CHAPTER ONE GENERAL INTRODUCTION 1.1 Background Certainly, microfinance is not a new concept in Ghana.

It has always been common practice for people to save and/or take small loans from individuals and groups within the context of selfhelp in order to engage in small retail businesses or farming ventures (Asiama and Osei, 2007). Anecdotal evidence suggests that the first credit union in Africa was probably established in Northern Ghana in 1955 by the Canadian Catholic missionaries that were there at the time. However, Susu, which is one of the current microfinance schemes in Ghana, is thought to have originated in Nigeria and spread to Ghana from the early 1900s. Over the years, the microfinance sector has thrived and evolved into its current state thanks to various financial sector policies and programmes such as the provision of subsidized credits, establishment of rural and community banks (RCBs), the liberalization of the financial sector and the promulgation of PNDC Law 328 of 1991, that allowed the establishment of different types of non-bank financial institutions, including savings and loans companies, finance houses, and credit unions etc. (Asiama and Osei, 2007).

The microfinance industry has grown rapidly during the last decade in breadth, depth, and scope of outreach. The rapid growth seems to continue, given the massive unserved and underserved market. The erstwhile microenterprise-credit-only institutions are now providing a broader range of credit products. Their loans are no longer confined to short-term working capital loans but now also include loans with relatively longer maturities, and those intended for other purposes

such as acquiring fixed assets (Fernando, 2008). Some microfinance institutions (MFIs) even venture into the financing of agricultural operations. Other MFIs have expanded their deposit services, thus contributing to the expansion of the scope of outreach. Grameen Bank in Asia, for example, has achieved impressive results in mobilizing voluntary savings through its new deposit products offered under the Grameen Pension Scheme to the members, and other deposit products offered to both members and nonmembers (Rutherford 2006).

The last two decades have also seen a significant increase in the diversity of institutions providing financial services to the poor and low-income households. The previous predominance of nongovernment organizations (NGOs) in the retail markets of many countries has been challenged by new developments such as the transformation of some pioneering NGOs into fully or partially regulated financial entities, the emergence of specialized microfinance banks, the entry of commercial banks into microfinance, and the increased involvement of cooperatives and rural banks (Fernando, 2008).

One of the significant changes in the microfinance industry has been the growth in commercial and semi-commercial borrowings, including loans to finance small and medium enterprises (SMEs) operations. In 2009, ProCredit in Ghana added SMEs finance and project finance to its product and services delivery (www.procerdit.com.gh). This implies that ProCredit grant commercial loans that hitherto microfinance institutions (MFIs) do not lend such quantum of loan. According to Abrams and Stauffenberg (2007), in the last 3 years, the volume of international private lending for microfinance has exploded: in 2005 alone, outstanding loans doubled to nearly $1 billion. Structured finance transactions are also becoming important in the

microfinance market. In 2006, Bangladeshi MFI BRAC securitized the $180 million equivalent of its portfolio (Fernando, 2008).

Although MFIs and the industry have suffered serious setbacks in some countries, the industry has been relatively stable in most countries. A number of institutions such as BRAC and the Association for Social Advancement in Bangladesh, the SKS Microfinance and Spandana in India, and the Compartamos in Mexico have managed to sustain their growth rates remarkably well without sacrificing portfolio quality (Fernando, 2008). The incredible resilience of the industry was exhibited for example in Asia during the financial crisis in the late 1990s and the aftermath of the tsunami which struck Asia in 2005 (Fernando, 2008). However, it must be recognized that the changes in markets, products and services, delivery models, and technology used in the industry have had, and continue to have, profound implications on the overall risk profile of the industry over time. MFIs or others which provide microfinance services can no longer afford to focus on credit risks on an ad hoc basis, often in a reactive manner. Risks in microfinance must be managed systematically and the importance of risk management will further increase as the industry matures further and microfinance markets become more competitive (Powers 2005).

Fatemi and Fooladi (2006) observed that the engagement of risk management practices in financial institutions cannot be overemphasized. One of the most important forms of these practices pertains to the management of credit risk, particularly for banks and other firms in the financial services industry. Credit risk arises from uncertainty in a given counterpartys ability to meet its obligations. The increasing variety in the types of counterparties and the ever-expanding

variety in the forms of obligations have meant that credit risk management has jumped to the forefront of risk management activities carried out by firms in the financial services industry.

1.2 Statement of the problem

Microfinance institutions like other commercial banks face various risks that can be categorized into three groups; financial [with credit risk being a component], operational and strategic (Cornett and Saunders, 1999). These risks have different impact on the performance and sustainability of MFIs. The magnitude and the level of loss caused by credit risk compared to others is severe to cause institution failures (Chijoriga, 1997). Poor loan quality has its roots in the information processing mechanism. BrownBridge (1998) observed that these problems are at their acute stage in developing countries. The problem often begins right at the loan application stage (Liuksila, 1996) and increases further at the loan approval, monitoring and controlling stages, especially when credit risk management guidelines in terms of policy and strategies/procedures for credit processing do not exist or weak or incomplete.

Moreover, the growth of the microfinance industry has changed the risk profile of MFIs. Yet many MFIs seem to continue to seek growth without much attention to attendant risks (Fernando, 2008). Surprisingly, many MFIs appear to neglect credit risk management which helped MFIs achieve high growth rates historically.

Given importance of the need for good credit risk management practice, it is surprising to observe that not much is known about the extent by which MFIs engage in the practice of credit

risk management from the sub region perspective. In recent years, a number of studies have provided the discipline with insights into the practice of risk management from Asia and Pacific region perspective. Powers (2005) and Fernando (2008) provided a comprehensive picture of the risk management practices of Asian MFIs including credit risk management. However, not much has been reported on the state of the art in the practice of credit risk management among MFIs in Ghana.

