Research problem statement

Banking Institutions play an important role that cannot be overstated. By carrying out a research on effects of credit control of Banking Institutions, it will be easy to draw appropriate credit control policies. Given that the primary source of revenue for financial institution is interest from loans, it is important that sound control of credit facilities be installed to oversee collection and receipt of periodic installments. Today financial institutions have set up credit management policies to evolve effective portfolio performance. If credit management policies are efficiently applied may lead to good portfolio performance of financial institutions (Fross, 2000). Loan regulations, rescheduling and impairment recognition are some of the policies used by most financial institutions to manage credit. This has called for many financial institutions like pride bank limited to design various credit management policies to support their endeavors in ensuring a sound portfolio performance. The study will also help to challenge banks to adopt credit control policies that suite them in hedging credit risk that face majority of financial institutions. There being various credit control techniques, the study will be looking for the most appropriate technique that can be used to mitigate the problems available in terms of payment of loans. This study will benefit established and upcoming banks to know how credit control affects financial performance and to be able to choose the most effective credit control policies.







Literature review

2.1 Introduction

The literature review will evaluate previous research on the dynamics of credit risks which are problems related to credit risk and possible solutions. PICO article search strategy will be embraced to ensure that the mandatory studies for this assessment are accessible.

2.2 Credit risks and the associated problems

Credit risks are commonly experienced by retail banks. A retail bank can get explained as a type of financial institution used by ordinary individuals in doing their daily business operations. Credit risk is uncertainty that the counterparty will not succeed in repaying the loan entirely or part of it. It includes payments delays or loan agreement defaulting (Onyiriuba, 2016).  It gets known that credit risk is among the top most dangerous bank risks, for that sole reason there exists a separate credit section operated around the management’s view of a credit culture.  The credit management department goal is maximizing the shareholder added value through the concept of credit management (Onyiriuba, 2016). Credit risk is high in retail banking if a loan is given and the collateral is undervalued, and that means recovery process will be affected.

There is a significant difference between risks related to people and credit risk associated with organizations because these risks arise apparently within the organization’s corporate services, business services, and cycle services and from organizational investment operations. Unlike individual credit risk, corporate credit risk has reduced loss pace but increased severity (Fross, 2000).  It is impacted by both primary economic status and by the borrower particular events. Given the loss events in frequency in such portfolios, the high-risk business officer recognizes that the significant losses absence is any given year or over several years is not primarily representative of institutional holdings risks (Fross, 2000).

Various services are offered by retail banking to people because it aims to be a single stop for as many financial aspects as possible on behalf of personal retail customers. The range of essential services offered to individuals comprise of  accounts checks, saving accounts, credit lines, personal loans, mortgages, debit cards, credit cards among others (Onyiriuba, 2016). It gets observed that the local banking services are utilized by most consumers; since they offer onsite client service for the entire retail client’s business needs. The local retail bank locations are also important in providing customer service and financial advice through financial representatives. That is the case when the financial representatives are first applications underwriting contact connected to credit-approved packages.  There is a broad range of services that get offered to organizations by retail banking. They include; loan offers and other credit commodities and this is the largest business area within retail banking and one of the most significant profits and loss sources for the bank (Onyiriuba, 2016). Also, cash management and treasury services applied by institutions in managing working capital and currency conversion demands; employee services such as payroll and team retirement plans; equipment lending in the form of structured customized loan and leases for an array of the material used by institutions in diverse areas such as manufacturing among others. Asset management and security underwriters are also related services through their investment banking arms (Fross, 2000).

The existence of a credit department in retail banking is of great help because it helps in assessing the credit risks through laying out the facts of the client or an institution. What follows is running a report because it is important to determine the skeletons in the individual or institutional closet though they meet the agency requirements (Bandyopadhyay, 2016). The bank has been keen on managing these risks through taking security for the extended loan which the retail bank can assume ownership of in a situation of loan agreements defaulting (Bandyopadhyay, 2016). In offsetting the marginal default probability increasing, the bank asks for more assets if the market price of collateral becomes volatile. Another credit risk management aspect adopted by the bank is portfolio building with diversification between moderate and high-risk lending with the aim of reducing the credit losses.

