THE IMPACT OF CREDIT MANAGEMENT ON PERFOMANCE: A

STUDY OF KENYA COMMERCIAL BANK BRANCHES IN LAIKIPIA

COUNTY

PHILIP MISILI MUSYOKA

D53/OL/NYI/24264/2014

A RESEARCH PROJECT PROPOSAL SUBMITTED IN PARTIAL FULFILLMENT

OF THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTER OF

BUSINESS ADMINISTRATION OF THE KENYATTA UNIVERSITY

NOVEMBER, 2015

Declaration

This proposal is my original work and has not been presented for a degree in any other

university.

Signature_________________________ Date____________________

Name: Philip Musili Musyoka

D53/OL/NYI/24264/2014

Supervisors:

This proposal has been submitted for the review with our approval as University supervisors.

Signature __________________________Date__________________

Name: Dr. ……….

School of Business

Signature __________________________Date__________________

Name:

Chairman, Department

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TABLE OF CONTENTSDeclaration.................................................................................................................................iiDedication................................................................................................................................viAcknowledgement..................................................................................................................viiAbbreviations and Acronyms..............................................................................................viiiOperational Definition of Terms...........................................................................................ixABSTRACT..............................................................................................................................xCHAPTER ONE......................................................................................................................1INTRODUCTION....................................................................................................................11.1 Background of the Study.....................................................................................................11.1.1 Credit Management...........................................................................................................21.1.2 Firm Performance.............................................................................................................31.1.3 Financial Services Sector in Kenya..................................................................................51.2 Problem Statement...............................................................................................................51.3 General Objective of the Study............................................................................................71.3.1 Specific Objectives...........................................................................................................71.4 Research Hypothesis............................................................................................................71.5 Justification of the Study.....................................................................................................81.6 Scope of the Study..............................................................................................................81.7 Limitation............................................................................................................................91.8 Assumptions of the Study...................................................................................................9CHAPTER TWO...................................................................................................................10LITERATURE REVIEW.....................................................................................................102.1 Introduction........................................................................................................................102.2 Theoretical Review............................................................................................................102.2.1 Transactions Costs Theory.............................................................................................102.2.2 Asymmetric Information Theory....................................................................................112.2.3 Theory of Performance...................................................................................................112.2.4 Pecking Order Theory....................................................................................................122.3 Credit Management Practices............................................................................................132.3.1 Credit Scoring.................................................................................................................142.4 Financial Performance.......................................................................................................152.4.1 Profitability.....................................................................................................................162.4.2 Efficiency........................................................................................................................162.5 Empirical Literature Review..............................................................................................172.5.1 Credit Policy and Bank Performance..............................................................................172.5.2 Credit Scoring Mechanism and Bank Performance........................................................182.5.3 Credit Monitoring Style and Bank Performance...........................................................192.6 Summary of the Research gaps..........................................................................................202.7 Conceptual Framework......................................................................................................21CHAPTER THREE...............................................................................................................22

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RESEARCH METHODOLOGY.........................................................................................223.1 Introduction........................................................................................................................223.2 Research Design.................................................................................................................223.3 Study Population................................................................................................................233.4 Sampling Size and Sampling Procedure............................................................................233.5 Data Sources and Collection..............................................................................................243.6 Data Collection Procedure.................................................................................................253.7 Validity of Data Collection Instruments............................................................................253.8 Reliability of the Research Instrument..............................................................................253.9 Data Analysis and Presentation.........................................................................................263.10 Ethical Considerations.....................................................................................................27REFERENCES.......................................................................................................................28APPENDICES........................................................................................................................31Appendix I: Letter of Transmittal............................................................................................31Appendix II: Questionnaire......................................................................................................32Appendix III: Budget..............................................................................................................33Appendix IV: Work Plan.........................................................................................................33

iv

Dedication

This research work is lovingly dedicated to my dad Daniel Musyoka and my mum Agnetta

Musyoka who have shown me great support in my quest for education.

v

Acknowledgement

This research project could not have been possible without the valuable input of a number of

groups whom I wish to acknowledge. First and foremost, great thanks to God for His grace

and the gift of life during the period of the study. Special appreciation goes to my supervisor

Dr. Omagwa. I wish to sincerely acknowledge his professional advice and guidance in the

research project. Thanks to the entire academic staff of the school of business for their

contribution in one way or another.

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Abbreviations and Acronyms

CBK- Central Bank of Kenya

FIs- Financial Institutions

GDP- Gross Domestic Product

GoK- Government of Kenya

IMF- International Monetary Fund

MFIs- Micro Finance Institutions

SACCO- Savings and Credit Cooperative Societies

SME- Small and Medium Enterprises

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Operational Definition of Terms

Collateral security- Property or other assets that a borrower offers a lender

to secure a loan.