1.3 Objectives The general objective of the study is to assessing credit risk management practices of MFIs in the in Ghana. The specifics objectives of the study are to:

To ascertain MFIs understanding of credit risk and credit risk management To establish whether MFIs efficiently assess credit risk To identify method(s) use by MFI to identify credit risk To ascertain whether MFIs have an efficient credit risk monitoring and controlling system

To establish the efficiency of credit risk analysis To establish the efficiency of credit risk management practices of MFIs To identify the challenges MFIs face in managing credit risk

1.4 Research questions

Following these objectives, the research seeks to address the following questions: What is the understanding level of MFIs on credit risk and credit risk management?

Do the MFIs efficiently assess credit risk in general? How effective is the credit risk management practices been adopted by the MFIs? What are the methods uses by MFIs to identify credit risk? Do the MFIs have an efficient risk monitoring (RM) and controlling system? Do the MFIs analysis credit risk efficiently? Do the MFIs engage in an efficient credit risk practices? What challenges do MFIs face in managing credit risk?

1.5 Significance of the study The study will serve as a point of reference to microfinance researchers and practitioners in the financial sector in general and microfinance institutions in particular. As the sector is growing and contributing immensely to the economy of Ghana and also providing informal credit as an instrument for poverty reduction among people who are economically active but financially constrained and vulnerable, there is therefore a need for the institutions and the staffs in the industry to have information on credit risk management to that ensure that the industry run effectively and sustainability. This would help them to formulate good policies to help sustain the sector to contribute immensely to poverty reduction in Ghana. This is crucial since Ghana is striving to achieve Millennium Development Goals by halving poverty in 2015. Apart from contributing to the existing literature on sustainability of microfinance institutions and to the body of academic knowledge for financial and accounting students, the study will also identify other areas that need further research.

1.6 Scope and Limitation of the study

The study would focus on selected microfinance institutions in Kumasi that has been operated for the past five years. Microfinance institution that has operated for five-year period and surviving has gone through some challenges and had got some experience in lending and also credit risk management to some extent. The credit risk management practices would be ascertained from the service providers perspective.

The time available for the study also makes it a bit difficult to spread the research into the entire region of Ghana where microfinance institutions operate although that might have been ideal. Also, financially it is not practical to cover all the microfinance institutions in Ghana.

1.7 Organization of the study

The work will be organized into five chapters as follows: Chapter I Introduction, which will consist of the background of the study, problem

statement, aims of study, hypotheses, scope and limitations of the study. Chapter II study. Chapter III Methodology which will seek to outline the materials and methods (sources of Literature Review, which seeks to provide the theoretical or empirical of the

data, data collection instruments and methods as well as the data analysis methods) employed in the study.

Chapter IV

Results and Discussions, the presentation of results obtained by the study in the

form of organized data that is easily understood. This section will also have the discussion of the findings in the light of relevant literature. The final chapter, Chapter V will then focus on the conclusions and recommendations which will bring out the findings and advices of the study. It will also bring out recommendations for future works stating clearly the areas of further research.

CHAPTER TWO LITERATURE REVIEW 2.1 Overview of Microfinance Microfinance encompasses the provision of financial services and the management of small amounts of money through a range of products and a system of intermediary functions that are targeted at low income clients. Microfinance refers to provision of small loans and other facilities like savings, insurance, transfer services to poor low-income household and microenterprises (MoFEP, 2007). Microcredit also refers to a small loan to a client made by a bank or other institutions.

2.2 Evolution of Microfinance in Ghana

The concept of microfinance is not new in Ghana. Traditionally, people have saved with and taken small loans from individuals and groups within the context of self-help to start businesses or farming ventures. Available evidence also suggests that the first Credit Union in Africa was established in Northern Ghana in 1955 by Canadian Catholic Missionaries (Asiama and Osei, 2007). Susu, which is one of the current microfinance methodologies, is thought to have

originated in Nigeria and spread to Ghana in the early 1990s. Microfinance has gone through four (4) distinct phases worldwide of which Ghana is no exception. These stages are described below:

Phase One: The provision of subsidized credit by Governments starting in the 1950s when it was assumed that the lack of money was the ultimate hindrance to the elimination of poverty. Phase Two: Involved the provision of micro credit mainly through NGOs to the poor in the 1960s and 1970s. During this period sustainability and financial self sufficiency were still not considered important. Phase Three: In the 1990s the formalization of Microfinance Institutions (MFIs) began. Phase Four: Since the mid 1990s the commercialization of MFIs has gained importance with the mainstreaming of microfinance and its institutions into the financial sector.

In Ghana, the term microfinance is understood as a sub-sector of the financial sector, comprising most different financial institutions which use a particular financial method to reach the poor. Microfinance sector in Ghana comprises various types of institutions and these have been grouped into four (4) categories, namely: Formal suppliers such as savings and loans companies, rural and community banks, as well as some development and commercial banks; Semi-formal suppliers such as credit unions, financial non-governmental organizations (FNGOs), and cooperatives; Informal suppliers such as susu collectors and clubs, rotating and accumulating savings and credit associations (ROSCAs and ASCAs), traders, moneylenders and other individuals.

 Public sector programmes that have developed financial and nonfinancial services for their clients (BOG, 2007)

2.3 Microfinance and Development Microfinance encompasses the provision of financial services and the management of small amounts of money through a range of products and a system of intermediary functions that are targeted at low income clients. It includes loans, savings, insurance, transfer services and other financial products and services (Asiama and Osei, 2007). Microfinance is thus one of the critical dimensions of the broad range of financial tools for the poor, and its increasing role in development has emanated from a number of key factors that include:

The fact that the poor need access to productive resources, with financial services being a key resource, if they are to be able to improve their conditions of life;

The realization that the poor have the capacity to use loans effectively for incomegeneration, to save and re-pay loans;

The observation that the formal financial sector has provided very little or no services to low-income people, creating a high demand for credit and savings services amongst the poor;

The view that microfinance is viable and can become sustainable and achieve full cost recovery.

Studies have shown that micro-finance plays three broad roles in development:

It helps very poor households meet basic needs and protects against risks,

It is associated with improvements in household economic welfare, It helps to empower women by supporting women's economic participation and so promotes gender equity.

