Credit Risk Management In Micro finance Institutions (A Case Study of Eshet Micro finance Institution Jimma Branch)

Credit Risk Management In Micro finance Institutions

 (A Case Study of Eshet Micro finance

Institution Jimma Branch)

A Research Proposal Submitted In Partial

Fulfillment of B.A Degree In Banking And Finance

BY: Milion Belay

To Advisor Yibeltal Ayalew

Co-Advisor Semere Getahun

Jimma University

College of Business and Economics

 Department of Banking and Finance

January 2013

Jimma, Ethiopia

ABSTRACT

The main purpose of this study is to assess the credit risk management practice of Eshet MFI on Jimma branch specific issues like client screening and delinquency was addressed, in addition the institution most frequently use clients screening mechanism, personal or group guarantee and assessment of business venture.

Thus the institution should employment other way of income generating activities other than high interest and service at minimum credit risk.

ACKNOWLEDGEMENT

First of all I would like to thank God for his helped me the inception to end this proposal.

I Would like to express my deepest thank to my adviser Mr. Yibeltal Ayalew and Mr Semere Getahun for Unlimited encouragement, constrictive and useful suggestion.

I wish to express my thanks to my mother for their great deal of financial support.

ACRONYMS

MFI: Micro Finance Institution

MFIs: Micro finance Institutions

5C’s: Capital

Collateral

Capacity

Character

Condition

Table of Contents

Contents                                                                                         Page

    Abstract................................................................................................. I

    Acknowledgement.................................................................................. II

    Acronyms............................................................................................... III

Table of Content........................................................................................ V

CHAPTER ONE.......................................................................................... 1

1. INTRODUCTION.................................................................................... 1

1.1     Background.................................................................................... 1

1.2     Background of the Organization....................................................... 2

1.3     Statement of the problem................................................................ 3

1.4     Objective of the study...................................................................... 4

1.5     Significance of the Study................................................................. 4

1.6     Scope of the study........................................................................... 5

CHAPTER TWO

   2. LITERATURE OF REVIEW ................................................................... 6

    2.1 Definition of credit deliver............................................................... 6

    2.2 Methods of credit delivery................................................................ 6

        2.2.1 Individual loans....................................................................... 7

        2.2.2 Group based lending................................................................. 7

  2.3 Loan product design ......................................................................... 7

  2.4 Client screening................................................................................ 8

  2.5 Delinquency management ................................................................ 10

  2.6 Credit Monitoring.............................................................................. 11

CHAPTER THREE..................................................................................... 14

  3. METHODOLOGY OF THE STUDY............................................................. 14

 3.1 Source of data.................................................................................... 14

 3.2 Methods of data collection.................................................................. 14

 3.3 Sample size and sampling techniques................................................. 14

 3.4 Data analysis and interpretation........................................................ 15

 CHAPTER FOUR...................................................................................... 16  4.TIME BUDGET AND COST BUDGET................................................................................. 16

    4.1 Time budget.................................................................................... 16

    4.2 Cost budget..................................................................................... 17

         References.......................................................................................

         Appendix A......................................................................................

        Appendix B.......................................................................................

CHAPTER ONE

1.  INTRODUCTION

1.1 Background of the Study

Similar to other sub Sahara Africa Countries the socio economic situation of Ethiopia is characterized by low growth of income some of the problems are social services, high population growth, economic inefficiency on  high unemployment e.t.c. Microfinance is relatively new industry which arose in the early 1980’s after the faller of the government delivery of subsidized credit to poor farmer. Micro finance there come in as the beginning of seeking effective market oriented solutions to the provision of substantial and effective financial resource for poor groups of people who do not have access to financial service from formal government and private financial institution.

Hence microfinance is emerged as his provision of financial service to poor, low income and active group of people in both urban and rural area in general. So provide financial service to face lack of capital to start up new business or to improve him existing one.

Microfinance here refers mainly to credit provision and saving  mobilization, some microfinance also provide insurance service, pension management and money transfer service.

The number of micro finance institutions that operate in the country has reached 28 at the end of 2012. More than 80% of this micro finance institution in the country have been operating in the rural areas where access to formal financial institution was nearly impossible.