2.3 Credit risk management

Fight (2004) defines credit risks as the threats that banks and other financial institutions face whenever borrowers fail to make payment for the money given to them as a loan by the banks. Credit risk management is all about the practices and activities carried out to mitigate the losses by paying attention to the sufficiency of a bank’s assets and loan reserves at any particular time. Even though credit risk management has been a challenge to the banks and other financial organizations, it is critical in the prevention of losses. Credit risk management is a critical operation in the banking industry because they handle a lot of money. It is essential to carefully and accurately monitor how a financial institution lends out the money and the people they give the money. Due to the risks such as non-payment, money laundering, and financing terrorism, the banks need to implement a credit risk management operation to aid them in solving the cases of credit losses by the management of credit exposure within appropriate and acceptable limits (Fight, 2004).

The credit risk management helps the banks and other financial institutions to know their customers better and decide on whether the customer; the company or an individual is subject to credit. It is clear that nobody wants to or enjoys losing money.  The credit risk management also enables the banks to decide for themselves whether the borrowed money is for a reasonable and legitimate purpose (Fight, 2004). It also helps them establish the fact that the money that will be paid will come from a legal source and will be paid within the agreed time. Through the credit risk management, financial institutions ensure that there is no conflict of interests in their operations of lending; they make sure that all their customers receive the same services with same conditions without any exceptions. It makes it easier for them to make quick decisions and deliver faster services when they digitize the customer’s information and ensure that the information is protected conforming to the data protection laws and any other rule (Fight, 2004).

Banks and other financial institutions need the credit risk management to monitor or track down external events such as the economic changes and many others to be able to adjust their interest rates according to the changes. It also trains and creates awareness among employees of the effects of frauds and misappropriation of funds can cause to the company (Fross, 2000).

It is quite apparent that some banks are good at managing risks and did a better job compared to others. Taking an example of Subprime mortgages, the banks invested in assets that they never understood fully, they just got involved because their neighbors did the same.  They invested and gave out mortgages while assuming that the real estate industry could only go up. They never for a second think that just like any other businesses, the investment could fail too. The stress that came after many people lost their jobs and were unable to pay back the loans were so devastating, and the banks could not deal with it (Fight, 2004). A bank could have remained out of business totally, which would have yielded a few benefits amid the great years however diminished losses in 2007 – 2009. Would that have been “legitimate” risk administration? Perhaps, yet the bank couldn’t remain out all things considered, or it wouldn’t profit. And all organizations have dangers; subprime might not have been the most noticeably awful risk/remunerate proportion.

According to Witzany (2017), a failure of a credit risk management strategy can cost a financial institution a lot. Some of the effects they can face include the financial losses; this can occur in cases whereby the debtor becomes bankrupt and fails to pay the money back. Another implication is the credibility blows; bad credits or bad debtors affect the credibility of a financial institution. The can create a negative impression that can result in adverse outcomes (Witzany, 2017).Another consequence of the failure of credit risk management is shattered reputation. This mostly applies to small financial institutions that depend on the repayment of loans for survival. When the debts are not paid due to bad credit risk management, the reputation of the institution suffers a great deal

Banks carry out credit risk mitigation in two different stages; pre-sanction and post sanction stages. Pre-sanction involves all the activities that are done before the loan is given to the borrower. The activities in this stage include identifying the borrower and the purpose for which the credit is taken, knowing the period the loan will take to be repaid and determining if the repayment source will be legal (Witzany, 2017). It also involves the establishment of security for the loan, the profitability and sanctioning of limits. The post sanction stage involves accurate documentation of the limits, stamping, execution, and the registration of mortgages and many more. This is a process that when carried out appropriately, the banks are not exposed to credit risks.

According to Carty and Fons, (1993), credit risk entails the likelihood that the intrinsic threat of the asset transfers to a lesser quality level, thus leading to decreased security principles in a market-to-market valuing environment. Over the last ten years, a number of the international main expansion monetary institutes, particularly commercial banks have established sophisticated schemes to measure and total credit risk across topographical and invention lines (Carty and Fons, 1993). Altman (2004) reinforced the above sentiments by deliberating that in credit risk administration, approaches are established to permit a tailored and malleable method to price amount and risk managing. According to Wiley, (1998), flawed data on creditors can lead to credit restriction. The effects ofthe initiation of simple and risk-weighted capital capability necessities and rationing have been premeditated broadly, both empirically as exposed by the Basel board on Banking Management (1999), and ideally as discussed by Freixas and Rochet (1997).

