Download Impact of Interest Rates on Loan Portfolio Performance in Ugandan Indigenous Banks and more Thesis Computer Science in PDF only on Docsity!
2.2 LOAN PORTFOLIO PERFORMANCE.
According to the Financial Dictionary (n.d), portfolios are loans that have been made or bought ad are held for repayment. Loan portfolios are the major asset of banks, thrifts, and other lending institutions. The value of a loan portfolio depends not only on the interest rates earned on the loans, but also on the quality or like hood that interest and principal will be paid. The loan portfolio is typically the largest asset and the predominate source of revenue. As such, it is one of the greatest sources of risk to a bank’s safety and soundness. The level of interest risk attributed to the bank’s lending activities depends on the composition of its loan portfolio and the degree to which the terms of its loans (e.g., maturity, rate structure, and embedded options) expose the bank’s revenue stream to changes in rates. (Comptroller’s hand book, 1998:6). Effective management loan portfolio and credit function is fundamental to a bank’s safety and soundness. Loan portfolio management is the process by which risks that are inherent in the credit process are managed and controlled. Good loan portfolio managers have concentrated most of their effort on prudently approving loans and carefully monitoring loan performance.
All banks need to have basic loan portfolio management principles in place in some form. This includes determining whether the risks associated with the bank’s lending activities are accurately identified and appropriately communicated to senior management and the board of directors, and, when necessary, whether appropriate corrective action is taken (Comptroller’s hand book, 1998). Loan portfolio management (LPM) is the process by which risks that are inherent in the credit process are managed and controlled. Because review of the loan portfolio management process is so important, it is a primary supervisory activity. Assessing LPM involves evaluating the steps bank management takes to identify and control risk throughout the credit process. The assessment should focus on what management does to identify issues before they become problems (Comptroller’s Hand Book, 1989:1). Specific measurable goals for the portfolio are established by loan portfolio objectives. They are an outgrowth of the credit culture and risk profile (Comptroller’s Hand Book, 1989:13). The board of directors must ensure that loans are made with the following three basic objectives in mind:
- F 0B 7 To grant loans on a sound and collectible basis.
- F 0B 7 To invest the bank’s funs profitably for the benefit of shareholders and the protection
of depositors.
- F 0B 7 To serve the legitimate credit of their communities.
Banks require that senior management and the board of directors to develop medium- and long- term strategic plans to meet objectives for the loan portfolio. These strategies should be consistent with the strategic direction and risk tolerance of the institution. They should be developed with a clear understanding of their risk/reward consequences. They should be reviewed periodically and modified as appropriate. Loan portfolio performance, on the other hand, refers to the rate of profitability or rate or return of an investment in various loan products thus broadly, it looks at
the number of clients applying for loans, how much they are borrowing, timely payment of installments, security pledged against the borrowed funds, rate of arrears recovery and the number of loan products on the chain. The loan products may comprise of; Salary loans, Group guaranteed loans, Individual loans and corporate loan (Puxty et al, 1991). Since one of the main tasks of commercial banks is to offer loans and their main source of risk is credit risk, that is, the uncertainty associated with borrowers’ repayment of these loans. A non- performing loan (NPL) may be defined as a loan that has been unpaid for ninety days or more (Greenidge and Grosvenor, 2010). Such loans unpaid affect the bank loan portfolio performance. For effective loan portfolio performance banks should pay attention to several factors when providing loans in order to curtail the level of impaired loans (Khemraj and Pasha, n.d: 23). Specifically, commercial banks need to consider the international competitiveness of the domestic economy since this may impair the ability of borrowers form the key export oriented sectors to repay their loans which in turn would result in higher nonperforming loans. These lending institutions should also take the performance of the real economy into account when extending loans given the reality that loan delinquencies are likely to be higher during periods of economic downturn. Finally, banks should constantly review the interest rates on loans since loan delinquencies are higher for banks which increase their real interest rates. 2.3 Lending policies in Centenary Bank.