1.2     Background of the Organization

Eshet MFI was established in legal registered by the national bank of Ethiopia, according to proclamation No 40/1996. Based on commercial code of Ethiopia and proclamation No 40/1996 Eshet microfinance established in March 2000 E.C Total number of branch is five /5/. Total  number of client 7119 out of which 2098 are urban and 5021 rural clients.

Objectives

• To improve the social condition of the people
• To provide sustainable development finance to low income people
• To encourage and promote the saving habit of individuals.

Vision

The spire to be a financially self-sustaining model MFI enhancing mainly livelihood of low income people

Mission

To provide need based financial service to strengthen the economic base of the low income rural and urban people through increased access to sustainable and cost efficient financial service.

1.3     Statement of the problem

Microfinance institution have a critical role by providing different financial product and services for the people and those who lack collateral to lend from formal financial institution, like bank, insurance companies  in both rural and urban areas. There service may be measured by quality of there service, way of giving loan, accepting saving deposits and insuring their customer and follow up /supervision/

Generally, MFI in Jimma is giving available credit service targeting to ensure sustainable life and development to the rural and some urban areas. Some of the hindrance factors to accomplish their goals are.

·         How Eshet MFI control activities of credit   system?

·         How Eshet MFI follow up loan granted regularity?

·         What is the effect of application of credit policy while granting loan to it’s customer on its repayment?

·         How Eshet MFI evaluate the operational efficiencies and other related activities related to credit and it impact?

Granting loan is supposed to be one of the most important activities of Eshet MFI in Jimma branch. Their mandate is that to control the loan repayment and disbursement. Currently credit managers of MFI devote great time and emerge to handle effectively and provide the society those have lower income.

1.4     Objective of the Study

Microfinance institution can contribute to the enhancement of standard of living and economic development as a whole. To improving the living standard of rural illiterate and poor people by using the instrument called microfinance institution.

1.  General  Objective

The general objective of the study is to asses the overall credit risk management system of the institution.

2.  Specific Objective

The specific objectives of the study are:

o   To see whether customer of the institution are satisfied with the loan product design.

o   To assess whether the client screening procedures following the credit manual of the organization.

o   To see whether the institution monitor credit risk by analyzing portfolio quality

o   To forward appropriate recommendation based on finding

1.5      Significance of the Study

This study will be expected to investigating the following significance, such as

o   It can help the institution to evaluate its operational performance and adjust some risk to the minimum.

o   It helps the researcher to improve the skill and knowledge about the credit risk management.

o   It will helps for the other researcher as a reference when they conduct study on similar study areas.

1.6      Scope of the Study

The Study will covers the MFI of Eshet Jimma branch on the credit risk management it also includes the credit officer with in the Jimma branch. The study will be limited in Jimma because of budget constraints cost and other necessary materials if the research is far from his/her resident.

CHAPTER TWO

2.  LITERATURE REVIEWS

2.1 Definition of Credit and Credit Risk

Credit borrower fund with specified term of repayment. When there are in sufficient accumulated saving to finance a business and when the return on borrowed funds exceed the interest rate changed on the loan it makes sense to borrow rather  than postponed the business activity until sufficient saving can be accumulated. He also stated that loans are generally made for productive purposes that are to generate revenue with in a business (ledger Wood 1998:34).

Credit risks is the chance that a debtor or financial instrument issues will not be able to pay interest. or repay principal according to the terms specified in the credit agreement.

2.2 Methods of Credit Delivery

Most micro finance institution has trend they best by ensuring that the services offered meet the demand of clients that operation area are as efficient as possible and cost are minimized that the fee and interest rate are sufficient to cover cost and that client are motivated to repay loans. According to ledger wood methods of credit delivery can generally be divided in to the following two categories.

o   Individual loans

o   Group based landing

2.2.1 Individual loans

Individual loans are delivered to individuals based on their ability to provide the MFI with assurance of repayment and some level or security.

Individual lending is requires frequent and close contact with individual clients, in both rural and urban areas individual lending is often occurred on financing production orientated business.