Gup Fraser and Korari (1989) maintained that, failure is usually the result of reckless lending, lack of diversification or both. To this end Hempel, Simonson and Coleman (1994) stated that effective organization and control of the lending function are vital to the profitability and solution of everybank. Writing in support of the need for proper lending procedures, Cores and Hempel (1990) recommended the formulation and implementation of sound lending policies and so considered these to be among the most important responsibilities of bank directors and management. On their part, Rose and Korari (1995) believed that before establishing a loan policy, the institutions needs to be concerned about how individual applicants are evaluated. Rose and Korari (1995) outlined the following components: objectives: development and re- examination of loan policy provide directors with the opportunity to evaluate the role of the bank in community economic development its support to business and other important issues.

The bank of Ghana credit manual for banks maintains that the credit facilities may be granted for the purpose of conducting or carrying on, developing or improving farm, fishing, industrial and commercial operations to benefit the community. It continues that credit facilities may also be extended to maintain the efficiency of eligible borrowers in connection with their health, education and subsistence. Writing on the importance of the lending function, Crosse and Hempel (1980) argued that, traditionally and practically, the foremost obligation of a bank is to supply the credit need of business enterprises including business operations.


Affirming this stance, Rose and Korari (1995) touched on its significance of quantitative contribution of lending to the bank income, as well as the important role it plays in the social function that the banks perform in the economy. For a full realization of the above benefit, the banks first type or forms of credit is loan. The second type is the overdrafts. This is the amount a customer is allowed to overdraw over and above his or her normal deposit with the bank. Interest is charged only to the excess amount over the deposit. It is usually granted to the current account holders. In addition, Valentine and McCarthy (1995) further observed, discounting bill as a third form of credit. When a holder of a bill wants money from his bank and collects the money the amount he will collect from his bankers is less than the face value of the bill. The difference is a fee charged by the bank called discounting charges for performing suchservices.


As a banking and financial services company, Barclays is exposed to both of the commercial risks and investment risks. In the corporate banking division, Barclays takes a default risk when lending money to individuals or other corporations. Any sudden cash outflow from many individual customers at the same time can cause panic and losses to the bank, but having a powerful ERM will provide detail instructions and scenarios on what to do so that Barclays can avoid having its operations frozen (Valentine and McCarthy, 1995).  This type of market risk can also happen in any corporations that have signs of financial distress or default risk. Barclays needs to have some forms of risk control in each level of management to foresee and react to these issues. On the investment bank side, any public information or events will affect the company stock performance. If a corporation investor fails to repay certain debt payment, it will cause a decline in Barclays’ stock performance. This credit risk can be resolved through a series of actions including imposing limited amount of cash withdrawals to avoid cash shortage or setting higher borrowing rate to bad-credit corporations.

Roncalli (2016) defines credit risk as the ability of a bank’s borrower or any other counterparty will not meet its commitments by all the terms agreed. Credit risk is the most unreasonable risks in the banking industry it threatens the bank’s solvency (Roncalli, 2016).  The credit risk management is the financial institution’s practice to curb financiallosses by having knowledge about loan loss reserves and the bank’s adequacy capital (Ryjenko 2013).

Credit Risk Management began to be examined after the World War II. Different sources have indicated that the origin is dated back in 1955 to 1964.  Dionne (2013) revealed that there were no documents for credit risk management by then and there was no university offering the course. There are two major books which published by Mehr (1963) and Williams (1964). The book’s contents purely covered Risk Management, the corporate financial risk was not incorporated in the book. On the contrary, financial engineers invented technological risk management tools. The operational risks covered technological losses partially. Currently, financial institutions control the operational risks which are also regulated for commercial banks and insurance firms.

In the past decade, credit risk received much attention due to financial loses the international financial institutions faced (Saunders, A. and Cornett, 2014). The financial crisis has led banking industry to take measures to curb any future economiclosses which might be caused by poor management of loans and poor loan recovery strategies. The credit risk management provides the best solution to such problems. The credit risk management is the crucial component of the essential approach to risk management in the banking industry (Arora and Kumar, 2014).

The key requirement for credit risk management is the banks’ ability to discerningly and productively manage the customer’s credit lines. To reduce the chances of over saving, liquidation and terrible obligation financial institutions must be able to understand their customer’s financial assessment history, the quality of their budget and the dynamic installment design (Van D. Mesler, 2013). The management for a loan does not end until the client pays the last installment or clears the loan. Therefore, as the financial condition change the bank’s approach for credit may also change. Despite the fact that several scholars have been done on the credit risk management, this issue has not been fully covered and evaluated.

