A Survey of Credit Risk Management Techniques Used by Microfinance Institutions in Kenya

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A Survey of Credit Risk Management Techniques Used by
Microfinance Institutions in Kenya

Sifun,o -. .isa/a
1
0 Ro1ert Sili/he Si2i3u
2

1.School of 4usiness) 5ni6ersit3 of Nairo1i. !.&. 4o7 *+197-++1++) Nairo1i) .en3a
2.8he 9atholic 5ni6ersit3 of -ast Africa) :e"art2ent of Accounting and Finance) !.&. 4o7 9+$-*+1++ -ldoret
-2ail of the corres"onding author; sifun,o./isa/a<g2ail.co2

Abstract
8his stud3 had two o1,ecti6es. First) to identif3 the techni=ues used 13 2icrofinance institutions in the
2anage2ent of credit ris/ in .en3a. Second) to e7a2ine the 2ain challenges facing the 2icrofinance institutions
in the 2anage2ent of credit ris/. 8he stud3 used a descri"ti6e research design. A sur6e3 research design was
used to collect the data. A sa2"le si>e of thirt3 2icrofinance institutions was sur6e3ed. 8he sa2"ling fra2e
included the 9entral 1an/ of .en3a :irector3 2++6# of 2icrofinance institutions. !ur"osi6e sa2"ling was used
to select one credit officer and one loan officer fro2 each of the sa2"led institutions. !ri2ar3 data was collected
using se2i-structured =uestionnaires. 8he =uestionnaires were dro""ed and "ic/ed u" later and others were sent
and recei6ed 6ia e2ail. 8he target res"ondents were the institutions? loans and credit officers. :ata anal3sis
in6ol6es co2"utation of su22ar3 statistics such as 2eans) "ercentages and standard de6iations. 8he stud3
esta1lished that 2ost 2icrofinance institutions use 69 techni=ues of credit ris/ 2anage2ent. 8he results also
re6ealed that understanding the organi>ations e7"osure to credit is treated as critical 13 the 2icrofinance
institutions. 8o a6oid loan losses) the 2icrofinance institutions used follow u"s. 8he results also show that @FIs
ta/e loan re6iew anal3sis as crucial as"ects of ris/ 2anage2ent 13 doing "ro"er docu2entation and anal3sis.
8he institutions also use litigation in situations where the 1orrower?s financial situation and structure ha6e 1een
altered and the original "ro2ised 6alue of collateral differ. 8he stud3 esta1lished that a 2a,orit3 of the
institutions used 9redit @etri7 to 2easure the credit 2igration and default ris/. 8he results also show that the
2icrofinance institutions are faced with the challenge of strict o"erational regulations fro2 the 9entral 4an/ of
.en3a. 8he go6ern2ent had not "ut an3 "olic3 in "lace to go6ern the o"erations of the @FIs. Aoan reco6er3 is a
2a,or challenge to the 2a,orit3 of the institutions.
Keywords 9redit Ris/ @anage2ent) @icrofinance Institutions) 9redit @igration) 9redit @etri7) Aoan Re6iew
Anal3sis

!" Introduction
9redit ris/ is the ris/ of loss due to a de1tor?s non-"a32ent of a loan or other line of credit either the "rinci"al or
interest cou"on# or 1oth. A loan is a t3"e of de1t. All 2aterial things can 1e lend 1ut the focus here is
e7clusi6el3 on 2onetar3 loans. Ai/e all de1t instru2ents) a loan entails the redistri1ution of financial assets o6er
ti2e) 1etween the lender and the 1orrower. A 1orrower initiall3 recei6es an a2ount of 2one3 fro2 the lender)
which is "aid 1ac/) usuall3 1ut not alwa3s in regular install2ents) to the lender. 8his ser6ice is generall3
"ro6ided at a cost) referred to as interest on the de1t. Acting as a "ro6ider of loans is one of the "rinci"al tas/s
for financial institutions. For other institutions) issuing of de1t contracts such as 1onds is a t3"ical source of
funding. 4an/ loans and credit are 2ain 2eans to increase the 2one3 su""l3. Interest is the rent "aid on
1orrowed 2one3. Aenders recei6e interest as co2"ensation for foregoing the use of their funds now. 8he
original a2ount lent is called the "rinci"al) and the "ercentage of the "rinci"al which is "aid B "a3a1le o6er a
"eriod of ti2e s the interest rate I6e3) 2++2C Deaton) 2++2#.
Financial ser6ices ha6e witnessed a significant change in the 2ar/et since the earl3 199+s. 8he traditional lines
of de2arcation 1etween the different financial ser6ice "ro6iders were eroded as 1uilding societies 2o6ed into
the current account 1usiness) ta/ing a slice of the high street 1an/s? 2ar/et) and 1an/s retaliated 13 2o6ing into
the 2ortgage 2ar/et in a 2uch 1igger wa3 and ta/ing a slice of the 1uilding societ3 2ar/et. @ergers and
ac=uisitions co2"ounded the tur2oil as 2anage2ent s/ills for these new o"erations 1eca2e stretched. 8he "ace
of change has continued to accelerate as organi>ations get into the 21St 9entur3. 8his is attri1uted to
technological ad6ance2ent) glo1ali>ation of 2ar/ets) de2and for 2ore creati6it3 and inno6ation 13 custo2ers
for the 2anufactured goods and ser6ices. 8he s"eed and "ace of change de2anded of organi>ations is enor2ous
and this has co2"elled the2 to loo/ for 2ore inno6ati6e and creati6e wa3s if the3 are to sta3 in 1usiness
A22ons) 2++1#.