Commercial bank- An institution which accepts deposits, makes business loans

and offers related financial services

Loan: Credit facility offered by a financial institution

Micro credit: The lending of small amounts of money at low interest to

small enterprises

viii

ABSTRACT

Credit management is one of the most essential activities in any commercial bank. Lack of sound credit management practices leads to pitfalls in the banking sector. The general objective of this study is to evaluate the impact of credit management on financial performance of KCB Bank Group. The study specifically seeks to determine the impact of credit policy, credit scoring mechanism and credit monitoring style on financial performance of KCB bank branches in Laikipia County. The research shall adopt the use of mixed method approach research design which is the application of both qualitative and quantitative approaches.The researcher will draw the population from the KCB bank branches in Laikipia County where the 78 staff members will be targeted. The study will use census survey on managerial and supervisory staff while simple random sampling (at 30%) will be used on other category of staff giving a total sample size of 37. The study will obtain secondary data through a data collection form that will indicate the profitability and loan sales of the banks. However, a semi- structured questionnaire will be used to collect primary data from the bank staff. The researcher will employ self-administration approach of data collection. The pre-testing will be carried out on a sample consisting of ten (10%) of the respondents; from Equity bank, Laikipia town branch. The study will use ‘split-halves’ and ‘internal consistency’ method to measure reliability. Responses in the questionnaires will be tabulated, coded and processed by use of a computer Statistical Package for Social Science (SPSS) program to analyze the data. The responses from the open-ended questions will be listed to obtain proportions appropriately; the response will then be reported by descriptive narrative. Both descriptive and inferential statistics will be used to analyze the data. Mean and standard deviations will be used as measures of central tendencies and dispersion respectively. The relationship between the dependent variable and the independent variables will be tested using Pearson’s correlation.

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CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The importance of credit management by commercial banks has attracted much attention in

recent years and has become an important topic for economists and policymakers working on

financial and economic development. This interest is driven in part by the fact that

commercial banks account for the majority of buoyant firms in an economy and thus provide

a significant share of employment (Demirguc-Kunt & Huzinga, 2013). Furthermore, most

SMEs usually get funding from commercial banks in order to develop, grow and contribute

to the economic development (Boahene, Dasah & Agyei, 2012). The recent attention on

credit management also comes from the perception among academicians and policymakers

that banks that lack appropriate credit management mechanisms risk making huge losses

(Demirguc-Kunt & Huzinga, 2013). As put in by Nzotta (2004), credit management greatly

influences the success or failure of commercial banks.

Credit management is one of the most essential activities in any commercial bank (Gatuhu,

2013). Therefore, credit management cannot be overlooked by any economic enterprise

engaged in credit irrespective of its business nature. Lack of sound credit management

practices leads to pitfalls in the banking sector. Scheufler (2002) summarizes these pitfalls as

failure to recognize potential frauds, under-estimation of the contribution of current customers to

bad debts, getting caught off guard by bankruptcies, failure to take full advantage of technology,

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and spending surplus resources on credit evaluations that are not related to reduction of credit

defaults.

With the rise in bankruptcy rates, the probability of banks incurring losses has risen

(Omboto, 2014). Economic pressures and business practices are forcing organizations to

slow payments while on the other hand resources for credit management are reduced despite

the higher expectations. Therefore it is a necessity for credit professionals to search for

opportunities to implement proven best practices (Gatuhu, 2013). Timely identification of

potential credit default is important as high default rates lead to decreased cash flows, lower

liquidity levels and financial distress. In contrast, lower credit exposure means an optimal

debtors‟ level with reduced chances of bad debts and therefore financial health (Gatuhu,

2013).

1.1.1 Credit Management

Myers and Brealey (2003) describe credit management as methods and strategies adopted by

a firm to ensure that they maintain an optimal level of credit and its effective management. It

is an aspect of financial management involving credit analysis, credit rating, credit

classification and credit reporting. Nelson (2002) views credit management as simply the

means by which an entity manages its credit sales. It is a prerequisite for any entity dealing

with credit transactions since it is impossible to have a zero credit or default risk. Nzotta

(2004) opined that credit management greatly influences the success or failure of commercial

banks and other financial institutions. This is because the failure of deposit banks is

influenced to a large extent by the quality of credit decisions and thus the quality of the risky 2

assets. He further notes that, credit management provides a leading indicator of the quality of

deposit banks credit portfolio. A key requirement for effective credit management is the

ability to intelligently and efficiently manage customer credit lines. In order to minimize

exposure to bad debt, over-reserving and bankruptcies, companies must have greater insight

into customer financial strength, credit score history and changing payment patterns. Credit

management is concerned primarily with managing debtors and financing debts (Gatuhu,

2013).

Credit management starts with the sale and does not stop until the full and final payment has

been received. It is as important as part of the deal as closing the sale. In fact, a sale is

technically not a sale until the money has been collected. It follows that principles of goods

lending shall be concerned with ensuring, so far as possible that the borrower will be able to

make scheduled payments with interest in full and within the required time period otherwise,

the profit from an interest earned is reduced or even wiped out by the bad debt when the

customer eventually defaults (Diagne & Zeller, 2001).

1.1.2 Firm Performance

Companies that achieve organizational performance enhance the engagement culture by

decentralizing the decision-making process and allowing employees to contribute thus

benefiting from multiple perspectives (Kungu, Desta & Ngui, 2014). Khan, Farooq and Ullah

(2010) analysis shows that companies with the highest levels of performance also have high

levels of employee engagement. Their employees are visible involved and with a leadership

platform that bolsters the company's mission and involves all employees in developing

strategy (Khan, Farooq & Ullah, 2010).