Financial institutions play a crucial role in the development and sustainability of the world economy. They perform a paramount task of managing the financial risk on their client’s behalf by pooling of credit risk specialist such as brokers. Banks are the intermediaries between the savers and the borrowers or customers by collecting all the cash deposits from the extra unit and giving them out to the deficit cell. Financial institutions act as debt and capital makers, and they play a major role in transferring the capital from the investors to the institutions that need the capital (Arora and Kumar, 2014). Banks and other financial institutions ensure that there is a flow of money through the economy.

Credit results from borrowing and investment and therefore, debt is created. Credit and debt represent both sides of a coin i.e. credit being what is provided and debt that which is owed (Finley, 2008). Credit risk can be defined as the potential that a borrower or counterparty will fail to meet their commitments as per the agreement, according to the Basel Committee on Banking Supervision (1999).  Credit risk management aims at maximizing a bank’s risk-adjusted rate of return by retaining credit risk exposure within adequate limits (Basel Committee on Banking Supervision, 1999). The risk is also one of the key capital performance indicators proposed in various regulatory regimes. There is a need for banks to manage credit risk inherent in their combined portfolio and ensure full monitoring of risk in individual credit transactions. An efficient management of credit risk is an essential constituent of a wide-ranging approach to risk management which is crucial to the long-term success of any financial institutions (Nijskens and Wagner, 2011).

Financial institutions have different internal credit models fto cater for risk management. Credit portfolio models go into distinguishing credit risk depending on various parameters such as, among others, geography, industry, and credit grade. A numerical simulation is, subsequently, run to generate a large number of scenarios, which simulate various states of the economy and the resulting bearing of each on the credit portfolio value. The analysis aids portfolio managers to make decisions on the best portfolio composition, based on their risk appetite and performance targets (Caouette et al., 2008).

Credit risk management should control the financial institution’s operations so as to be sustainable and reach more customers. Despite all these, over the years there has been a lot of problems in the banking industry in all the matured and the emerging economies (Carroll and Buchholtz, 2014). The banking sector challenges mostly financial distress have highly affected them some have been closed down by the regulatory authority. The weakness in the credit risk management has also been highlighted as the main bank’s challenge.

2.4 Solution to credit risks problems

The major credit controls are loan product design, credit committees and delinquency management.

2.4.1 Loan Product Design

A significant portion of the default risk by designing loan product that is able to meet the need of the clients. The features of the loan include the interest rates, size of the loan, collateral requirements, and repayments schedule and among other items. The products of the loan should always be tailored towards addressing a specific purpose which the loan intends to achieve (Carroll and Buchholtz, 2014).

2.4.2 Credit Committees.

A committee of persons to make the critical decisions concerning loans is established as an essential control in reducing the fraud risk. When only one individual loan officer has the power to dictate the people who receives the loans or which loans to be written off or even rescheduled, the power and privilege can be easily abused and covered up. Although the loans officer is able to work and serve on the credit committee at least some other individuals with even greater authority are involved. A part from approving loans, the credit committee also monitors the loan progress and assisting borrowers in case they have any repayment challenges (Carroll and Buchholtz, 2014).

2.4.3 Delinquency Management

Delinquency is the failure by a customer to repay an obligation as and when it falls due. Banking Institutions seek to minimize delinquencies using management methods for instance using institutional Culture. This is a critical delinquency management method that involves cultivating a culture in the organization that embraces minimum or zero tolerance of loan arrears and late payments immediately follow (Carroll and Buchholtz, 2014). The clients who had delinquency issues recently are reminded that their repayment day is soon approaching.

2.4.4 Client Orientation

The nature of products, information communication technology and staff training are some of the factors that the client must be familiar with before receiving a loan. Market oriented products should be developed in order to retain their members and attract new customers (Carroll and Buchholtz, 2014). Therefore, institutional culture must be communicated to clients before being issued with loans. Latest information technology must be equipped to all staff through training and development.

2.4.5 Staff Incentives

Staff interest should not interfere with the delivery of the product. Staff incentive system can be effective through; clearly laying out promotion scheme for the employees, implementation of proper and fair promotion policies, proper training to enhance productivity, strict adherence to the rules and regulations, offering of increased medical package, revision of benefits scale, and staff participation in decision making (Carroll and Buchholtz, 2014).Clients should be penalized for delayed payment through delinquency fees pegged to the number of days late and limiting access to repeat loans based on repayment performance. Clients with good record can be introduced to automatic loan that has reduced interest rate with reduced processing time of less than a day (Carroll and Buchholtz, 2014).