Since the 2id 199+s new "la3ers such as high street retailers ha6e 2o6ed aggressi6el3 into the financial ser6ices
2ar/et offering credit cards) current accounts and) 2ore recentl3) sa6ings accounts to their custo2ers. In 2an3
cases these ha6e 1een as ,oint 6entures with a traditional financial ser6ice "ro6ider) 1ut) for others) it has 1een a
6enture into the un/nown. Increased 2edia attention has raised the le6el of custo2er awareness in financial
ser6ice 2atters and has resulted in a willingness to trade lo3alt3 for co2"etiti6e "ricing. Financial ser6ice
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"ro6iders ha6e res"onded 13 "ro6iding a wider range of "roducts) often with short-ter2 ad6antages) in res"onse
to a co2"etitor?s new "roduct rates) technological ad6ance2ent has ena1led organi>ations to change their
"roduct features on a 2ore regular 1asis to re2ain co2"etiti6e Eh32ar/) 199$#.
8he co2"etiti6e threat and "otential loss of 2ar/et share ha6e "ro2"ted 2anagers to find wa3s and techni=ues
of 2anaging the ris/ to financial ser6ice "ro6iders es"eciall3 fro2 their lending o"erations. 8he 2icrofinance
industr3 has witnessed new entrants into the credit ris/ 2ar/et) willingness of custo2ers to Fsho" aroundG for
the 1est deals and the need to o"erate efficientl3 as "ossi1le in order to i2"ro6e co2"etiti6eness Anson et. al.
2++%#.
!"! Credit Risk Management
@ini2i>ing 1ad Aoans has 1enefits to all the "arties in6ol6ed es"eciall3 the lenders Heller) 2++1#. First) it hel"s
in the identification of "otential credit ris/s related to loan structuring) underwriting and docu2entation.
Secondl3) it hel"s in gathering infor2ation re=uired to 2onitor 1orrower relationshi"s for changes in ris/)
including deter2ining the a""ro"riate le6el of 2onitoring and identif3ing infor2ation re=uired. 8hirdl3) it hel"s
in the e6aluation of changes in credit ris/ that re=uire action) including assessing internal and e7ternal factors
and recogni>ing and e6aluating earl3 warning signals. Fourthl3) it assists in selecting a""ro"riate solutions to
sol6e e2erging credit "ro1le2s 13 using strategies that o"ti2i>e the outco2e for the institution. Fifthl3) it assists
in the recognition of lending situations that entail legal ris/ or e7"osure to lender lia1ilit3. Aastl3) it hel"s in the
identification of the "otential i2"act of 1ad loans on the institution.
9or"orate treasurers ha6e in recent 3ears grown accusto2ed to 2anaging 6arious di2ensions their fir2s? ris/
"rofiles Anson et.al. 2++%#. 8he use of deri6ati6es to hedge interest rate and foreign e7change e7"osure has
1eco2e a co22on"lace. 8he arra3 of deri6ati6e instru2ents include futures contracts) forward contracts) o"tion
contracts) swa" contracts) ca" and floor agree2ents Anson et.al. 2++%#. Indeed) for 2ulti-national fir2s) the
2anage2ent of such e7"osure is a routine of the treasur3 function Anson et.al. 2++%#. &ne as"ect of financial
ris/ that has "ro6en difficult to hedge) howe6er) has 1een that of credit ris/ facing fir2s. 8his ris/ ta/es se6eral
o16ious for2s. For e7a2"le) a non-financial cor"oration holding a large "ortfolio of the 1onds of its custo2ers
andBor su""liers is clearl3 e7"osed to credit ris/ Anson) et.al. 2++%C 4ritish 4an/ers? Association) 2++2#.
9redit ris/ is the "otential that a 1an/ 1orrower or counter"art3 will fail to 2eet its o1ligations in accordance
with agreed ter2s. 8he goal of credit ris/ 2anage2ent is to 2a7i2i>e a 1an/?s ris/-ad,usted rate of return 13
2aintaining credit ris/ e7"osure within acce"ta1le "ara2eters @ar/) 2++6#. 4an/s need to 2anage the credit
ris/ inherent in the entire "ortfolio as well as the ris/ in indi6idual credits or transactions. 4an/s should also
consider the relationshi"s 1etween credit ris/ and other ris/s. 8he effecti6e 2anage2ent of credit ris/ is a
critical co2"onent of a co2"rehensi6e a""roach to ris/ 2anage2ent and essential to the long-ter2 success of
an3 1an/ing organi>ation @ar/) 2++6#.
