fiebig, M., Hannig, A., and Wisniwski, S., (2005), Savings in the Context of Microfinance.
State of Knowledge, Washington, D.C: CGAP
Hermes, N., Lensink, R., and Meesters, A., (2009), Financial Development and the Efficiency
of Microfinance Institutions, Centre for International Banking, Insurance and Finance
Working Paper, University of Groningen

Deposit taking microfinance institutions (MFIs), as lenders, are faced with credit risk as one of
the major risks in their business of lending (Okwoma, 2012). StiglitzandWeiss(2010)describeit
asthatuncertainty associated with the borrowers repayment of credit facilities from commercial
banks. Poorly managed credit risk leads to non-performing loans (NPLs) which pose a threat to
the financial profitability of an institution and can lead their eventual collapse (Gitahi 2013).
Lending is one of the key principle activities of MFIs and the loan portfolio is the largest asset
and the predominant source of revenue for the lending institutions.

Okwoma, D., (2012), The Effect of Corporate Social Responsibility on the Financial
Performance of Commercial Banks in Kenya, International Journal of Business and
Public Management, 2(3), 3740.
Stiglitz,J.E.,andWeiss,A.,(2010),CreditRationinginMarketswithImperfectInformation,
AmericanEconomicReview.
Gitahi, R., (2013), The Effect of Credit Reference Bureaus on the Level of Non-Performing
Loans in the Commercial Banks in Kenya, International Journal of Research in
Management Economics and Commerce, 3(4), 79.

The Banking (Credit Reference Bureau) Regulations, 2008 became effective in February 2009.
The regulations came about following the amendment of the Banking Act and the adoption of

1
instruments of reform when the Government of Kenya (GoK) legislated Credit Reference
Bureaus (CRBs) via legal notice No. 97 of 11 th July 2008 to be used by commercial banks. The
purpose of CRBs reforms in the banking sector was to achieve increased stability, effectiveness,
and access to financial services. Presently, the Regulations require all licensed banks, SACCOs
and MFIs to share information on NPLs through a Credit Reference Bureau (CRB) licensed by
CBK. The role of licensed CRBs is to collect, collate and process data received from approved
sources of information and generate credit reports to be used by lenders.

1.1.1 Credit Referencing

Ferretti (2006) defines Credit Reference Bureaus (CRBs) as private companies that compile
databases accessible by potential lenders to help them evaluating a consumer's credit application.
Credit referencing on the other hand is defined as a typical response to information asymmetry
problems between lenders and borrowers (Olegario 2003). CRBs provide information to
potential lenders about an applicant's credit record consisting of details of the payment and credit
history of an individual, financial accounts and the way they have been managed. They
complement the central role played by banks and other financial institutions in extending
financial services within an economy and assist lenders in making faster and more accurate credit
decisions (Padilla and Pagano, 2010). Barron and Staten (2013) argue that lenders could
significantly reduce their default rate by including more comprehensive borrower information in
their default prediction models.

Barron, J. M., and Staten, M., (2003), The Value of Comprehensive Credit Reports: Lessons
from the U.S. Experience, Boston, MIT Press.
Padilla J. A., and Pagano, M., (2010), "Sharing Default Information as a Borrower Discipline
Device", European Economic Review, 44(10), 1951-1980.
Ferretti, F. F., (2006), Re-thinking the Regulatory Environment of Credit Reporting: Could
Legislation Stem Privacy and Discrimination Concerns? Journal of Financial
Regulation and Compliance, 14 (3) 254 272Free Press, New York.
Olegario,R.,(2003),CreditReportingAgencies:AHistoricalPerspective,Cambridge,MA:
MITPress.

CRBs can either a publically or privately owned entity that consolidates information on
borrowers from lenders. Hahm and Lee (2008) opine that the success of the voluntary
information sharing scheme is still difficult and at a premature stage but studies have illustrated
that comprehensive information helps lenders better predict borrower default. Histories of ones

2
credit not only provide necessary input for credit underwriting, but also allow borrowers to take
their credit history from one financial institution to another, thereby making lending markets
more competitive and more affordable. According to Kallberg and Udell (2003), historical
information collected by a credit bureau has powerful default predictive power. Pagano and
Jappelli (2013) found that credit bureaus assist in making credit accessible to more people and
enables lenders and businesses reduce risk and fraud.

Kallberg, J. G., and Udell, G. F., (2003), The Value of Private Sector Credit Information,
Journal of Banking and Finance and Institutional Economics, 2(1) 45-65.
Pagano, M., and Jappelli, T., (1993), Information Sharing in Credit Markets, The Journal of
Finance, 43(5), 1693-1718.

