Home Research PapersCREDIT RISK MANAGEMENT AND NON-PERFORMING LOANS OF COMMERCIAL BANKS IN KENYA MBURU MUTHONI IRENE D58/CTY/PT/24784/2013 A RESEARCH PROPOSAL SUBMITTED TO THE SCHOOL OF BUSINESS IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF A DEGREE IN MASTER OF SCIENCE IN FINANCE OF KENYATTA UNIVERSITY MAY

CREDIT RISK MANAGEMENT AND NON-PERFORMING LOANS OF COMMERCIAL BANKS IN KENYA MBURU MUTHONI IRENE D58/CTY/PT/24784/2013 A RESEARCH PROPOSAL SUBMITTED TO THE SCHOOL OF BUSINESS IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF A DEGREE IN MASTER OF SCIENCE IN FINANCE OF KENYATTA UNIVERSITY MAY

CREDIT RISK MANAGEMENT AND NON-PERFORMING LOANS OF COMMERCIAL BANKS IN KENYA

MBURU MUTHONI IRENE
D58/CTY/PT/24784/2013

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A RESEARCH PROPOSAL SUBMITTED TO THE SCHOOL OF BUSINESS IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF A DEGREE IN MASTER OF SCIENCE IN FINANCE OF KENYATTA UNIVERSITY

MAY, 2018

Declaration

This research proposal is my own original work and has not been presented for the award of a degree in this university or any other learning institution.
Signature……………………………. Date…………………………………….
Mburu Muthoni Irene
D58/CTY/PT/24784/2013

We confirm that the work in this proposal was done by the candidate under our supervision
Signature…………………………………………Date……………………………….
Dr. Lucy Wamugo (PhD)
Department of Accounting and Finance
School of Business,
Kenyatta University

Signature………………………………………… Date……………………………….
Dr. Stephen M.A Muathe (PhD)
Department of Business Administration
School of Business,
Kenyatta University

Dedication
I dedicate this work to my family for their moral support and encouragement during the undertaking of this work. To the almighty God I will forever be grateful for His blessings without which it would be impossible to accomplish anything.

Acknowledgement

I thank God for the grace in the achievement of writing this proposal. Special thanks to my supervisors Dr. L. Wamugo (PhD) and Dr. Stephen M.A Muathe (PhD) for their time, insight and dedication as they guided me in writing this research proposal. I thank Kenyatta University for giving me an opportunity of studying. I also thank my respondents for without them the research would not be complete. Special thanks to my husband Grishon for his moral and spiritual support.

May the Almighty God bless you all.

Table of Contents
Declaration ii
Dedication iii
Acknowledgement iv
List of Tables vii
List of Figures viii
Operational Definition of Terms ix
Abbreviation and Acronyms xi
Abstract xii
CHAPTER ONE: INTRODUCTION 1
1.1 Background to the Study 1
1.1.1 Credit Risk Management 2
1.1.2 Non-Performing Loans 9
1.1.3 Commercial Banks in Kenya 10
1.2 Statement of the Problem 11
1.3 General Objective 12
1.3.1 Specific Objectives 12
1.3.2 Research Hypothesis 13
1.4 Significance of the Study 13
1.5 Scope of the Study 14
1.6 Limitations of the Study 15
1.7 Organization of the study 16
CHAPTER TWO: LITERATURE REVIEW 17
2.1 Introduction 17
2.2 Theoretical Review 17
2.2.1 Asymmetric Information Theory 17
2.2.2 The 5 C’s Model for Credit 18
2.2.3 Credit Risk Theory 19
2.3 Empirical Review 20
2.3.1 Credit Risk Management and Non-Performing Loans 20
2.3.2 Collection Policy and Non-Performing Loans 23
2.3.3 Client Appraisal and Non-Performing Loans 25
2.3.4 Lending Policy and Non-Performing Loans 27
2.3.5 Central Bank Prudential Guidelines and Non-performing Loans 28
2.4 Research Gaps 30
2.5 Summary of Literature Review 34
2.6 Conceptual Framework 35
CHAPTER THREE: RESEARCH METHODOLOGY 38
3.1 Introduction 38
3.2 Research Design 38
3.2.1 Research Philosophy 38
3.3 Target Population 38
3.4 Sampling Procedure and Sample Size 39
3.5 Data Collection Instruments 39
3.5.1 Reliability Tests 40
3.5.2 Validity Tests 40
3.6 Data Analysis 40
3.6.1 Diagnostic Tests 41
3.7 Ethical Considerations 43
REFERENCES 44
APPENDICES 44
Appendix I : Letter to the Respondent 52
Appendix II: Questionnaire 53
Appendix III: Time Frame 57
Appendix IV: Research Budget 58

List of Tables
Table 2.1: Research Gaps 30
Table 3.1 Target Population 39

List of Figures
Figure 2.1 Conceptual Framework 36

Operational Definition of Terms

Bank rate It is the rate charged by the central bank for lending funds to commercial banks.
Collateral These are securities pledged for the payment of a loan to commercial banks.
Credit Crunch It a situation where there is lack of funds available in the credit market, making it difficult for borrowers to obtain financing from the commercial banks.
Credit risk This is the risk that a borrower will default on a debt by failing to make required payments within stipulated time.
Credit Risk Management This is the set of practices and procedures adopted by commercial banks to minimize the risk exposure emanating from non-timely repayment of loans. The practices include credit collection practices, client appraisal practices and lending practices.
Loan Default This is when borrowers from commercial banks are willing but not able to repay loans and also when borrowers are able but not willing to repay loans.
Performing Loan This is a debt held by commercial banks in Kenya on which the borrower has historically made payments on time.
Non-performing loan It is a loan held by commercial banks that is in default and the borrowers are not repaying as per the terms of the repayment.
Return on Investment It is the benefit to the investor resulting from investing in a commercial bank.

Abbreviation and Acronyms
CBK Central Bank of Kenya
UAE United Arab Emirates
IMF International Monetary Fund
NPL Non Performing Loans
CRB Credit Reference Bureau
SPSS Statistical Packages for Social Scientists
CRM Credit Risk Management

Abstract
Non-performing loans remain the highest detrimental factor to development of the financial sector and negatively impact on banks’ ability to lend. In Kenya, banks’ non-performing loans remain higher than the recommended rate. Most borrowers lack collateral and adequate information to enable commercial banks to fully assess their ability to repay the loans. The study will therefore aim at examining credit risk management and non-performing loans of commercial banks in Kenya. Specifically, the study seeks to establish the effect of collection policy, client appraisal and lending policy on the non-performing loans of commercial banks in Kenya. The study will also determine the moderating role of the central bank prudential guidelines on the relationship between credit risk management and non-performing loans. The underpinning theories in the study will be Asymmetric Information theory, the 5Cs model for credit and Credit risk theory. The study will use descriptive research design and the research philosophy to be adopted will be positivism. The target population will be 43 banks in Kenya and a census approach will be used. Both primary and secondary data will be used. Primary data will be collected through interviews and questionnaires while secondary data will be obtained from review of existing bank loan records in relation to loan amount advanced and non-performing loans for a period of five years from 2013-2017. The data collected will be analyzed using both descriptive and inferential statistics with the help of SPSS version 17. Descriptive statistics to be used will include mean, frequencies and standard deviation. Multiple regression analysis and correlation analysis will be used to establish the relationship between the dependent and independent variables.