The literature suggests that micro- finance creates access to productive capital for the poor, which together with human capital, addressed through education and training, and social capital, achieved through local organization building, enables people to move out of poverty. By providing material capital to a poor person, their sense of dignity is strengthened and this can help to empower the person to participate in the economy and society (Otero, 1999). The aim of micro-finance according to Otero (1999) is not just about providing capital to the poor to combat poverty on an individual level, it also has a role at an institutional level. It seeks to create institutions that deliver financial services to the poor, who are continuously ignored by the formal banking sector. Littlefield and Rosenberg (2004) argue that the poor are generally excluded from the financial services sector of the economy so MFIs have emerged to address this market failure. By addressing this gap in the market in a financially sustainable manner, an MFI can become part of the formal financial system of a country and so can access capital markets to fund their lending portfolios, allowing them to dramatically increase the number of poor people they can reach (Otero, 1999). More recently, commentators such as Littlefield, Murduch and Hashemi (2003), Simanowitz and Brody (2004) and the IMF (2005) have commented on the critical role of micro-credit in achieving the Millennium Development Goals. According to Simanowitz and Brody (2004) micro-credit is a key strategy in reaching the MDGs and in building global financial systems that meet the needs of the most poor people." Littlefield, Murduch and Hashemi (2003) state "micro-credit is a critical contextual factor with strong

impact on the achievements of the MDGs. Micro-credit is unique among development interventions: it can deliver social benefits on an ongoing, permanent basis and on a large scale". However, some schools of thought remain skeptical about the role of micro-credit in development. For example, while acknowledging the role micro-credit can play in helping to reduce poverty, Hulme and Mosley (1996) concluded from their research on micro-credit that "most contemporary schemes are less effective than they might be" (1996, p.134). The authors argued that micro-credit is not a panacea for poverty-alleviation and that in some cases the poorest people have been made worse-off. This notwithstanding, microfinance has emerged globally as a leading and effective strategy for poverty reduction with the potential for far-reaching impact in transforming the lives of poor people. It is argued that microfinance can facilitate the achievement of the Millennium Development Goals (MDGs) as well as National Policies that target poverty reduction, empowering women, assisting vulnerable groups, and improving standards of living. As pointed out by the former UN Secretary General Kofi Annan during the launch of the International Year of Micro Credit (2005), Sustainable access to microfinance helps alleviate poverty by generating income, creating jobs, allowing children to go to school, enabling families to obtain health care, and empowering people to make the choices that best serve their needs." (Kofi Annan, December 2003). Although microfinance is not a panacea for poverty reduction and its related development challenges, when properly harnessed it can make sustainable contributions through financial investment leading to the empowerment of people, which in turn promotes confidence and selfesteem, particularly for women.

2.4 The Need for Microfinance in Ghana

The main goal of Ghanas Growth and Poverty Reduction Strategy (GPRS II) is to ensure sustainable equitable growth, accelerated poverty reduction and the protection of the vulnerable and excluded within a decentralized, democratic environment (MoFEP, 2007). The intention is to eliminate widespread poverty and growing income inequality, especially among the productive poor who constitute the majority of the working population. According to the 2000 Population and Housing Census, 80% of the working population is found in the private informal sector. This group is characterized by lack of access to credit, which constrains the development and growth of that sector of the economy (MoFEP, 2007). The observation was stressed in the International Monetary Fund Country report on Ghana of May 2003 that weaknesses in the financial sector that restrict financing opportunities for productive private investment are a particular impediment to business expansion in Ghana.

Microfinance perceived as a financially sustainable instrument meant to reach significant number of poor people of which most are not able to access financial services because of the lack of strong retailing financial intermediaries. Access to financial services is imperative for the development of the informal sector and also helps to mop up excess liquidity through savings that can be made available as investment capital for national development (World Bank- Africa Region, 1999). Microfinance as a sector has the potential to reduce poverty by bringing a significant improvement in the lives of the active poor who are largely women.

2.5 Profiles of Microfinance Institutions (Apex Bodies) in Ghana 2.5.1 Ghana Co-Operative Credit Unions Association (GCCUA)

The Ghana Co-operative Credit Unions Association (CUA) Ltd was established in 1968 as the apex body of the credit union movement in Ghana. It does not represent the interest of only the movement at the local level but International levels too. The aim of its establishment was to develop itself into a sustainable financial institution and to create an enabling environment for credit unions operations. As a credit union leader, CUA has a responsibility of promoting, educating and training at all levels of the movement. In order to ensure the viability and sustainability of Credit Unions, CUA offers both technical and financial services to its members including education and training, auditing, bookkeeping, computer services, general supervision and Risk Management Insurance Service (MoFEP, 2007).

CUA has over the last five years received support from the Rural Financial Services Project. These include assistance in building the capacity of its affiliates through numerous training programs, provision of means of transport like motorbikes, a Pickup and a cross country vehicle and Computers, printers and accessories to help in the Data Management of CUA both at the head office and regional levels.

Currently, there are two hundred and sixty two (262) active credit unions in Ghana, with a total membership of over one hundred and sixty thousand (160,000) even though it is believed that its total membership is about two hundred and seven thousand, four hundred and two (207,402).

CUA has taken some initiatives such as training center for Credit Unions, Home Banking Scheme (New Product) and Micro Finance for the active poor (MoFEP, 2007). Table 2.1 summarize the annual performance of credit unions.

Table 2.1 Summary of Credit Unions Annual Performance

DETAILS Members

2001 96,052

2002 125, 000 150.2 88.3 200.0

2003 132,000 206.0 142.0 250.0

2004 163,860 354.7 216.6 423.8

2005 174,026 425.3 315.2 50.7

2006 202,390 584.2 396.5 702.1

Deposits (billion) 84.6 Loans (billion) Total (billion) 59.4

asset 98.6

Source: Ministry of Finance and Economic Planning, 2007

2.5.2 Ghana Co-Operative Susu Collectors Association (GCSCA)

The Ghana Co-operative Susu Collectors Association, (GCSCA) was established in 1994 as an umbrella organization for all Regional Susu collectors Societies in Ghana. The association was formed to (self)-regulate the activities of Susu Collectors and instill practices, which would build clients confidence in their deposits mobilisation.