The development of CRBs has highlighted the growing importance of the credit information
sharing mechanism in Kenya (Sigei, 2010). It is highly anticipated that credit information
sharing will continue to be instrumental in the decision making process of credit providers in
Kenya as they seek to mitigate risks associated with information asymmetry. Since the
commencement of the Credit Information Sharing (CIS) mechanism, all the 43 licensed
commercial banks in Kenya and institutions under the Deposit Protection Fund Board continue
to submit negative credit information to the licensed CRBs within the Central Bank of Kenya
(CBK) set timeframes (CBK, 2014). In addition, all the banks have incorporated the CIS
mechanism in their credit appraisal systems by obtaining credit reports from the CRBs while
appraising loan applications.

Sigei,R.S.,(2010),EvaluatingtheEffectivenessofCreditReferenceBureauinKenya: The
CaseofKCB,UnpublishedMBAproject,UniversityofNairobi.
Sacerdoti,E.,(2005),AccesstoBankCreditinSubSaharanAfrica:KeyIssuesandReform
Strategies,IMFWorkingPaperSeries,5(166).
Central Bank of Kenya (2014), Bank Supervision Annual Report (2010-2014), Central Bank
of Kenya, Nairobi.

1.1.2 Credit Risk Mitigation in MFIs

Pereira (2012) defines credit risk as the distribution of financial losses due to unexpected changes
in the credit quality of counterparty in a financial agreement. FreixasandRochet(2009)add that
credit risk is the risk that the promised cash flows from loans and securities held by financial
institution may not be paid in full. This means that borrowers may default in interest and
principal payment, hence causing financial loss to the financial institutions.

3
MFIs need data to screen credit applications and to monitor borrowers and when such
information is not available, MFIs risk adverse selection or moral hazard in its lending activity.
Adverse selection arises when some information about the borrowers characteristics remain
hidden to the lender and can lead to an inefficient allocation of credit (Bartrametal.,2008).On
theotherhand,moral hazard occurs from the lenders inability to observe borrowers actions that
affect the probability of repayment (Holmstrom,2009). This creates the danger of opportunistic
behaviour or moral hazard by the borrower and informational disadvantage by the bank leading
to inefficient allocation of credit.

Bartram,S.M.,Fehle,F.R.,andShrider,D.,(2008)."DoesAdverseSelectionAffectBidAsk
SpreadsforOptions?JournalofFuturesMarkets,28(5):417437.
Holmstrom,B.,(2009),"MoralHazardandObservability",BellJournalofEconomics,pp.74
91.

According to Hogen et al. (2008), the mitigation of credit risks is the core business in the deposit
taking and lending business. Therefore there is need to have appropriate risks management
mitigation strategy in order to reduce risk of loan default because a financial institutions
viability is weakened by the loss of principal and interest. Colguilt (2007) adds that if mitigation
of credit risk are not addressed, the institution will incur financial losses, incur costs taken to
recover the capital at risk and fail in its social role of providing loans to members of society to
improve their living standards.

Pereira, J. P., (2012), Credit Risk, Finance Department, ISCTE Business School, Lisbon.
Freixas, X., and Rochet, J., (2009), Microeconomics of Banking, MIT Press, Cambridge
Colguilt, J. (2007), Credit Risk Management: How to Avoid Lending Disaster and Maximize
Earnings, McGraw Hill.

Dagher and Kazimov (2014) observe that MFIs generally charge a higher interest rate to
borrowers who are more likely to default, a practice they call risk-based pricing as one of the
ways of mitigating credit risk. This is because they consider factors relating to the loan such as
loan purpose, credit rating, and loan-to-value ratio. Banks may also write stipulations on the
borrower, called loan covenants, which are included in the loan agreements. According to
Cornett et al. (2011), such agreements include requirements for borrowers to periodically report
their financial conditions, refrain from paying dividends, repurchasing shares, borrowing further,

4
or other specific, voluntary actions that negatively affect the company's financial position or may
require the lender to repay the loan in full, at the lender's request.

Dagher, J., and Kazimov, K., (2014), Bank Liability Structure and Mortgage Lending During
the Financial Crisis, Journal of Financial Economics, 3(1), 33 41.
Cornett, M. M., McNutt, J. J., Strahan, P. E., and Tehranian, H., (2011), Liquidity Risk
Management and Credit Supply in the Financial Crisis, Journal of Financial Economics,
101(3), 297-312.