CHAPTER ONE: INTRODUCTION
1.1 Background to the Study
Credit risk occurs when a debtor fails to fulfill his obligations to pay back the loans to the lender (Lalon, 2015). It is the current and prospective risk to earnings or capital arising from an obligator’s failure to meet the terms of any contract with the bank or otherwise to perform as agreed (Kargi, 2011). While financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties (Doriana, 2015).
For most banks, loans are the largest and most obvious source of credit risk (Basel III, 2017). Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences (Kibor, 2015). Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred (Lalon, 2015).
Commercial banks are predominant financial institutions and their changes in performance and structure have far reaching implications on the economy (Bohnstedt et al, 2000). The very nature of the banking business is so sensitive because more than 85% of their liability is deposits from depositors (Saunders and Cornett, 2005). Banks use these deposits to generate credit for their borrowers, which in fact is a revenue generating activity for most banks. This credit creation process exposes the banks to high default risk which might lead to financial distress including bankruptcy. In the world of volatile cash movements and increasing global lending and borrowing of funds, few banks if any remain unaffected by borrower’s late and non-payment of loan obligations. This results from the bank’s inability to collect anticipated interest earnings as well as loss of principal resulting from loan default (Maraga, 2008).
1.1.1 Credit Risk Management
Risk is defined as the likelihood of an event occurring which affects an organization’s objectives by provoking an unexpected future outcome (Petersen ; Raghuram, 2008). Risk is associated with the uncertainty of the outcomes of an event, capturing the probability of a loss and its magnitude. (Berg, 2010). Financial risk refers to the exposure of uncertainty, which is a crucial element of pursuing business activities. In addition, financial risk can be examined as a combination of the probability and frequency of an event. (Schmid, 2010). Business risk refers to those risks that may affect a bank’s business growth, marketability of its product and services and likely failure of its strategies aimed at business growth. These risks may arise on account of management failures, competition, non- availability of suitable products/services and external factors (Kairu, 2009). Credit risk, the most frequently addressed risk for Commercial banks, is the risk to earnings or capital due to borrowers late and non-payment of loan obligations. Credit risk encompasses both the loss of income resulting from the Commercial bank inability to collect anticipated interest earnings as well as the loss of principal resulting from loan defaults (GTZ 2000).
Credit risk management of commercial banks has been towards implementation of more robust credit management approaches that will ensure soundness of the financial institutions. The global financial crisis in 2008/2009 and the credit crunch that followed put credit risk management into the regulatory spotlight. As a result, regulators began to demand more transparency. They wanted to know that a bank has thorough knowledge of customers and their associated credit risk with Basel III attempting to create an even bigger regulatory burden for banks (Sungard Report, 2018). Basel III (2017) review sought to review credit management models by adopting global approaches while at the same time regular assessment of credit risk among the peer banks and counterparts. Commercial banks were required to maintain a capital charge for potential mark-to-market losses of a result of the deterioration in the creditworthiness of counterparty (Basel III, 2017). With the need to ensure sound financial institution, commercial banks are expected to adopt more aggressive credit risk management.
Credit risk management in a bank basically involves its practices to minimize the risk exposure and occurrence (Lalon, 2015). For a commercial bank, lending activities form a critical part of its products and services. According to Greuning & Bratanovic (2009), “more than seventy percent of a bank’s balance sheet generally relates to this aspect of risk management”. Therefore, credit risk management is crucial to any banks success. Risk management is recognized in today’s business world as an integral part of good management practice (Lalon, 2015). Commitment to credit risk management is an essential component of a comprehensive technique to risk management and critical to the long-term success of all banking institutions (Kithinji, 2010). Poor credit risk management practices lead to rising non-performing loans which compress profit margins of commercial banks hence bringing about the most challenging environment for banks (Saunders & Allen, 2010).
In the course of their operations, financial institutions are adversely exposed to numerous risks as they seek to meet their primary goals, the nature and complexity of which have changed rapidly over time. The failure to adequately manage risks exposes financial institutions to adverse effects on their financial performance including reduced profitability and liquidity problems, ultimately rendering them unsuccessful in achieving their strategic business objectives. In the worst case, inadequate risk management may result in circumstances so catastrophic in nature that financial institutions cannot remain in business (Haneef et al., 2012).
Credit risk management is very important to banks as it is an integral part of the loan process. It minimises bank risk, adjusted risk rate of return by maintaining credit risk exposure with view to shielding the bank from the adverse effects of credit risk. Banks are investing a lot of funds in credit risk management modeling (Jamaat & Asgari, 2010). Efficient management of credit risk is a part of comprehensive risk management method and the basic condition for long term success of each bank. Credit risk management function in banks needs to be a robust process that enables the banks to proactively manage the loan portfolios to minimize the losses and earn an acceptable level of return to its shareholders (Kimeu, 2008).
When a commercial bank grants credit to its customers, it incurs the risk of non-payment. Credit risk management refers to the systems, procedures and controls which a Bank puts in place to ensure the efficient collection of customer payments and minimize the risk of non-payment (Naceour & Goaied, 2003). Credit risk management forms a key part of a company’s overall risk management strategy (Richardson, 2002). Banks have credit policies that guide them in the process of awarding credit. Credit control policy is the general guideline governing the process of giving credit to bank customers. The policy sets the rules on who should access credit, when and why one should obtain the credit including repayment arrangements and necessary collaterals. The method of assessment and evaluation of risk of each prospective applicant are part of a credit control policy (Hardy, 2006).
1.1.1.1 Collection Policy
In the past decade, most financial institutions were not keen in their efforts on timely credit recovery and consequent reduction of Non-Performing Assets as today (Early, 2006). Debt collection is defined as a process of pursuing loans which have not been repaid and managing to recover them by convincing the loaners to make attempts to repay their outstanding loans. Few customers have been established to complete their payments while others don’t pay at all (Kariuki, 2010). This has resulted in the formulation of policies that banks should adhere for effective credit policies which may include collection policy to avoid non-performing loans.
The collection policies aim to stimulate the non-payers to pay therefore avoiding non-performing loans. Collection policy adopted by commercial banks affects the level of non-performing loans. This is because lack of stringent collection policy leads to overdue collection amounts and hence non-performing loans (Gakure et.al, 2012). Further, non-performing loans increase with collections going far more into the future. The need to reduce non-performing loans has seen commercial banks aim at reducing the collection period by adopting stringent collection policy (Otieno & Nyagol, 2016).
However, while credit collection policy is hypothesized to have a significant influence on the non-performing loans, some of the empirical evidence tends to contradict this. Owusu (2008) found out that credit collection did not affect non-performing loans since collection policy did not adequately assess the inherent credit risk to guide the taking of appropriate credit decision. Similarly, Muturi (2016) found that the existing collection policies were not sufficient enough in providing information on loan repayment schedules, credit worthiness and catering for the overhead costs.
According to Montana (2012), bank debt recovery is assuming an alarming trend as its growth is looking almost unstoppable. The low debt repayments and difficulties in loan collections have been largely attributed to the poor economy and high living standards. The effectiveness of the loan policy will be based on the minimization or elimination of defaults on loan repayment. Though Kenya has a well-developed commercial bank sector compared to most of Africa, it still faces challenges of loan administration and collection of loans (Otieno & Nyagol, 2016).