The GCSCA is one of the indigenous Microfinance institutions with a broad clientele base and a wider environment for funds mobilization. The few years of Microfinance transformation has also led to a massive evolution in the operations of Susu Collection in the microfinance sector. The main services provided by Susu Collectors are savings mobilization and sometimes the provision of mobile services for individuals and groups in rural and urban areas. Currently, GCSCA has regional offices in all the regions and some districts in the country with a total membership of one thousand three hundred and thirty-five (1,335) (MoFEP, 2007).

2.5.3 Association of Financial NGOs (ASSFIN)

The Association of Financial NGOs was inaugurated in 2005 as an apex organization of all financial organizations in Ghana with the aim of regulating the activities of member institutions as well as advocating for the development of financial NGOs. ASSFIN is accredited as a private voluntary organization in development. It has been registered as a organisation under limited guarantee under Act 179 of the Companies Code of 1963 Currently, the operations of ASSFIN are run by a 7-Member Executive Council at the National level supported by 3-Member Executive Committee at the three Zonal levels. The current membership of ASSFIN is 96 Institutions spread across the length and breadth of the country (MoFEP, 2007).

2.5.4 Ghana Cooperative Council (GCC)

The Ghana Co-operatives Council is the supra Apex body of all cooperatives in Ghana. It is an independent apex organization that promotes and develops cooperatives and other self-help organizations on a sustainable basis. The Council facilitates an enabling environment and provides quality services for the economic and social well being of its members, non-members and communities. The Council practices and upholds the co-operative principles and values of democracy, co-operation, community development, honesty, transparency and care for its members. Ghana Co-operatives Council was registered in 1957 by the Department of Cooperation as a nontrading, non-governmental organisation. Specifically it was formed to take over the function of cooperative education from the Department of Co-operation. On January 22, 1973, the alliance was reregistered by the Department of Co-operatives as the Ghana Co-operatives Council (GCC) as it is known today. It operates in four (4) sectors, these are: Agriculture, Industry, Finance and Service (MoFEP, 2007). There are currently thirteen national apex Co-operative Associations that are affiliated to the Council and all national Co-operative Associations are listed in the council. The Council is run by Board of Directors drawn from the National Associations.

2.5.5 Ghana Microfinance Institution Network (GHAMFIN)

Ghana Microfinance Institution Network (GHAMFIN) is a network with a diverse range of Microfinance practitioners comprising: Savings & Loans Companies, Rural and Community Banks, Credit Unions, FNGOs, Susu (savings) Collectors, and Business Development Service Providers as well as Apex bodies such as the ARB Apex Bank Ltd, Ghana Credit Union Association (MoFEP, 2007).

The GHAMFIN seeks to promote the growth and development of the microfinance industry in Ghana. The focus has been on building the capacity of microfinance institutions to improve upon their performances, thus, enabling them to provide long-term sustainable and affordable access to financial services to meet the needs of their clients, majority of whom are women living in rural communities.

2.5.6 ARB Apex Bank

The ARB Apex Bank Ltd. is a mini Central Bank for the Rural/ Community Banks (RCBs). The idea of rural banking date back to about three (3) decades in the form of a dialogue between Bank of Ghana and Ministry of Finance about what was called junior league of banking institutions to serve the special needs of the rural population. The traditional licensed banking institutions were concentrated at the urban centers hence it became necessary to bring the rural population into the banking system under rules designed to suit their socioeconomic circumstances and the peculiarities of their occupation in farming and craft making (MoFEP, 2007).

The ARB Apex Bank Ltd. is mainly financed through the Rural Financial Services Project (RFSP). The RFSP is a Government of Ghana project designed to holistically address the operational bottlenecks of the rural financial sector with the aim of broadening and deepening financial intermediation in the rural areas. To date, there are one hundred and twenty five (125) Rural/Community banks with over five hundred (500) branches/agencies in the country.

The Rural/ Community Banks under Apex Bank undertake a mix of microfinance and commercial banking activities structured to satisfy the needs of the rural areas. Some of the activities are: Provision of banking services by way of funds mobilization and credit to cottage industry operators, farmers, fishermen and regular salary employees. Grant credits to customers for the payment of school fees, acquisition/rehabilitation of houses and to meet medical expenses. Devote part of their profits to meet social responsibilities such as donations to support education, health, traditional administration and the needy in their respective communities. Specific gender programmes focusing on women-in-development and credit-with-education activities for rural women.

2.6 Products and Practices of Microfinance Institutions Rural and Community Banks (RCBs) Steel and Andah (2003) indicated that rural banks initially made standard commercial loans to individuals or groups, often related to agriculture. While term lending may have been justified by the agricultural planting cycle or investment in a productive asset, it tended to result in portfolio performance problems, as borrowers had difficulty making balloon payments and RBs had weak capacity to follow up and enforce repayment. During the 1990s, however, a number of the more progressive RCBs drew on emerging microfinance techniques to introduce new programs for saving and credit, often in association with NGOs that could provide the expertise in implementing the approach. Loans of this type are generally short-term (4-6 months) with

weekly repayment, averaging around $50-75 but ranging up to several hundred dollars, with compulsory up-front savings of 20% that is retained as security against the loan, complementing group or individual guarantees as the other principal form of security. Box 1 provide four interrelated methodologies of credit programs by RCBs Box 1: Types of Group and Individual Savings and Credit Programs

Group savings with credit: A group of members (whether pre-existing or formed for this purpose) open a joint bank savings account and mobilize initial savings deposits to .qualify for a loan. Group savings may be used as security against loans, and also are used to invest in T-bills for the group. Groups usually are made up of 3-4 sub-solidarity groups.

Group and individual savings with credit: Group members contribute to both a joint group account and their individual accounts. The group may be a village bank of 25-40 members; or as small as 5 members. While both individual and group savings accounts are used as collateral, the individual account includes the members additional personal savings. Loan repayments are made by individuals but handled through the group account. Examples include Nsoatreman, Bosomtwe, and Lower Pra RBs.