For 2ost financial institutions) loans are the largest and 2ost o16ious source of credit ris/ @ar/) 2++6#.
Dowe6er) other sources of credit ris/) include the 1an/ing 1oo/ and the trading 1oo/) and off the 1alance sheet
acti6ities. Financial institutions are increasingl3 facing credit ris/ or counter"art3 ris/# in 6arious financial
instru2ents other than loans) including acce"tances) inter-1an/ transactions) trade financing) foreign e7change
transactions) financial futures) swa"s) 1onds) e=uities) o"tions) and in the e7tension of co22it2ents and
guarantees) and the settle2ent of transactions @ar/) 2++6#. Financial and industrial cor"orations ha6e e6er3
incenti6e to i2"ro6e their 2odeling and trading of "ro1le2 loanBcredit ris/. 8he e7"losi6e growth of the credit
deri6ati6es 2ar/et in the industrial and co22ercial sector has distri1uted credit ris/ through the financial s3ste2)
"ac/aged in new for2s. An e7"anding credit ris/ 2ar/et raises "ossi1ilities for cor"orate treasurers to 2ini2i>e
e7"osure to credit ris/ @ar/) 2++6#.
Institutional concerns a1out co22ercial credit ris/ are on the rise due to econo2ic uncertainties) incidents of
cor"orate 2isconduct and o6ere2"hasis on loan "ortfolio growth during 1oo2 3ears Iua3 and .othari) 2++*#.
-ffecti6e ris/ 2anage2ent 1egins with sound underwriting "ractices) including loan structuring and
docu2entation. After the loan is 1oo/ed) accounta1ilit3 for its ulti2ate re"a32ent rests with indi6iduals who
need to 2onitor) e6aluate and ta/e action on credit issues. Ehile these indi6iduals are li/el3 to ha6e had training
and e7"erience in anal3sis and underwriting) 2ost need additional s/ills and /nowledge to acti6el3 "re6ent and
sol6e "otential "ro1le2s while 2anaging the e7isting credit relationshi" Iua3 and .othari) 2++*#.
8his has necessitated a strong 1usiness case to gain su""ort and co22it2ent fro2 2anage2ent) 13 first
identif3ing the /e3 1usiness needs of credit ris/ or "ro1le2 loan 2anage2ent and focusing around these needs
as a strateg3 Eh32ar/) 199$#. 8his effecti6el3 1alance high and low ris/ 1usiness and 2aintain good 1usiness.
Secondl3) the institution o"ti2i>es 1usiness 6olu2es 13 o"erating efficient s3ste2s and "rocesses) full3
understand their e7"osure to the custo2ers) "roacti6el3 forecast how 2an3 loans 2ight go 1ad and finall3)
2ini2i>e losses when loans go 1ad through a =uic/ and effecti6e res"onse Eh32ar/) 199$#.
Settle2ent ris/ includes ele2ents of li=uidit3) 2ar/et) o"erational and re"utation ris/ as well as credit ris/3
Eh32ar/) 199$#. 8he le6el of ris/ is deter2ined 13 the "articular arrange2ents for settle2ent. 8here are
se6eral factors that ha6e a 1earing on settle2ent ris/ Eh32ar/) 199$#. First) the ti2ing of the e7change of
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6alue which in nor2al circu2stances /ee" on changing o6er ti2e. 8he second is the "a32ent or settle2ent
fre=uenc3) which 2a3 1e different fro2 the initial agree2ent. 8he third is the role of inter2ediaries and clearing
houses in the settle2ent "rocess. 8he o1,ecti6e of settle2ent ris/ is to 2eet the challenges ahead and guarantee
future su"erior "erfor2ance. @ost financial institutions ha6e 1een a1le to loo/ outside their own set-u"s for
2ore su"erior "erfor2ances and 2anaged to internali>e what the3 ha6e o1ser6ed in the 2anage2ent of their
credit ris/ I6e3) 2++2#.
!"# The Microfinance Sector in Kenya
@icrofinance "ro6ides an enor2ous "otential to su""ort the econo2ic acti6ities of the "oor and thus contri1ute
to "o6ert3 alle6iation Eorld 4an/) 2+12#. Eides"read e7"eriences and research ha6e shown the i2"ortance of
sa6ings and credit facilities for the "oor and @S-s Eorld 4an/) 2+12#. 8his "uts e2"hasis on the sound
de6elo"2ent of 2icrofinance institutions as 6ital ingredients for in6est2ent) e2"lo32ent and econo2ic growth.
8he "otential of using institutional credit and other financial ser6ices for "o6ert3 alle6iation in .en3a is =uite
significant. A1out 1$ 2illion "eo"le) or 6+J of the "o"ulation) are "oor and 2ostl3 out of the sco"e of for2al
1an/ing ser6ices. According to the National @icro and S2all -nter"rise 4aseline Sur6e3 of 1999) there are close
to 1.* 2illion @S-s e2"lo3ing nearl3 2.* 2illion "eo"le or 2+J of the countr3?s total e2"lo32ent and
contri1uting 1$J of o6erall I:! and 2(J of non-agricultural I:!. :es"ite this i2"ortant contri1ution) onl3
1+.%J of the @S-s recei6e credit and other financial ser6ices. 8he for2al 1an/ing institutions in .en3a o6er the
3ears ha6e regarded the infor2al institutions as ris/3 and not co22erciall3 6ia1le. Dowe6er) this situation is fast
changing due to increased co2"etition in the 1an/ing industr3 in .en3a.