1.1.1.2 Client Appraisal
Client appraisal is a process undertaken mainly to determine whether to accept or reject the proposal for credit from clients. This involves an evaluation of the repayment capacity of the borrowers (Gakure et.al, 2012). The primary objective is to ensure the safety of the money of the bank and its customers. The process involves an evaluation of credit worthiness of the borrower and future expected stream of cash flows with the amount of risk attached to a specific borrower. This entails gathering adequate information about a client before granting a credit facility. It ensures that the loans are granted to the right hands and the capital and interest income of the bank is relatively secured (Auren, 2003).
Client appraisal is therefore crucial in any credit management that highly determines the level of non-performing loans. Lack of adequate client appraisal guidelines and exclusive use of qualitative methods of loan assessment results in loans not being repaid on time (Mathara, 2007). The recognition of the importance of client appraisal system has led to commercial banks adopting more comprehensive client appraisal method, both qualitative and quantitative (Ombaba, 2013). During appraising term loans, a financial institution would focus on evaluating the credit-worthiness of the company and future expected stream of cash flow with the amount of risk attached to them.
The appraisal tries to assess the correctness or reasonability of the estimates of costs and expenses and the projected revenues. These may include the estimation of the selling price, cost of machinery, the overall cost of the project and the means of financing. Through appraisals, bad credit may be steamed out through proper and early identification. Thus, effectiveness of risk appraisal has a direct influence on loan performance. However, according to Auronen (2003), information asymmetry is essential for ensuring the desired effects are achieved thus reducing the chances of default greatly.
1.1.1.3 Lending policy
Lending in commercial banks ought to be effectively carried out as it is the basis for having a sound developing economy (Gennaioli, Andrei and Robert, 2012). The lending system should therefore be formulated to attain total benefit to all different interest group of the bank, which includes the shareholders, depositors and the borrowers (Parlour and Winton, 2008). In this regard, lending policies enables the banks to offer the credit to worthy customers using specified guidelines. The recognition of the importance of lending policy on non-performing loans has led to banks constantly updating their lending policies to fit the changing environment (Kibor, 2015).
The lending policies guide the bank on issuing out loans to customers and ensuring proper credit risk management (Kithinji, 2010). These should be aligned with the general bank plans and factors such as existing credit policies and prevailing country’s economy status. Prior to the establishment of the lending policies, banks mainly issued out credits to anyone who expressed their creditworthiness. This resulted in large volumes of bad credit leading the banks to be more cautious thereafter (Abuor, 2004). Lending policies therefore enforce the banks to establish a clear process for approving new credit as well as for the extension to existing credit.
Majority of commercial banks have customized the own lending policies to fit the local market and to gain a competitive edge. However, they still face from poor lending practices (Altunbas et al, 2009). It thus sensitizes on the importance of monitoring and providing the necessary steps that are related to lending both to individuals and corporates (Crowley, 2007). This has seen the CBK to issue guidelines on the implementation of more detailed lending procedures and practices in the banks, with each bank being required to prepare Credit Policies Guidelines (CPG) for making lending decisions (CBK, 2015).
1.1.1.4 Central Banks prudential guidelines
Prudential guidelines are an appropriate legal framework for financial operations. This entails the supervision and monitoring of deposit taking institutions such as the banks and setting out requirements for their risk taking (Brownbridge, 2002). It is a significant contributor to minimizing and preventing financial related problems. The goal of regulatory reforms and guidelines is to help banks and other financial institutions become stronger players and ensuring longevity. (Ndungu, 2010).
The prudential guidelines are essential in establishing a well monitored and well set out rules for operation of financial activities with easy supervisions. It’s therefore imperative that an effective supervision is expected to lead to a healthy banking industry that possesses the power to propel the economic growth (Kamau and Were, 2013). Lack of prudential guidelines is undesirable as it may lead to bank failures and systemic instability (Brownbridge, 2002). The prudential reforms in developing countries are usually based on upgrading banking laws in accordance with international best practice such as bringing minimum capital requirements in line with Basel Capital Accord and strengthening the supervisory capacities of regulatory agencies (Barth, Caprio and Levine. 2001).
In Kenya, prudential guidelines are issued by CBK in attempts to reduce the risk level that the bank creditors are faced with (Plosser, Kovner and Hirtle, 2016). Following financial crisis in 2008, central banks across the world have required adoption of stringent credit management. The level of disclosure of non-performing loans has also been enhanced. The criteria of categorizing loans as non-performing loans have been adopted by Central Bank in Kenya among other federal banks globally in line with BASEL III requirements. Commercial banks are now more than in the past required to analyze risks facing credit and constantly evaluate the risk facing the loans (Kairaria, 2014).
1.1.2 Non-Performing Loans
Non-performing loans (NPLs) are loans that are in default or close to being in default. Many loans become non-performing after being in default for 90 days, but this can depend on the contract terms (Saunders & Allen, 2010). A loan is non-performing when payments of interest and principal are past due by 90 days or more, or at least 90 days of interest payments have been capitalized, refinanced or delayed by agreement, or payments are less than 90 days overdue, but there are other good reasons to doubt that payments will be made in full (International Monetary Fund, 2005).
Commercial banks in Kenya have recorded higher non-performing loans than the standard globally (World Bank, 2016). In 2016, banks non-performing loans to total gross loans were 7.8% and five years average of 5% which was higher than the recommended rate of 1% (World Bank, 2016). This raises great concern and the reason why the study will examine credit risk management and non-performing loans among commercial banks in Kenya.
Ekrami and Rahnama (2009) stated that the high amount of NPLs represents high credit risk in today bank system and this encounters banks with market risks and liquidity risk. Although banks are trying to control the risks within the organization, high percentage of this risk and its consequences for the future could not be ignored. NPLs occur due to weak criteria of credit, ineffective policies, risk acceptance without regard to limitation of bankroll and wrong functional indicators (Morton, 2003).
Performance of loans is measured by the percentage of non-performing loans. It is the sum of borrowed money upon which the debtor has not made his scheduled payments for at least 90 days (Bank for International Settlements, 2016). The opposite of non-performing loans is a performing loan which is a loan that is not in default, or is not about to be, with a reasonable expectation that the loan will not enter default even though it has not technically defaulted yet (Petersen & Raghuram, 2008). As a general rule, banks and other financial institutions like to avoid non-performing loans, because there is a risk that they will not be able to recover the principal left on the loan, let alone the interest which has accrued (Otieno & Nyagol, 2016). Loan products comprise of salary loans, group guaranteed loans, Individual loans and corporate loans (Puxty et al., 1991).
1.1.3 Commercial Banks in Kenya
According to (Campbell, 2007), a Commercial Bank is a financial institution that provides financial services, including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creation of credit. The Kenyan financial system is dominated by commercial banks as financial intermediaries that act as intermediaries between the surplus economic units and the deficit economic units. Commercial Banks and Mortgage Finance Institutions are licensed and regulated pursuant to the provisions of the Banking Act and the Regulations and Prudential Guidelines issued there under. They are the dominant players in the Kenyan Banking system and closer attention is paid to them while conducting off site and on site surveillance to ensure that they are in compliance with the laws and regulations. Currently, there are 43 licensed commercial banks in Kenya of which 29 are locally owned, and 14 are foreign owned (Central Bank of Kenya, 2017).
The Kenyan banking sector has undergone many regulatory and financial reforms in the past. Such reforms have brought in important changes to the banking sector as well as inspiring foreign banks to enter the Kenyan market (Otieno & Nyagol, 2016). The banking sector is governed by the Banking Act and including Prudential Guidelines. Commercial banks in Kenya are required by CBK to submit audited annual reports, which include their financial performance and in addition disclose various financial risks in the reports including liquidity risk, credit risk as well as management of credit risk. Effective management of credit risk practices involve reporting and reviewing to ensure credit risk is well identified, assessed, controlled and informed responses are well in place by commercial banks. When the loan is issued after being approved by the bank’s officials, the loan is usually monitored on a continuous basis so as to keep track on all the compliance issues/terms of credit by the borrower (CBK, 2017).
1.2 Statement of the Problem
Non-performing loans remain the highest detrimental factor to development of the financial sector (World Bank, 2016) and negatively impact on banks’ ability to lend (Doriana, 2015). There has been concern on the level of non-performing loans in Kenya which has been higher than the recommended rate of 1%. World Bank (2016) report indicated that commercial banks in Kenya were recording higher non-performing loans than the standard globally. In 2016, banks non-performing loans to total gross loans were 7.8% and five years average of 5% which was higher than the recommended rate of 1% (World Bank, 2016). Therefore, credit risk management and the level of non-performing loans is very important to banks since it contributes immensely to interest income and affects the financial performance and ability to lend (Jamaat & Asgari, 2010).
Studies on the relationship between credit risk management and non-performing loans have not been conclusive because they have paid attention to the relationship between credit risk management practices and bank performance without examining non-performing of loans. For instance Gakure et,al (2012) investigated the effect of credit risk management techniques on the banks performance of unsecured loans. Although the study did not examine the various credit management techniques, it confirmed the importance of credit management among commercial banks in meeting banks objectives. Otieno and Nyagol (2016) explored the relationship between credit risk management and financial performance: empirical evidence from microfinance Banks in Kenya. The study found that credit management had a negative effect on financial performance of Commercial Banks. Oretha (2012) studied the relationship between credit risk management practices and financial performance of commercial banks in Liberia. The study found a positive relationship between credit risk management practices and financial performance.
Despite numerous studies that have been conducted with regard to credit risk management, there is no adequate literature focusing on credit risk management and non-performing loans among commercial banks in Kenya. In an effort to address this gap, this study will focus on credit risk management and non-performing loans of commercial banks in Kenya.
1.3 General Objective
The main objective of this research is to study credit risk management and non-performing loans of commercial banks in Kenya.
1.3.1 Specific Objectives
i. To study the effect of collection policy on non-performing loans of commercial banks in Kenya.
ii. To analyze the effect of client appraisal on non-performing loans of commercial banks in Kenya.
iii. To determine the influence of lending policy on non-performing loans of commercial banks in Kenya.
iv. To determine the moderating role of the central bank prudential guidelines on the relationship between credit risk management and non-performing loans.
1.3.2 Research Hypothesis
H01: Collection policy has no significance on the non-performing loans of commercial banks in Kenya.
H02: Client appraisal has no significant effect on the non-performing loans of commercial banks in Kenya.
H03: Lending policy does not significantly influence the non-performing loans of commercial banks in Kenya.
H04: Central bank prudential guidelines have no moderating role on the relationship between credit risk management and non-performing loans.
1.4 Significance of the Study
The question of credit risk is of enormous importance for regulators, investors, commercial banks, researchers and scholars. Specifically, the non-performing loans are important since they play key role and have the capacity to boost financial performance of commercial banks. The results of this research will have implications and importance to various stakeholders who will benefit from the study findings and recommendations.
Regulators and policy makers of the banking industry include the Central Bank of Kenya. They will benefit from the study since the research will provide the basis for regulatory policy framework to mitigate the financial system from financial crisis and to better appreciate and quantify those credit risk exposures. The regulators will be able to formulate policies in relation to credit risk management on non-performing loans.
To investors, this study will help them to understand the factors that influence the returns on their investments. The investors will be able to project the extent of performance of loans based on the credit risk practices put in place by commercial banks. Non-performing loans affects financial performance of commercial banks. Financial performance of commercial banks affects the level of investors returns in terms of earning per share.
To commercial banks and financial sector, this research will provide an insight into the credit risk attributes which may need to be incorporated in their loan awards process and the factors that determine success of administration of loans. The management of commercial banks will be able to understand the measures that they need to put in place to improve performance of loans. The bank loans have the capacity to improve performance of commercial banks if appropriately administered.
To the general public, the study will lead to improved performance of loans. This will improve bank’s ability to offer more loans to the public and therefore improve the performance of their firms. Further, credit access will improve and in turn lead to improved performance of the economy of large. Improved economic performance will reduce level of poverty and improve security levels and other social problems.
Researchers and Scholars will find this study important in facilitating an increase in the general knowledge of the subject and will act as a reference material to future researchers and scholars. The study will make recommendations of the areas in which researchers may consider for future studies. The recommendations when used together with the empirical studies by this study will form strong basis for future research.
1.5 Scope of the Study
The study will be based on all 43 commercial banks operating within Kenya. All the commercial banks will be studied to ensure that the results apply to all commercial banks in Kenya and hence more reliability of the data. The study will target personnel working in the credit department and the management of the commercial banks operating in Kenya. These respondents will be studied since they are considered to be best placed to provide accurate and reliable information relating to this study. The data sought will relate for a period of five years from 2013 to 2017. This period is considered most appropriate since it has seen a number of banks being placed under receivership due to huge amounts of non-performing loans. Further, within this period, many banks have implemented more stringent credit risk management strategies to comply with guidelines issued by Central bank of Kenya.
1.6 Limitations of the Study
Although a lot has been written about credit risk management and commercial banks, scarcity of literature relating to CRM and non-performing loans will be one of the challenges that might be encountered during the study. The researcher will seek to limit this aspect by engaging peers and experts on issues relating to CRM and non-performing loans in the Commercial Banking sector.
Respondent’s cooperation will also be an issue during the study. Some respondents will be uncooperative due to different reasons including busy schedules and sensitivity of some information. Further due to fear of victimization the researcher will ensure that confidentiality is upheld in the course of the study. To mitigate this limitation, the researcher will obtain all the necessary permission from the relevant authorities and book appointments appropriately.
The scope of the study will not be extensive enough to capture the views of all the stakeholders involved in credit risk management practices. Thus, the study findings may not be fully representative. The researcher hopes to mitigate this by opening up the research gap to other scholars and academicians who can undertake it in other sectors. The researcher also anticipates the selected variables are a common standard within the financial sector thus, will enhance the research findings.
1.7 Organization of the study
Chapter one provides the background of the study, statement of the problem, the research objectives and research questions. The researcher will also examine the significance of the study, scope of the study and the limitations of the study. Chapter two presents a review of the relevant literature examines the theories relevant to the study and develops a conceptual framework for the study. Chapter three discusses the research methodology including the research design, target population, sampling procedure and sample size, data collection tools and procedure, data analysis, pilot study and ethical considerations.