2.2.2 Group Based Lending

Group based approach makes loans to group that is either individuals who are members of a group and guarantee each others loans or to groups the sub loan to there member  Group based lending involves the formation of group of people who have a common wish to financial service. Furthermore, that if this here group member are jointly liable for each individual loans this representation a form of group collateral.

2.3 Loan Product Design

For microfinance institution on hare starts from design loan product to assessing clients to recovering lines extended. In design loan product involves establishing appropriate loan amount and loan terms. Collateral requirements or substitutes, interest rates fees and potentially compulsory saving or group contributions /ledger wood in handbook 1999:34/. Additionally Churchill and Dan coster in handbook 2001:15 presented the following texture of loan product design that MFI should consider in developing /designing/ its loans so that can mitigate its credit risk and delinquency.

§  Loan amounts reflecting clients repayment capacity. Eligibility criteria for a loan request.

§  Loan terms machine the loan terms to the client need so that they could repay the loan easily and comfortable. Collateral use of the innovative way of banking loans, including collateral substitutes peer pressure, group guarantees, character based lending, legislations, public embarrassment and alternative collateral. /Compulsory saving, personal garantee, pledging asset/

§  Loan pricing the lending methodologies and loan product design are supply driven instead of being demand giving clients. Clients of MFI are forced to fit to the procedural. The MFI have not attempted to involve in market study and develop and design a new loan product.

2.4 Client Screening

Client screening is one of the criteria for MFIS to provide credit. To MFIS it sees the over all ability and willingness of the customer to repay the loan. Mostly in smaller loans clients screening the important factor to determine the clients who will pay and who will not pay. In general the MFI’S evaluate the ability the clients by using screening in screening the institution usually use the 5c.

A.     Character: CHURCHILL and coster in handbook 2001:38) defined characters as “an indication or the applicant willingness to repay and run the enterprise” it also refer to the client willingness to meet it obligation to pay it credit. /Campaign in handbook, 2000:23/ Presented the following character screening techniques.

§  Checking personal and community reference to assess the applicants regulation.

§  User peer group in which client select other group members who they believe are honest are honest are reliable.

§  Maintain black list of poor performers to avoid repeat landing of bad client.

B.    Capacity: - This refers to the cash flows of the borrowers (from his business or house holds income) to services, loaned repayment. It is also the ability of client to meet credit obligation out of operating cash flows. Capacity is assess and become as the loan size increases /Churchill and Dan coster handbook 1999:38)

C.    Capital: - it refers to the application’s financial reserve it applies only to people who have property, it also means that the net work of the business. If he or she borrowed from the MFI and invested to start business, it indicated they are committed to the business. /MFI handbook 2005:12/

D.    Collateral:_ This refers to an asset that an applicant is willing to code in case of non repayment and guarantee by a person to pay loan in case of default /Churchill and Dan costr in handbook, 2001, 38/. According to (Gitman, 2003:45) the amount of assets the applicant has available for use in securing the credit. Traditional collateral is not a major part of the loan design rather MFI’s are both alternative and substitute collateral.

In general collateral is the most important thing to reduce the credit risk in client screening when on credit office revaluate the credit the major consideration to take place is collateral the client will repay the credit because of collateral so the credit risk is minimized.

E.     Condition: - This refers to assess the current business client of environment of a client of a client operate as well as unique circumstance affecting the credit transaction since the MFI’S don’t have expects to analyze all the condition form all types of business the primary means of controlling the credit risk posed by business condition is to require and that applicant be in business of for a certain period usually 6 to 12 months before they are eligible for a loan.

In general 5 C’s is the most important tool for controlling credit risk the clients have to fulfill all the condition to be eligible for loan other  wise if he/she failed to fulfill one of the conditions they are not eligible  for loan.

2.5 Delinquency Management

The two controlling system loan predict design and client screening is use only to reduce the rate of non-repayment the institution must have good delinquency management cultural to embrace zero tolerance for arrears and immediate follow up of all late promotes use this institution also have to orient property each new client regarding about credit polices on delinquency management in relation to this CARE economic department unit resounded the 42 following delinquency management method. Churchill in handbook 2000:42.

