THE EFFECT OF CREDIT RISK MANAGEMENT PRACTICES ON THE LEVEL OF

NON- PERFORMING LOANS ON COMMERCIAL BANKS IN KENYA

A CASE STUDY OF COMMERCIAL BANKS LENDING TO SMEs IN KENYA

JAMES MUKULO NDAMBUKI

BAF-05-0081-2021

MARCH 2024
 DECLARATION

This research project is my original work and has not been presented for a degree in any other
university
sign……………… date………………
James Mukulo Ndambuki
BAF-05-0081/2021

This project has been submitted for examination with my approval as university supervisor
Sign………………. Date………………
Mr.James Mincha
School of business and economics
Zetech university

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 ACKNOWLEDGEMENT

I wish to give my deepest gratitude to God the almighty who has given me strength, grace and
resources to persue my education.
My supervisor Mr. James Mincha for his great support, constructive feedback and thorough
understanding to keep me diligent.
I acknowledge the assistance from friends, classmates and all those who gave insight in any stage
in the writing of this project.

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 DEDICATION

This Research project is dedicated to my parents and brother who form an integral part of my
life.

iii
 ABSTRACT

Small and medium Enterprises Sector was formerly considered as the missing middlebecause the
businesses were too small to be financed by commercial banks and too largeto be financed by
microfinance institutions. This financing gap has however startedshrinking, but on the other hand
the high percentage of nonperforming loans ofcommercial banks are associated with the SME
sector. The immediate consequence ofnonperforming loans in the banking industry leads to bank
closure. The objective of thestudy was to establish the effect of credit risk management
techniques used to evaluateSMEs on the level of Nonperforming loans by Commercial banks in
Kenya.A descriptive study of credit risk management techniques was used by commercialbanks
in Kenya was carried out on all the banks. A regression analysis was developed inorder to
examine the relationship credit risk management and SME Nonperformingloans in Banks in
Kenya.The study established that there is a negative relationship between Credit
RiskManagement and Non-performing loans. Implying that the level of nonperforming loansis
inversely affected by credit risk management practices. To identify, analyze, monitorand mitigate
loan losses in the SME sector, most banks visited their SME businesspremises, sent credit
reminders, used risk based pricing and collateralized their loans.The paper recommends a
thorough re-examination of economic importance of SMEs inKenya and calls upon more
efficient support strategy and fund allocation from thegovernment and banks.

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 Table of Contents
DECLARATION........................................................................................................................................i
ACKNOWLEDGEMENT.........................................................................................................................ii
DEDICATION..........................................................................................................................................iii
ABSTRACT..............................................................................................................................................iv
LIST OF TABLES..................................................................................................................................viii
LIST OF FIGURES..................................................................................................................................ix
CHAPTER ONE........................................................................................................................................1
INTRODUCTION.....................................................................................................................................1
1.1 Introduction...............................................................................................................................1
1.2 background of the study............................................................................................................1
1.2.2 The Impact of SME on Economic Development.....................................................................3
1.2.3 Obstacle to Small Medium Enterprises Financing By Commercial Banks..........................3
1.3 statement of the problem...........................................................................................................4
1.4 research objective......................................................................................................................5
1.4.1General objective.......................................................................................................................5
1.4.2Specific objectives......................................................................................................................5
1.5 research question.............................................................................................................................5
1.6 research hypothesis.......................................................................................................................5
1.6.1 hypothesis one...........................................................................................................................5
1.6.2 hypothesis two...........................................................................................................................5
1.6.3 hypothesis three........................................................................................................................6
1.7 importance of the study...................................................................................................................6
1.8 limitation of the study......................................................................................................................6
1.9 scope of the study.............................................................................................................................7
1.10 Defination of terms........................................................................................................................7
CHAPTER TWO.......................................................................................................................................8
LITEATURE REVIEW............................................................................................................................8
2.0 Introduction.....................................................................................................................................8
2.1 Theoretical framework....................................................................................................................8
2.1.1 Information Theory of credit...................................................................................................8
2.1.2Power Theory of Credit.............................................................................................................8
2.2 Financial Risk..................................................................................................................................8

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 2.2.1 Credit risk.................................................................................................................................8
2.2.2 Sources of credit risk................................................................................................................9
2.2.3 Need for Credit Risk Management........................................................................................10
2.3 Credit Risk Management Process................................................................................................11
2.3.1 Credit risk identification........................................................................................................11
2.3.2 Credit Risk Mitigation............................................................................................................11
2.3.3 Credit Risk Analysis...............................................................................................................11
2.3.4 Credit Risk Monitoring and Control.....................................................................................13
2.4 Empirical Evidence........................................................................................................................14
2.5 Conceptual Framework.................................................................................................................16
2.6 Conclusion of the literature...........................................................................................................17
CHAPTER THREE.................................................................................................................................18
RESEARCH METHODODLOGY........................................................................................................18
3.1 Introduction...................................................................................................................................18
3.2 Research Design.............................................................................................................................18
3.3 Population Sample.........................................................................................................................18
3.4 Data Collection Instrument and Procedure.................................................................................18
3.5 Data Analysis.................................................................................................................................18
CHAPTER FOUR...................................................................................................................................20
DATA ANALYSIS, PRESENTATION AND INTERPRETATION...................................................20
4.1 Introduction...................................................................................................................................20
4.2 General Information......................................................................................................................20
4.2.1 Response Rate.........................................................................................................................20
4.2.2. Incorporation of the Banks...................................................................................................20
4.2.3. Nature of Operation of the Banks.........................................................................................21
4.2.4 Period of Existence.................................................................................................................21
4.2.5 Position of the Respondent.....................................................................................................22
4.3. SME Lending History...................................................................................................................22
4.3.1 Concentration of SME clients................................................................................................22
4.3.3Trend in terms of growth rate of SMEs accounts..................................................................23
4.3.4 How the growing Trend in SME accounts has affected the Level of nonperforming loans
in the banks?....................................................................................................................................23
4.4 Credit management techniques used for evaluating SMEs loan................................................24

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 4.4.1 Credit Risk Identification for SMEs......................................................................................24
4.4.2 Characteristics considered when evaluating the credit worthiness of SMEs clients..........24
4.4.3 Credit risk mitigation techniques of managing loan losses does your institution..............25
use on SMEs.....................................................................................................................................25
4.4.4 Credit Risk Monitoring..........................................................................................................26
4.4.7 Rate of loan default for SMEs compared to the Large Companies.....................................26
4.5 Non Performing Loans Analysis...................................................................................................28
4.6 Regression Analysis.......................................................................................................................28
CHAPTER FIVE.....................................................................................................................................30
SUMMARY, CONCLUSION AND RECOMMEDATIONS...............................................................30
5.1 Introduction...................................................................................................................................30
5.2 Summary and Conclusions...........................................................................................................30
5.3 Policy Recommendations..............................................................................................................31
5.4 Limitations and Assumptions of the Study..................................................................................32
5.5 Suggestions for Further Study......................................................................................................32
REFERENCES........................................................................................................................................33
APPENDICES.........................................................................................................................................35

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 LIST OF TABLES

Table 1: Incorporation of banks.................................................................................................................20

Table 2: Nature of Operation of the Bank.................................................................................................21
Table 3: Period of Existence.......................................................................................................................21
Table 4: Position of the Respondent..........................................................................................................22
Table 5: Concentration of SME clients.......................................................................................................22
Table 6: Growth trends of SME accounts..................................................................................................23
Table 7: Method used by banks for Credit Risk Identification...................................................................24
Table 8: Characteristics considered when evaluating the credit worthiness of SMEs clients....................25
Table 9: Credit Risk Mitigation...................................................................................................................25
Table 10: Asset Quality and Provisions......................................................................................................28
Table 11.....................................................................................................................................................29

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 LIST OF FIGURES
Figure 1: Conceptual Framework...................................................................................................................
Figure 2: Growth rate Trend of SME accounts on the level of NPLs..........................................................23
Figure 3: Distribution of credit reminder...................................................................................................26
Figure 4: Rate of loan default for SMEs compared to the Corporate Clients.............................................27

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 ABBREVIATIONS

CBK : Central Bank of Kenya

CRB : Credit Reference Bureaus
FSD : Financial Sector Deepening
NPL : Non-Performing Loans
SME . Small and Medium Enterprises

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 CHAPTER ONE

INTRODUCTION

1.1 Introduction

This chapter examines the background of the research topic, define what small medium
enterprises are, their impact on economic development and the obstacle they face while being
financed by commercial banks. Statement of problem will also be discussed along with the
objectives of the study and finally the importance of the study is another part of the study that
this chapter will try to identify.