Individual savings with group credit: Individuals lodge their savings through the group, which receives a loan for distribution to members after a qualifying period and collection of the required level of savings, and they continue to save into their individual accounts as they repay the loan. The group handles the collection of savings and repayments, acts as the interface with the loan officer, and bears group responsibility for recovery (though the loans are made to

individual members). Example: Freedom from Hungers Credit with Education program, operated through Brakwa, Lower Pra, Nsoatreman and Nandom RBs, Bulsa Community Bank, and Womens World Banking Ghana (Quainoo, 1997).

Individual savings with credit: direct lending to individuals, either that who had established a credible history as a member of a group but who need larger or separate loans, or in cases where a group approach is not suitable. Examples: Lower Pra RB; Nsoatreman RBs District Assembly Poverty Alleviation Program.

Source: Chord, 2000 cited in Steel and Andah, 2003

Saving and Loans (S&Ls) Companies

Steel and Andah (2003) stated that S&Ls generally use the loan product similar to one provided by RCBs. For example, First Allied S&L uses a group and individual savings with credit scheme with existing, registered occupation-based groups such as butchers, kente weavers, carpenters, and other associations (Chord, 2000). S&Ls have also been leaders in innovating. Citi S&L uses Susu Clubs or any other economic association for their group loan product, with joint group guarantee and savings bank balance up to 50% of loan amount. It has pioneered linkages with susu collectors as well as clubs, including through other forms of individual loan products. Citi also has a micro-leasing product available to clients with at least two successful loan terms (Anin, 2000).

Credit Union Association

Individual members make predetermined periodic deposits into their accounts and may borrow up to two times their savings balance (Steel and Andah, 2003). Most CUs require borrowers to provide security, in addition to being in good standing with their deposits. Ideally, this can be in the form of a guarantee from another member of the credit union who has adequate uncommitted savings balance. Some CUs use the susu method in the collection of deposits and loan repayments. CUA is an innovator in providing both credit insurance (which pays off the outstanding loan balance in case of the death of a borrower) and a contractual savings program (which matches savings, up to a limit, if held at death or to maturity) (Gallardo et al. 2002).

2.7 Credit risk management in Microfinance Institution

Lending has been, and still is, the mainstay of microfinance business, and this is more true to emerging economies (Richard et al., 2008). To most of the transition economies, however, and Ghana in particular, lending activities have been controversial and a difficult matter. This is because small business firms on one hand are complaining about lack of credits and the excessively high standards set by financial institutions, while financial institutions on the other hand have suffered large losses on bad loans (Richard, 2006). It has been found out that in order to minimize loan losses and so as the credit risk, it is essential for financial institutions to have an effective credit risk management (CRM) system in place (Santomero, 1997; Basel, 1999). Given the asymmetric information that exists between lenders and borrowers, financial indtitutions must have a mechanism to ensure that they not only evaluate default risk that is unknown to

them ex ante in order to avoid adverse selection, but also that can evolve ex post in order to avoid moral hazards. Fernando (2008) reported that microfinance credit risk was initially assumed to have been confined almost entirely to risk associated with the possible default by borrowers of MFIs. This is reflected in the definition of credit risk as the risk to earnings or capital due to borrowers late and nonpayment of loan obligations. However, a broader definition of credit risk also includes the risk of default by other financial institutions, which have payment obligations to MFIs (Bruett 2004). This is particularly true with MFIs that continue as NGOs. Such payment obligations may arise because MFIs use those institutions as depository institutions, investment outlets, or for money transfers. Also, such risks may arise due to the agency services that MFIs provide to other financial institutions. MFIs suffer losses when these institutions are unable or unwilling to meet their payment obligations. However, MFIs tend to overlook this dimension of credit risk although it is real, as evident in some cases. For example, when the National Bank (central bank) of Cambodia suspended the license of the Farmers Bank in 1997, the bank ceased operations and ACLEDA (which was an NGO-MFI at that time) was not able to recover $267,932 that it held on account with the Farmers Bank (Clark 2006). Similarly, a number of cooperative rural banks in Sri Lanka lost access to their deposits when a commercial bank that held a significant amount of their deposits ran into difficulties and its accounts were frozen and operations were suspended by the central bank (Fernando, 2008). Credit risks are more acute today than in the early stages for those MFIs which have accumulated a significant amount of reserves, part of which in turn is kept in other financial institutions in the form of deposits or investments.

Aside from generally recognized default risks by clients, another type of credit risk arises when MFI clients deposit their savings in other financial institutions which are weak and not covered by a credible deposit protection scheme. Clients may not have ready access to their funds and thus lose a source of loan repayment for their MFI loan if the bank where they keep their deposits runs into difficulties (Bruett 2004). In such cases, loan recovery rates may suddenly fall.

The assets of most MFI portfolios consist of loans which are relatively illiquid and carry the greatest credit risk (Koch and MacDonald, 2000). As argued by the theory of asymmetry information, it may be inconceivable to differentiate good borrowers from bad borrowers (Auronen, 2003), which is likely to lead to adverse selection and moral hazards problems. Adverse selection and moral hazards have led to significant collection of non-performing accounts (Bofondi and Gobbi, 2003). Risks in microfinance must be managed in a systematic manner and the importance of risk management will further increase as the industry matures further and microfinance markets become more competitive (Powers 2005). Risk management is considered the identification, assessment, and prioritization of risks followed by an organized and economical application of resources to reduce, monitor, and check the likelihood and effects of unfortunate events or to maximize the realization of opportunities. As stated by Heffernan (1996) and Kealhofer (2003), various risk-adjusted performance evaluations have been suggested. These, however, concentrate on risk-return trade-off. Thus, in each activity, the underlying risks are evaluated and charge consequently for the capital expected to back it. The effective systems that check repayment of loans by borrowers is vital in tackling asymmetric information problems and in minimizing the rate of loan losses of any financial institution (Basel, 1999; IAIS, 2003). Efficacious CRM requires building an appropriate CR

