Background of the study
Banking operations undertaken by commercial banks and the services offered are diverse and well spread out. Lending however remains the principal operation that forms the backbone of banking services (Basel, 2002). Commercial bank are institutions that provide services such as accepting deposits, providing business loans and offering basic investment products. They are able to provide this services by acting as a financial intermediary between individuals and firms with surplus economic units and those with a deficit, this is known as ‘credit creation’. In return they earn profits by charging an interest on loans lent to the individuals and firms with a deficit. Through this process the commercial banks are exposed to various risks, one key risk would be loan defaulting, due to lack of information asymmetry between the various financial players. This allows one borrower with a bad credit history to go ahead and borrow in another different commercial bank leading to higher rates of defaulting, this leads to huge losses for the commercial bank sending them into financial distress ultimately ending in them liquidating.
The Kenyan Government interceded to protect the commercial banks from borrowers, before 2008 the Banking Act had a clause that made it illegal for banks to share their customers banking details with each other, but on July 2008 a new law was passed by the Central Bank of Kenya, that made it mandatory for banks to share his information. This lead to the creation of the Credit Reference Bureau. Credit Reference Bureau collect, manage and disseminate customers’ information to lenders within a provided regulatory framework. In Kenya, the Banking (Credit Reference Bureau) Regulations, 2008 which was operationalized effective 2nd February 2009. Credit histories not only provide necessary input to lenders but also allow borrowers to take credit histories to other lending institutions thus making lending more competitive, more affordable and less risky.
Sharing of credit information between financial institution reduce the risk of defaults and thus leading to positive impact on economy. With support of CRBs commercial banks can make faster and more accurate credit decisions.
The main aim of this study is: to determine the impact of sharing credit information on loan defaulting rate, to identify the various factors that lead to loan defaulting and finally to evaluate the performance of commercial banks due to introduction of credit information sharing.
Interest rate is the price a borrower pays for the use of money they borrow from a lender/financial institutions or fee paid on borrowed assets, Crowley (2007). Commercial banks charge interest rates to cover cost of intermediation i.e. cost mobilization of funds, cost for transacting and as a premium for the risk they are undertaking when loaning out funds.
Interest rates tend to vary from one institution to another due to asymmetry of information, diseconomies of scale, lack of sufficient information, regulations and taxes. The above lead to high intermediation cost in turn leading to a high interest rate spread which is what the bank charges on a loan compared to its costs of money. This affects small borrowers as the pay a high fixed cost of intermediation to get small amount of funds. Hence the borrowers may be unable to pay back the principal plus the interest leading to a high loan default rate.
Information asymmetry describes the condition in which relevant information is not known to all parties involved in an undertaking (Ekumah and Essel, 2003). This situation was highly prevalent in the Kenyan banking sector in the late 80’s, 90’s and early 2000’s, when the Banking Act did not allow banks to share credit information of customers among themselves. Borrowers known as serial defaulters took advantage of this by taking loans from various banks with no aim of repaying them at all. This lead to banks holding many non-performing loans which in turn weighed them down financially.
Prof. Njuguna Ndung’u, Governor of Central Bank of Kenya (2007-2015), facilitated a Banking Act that allowed banks to share credit information through a Credit Reference Bureau. This move was sought to reduce the number of non-performing loans that banks held. To the Kenyan economy it would have protected both financial players and good credit borrowers from harassment, allowing every borrower to be charged interest rates in accordance to their credit score, and banks to reduce the amount of bad debts they held.
Credit criteria are the various characteristics that lenders analyze when scrutinizing a prospective borrower. Credit criteria include borrower’s assets and liabilities, income and expenses and credit history. According to the federal financial institution examination council (2011), all commercial banks must have a written Customer Identification Program which must be implemented to enable banks to form reasonable beliefs that it knows the true identity of each of its customers. Customer identification procedure help to prevent identity theft, financial fraud, money laundering and terrorist financing and reduce loan defaults. While opening different accounts, the bank collects documents to identify and verify the customers as required under the existing laws to demonstrate that it has performed the know your customer(KYC) procedure(Coinonline,2015). Banks are required to know all types of their customers not only at a customer level but also at a contract level monitoring the clients’ accounts movement. This will help the banks to be able to assess financial status and credit worthiness of the customers.