• Institutional Culture:-Those involve cultivating an institution culture embraces zero tolerance for arrears and immediate follow up on late payment.
• Client or initiation:- As a part of zero tolerance  institutions culture with on MFI’S orient each new client regarding the credit polices or delinquency.
• Staff incentives: - The staff of MFI’s play leading role in minimizing the MFI’s delinquency, hence financial and non financial incentives should be provided to the staff. This system may include disincentive such as holding the office accountable for making credit decisions.
• Diligence Penalty: - Clients should be penalized for late repayment this would include diligence fees pegged to the number of day’s late and limiting access to repeat loan based on performance and public embracement.
• Enforcing Contracts: - An MFI enforcers it contracts, especially on those clients having a wanted and uncooperative behavior in repaying their loans through the judicial system.
• Loan rescheduling a work rescheduling involves extending the loan period and/or reducing the installment size but before rescheduling the MFI should assess whether the client is willing and unable to pay.

• Works out measures and strategies are used to collect loans that already are in problem. It involves rehabilitation of agreement with the borrower if it can get out of problem. Extending the loan period injecting additional capital controlling expenditure e.t.c.

2.6 Credit Monitoring

Credit monitoring is helpful in avoiding any unusually activated before it happen. MFI’s use credit monitoring to analyze the portfolios quality periodically and to modify policies and procedures before the loan quality reterioates. MFI’s use portfolio quality indicator in monitoring  loans. Portfolio quality indicator can be measured using five /5/ methods which are repayment rate, portfolio quality ration, portfolio at risk, delinquent borrowers and loan loss ratios.

1. Repayment Rate

This is to one and the most important measurement for the historical rate or loan recovery. It indicated the amount of payment receive with respect to the amount due but it will not measure the banking finance quality of  recent portfolios but if the institution have low repayment rate it indicate the portfolio quality is decreasing rapidly if the MFI’s portfolio quality is decreasing in the denominator to the present loan will be can low and numerator collection rate to the  MFI Collection rate be high even if the collection rate is unchanged flow MFI (handbook 2005:16) (Ledger wood in handbook 2000,207) has presented the following three formulas to measure repayment rate.

Repayment :-       

Rate

On time repayment=

rate

Repayment  rate=

including

2. Portfolio quality ration

The portfolio quality ratios measure the quality of the present portfolio of MFI this measurement is used to indicate the level of risk in the present portfolio or the institution. Ledger wood in handbook 1999 presented the formula portfolio of the quality ratio to measure the quality of the MFI   portfolio.

Arrears ratio=  

3. Portfolio at risk

Portfolio at risk measurement the total balance of all loans that are in arrears it also indicates whether the delinquency is doing and can proving or deteriorating /ledger wood in handbook 1999:23/ present the formula.

Performing at risk=

4. Delinquent borrowers

The number of delinquents borrowers as one of the methods to measure portfolio quality. If the ration of delinquent borrowers is lower than the portfolio at risk or the arrears rate then it is likely that larger.

CHAPTER THREE

3. Methodology of the Study

3.1 Source of Data

• For the effectiveness of the study the investigator will use both primary and secondary data.
• Primary data will collect from employee and Eshet MFI head.
• Secondary data will collect from organizational records, manuals, reports and bulletings.

3.2 Methods of Data Collection

§  In order to achieve its objective the researcher will gather /collect/: -

o   Primary data through questionnaire from employee and through interview from Eshet MFI head.

o   Secondary data through observation which means by simply through eyes from report, organizational records and bulletins.

   3.3 Sample Size and Sampling Techniques

§ While nine /9/ employees will participate in the research Judgmental sampling method  /techniques/ to be used. Due to this the researcher will distribute questionnaires to all selected employees of the organization and interviews use for the organizations management heads.

3.4 Data Analysis and Interpretation

• The collected data from different source will be organized, tabulated and classified in percentage. According to their similarity using tables and percentage.
• The interpretation of the data will be in descriptive method.
• The interpretation  of the data will be expressed in clear, precise and meaningful way, based on this some reasonable recommendation will be made.  