CHAPTER TWO: LITERATURE REVIEW
2.1 Introduction
The second chapter of this research will dwell on a theoretical and empirical review of the literature that will underpin the research. Further the chapter will outline the conceptual framework that will show the association between the research variables.
2.2 Theoretical Review
This section will discuss the theories that are established by other researchers, authors and scholars and are relevant to credit risk management. The study will specifically review asymmetric information theory, 5 C’s model for credit and credit risk theory.
2.2.1 Asymmetric Information Theory
The Asymmetric information theory was first introduced by Akerlof’s 1970. The theory shows that there exists information asymmetry in assessing bank lending applications (Binks & Ennew, 1997). Information asymmetry theory describes the condition in which relevant information is not known to all parties involved in an undertaking (Ekumah & Essel, 2003). Eppy (2005) describes a condition in which all parties involved in an undertaking do not know relevant information. The theory point out that perceived information asymmetry poses two problems for the financial institution, moral hazard, monitoring entrepreneurial behavior and adverse selection that is making errors in lending decisions (Denis, 2010).
Asymmetric information theory relates to the study in that there exists information gap between the commercial banks and the loan borrowers. There is information that the loan borrowers may have that commercial banks don’t have. This calls for credit risk management on administration of loans to reduce the effect of credit risk and exposure on commercial banks. With credit sharing among commercial banks, banks can assess the quality of credit applicants assessment and lead to careful lending to customers. By reducing information asymmetry between lenders and borrowers, loans can be extended to safe borrowers who had previously been priced out of the market, resulting in higher aggregate lending and low default rates. Thus, according to the theory, credit information sharing will reduce the level of non-performing loans suffered by commercial banks in Kenya. Further, credit risk management will therefore be expected to lead to reduction in non-performing loans.
2.2.2 The 5 C’s Model for Credit
Lending Institutions build their credit policy around the 5 C’s of credit: Character (of the applicant), Capacity to borrow, Capital (as backup), Collateral (as security), economic Condition. These assessments are based upon lenders own experience taking into consideration not only historical information but also the futures view of the borrowers’ prospects (MacDonald et al., 2006).
The 5 C’s details the five important factors that commercial banks will use in administration of credit which are expected to lead to improved performance of loans. Character refers to the maturity, honesty, trustworthiness, integrity, discipline, reliability and dependability of a customer. A person of good character will be open and divulge information about them in the process of the decision making. Capacity refers to the ability of a client to service his debt obligation fully. This is determined by reviewing sources of income versus obligations to determine his paying ability based on past information about the borrower. Capital refers to the borrower’s wealth position measured by financial soundness and market standing. The loan officer looks at what would happen if there is deterioration in the borrower’s financial condition. Would they still be able to meet the debt obligation?
Condition looks at the commercial, socio-economic, technological and political environment to assess the successful implementation of the project, therefore, the recovery of the loan issued. It looks at the sources of cash and how they vary with the business cycle and consumer demand. Collateral is a security issued to secure a loan. These guarantee the issuer of credit to a source of income in the event of failure or inability of the loan holder to pay their debt. Securities include land, building, machinery and others which may sometimes prove to be difficult to dispose of in loan recovery (MacDonald et al., 2006). This model is fundamental to this study as it will guide on how client appraisal is undertaken by commercial banks to foster less non-performing loan levels.
2.2.3 Credit Risk Theory
Melton 1974 introduced the credit risk theory otherwise called the structural theory which is the default event derived from a firm’s asset evolution modeled by a diffusion process with constant parameters. Such models are commonly defined “structural model “and based on variables related a specific issuer. An evolution of this category is represented by asset of models where the loss conditional on default is exogenously specific. In these models, the
default can happen throughout all the life of a loan (Long, P., Schwartz, 1995)
Although people have been facing credit risk ever since early ages, credit risk has not been widely studied until recent 30 years. Early literature (before 1974) on credit uses traditional actuarial methods of credit risk, whose major difficulty lies in their complete dependence on historical data. Up to now, there are three quantitative approaches of analyzing credit risk: structural approach, reduced form appraisal and incomplete information approach (Crosby et al, 2003). The credit risk theory details the nature of credit risk management on non-performing loans among commercial banks. The theory affirms that credit risk management is dynamic and has a standard approach to managing and mitigating the risk.
2.3 Empirical Literature Review
This section explores empirical studies in view of the study variables. The business of a financial institution is to manage credit risks through collection policy, client appraisal, lending policy and Central Bank’s prudential guidelines.
2.3.1 Credit Risk Management and Non-Performing Loans
Balgova, Nies and Plekhanov (2016) studied economic impact of reducing non-performing loans. The purpose of the study was to determine how non-performing loans affected economic performance. Longitudinal design was used. The study found that reducing non-performing loan has an unambiguously positive medium-term impact on the economy. While countries that experienced an influx of fresh credit grew the fastest, the economies that actively sought to resolve non-performing loan did comparably well. The study did not examine the how credit management practices affected non-performing loans. However, the study confirmed the negative consequences of non-performing loans in an economy and hence need to manage the same.
Otieno and Nyagol (2016) studied the relationship between Credit risk management and financial performance: empirical evidence from microfinance banks in Kenya. The purpose of the study was to establish the relationship between Portfolio at risk, loan loss Provision coverage ratio and performance of commercial banks. Longitudinal research design was used. The findings were that credit risk management parameters had a strong negative correlation, giving a significant negative relationship with performance measures. Thus, the study concluded the existence of a significant relationship between Credit risk management and performance and that credit risk management impacts performance of microfinance banks. The study did not explore how credit risk management affected non-performing loans. However, the study confirms the importance of credit risk management practices on financial performance.
Ahmed and Malik (2015) examined the credit risk management and loan performance: empirical investigation of micro finance banks of Pakistan. The purpose of the study was to evaluate the influence of credit risk management practices on loan performance while taking the credit terms and policy, client appraisal, collection policy and credit risk control as the dimensions of the credit risk management practices. Multiple regression analysis was used. The results of the analysis indicated credit terms and client appraisal had positive and significant impact on the loan performance, while the credit terms and policy and collection policy and credit risk had positive but insignificant impact on loan performance. The study did not look at the specific practices affecting non-performing loans. The current study will look at the specific practices affecting the non-performing loans.
Doriana (2015) studied the impact of non-performing loans on bank lending behavior: evidence from the Italian banking sector. The aim of this study was to understand the bank lending behavior during financial crisis, in particular whether an increase of credit risk during this period can lead banks to reduce their lending activity. Descriptive research design was used. The findings showed a negative impact of credit risk on bank lending behavior, with regard to both credit risk measures: the non-performing loans and the loan loss provision ratio. However, the study did not examine the importance of credit risk management practices on non-performing loans. The current study will examine the importance of credit risk management practices on non-performing loans.
Ofonyelu and Alimi (2013) studied perceived loan risk and ex post default outcome. The purpose of the study was to determine how the bank’s risk on borrowers affected non performing loans. The study adopted a descriptive research design. The study found that non-performing loans could be reduced through credit analysis which involves analytical manipulation i.e. ratios and trend analysis, the creation of projections and a detailed analysis of cash flows. While the study confirmed the importance of credit management in managing non-performing loans, the study did not document the specific components affecting non-performing loans. The specific components relating to credit risk management will be examined in the current study.
Gakure et.al (2012) investigated the effect of credit risk management techniques on the banks performance of unsecured loans. The purpose of the study was to determine how credit management techniques affected the banks performance. The study used descriptive research design. The study found that credit risk management techniques had a positive impact on the banks performance. Although the study did not examine the various credit management techniques and their effect on non-performing loans, the study confirmed the importance of credit management among commercial banks in meeting banks objectives. The current study will examine credit management techniques and their effect on non-performing loans.
Moti (2012) studied the effectiveness of credit management system on loan performance: empirical evidence from micro finance sector in Kenya. The purpose of the study was to assess the effectiveness of credit management systems on loan performance of microfinance institutions. The study adopted a descriptive research design. Credit management practices were found to have minimal effect on loan performance. Collection policy was found to have a higher effect on loan repayment. The study did not use both secondary and primary data and hence affecting reliability of the findings. The current study will therefore use both secondary and primary data and study the non-performing loans of commercial banks.
2.3.2 Collection Policy and Non-Performing Loans
Muturi (2016) examined the effect of collection policy on loan performance in deposit taking microfinance banks in Kenya. The purpose of the study was to determine the effect of collection policy on loan performance in deposit taking microfinance banks in Kenya. The study used exploratory research design. The findings were that general trend of credit worthiness, existing credit policy, state of the economy and overhead, cost policy and loan repayment affected performance of loans. The study however did not examine the credit risk management practices adopted by microfinance banks. The current study will examine the credit risk management practices adopted by commercial banks.
Muasya (2013) conducted a study on the relationship between credit risk management practices and loan losses among commercial banks in Kenya. The purpose of the study was to determine the relationship between credit risk management practices and loan losses among commercial banks in Kenya. The study used descriptive research design. From the study findings, one of the most effective method of curbing loan losses was implementation of a strict collection policy supported by tight lending policies that will ensure better loan repayments. The study however failed to take into consideration how collection policy has reduced the risk of non-performing loans. This will be examined by the current study among commercial banks in Kenya.
Oretha (2012) studied the relationship between credit risk management practices and financial performance of commercial banks in Liberia. The purpose of the study was to determine the relationship between credit risk management practices and financial performance of commercial banks in Liberia. The study used qualitative research design. The study findings showed that better collection policies enhance the loan recovery which is a determinant of better financial profitability. The study however did not examine the non-performing loans. The current study will look at how non-performing loans affect commercial banks in Kenya.
Byusa and Nkusi, (2012) studied the effects of credit policy on bank performance in selected Rwandan Commercial banks. The purpose of the study was to determine the effect of collection policy on bank performance in selected Rwandan Commercial banks. The study adopted exploratory research design. The study found that in the Rwandan Financial sector banks had been faced by a persistent increase in high non-performing loans. The study confirmed the non-performing loan problem among commercial banks though the study did not examine loan performance but overall bank perfromance. The current study will examine the non-performing loans of commercial banks in Kenya.
Dawkin (2010) examined the micro finances double bottom line; the relationship lending constructs. The purpose of the study was to examine the micro finances institutions profitability in relations to lending. Descriptive research design was used. The study found that collection efforts may include attaching mandatory savings forcing guarantors to pay, attaching collateral assets and courts litigation. Notably, the study focus was on microfinance institutions which may be different from commercial banks. The study did not explore the credit management practices adopted by microfinance institutions and how they affected non-performing loans. The current study will explore the credit management practices adopted by commercial banks and how they affect the non-performing loans.
Owusu (2008) examined credit management policies in rural banks in Accra Ghana. The purpose of the study was to examine the credit management policies adopted in rural banks. The study adopted a descriptive research design. The study found out that credit collection did not adequately assess the inherent credit risk to guide the taking of appropriate credit decision. He also found out that the drafted credit policy documents of the two banks lacked basic credit management essentials like credit delivery process, credit collection and management practices among others to adequately make the loan awards more robust. The study however did not assess the impact of credit risk management on non-performing loans. The current study will look at the impact of credit risk management on non-performing loans.
2.3.3 Client Appraisal and Non-Performing Loans
Ombaba (2013) sought to review the factors contributing to high rates of non-performing loans in Kenya despite the introduction of the Central Bank Rate. The purpose of the study was to determine the factors contributing to high rates of non-performing loans. The study used descriptive research design. The study found that the bank management did not assess the loans sufficiently to ensure funds borrowed were used for the intended purpose. The study relied on secondary data in studying the spread of non-performing loans and failed to consider primary data. The current study will consider both secondary and primary data.
Louizies et al. (2012) studied the drivers of non-performing loans in the greek financial institutions. The purpose of the study was exploring the drivers of non-performing loans. The study used survey research design. The study found that information sharing and an increase in future non-performing were negatively associated. The data needed to the application and to monitor borrowing were not freely available to banks. When banks did not have such information, they were found to face problems with lending activities. Therefore, credit information sharing plays a vital role in client appraisal. The study however did not explore the credit risk management practices and how they affect non-performing loans. The current study will explore the credit risk management practices and how they affect non-performing loans.
Nganga (2011) studied stakeholder perception of credit reference bureau service in Kenya Credit Market. The purpose was to explore the stakeholders perception of credit reference bureau service in Kenya credit market. The study used qualitative data using descriptive design. The study found that without full file information sharing, lenders mistake good risks for bad, and vice versa. Their loan portfolio, therefore, will consist of more risky loans and, over time, higher interest rates. This study did not examine the credit risk management practices but detailed the importance of credit information sharing at loan appraisal stage. The current study will examine the credit risk management practices and how they affect the non-performing loans.
Orua (2009) conducted a study on the relationship between loan applicant appraisal and loan performance of microfinance institutions in Kenya. The purpose of the study was to determine the relationship between loan applicant appraisal and loan performance of microfinance institutions in Kenya. The study used descriptive research design. The study found that short-term debt significantly impacted MFI outreach positively. Long term debt however showed positive relationship with outreach but was not significant with regard to default rates. While the study clustered loan categories based on repayment period, it did not cluster the loans based on riskiness where practices on risky customers will be different from less risky customers. Further, the study was done on MFIs which are significantly different from commercial banks. The current study will cluster loans based on riskiness where risky customers will be different from less risky customers.
Mathara (2007) studied the response of National Bank of Kenya Ltd to challenges of non-performing loans. The purpose of the study was to seek the response of National Bank of Kenya to the challenges of non-performing loans. Descriptive research design was used. The study found the following factors to have led to high levels of non-performing loans in the bank: lack of adequate client appraisal guidelines, poor credit risk management practices, use of qualitative methods of loan assessment and poor monitoring and evaluation systems. However, the study relied on qualitative data such as character of the borrower, reputation of the borrowed and the historical financial capability of the borrower as opposed to the used of quantitative techniques. Reliability of qualitative data is in doubt and this will be addressed by the current study. In situation where qualitative data will be used, quantification will be done to allow better objectivity in measurement.
2.3.4 Lending Policy and Non-Performing Loans
Kibor (2015) studied the influence of lending policy on loan performance in commercial banks in Nakuru Town, Kenya. The purpose of the study was to determine the relationship between lending policy and loan performance in commercial banks. A descriptive and correlation research design was adopted. The findings indicated that there exists a moderately strong and positive relationship between lending policy and loan performance. It is also indicated that the relationship was statistically significant. The study however failed to take into consideration how lending policy has reduced the risk of non-performing loans. The current study will review lending policy and non-performing loans of commercial banks in kenya.
Ayodele, Thomas, Raphael and Ajayi (2014) carried out a study on the impact of lending policy on the performance of Nigerian Commercial Banks using Zenith Bank Plc as a case study. The purpose of the study was to determine the impact of lending policy on the performance of Nigerian commercial banks. The study used survey research design. The findings from the study showed that having a good credit policy in place goes a long way in minimizing the incidence of bad debts. The study did not use secondary data nor incorporate external factors that affect the non-performing loans. The current study will use both primary and secondary data and incorporate external factors affecting the non-performing loans.
Gennaioli, Andrei and Robert (2012) studied the match between the size of the loan and the borrower’s ability to repay the loan. The purpose of the study was to find out the level of bank’s compliance to lending policy and size of loans advanced. The study used descriptive research design. The study found that efficient loan sizes fit borrower’s repayment capacity and stimulate enterprise performance. If the amount of loan released is enough for the purposes intended, it will have a positive impact on the borrower’s capacity to repay. On the other hand, in the case of over and under finance, the expected sign is negative. However, the study did not examine other aspects of credit risk management and thus the findings were not conclusive. The current study will examine the broader aspects of credit risk management and their effect on non-performing loans.
2.3.5 Central Bank Prudential Guidelines and Non-performing Loans
Plosser, Kovner and Hirtle (2016) studied the impact of supervision on bank performance. The purpose was to establish how supervision of banks had affected bank performance. The study used a matched sample approach. The study found that top banks were less volatile, held less risky loan portfolios, and engaged in more conservative reserving practices, but did not have lower earnings or slower asset growth. The findings thus confirmed importance of bank regulation even though the study did not relate bank supervision to non-performing loans. The current study will relate bank supervision to non-performing loans.
Kairaria (2014) aimed at assessing the effect of capital adequacy requirement on credit creation by commercial banks in Kenya. The purpose of the study was to assess the role capital adequacy had played in enhancing credit access. Causal research design was used. The study revealed that capital adequacy requirement introduced by Basel 1 had a negative impact on credit creation by banks in Kenya. The study however did not assess the impact of capital adequacy requirement on non-performing loans. The current study will assess the impact of capital adequacy requirement on non-performing loans.
Aigbogun (2011) studied perceived impact of prudential guidelines on the services and performance of commercial banks in Nigeria. The purpose of the study was to assess how the prudential guidelines had affected performance of commercial banks. Findings indicated that there was increased need for bank supervision from the regulatory bodies. The bank’s prudential guidelines had helped to check the mismatch between banks’ reported and actual profits and also ensured early detection of fraud, distress and deterioration of banks credit portfolio. The study was however done in Nigeria and not in Kenya and whether these findings would be the same wasn’t established. The study did not also relate prudential guidelines to non-performing loans. The current study will be done in Kenya and will relate prudential guidelines to non-performing loans.
Ismail (2011) examined the impact of prudential guidelines and deregulation on the Nigerian banking industry. The purpose of the study was to establish how the prudential guidelines affected the banking sector. The study used descriptive research design. The study found that while the giant banks were positively affected by the regulation and returned them to profitability and sanity, small banks performance reduced. This was reported to be the case since small banks were declaring fictitious profit due to inadequate prudential guidelines. The guidelines also made banks to classify their loans as performing and non-performing by reducing their risk of incoming bad debts. The study therefore confirms the importance of prudential guidelines in terms of reporting performing and non-performing loans and thus the reason for incorporating the same as a moderating variable.