In the relationship between the borrower and lender unexpected misfortunes sometimes occur leading to default in in schedule payments. This default on a persistent basis becomes a bad debt to the financial institution .these bad depts. Are referred to as non-performing loans (Mutie, 2006).The main challenge faced by commercial banks is the issue of loan non-performance, commercial banks earn their income by lending moneys to borrowers. Over the recent years these commercial banks had been facing high rate of loan default. These high rate of loan default has put the banks in high risk and some even have collapsed. In our study we shall be looking at what is the cause or what leads to non-performing loans. Factors like inflation, interest rates, and economic growth affect positively or negatively loan performance. A high ratio of non-performing loans is a reflection of imprudent lending practices and poor credit management. It poses a threat to a customer deposits. When loans becoming non-performing, they hurt the banks liquidity and impact negatively on its earnings. Banks can now escape the risks arising from loan default from acquiring customers’ credit history from other lenders, hence reducing the rate of loan defaults. CRBs has play major role in providing these customers credit history to the commercial banks. These information would assist them in making accurate credit decision.
Relationship between the dependent and independent variables.
The loan default rate in the commercial banks has been a major challenge. Hence a solution on how to reduce the credit risks facing this institutions had to be arrived at. There are various variables that can be controlled in order to help reduce this risks that face the banking sector and these variables are the independent variables.
The banking sector in Kenya has faced a challenge of high loan default due to information asymmetry. Information asymmetry being the situation where one party has greater knowledge than the other parties. This was evident more in the 80s and 90s where the credit information was not allowed to be shared between the lenders. The serial defaulters took advantage of the situation and would borrow money from one institution to another with an intention of not paying back. This was due to the borrowers having more information about their credit histories than the lenders had. This in turn led to high loan default rate that led to financial distress and collapse of some institution.
This led to establishment of credit reference bureau in 2008 that facilitated the credit information sharing mechanism among the lenders. Credit information sharing enables the banks to get access of a Credit Report. A Credit Report is a report generated by the CRB, the credit report contains detailed information on a borrower’s credit history, the borrowers identity, credit facilities, bankruptcy and late payments of previous obligations and latest checks made by other prospective lenders. The credit creation hence became less risky .lenders were able to assess the profile of their potential customer and make better decision when lending money to them as they were able to determine their customers credit risks as all their credit histories was available to them. Information asymmetry creates incentive for borrowers to perform in the credit information sharing positively affected the loan default rate as the default rates reduced.
Commercial bank charge interests on loan as their form revenue. Interests rate is the price a borrower pays for the use of money they borrow from the financial institution or fee paid on borrowed assets, (Crowley 2007). Interest rates vary depending on the state of the economy and other factors. This factors according to (Chand, 2002 and Asian Development Bank, 2001) were lack of sufficient competition, diseconomies of scales due to small size of markets, high operating and fixed costs, high transportation cost of funds due to expensive telecommunication, existence of regulatory controls and perceived market risks. All this lead to high intermediation costs which caused high spread. Commercial banks are faced with the credit risks due to the uncertainties of loan repayments. Not all loans are paid back and thus bad debts accumulate with the commercial banks leading to financial distress. Matu (2001), showed that the high levels of non-performing loans puts pressure on the banks to retain high lending rate (interest rates) in an attempt to minimize losses associated with these loans. Hence commercial banks end up charging high interests rates in order to compensate on the credit risks. According to (Chand, 2002) when there is high intermediation costs, reflected in the high interest rates spread; the borrowers may be unable to repay his/her loan owing to the costs of such borrowings. This leads to high risk of loan default hence non-performance. Kiyai (2003), showed that a combination of different techniques of enticing defaulting customers yield better results. He stated debt restructuring by redefining interest rates was the top preferred method of addressing the problem of non-performing loans (NPLs). He found out that no relationship existed between debt restructuring and the levels of NPLs.
Credit criteria are the standards by which the lender compares an individual’s financial profile with its qualifications to determine credit worthiness. Most lenders use the same set of of criteria including payment history, debt-credit ratio, debt-income ratio, type and mix of debts, number of credit inquiries, and employment status. Credit criteria can also include the number of open accounts with other creditors and the borrowers standing with each one. Any single credit creation can be used to deny credit to the prospective borrowers, but the lenders must obey all laws of the credit protection act.