2.4.6 Loan Rescheduling

It is a common practice for borrowers to be willing to repay the loans but they are unable to do so. Therefore, it is appropriate for the Banking Institutions to negotiate with the defaulters in order to reschedule a number of loans. Under extreme circumstances, it can be achieved through extending loan term or reduction of the instalment size. The alternative way is to keep monitoring sticky defaulters for loan recovery (Carroll and Buchholtz, 2014). The loan policy should specify circumstances under which the penalty can be waived.

2.4.7Corporate governance

Corporate governance elaborates the relation between the company and its political, social and economic environment, in which it operates. The management and administration of many businesses are enhanced if combined efforts to stop corruption and other types of irregularities are to achieve desired results (Knell, 2006). Companies are required to set right legal framework by defining the roles of the board of directors, and chief executives and the related structure of authorities and responsibilities of each level of corporate governance. Good governance will impact on the general performance of the organization. The key stakeholders are the board of directors, management and other shareholders. Other players include employees, suppliers, customers, bankers, regulators, and the locals (Knell, 2006).

Good corporate governance protects a company from exposure to financial distress in future (Bhagat and Jefferis, 2002). This normally has an effect on ensuring stable financial performance hence more investments being available to the organization. Management and board of directors and how these are structured will have a bearing on the direction the firm takes and its ability to survive in the industry (Donaldson, 2003). Firms which have put in place strong governance practices will do better compared to the rest in the industry.  When a company embraces good governance and legal framework in its management and operations will have an effect on its financial profitability hence will attract more capital hence beneficial to all its stakeholders. Bad governance framework leads to weak financial results and risky financing patterns, hence prone to macroeconomic crises. Other researchers agree that good corporate governance is a requisite for enhancing investor confidence and market liquidity (Donaldson, 2003).

Andrew (2012) did a study on; the linkage existing between corporate governance and credit risk within commercial banks in Liberia. The study employed a cross-sectional survey design. The population of the survey was composed of 8 commercial banks, which had been operating during the period from 2006 to 2010. Data was fetched from the banks’ annual statements and then sorted on board dimensions like duality, size, and cognitive diversity, under the focus of corporate governance. The data was, subsequently, analyzed using eegression and correlation analysis. The outcome of the study showd that there were small insolvency risks in the banking industry in Liberia. This was because the highes insolvency risk stood at 0.411307 and the lowest at 2.5575. sonsequently, the bankruptcy risk recorded was -0.1929 (Andrew, 2012).  The study also found that corporate governance within the study scope was negatively correlated with bankruptcy risk (Pearson Correlation Coefficient, R= 0.572 with an adjusted R2 = -0.570). In conlcusion, it was ascertained that larger boards do not automatically lead to an eventual increase in insolvency risk and lack of coordination like prior studies have often proposed.  The highlights of the survey were that of a result that is opposed to the various results of some studies that treat the problems of “corporate governance” of the banking sector in such a way that the authors often suppose that the manager is averse to risk (Andrew, 2012).   The study, conclusively, recommended the need to question the wisdom that larger boards are detrimental to corporate governance.

Wangui (2014), did a study onthe effect of corporate governance on enterprise risk in commercial banks in Kenya. The study employed a cross-sectional study to fill the research gap. The primary data was then collected using questionnaire method. Individual questionnaires were designed and sent to internal audit managers for their response in to answer the research question. The findings proved that the board size, CRO presence in executive council, as well as board independence,   afftecd the CAMEL rating in an active modus, while board diversity itself had an adverse effect on the same score. The study had few limitations with one of the most discernible being a low response rate from the banks, although it turned out to be sufficient for the study. the study countered this limiation by providing questions that would accurately provide results and persuade banks to cooperate in providing the information. The dynamics of the study recommended the banks’ CAMEL rating to get centralized by the Central Bank of Kenya fro an easier and straightforward analysis and also to enable other analytical techniques to get employed in the analysis. There was also a recommendation in increasing independent directors and expanding the board size since these facets of corporate governance were believed to improve the banks’ enterprise risk management.

2.4.8 Collection Policy

For effective credit control, various organizations have different policies set in place. Collection policy is needed since not all clients pay loans in time.  Collection policies must be put in place to accelerate collections from slow payers and reducing bad debt losses. The credit policies need to be reviewed regularly in order to remain competitive against the changing lending environment. The Banking Institutions must adopt protective measures of its portfolio to guarantee the profitability and financial productivity of its loan portfolio. The Banking Institutions should have basic collection guidelines, skills and disciplines for protecting and cleaning up the loan portfolio (Stiglitz and Weiss, 1992).