According to the !o6ert3 Reduction Strateg3 !a"er !RS!# of 1999) a large nu21er of .en3ans deri6e their
li6elihood fro2 the @S-s. 8herefore) de6elo"2ent of these institutions re"resents an i2"ortant 2eans of
creating e2"lo32ent) "ro2oting growth) and reducing "o6ert3 in the long-ter2 www.treasur3. go./eB#.
Dowe6er) in s"ite of the i2"ortance of these institutions) e7"erience shows that "ro6ision and deli6er3 of credit
and other financial ser6ices to the @S-s 13 for2al financial institutions) such as co22ercial 1an/s has 1een
1elow e7"ectation. 8his 2eans that it is difficult for the "oor to cli21 out of "o6ert3 due to lac/ of access to
finance for their "roducti6e acti6ities Sifun,o) 2+1%#. 8herefore) new) inno6ati6e and "ro"er 2odes of financing
low-inco2e households and @S-s 1ased on sound o"erating "rinci"les need to 1e de6elo"ed www.treasur3.
go./e#.
In the "ast) 2icrofinance institutions @FIs# esta1lished using either an NI& or a Sa6ings and 9redit 9o-
o"erati6e Societies fra2ewor/. @icrofinance institutions ha6e 1een i2"ortant sources of credit for a large
nu21er of low inco2e households and @S-s in the rural and ur1an areas of .en3a. 8he @FIs ha6e) howe6er)
o"erated without an a""ro"riate "olic3 and legal fra2ewor/. 8here is therefore need to focus 2ore on these
institutions to enhance their effecti6eness in the "ro6ision of sa6ings) credit and other financial ser6ices to the
"oor and @S-s. 8he Io6ern2ent of .en3a recogni>es that greater access to) and sustaina1le flow of financial
ser6ices) "articularl3 credit) to the low-inco2e households and @S-s is critical to "o6ert3 alle6iation
www.treasur3. go./e#.
&6er 1++ organi>ations) including a1out (+ NI&s) "ractice so2e for2 of 2icrofinance 1usiness in .en3a.
A1out 2+ of the NI&s "ractice "ure 2icro financing) while the rest "ractice 2icro financing alongside social
welfare acti6ities. @a,or "la3ers in the institutions are fift3 two www.treasur3.go./e#.
!"$ The Statement of the %rob&em
@icrofinance institutions in .en3a ha6e faced a nu21er of constraints as regards credit ris/ 2anage2ent. 8hese
constraints need to 1e addressed to ena1le the2 i2"ro6e outreach and sustaina1ilit3. 8he 2a,or i2"edi2ent to
the de6elo"2ent of 2icrofinance 1usiness in .en3a is lac/ of s"ecific legislation and set of regulations to guide
the o"erations of the 2icrofinance institutions. :es"ite the fact that @FIs are for2ed under eight Acts of
"arlia2ent) there e7ist no regulations to address issues regarding to ownershi") go6ernance) and accounta1ilit3.
8his has contri1uted to a large e7tent to the "oor "erfor2ance and e6entual de2ise of 2an3 @FIs 1ecause of a
lac/ of a""ro"riate regulator3 o6ersight www.2icrofinancegatewa3#. Aac/ of regulations has resulted in
2icrofinance institutions o"erating without sound credit 2anage2ent "rocedures) which has lead to a high le6el
of non-"erfor2ing loans.
8herefore) to sti2ulate the de6elo"2ent of the institutions) "ro"er techni=ues should 1e "ut in "lace in credit ris/
or "ro1le2 loan 2anage2ent. Setting a""ro"riate laws) regulations and su"er6ision fra2ewor/ also i2"acts
"ositi6el3 on credit ris/ 2anage2ent www.2icrofinancegatewa3.org) www.treasur3.go./e#. For 2ost
2icrofinance institutions) loans are the largest and 2ost o16ious source of credit ris/. Dowe6er) other sources of
credit ris/ include the 1an/ing 1oo/) the trading 1oo/) and off-the-1alance-sheet acti6ities. 8he focus of this
stud3 is on loans as source credit ris/ a2ong @FIs.
9redit ris/ arises fro2 uncertaint3 in a gi6en counter"art3?s a1ilit3 to 2eet its o1ligations. 8he increasing 6ariet3
in the t3"es of counter "arties fro2 indi6iduals to so6ereign go6ern2ent# and the e6er e7"anding 6ariet3 in the
for2s of o1ligations has 2eant that credit ris/ 2anage2ent has ,u2"ed to the forefront of ris/ 2anage2ent
acti6ities carried out 13 2icrofinance fir2s in the financial ser6ices industr3.