environment; working under a healthy credit lending process; maintaining an appropriate credit administration that necessitate monitoring process and adequate controls over credit risk (Greuning and Bratanovic, 2003; IAIS, 2003). These calls for top management of MFIs to ensure that there are thorough and authorized guidelines in managing credit risk. Thus, all guidelines are properly conveyed throughout the MFI so that all parties involved in CRM understand them. For a sound CRM system in a financial institution, the basis should include the background and allotment of the credit facility and the mod in which a credit portfolio is managed. Thus, how loans are initiated, evaluated, monitored and collected (Basel, 1999; Greuning and Bratanovic, 2003). Screening out potential borrowers is an important activity that has greatly been advocated by, among others, Derban et al. (2005). With regards to the asymmetric information theory, a accumulation of dependable information from potential borrowers becomes vital in achieving effective screening. Qualitative and quantitative techniques may be employed in assessing borrowers. A significant challenge of employing qualitative models is its immanent nature (Bryant, 1999; Chijoriga, 1997). However, borrowers attributes evaluated through qualitative models can be allotted numbers with the sum of the values compared to a threshold. This system is termed as credit scoring (Heffernan, 1996). This process cannot only minimize processing costs but also reduce immanent judgments and potential biases (Bluhm et al., 2003; Derban et al., 2005). The rating systems if significant should indicate changes in anticipated level of loan loss (Santomero, 1997). Quantitative models make it possible to numerically prove which factors are essential in explaining default risk, assess the proportional level of importance of the factors, improve the pricing of default risk, be more able to screen out bad loan applicants and be in a better position to calculate any reserve necessary to meet anticipated future loan losses (Chijoriga, 1997).

Distinctly established process for approving new credits and extending the existing credits has been found to be very important while managing CR (Heffernan, 1996). Monitoring of borrowers is very crucial as current and possible exposures change with both in time and the movements in the fundamental variables (Donaldson, 1994; Mwisho, 2001), and also very important in dealing with moral hazard problem (Derban et al., 2005). Monitoring requires, among others, regular reach with borrowers, generating an environment in which a financial institution can be seen as an entity that can figure out problems and as a hopeful adviser; formulate the culture of being supportive to borrowers whenever they are seen to be in trouble and are straining to handle the situation; monitoring the flow of borrower's business through the bank's account; regular review of the borrower's reports as well as regular visit to the borrowers work place; updating borrowers credit files and periodically reviewing the borrowers rating allocated at the time the credit was given (Donaldson, 1994; Mwisho, 2001). Al-Tamimi and Al-Mazrooei (2007) investigated the degree to which the financial institutions of UAE use risk management practices and techniques in dealing with different types of risk. They compared risk management practices between national and foreign banks. The study found that the three most important types of risk facing the UAE banks are foreign-exchange risk, followed by credit risk and then operating risk. The study also found that UAE banks are efficient in managing risk. The results indicate that there is a difference between the national banks and foreign banks in the practice of risk assessment and analysis.

2.8 Tools of credit risk management

Tools like collateral, loan securitization, credit rationing, and loan syndication are used by financial institutions in controlling credit losses (Berger and Udell, 1992; Hugh, 2001). As also observed high-quality CRM staffs are decisive to check that the profoundness of knowledge and judgment required is always available (Wyman, 1999). Donaldson (1994) and Jeremy and Stein (1999) mentioned that computers can be employed in credit analysis, monitoring and control. When computers and IT based programmes are used in CRM they make it simple and easy to know the course of credits within the portfolio. Risk management is primarily about people (Marphatia and Tiwari, 2004). Thus how they think and how they act and react with each other. Obviously, technology is only a tool which may be ineffective if found in the wrong hands. This emphasizes on the importance of qualified staff in managing credit risk.

Moreover, Fatemi and Fooladi (2006) indicated that there are vendor-marketed models developed that can be used to measure credit migration and default risk at the portfolio level and that can also be used to allocate capital. This category includes models marketed by CreditMetrics, CreditRisk+, KMVs Portfolio Manager, and McKinseys Credit Portfolio View

Marketed by J.P. Morgan, CreditMetrics was one of the first portfolio models developed for evaluating credit risk. It incorporates a methodology for assessing a portfolios value at risk (VAR) arising from changes in counterparty credit quality. It establishes an exposure profile of each counterparty, represented within the portfolio, and combines the volatilities of the individual instruments (taking into account correlations between credit events) to model the volatility of the aggregate portfolio.

CreditRisk+, marketed by Credit Suisse, is an adaptation of the Credit Suisse Groups methodology for setting loan loss provisions. It is capable of assessing risk capital requirements in an environment where illiquid loans (with little associated data) are held to maturity. Accordingly, its methodology may be more appropriate for firms with retail and institutional loan portfolios, as opposed to those with more bond-oriented compositions.

KMVs Portfolio Manager measures the risk and return characteristics of a portfolio and allows the user to explore the incremental effect of a changing exposure to an individual asset. It also provides for an examination of the effect of a large-scale change to the portfolio mix and, an assessment of potential changes in tactics and strategy. Further, it can be a valuable tool for determining aggregate capital requirements and the allocation of economic capital.

Finally, McKinseys Credit Portfolio View takes into account specific country and industry influences in order to arrive at better estimates of default and credit migration probabilities. It incorporates the evolution of the global macro-economy into country- and industry-specific speculative default rates. It then maps these rates into cumulative migration probabilities by country and by industry.

As this brief description of some of these models suggests, the increasing complexity of the world of credit risk has given rise to an equally complex set of models designed to measure and manage this risk. This study is also to ascertain whether MFIs in Ghana make use of any of these models in credit risk management.