CHAPTER FOUR

4. Time Budget and Cost Budget

4.1 Time budget

No	Item	Expected time to Complete
		Oct	Nov	Dec	Jan	Feb	Mar	Apr	May
1	Title Selection		x
2	Problem identification		x
3	Proposal Writing			x	x
4	Data collection					x
5	Data processing and tabulation						x
6	Data interpretation							x
7	final report writing								x
8	Presentation of paper								x

4.2 Cost Budget

There are different costs to be incurred to undertake the study. The researcher estimates the following minimum cost per item

No	Item	Quantity	Unit Cost		Total Cost
			Birr	Cent	Birr	Cent
1	Personal Cost		300	00	300	00
2	Secretary		200	00	200	00
3	Transportation cost		2	75	30	00
	Stationary
4	Paper	2	68	00	136	00
5	Pen	8	3	00	24	00
6	Pencil	2	1	00	2	00
7	Binder	1	18	00	18	00
8	Eraser	2	1	00	2	00
	Sub Total				712
	Miscellaneous Expense				250
	Total Cost				962

REFERENCE

1. Gitman Lawrence Principle of Managerial Finance 13^th edition 1997.
2. Ledger Wood Joanna Micro Finance hand book sustainable baking with poor institutional and financial perspective in world Bank 1999.
3. Zenabu Abera Banking theory and procedure part II Addis Ababa Commercial College, 2004
4. Compain improving internal Control. A practical guide form micro Finance Institution prepared by Microfinance Net Work with GT2 technical No 1, 2000.
5.  Churchill craig and Dan caster Microfinance hand book car 2001
6. Demister rovber financial institutions markets management second edition grew hill INC USA 1986
7. http/WWW/ Credit policy.com/

Jimma University

College of Business and Economics

Department of Banking and Finance

Appendix A

Questionnaires for employees

Dear respondent!

Questionnaires to involved in credit system of Microfinance institution in case study of Eshet Jimma Branch.

Finally, you are required to answer each question kindly and honestly and researcher promise all the finding will be reported and communicate your copy of the most confident.

Personal background

1. Sex       Male          Female     

2. Age        20-30       51-65     

                  31-50          > 65           

3. Educational status in grade.

     Degree                   Diploma

     Certificate               < 12

4. Marital Status

          Married                 Divorced

         Unmarried             Windowed

 Part II Subject Matter

5. Explain our organization writ off credit policy and loan approach   limit from beginning to end?

 _____________________________________________________________________

_____________________________________________________________________

6. Does your institution uses the five C’s in client screening or give loan to those who are political enforced to? Five C’s       Political criteria       both      

7. Do you apply character screening method?

     Yes              No     

8. How you can identify your customers character?

_____________________________________________________________________

_____________________________________________________________________

9. Do you assess the client capacity to repay the loan by looking their        

business or personal income?    Yes              No     

10. Do you institution a credit policy?

       Yes                  No

11. Which type of financial service does institution give?

       Individual         Group         Both    

12. Do you agree on the eligibility criteria that Eshet MFI required for   

      Loan request?     Yes                No       

13. If you answer to /12/ is no what other adjustment should be made?

     ____________________________________________________________________

  _____________________________________________________________________

14. Taking your condition, capacity and collateral in to consideration 

      does the institution give enough amount of loan?

        High          Law    

15. If your answer to/14/ is low fulfilling the above why do you thing the

      credit is low?

     ____________________________________________________________________

  _____________________________________________________________________

16. After disabusing a loan does MFI provide you enough periods to  

      repay the loan?  Yes             No

17. If you response is no to /16/ how long must be the loan term?

     ____________________________________________________________________

  _____________________________________________________________________

Appendix B

Interview Schedule

1. When the Eshet MFI as the institution start Work?
2. How you organize the clients?
3. How you control the loan repayment?
4. How you control default?
5. How to evaluate the operational efficiencies and other related activities related to credit and its impact?

DECLARATION

I under designed declare that this research proposal is my original work and has not been presented for a degree program in other University. All the material used for this research proposal has been duly acknowledged

       Name of Student ________________________

       Signature _______________________________

       Date ___________________________________

This Essay proposal has been submitted for examination with my approval as a University advisor

       Name of Student _____________________________

       Signature ____________________________________

       Date _________________________________________