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A nu21er of studies ha6e "ro6ided the insights into the "ractice of ris/ 2anage2ent within cor"orate institutions.
Fate2i and Ilau2 2+++# "ro6ided a co2"rehensi6e "icture of the ris/ 2anage2ent "ractices of Ier2an fir2s.
8his stud3 e7a2ined interest rate ris/ 2anage2ent) foreign e7change ris/ 2anage2ent) and the use of
deri6ati6es) ris/ 2anage2ent s3ste2s) and the 1eha6ioral as"ects of ris/ 2anage2ent. 8he authors co2"ared the
"ercei6ed rele6ance of different t3"es of ris/ with the intensit3 of their 2anage2ent and re"orted that no
res"ondents ad2itted 2a,or difficult3 in de6elo"ing a ris/ 2anage2ent s3ste2. 8he3 found out that fir2
sur6i6al is rated as the to" goal of ris/ 2anage2ent. Further) the3 o1ser6ed that half of the fir2s centrali>e
treasur3 2anage2ent and $$J use deri6ati6es. 8he3 also ran/ed deri6ati6es used and their associated "ro1le2s.
Jalil6and et al. 1997# and Iec>3 et al 1997# in6estigated deri6ati6e use and ris/ 2anage2ent "ractices 13 5..
non-financial co2"anies. 8he3 sur6e3ed %+1 5... non-finance co2"anies and in6estigated the e7tent to which
deri6ati6es are used and how the3 are used to 2anage e7"osures. 8he3 found out that large fir2s used
deri6ati6es than "ri6ate fir2s and deri6ati6es usage is greatest a2ong international fir2s. Further) the3 o1ser6ed
that of the fir2s not using deri6ati6es) half do not) 1ecause their e7"osures are not significant. 8he 2ost
i2"ortant reason for not using deri6ati6es is the high costs of esta1lishing and 2aintaining deri6ati6es "rogra2s.
8he3 also o1ser6ed that foreign e7change ris/ is the 2ost co22onl3 2anaged ris/. :eri6ati6es are used to
2anage the 6olatilit3 in cash flows. 4el/ and Ilau2 199+#) Aessard and Haheer 199+#) -deishain 1992#)
Ilau2 and Roth 199*#) 4atten et al. 199*# also anal3>ed the e7change ris/ 2anage2ent "ractices of
2ultinational cor"orations.
8he onl3 local stud3 on credit ris/ 2anage2ent was done 13 N,iru 2++*#. It co6ered coffee coo"erati6es in
-21u district. 8his stud3 was a census stud3 of 2% sa6ings and credit coo"erati6e societies. De found out that)
none of the credit societies use =uantitati6e 2ethods to e6aluate the credit worthiness of their 2e21ers. Dowe6er)
the3 used =ualitati6e 2ethods onl3 li/e the 69s techni=ue i.e. character) ca"acit3) condition) collateral) ca"ital
and control 1ut to a s2all e7tent. In addition) he o1ser6ed that there e7ists a co22on feeling that shared
infor2ation 1etween coffee coo"erati6e societies is 6ital in filtering out un-creditworth3 2e21ers. De also
o1ser6ed that large societies 2anage their credit ris/s 1etter than s2all ones since the3 ha6e a lower le6el of
credit default. 8his was attri1uted to the fact that large societies e2"lo3ed =ualified and e7"erienced staff. 8his
stud3 is as an i2"ro6e2ent to the stud3 done 13 N,iru 2++*#. It uses a large sa2"le of *+ 2icrofinance
institutions registered under the eight Acts of !arlia2ent and inter6iewed 2ore 2anagers res"onsi1le for 2a/ing
credit decisions and 2anaging credit ris/.
Ehile the a1o6e research outco2es "ro6ide 6alua1le insights in credit ris/ 2anage2ent) the3 onl3 "ro6ide
"artial insight on techni=ues of credit ris/ 2anage2ent 13 the @FIs in .en3a. 8here is no /nown stud3 to the
researchers) which has 1een done on the sur6e3 of techni=ues of credit ris/ 2anage2ent in @icro-Finance
Institutions in .en3a. 8herefore) this stud3 answered the following =uestion; Ehat credit ris/ 2anage2ent
techni=ues are used 13 2icrofinance institutions in .en3aK

#" 'iterature Review
In order to assess the credit ris/) it is necessar3 to ta/e a close loo/ at the 1orrowers? econo2ic and legal
situation as well as the rele6ant en6iron2ent e.g. industr3) econo2ic growth rate and e2"lo32ent rate Se3fried)
2++1#. 8he =ualit3 of credit a""raisal "rocesses de"ends on two factors. 8he first is a trans"arent and
co2"rehensi6e "resentation of the ris/s when granting a loan. 8he second is an ade=uate assess2ent of these
ris/s Raai, et al) 2++(#. Further2ore) the le6el of efficienc3 of the credit a""raisal "rocesses is an i2"ortant
rating ele2ent. :ue to the considera1le differences in the nature of 6arious 1orrowers e.g. "ri6ate "ersons) listed
co2"anies) so6ereigns# and the assets to 1e financed e.g. residential real estate) "roduction "lants) 2achiner3#
as well the large nu21er of "roducts and their co2"le7it3) there cannot 1e a unifor2 "rocess to assess credit
ris/s Raai, et al) 2++(#.