1.2 background of the study

Banks as financial intermediaries are very significant in the economy of every nation. The
importance of banks to the economy lies mainly in their ability to facilitate savings and grant
credit to various economic sectors. Lending operation are typically the main banking activities
and most profitable asset of credit institution, but this activity involves huge risk to both the
lender and the borrower. In many markets, banks have to operate in an economic environment
that is affected by existence to obstacle of good credit management hence financial institutions
are exposed to risk. Credit risk is the major risk due to its impact on general performance of the
bank. Credit risk problem begins when depositor’s money (savings) is lend to borrower(loan)
who in return fails to make interest or principle payment for specified period hence causing
complication in management. “ where credit is not properly channeled, controlled and
administered, it leads to devastating effect on banks leading to financial losses , reducing the rate
of investors , lenders , borrowers and depositors will also end up losing confidence and maybe
withdrawing their funds in fear of reduction in profitability and further into bank distress and
failure “(Berger and Christa). Managing credit risk is a difficult task to any financial institution
and also the core one in the globe especially where economic event and financial system are
linked.
There is a negative relationship between credit risk management and non- performing loans.
Implying that, the level of non- performing loan is inversely affected by credit risk management
practices adopted by commercial banks. In order to bridge the risk profit gap, a microeconomic
framework for meditation is therefore required for depositors and lender. The complexity of
lending underline its importance as the highest most profitable aspect of bank operation lending
is therefore something that must be carried out with minimum loss. The quality of bank loan will
ultimately improve profitability and corporate survival

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To most of transitioning economies lending activities has been controversial and difficulty matter
this is because business firms are complaining about lack of credit and excessively high
standards set by financial institutions while financial institutions on the other hand have suffered
large losses due to bad loans, it has been found in order to minimize loan losses (credit risk} it is
essential for financial institution to have an effective credit risk management system in place. it
has therefore become imperative for financial institution to sustain the discipline attain these past
few years and stay focus on fundamentals of credit as standard measure to improve the quality of
loan portfolio. Lenders need to assess lending risk and device an effective way to hedge against
risk related to the borrower’s industry management and operation
Due to scarcity of information in the financial world which interestingly is fragile in nature, both
allocation of credit and use of credit are more prone to disturbance. Poor loan quality has its root
in information processing mechanism (Brown Bridge) observed that these problems are at their
peak stage in developing countries. Since capital market in developing countries is not yet well,
banks face intense challenges in management of credit risk management. Government control
frequent instability in the business environment which undermines the financial condition of the
borrowers. This shows that risk management should ensure the protection of assets and profit of
an organization .The only way this can be achieved is by arresting potential loss before they
occurs. The Kenyan financial industry has suffered from adverse disturbance resulting in distress
in some institution. Although borrowers themselves play a role in mounting of credit risk, the
failure of financial sectors to manage their risk reduce not only the financial system ability to
allocate capital effectively but also erodes public confidence in financial sector.
Credit risk management is a structured approach to manage uncertainties through risk
assessment, developing strategies to manage it and mitigation of risk using managerial resources.
These strategies include reducing the negative effect of risk and accepting some of the
consequences of a particular risk and transferring risk to another party. Lack of scientific models
of financial assessment has enabled freedom given to management during subjective decision
making hence extending credit to a person due to his reputation or to meet personal agenda.
Commercial banks in Kenya have faced difficulties over the years for many reasons. Laxity
credit standards to the borrowers, poor portfolio risk management and competitive climate
(Central Bank of Kenya Annual Report ). The central bank of Kenya developed risk management
guidelines for the purpose of giving direction to banks on risk management and creating working
frame work befitting international best practices which require banks to have a fully independent
credit risk management responsible for capital adjustment and provision for escalating non-
performing loans
1.2.1 Definition of Small Medium Enterprises
According to Felix Cheruiyot (Feb 22nd 2023) SME is a small business with annual sales lower
than Ksh 1 million. Small enterprises are those with that have 10-49 employees. A medium-
enterprises has 50-99 employees. SME are owned and managed by individuals or small groups
of people who bring together their limited resources to start and run a business. Most of these
ventures have informal approach to operations. They also go hand in hand with level of

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innovation and this is due to the availability of limited resources especially in third world
countries like Kenya. These types of enterprises require a good level of creativity to overcome
challenges and offer a healthy competition to the market. These creativity observed from SME
puts any economy in a state at the forefront of innovation, coming up with new and unique
products and services to meet customer needs. SMEs are found in various sectors in an economy
including; manufacturing and professional services. From the above description we can conclude
that SME contribute to global competitiveness by introducing new ideas, technologies and
product to the market and by doing this they help in influencing consumer choice due to range of
products and services that meet the need of different consumers.

1.2.2 The Impact of SME on Economic Development

SMEs play a huge role in stabilizing the economy of any country. SMEs are source of
employment, in a country like Kenya three quarters of workforce is estimated to be employed by
small and medium-sized enterprises this makes it a factor in reducing the rate of unemployment.
Secondly positively take part in economic growth, in a developing country like Kenya they
contribute highly in Kenya’s Gross Domestic Product. Joram Mwinamo, the chief Executive of
SNDBX, projected that the SMEs sector will contribute a whopping 50% to the country’s GDP
in the next three years. Among many other factors attracting foreign investors is one of them
SMEs helps in portraying the country as investment friendly and full of opportunities. Hence it
helps in attracting them as investors are looking in investing in a stable and growing economy.

1.2.3 Obstacle to Small Medium Enterprises Financing By Commercial Banks

SMEs face number of challenges that hinders them from acquiring adequate financing this
include; lack of collateral a major challenge faced by mostly the newly established enterprises.
Lenders will often request for collateral when borrower will try to access funding. Banks
definitely ask for collateral to mitigate the risk that may be due to moral hazard. The size of
collateral offered will also determine the size of funding. Lack of collateral may also lead to
higher interest rate offered by commercial bank. Secondly, high risk profile witnessed by SMEs
as compared to big co-operates this is mainly due to competitive nature of SMEs as owners are
trying to be creative and innovative on daily basis. This kind of healthy competition makes them
to experience more variable rate of return and maybe high rate of failure. The risk is estimated to
be high due to less equipped in terms of both human and capital resources to withstand economic
adversities this is made evident from what many countries experienced during Covid 19
pandemic. So if the enterprises fail to produce adequate accounting system which undermines the
accessibility and reliability of information concerning profitability and repayment capacity. The
banks or financer may view this as a negative factor with greater risk that the lender will not get
paid on time. Another major obstacle is information asymmetries, this is where one party in
transaction has better information than the other party. As for SMEs they may lack that level of

3
financial transparency or better financial document as those of large firms this may be due to low
level of education of small entrepreneurs. This factor majorly affects the developing countries,
hence this makes it difficult for the banks to lend off money. At times the information provided
to banks may not be accurate and realistic in this case banks may find themselves reducing the
amount of loans borrowed or refuse to lend money.

1.3 statement of the problem

With increase in credit transaction and loan customers in the nation economy, credit expansion
has been witnessed in Kenyan financial sector. The trend of event in this sector shows that bank
deposit-loan ratio increases as the economy grows but credit risk has been on an increase in
increase in loan demand. Credit being an important source of finance to SMEs, it gives them
chance to develop their enterprises which in one way increase their lifespan, it also enable them
to take part in new technology trends, enhance creativity, innovation and maybe expansion of
their business but this may not be the case as the commercial bank may not facilitate the SMEs
with the required amount of loan or fail to lend out due to their lending terms and conditions
From the banks’ point of view, some of the existing SMEs cannot access loans and this is
because they are yet developed and they still have short history and realistically that’s a risk bank
cannot bare taking. With that being a factor, some entrepreneurs lack education and the ability to
convince commercial banks that their enterprises are worthy receiving loans from the banks or
any financer since the problem of credit risk arise immediately a customer makes his request for
manager to make his decision. This problem then enlarges when repayment by customer is not
met and debt irrecoverable. So this may make the bank decide not to grant a loan to borrower.
The most avoided factor of this credit risk is the possibility that the borrower will not repay the
loan. This credit risk has effect of exposing banks to problem loans when they crystalize.
Traditionally credit was made in association with one’s financial status, business sustainability,
reputation and liquidity but the unstable situation in Kenyan financial market, makes it difficult
for banks to rely on mentioned determinants. Businesses condition are often
unpredictable(reason as to why SMEs have high risk profile as some did not manage to cope
with covid 19 pandemic) and can lead to changes in borrowers financial position and affect their
ability to repay the loan at the date of maturity leading to increase rate of non- performing loans.
Lender in Kenya try to address this risk assessment problem by either not lending at all,
including a well appraised collateral or having high interest rates this enable the bank to prevent
the effect of credit risk of losing part or the entire loan including the interest receivable on such
loans. This may also lead to lack of trust on the banking sector from the customers. Failure to
effectively manage credit risk leading to increase in non-performing loans, bank profits will
decline including the bank ability to fulfill its short term and long term obligation.
Properly managing of credit risk is the exercise of preventing financial losses related to credit
risk with the sole aim of increasing firms risk adjusted return rate and understanding the
sufficiency of financial institutions capital credit loss reserves at a particular point of time.