When commercial banks assess the potential borrowers profile they are able to distinguish between the serial defaulters to those borrowers who show potential of paying their loan from their profile. Thus credit criteria is important as it helps to reduce the loan default rate which poses as the biggest challenge that commercial banks undergo. Credit criteria also helps to reduce the problem of information asymmetry. Hence the use of credit criteria has led to the improvement of the commercial bank performance in terms of profitability, sustainability and growth of the banking sector.
STATEMENT OF THE PROBLEM.
The commercial banks has a wide portfolio but certainly the main source of income is from the lending as they charge interests on loans. However some borrowers default in paying their loans. This in turn has led to a series of problems such as collapse of some of the lending institutions due to the accumulation of non-performing loans and other economic problems may arise. In various developing countries, credit information systems are still in their infancy. And information sharing among banks remains weak (Luoto, McIntosh & Wydick, 2007). This happens to be the case in the banking sector in Kenya .There exists information asymmetry in the banking sector as the lenders don’t have the same information about their borrowers. This has led to the borrowers taking advantage of the information asymmetry that already exists by borrowing money from different lending institution and failing to pay their loans when they fall due to the heavy burden of loans that they have accumulated. The serial defaulters have led to negative impacts on the commercial banks and the economy at large as the commercial banks have resulted in charging high interest rates in order to cover for the risk of loan defaults. The commercial banks performance has also been adversely affected as there is no stability in this sector and thus leading to slow growth rate of the commercial banks. The main problem arises from lack of sufficient information about the credit worthiness of the borrowers. Who do we trust? This in turn has forced the commercial banks to focus on diversifying their portfolios to the risk free market and that is investing on government securities such as treasury bills. This thus leaves borrowers on tight spot and eventually affecting the economy as there are less investments going on. On the long run a solution has to be found on ways of curbing information asymmetry and reducing the loan default rates and achieving a stable financial sector where the participants are in apposition to meet their financial obligations. The general increase in profitability can only be sustained if customers are able to service their loans. Credit Reference Bureaus was introduced in the Kenyan banking sector to facilitate the concept of credit information sharing and to mitigate information asymmetry and the credit risk (Mugwe $ Olweny, 2015). Nonetheless the commercial bank continues to face difficulties in managing non-performing loans and hence the need to explore the effect of credit information sharing on non-performing loans of commercial banks in Kenya.
1. To determine impacts of sharing credit information on loan default rate.
2. To assess the performance of commercial banks due to credit information sharing.
3. To identify factors that lead to loan defaults.
1. What are the impacts of credit information sharing on loan performances in commercial banks?
2. How commercial banks has been improving due to credit information sharing?
3. What are the factors that lead to loan default?
JUSTIFICATION OF THE STUDY.
The findings of the study will be beneficial to several individual and will help them in better decision making.
The academicians being charged with disseminations of knowledge to various stakeholders will find the study useful as it will highlight areas of further research and study and will as well contribute to new knowledge. This study will give a highlight of how operational losses from loan default affect various stakeholders from the banking sector.
Investors bring their money into a business and come with expectations of getting returns from their investments and hence they need to do thorough research on where they invest and commit their money in order to avoid making losses. This study will help investors in the banking sector recognize the overall risks that arises due to non-performing loans and how they affect their expected returns and hence better decision making.
Commercial Banks Management
This study will help the bank managers appreciate the need to monitor and control non-performing loans as it affects the profitability and sustainability of these institutions. The study will also show managers of the great need to emphasize on checking their customers credit histories before approving loans.
Customers / Depositors
The study will help show the need to assess the commercial banks profitability and sustainability. When there are high levels of non-performing loans then it means that there are high risks that may lead to collapse of the institutions if the situation is not managed.
Financial and management consultants offer advice on better investment and management decisions. Hence they can use this study to advice their clients on the best way to manage the non-performing loans.
Credit Reference Bureau
This study findings will also help the CRBs improve on credit information sharing in Kenya as they come up with improved polies that will help mitigate the problem of information asymmetry.
SCOPE OF THE STUDY.
The study will seek to examine the effect of credit information sharing by CRBs on non-performing loans of commercial banks. The study will mainly focus on major banks that is Kenya Commercial Bank (KCB) and Equity Bank. The study will focus on credit information sharing(CIS) and particularly on how CIS will help reduce default rate, effect on interest rates charged on these loans and how performance of these commercial banks will be affected. The study will be conducted over a period of five months.