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The good performance of any company begins to crystallize only after its leaders create an

engagement culture among employees (Kungu, Desta & Ngui, 2014). Turyahebya (2013)

defines financial performance as the ability to operate efficiently, profitably, survive, grow

and react to the environmental opportunities and threats. In agreement with this, Sollenberg

and Anderson (1995) assert that, performance is measured by how efficient the enterprise is

in use of resources in achieving its objectives.

Existing literature on the how to measure organizational performance varies across studies

(Comb, Crook & Shook, 2005). The contradictions between studies are mostly caused by

different concepts and measurement approaches of organizational performance. This is

majorly due to completely different concepts and measurement systems, with each newer

study applying a new construct measurement approach on organizational performance (Khan

et. al. 2010). Consequently, the interest into measurement approaches, construct validation

and conceptual nature of organizational performance is very elusive for most researchers.

However, Combs, Crook and Shook (2005) distinguished between operational and

organizational performance. In their framework, operational performance combines all non-

financial outcomes of organizations while the conceptual domain of organizational

performance is limited to economic outcomes. But this study combines the two perspectives

of performance and identifies four organizational performance dimensions: profitability and

growth in customer base.

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1.1.3 Financial Services Sector in Kenya

The banking sector in Kenya operates in a relatively deregulated environment governed by

the companies’ Act, the Banking Act, the CBK Act and the various prudential guidelines

issued by the CBK. In Kenya there are a total of 42 banks which are all for the same market

share (CBK Annual Report, 2010). Before 1983, the formal banking system in the country

was dominated by state owned banks that had a monopoly in terms of their spread and

operations (Hinson & Hammond, 2006). Hinson and Hammond (2006) report that, with the

passage of the universal banking law however, all types of banking can be conducted under a

single corporate banking entity and this greatly reorganises the competitive scopes of several

banking products in Kenya. Thus reform and deregulation has brought the banking sector

into the competitive arena in terms of customers and products. This means sound credit

management decisions should take into consideration factors that promote customer

satisfaction, customer retention, customer loyalty, increased market share and firm

profitability.

1.2 Problem Statement

Sound credit management is a prerequisite for a financial institution‟s stability and

continuing profitability, while deteriorating credit quality is the most frequent cause of poor

financial performance and condition. According to Gitman (1997), the probability of bad

debts increases as credit standards are relaxed. Firms must therefore ensure that the

management of receivables is efficient and effective .Such delays on collecting cash from

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debtors as they fall due has serious financial problems, increased bad debts and affects

customer relations. If payment is made late, then profitability is eroded and if payment is not

made at all, then a total loss is incurred. On that basis, it is simply good business to put credit

management at the „front end‟ by managing it strategically.

The excessively high level of non-performing loans in the banks can be attributed to poor

corporate governance practices, tax credit administration process and the absence or non-

adherence to credit risk management practices. Thus far, the major cause of serious banking

problems continues to be related to low credit standards for borrowers and as well counter

parties, poor portfolio management, and lack of attention to changes in economic or other

circumstances that can lead to delineation in the credit standing of bank’s counter parties.

Thus, the biggest problem facing banking and other forms of financial intermediaries is the

risk of customers or counter party default. Recently, the banking sector witnessed rising non-

performing credit portfolios. This has contributed to the financial distress in banking sector.

Also focused has the existence of predatory debtors in the banking system whose Modus

Operandi involves the abandonment of their debt obligation in some banks only to go ahead

and contract new debts in other banks. In literal sense, it is inimical to state that, the

increasing amount of non-performing loans in the credit portfolio hinders banks from

achieving their objectives to operate successfully and profitably, since a large chunk of banks

revenue accrues from loans from which interest in derived.

Matu (2008) carried out a study on sustainability and profitability of banking institutions and

noted that efficiency and effectiveness were the main challenges facing Kenya on service

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delivery. Gitau (2010) did a study on assessment of strategies necessary for sustainable

competitive advantage in the banking and microfinance industry in Kenya with specific focus

to Faulu Kenya. Achou and Tenguh (2008) also conducted research on bank performance

and credit risk management and found that there is a significant relationship between

financial institutions performance; in terms of profitability; and credit risk management.

However, most of the studies reviewed focused more on loan performance and ignored other

aspects of performance; a gap this study seeks to fill by focusing on KCB bank branches in

Laikipia County.

1.3 General Objective of the Study

The general objective of this study is to evaluate the impact of credit management on

financial performance of KCB Bank branches in Laikipia County.

1.3.1 Specific Objectives

The study will be guided by the following specific objectives:

1. To determine the impact of credit policy on financial performance of KCB bank

branches in Laikipia County.

2. To establish the impact of credit scoring mechanism on financial performance of

KCB bank branches in Laikipia County.

3. To evaluate the impact of credit monitoring style on financial performance of KCB

bank branches in Laikipia County.

1.4 Research Hypothesis

The following hypotheses will be tested in this research:

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H1- Credit policy has no impact on financial performance of KCB bank branches in Laikipia

County.

H2- Credit scoring mechanism has no impact on financial performance of KCB bank

branches in Laikipia County.