4
( Gitman 1997)indicated that the probability of evasion of payment of loans increases as firm
loan measures are overlooked. Societies should subsequently and accordingly guarantee that the
management of receivables is not just practical but also correspondingly feasible. These kind of
deferrals on money collection from obligated folks as they grow have higher avoidances, caused
terrible financial issues and affecting consumer relations. Although banks in Kenya have had risk
management policies that help them in minimizing the impact of non-performing loans, this has
not be the case from stats shown by commercial banks who are still having high rate of non-
performing loans
Although other researches have been conducted on the same subject, it seems that they have not
fully covered other essential parts that will enable our banks in Kenya to attain the lowest rate of
non-performing loans

1.4 research objective

1.4.1General objective
To determine effect of credit risk management practices on the level of non-performing loans in
commercial banks in Kenya
1.4.2Specific objectives
i. To assess the impact of loan portfolio diversification on non-performing loans
ii. To analyze the influence of credit risk assessment models on non-performing loans
iii. To examine the role of risk monitoring and reporting system to managing non-performing
loans
1.5 research question
i. How does the level of loan portfolio diversification affect the incidence of non-
performing loans in commercial banks in Kenya?
ii. What are the different credit risk assessment models used by commercial banks in Kenya,
and how do they vary in terms of complexity and predictive accuracy?
iii. What is the impact of timely risk monitoring and reporting on the mitigation of non-
performing loans in commercial banks, and how does it contribute to overall risk
management effectiveness?
1.6 research hypothesis
1.6.1 hypothesis one
HO A higher level of loan portfolio diversification in commercial banks in Kenya is associated
with a lower incidence of non-performing loans."
H1 A higher level of loan portfolio diversification in commercial banks in Kenya is not
associated with a lower incidence of non-performing loans
1.6.2 hypothesis two
HO There is a significant variation in the complexity and predictive accuracy of credit risk
assessment models used by commercial banks in Kenya.

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H1 There is no significant variation in the complexity and predictive accuracy of credit risk
assessment models used by commercial banks in Kenya
1.6.3 hypothesis three
HO; Timely risk monitoring and reporting significantly contribute to the mitigation of non-
performing loans in commercial banks, leading to improved overall risk management
effectiveness."
H1 Timely risk monitoring and reporting does not contribute to the mitigation of non-performing
loans in commercial banks, leading to fail in overall risk management effectiveness."

1.7 importance of the study

This study will help banks in their endeavor to cultivate better methods of managing credit for
the borrowers through understanding the issue that are faced by the borrowers and factors that
will determine the success of the loan.
This study becomes important because of the volume of bad debt, which has mounted in banks
over the years. the magnitude of non-performing credit in the banking system is a cause of
concern to different stake holders including bank management which granted the credit, bank
directors some of whom took the credit, depositors whose fund has been misappropriated, bank
supervisors, government responsible for protecting the banking system and the society at large.
This concern, arise not only because of the potential losses to depositors but because of the likely
loss of confidence in the banking system arising from systematic distress. When credit is not paid
the banking system would be unable to pay intermediating role. It thus becomes obvious that
everyone has a role to play in finding solution.

1.8 limitation of the study

A research work of this nature is fraught with many limitations. The finding of the study may be
specific to the context of Kenya and may not be directly applicable to other countries or regions
since banking industry, regulatory environment and economic condition may vary across
different countries. Secondly, changes in banking regulation during or after the study period may
not impact the effectiveness of credit risk management practices. Unavailability of credit
textbooks and the quality and availability of data can be significant constraint, incomplete or
inaccurate data may affect the reliability and validity f the study findings. Finally, the banking
industry is influenced by various sector-specific factors, such as changes in interest rate,
financial market condition and competition. The study may not be able to account for all this
factors potentially limiting the scope of its findings.

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1.9 scope of the study

The scope of the study shall be limited to effects of credit risk management practices on the level
of non-performing loans in commercial banks in Kenya. It shall be within the frame of
population size which comprises of all commercial banks in Kenya. However, the sample size of
the study is restricted to Equity Bank of Kenya, Kenya Commercial Bank and a coupled with
information from Cooperative Bank. Focus will be on risk management department of the stated
banks. The study will cover mainly some part of Central Kenya (Kiambu) where both depositors
and borrowers will be directly involved.

1.10 Defination of terms

Credit risk management-it’s the practice of mitigating losses by understanding the adequacy of a
bank’s capital and loan loss reserves at any given time
Credit risk-it’s the probability of loss due to a borrower’s failure to make payments on any type
of debt.
Credit-it’s the ability of a borrower to obtain goods, services or money with the understanding
that the payment will be made in the future.
Risk-it’s potential of gaining or losing something of value.
Management-this is the process of planning, organizing, coordinating, directing and controlling
resources to achieve organizational goals effectively and efficiently.
Non-Performing loans-loans that have not generated the expected income for the lender because
the borrower has failed to make payment of the principal and interest as scheduled.
Bank-its institution that deals with money and its substitutes and provide other money related
services.
Loan-a sum of money or its substitute borrowed that is expected to be paid back with interest.

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 CHAPTER TWO

LITEATURE REVIEW
2.0 Introduction

Empirical studies that have been done in the field of credit risk management will be examine in
this chapter
2.1 Theoretical framework

2.1.1 Information Theory of credit

Stiglitzetal 1981 stated that lenders are most likely to extend more credit while financing non-
viable project if they have more information about their borrowers, their credit history or other
lenders to the firm. If financial institution could better predict the probability of repayment of
credit by the potential customer then the amount of credit to firms and individual would be large.
Financial institution need information on repayment history of potential customer to be collected
and provided to them so having active private or public registries who are crucial for deepening
credit market. Each party has to give just information during credit transaction as it has important
implication on the nature of credit contrac: the ability of credit market to match borrowers and
lenders efficiently and the role played by the rate of interest in allocating credit among
borrowers.

2.1.2Power Theory of Credit

On trying to find out when lenders are more willing to extend credit, realistically, Djankov et al
found out that it’s when they are allowed to more easily force payment by either grab collateral
or even to gain control of the firm therefore in a state the existence of legislation that protects
creditors right on the quality procedure that leads to repayment of credit to some extent is a
limiting factor on the amount of credit in the country. As stated in power theory of credit;
financial institutions are more willing to extend credit if they can easily enforce repayment or
seize collateral.

2.2 Financial Risk

Managing financial risk is among the main issue of financial institutions need to
address hence finding themselves putting most of their resources in developing a
methodology that will reduce individual credit risk and maintaining quality
portfolios. These types of risks include financial risk, investment portfolio risk,
liquidity risk, interest rate risk and foreign exchange risk and interest rate risk.