Further various theories can be employed to reduce the threats associated with credit risks.  Overtime, various scholars and professionals have developed theories in connection to credit control and its effect on performance of organizations. The theories that are relevant to the research problem will be in relation to information asymmetry and the transaction cost. Information is important because it help lenders in making credit appraisal decisions (Stiglitz and Weiss, 1992).  However, in cases where such relevant information is not available or there is a gap of information between the lender and their clients, this is a problem of asymmetry information. Further, cost of business can be reduced and will be expounded in the transaction cost theory.

2.4.9 Asymmetrical information theory

In relation to credit control, asymmetry information refers to a situation where one party of the lending institution has more information than the other. In a lending contract, this would refer to a situation where the borrowers of a saving and credit society are aware of the risk and returns facing their investments, thus, limiting their ability to repay their loans. Banking Institutions, who are lenders in this case, are never aware with the same risk and cannot, therefore, be in a position to understand the risk of their loan portfolio (Stiglitz and Weiss, 1992).

Stiglitz and Weiss (1992) state in their research that information asymmetry can pose two “conditions for a micro-finance institution which are the moral hazard and adverse selection. Moral hazards are disadvantages posed by monitoring strategies while adverse selection is making of poor lending decision based on immoral advantages. Therefore, banks would be in a difficult position to make sound lending decision especially where the amount involved is small. These institutions may find it difficult to spend huge amount for monitoring and verifying credit worthiness of small customers.

Before a loan is advanced to customers, there is a due process of verifying a customer credit worthiness. Information asymmetry affects the level of decision making given many banks do not have sufficient information regarding the risk and uncertainty in the customers income (Bebczuk, 2003). Effectively, the Banking Institutions may not be able to access relevant information or the cost may be unbearable and this brings a problem to the control of credit for the institutions. The greater effect is that the performance of these institutions is affected by the adverse selection made during customer screening.

2.4.10 Transaction cost theory

Transaction costs are cost involved in the activities surrounding the issue of loans to clients. The theory was developed by Schwartz in 1974 and opines that credit organizations are likely to have an advantage over the traditional lenders in the analysis of customer’s credit worthiness. In addition, these institutions are better placed in monitoring and influencing their customers to repay loans. What that may mean for banking Institutions is reduced cost of credit control and the cost of doing business in general. The theory expounds on the cost advantages experienced through proper credit control strategies.

Petersen and Rajan (1994) categorize the advantages in various groups as follows. Access to information advantage, management of the client and obtaining salvage value from the current assets. Access to buyers’ information for the purpose of credit appraisal can be an advantage to banking institutions. In the course of doing business, organizations are able to obtain clients information based on the frequency and amount of each transaction with the banking institutions. Signs of reduced credit worthiness can be detected by rejecting discount and waivers for early repayment and delayed payment of loan instalments. The overall effect is reduced cost of transactions, reduced levels of credit default and non-performing loans, and improvement in the performance of organizations.

2.4.11 Three Lines of Defense Theory

The three lines of defense theory is a model that has gained a lot of attention globally. A company’s top management has to set an effective system of internal controls to ensure accountability for risk assessment, which is seen as the first line of defense (Kersnar, 2009).

Boards of directors and senior management are the main players served by the lines of defense and are well placed in ensuring that this model is reflected in the organization’s risk management and control processes. It is mandatory for the three lines to exist in some form in all agencies, despite their size or complexity. Where the three separate lines exist and can be clearly identified in an organization then risk management is considered to be strong (Hakim and Neamie, 2011). However, in some groups which are deemed to be small some of the lines may be combined together.

According to Badara and Saidin, (2014) implementation of the three lines of defense has to be clearly communicated to senior management and governing bodies and the prospect that information be shared and activities harmonized among the various teams responsible for dealing with the organization’s risks and controls.

2.4.12 Credit Risk Theory

Melton (1974) introduced the credit riskapproach also referred to as the structural theory. The theory explained a defaulting event derived from an organization’s asset evolution modeled by a distribution process with constant parameters. The author noted that the class of models is referred to as structural model and based on variables related a particular issuer. An evolution of this type is categorized by an asset of models where the loss conditional on default is precise. Here, the default can occur continuously in the life of a corporate bond and not only in development (Longstaff and Schwartz, 1995).