H3- Credit monitoring style has no impact on financial performance of KCB bank branches

in Laikipia County.

1.5 Justification of the Study

The study findings may aid banks, the government, employees and other stakeholders.

Commercial banks will ascertain if the proper lending framework is in place for effective

micro lending from the findings of this study. The study findings will help in analyzing the

existing credit management practices that affect banking institutions.The study findings will

help the policy makers re-evaluate the current methods used to manage credit and possibly

develop other means to improve performance.

Scholars in the field of credit management will use the information to understand the state

of the sector better. They might also use the information as a reference point to research on

the credit strategy formulation and innovations in other industries. Finally, the Government

may find the information useful in diagnosing the problems affecting the banking sector

liquidity and come up with regulative solutions.

1.6 Scope of the Study

The study will focus on performance of the banks for a four year period; 2010-2014.The

study will only focus KCB bank branches in Laikipia County and therefore the findings may

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not reflect the perception of the entire country. This study focuses on banks only; but neither

focuses on other financial service businesses which are not necessarily banks; such as MFIs

and SACCOs. The study will focus on three aspects of credit management thereby ignoring

other aspects of credit management. The study further seeks to interview bank staff only

thereby ignoring other stakeholders in credit management.

1.7 Limitation

Staff from KCB bank may decline to give information concerning their credit management

and performance due to the fear of competitors and privacy codes. However, the researcher

will clearly outline the motive of the study to them before embarking on data collection.

Time will also be a limiting factor since businesses operate on very tight schedule. Moreover,

a bigger sample size would have been appropriate were it not for the cost and time

constraints. The researcher will plan to interview the respondents on days when they are not

very engaged.

1.8 Assumptions of the Study

The researcher assumes that the respondents will be sincere and provide truthful information.

The respondents will understand the significance of the study and will be objective in the

responses they give to the researcher.

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CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction

This chapter concentrates on reviewing the literature with a view of understanding how other

researchers have contributed and the extent of the findings regarding accessibility of finances

and the performance of Bank. The chapter also reviews the theories relevant to the dependent

and independent variables.

2.2 Theoretical Review

2.2.1 Transactions Costs Theory

First developed by Schwartz (1974), this theory conjectures that suppliers may have an

advantage over traditional lenders in checking the real financial situation or the credit worthiness

of their clients. Suppliers also have a better ability to monitor and force repayment of the credit.

All these superiorities may give suppliers a cost advantage when compared with financial

institutions. Three sources of cost advantage were classified by Petersen and Rajan (1997) as

follows: information acquisition, controlling the buyer and salvaging value from existing assets.

The first source of cost advantage can be explained by the fact that sellers can get information

about buyers faster and at lower cost because it is obtained in the normal course of business. That

is, the frequency and the amount of the buyer‟s orders give suppliers an idea of the client‟s

situation; the buyer‟s rejection of discounts for early payment may serve to alert the supplier of a

weakening in the credit-worthiness of the buyer, and sellers usually visit customers more often

than financial institutions do.

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2.2.2 Asymmetric Information Theory

Information asymmetry refers to a situation where business owners or manager know more about

the prospects for, and risks facing their business, than do lenders (PWHC, 2002) cited in Eppy

(2005). It describes a condition in which all parties involved in an undertaking do not know

relevant information. In a debt market, information asymmetry arises when a borrower who takes

a loan usually has better information about the potential risks and returns associated with

investment projects for which the funds are earmarked. The lender on the other hand does not

have sufficient information concerning the borrower (Edwards & Turnbull, 1994). Perceived

information asymmetry poses two problems for the banks, moral hazard (monitoring

entrepreneurial behavior) and adverse selection (making errors in lending decisions). Banks will

find it difficult to overcome these problems because it is not economical to devote resources to

appraisal and monitoring where lending is for relatively small amounts. This is because data

needed to screen credit applications and to monitor borrowers are not freely available to banks.

Bankers face a situation of information asymmetry when assessing lending applications (Binks &

Ennew, 1997). The information required to assess the competence and commitment of the

entrepreneur, and the prospects of the business is either not available, uneconomic to obtain or

difficult to interpret. This creates two types of risks for the Banker (Deakins, 1999).

2.2.3 Theory of Performance

The Theory of Performance (ToP) by Elger (2007) develops and relates six foundational

concepts to form a framework that can be used to explain performance as well as performance

improvements: context, level of knowledge, levels of skills, level of identity, personal factors,

and fixed factors. To perform is to produce valued results (Elger, 2007). A performer can be an

individual or a group of people engaging in a collaborative effort. Developing performance is a

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journey, and level of performance describes location in the journey (Tomlinson, Kaplan,

Renzulli, Purcell, Leppien & Burns, 2002). While some factors that influence improving

performance are immutable, other factors can be influenced by the organization or by others

(Elger, 2007). The factors that can be varied fall into three axioms for effective performance

improvements. These involve a performer’s mindset, immersion in an enriching environment and

engagement in reflective practice (Bradford, Brown & Cocking, 2000). A ToP informs learning

by organizations through the idea of examining the level of performance of the organization

(Bradford et. al. 2000). This theory will go to support the variable on bank performance. This

theory of performance will be tested against the variable on bank performance and how it is

affected by credit management in the study.