#" ! (verview of the Credit A))raisa& %rocess
8he credit a""raisal "rocess consists of se6en ste"s; Ac=uisition of credit s"ecific custo2er ser6ice) collection
and re6iew of data) credit re6iew) collateral and ris/ assess2ent) docu2entation) a""ro6al and i2"le2entation of
the credit decision. 8he 6ast 2a,orit3 of credit institutions ser6e a nu21er of different custo2er seg2ents. 8his
seg2entation is 2ostl3 used to differentiate the ser6ices offered and to indi6iduali>e the res"ecti6e 2ar/eting
efforts Se3fried) 2++1#. As a result) this seg2entation is 1ased on custo2er de2ands in 2ost cases. 4ased on its
"olic3) a financial institution tries to 2eet the de2ands of its custo2ers in ter2s of accessi1ilit3 and a6aila1ilit3)
"roduct range and e7"ertise) as well as "ersonal custo2er ser6ice Raai, et al) 2++(#.
In "ractice) lin/ing sales with the ris/ anal3sis units is not an issue in 2an3 cases at first. 8he sales organi>ation
often deter2ines the "rocess design in the ris/ anal3sis units. 8hus) the e7isting 6ariet3 of seg2ents on the sales
side is often reflected in the structure and "rocess design of the credit anal3sis units 4essis 2++2#. Ehile
classifications in ter2s of custo2er seg2ents are) for e7a2"le) co2"le2ented 13 "roduct-s"ecific seg2ents)
there a""ears to 1e no unifor2 2odel. Ii6en the different si>es of the financial institutions) the lac/ of 6olu2e of
co2"ara1le clai2s in s2all financial institutions renders such a 2odel inade=uate also for reasons of co2"le7it3)
'ol.() No.1*) 2+1%

(
efficienc3) and custo2er orientation 4ol) 2++*#. Irres"ecti6e of a financial institution?s si>e) howe6er) it is
essential to ensure a trans"arent and co2"rehensi6e "resentation as well as an o1,ecti6e and su1,ecti6e
assess2ent of the ris/s in6ol6ed in lending in all cases Raai, et al) 2++(#. 8herefore) the criteria that has to 1e
ta/en into account in "resenting and assessing credit ris/s deter2ine the design of the credit a""raisal "rocesses.
Johnson and Johnson 19$(#) De2"el and Si2onson 1999# and .och and @acdonald 2+++# all "ointed out that
the acti6ities in the "rocess of co22ercial and industrial 9LI# loans follow eight ste"s. 8hese ste"s are
a""lication) credit anal3sis) decision) docu2ent "re"aration) closing) recording) ser6icing and ad2inistration) and
collection. 8hese acti6ities and the "ri2ar3 tas/s for those res"onsi1le for these acti6ities 2ust 1e well
docu2ented. 8he first ste" of the 9LI loan "rocess is the a""lication) which is conducted 13 a loan officer. 8his
ste" according to the 9onsultati6e Irou" to Assist the !oorest 9IA!) 2+++#) co6ers the initial inter6iew and
screening of a loan re=uest. Secondl3) the credit anal3sis fro2 the infor2ation gathered fro2 the 1orrower is
conducted 13 the credit de"art2ent. 8he anal3st then "re"ares a reco22endation re"ort for the loan officer
a1out whether the loan should 1e granted) re,ected) or =ualified. In the third ste") the loan officer o1tains the
credit anal3sis re"ort and deter2ines whether the re"ort accuratel3 descri1es the 1orrowing ca"acit3 and
characteristics of the 1orrower. If collateral is re=uired) the a2ount of collateral and additional collateral
docu2entation are indicated 9o"esta/e) 2++1#.
In the fifth ste") the loan officer o1tains the 1orrower?s signatures and recei6es collateral. 8hen the loan
o"eration is closed and the loan "roceeds. 8he si7th ste" is the recording of the loan conducted 13 the loan
o"eration and credit de"art2ent staff. A loan o"eration cler/ classifies and codes the loan for entr3 into the
co22ercial loan s3ste2) and he or she re6iews the loan for co2"liance with the 1an/?s loan "olicies. Finall3)
the loan o"eration cler/ and credit de"art2ent staff 2e21er file the loan notes) authori>ation) and recei"ts in
designated files. 8he se6enth ste" is loan ser6icing and ad2inistration conducted 13 a loan o"eration o"erator) a
loan officer) a credit de"art2ent staff 2e21er) and a financial anal3st. 8he loan o"eration staff "erson "re"ares
the loan "a32ent notices to notif3 the 1orrower and is res"onsi1le for recei6ing "eriodic "a32ents. 8he loan
officer 2a/es "eriodic 6isits and custo2er calls to o1tain new financial state2ents fro2 the 1orrower and
"ro6ides that infor2ation to credit de"art2ent and re6iews the loan for co2"liance with the loan agree2ent. A
credit de"art2ent financial anal3st also recei6es and re6iews the 1orrower?s "eriodic financial state2ents
:e2irag) 2++%#.