CHAPTER THREE METHODOLOGY AND PROFILE OF THE STUDY AREA

3.0 Introduction This chapter covers the methods and materials of the study. It takes into account the entire research design that is methods adopted in the sampling technique; sample size of the study; the nature and source of data, and the way these data were collected and analyzed. The purpose of the research, research approaches and strategies of the study are also discussed in this chapter. The chapter also captures the background of the study area

3.1 Purpose of Research Research purpose has been classified by Saunders et al., (2007) into 3 types exploratory, descriptive and explanatory. The exploratory research is a valuable means of finding out what is happening; to seek new insight; to ask questions and to assess phenomenon in a new light (Robson, 2002). The main purpose for an exploratory research is to collect as much data as possible in a specified area of research and enlighten it in a versatile approach. The descriptive research aims to present a complete description of a subject within its context (Yin, 1993). This research approach answers the questions: what, who, where, when and how. Descriptive researches are often used when it already exist an amount of knowledge about the subject, this knowledge can then be used to categorize into models. The explanatory research presents data relevant for cause-effect relationships. It is therefore the best approach to adopt n explaining how events occur (Saunders et al., 2007). This paper mainly had an exploratory research purpose since it aims a deeper understanding of the credit risk management practices in microfinance institutions and the effectiveness of these practices in managing credit risk.

3.2 Research Approach Saunders et al. (2007) mentioned that research can approach its problem in two main varieties of ways. An approach can be: i. Either a deductive or an inductive research approach

ii. Either a qualitative or quantitative approach or both This study adopted a deductive approach as it is based on existing literature and theories. The empirical data gathered were only compared to the exiting theories and conclusions drawn. According to Yin (2003), the differences between qualitative and quantitative approaches are the assumptions they built on. In qualitative research approach, the data collection is based on soft as in the form of qualitative interviews. The quantitative approach however refers to measurement by data collection and statistical facts (Saunders et al., 2007). According to Yin (1993), a qualitative research approach is used when the research deals with a smaller number and/or amount of material and when the research is based on words. A qualitative approach enables the researcher to comprehensively understand a certain problem, and has a holistic view (Saunder et al., 2007). Furthermore, qualitative research is exceptionally helpful identifying the scope of the research and used to fully understand the views, opinions and attitudes that the researcher come across. According to Silverman (2000), the strength of qualitative research is its focus on actual practice and how social interactions are routinely performed. Quantitative research is to express a better understanding of the material, and also to answer questions why and how and sees the connection between different variables. The qualitative research approach was adopted in answering the questions on the challenges MFIs face in managing credit risk. The quantitative approach was however more helpful in ascertaining the MFIs understanding of credit risk, efficiency of credit risk assessment, methods use to identify credit risk, efficiency in credit risk monitoring and controlling system, the efficiency of credit risk analysis and the efficiency of credit risk management practices.

3.3 Research Strategy

The research strategy is often described as the general plan to answer the research questions poise by the researcher (Saunders et al., 2002). According to Yin (1994), there are five major research strategies used to answer research questions which are experiments, surveys, archival analysis, histories and case studies. The study adopted a case study approach. The study was a case study of the credit risk management practices in microfinance institution in Ghana using the Kumasi as a case. Yin (1994) suggests that a case study methodology is a preferred research approach where the research question to be addressed is a type of how-why; control of the researcher over the research is none or very insignificant and the focus is on a contemporary phenomenon. Because of these differentiating characteristics, no approach could have answered and achieved the research questions and objectives respectively than the case research method. As Yin (1994) notes, cases are not samples and should not be selected as such. In the case study methodology, the focus is not on a limited number of predetermined independent variables, but on factors, which are helpful in explaining the observed phenomena. Kumasi is centrally located in the middle belt of Ghana. It is therefore endowed with almost all human characteristics of the country (in terms of tribes, religion and beliefs, etc) and therefore the region signifies the entirety of Ghana in a way.

3.4 Sampling Frame and Method The sampling frame for the questionnaires administration was all Microfinance Institutions operating and has been operating in Kumasi for the past three years.

A list of all Microfinance Institutions operating in Kumasi with their dates of commencement of activities was collected from the Bank of Ghana branch at Kumasi. Forty (40) MFIs of those that qualified as part of the sampling frame was selected were selected using the simple random sampling process. The simple random sampling technique gave all MFIs in the sampling frame an equal chance of being included in the sample. The characteristics of the individual enterprises were therefore irrelevant to their selection (Lind et al., 2005). To satisfy the condition of randomness, a table of random numbers was used in the sample selection to ensure that chance alone did not determine element than would have been.

3.5 Data Collection Instrument and Methods The research employed questionnaires to collect the data. The questionnaires were administered to three staffs (one staff from credit department, one from risk departments and other from administration) of each of the forty sampled MFIs. The questions were made of both closed and open-ended questions. The data gathering techniques used for the questionnaire included organizational variables of the MFIs respondents, products and services they offer, their understanding of credit risk management, efficiency of credit risk assessment, methods use to identify credit risk, efficiency in credit risk monitoring and controlling system, the efficiency of credit risk analysis and the efficiency of credit risk management practices and challenges the MFIs face in managing credit risk.

The organizational variable section of the questionnaire incorporated the following organizational information of the respondents: date of establishment; areas of operations; organizational types; operating status and regulatory frameworks/institutions of the MFIs.

The products and services centered on nature of products and services they offer over a period. Questions on credit risk management practices and challenges in credit risk management were also solicited. Question on understanding of credit risk management efficiency of credit risk assessment, efficiency in credit risk monitoring and controlling system, the efficiency of credit risk analysis and the efficiency of credit risk management practices section employed Likert Scale. All the respondents were asked to indicate their degree of agreement with each of the questions on a five-point Likert scale.

The first drafts of the questionnaire were pre-tested using 5 selected MFIs in Adum, Kumasi. This helped to fine tune the tools for possible re-design, reduce the total time spent on using each tool for the data collection and the relevant of the responses to the answering of the study questions. Questionnaires with covering letters were delivered personally to potential respondents at the various branches of the bank to eliminate the unreliability of the postal system. Annual reports, auditors report and credit risk policy of the various MFIs were thoroughly read and reviewed to serve as checks and balances to ensure accuracy of responds to the questions asked. Also the MFIs credit risk managers implements most decision and/or policy of credit risk and therefore the credit risk mangers was interviewed. The study therefore made use of both primary and secondary data. Appendix 1 presents the final structured questionnaire used for the study.

3.6 Data Analysis

The obtained data from the questionnaire were analyzed through Statistical Package for Social Sciences (SPSS) version 16. The statistical methods involved those of descriptive (mean and standard deviation) and inferential statistics (Pearson Correlation).