2.2.4 Pecking Order Theory

The pecking order theory by Myers and Majluf (1984) focuses on the immediate need for

funding based on the existence of a pecking order and provides a rational explanation for choice

in corporate finance. For a company, this order consists in order to focus on internal sources of

financing before resorting to external investors. Thus, the company follows a hierarchy of

financing, dictated by the need for external funds. In general, ‘financing by internal funds should

be promoted on the financing by external funds, according to the following hierarchy: cash

flow/debt/issue of shares (Myers & Majluf, 1984). At this level, it is necessary to clarify the

hierarchy of funding, driven by the need of external funding that follows any business according

to the theory of the Pecking Order. This theory will go in to support the variables on credit

monitoring style and credit scoring mechanism and how they affects bank performance.

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2.3 Credit Management Practices

Myers and Brealey (2003) describe credit management as methods and strategies adopted by a

firm to ensure that they maintain an optimal level of credit and its effective management. It is an

aspect of financial management involving credit analysis, credit rating, credit classification and

credit reporting. A proper credit management will lower the capital that is locked with the

debtors, and also reduces the possibility of getting into bad debts (Gatuhu, 2013). According to

Edwards (1993), unless a seller has built into his selling price additional costs for late payment,

or is successful in recovering those costs by way of interest charged, then any overdue account

will affect his profit. In some competitive markets, companies can be tempted by the prospects of

increased business if additional credit is given, but unless it can be certain that additional profits

from increased sales will outweigh the increased costs of credit, or said costs can be recovered

through higher prices, then the practice is fraught with danger (Kariuki, 2010).

Most companies can readily see losses incurred by bad debts, customers going into liquidation,

receivership or bankruptcy. The writing-off of bad debt losses visibly reduces the Profit and Loss

Account (Omboto, 2014). The interest cost of late payment is less visible and can go unnoticed

as a cost effect (Knox, 2004). It is infrequently measured separately because it is mixed in with

the total bank charges for all activities. The total bank interest is also reduced by the borrowing

cost saved by paying bills late (Knox, 2004). Credit managers can measure this interest cost

separately for debtors, and the results can be seen by many as startling because the cost of

waiting for payment beyond terms is usually ten times the cost of bad debt losses (Knox, 2004).

Effective management of accounts receivables involves designing and documenting a credit

policy (Gatuhu, 2013). Many entities face liquidity and inadequate working capital problems due

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to lax credit standards and inappropriate credit policies. According to Pike and Neale (1999), a

sound credit policy is the blueprint for how the company communicates with and treats its most

valuable asset, the customers. Scheufler (2002) proposes that a credit policy creates a common

set of goals for the organization and recognizes the credit and collection department as an

important contributor to the organization’s strategies. If the credit policy is correctly formulated,

carried out and well understood at all levels of the financial institution, it allows management to

maintain proper standards of the bank loans to avoid unnecessary risks and correctly assess the

opportunities for business development (Omboto, 2014).

2.3.1 Credit Scoring

The first step in limiting credit risk involves screening clients to ensure that they have the

willingness and ability to repay a loan. Banks use the 5Cs model of credit to evaluate a customer

as a potential borrower (Abedi, 2000). The 5Cs help banks to increase loan performance, as they

get to know their customers better. These 5Cs are: character, capacity, collateral, capital and

condition. Character refers to the trustworthiness and integrity of the business owners since it’s

an indication of the applicant’s willingness to repay and ability to run the enterprise. Capacity

assesses whether the cash flow of the business or household can service loan repayments. Capital

refers to the assets and liabilities of the business or household. Collateral refers to access to an

asset that the applicant is willing to cede in case of non-payment or a guarantee by a respected

person to repay a loan in default. Finally, conditions refer to a business plan that considers the

level of competition and the market for the product or services as well as legal and economic

environment .The 5Cs need to be included in the credit scoring model.

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The credit scoring model is a classification procedure in which data collected from application

forms for new or extended credit line are used to assign credit applicants to credit risk classes

(Constantinescu, 2010).Inkumbi (2009) notes that capital and collateral are major stumbling

blocks for entrepreneurs trying to access capital. This is especially true for young entrepreneurs

or entrepreneurs with no money to invest as equity; or with no assets they can offer as security

for a loan. Any effort to improve access to finance has to address the challenges related to access

to capital and collateral. One way to guarantee the recovery of loaned money is to take some sort

of collateral on a loan. This is a straightforward way of dealing with the aspect of securing

depositors’ funds.

2.4 Financial Performance

According to Hermes and Lensink (2007), the financial systems approach, which emphasizes the

importance of financial performance, is likely to prevail the poverty lending approach. The

argument is that finance institutions have to be financially sustainable in order to guarantee a

large-scale outreach to the poor on a long-term basis (Kariuki, 2010). Measuring and comparing

the performance of banks has been difficult due to both a lack of publicly available financial

information and differences in reporting (Michael &Miles, 2007). A myriad of financial ratios

are available for assessing the performance of banks (CGAP, 2003). Although it is difficult to

synchronize the different interpretations of all the ratios, they provide alternative perspectives in

assessing the performance of banks for each of the domains namely: profitability, efficiency,

leverage and risk .In essence, interpreting the determinants of banks’ financial performance due

cognisance should be taken of the precise focus of each ratio (Kariuki, 2010).