2.4 Research Gaps
Table 2.1: Research Gaps
Author & Year Title Methodology Findings Knowledge Gaps How the Proposed Study will Fill the Gap
Balgova, Nies and Plekhanov (2016) Economic impact of reducing non-performing loans Longitudinal design Reducing non-performing loan has an unambiguously positive medium-term impact on the economy Did not examine how credit management practices affected non-performing loans. Will look at how credit management practices affects non-performing loans
Ofonyelu and Alimi (2013 Perceived loan risk and ex post default outcome Descriptive research design.
Non-performing loans could be reduced through credit analysis The study did not document the specific components affecting non-performing loans. Will incorporate practices affecting non-performing loans.
Moti
(2012) Effectiveness of credit management system on loan performance
Descriptive research design Credit management practices was found to have minimal effect on loan performance The study did not look at the non-performing loans and did not use both secondary and primary data. Will use both secondary and primary data and will look at the non-performing loans.
Muasya (2013) Relationship between credit risk management practices and Loan Losses among commercial banks in Kenya Descriptive research design Adopting stringent credit collection policies and lending policies will enhance loan performance. Failed to take into consideration how collection policy reduces risk of NPL. Will study the effect of collection policy on the NPLs.
Oretha (2012) Relationship between credit risk management practices and performance of commercial banks in Liberia. Qualitative research design. Better credit collection policies enhance the loan recovery. Failed to take into effect the non-performing loans Will look at how non-performing loans affect commercial banks in Kenya.
Byusa and Nkusi (2012) Effects of credit policy on bank performance in selected Rwandan Commercial banks Exploratory research design Rwandan Financial sector banks were faced by a persistent increase in high non-performing loans. Did not take into consideration loan performance but overall bank performance. Will look at non-performing loans of commercial banks in Kenya.
Owusu (2008) Credit management policies in Rural banks in Accra Ghana. Descriptive research design.
Banks lacked credit collection policies thus hampering loans recovery. Did not assess the impact of credit risk management on non-performing loans. Will look at the impact of CRM on NPLs of commercial banks in Kenya.
Ombaba (2013) Assessing the Factors Contributing to high rates of Non-Performing Loans in Kenya Descriptive research design Bank management did not assess the loans sufficiently to ensure funds borrowed are used for intended purpose. The study relied on secondary data by studying the spread of NPLs.
This study will utilize both primary and secondary data.