8
2.2.1 Credit risk
This is the most addressed risk by commercial banks. It is sourced by failure to
repay the interest and principal as per the loan terms. Its mostly since it involves
both loss of income since commercial banks are not able to collect anticipated
interest earnings as well as loss of principal resulting from loan defaults (GTZ
2000). Hence it becomes difficulty to address since there is always availability of
the probability money not coming back whenever a commercial bank lends to a
client.
The most obvious source of credit risk is loans although financial institution
observing other sources of credit risk including foreign exchange transaction, bong
and guarantee and trade financing. (Fun Ho et al 2009) banks should have a keen
awareness of need to identify, measure monitor and control credit risk as well as
have adequate capital against these risk.
The main objective of credit risk management is to maximize a bank’s risk adjusted
rate of return by maintain credit risk exposure within the acceptable parameters.
Institutions are not only required to manage individual credit or transaction but also
the credit risk inherent in the entire portfolio. Basel committee in 1999 stated that
the effective management of credit risk is a crucial component of a comprehensive
approach to risk management and essential to the long term success of any lending
organization.
Both transaction risk and portfolio risk are included in credit risk: Transaction risk
refers to the risk within individual loan. Financial institution mitigates this risk
through borrower screening technique, underwriting criteria, and quality procedure
for loan disbursement, monitoring, and collection, while portfolio risk refers to the
risk obtained in association of the overall loan portfolio. Policies on diversification
whereby risk is be avoided from concentrating in a particular section, maximum
loan size to be issued, type of loans and structures lessen portfolio risk
2.2.2 Sources of credit risk
Lack of clear communication about product and methodology is a very influential
factor in sourcing credit risk. It is very important to have accurate procedure and
clear communication of policies. Confusion and delinquencies comes as results of
client not being familiar with policies and procedures. Delinquencies can also
happen as an aftermath of a natural disaster such as flood, drought, earthquakes or
epidemic (in Kenya commercial banks experienced a period of high delinquencies
during the covid 19 pandemic)
Poor or weak appraisal of loans is one of the major reasons for credit risk. Before
giving any loan, client’s repaying capacity needs to be figured out and status of
business and cash flows must be assessed.as this is essential in coming up with
decision whether the customer should be given a loan and amount of loan that suits
their paying capacity as loans given beyond repaying capacity put client in stress

9
situation as they do not have sufficient income to repay installments resulting in
credit risk
2.2.3 Need for Credit Risk Management
In economies where capital market is not yet well developed mostly third world
countries lending is still the mainstay of commercial banks though lending activities
in these transitioning economies has been controversial and difficult matter. This is
because business firms on one hand are complaining about lack of credit and
excessively high standards set by commercial banks, while financial institution on
the other hand have suffered large losses on bad loans
Basel (2010) found out that in order to minimize loan losses thus credit risk, it is
essential for financial institution to have effective credit risk management system in
place. With the presence of asymmetric information existing between lenders and
borrowers, commercial banks need to have a criteria that ensures that they not only
deal with credit risk that is familiar to them, this help in avoiding moral hazard. An
effective and efficient system that ensures repayment of loans by borrower is
critical in dealing with asymmetric information problems and in reducing the level
of loans losses, thus the long term success of any banking organization. Credit risk
management is essential in optimizing the performance of financial institution
(Basel 2010)
Greuning and Bratonovic (2003) stated that the basis of a sound credit risk
management system includes guidelines that clearly outline the scope and allocation
of bank facilities and manner in which credit portfolio is managed that is how loans
are originated, appraised, supervised and collected. Derban, Binner and Mullineux
(2005) recommended that borrowers should be screened especially by banking
institution in form of credit assessment.
Reliable information should be collected from the potential borrower as it is crucial
in accomplishing effective screening as indicated in the asymmetric information
theory. Financial institution can use quantitative and qualitative models can be used
in assessing the client. Qualitative models are subjective in nature and that makes it
a major challenge on using it. However, according to Derban, Binner and Mullineix
(2005) borrowers attributes assessed through qualitative models can be assigned
numbers with the sum of the values compared to a threshold. On using this model
commercial banks are reduced on processing cost and the effect of subjective
judgment and maybe possible biases. If changes in expected level of credit loans
losses indicated then rating system will be important. Brown Bridge (1989)
conclude that quantitative models make it possible to numerically establish which
factors are important in explaining default risk, evaluating the relative degree of
importance of factors, improving the pricing of default risk, screening out bad loan
applicants and calculating any reserve needed to meet expected future losses
(Derban et 2005).

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2.3 Credit Risk Management Process
2.3.1 Credit risk identification
For effective risk management it is essential to try and identify credit risk. For
financial institution to manage the risk facing them effectively they need to have
clear criteria on how to identify these risks. According to Christen and Pearce
(2005), the first step in credit risk identification is implementation of credit risk
management function to establish crucial observation areas inside and outside the
corporation.
The use of credit policies to establish the framework for lending and reflect an
institution’ credit culture and ethical standard. To be effective, policies must be
communicated in a timely fashion, be implemented through all levels of the
organization by appropriate procedures and periodically in light of changing
circumstances.
2.3.2 Credit Risk Mitigation
The main goal of credit mitigation is to reduce the impact of credit risk. There are
different types of tools used to mitigate risk including; diversification of risk,
adequate collateral, a guarantor, use of deposit account, insurance against risk, loan
covenant and credit derivative. Continual participation in the credit risk
management policy and strategies may also be effective in mitigating risk.
Availability of peer or group lending is essential in mitigating credit risk by
evading the risk of lending without collateral as large number of borrowers within
the group act as insurance cover for the institution while those members of the
group who are yet to receive the loans become bank agent in debt collection so as
they can have access to their loans also. The work of Credit Officers is therefore
shifted to these group members who are obligated to work overtime since they have
interest. Group savings may act as guarantee instead of formal collateral.
2.3.3 Credit Risk Analysis
Credit risk analysis is a process where lending decisions are based on an
evaluation of the firm’s financial position and its future prospects. It consist in
estimating the probability that the borrower will fail to repay its credit in
accordance with the terms and condition agreed and the expected loss that a bank
will incur incase the credit is not settled according to Guimon (2005), this process
involves an estimation of the firm’s future cash flow and of value of the assets that
could be provided as collateral or security for the credit in the event of default.
Terms and condition of contract and decision to lend are basically based on the
strength of the firm’s balance sheet. With certified audited financial statement,
which is also a lending rule that places emphasis on evaluating information from the
firm financial position can be used in financial estimate lending though this is
suited for those firms who are transparent. Hence lending to large firm is likely to

11
be a rule of choice. Berder and Udell (2001) added that when adapting this rule for
small firms, the firms must be one with long histories, relatively transparent
transaction and strong audited financial statement.
Feldman Master in 1997 defined Credit Scoring as numerical expression that
involves attaching heavy statistical weights to the financial condition and history of
the principal owner given that the credit worthiness of the owner and that of the
firm are closely related for most small and medium business. According to the
Banking Act of Kenya (cap 488), each bureau shall develop a credit score for every
person whose credit information has been submitted to the bureau also each bureau
shall retain for a period of at least five years the credit score of any person in its
possession or control. It also states that a customer credit score shall not be used
solely to deny the customer a loan, credit facility or any other financial service but
shall be used as one of the factors to inform the decision-making process when
determining the customer’s application for loan, credit facility or any other
financial service. For SMEs credit score include financial nature of both business
and business owner. Credit score is an essential process in identifying ad preventing
risk since; monitoring loan performance risk I crisis situations and structuring
facilities based on the credit score ratings, borrower viability and growth potential
will be evaluated, entrepreneurial capabilities being assessed and determining
financial requirement and earnings for bank, scoring system utilize information
relating to the traditional 5Cs of credit.
Character, its always assess whether the borrower has a good history of repaying his
loan on time and in full hence good borrower’s reputation and trustworthiness are
observed. Financial institution often review borrower’s credit score repayment
history and credit report to assess their character. Positive character shows how
reliable and responsible the lenders are. When lenders are attributed by
trustworthiness, maturity, discipline, honesty, dependability, and integrity, they will
settle their loan regardless it is secured or not. They will also not hide any financial
fact from commercial banks because they will always seek guidance from the
institution
Capacity, it assess the customer’s ability to clear his debt on time and in full. The
bank will determine whether the customer is able to achieve that by evaluating
customer’s income, employment stability and the existing debt obligation. The bank
will assess whether you have experience of borrowing and paying if the client has
borrowed from different banks and settled his loan on time then they will consider
him discipline and has high probability of keeping good record. The problem comes
when the borrower claims he is discipline while it’s their loan or maybe their
second loan then they will need to produce collateral to secure the loan.
Condition, these are mainly external factors that may affect the borrower’s ability to
settle his debt on time. These mainly include; economic condition, industry trends
and maybe the purpose of the loan hence economic environment need to be assessed