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2.4.1 Profitability

Return on Assets (ROA) falls within the domain of performance measures and tracks bank’s

ability to generate income based on its assets. The ratio excludes non-operating income and

donations.ROA provides a broader perspective compared to other measures as it transcends the

core activity of banks namely, providing loans and assessing profitability regardless of the

bank’s funding structure. ROA is expected to be positive as a reflection of the profit margin of

the bank, otherwise it reflects non-profit or loss (Mix Market, 2011). In banks and other

commercial institutions, the commonest measures of profitability are Return on Equity (ROE),

which measures the returns produced for the owners, and Return on Assets (ROA), which

reflects that organization’s ability to use its assets productively (Kariuki, 2010).

These are appropriate indicators for unsubsidized institutions. But donor interventions more

typically deal with institutions that receive substantial subsidies, most often in the form of grants

or loans at below-market interest rates. In such cases, the critical question is whether the

institution will be able to maintain itself and grow when continuing subsidies are no longer

available (Pandey, 2008). To determine this, normal financial information must be adjusted to

reflect the impact of the present subsidies. Three subsidy-adjusted indicators are in common use:

Financial Self-sufficiency (FSS), Adjusted Return on Assets (AROA), and the Subsidy

Dependence Index (SDI) (Turyahebwa, 2013).

2.4.2 Efficiency

Efficiency of banks is measured by the share of operating expense to gross loan portfolio in most

cases (Gatuhu, 2013). The ratio provides a broad measure of efficiency as it assesses both

administrative and personnel expense with lower values indicating more efficient operations. The

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debt equity ratio is a member of the asset or liability management ratios and specifically attempt

to track bank’s leverage (Gatuhu, 2013). This measure provides information on the capital

adequacy of banks and assesses the susceptibility to crisis. Microfinance investors mainly rely on

this ratio as it helps to predict probability of a bank honoring its debt obligations (Turyahebwa,

2013). However, its use should always be contextualized as high values could lead to growth of

banks. The Operating Expense Ratio is the most widely used indicator of efficiency, but its

substantial drawback is that it will make a bank making small loans look worse than an bank

making large loans, even if both are efficiently managed (Turyahebwa, 2013). Thus, a preferable

alternative is a ratio that is based on clients served, not amounts loaned. If one wishes to

benchmark a bank’s Cost per Client against similar banks in other countries, the ratio should be

expressed as a percentage of per capita Gross National Income; which is used as a rough proxy

for local labor costs (Gatuhu, 2013).

2.5 Empirical Literature Review

2.5.1 Credit Policy and Bank Performance

Ghimire & Abo (2013) did a study on Ivorian banks’ credit policies: constraining factors and

performance. The methodology adopted by the study included descriptive statistics, cross-

tabulations along with dependency tests of Chi-square and Cramer’s value. Moreover,

correspondences analyses or joint-plots were computed, displaying the relationships between the

most pertinent variables and bank performance. The study adopted structured questionnaires

which were sent out to respondents in four major commercial banks namely: Bank Internationale

de l’Afrique de l’Ouest, Ecobank, Banque Atlantique and Societe Generale de Banque Cote

d’Ivoire. The study targeted a total of fifty managers. Out of 50 questionnaires sent in both rural

17

areas of Abengourou and urban areas of Abidjan, only 36 responses were received. The

computed percentage shows that firms having flexible credit policies and strict credit policies

had achieved loan sale out targets at 100% and 83.3% respectively. The findings revealed that

credit policy indeed affect performance of the banks. However, the study focused on loan sale

out targets as the only aspect of performance, a gap the current study seeks to fill.

Azende (2012) did a study on credit management and performance of banks in Nigeria. This

study assessed the impact of credit policy on performance of the banks; using banks in Benue

and Nasarawa States as case study. Mean scores and standard deviation were used to present and

analyze the primary data obtained via questionnaires. Correlation was used to substantiate

whether there was similarity. Simple percentages combined with mean scores were used to test

hypothesis one on credit policy and performance while Chi-square was used to test hypothesis

two on collateral security and performance. The result showed that the banks with strict credit

policies were significantly preferred by corporate clients for loans than those with relaxed credit

policies. Therefore the study concluded that indeed credit policy affects bank performance. The

study recommended that both the government and the banking sector should mutually agree on a

credit policy acceptable to all. However, the study mainly focused on collateral security as an

aspects of credit policy, a gap the current study seeks to fill.

2.5.2 Credit Scoring Mechanism and Bank Performance

A study by Iopev and Kwanum (2012) on how credit scoring mechanism affects financial

performance of banks was done in Nigeria. The study adopted a survey research design. To

achieve the objective of the study, one hundred and ten (110) bank staff from Benue state were

interviewed using an open-ended questionnaire. Data collected was analyzed using descriptive

18

statistics. The findings revealed that about eighty four percent of respondents agreed that the

credit scoring mechanism affects performance of bank loans. However, the study failed to give a

detailed statistical relation between credit scoring mechanism and the performance of the banks;

a gap the current study seeks to bridge.