Although credit risk has been in existence from time immemorial, it is an area that has not been widely studied until recently. Initial literature (Pre 1974) on credit uses customary actuarial approaches of credit risk, the challenge being reliance on past data. Three quantitative methods of examining credit risk exist to date: structural technique, condensed form assessment and partial information approach (Crosbie et al., 2003). There is a risk of nonpayment when a bank grants credit to its customers. Therefore the schemes, procedures, and controls established by a bank to ensure an effectual gathering of loan repayments hence reducing the risk of non-payment are called credit risk management (Naceour and Goaied, 2003).



This chapter presents the conception of credit risk and specifically with respect to credit scoring linked to non-performing loans. It will lay emphasis on the underlying theories to develop the prevailing theoretical framework. Lastly, the chapter will examine the correlation between the credit scoring practices and the extent of non-performing loans in financial institutions.


Credit Risk


There have been substantial developments both theoretically and practically with respect to the measurement and management of risks since the implementation of Basel I. A significant number of novel financial instruments, for instance credit derivatives, have augmented the capability of financial institutions, for instance banks, to control and alleviate risks from exchange undertakings (Lind, 2005). Above and beyond, there has been a prompt growth in the direction of bigger and more intricate banking groups with wide-ranging operations, from an international standpoint (Lind, 2005). As a consequence, a methodically reviewed context for capital requirements was essential.

A new context for bank capital was unveiled in the 2004 financial year and started being carried out in 2007 by banks that are active in a global setting. It is imperative to note that the Basel II is centered on three specific pillars including:

  1. Minimum Capital requirement
  2. Supervisory Review
  3. Market Discipline


The first pillar takes into consideration the minimum capital requirement, that is, the imperative which a bank computes its regulatory capital. The minimum required capital ratio, which was initially set at 8 percent, continued to be the same even under the Basel II while the manner in which to compute the risk-weighted-assets has been altered. In particular, Basell II made wide ranging alterations to the manner in which credit risk is treated. It delineated three methods of measuring credit risk: the homogeneous method for banks that are not sophisticated which is akin to Basel 1 but encompassing more risk weights, the internal ratings based (IRB) approach which implies that the risk weights and the capital requirements are somewhat centered on the individual bank’s internal approximations, the progressive IRB approach which an even larger part of the capital requirements is influenced by the banks’ own calculations (Ferguson, 2003 and Lind, 2005).

As to the Pillar 2 of Basel II, deals with the supervisory practices of assessment and has been a complement to the minimum capital requirement. As a result, it necessitates a frequent interrelation between banks and managers in the examination and planning of capital adequacy (Lind, 2005). The final pillar attempts to supplement these activities by means of a more potent a comprehensive market discipline by revelation of bank’s key information of risk evaluation procedures and capital adequacy (Ferguson, 2003). This, in some measure, could facilitate market partakers to measure the bank’s risk profile and level of capitalization.

Determinants of Non-Performing Loans

Non-performing loans can be delineated as loans on which the borrowers fail to make interest payments on reimbursing any principal. The point at which the loan is categorized as being non-performing by the financial institution, and also when it comes to be bad debt is reliant on the local regulations. More often than not, loans are declared to be non-performing when the schedules payments are not made for a time period of at least 3 months or 90 days for commercial banking loans for 6 months or 180 days with respect to consumer loans. The inference of this is that there are no interest or principal payments made on the borrowed loan within a particular period (Hull, 2012).

The fundamental causes of nonperforming loans take into account diminished attention and consideration to loan borrowers, absence of plans by financial institutions as lenders to cope with risk, lack of proper credit models, and also fragile follow-up systems (Islam et al., 2005). Based on a research study undertaken by Bhide et al. (2002), it is outlined that the key issue of nonperforming loans emanated from poor debt recovery practices, insufficient legal structures, shortcomings and flaws in underlying security, and insufficient risk management approaches amongst others.

In accordance to a World Bank Policy Paper undertaken by Fofack (2005), there are different ascertained primary sources of nonperforming loans to exceedingly high credit risk, growth of the economy, appreciation of the real exchange rates, the real interest rate, loans between banks and also net interest margins. Virtual outcomes demonstrate that macroeconomic stability and growth of the economy are linked with a deteriorating level of nonperforming loans whereas negative macroeconomic shocks combined with greater cost of capital in addition with lower interest margins are linked with an increasing scope of nonperforming loans.

A research study conducted by Lis et al. (2000), the authors employed a simultaneous equation model that was capitalized in delineating losses incurred in bank loans in Spain through the use of a number of aspects, comprising of the growth rate of the Gross Domestic Product (GDP), the growth of the bank loan, the size of the bank, debt to equity ratios of the organization, capital asset ratio, power of the default entities within the marketplace and the net interest margin. The authors of the study established that growth of the GDP, the size of the bank, and the capital asset ratio had an adverse impact whereas growth of the loan, indemnity, net interest margin, regulation of the prevailing regime, and debt to equity ratio had a positive impact on problem loans.