12
as is critical to determine whether the borrower can get credit. Financial institution
need to assess how external factors are going to impact the borrower’s ability to
meet his debt obligation. Changes in interest rates could or economic downturns
could affect repayment capacity.
Capital, financial institutions also consider the amount of capital that the borrower
has put forward to the potential investment. A large amount of capital can provide a
cushion against potential losses. Financial institution need to assess the borrower’s
net worth, do an appraisal on the asset and also assess the level of financial
commitment they have in the project. This will reflect the amount of equity the
borrower has at risk.
Collateral, these are asset or property that the borrower is willing to pledge as
security for the loan. It acts as a source of assurance to the bank that the loan will
not result to a loss. Commercial banks will always conduct a proper appraisal to
determine the value of the collateral offered; the quality, depreciation and
marketability of the collateral are important factors.
While each of the above factors is important on their own right, they however
should not be considered in isolation. While adverse record on each one is enough
to reject an application, good report on all aspects improve the probabilities of
success. Therefore, these elements can be used individually or in combination,
depending on the level of quality of credit appraisal required and amount of credit
involved. The credit rule is meant to help financial institution in Kenya to
thoroughly evaluate and assess the credit worthiness of existing and potential
customer before awarding them new or further credit and hence exposure of banks
and the avoidance of non-performing loans. The credit scoring rule covers the entire
area of credit risk and hence its application in credit risk appraisal will ensure that
banks and financial institution protect their asset against loss (Abedi 2000).
Relationship lending rule applies where commercial banks base decision to lend in
substantial part on long term relationship build with the borrower or on property
information about the firm and its owner. This information is obtained through
provision of loans (Berber and Udell, 1995) and deposit financial product
(Nakamura 1993). More information may also be gathered from community
members such as suppliers and customers. This information gathered over time is
considered valuable compared to the business’s financial statements, collateral and
credit scores. This information helps relationship lenders with the highest
probability of the real image of the business or firm. However, it involves role of
staff in gathering information which adds extra cost to commercial banks. There is
still a gap in the empirical literature as to how to determine how the relationship
lending works and how the organizational structure of the banks aids their ability to
deliver. It is also necessary to determine how recent changes in the economic
environment are likely to affect the availability of credit to small businesses.

13
2.3.4 Credit Risk Monitoring and Control
The last step of credit risk management process is monitoring. After the loan is
approved it is exposed to other risk hence effective monitoring and control
strategies are used to identify, assess and mitigate credit related issues. The loans
need to be continuously watched over. The borrower’s compliance with credit terms
need to tracked, conducting periodic valuation on the collateral, monitoring timely
repayment and any signs of irregularity to be identified early in advanced.
Accordingly, the credit risk management program of each institution must include
procedures governing the regular formal review and where applicable. Because of
their frequent contact with borrowers, Credit Officers are in position to detect
changes in borrower’s operations or financial condition. This permits these officers
to identify potential problems before they may be discovered by credit reviewers.
Accordingly, credit reviewer’s systems must ensure that a credit officer is
monitoring credit u quality and, where applicable. The objective of effective credit
review system includes; identify potential sources of credit risk this may be
obtained by observing changes in economic trends, industry trends and evaluating
individual credit and their commitment. Monitoring can also be done by
implementing an effective credit score or rating system. Diversifying credit
portfolio to spread risk as it may help to reduce the impact of risk affecting a
particular sector or group of borrowers. Setting credit limit and exposure controls so
that commercial banks are not exposed to excessive risk, conducting regular reviews
of credit portfolios, implement a early warning system of potential credit issues,
collateral management, stress testing, policy and procedure compliance and finally
monitoring economic and industry trends
2.4 Empirical Evidence
In 1981 Stiglitz and Weis observed that small and medium scale firms with
opportunities to invest in positive net present value project may be blocked from
doing so because of adverse selection and moral hazard problem. Adverse selection
problems arise when potential providers of external finance cannot readily verify
whether the firm has access to quality project. Moral hazard problems are associated
with the possibility of SMEs diverting funds made available for them to fund
alternative projects or develop the prosperity to take excessive risk due to some
pervasive incentive structure in the system.
Financing the small and medium enterprises in Africa is considered risky and as
result they are charged highly on loans. An average of 1.97% of the loan value of
small firms and 1.79% of medium sized firms are generally twice as high in
developing countries in terms of fee payment. Small and Medium Enterprises loans
in Africa appear riskier than those in developed countries. This may be due to the
high interest rates observed in Africa, thus the share of non-performing loans among
the small firm loans I Africa averages 14.5 % compared to 5.5 % in developed
countries. The non-performing loans ratio for medium sized firms is also higher in
Africa (6.8%) than in other countries (5.1%) (Beck)

14
Berger and Udell further noted that shocks to the economic environment in which
both banks and SMEs exist can significantly affect the willingness and capability of
banks to lend to small and medium scale firm. These shocks come in variety of
forms such as technological innovation, regulatory regime shifts, and shifts in
competitive conditions and changes in the macroeconomics environment. Financial
institution respond to these shocks in a number of ways, one of which is to develop
stringent lending rules that not only avail them of full information about the firm
and the owner, but also ensure that their investment in such firms are guaranteed in
both the short and long-run
Ogujiub et al (2004) established that access to credit market for small and medium
scale business in Nigeria was limited to macroeconomic instability and uncertain in
the business environment which had forced banks to lend short to SMEs and
overdraft and short term loans are made available at very high interest rates. They
also found out that they are heavily collaterized. The implication of the study
established is that many SMEs do not have access to bank loans.
Local studies done by the financial sector deeping in Kenya (2008) with the
objective of establishing whether lenders in Kenya used credit scoring rule to
evaluate credit worthiness of employees before give them loans found out that most
lenders used their own internal models to develop scorecard from their data. The
research found out that the main reason why lenders relied on internal ratings was
because there was no credit reference bureau (CRB) that was licensed at that time
the research was conducted.
In a related study in Kenya by Ongweso (2006), found out that loans losses were
attributed to ineffective credit risk management approaches adopted by the financial
institution and therefore there exist a relationship between credit risk management
practices and firm performance. Oketch(1995) studied demand and supply of SMEs
finance in Kenya and established that the size of loans to various borrowers depends
on the lending methodology where funds are lent to individual, appraisal depends on
business assessment, collateral. Business needs and replacement capacity, type of
business and availability of funds. For group based loans it depends on age of the
group appraisal of the project, past payment records, demand by client and
availability of funds. Oketch used SME financers and did not consider the influence
of rationing on SMEs operation. Rukwaro (2000) took the perspective of both the
SMEs and indeed concluded that credit rationing impacts negatively on the
operation of the SMEs.
According to study conducted by FinAccess (2007), found out that, Kenya’s financial sector is
the most advanced in East Africa, but only an estimated 55% to 60% of the population had ever
access to financial service. The study also found out that the key issue for access to financial
service is income, driven by three determinants which were being able to afford the minimum
balance and costs for a bank account, being able to afford bus fare to the bank, and finally having

15
 sufficient ‘excess’ cash to justify having a bank account. The commercial banks have used these
criteria to categorize their customer as either being creditworthy or uncreditworthy

2.5 Conceptual Framework

Independent Variable
Loan Portfolio Dependent Variable
Diversification

Risk management,
income stability,
regulatory
compliance, customer
needs, liquidity
management
competitive and

Credit Risk
Assessment Models
Level of Non-Performing
Traditional scorecards, Loans
behavioral scorecard
& application Profitability of banks,
scorecard market stability, economic
growth & bank cost-to-
income ratio

Risk Monetary &

Reporting System

Data collection and

aggregation, risk
identification, risk
measurement and
qualification, risk
mitigation and
response

Figure 1: Conceptual Framework

16
2.6 Conclusion of the literature
Credit risk management is structured approach to managing uncertainties through
risk assessment, developing strategies to manage it and mitigation of risk using
managerial resources. The strategies include risk sharing, avoiding the risk,
reducing the effect of risk and accepting some or all of the consequences of
particular risk. Lending has been and still is the mainstay of financial institution
and this is more to emerging economies of developing countries where capital
markets are not well developed. To most of transitioning economies, lending
activities has been controversial and difficulty matter, this is because this is
because SMEs on one hand are complaining about lack of credit and excessively
high standard set by financial institution have suffered large loan losses on bad
loans. It has been found out that in order to minimize loan losses thus credit risk, it
is essential for financial institution to have effective credit risk management system
in place.