Louizies et al(2012) A study on the drivers of Non-Performing Loans in the Greek Financial Institutions. Survey Research Design Lack of credit sharing information negatively impacted the performance of loans. The study did not explore the CRM practices and how they affect NPLs The current study will explore the CRM practices and how they affect the NPLs.
Orua (2009) Relationship between loan applicant appraisal and Loan performance of MFIs Descriptive research design Lack of proper client appraisal leads to mismatch in debt awards. The study focused on MFI’s and award of only short term loans. Will focus on commercial banks non-performing loans and will consider all categories of loans.
Mathara (2007) The response of National Bank of Kenya Ltd to the challenges of non-performing loans. Descriptive research design Poor credit risk management and loan assessment led to poor loan performance.
Reliance on qualitative borrower assessment led to poor loan performance. Did not study the influence of client appraisal as a challenge to loan performance. Will consider the effects client appraisal on the non-performing loans.
Kibor (2015) Influence of lending policy on loan performance in Commercial banks in Nakuru Town. Descriptive research design.
There exists a moderately strong and positive relationship between lending policy and loan performance The study failed to take into consideration how lending policy has reduced the risk of non-performing loans Will show how lending policy has reduced the risk of non-performing loans
Ayodele, Thomas, Raphael & Ajayi (2014) Impact of lending policy on performance of Nigerian Commercial Banks Survey research design Good credit policies promote better loan books. Did not use secondary data nor incorporate external factors that affect the loan performance. Will rely on both primary and secondary data. Will take into consideration external factors in terms of CBK regulations.
Aigbogun (2011) Impact of prudential guidelines on the services and performance of commercial banks in Nigeria Descriptive research design.
There was increased need for bank supervision from the regulatory bodies The study did not relate prudential guidelines to non-performing loans Will relate prudential guidelines to non-performing loans