1.1.3 Deposit Taking Microfinance Institutions in Kenya

MFIs refer to institutions that engage in fairly minor financial transactions using various
methodologies to serve low income household, microenterprises, small scale farmers and others
who lack access to traditional banking services (Kohen et al., 2008). In the last four decades, the
phenomenon of MFIs has gained unprecedented importance on a world wide scale due to being
regarded as a sustainable source of finance, new employment, innovation and economic growth
(Marguerite, 2005). They are regarded to be of fundamental importance to every economy as they
spur economic growth and wealth creation.

MargueriteS.R.,(2001),TheMicrofinanceRevolution:SustainableFinanceforthePoor,Irwin
McGrawhill,WashingtonD.C
Kohen, M., Hopkins, D., and Lee, J., (2008), Financial Education: A Bridge between Branchless
Banking and Low-income Clients, Washington DC: Microfinance Opportunities.

In Kenya, MFIs engage in micro-credit or micro-finance. They offer banking services for the
lowest amounts of money, bring credit savings and other essential financial services within the
reach of the millions of people who are too poor to be served by regular banks and cannot offer
sufficient collateral (Dondo, 2001). The MFIs in Kenya are registered under different Acts of
parliament like: the Non-Governmental Organizations Coordination Act; the Building Societies
Act; The Trustee Act; The Societies Act; The Companies Act; The Banking Act; The Kenya Post
Office Savings Bank Act and Microfinance Act. Their operation, business establishment,
licensing and supervision are regulated by Microfinance Act, 2006 which became operational
2008.

Dondo, A. (2001), Microfinance in Kenya: An Overview, K-Rep Occasion paper No. 33, Nairobi,
Kenya, K-Rep.

5
The Kenyan microfinance sector is rated as one of the most vibrant in Sub-Saharan Africa with a
diversity of institutional forms and a good infrastructure to serve the poor. However, its activities
remained unregulated 2006 and limited their financial performance. Institutions were set up
easily without any barrier like minimum capital requirements ( Muganga, 2010). In 2008, the
Microfinance Act of 2006 supported by the Deposit Taking Microfinance Regulations of 2008
together paved the way for institutional transformation in Kenya. In addition, the support of the
Financial Sector Deepening (FSD) Kenya saw Faulu Kenya and Kenya Women Finance Trust
(KWFT) engage in the process that led to their licensing as the pioneer deposit-taking
microfinance institutions (DTMs) in Kenya. The success of these transformations helped the two
institutions to maintain better financial performance in the market. Currently, Kenya boast 6
registered deposit taking MFIs including Rafiki Deposit Taking Microfinance Ltd, Remu DTM
Limited, SMEP DTM Limited and Uwezo DTM Ltd.

Muganga D. L. (2010), The Role of Regulation and Supervision of Microfinance Institutions:

Implications for the Development of NonDeposit Taking Microfinance Regulation in
Kenya,TheStateUniversityofBergamo.

1.2 Research Problem

Deposit taking MFIs need to place measures to enhance mitigation of the effects of credit risk
particularly in the developing world and in African countries because of the profiles of the
average borrower and the regulatory environments (Dankwah, 2012). To overcome the challenge
of credit risks, MFIs are required to monitor the behaviour of borrowers and detect potential loan
defaulters. Thus, the idea of establishing credit CBR regulation has been cited as one of the
proactive measures against credit risk that deposit-taking MFIs face (Madise, 2011). The CRBs
enhance collection, collation and processing of NPLs data from approved sources of information
and generate credit reports to be used by lenders.

Dankwah, E., (2012), The Relevance of Credit Reference Bureau and its Effect on the Financial
Industry in Ghana, International Journal of Business, Humanities and Technology, 2(2),
2.
Madise, S., (2011), Developing an Independent Regulatory Framework for the Financial Sector
in Malwai, Journal of Emerging Issues in Economics, Finance and Banking (JEIEFB),
2(3), 20102011.
Migwi, J., (2013), Credit Monitoring and Recovery Strategies Adopted by Commercial Banks
in Kenya, Journal of Modern Accounting and Auditing, 2(2), 2730.

6
The microfinance sector in Kenya has experienced some major failures because of inadequacies
in its operation especially credit reference bureau (Migwi, 2013). Considering the sectors
remarkable outreach in recent years, its future growth and sustainability depends on how well
MFIs mitigate their credit risks. Numerous empirical studies have been undertaken on credit
reference bureaus but very little attention has been given to credit risk mitigation.