17
 CHAPTER THREE

RESEARCH METHODODLOGY
3.1 Introduction
This chapter outlines the research design and research methodology that was adhered to in
conducting this study. Research design, population of the study, sample size, sample frame, data
collection methods and data analysis and presentation will all be described

3.2 Research Design

The research design major emphasis was on determining a cause that effect the relationship
between the two variables ie: independent variable (Effect of credit risk management practice)
and dependent variable (the level of non-performing loans). The causal design enabled the
researcher to establish the relationship between credit risk management practice on SMEs and
the level of non-performing loans of commercial banks in Kenya

3.3 Population Sample

A census survey was conducted involving all 38 commercial banks in Kenya licensed under the
banking act as 19 June 2022 as per the central bank of Kenya

3.4 Data Collection Instrument and Procedure

This research was conducted by the use of primary data and secondary data. Structured
questionnaire and unstructured questionnaire were used to collect primary data which helped to
cover wide range of baseline information about credit risk management practices. The response
was obtained from credit managers and credit officers from various commercial banks. The
questionnaire was divided into three parts; Part A, Part B and Part C. Their objective was;
gathering information about commercial banks, getting the response of commercial banks
involvement in SMEs and focusing on the main credit risk management practices adopted by
commercial banks on evaluating SMEs respectively. To get information on the level of non-
performing loans, financial statements of commercial banks were used in collection of secondary
data.

3.5 Data Analysis

The aim of this study is to investigate the credit risk management technique used by commercial
banks in Kenya in evaluating SMEs and their relationship to non-performing loans. Qualitative
and Quantitative techniques were used in analyzing the data, since there was collection of raw
data from the field, the data had to be sorted summarized in table and diagrams. This was
achievable by the using several stages of data analysis. Completed questionnaires were edited for
completeness and consistency. The data was then coded and checked of any error and omission.

18
After analyzing the collected data, the results were presented in the form of table, percentage and
graphs to analyze the data. The data will then be analyzed using Excel and statistical package for
social science (SPSS). Content analysis will also be used in the analysis of some open-ended
questions.
Model used
SME Non-Performing Loans=f (x1+x2+x3)
Thus SME NPL =b0+b1x1+b2x2+b3x3=b4x4+e
Non-performing loan ratio is ratio of non-performing loans/Total Number of outstanding loan
portfolio
x1 is credit risk identification
x2 is credit risk analysis
x3 is credit risk mitigation
x4 is credit risk monitoring
e is the error term

19
 CHAPTER FOUR

DATA ANALYSIS, PRESENTATION AND INTERPRETATION

4.1 Introduction
As set out in the research methodology this chapter will present analysis and findings of the
study. Questionnaire which were design in line with the objective of the study were used as
research instruments in gathering the data which has then been presented in qualitative form,
followed by analysis and discussions of the data results.
4.2 General Information
4.2.1 Response Rate
The study targeted 38 respondents in collecting data. 32 out of the 38 target respondents,
completed and returned the questionnaire contributing to 84.21 % response rate.
4.2.2. Incorporation of the Banks
The study sought to establish where the bank was incorporated. The results outlined in the figure
below reveal that of the 90.625 % of the banks that participated in the study were locally
incorporated while the other 9.325 % were incorporated in other countries This indicates that
majority of the respondents are banks that were incorporated locally.

Table 1: Incorporation of banks

Frequency Percentage

Foreign 29 90.625%

Local 3 9.325%

Total 32 100%

20
4.2.3. Nature of Operation of the Banks
In this section 50 % of the banks surveyed served only the local market while 34.375% of the
banks surveyed served the both the local and regional neighboring countries and the rest 15.625
% served different markets all over the world.
Table 2: Nature of Operation of the Bank

Frequency Percentage

Local 16 50%

Regional 11 34.375%

Multinational 5 15.625%

Total 32 100%

4.2.4 Period of Existence

Period of Existence out of the 32 responses showed that 1 bank had been in existence for a
period of less than five years but more than one year another bank had been in existence
for a period of 6 to 10 years. The rest 30 banks surveyed have been in existence for a
period of over 10 years.
Table 3: Period of Existence

Less than one year Frequency Percentage

1-5 years 1 3.125%

6-10 years 1 3.125%

Over 10 years 30 93.75%

21
4.2.5 Position of the Respondent
The target respondents were banks officers who worked in the credit department, Credit Officers
who participated in the survey formed 81.25% of the total target while Credit Managers were
18.75% of the response rate.

Table 4: Position of the Respondent

Position of the respondent Frequency Percentage

Credit officer 26 81.25%

Credit manager 6 18.75%

Total 32 100%

4.3. SME Lending History

4.3.1 Concentration of SME clients
Data presented showed that majority of SME clients are located in the urban and suburban areas,
with a concentration of 87.5% while SME clients in the rural area make up to 12.5% of the
clients. This means that most SMEs in the rural don’t have access to formal banking.

Table 5: Concentration of SME clients

Concentration Frequency Percentage

Urban 28 87.5%

Rural 4 12.5%

Total 32 100%

22
4.3.3Trend in terms of growth rate of SMEs accounts
Due to rapid competition that has now forced the banks to look for market in the SMEs sector a
growth rate on the number of SMEs account was on increase and this was seconded by the banks
surveyed

Table 6: Growth trends of SME accounts

frequency Percentage

Decrease 32 100%

Increase 0 0%

4.3.4 How the growing Trend in SME accounts has affected the Level of nonperforming
loans in the banks?
67% of the banks surveyed stated that the growth rate in the number of SME accounts
contributed to number of delinquent accounts in their loan books, the main reason is due to
venerability of SME to shocks in the economy as Inflation and Political risks. The other 33%
stated that the growth rate in the number of SMEs did not affect the trend of delinquent loans on
an increasing trend.

SME NPLs

Higher NPLs Lower NPLs

Figure 2: Growth rate Trend of SME accounts on the level of NPLs

23
4.4 Credit management techniques used for evaluating SMEs loan
4.4.1 Credit Risk Identification for SMEs

Table 7: Method used by banks for Credit Risk Identification

Mean Std dev

Visiting client premises 3.81 0.36

Credit scoring mechanism 3.71 0.217

Credit reference bureaus 3.59 0.74

Audited financial statement 3.125 0.25

As per the study finding the most important source of information when evaluating credit
worthiness of SMEs was visiting SMEs business in person which was represented by a mean of
3.81, this is important for the Credit officer to verify the physical residence of trading and gather
any information that may assist in Credit risk identification. The first runners up is the use of
credit scoring to assign a credit score to the SME clients this was shown by a mean rate of 3.71.
The use of credit referencing bureaus is gaining momentum in the Kenyan banking system this is
indicated by a mean of 3.59. Audited Financial statements method was the least method that was
used in credit risk identification and this is due to lack of proper records concerning their
businesses, unless SMEs have transparent transactions, long histories and are audited annually by
a Certified Public Accountant banks cannot use this method.
4.4.2 Characteristics considered when evaluating the credit worthiness of SMEs clients
The study went further to establish the various characteristics considered when assessing an
applicant before availing credit. Data in this section was analyzed using a likert scale. Results
presented in table 4.8 shows that the most important characteristic considered when evaluating
an SME applicant was the capacity of the SME to repay the loan with a high mean of 3.93
followed by the character of the borrower shown by a mean of 3.65 Amount of outstanding debt
was shown by a mean of 3.84 and length of lending history show by a mean of 3.21 and
Inspecting late payments was the least characteristic considered when evaluating an applicant
before availing credit for SMEs.

24
Table 8: Characteristics considered when evaluating the credit worthiness of SMEs clients

mean Std dev

Capacity to pay 3.93 0.44

Amount of outstanding debt 3.84 0.81

The character of reputation 3.65 0.44

Length of credit history 3.21 0.50

Inspecting late payment 2.84 0.71

4.4.3 Credit risk mitigation techniques of managing loan losses does your institution
use on SMEs
The most used technique used by commercial banks in Kenya in credit mitigation was found to
be Risk Base Pricing. This was shown by the high interest rates that were charged on SME credit
applicants to compensate for high risk that involved lending to SME clients. This was closely
followed by use of Collateral where the study findings showed that majority of SMEs business
loans were heavily collateralized. Others required that the SME to have a saving history with the
bank to enable the bank monitor the business cash flows. The use of a personal guarantor was
used in instances where the Collateral pledged by the SME client was not sufficient and the
guarantor had to guarantee part of the loan
Table 9: Credit Risk Mitigation

Mean Std deviation

Risk based pricing 3.93 0.32

Collateralization 3.78 0.88

Deposits 3.37 0.44

Personal guarantor 3.0 0.74

Insurance 2.81 0.50

25
Banks that used guarantors for SMEs, accepted guarantors who were only account holders and
had certain percentage of money in their accounts which would be used to guarantee the loan for
the period of the loan. Collateral that was used as security for the loan for SMEs included Motor
Vehicle log book, Land title deeds, Immovable Assets and Chattels.
4.4.4 Credit Risk Monitoring

disribution credit reminder

1-3 months 3-6 months

Figure 3: Distribution of credit reminder

Credit reminders are part of the credit monitoring process. Of the 32 respondents 27 (84.38%)
acknowledged their institutions provide credit reminders within 1 to 3 months. 5 (15.62%) stated
their institutions provide credit reminders after 3 to 6 months.
4.4.7 Rate of loan default for SMEs compared to the Large Companies
Study findings found out that 64% of respondents indicated that the rate of loan default was
higher among their SME clients, this was mostly the case for banks that capitalized on giving
credit facilities to SMEs, compared to 36 % of the respondents who indicated that the rate of
default was higher among the other clients.