In the eighth stage) the loan officer 2a3 recei6e "eriodic delin=uenc3 infor2ation and need to follow u" on this
with 1orrowers. 8he loan officer also needs to ad,ust loan ter2s and conditions as dee2ed necessar3) and to ta/e
legal action if non-collecti1le "rocedures and foreclosure on the loan are re=uired. After anal3>ing these lending
acti6ities) a 6alue chain of lending acti6ities can 1e identified) and the rationale for deter2ining how 6alues are
created can 1e deter2ined :e2irag) 2++%#.
#"# Ste)s 'eading u) to the Credit Review
8he e7ecution of the credit re6iew is 1ased on e7ternal and internal data on the credit a""licant Raai, et al)
2++(#. -s"eciall3 for e7tensi6e e7"osures) considera1le resources 2a3 1e tied u" in the "rocess of collecting the
data) chec/ing the data for co2"leteness and "lausi1ilit3) and "assing on the data to "eo"le in charge of handling)
anal3>ing) and "rocessing the e7"osure within the 1an/. 8hese ste"s can also lead to a large nu21er of
"rocedural errors. Since the data included for2 the 1asis for the credit re6iew) errors in collecting) aggregating)
and "assing the2 on are es"eciall3 rele6ant also fro2 a ris/ "ers"ecti6e 4essis 2++2#.
#"#"! *ata Co&&ection
8he assess2ent of a credit a""licant?s credit standing is 1ased on different data sources and data t3"es in
accordance with the t3"e of 1orrower Raai, et al) 2++(#. In an3 case) a 1an/ 2ust alwa3s 1e interested in ha6ing
co2"rehensi6e and current data on the econo2ic and "ersonal situation of the 1orrower. In order to ensure
consistent custo2er ser6ice) the res"ecti6e account 2anager will t3"icall3 coordinate the gathering of
infor2ation. 8he credit re6iew incor"orates not onl3 econo2ic data 1ut also =ualitati6e infor2ation concerning
the 1orrower. 8he account 2anager should thus include a co2"lete and critical "icture of the 1orrower 4essis
2++2#. In order to ensure that all the infor2ation gathered 13 the account 2anager is "assed on to the "erson in
charge of the credit re6iew) it would 1e ad6isa1le to "re"are standardi>ed and structured re"orts on custo2er
6isits. In "ractice) this has "ro6en effecti6e in directing con6ersations with custo2ers as desired. 8his "rocedure
ensures that infor2ation is gathered in its entiret3 and in an efficient 2anner. 8he la3out of the 6isit re"orts
should 1e s"ecified for each seg2ent and should 1e included in the internal guidelines Raai, et al) 2++(#.
8o 2a/e sure that the data collected is co2"lete) 2andator3 lists showing what data are re=uired should 1e used.
8hese lists then ha6e to 1e ada"ted to the re=uire2ents of the credit re6iew "rocess confor2ing to the t3"e of
1orrower in each case Sto2"er 2++%#. In addition to indi6idual 1orrower data) 2an3 cases will re=uire general
infor2ation on the econo2ic situation of a region or an industr3 to allow a co2"rehensi6e assess2ent of credit
a""licationC here) the 1an/ can 2a/e use of e7ternal sources. If a 1an/?s credit "ortfolio shows a focus on certain
industries or regions) 1an/s are ad6ised to conduct their own anal3ses of the econo2ic situation in these fields M
this is "articularl3 true if the a6aila1le e7ternal infor2ation lac/s the necessar3 detail andBor currenc3 Raai, et al)
'ol.() No.1*) 2+1%

6
2++(#.
Eith regard to the credit re6iew) it is "articularl3 i2"ortant to constantl3 u"date custo2er data) and the 1an/
should include "rocedures and ti2efra2es in its internal guidelines. In ter2s of indi6idual "rocesses) it should 1e
ensured that "eriods should 1e co2"ared at regular inter6als in assessing the e7"osure. 8herefore) the rele6ant
data should 1e a6aila1le at least the "re6ious two) 1ut "refera1l3 the last three 3ears Raai, et al) 2++(#.
#"#"# %&ausibi&ity Check and %re&iminary Review
4efore a credit e7"osure is su1,ected to a co2"rehensi6e credit re6iew) the e2"lo3ee initiall3 charge should
conduct a "lausi1ilit3 chec/ and "reli2inar3 re6iew 4ol) 2++*#. 8his chec/ should loo/ at the co2"leteness and
consistenc3 of the docu2ents filed 13 the 1orrower to 2ini2i>e an3 "rocess loo"s and the need for further
in=uiries with the custo2er. In addition) the sales de"art2ent should carr3 out an initial su1stanti6e chec/ 1ased
on a select few rele6ant criteria. 8he o1,ecti6es include the creation of awareness and acti6e assu2"tion of
res"onsi1ilit3 for credit ris/ on the "art of the sales de"art2ent Raai, et al) 2++(#. 8he "reli2inar3 chec/ is
es"eciall3 significant in seg2ents with high re,ection rates) as a co2"rehensi6e credit re6iew ties u"
considera1le resources in these seg2ents. 8he "reli2inar3 chec/ should "re6ent e7"osures which will 2ost
li/el3 1e re,ected fro2 t3ing u" ca"acities in ris/ anal3sis. 8he resulting reduction in nu21er of cases dealt with
13 ris/ anal3sis allows a 2ore detailed scrutin3 of "ro2ising e7"osures and is thus desira1le it ter2s of ris/ as
well as efficienc3 Raai, et al) 2++(#.