All loans in the commercial portfolio shall be continuously monitored to ensure that portfolio
quality does not deteriorate. Loan officers should monitor the performance of borrowers primarily to reassure themselves that a borrower will continue to be in position to honor the terms of the loan and that the quality of our loan portfolio is within acceptable parameters (2005: 41). Monitoring is necessary for purposes of ensuring that:
- Terms of repayment are observed and any obligation complied with
- Trends and portfolio swifts are monitored
- No diversion of funds occurred
- Security values have not been eroded
The credit policies (2005: 45) asserts that, at least every month the Head of the branch Credit department shall undertake a thorough review of all loans more than 30 days in arrears and report to Head Office on the reasons for loan failure. This will be valuable feedback on the effectiveness of the bank’s loan policy and procedure. In addition, special reports may from time to time be requested by head office. 2.3.2 Compliance with regulations According to the credit policy (2005: 11-13) on restrictions and concentrations;
- a) BOU regulations stipulate that aggregate loans to a single borrower or related group of the borrowers (as defined in the Financial Institutions Act) shall be limited to no more than 25% of the core capital. Whereas this requirement remains, as an Internal control mechanism to ensure that CERUDEB penetrates the Commercial/Corporate sector cautiously, the maximum amount of loan for one single individual borrower or group of related borrowers shall be limited to no more than 1 billion for new borrowers and 1.5 billion for recurrent borrowers with excellent performance. The board will consider raising the limit upon recommendation by management front time to time.
- b) The bank shall comply with all regulations stipulate in the FIA 2004, notwithstanding the above internal limits
- (i) The bank shall not grant or promise to grant to a single person or to a group of related persons any advance or credit accommodation which is more than 25% of its capital
- (ii) Notwithstanding the above however, the Bank may grant advance or credit facility in excess of 25% but not more than 50% of its capital if the facility is self-liquidating, and its maturity or expiry does exceed three year and is adequately secured by:
- o Uganda Government Securities to be pledged to the bank
- o Fixed Deposits held by the bank
- (iii) In addition to but without derogation from sub sections (a-c) above, the bank shall not have large exposures, which in aggregate exceed 800% of the total capital
- (iv) Notwithstanding sub sections (a) and (b) above, the bank may grant to another financial institution an advance or credit facility:-
- o Shall not exceed fifty percent of the Bank’s total capital
- o Shall not have a maturity exceeding one year
- o Shall immediately be reported to the central bank
- (v) Where the advance or credit facility by the bank to another financial institution exceeds one year, it shall be secured in accordance with sub section (iii) above
(c) Advances or credit facilities to a single borrower shall mean all loans and credit accommodation made by the bank to one or more persons with common interest. A common interest shall be deemed to exist between persons for the purposes of this section if:-
- (i) The exposure to those persons constitutes a single exposure because of the fact that one of them directly or indirectly exercises control over the others
- (ii) Although the persons to whom the bank is exposed are different entities, they are so interconnected that if on one of them experiences financial difficulties, another one or all of them are likely to experience lack of liquidity
- (iii) The persons are affiliates within the meaning of this sub section.
- (iv) Those persons are related persons within the meaning of this subsection
- (v) Those persons have common control
- (vi) Those persons are associated within the meaning of this subsection
2.3.3 Working out problems loans and recovery The credit policy (2005: 43) puts forward the following Work out strategies; that each problem loan is different and no routine is universally applicable. A problem loan can be resolved in any of the following ways:-
- F 0A 7F 02 0Provide a debt restructuring/rescheduling program
- F 0A 7F 02 0Additional collateral/guarantees
- F 0A 7F 02 0Injection of additional funds
- F 0A 7F 02 0Liquidation of collateral
- F 0A 7F 02 0Liquidation of other assets
- F 0A 7F 02 0Calling on guarantors to repay
- F 0A 7F 02 0Arranging for joint venture partner and capital contribution
- F 0A 7F 02 0Working with management to define problems and potential solutions
- F 0A 7F 02 0Arranging sale of operating company to third party
- F 0A 7F 02 0Replacing management
- F 0A 7F 02 0Etc
2.4 Literature Survey A literature on the role of interest rates on loan portfolio performance in indigenous commercial banks in Uganda indicates that an attempt has been made by a few researchers. Most of the studies in this respect, however, focused on Credit management and loan portfolio performance in Commercial Banks. Moreover, a few of the studies undertaken have focused on other aspects of credit risk management other than interest rates and their effects on loan portfolio performance in commercial banks.