26
 Loan Default Rate

Corporate client SMEclient

Figure 4: Rate of loan default for SMEs compared to the Corporate Clients

27
4.5 Non Performing Loans Analysis
Table 10: Asset Quality and Provisions

Asset quality of provision

Year 2017 2018 2019 2020 2021 2022

Net asset 636,000 755,300 951,232 1,183,654 1,353,654 1,678,112
Gross loan 415,300 473,100 533,796 670,372 757,760 914,920
Net loans 377,400 437,900 518,920 656,678 721,615 876,357
Gross non-performing loans 106,500 100,700 56,775 61,869 60,741 57,637
Interest in suspense 37,900 35,300 14,876 13,694 9,839 9,908
Total non-performing loans 68,600 65,300 41,899 48,175 50,902 47,730

Specific provision 39,000 41,700 23,503 25,519 26,308 28,645

Net non-performing loans 29,600 23,600 18,395 22,655 24,596 19,084

Gross loans 65.20% 62.60% 56.12% 56.64% 56.00% 56.50%

Gross NPL 25.70% 21.30% 10.64% 9.25% 8.00% 6.30%
Net NPL 7.10% 5.00% 3.45% 3.38% 3.20% 3.20%

From the Non-performing data obtained from audited financial accounts of Commercial
banks in Kenya, the trend of non-performing loans was declining from Ksh 68,600 Million in the
year 2005 to Ksh 65,300 Million in the year 2006 to Ksh 41,899 Million, In the year 2008 and
2009 there was an increase in non-performing loans to Ksh 48,175 Million and Ksh 50,902
Million respectively this was after the postelection violence in Kenya that affected the macro-
economic stability for businesses and hence an increase in non-performing loans. The overall
value of Net Nonperforming loans over Gross Non performing has been declining over the years,
this is as a result of improved credit risk management practices and economic growth in the
country.
4.6 Regression Analysis
A regression equation was used to determine the relationship where the Predictor variables are
Credit risk Identification, Credit risk analysis, Credit risk mitigation and Credit risk monitoring
SME Non-performing loans is the independent variable

28
Table 11

Model Unstandardized Standardized

Coefficient Coefficient
B Std error Beta T Sig
Constants 0.74 0.428 4.970 0,011
Credit Risk -0.36 0.357 -0.91 -2.459 0.036
Identification
Credit Risk -0.245 0.981 -0.19 -0.76 0.126
Analysis
Credit Risk -0.164 0.234 -1.83 -1.524 0.23
Mitigation
Credit Risk -0.232 0.063 -2.23 -2.341 0.018
Monitoring

The equation is
Y=0.741-0.361x1-0.245x2-0.164x3-0.232x4
From the regression equation it was established that holding Credit Risk Identification, Credit
risk analysis, Credit risk mitigation Credit risk monitoring at a constant non-performing loans
would stand at 0.741.
A unit increase in credit risk identification would lead to a decrease in the level of
nonperforming loans by 0.361
A unit increase in credit risk analysis would lead to a decrease in the level of nonperforming
loans by 0.245
A unit increase in credit risk mitigation would lead to a decrease in the level of nonperforming
loans by 0.164
A unit increase in credit risk monitoring would lead to a decrease in the level of nonperforming
loans by 0.232

29
 CHAPTER FIVE

SUMMARY, CONCLUSION AND RECOMMEDATIONS

5.1 Introduction
From the analysis and data collected, the following discussions, conclusions and
recommendations were made. The responses were based on the objectives of the study.

5.2 Summary and Conclusions

This study offers insights into the lending practices of Kenyan banks towards the small and
medium enterprises (SMEs) in Kenya. The results were based on the analysis of responses of
Credit managers and Credit Officers of 32 commercial banks that provide SMEs with credit
facilities. Findings reveal that the number of SME accounts in Kenyan Banks is on an upward
trend; this is as a result of increased competition in the industry that has forced banks to look for
new markets in the SME market. With the increase in the number of SME accounts, findings also
show that the volume of loans disbursed by commercial banks in Kenya have also being
increasing. Majority of the SME accounts are mostly concentrated in the urban and suburban
areas that means that most of the SMEs in the rural areas still do not have access to Formal credit
facilities.
Lack of access to finance is ranked one of the top obstacles to SME growth. This is rooted on the
information asymmetry problem facing both lenders and SME borrowers. The production of
quality credit information will help close the information gap. Commercial banks in Kenya use
different credit risk management tools to ensure that techniques and assessment models manage
their credit risk which have one main objective of reducing the amount of loan default which is a
principal cause of bank failure. Sound credit risk management policies have lower loan default
ratios (bad loans).
The Study Concludes that Commercial banks in Kenya used a combination of methods to
identify credit risk among SMEs this includes Visiting Clients premises, Using Credit Scoring
mechanism, Using information from the Credit reference Bureaus and also using Audited
financial statements .Visiting the Clients Premises was the most commonly used method by
Commercial banks in Kenya to Identify Credit risk among SMEs which have a mean response
rate of 3.81,this was mainly used to verify physical address of the business and identify potential
sources of credit risk for the SME customers, this was followed closely by the use of credit
scoring mechanism.
With the introduction of the Credit Reference Bureau regulations (2008) (CRB) banks have
quickly adopted the policy and are using licensed credit referencing bureau to identify credit risk
among the SME credit applicants. Credit information sharing through the credit reference
bureaus will enable borrowers build a track record that can be used in accessing credit and thus

30
bridge the information gap that exists between the Lenders and the SMEs. This will be especially
pertinent to those borrowers in the informal and small and Medium Enterprises (SMEs) who
have a track record and good performance to use it to access credit. Audited Financial Statements
was the least popular method used in Risk Identification for SMEs this is because most SME do
not have proper records concerning their businesses. Banks that used this method for SMEs used
them on SMEs with transparent transactions, long histories and were audited annually by a
Certified Public Accountant
Despite the importance of SME to economic growth and creating employment opportunities
SMEs operate in very risky environment thus Commercial banks in Kenya have responded with
very rigid terms and conditions to prevent/avoid instances of non-performing loans. This is
shown by the high interest rate that is charged to clients in this category compared to bank
lending to the large corporate clients. The high interest rates is as a result of Information
asymmetry between the lender and the SME, Moral Hazard, high transaction costs and
insufficient Collaterals and guarantees. Credit facilities to SMEs are heavily secured with
Physical Collateral as Land Title deeds, Motor Vehicle Log books, Business equipment, Chattels
and personal guarantors. Borrowers without access to such collateral have been constrained in
accessing credit. This findings confirm previous case studies done ( Beck et al ,World bank
(2008)), On the high interest rates charged on SME clients in developing countries compared to
SMEs in developed countries. Commercial banks in Kenya also require that the SME to have
operated a Deposits/Savings accounts for a period of six to twelve months before availing credit
facilities to them. This is an effective tool for monitoring the cash flow of the business. Personal
guarantors are used in SME lending when the collateral pledged is not enough to cover the
security, in most banks the guarantor is an account holder with the lender. Findings also show
that the amount of credit disbursed by commercial banks in Kenya has been increasing from Ksh
415,000 in the 2017 to KSh 914,910 in the year 2021, Consequently the amount of non-
performing loans has declining apart from the year 2019 and 2020 where there was an increase in
non-performing loans to Ksh 48,175 Million and Ksh 50,902 Million respectively this was after
the postelection violence in Kenya that affected the macro-economic stability for businesses and
hence an increase in nonperforming loans. The analysis found a negative relationship between
nonperforming loans and the credit risk management variables used in the study.