Muguchu (2013) did a study on the relationship between credit scoring mechanism and financial

performance of MFIs in Nairobi, Kenya. The study sought to find out whether there was

relationship between the two variables. The study focused on the imperfect information theory.

The study used secondary sources of data. Secondary data was sourced from the financial

records from the year 2008 to 2012. The study employed descriptive analysis as well as

regression analysis to analyze the data collected. The target population under study was the

licensed MFIs within Nairobi County. Cluster sampling of Bank in the central business district in

Nairobi was done by clustering the BANK based on the streets where they were located. A

sample of 40 MFIs within the central business district was selected for the survey. Descriptive

analysis as well as regression analysis found that there was a positive relationship between credit

scoring mechanism and return on investment for the MFIs. The study recommended that a

financial institution be set to have special lending structures for Bank to enable them access

credit. However, the study used secondary data only, a gap the current study seeks to fill.

.

2.5.3 Credit Monitoring Style and Bank Performance

Nkuah., Tanyeh & Gaeten (2013) did a study on effect of credit monitoring methods on banks in

Ghana: challenges and determinants of performance. The study focused on the credit rationing

theory propounded by Stiglitz and Weiss (1981). The study employed the quantitative approach

19

of research in which the probability sampling criteria; specifically the stratified and simple

random sampling; were employed to select eighty bank staff from the Wa Municipality. The

major findings for the study indicated that there exist significantly, positive relations between

credit monitoring methods and bank performance. The study also revealed that some monitoring

activities such as business registration, documentation, business planning, asset ownership, and

others also impact heavily on banks financial performance. However, the study only focused on

banks that were within the town location; a gap the current study seeks to fill.

Minh (2012) did a study on the effects of credit monitoring on performance of banks in Vietnam.

Due to the characteristics of data, the study could not aim at in-depth specific problems, but at

general pictures of bank financing including endogenous and exogenous variables. The

binominal logit model was used to assess the influence of credit monitoring style on financial

characteristics of the banks such as credit worthiness and profitability. The study adopted

discriminant and cluster analysis to contribute to the findings. Basing on logistic model, the

study found that besides conclusions that were consistent with other studies, there were also

interesting unprecedented conclusions. The study showed that, banks in Vietnam are largely

affected by credit monitoring styles. However, this did not apply to banks in Central North where

it was extremely easy for small business to access funding.. However, the study concentrated on

predetermined list of banks funded by World Bank, a gap the current study seeks to fill.

2.6 Summary of the Research gaps

Most of the studied reviewed focused on loan performance aspect of the banks only while others

focused more on banks that were within the town location or had a predetermined list of banks.

20

Other studies used secondary data only thus ignoring primary data. These are the gaps the current

study seeks to fill.

2.7 Conceptual Framework

A conceptual framework is a theoretical structure of assumptions, principles, and rules that holds

together the ideas comprising a broad concept (Huberman, 1994). Bank performance is the

dependent variable, while credit management forms the independent variable. The indicators for

the various variables are as illustrated in figure 2.1.

Independent Variables Intervening Variable Dependent Variable

Figure 2.1: Conceptual Framework

Source: Researcher (2015)

21

Credit scoring technique:Scoring platformCredit requirements

Credit policy:Credit controlCredit risk

Credit monitoring style:Post loan follow upNon-performing loans

Bank Performance:

ProfitabilityLoan sales

Central Bank

Regulations

CHAPTER THREE

RESEARCH METHODOLOGY

3.1 Introduction

This chapter presents the methodology that will be used to carry out the study. It further

describes the research design, type and source of data and research instruments to be used to

collect data. It also describes the target population and the data analysis method.

3.2 Research Design

According to Kothari (2007), research design is defined as framework that shows how

problems under investigation will be solved. The research shall adopt the use of mixed method

approach research design which is the application of both qualitative and quantitative

approaches. Both qualitative and quantitative data shall be collected and converged in order to

provide a comprehensive analysis of the research problem. Creswell, Plano Clark, (2003) refer to

this design as concurrent triangulation design because it involves the concurrent but separate

collection and analysis of quantitative and qualitative data. Creswell and Clark (2011) refer to it

as the convergent design because it involves collecting and analysing two independent strands of

data in a single phase, merging the two results and the looking for convergence and divergence

relationships between the two.

22

3.3 Study Population

According to Mugenda (2003), population is an entire group of individuals, events or objects

having a common observable characteristic. The researcher will draw the population from the

KCB bank branches in Laikipia County. The target population will be staff at the bank. The

population of staff in KCB branches in Laikipia County is approximately 78; as shown in table

3.1.

Table 3.1: Bank Staff Population

Category of Staff Population

Management 5

Supervisory 14

Others 59

Total 78

Source: Economic Survey (2014)

3.4 Sampling Size and Sampling Procedure

A sample is a small proportion of a population selected for observation and analysis while

sampling is a deliberate rather than a haphazard method of selecting subjects for observation to

enable scientists infers conclusions about a population (Kothari, 2007). The study will adopt

stratified random sampling whereby each category of the staff will be sampled independently as

shown in the table 3.2. The study will use census survey on managerial and supervisory staff

while simple random sampling (at 30%) will be used on other category of staff.