Nakeba (2010) conducted a study on the role of credit management in the performance of
indigenous commercial banks. His study was focused on Centenary Bank Entebbe road branch covering the entire staff of the branch with a sample size of 64 respondents who comprised of Managers, Accountants, Auditors, Credit and Loan officers, Banking assistants and some other
making accurate forecasts about the future performance of the portfolio and ensuring that there is
proper management and monitoring of third party servicers who should ensure strict compliance with management policies.
Raghavan (2005) also observes that loan portfolio quality improvement can go as far as conducting independent credit audits to check for the status of compliance, review of risk rating and pick up warning signals and recommendation for corrective action taken with the objective of improving credit quality. He further notes that the need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and reducing exposure to interest rate risk. There is therefore need for rapid portfolio reviews and proper ongoing system for identification of credit weaknesses in advance. KPMG (2001) mentions that loans that get into trouble bring both direct and indirect losses to the bank, which reduces the returns on its portfolio. They further recommend that there should therefore be a sound credit management system with adequate control mechanisms like credit disbursement controls, credit audits and credit Management information systems that can guide proper credit pricing and adequate credit work outs before loan approval. Then the bank should develop a recovery strategy carefully analyzed according to the industry dynamics which involves determining the nature of the industry environment and the borrower’s position within the industry, the borrowers’ financial condition which involves determining the borrower’s capacity to repay through cash flows, collateral liquidation, or other sources. The bank can thereafter come up with either portfolio exit where the decision not to issue credit to the prospective client is undertaken or come up with restructuring policies where a decision to negotiate for reducing the principal with the client is undertaken, once restructuring policies are undertaken, a loan loss provision should be maintained to safeguard against loan losses. Loan restructuring according to HB (2012) helps the borrower reduce his administrative burdens and improve cost effectiveness, hence being able to meet his loan obligations. 2.4.1 Interest rates In Uganda, interest rate decisions are taken by the Bank of Uganda and it is reported by the same to all commercial banks. The rate is set independently by the Bank, depending on its forecast of the future inflation and other economic variables like estimate of growth of real economic activity, to influence lending
behavior of commercial banks so as to foster stability and a sound financial system (Bank of Uganda Act, 2000). The problem of interest rates and loan portfolio performance is not unique in Uganda. Others outside Uganda have researched on it considerably. The interest rate aspects of loan portfolio performance are discussed based on the theoretical and practical recommendations outlined in other research works done elsewhere outside Uganda. Saurina (2005) defines interest as the amount a borrower pays in addition to the principal of loan to compensate the lender for the use of the money while Interest rates are the expressions of interest as a percentage of the principal. Whereas interest rate is a rate which is charged or paid for the use of money, an interest rate is often expressed as an annual percentage of the principal. It is calculated by dividing the amount of interest by the amount of principal. In general, interest rates rise in times of inflation, greater demand for credit, tight money supply, or due to higher reserve requirements for banks. A rise in interest rates for any reason tends to dampen business activity (because credit becomes more expensive) and the stock market (because investors can get better returns from bank deposits or newly issued bonds than from buying shares).
Baxley (1996) noted that lending is the principal business activity for most commercial banks.