The details of the scoring for the Likert Scale used for this assessment are presented below:

1 Strongly Disagree: That the respondents strongly disagree with the statement or the issues as it applies to credit risk management of the MFIs. 2 Disagree: That the respondent disagrees more than she/he agrees with the issue with regards to credit risk management of the MFIs. 3 - Not sure: This means that respondents are not able to give knowledgeable response on the issue. It also denotes a position of neutrality. 4 Agree: The respondent agrees more that she/he disagrees with statement or issues on credit risk management of the MFIs. 5 Strongly agree: Respondent strongly agrees with the statement/issue as it applies to credit risk management of the MFIs. The assessment of the understanding credit risk management, efficiency of the assessment of credit risk, efficiency in credit risk monitoring and controlling system, the efficiency of credit risk analysis and the efficiency of credit risk management practice were done in two main levels. The aggregate rating, based on the score of the various statements under each thematic areas of the credit risk were used for the study. In this situation, an aggregate score above 50% of the expected aggregate total score was deemed to demonstrate a Good grade whilst below 50%

was assigned a Poor grade. The ratings were compared to the organizational backgrounds of the respondents using cross tabulations and the chi square test of dependency. On the second level, the Likert questions under each thematic areas of the credit risk were analyzed. On the basis of the scoring scale, it could be deduced that a mean score below 3 of each statement of a theme denotes a general disagreement with that statement. On the other hand, any mean score of above 3 was deemed to indicate an agreed general perception on the statement. The responses of the open-ended questions of the questionnaire were subjected to descriptive analysis and conclusions drawn.

3.7 Background of Kumasi

Kumasi is located in the transitional forest zone and is about 270km north of the national capital, Accra. It is between latitude 6.35o 6.40o and longitude 1.30o 1.35o, an elevation which ranges between 250 300 metres above sea level with an area of about 254 square kilometres. The unique centrality of the city as a traversing point from all parts of the country makes it a special place for many to migrate to. The metropolitan area shares boundaries with Kwabre East District to the north, Atwima District to the west, Ejisu-Juaben Municipal to the east and Bosomtwe to the south. With a population of 1,517,000, Kumasi is the second-largest city in the country. The largest ethnic group is the Ashanti, but other ethnic groups are growing in size. Approximately 80% of the population is Christian and 5% Muslim, with a smaller number of adherents to traditional beliefs (wikipedia, 2010).

Kumasi is a rapidly growing one with an annual growth rate of 5.47 per cent (Regional Statistical Office, Kumasi) cited at http://www.ghanadistricts.com/districts/. It encompasses about 90 suburbs, many of which were absorbed into it as a result of the process of growth and physical expansion. The 2000 Population Census kept the population at 1,170,270. It was however projected to 1,610,867 in 2006 and has further been projected to be 1,889,934 by 2009. Labour Force The 2000 census results show that 76.9 percent of the population aged 15 years and older in the region is economically active. The proportion of the economically active population that is those who worked, for at least one day, in seven days prior to the census was 71.4% in the Kumasi metropolis. The proportion of the unemployed population in the Kumasi Metropolis is 16.0%. The unemployment rates are more pronounced in the metropolis than the remaining urban areas. This general trend is the same for both sexes and may be as a result of the high rural urban drift, apparently in search of non-existent jobs. Students form the highest proportion of those who are not economically active in the metropolis, whereas the aged together with the retired form a relatively high proportion.

The Sectors of the Metropolitan Economy

The major sectors of the economy fall under Trade/ Commerce/Services which accounts for about 71%, Manufacturing/Industry which takes up of 24% and the Primary Production sector which takes only5%.

Primary Production

The primary production sector of the metropolis is made up of urban agriculture and quarrying/sand winning. The agricultural sector, which is made up of farming, aquaculture, horticulture etc is limited to production of staple crops including maize, plantain, cocoyam, cassava, vegetables and nursery of industrial crops mainly oil palm, citrus fruits. There is also specialization in the distribution of food crops which are brought in from other parts of the country.

Manufacturing/ Industry

The Industrial Sector is made up of manufacturing (breweries, beverages) and wood processing (plywood, boards). Most of the industries are located in the Asokwa-Ahinsan-Kaase industrial area, the hub of large-scale formal industries. There is Vehicular parts production and service industry located at Suame Magazine which is the second largest industrial area in the metropolis.

The Informal production sector consists of Woodworking industries which are into the production of furniture located mainly at Anloga and Sokoban. There are pockets of wood workers who are also scattered metro-wide. Petty commodity production (carving, weaving and pottery) are also located at Ahwia. However, there is a decline in industry due to high cost of production resulting from high energy cost and cheap imports. There is also a vibrant construction industry (building and road constructions) in the metropolis.

Service (Trade/Commerce) Sector

Consists of an integrated system of markets at Adum CBD, Kumasi Central Market (single largest market in West Africa) with linkages to the satellite markets at Asafo, Bantama, Asawase, Ayigya, Ahinsan, Oforikrom, Tafo, Atonsu-Agogo, Santasi, Suame, Amakom, Bomso and Tarkwa, etc. In addition to these, Banking, Insurance, Transportation, Hotels, Restaurants and Traditional caterers (chop bars) and other Tourist sites are found in the city.

Major Economic Activities

Although many people in Kumasi are engaged in a form of employment (Employment level 86 percent) either with the private or public sector about 60 per cent of residents still have a lower standard of living resulting from low incomes. Kumasi is predominantly a trade/commerce (service economy inclusive) with an employment level of 71 per cent. This is followed by industry and agriculture with employment levels of 24 per cent and 5 per cent respectively. Kumasi has therefore established itself as a major commercial centre. Commercial activity is centered on wholesaling and retailing. Both banking and non-banking financial institutions also offer ancillary services. Other areas worth mentioning are the professionals in planning, medicine, engineering, teaching and law practice. Another group of service providers are hairdressers and dressmaker/tailors. The formal estate of large industries located along the Asokwa-Ahinsan-Kaase stretch is engaged in timber milling and plywood manufacturing for the local market and export.