Locally, Gitahi (2013) studied the effect of credit reference bureau on the level of non-
performing loans by the commercial banks. Using the case of Kenya Commercial Bank (KCB),
Sigei (2010) evaluated the effectiveness of credit reference bureau in Kenya while Nganga
(2011) studied on shareholder perception of credit reference bureau service in Kenya credit
market. Mumi (2010) reviewed the impact of credit reference bureau in financial institutions in
Kenya and Gaitho (2010) reviewed the role of credit reference bureau on credit access among the
commercial banks in Kenya. None of these studies have highlighted the effect of credit reference
bureaus regulation on mitigation of credit risks in deposit taking MFIs in Kenya. It is due to this
background that the study seeks to fill the knowledge gap by assessing the effect of credit
reference bureau regulation on mitigation of credit risks in the deposit taking microfinance
institutions in Nairobi City County. The study seeks to the research question; what is the effect of
credit reference bureaus regulation on mitigation of credit risks among deposit taking MFIs in
Nairobi City County?

1.3 Purpose of the Study

The purpose of the study is to examine the effect of credit reference bureaus regulation on
mitigation of credit risks among deposit taking MFIs in Nairobi City County.

1.4 Significance of the Study

1.4.1 The Government

The Government of Kenya will greatly benefit from this research through the Central Bank of
Kenya in policy formulation to grow the MFI sector. It is expected that the findings will inform
CBKs financial regulatory department in their quest to discharge the functions efficiently by
having a better understanding of the importance of the CBR regulation in credit risk mitigation.

7
1.4.3 Deposit-taking MFIs

The study may be useful to deposit taking MFIs in Kenya as it may help the the institutions in
the formulation of effective policies related to CBR and credit risk management in Kenya, the
understanding of the concept of credit referencing, both negative and positive on credit default
risk management. The findings of the study may be valuable to the MFIs industry stakeholders as
it provides an insight to the MFIs management into the best credit risk mitigation practices that
they can adopt in order to reduce the level of NPLs in the industry and also access to both types
of information can give businesses a more complete picture of a customers financial
commitments so they can make more informed decisions about extending credit.

1.4.3 Academicians and Other Researchers

It is expected that the findings of this study will contribute to the existing knowledge, address and
provide the background information to research organizations, individual researchers and scholars
who would want to carry out further research on Credit Reference Bureaus in Microfinance
institutions in Kenya. The study may help researchers, consultants and academicians to expand their
research into the effect of CBR regulation on credit risk mitigation in financial institutions in
Kenya.

1.5 Scope of the Study

The study seeks to assess the effect of effect of credit reference bureaus regulation on mitigation
of credit risks among deposit taking MFIs. The study will target registered deposit taking MFIS
in Nairobi City County. The credit managers of the institutions will be the source of primary data
used to answer the objectives. Three aspects of terrorism will be used to define the independent
variable; terrorist threats; terrorist attacks and terrorist kidnappings.

8
 REFERENCES
Araa, J., and Len, C., (2008), The Impact of Terrorism on Tourism Demand, Annals of
Tourism Research, 35(2), 299-315.

9
 CHAPTER TWO
LITERATURE REVIEW

2.1 Introduction

This chapter presents a broader context of the study subject in terms of past scholarly works
about Islamic banking. It reviews the concept and evolution of Islamic banking, related theories,
empirical studies and the conceptual framework.

2.2 The Underpinning Theories

Numerous theories have been proposed regarding Islamic banking, the concepts and conceptions
of the banking system. The theories have attempted to provide guidance in identifying the key
tenets of Islamic banking components globally. In this study, the underpinning theories reviewed
include; Islamic Banking theory, Islam and the Theory of interest, Chapra Model of Islamic
Banking and Profit and Loss Sharing Theory.

2.2.1 Adverse Selection Theory

Commercial banks through lending products are exposed to the adverse selection problems in
their credit risk assessment of credit facilities application [6]. The adverse selection problem
occurs due to the fact that commercial banks have access to information of their customers who
need to access credit facilities but lack similar information on other lending institutions [12].
This results to information asymmetry that disadvantages the good borrowers and increases the
cost of credit facilities (Otwori, 2013). The lending institutions in the context of asymmetrical
information settings are forced to price their credit facilities in terms of the interest rates in a
manner that is reflective of the borrowers pooled [19]. The CRB are designed to reduce
information asymmetry between various lending [19]. This is meant to assist the lenders
differentiate between good and risky borrowers [10]. Since the lenders are better able to profile
both the local and foreign credit facility applicants, then the good borrowers should be able to get
attractive interest rates due to their low risk profile [15]. The commercial banks also benefits
from having an improved pool of borrowers, decreases default rates and expansion of the credit
market [5].