5.3 Policy Recommendations

The Kenyan market is currently experiencing an improvement in information sharing following

the implementation of credit reference bureaus. This will over time reduce information
asymmetries that exist in the market today for the SME clients. However, banks must respond to
this by combining this information with different credit risk management techniques used to
evaluate SMEs by reviewing the lending terms and conditions of SMEs. The government can
also provide special support units which includes impacting appropriate business skill through
workshops, expert advisers and enterprises forums to SMEs client, this will help the equip the

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business with appropriate business management skills for future challenges and reduce instances
of nonperforming loans.

5.4 Limitations and Assumptions of the Study

The study focused on a few variables of the SME sector that contribute to non-performing loans,
more variables like information asymmetry, moral hazard of SME lending, loan interest rate, and
appropriate business skills.
The study focused on Commercial bank lending to SMEs whose findings may not be generalized
to cover all financial institutions that lend to SMEs.
Due to time constraints there was a limitation on the data collection method as the questionnaires
were dropped and picked, as opposed to conducting an interview which could have gathered
more information.

5.5 Suggestions for Further Study

The study suggests a study should be undertaken to investigate the effect of the Credit
referencing bureau in Kenya on the Access of Credit Facilities on the Small and Medium
Enterprises.
Further analysis should also be carried out to find out the credit risk management strategies that
microfinance institutions and Sacco’s use to evaluate the SMEs.

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Unpublished MBA Thesis,Kenyatta University
Alice Kombo, Wesonga Justus, Noah Murumba, Makworo Edwin (2011) .An Evaluation
of the Impact of Risk Management Strategies on Micro-Finance Institutions’
Financial Sustainability: A Case o f Selected Micro Finance Institutions in Kisii
Municipality, Kenya. Educational Research, Vol. 2(5) pp. 1149-1153.
Baydas Committee (1999) Banking Supervision of Micro finance institutions: experiences
from Latin America, Asia and Africa, Occasional paper 1 Washington D.C : Micro
Finance etwork. Bulletin October 2003.
Berger, A.N and G.F. Udell (2001). Small Business Credit Availability and Relationship
Lending-. The Importance of Bank Organizational Structure. Federal Reserve Board
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Bester, H. (1994). The role of collateral in a model of debt renegotiation”, Journal of
Money, Credit and Banking. Vol. 26 No. 1, pp. 72-86.
Bierman, C.2005. Black Economic Empowerment and Cash for Small and Medium Sized
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Brown Bridge (1998) Financial distress in local banks in Kenya, Uganda and Zambia:
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Basel (2010) ‘‘Principles of management of credit risk” Consultative paper issued by the
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Beck T,Demirguc-Kunt,A,Peris,M,S,(2008) Bank Financing for Small and Medium
Enterprises around the world: Drivers, obstacles. Business models and lending
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Buckley, J., 1997.International technology transfer by small and medium-sized
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CBK (2006,2007,2008,2009,2010). Annual bank Supervision Reports.

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Derban, W.K., Binner, J.M., & Mullineux, A. (2005). Loan repayment performance in
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Djankov S,Mcleish and Shleifer A, (2005) “ Private Credit in 129 Countries,” NBER
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Feldman, R., (1997). Banks and a Big Change In Technology Called Credit Scoring. The
Region Federal Reserve Bank of Minneapolis, September 19-25.
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Banking Vol 28 Number 45-65.
Greuning, H. and Bratanovic, S.B. (2003), Analyzing and Managing Banking Risk: A
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GTZ, January (2000). Liquidity Management: A Tool Kit for Microfmance Institutions,
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Guimon Jose (2005). Intellectual capital reporting and credit risk analysis. Journal of
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Loans of Commercial banks in Kenya. Unpublished MBA Research project UON.
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 APPENDICES
APPENDIX A:
List of Commercial banks in Kenya
1. Absa Bank Kenya Plc.
2. Access Bank (Kenya) Plc.
3. African Banking Corporation Ltd.
4. Bank of Africa Kenya Ltd.
5. Bank of Baroda (K) Ltd.
6. Bank of India.
7. Citibank N.A Kenya.
8. Consolidated Bank of Kenya Ltd.
9. Co-operative Bank of Kenya Ltd.
10. Credit Bank Plc.
11. Development Bank of Kenya Ltd.
12. Diamond Trust Bank (K) Ltd.
13. DIB Bank Kenya Ltd.
14. Ecobank Kenya Ltd.
15. Equity Bank Ltd.
16. Family Bank Ltd.
17. First Community Bank Ltd.
18. Guaranty Trust Bank (Kenya) Ltd.
19. Guardian Bank Ltd.
20. Gulf African Bank Ltd.
21. Habib Bank A.G Zurich.
22. HFC Ltd.
23. I & M Bank Ltd.
24. Kingdom Bank Ltd.
25. KCB Bank Kenya Ltd.

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26. Mayfair CIB Bank Ltd.
27. Middle East Bank (K) Ltd.
28. M Oriental Bank Ltd.
29. National Bank of Kenya Ltd.
30. NCBA Bank Kenya Plc.
31. Paramount Bank Ltd.
32. Prime Bank Ltd.
33. SBM Bank Kenya Ltd.
34. Sidian Bank Ltd.
35. Spire Bank Ltd.
36. Stanbic Bank Kenya Ltd.
37. Standard Chartered Bank (K) Ltd.
38. Victoria Commercial Bank Plc.
39. UBA Kenya Bank Ltd
(Source, CBK as at March 2023 )

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APPENDIX B: QUESTIONNAIRE
PART A: General Information
1. Name of the Commercial bank............................................................
2. Where Registered/incorporated...........................................................
Local (Kenyan) ( ) Foreign(Outside Kenya) ( ) Other ( )
3. Nature of Operation
A.) Regional ( ) c) Multinational ( )
b) Local ( ) d) Other ( )
4. How long has the bank being in Operation in Kenya
a) Less than 1 year ( ) c) Between 6 and 10 years( )
b) Between 1 and 5 years ( ) d) Over 10 years ( )
5. Please indicate your rank in the bank...................................................
PART B: SMEs Lending history
1. where are SMEs clients mostly concentrated?
Rural ( ) Urban ( )
2. What has been the trend in terms of SMEs account in recent past years?
Increasing ( ) Decreasing ( )
3. Has the above trend affect the level of non-performing loans in commercial banks in
Kenya?
Yes ( ) No ( )
If yes how has it affected the level of non-performing loans?

………………………………………………………………………………………………………
………………………………………..

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PART C: Credit Risk Mitigation Tools used on SMEs
1. Which credit risk identification technique(s) does your bank use in identifying risk for the
SMEs?

Not at all Least Moderate Most

Credit Referencing
Bureau
Visiting Clients Premises

Audited Financial
Statement
Credit Scoring
Mechanism

2. Which of the following most accurately describe your loan assessment method for
SMEs?
Statistical ( ) Relationship ( )
Based on the answer above what is the reason behind method of choice?
………………………………………………………………………………………………………
…………
3. Kindly select the credit criteria does your institution adopt to test credit worthiness of
your SMEs client(s)
Not at all Least Moderate Most
The character & reputation

Amount of outstanding debt

Capacity to repay
Length of credit maturity
Inspecting late payment

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4. Which of the following credit risk mitigation technique of managing loan losses does
your institution use on SMEs?
Not at all Least Moderate Most
Collateralization
Personal guarantor
Risk Based Pricing
Deposit & Saving account
insurance

If a guarantor what kind of personal guarantor does your bank require before lending to
SMEs?
………………………………………………………………………………………………
…………………………………………
If collateral, what kind of collateral does your bank require as security for the SMEs loan
given?
………………………………………………………………………………………………
…………………………………………
5. Credit reminder are part of credit monitoring procedure, how often does your institution
provide credit reminder to SMEs client(s)?
After 1 to 3 months ( )
After 3 to 6 months ( )
After 6 to 9 months ( )
After one year ( )

6. Is the rate of loan default higher for SMEs than for corporate client(s)
Yes ( ) No ( )
If yes what is the reason behind it
………………………………………………………………………………………………
…………….
7. How does this impact the interest rate pricing for SMEs relative to the corporate client(s)
Increase the rate ( ) decrease the rate ( )

Thanks for taking your time to complete the questionnaire

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