The loan portfolio is typically the largest asset and the predominate source of revenue. As such, it is one of the greatest sources of risk to a bank’s safety and soundness. Whether due to lax credit standards, poor portfolio risk management, or weakness in the economy, loan portfolio problems have historically been the major cause of bank losses and failures. Effective management of the loan portfolio and the credit function is fundamental to a bank’s safety and soundness. Piana (2002) states that the interest rate is the profit over time due to financial instruments. In a loan structure whatsoever, the interest rate is the difference (in percentage) between money paid back and money got earlier, keeping into account the amount of time that elapsed. When establishing the interest rate to the public, banks all over the world make reference to these rates (e.g. "1.5% more than Central Bank Base Lending Rate- BLR " - the famous
interbank interest rate for loans in Shillings). If the firm is a sound primary firm with excellent trustworthiness, the bank would agree an interest rate only slightly higher than the rate the same bank would be requested to pay in the inter banking market from other lending institutions. By contrast, for smaller industrial firms, the rate usually would be significantly higher because of the worsened credit risk. Pasha and Khemraj (2010), state that the impact of real interest rates on Non Performing Loans is extensively documented in the literature. In fact, several studies report that high real interest rate is positively related to this variable. This variable is constructed by subtracting the annual inflation rate from the weighted average lending rate of each bank. Using a pseudo panel-based model for several Sub-Saharan African countries, Fofack (2005) finds evidence that economic growth, real exchange rate appreciation, the real interest rate, net interest margins, and inter-bank loans are significant determinants of Non Performing Loans (NPLs) in these countries. The author attributes the strong association between the macroeconomic factors and non-performing loans to the undiversified nature of some African economies. UNDP report (2005) confirms that the commercial banking sector in Uganda is saddled with poor loan portfolios, estimated at 36 percent of their total loan portfolios. Commercial banks have got higher percentages of insider lending and concentration of credit compared to their total credit portfolios. This has resulted in a large share of non-performing advances and subsequent failures. Rajan and Dhal (2003) argue that whenever, a borrower commits breach of agreement in respect of repayment of schedule of the amount of loans with interest etc., we safely say that there are 'OVERDUES' in the Loan Account. Once the Loan A/c is an overdue A/c i.e. the borrower has committed default in repayment of loan amount as per the dates specified in the Agreement, then the Banker has necessarily to adopt measures which will result into recovery of overdue amounts. We now proceed to suggest certain measures to be adopted by Urban Co-op. Banks for effecting recovery of overdue amounts. Whenever the borrower commits default in repayment of loan amount, immediately the bank should serve ' Preliminary Notices' on the principal borrower and the sureties advising them to repay the amount of over dues with interest etc. Such
Preliminary Notices should invariably mention information which is of factual nature relating to: amount of loan sanctioned, date of sanction of loan, names of the sureties, amount of the loan sanctioned, and amount of over dues with interest etc. on a particular date. In addition to the above it must also be communicated the bank shall proceed to take further action against the principal borrower and sureties in case of failure to repay the amount of loan/over dues. It has been often said 'A' stitch in time saves nine'. Thus, the banker must be vigilant, right from the
Figure 2: Conceptual Model
Independent Variable. Dependent Variable. Interest Rates Regulatory environment
- F 0 B 7Central bank rates (BOU)
- (^) F 0 B 7Monetary Policy (ILT)
- F 0 B 7Credit Reference Bureau (CRB)
Loan Portfolio Performance
- F 0 B 7Bank safety & soundness
- F 0 B 7Risk management
- F 0 B 7Profitability
- F 0 B 7Loan applications
- F 0 B 7Number of clients on loans
- F 0 B 7Timely payment of loan installments
- F 0 B 7Provision for non-performing loans.
loan portfolio maintainance. compliance with regulattions working out problem loans. Mediating variables
- F 0 B 7Client ethical considerations
- F 0 B 7Bank credit policy
- F 0 B 7Economic situation
- F 0 B 7Committed loan officers
- F 0B 7 Loan assessment system
Source: Researcher 2013.
3 RESEARCH CONTEXT AND METHODS
Research methodology refers to the techniques used in carrying out research work, including the
theoretical and philosophical assumptions upon which the research is based (Saunders et al 2009). This chapter describes the procedures that were followed in conducting the study. These include, research design, population of the study area, sample and sampling techniques, data collection instruments, as well as the techniques that were used to analyze data. It also indicates the problems encountered in the study. The study employed quantitative methods. Quantitative research methods permit a flexible and iterative approach during data gathering while qualitative research methods try to find and build theories that explain the relationship of one variable with another. (Saunders et al, 2009) as (cited in Idaan, 2012: 28).