2.2.2 Moral Hazard Theory

The moral hazard theory is based on the notion that the borrower has an incentive to default
unless there are consequences to his future credit facility applications [19]. It is argued [1] that,
the moral hazard refers to the risk that a party to a transaction has not entered into contract in
good faith, has provided misleading information about its assets, liabilities or credit capacity or
has an incentive to take unusual risk in a desperate attempt to earn a profit before the contract
settles. On the other hand, it was argued [15] that, the moral hazard is that the risk that the
borrower may not utilize the funds prudently hence affecting his ability to repay the loan. The
lender has no way of monitoring the usage of the loan to ensure that it is being used in manner
that doesnt compromise the ability to repay the loan [1].

10
2.2.3 Bank Risk Management Theory
This theory developed by the David Pyle emphasis on the need for credit risk management for
the survival of the financial institution. In this context, it was argued [16] that, the theory is based
on the fact that credit risk management influences the banks profitability because without
effective and efficient credit risk management, banks profitability, liquidity and solvency are
unthinkable [10]. .According to the bank risk management theory, the bank must minimize the
credit risk using all means at its disposal including the use of CRB reports. The main sources of
credit risk include inappropriate credit policies, poor management and poor credit assessment
[16].

[1] Alloyo, P. (2013). The Effect of Credit Reference Bureaus on Financial Performance of
Commercial Banks in Kenya. International Journal of Business and Management
Invention, 2(2), 3031.
[2] Aucamp, J. (2010). A Comparative Study of Tax Relief Measures for Small, Medium and
Micro Enterprises in South Africa and Australia. International Journal for Management
Science and Terchnology, 3(4), 36474.
[3] Central Bank of Kenya,. (2014). Central Bank of Kenya Bank Supervision Annual Report
2013.
[4] Dankwah, E. (2012). The Relevance of Credit Reference Bureau and its Effect on the
Financial Industry in Ghana. International Journal of Business, Humanities and
Technology, 2(2), 2.
[5] Gichimu, S. (2013). Credit Reference Bureaus, Loans Advancement and Recovery
Performance by the Higher Education Loans Board of Kenya. Journal of Modern
Accounting and Auditing, 4(3), 3542.
[6] Gitahi, R. (2013). The Effect of Credit Reference Bureaus on the Level of Non-Performing
Loans in the Commercial anks in Kenya. International Journal of Research in
Management Economics and Commerce, 3(4), 79.
[7] Koitaba, E. (2013). An Analysis of Factors Influencing Financial Control Practices in
Community Based Organizations in Baringo County, Kenya. International Journal of
Financial Research, 2(1), 1419.
[8] Madise, S. (2011). Developing an Independent Regulatory Framework for the Financial
Sector in Malwai. Journal of Emerging Issues in Economics, Finance and Banking
(JEIEFB), 2(3), 20102011.
[9] Migwi, J. (2013). Credit Monitoring and Recovery Strategies Adopted by Commercial Banks
in Kenya. Journal of Modern Accounting and Auditing, 2(2), 2730.
[10]Mwiya, B. (2010). Credit Default in the Financial Sector: Need for Credit Reference and
Rating Agencies. Journal of Economics and International Business Research, 2(3), 41
43.
[11] Ngugi, J., Ndwiga, P., Waithaka, S., & Gakure, R. (2012). Effect of Credit Risk
Management Techniques on the Performance of Unsecured Bank Loans Njuguna, 2012
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Multinational Banks Operating in the East African Community. Journal of Emerging
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[13] Njunji, A. (2013). A Survey of Adoption of Agency Banking by Commercial Banks in
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36.
11
[14]Okwoma, D. (2012). The Effect of Corporate Social Responsibility on the Financial
Performance of Commercial Banks in Kenya. International Journal of Business and
Public Management, 2(3), 3740.
[15]Omari, M. (2012). Credit Reputation as Collateral: A Case for Improvement of the Legal
Regime on Credit Referencing in Kenya. Journal of Modern African Studies, 2(1), 4549.
[16] Otwori, C. (2013). The Relationship between Credit Referencing and the Level of Non-
Performing Loans of Commercial Banks in Kenya. International Journal of Business,
Humanities and Technology, 2(4), 3943.
[17] Scott, B. (2008). Increasing the South African Consumers Access to Credit through the use
of Nontraditional Sources.
[18] Siwela, M. (2011). The Development of the Credit Reference System: A Case Study of
Zambia. Journal of Accounting and Finance, 2(2), 102104.
[19]Wandera, M., & Kipyego, D. (2013). Effects of Credit Information Sharing on Non-
Performing Loans: The Case of Kenya Commercial Bank

12
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13