Several other research studies have conducted research on non-performing loans within banks. Based on a study undertaken by Ng’etich and Wanjau (2011), the author purposed to ascertain the impact of interest rate spread on the level of nonperforming assets in commercial banks.  The outcomes of the research study gave the inference that interest rate spread has an impact on performing assets within bank as it gives rise to an increase in the cost of loans that are charged on the loan borrowers. Furthermore, the authors came to the conclusion that regulations instituted on interest rates have significantly greater impacts on assets non-performance, owing to the reason that these sorts of regulations are a determining factor for the interest rate spread in financial institutions such as banks and also aid in alleviating moral hazards subsidiary to non-performing assets.

Furthermore, it has been ascertained that weak and improper credit assessment is a reason for non-performing loans within commercial banks. Specifically, Mutie (2006) makes it insightful that gaining accessibility to loans from financial establishments such as loans was relatively simpler on condition that the loan borrower has security and indemnity to be charged than the capability to service the loan. A number of different aspects such as cash flow projection, personality of the loan borrower, completion of previous loans taken and the capability of repaying were not deemed significant. As a result, a number of financial institutions ended up with several nonperforming loans as a result of unfinished, improper and unethical credit risk evaluation and assessment (Mutie, 2006).

Based on research carried by Negara (2012), the different causes leading to loan borrowers defaulting comprises of improper credit evaluation, poor loan monitoring, infantile credit culture, soft terms and conditions for providing credit and aggressive lending. Other causative factors comprise of compromised reliability, insufficient institutional capacity, prejudicial competition amongst banks, deliberate default by borrowers and their limitation in understanding, fund diversion for unintended purpose in addition to under financing or over financing by the banks.

Empirical Studies on Nonperforming Loans and Credit Scores

This section purposes to delineate the different empirical studies that have been undertaken by other authors in association to non-performing loans and the credit scores.

Samreen and Zaidi (2013) conducted a research study that examined the design and development of credit scoring model for the commercial banks within the nation of Pakistan. The key purpose of this particular study was to examine credit risk in commercial banks of Pakistan through the use of credit scoring models. In particular, a sample set of 250 individual borrowers who had taken individual loans from the different commercial banks of Pakistan, out of which 144 applicants had a perceptible past time of having no default ever, 51 applicants had default up to 30 days, and 37 applicants had 90 days default. The found out that the Credit Scoring Model for Individuals (CSMI) assessed the soundness of individual borrowers with 100 percent precision rate and well-known the high risk loan applications to low risk prior to default. The authors of the study capitalized on logistic regression and discriminant to back up the outcomes of developed credit scoring model. The accurateness rate of Credit Scoring Model for Persons was 100%, logistic regression (LR) had the accuracy rate of 98.8% and the discriminant analysis credit scoring model for individuals had the accuracy rate of 95.2%. Taking this into consideration, the authors of the research study have the recommendation that forthcoming research studies ought to make use of advanced credit scoring approaches such as genetic algorithms, fuzzy discriminant analysis and neural networks. For the generality and correctness of the outcomes created by the credit scoring models, they commended a huge data of individual borrowers

In a separate study, Mabvure et al (2012) investigated the causes of non-performing loans in Zimbabwe. A case study research design of CBZ Bank Limited was employed. Interviews and questionnaires were used to collect data for the study. The paper revealed that external factors are more prevalent in causing non performing loans in CBZ Bank Limited. The major factors causing non performing loans were natural disasters, government policy and the integrity of the borrower. Using descriptive study, Korir (2012) investigated the impact of credit risk management practices on the financial performance of Deposit Taking Microfinance institutions in Kenya. The number of the respondents was 36 staff working in all licensed Deposit taking microfinance institutions in Kenya. From the findings the study concludes that Deposit taking microfinance institutions in Kenya adopted credit risk management practices to counter credit risks they are exposed to and it also concluded that Deposit taking microfinance institutions adopt various approaches in screening and analyzing risk before awarding credit to clients to minimize on loan loss. This included establishing capacity/competition and conditions and use of collateral/security and character of borrower were used in screening and risk analysis in attempt to reduce manages credit risks. The study further concludes that there was a positive relationship between credit risk management practices and the financial performance of Deposit taking microfinance institutions.

























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