2.5 Summary of Literature Review
A review of empirical studies discussed in this study shows that there are mixed results on how credit risk management practices adopted by the financial institutions impacts the non-performing loans. In some instances, some studies show that credit risk management has a positive impact on the profitability of commercial banks while on the other hand, results show that credit risk management was found to have a negative significant impact on bank’s profitability through non-performing loans.
There is, therefore, the need for a study in the Kenyan context with regard to non-performing loans for comparison of results. Moreover, though there is increased literature on credit risk management and financial performance of commercial banks in developing countries, the literature on the Kenyan context is not extensive. It is based on these identified gaps that this study seeks to fill these knowledge gaps by conducting a study on credit risk management and non-performing loans of commercial banks in Kenya.
2.6 Conceptual Framework
According to Mutai (2010), a conceptual framework is a relationship between variables in a study showing them graphically and diagrammatically. The purpose is to help the reader quickly see the proposed relationship of concepts, (Orodho 2004). The conceptual framework outlines the relationship between variables to be used in the analysis. In this study, a conceptual framework is used as the study model to guide the relationship of the variables under study to keep the research work focused on the objectives of the study.

Independent Variables Moderating Variable Dependent Variable

H1

H4

H2

H3

Figure 2.1 Conceptual Framework
Source: Author (2018)

Independent variables for the study are the collection policy, client appraisal and lending policy. The collection policy is conceptualized by allowing late repayments, collection enforcements, guarantor payments on borrowers default, exceptions to the lending policy and continuous monitoring and control of loans. Client appraisal is conceptualized in the study by the 5Cs which include condition, collateral, credit, character and capacity of the borrower. Lending policy is conceptualized to consist of Credit limits, Credit terms, Deposits of advancing loans, customer documentation requirements, customer information and flexibility in interest rates.
The dependent variable for the study will be the non-performing loans that will be measured by the amount of non-performing loans to total loans. The conceptual framework further proposes a moderating role of the central bank prudential guidelines which have laid down control and regulatory mechanisms to ensure a sound financial system.

CHAPTER THREE: RESEARCH METHODOLOGY
3.1 Introduction
This chapter will discuss the methodology to be adopted by the researcher in carrying out the study. This chapter presents the population to be studied, the methods to be used to sample it, the instruments to be used in data collection and procedures that will be used in data analysis.
3.2 Research Design
The study will use descriptive research design. Descriptive research is the investigation in which quality data is collected and analyzed in order to describe the specific phenomenon in its current trends, current events, and linkages between different factors at the current time. Further, using descriptive research design will allow the researcher to generalize the findings of the study to all the commercial banks in Kenya.
3.2.1 Research Philosophy
The research philosophy to be adopted in this study will be positivism because only factual data will be used in the research. The researcher is also independent from the banking sector and thus will be purely objective on the concepts operationalization and measurement. This method will ensure that there is a distance between the subjective biases of the researcher and the objective reality of the study. The study objectivity will also be achieved through hypothesis generation and testing.
3.3 Target Population
According to Mugenda (2003), a population is a complete set of individuals, cases or objects with some common observable characteristics while target population refers to that population to which a researcher wants to generalize the results of a study. The target population for this study will be the 43 commercial banks with branches in Kenya. The study will target 43 credit managers, 43 finance managers and 43 compliance risk managers. The study will be conducted at the banks head office where the departmental heads will be the respondents as presented in Table 3.1.
Table 3.1 Target Population
Target Respondent Total Respondents
Credit Managers 43
Finance Manager 43
Risk and Compliance Manager 43
Total 129
Source: Author (2018)