23

Table 3.2: Sample size

Description Population Sample size Description

Managerial 5 5 Census

Supervisory 14 14 Census

Others 59 18 Simple random

sampling (30%)Total 78 37

Source: Researcher (2015)

3.5 Data Sources and Collection

The study will obtain secondary data through a data collection form that will indicate the

profitability and loan sales of the banks. However, a semi- structured questionnaire will be used

to collect primary data from the bank staff. The questionnaires are preferred in this study because

respondents of the study are assumed to be literate and quite able to answer questions asked

adequately. Kothari (2007) terms the questionnaire as the most appropriate instrument due to its

ability to collect a large amount of information in a reasonably quick span of time. It guarantees

confidentiality of the source of information through anonymity while ensuring standardization

(Kerlinger, 1973). It is for the above reasons that the questionnaire will be chosen as an

appropriate instrument for this study.

The questionnaire will contain a mix of questions, allowing for both open-ended and specific

responses to a broad range of questions. The questionnaire will be divided into two sections

where section one will deal with the demographic information while section two will deal with

the study variables. However, section two will be subdivided into three subsections in line with

the variables in the study objectives.

24

3.6 Data Collection Procedure

The researcher will obtain an introductory letter from the University to collect data from the

Bank, then personally deliver the questionnaires to the banks and have them filled in his

presence. The researcher will employ self-administration approach of data collection and monitor

the process to ensure that unintended people will not fill the questionnaire or are not interviewed;

by personally conducting the interviews. The questionnaires will be filled and assistance will be

sought where possible thus raising the reliability.

3.7 Validity of Data Collection Instruments

Validity is the degree to which a test measures what it is supposed to measure. For validity of

any measuring instrument to be qualified it must be subjected to a pre-test (Mugenda &

Mugenda, 2003). The researcher will test the validity of the instruments through a pilot study.

The pre-test will also allow the researcher to check on whether the variables collected could be

easily be processed and analyzed. The pre-testing will be carried out on a sample consisting of

ten (10%) of the respondents; from Equity bank, Laikipia town branch. Views given by the

respondents during pre-testing will be analyzed and used to improve the questionnaires before

actual collection of data. The researcher will also make consultations with his supervisor to

confirm validity of the research instruments.

3.8 Reliability of the Research Instrument

Reliability is the ratio of the true score variance to the observed score variance. It also refers to

the degree to which a test consistently measures whatever it is designed to measure (Yang &

25

Manfred, 2005). Thus the reliability of a standardized test is usually expressed as co-efficient

where the reliability co-efficient reflects the extent to which a test is free of error variance. The

study will use ‘split-halves’ and ‘internal consistency’ method to measure reliability. ‘Split-

halves’ method will be used by comparing the two halves of the responses to each other and

similarities identified. The more similarities between the two halves and each question can be

found the greater the reliability. Internal consistency method will be tested using Cronbach’s

Alpha. Cronbach's alpha is a measure of internal consistency, that is, how closely related a set of

items are as a group.  A "high" value of alpha is often used as evidence that the items measure an

underlying (or latent) construct (Warmbrod, 2007). Reliability with a predetermined threshold of

0.7 is considered acceptable. That is, values above 0.7 indicate presence of reliability while

values below signify lack of reliability of the research instrument (Warmbrod, 2007).

3.9 Data Analysis and Presentation

The process of data analysis will involve several stages namely; data clean up and explanation.

Secondary data will be analyzed using content analysis. The primary data will then be coded and

checked for any errors and omissions (Kothari, 2007). Frequency tables, percentages and means

will be used to present the findings. Responses in the questionnaires will be tabulated, coded and

processed by use of a computer Statistical Package for Social Science (SPSS) program to analyze

the data. The responses from the open-ended questions will be listed to obtain proportions

appropriately; the response will then be reported by descriptive narrative. Both descriptive and

inferential statistics will be used to analyze the data. Mean and standard deviations will be used

as measures of central tendencies and dispersion respectively. The relationship between the

dependent variable and the independent variables will be tested using Pearson’s correlation.

26

3.10 Ethical Considerations

This study will observe confidentiality and privacy of respondents. Consent will be sought from

all respondents before data collection. Humane treatment will be observed throughout the study.

Should the findings of this study be published, the researcher will ensure nothing can be traced

back to any of the respondents. Where possible, pseudonyms will be used unless a respondent

prefers use of their real names.

27

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APPENDICES

Appendix I: Letter of Transmittal

Philip Musili Musyoka,

Kenyatta University,

Dear Respondent,

RE: SURVEY DATA COLLECTION

My name is Philip Musili. I am a student from the Kenyatta University. I am conducting a

survey on credit management and performance. The information provided by you will be

treated confidentially and will not be disclosed to any third party. Information will only be

collected for the purposes of research in order to establish the relation of the two variables. I

therefore request you to feel free and provide honest answers without fearing any

intimidation or disclosure of the information.

Your assistance and cooperation will be appreciated.

Kind Regards.

Philip Musili,

Researcher,

Kenyatta University.

31

Appendix II: Questionnaire

Questionnaire to bank staff

32

Appendix III: Budget

Appendix IV: Work Plan

33