3.4 Sampling Procedure and Sample Size
The study will employ a census approach where all the managers heading credit control, finance and risk and compliance will be studied. No sampling will be done since the population is considered manageable.
3.5 Data Collection Instruments
The study will utilize primary data and secondary data. Primary data will be collected using a close-ended questionnaire. The researcher will personally administer the questionnaires to ensure that the respondents are accorded all the guidance sought in filling their responses. Further, the researcher will use secondary data from the existing banks financial records in relation to the number of loan advanced and amount of non-performing loans. Secondary data will be collected for a period of five years from 2013-2017 using secondary data collection sheet.
3.5.1 Reliability Tests
Reliability is defined as a measure of the degree to which a research instrument yields consistent results after repeated trials (Yin, 2009). Before actual data collection, piloting of the questionnaire shall be carried out (Silverman, 2010). A Cronbach alpha test will be conducted to measure the internal consistency and reliability of the data collection instruments. A score above 0.7 will be considered acceptable in view of Yin (2009).
3.5.2 Validity Tests
Validity is defined as the accuracy and meaningfulness of inferences, which are based on the research results. In other words, validity is the degree to which results obtained from the analysis of the data actually represents the phenomena under study (Golafshani, 2003 ). Riege (2003) defines validity as the degree to which a test measures what it purports to measure. Content validity of an instrument is improved through expert judgment. The researcher will remove bias in the research instrument by constructing it in line with the objectives of the study.
3.6 Data Analysis
Data collected will be sorted, edited, classified, coded into a coding sheet and analyzed using SPSS Version 17 for analysis. This package will be used to generate both descriptive and inferential statistics. Descriptive statistical measures that will be employed will include mean, frequencies and standard deviation while the inferential statistical measures will include multiple regression analysis to test the relationship between the dependent and independent variables and the correlation tests to test the association between the variables. The study will adopt a linear regression equation as depicted below;
Y = ? + ?1X1 + ?2X2+ ?3X3+? ……………………………………………………………………Equation 3.1
To assess the moderating effect of prudential guidelines on the relationship between non-performing loans and CRM, the following model will apply:
Y = ? + ?1 (X1Z) + ?2 (X2Z) + ?3 (X3Z) +?……………………………………..Equation 3.2
Where;
Y = Dependent variable (Non-performing Loans to total loans) for a period of five years
? = the model intercept
?1 – ?3= Coefficient of independent variables
X1 = Collection Policy
X2 = Client Appraisal
X3 = Lending Policy
Z = Moderating Variable: Central Bank prudential guidelines
? = Error Term
3.6.1 Diagnostic Tests
Diagnostic tests done on the data will include normality tests, heteroscedasticity, multicollinearity and autocorrelation.
3.6.1.1 Test for Normality
Multiple regression analysis assumes that data is normally distributed or else the results will not be reliable. Normality will be tested using the degree of skewness and kurtosis where values not in the range of +/-2 will indicate lack of normality on data. For independent variables which are not normally distributed, normalization will be done using the log of 10.
3.6.1.2 Test for Heteroscedasticity
Heteroscedasticity is a situation in which the variance of the dependent variable varies across the data, as opposed to a situation where the Ordinary Least Squares make the assumption that variance of the error term is constant. To test heteroscedasticity, the Breusch-Pagan/Cook-Weisberg test of detecting heteroscedasticity in linear models will be used. If heteroscedasticity will be found to exist, box-cox transformation will be used to make the dependent variable approximate to a normal distribution.
3.6.1.3 Test for Multicollinearity
Multicollinearity will be deemed to exist when two or more of the predictors in a model are moderately or highly correlated. Variance Inflation Factor and degree of tolerance will be used to test presence of multicollinearity. Multicollinearity occurs where the independent variables are strongly correlated and hence results of regression analysis are as a result of the correlation between the independent variables. Multicollinearity will be corrected by removing the highly correlated variables.
3.6.1.4 Test for Autocorrelation
Regression analysis assumes that the error terms are independent unless there is a specific reason to think that this is not the case. Usually violation of this assumption occurs because there is a known temporal component for how the observations were drawn. Durbin-Watson test will be used to test autocorrelation. Autocorrelation if found to be present will be corrected through use of a bias-corrected estimate of the autocorrelation, an adjusted t-test and expanding confidence interval coverage.
3.7 Ethical Considerations
The researcher will ensure that the respondents are willing to take part in the study without any undue cohesion, a letter of authority will be obtained from the institution and other relevant authorities before undertaking the study, an introduction letter will be availed to the respondents detailing the main objective of the study, avail the study findings sought by the respondents and maximum confidentiality will be upheld.

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APPENDICES
Appendix I : Letter to the Respondent

Dear respondent,
I am a student at Kenyatta University pursuing a Master of Science degree in Finance. In fulfillment of the university requirements, I am required to carry out a thesis on Credit risk management and non-performing loans of commercial banks in Kenya.
Kindly spare your time to fill this questionnaire to facilitate this thesis and be assured that it will only be used purely for academic purposes and will be treated with utmost confidentiality.
Please answer the questions with sincerity and to the best of your knowledge.

Thanks in Advance

Yours sincerely,
Irene M. Mburu
Reg No. D58/CTY/PT/24784/2013

Appendix II: Questionnaire
1. Please specify your department?
Credit Control ( )
Finance ( )
Risk and Compliance ( )
2. How long have you worked for the Commercial Bank?
1-3 years ( )
3-5 years ( )
5-8 years ( )
9 yrs. & above ( )
PART. B: CREDIT RISK MANAGEMENT AND NON-PERFORMING LOANS.
Please indicate the extent to which the following practices are applicable to your commercial bank. Please use a scale of 5 –Extreme extent, 4 – Large extent, 3 – Moderate Extent, 2 – Small Extent, 1 – Very Small Extent
3. Collection Policy 1 2 3 4 5
There exists an operational credit collection policy at the bank
Late repayments are allowed with prior approval and charges
Collection enforcements are done in-discriminatory according to the policy
Guarantor payments are sought when borrowers are in default as per policy
There is continuous monitoring and control of loans advanced

4. Client Appraisal 1 2 3 4 5
The bank considers the condition of the loan including logical need for the funds, business sense and proven business idea
Nature, value, marketability and quality of collateral in advancing loans
The bank determines the credit score of the borrowers using information from credit referencing bureau among other sources
The bank gathers information to assess the character of the borrow during credit appraisal
The bank assesses borrower’s ability to pay the debt and makes a decision strictly based on set criteria.

5. Lending Policy 1 2 3 4 5
The bank employs an elaborate lending policy that fits into the borrowers profile to reduce non-performing loans.
The lending policy clearly specifies credit limits which are strictly adhered to
Credit terms are precisely defined in the lending policy and guides the lending by the bank
The bank requires customers to have deposits against which loans are advanced
There exists minimum documentation required to be obtained before advancing loan
The bank offers loans based on flexible interest rates

6. To what extent have the Central banks prudential guideline affected the below. Use a scale of 1-5 where 5 – is to Extreme extent, 4 – Large extent, 3 – Moderate Extent, 2 – Small Extent, 1 – Very Small Extent.

Measure 1 2 3 4 5
The bank credit risk management practices
Commercial bank level of non-performing loans

PART. C: NON-PERFORMING LOANS
7. Kindly indicate the extent to which the credit risk management practices have affected the non-performing loans at your branch. Use a scale of 1-5 where 5 – is to Extreme extent, 4 – Large extent, 3 – Moderate Extent, 2 – Small Extent, 1 – Very Small Extent.
Performance Measure 1 2 3 4 5
Amount of Non-performing Loans to total loan

Appendix III: Time Frame
January
2018 Feb-April
2018 May
2018 June
2018 July
2018
Formulation of the problem.
Proposal writing
Data collection
Data analysis
Project Report Writing

Appendix IV: Research Budget
Item Cost
Printing 10,000.00
Data Collection 18,000.00
Transport 6,000.00
Miscellaneous 4,000.00
Total 38,000.00

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