In "ractice) the distinction 1etween two t3"es of chec/ criteria has "ro6en successful; red criteria) which) if
fulfilled) lead to an outright re,ection of the e7"osure also referred to as /noc/-out criteria# and 3ellow criteria)
which) if fulfilled) re=uire the sales staff to "resent a "lausi1le and well docu2ented ,ustification of the
res"ecti6e situation Raai, et al) 2++(#. If this ,ustification cannot 1e 2ade) the e7"osure also has to 1e re,ected.
In ter2s of efficienc3) it 2a3 1e necessar3 in certain custo2er seg2ents not to consider an e7"osure an3 further
if two or 2ore 3ellow criteria are fulfilled at the sa2e ti2e Raai, et al) 2++(#.
#"#"$ %assing on *ata
@a/ing sure that infor2ation is "assed on in its entiret3 is rele6ant fro2 a ris/ "ers"ecti6e Raai, et al) 2++(#.
8his concerns those "rocesses in which the credit a""ro6al "rocess is not concluded 13 the account 2anager
hi2self. If the internal guidelines "ro6ide for a transfer of res"onsi1ilit3) or if the re6iew is conducted 13 two or
2ore "eo"le) it is necessar3 to ensure that the set of rele6ant docu2ents is handed o6er. It would 1e ad6isa1le to
"re"are hando6er re"orts for this "ur"ose Raai, et al) 2++(#.
Dando6er re"orts should full3 reflect changes in res"onsi1ilit3 in the course of the credit a""ro6al "rocess as
well as an3 interface occurring in the "rocess Raai, et al) 2++(#. In "ractice) a 2odular cure has "ro6en
"articularl3 effecti6e for such for2s. If "ossi1le) the3 should 1e /e"t electronicall3 or) alternati6el3) as the first
"age of the res"ecti6e credit folder Raai, et al) 2++(#.
Raai, et al 2++(# further "oints out that sales e2"lo3ee has to use the 2odule ta1le or te7t 2odule# "ro6ided for
handing o6er the e7"osure to the res"ecti6e "rocess. 8his contains) a2ong other things) an enu2eration of the
docu2ents re=uired for the res"ecti6e ris/ anal3sis seg2ent co2"leteness chec/list#. &n the one hand) this
ensures a s2ooth transfer of the docu2ents) rid on the otherC it "re6ents inco2"lete files fro2 1eing handed o6er
to ris/ anal3sis. In addition) further 2odules) e.g. notes ta/en during custo2er a""oint2ents) should 1e included
in the hando6er re"orts. Further2ore) a""ro"riate 2odules should 1e included for all other interfaces 1etween
sales and ris/ anal3sis) or 1etween different "ersons in "rocessing Raai, et al) 2++(#.
#"#"+ Accounting for Risk As)ects
8he =ualit3 of the credit a""raisal "rocess fro2 a ris/ "ers"ecti6e is deter2ined 13 the 1est "ossi1le
identification and e6aluation of the credit ris/ resulting fro2 a "ossi1le e7"osure Raai, et al) 2++(#. 8he loans
officer uses 6isiting re"ort is to hel" hi2 understand the 1orrower?s associated "ro1le2s. 8he factors for
e6aluation generall3 used in this situation are in line with the 69 "rinci"les of 1asic lending. 8hese 69s) are
character) ca"acit3) ca"ital) collateral) conditions and control Rose) 1991#) which are also i2"ortant reference
inde7es or 1an/s when 2a/ing a credit anal3sis to decide whether or not a 1orrower is worth3 of a loan.
8he credit ris/ can 1e distri1uted a2ong four ris/ co2"onents which ha6e found their wa3 into the new 4asel
9a"ital Accord in the following referred to as 4asel II# 4essis 2++2#; !ro1a1ilit3 of default !:#) loss gi6en
default AI:#) e7"osure at default -A:# and 2aturit3 @#. 8he 2ost i2"ortant co2"onents in credit a""raisal
"rocesses are !:) AI:) and -A:. Ehile 2aturit3 @# is re=uired to calculate the re=uired ca"ital) it "la3s a
2inor role in e7"osure re6iew Raai, et al) 2++(#.
Re6iewing a 1orrower?s "ro1a1ilit3 of default is 1asicall3 done 13 e6aluating the 1orrower?s current and future
a1ilit3 to fulfill its interest and "rinci"al re"a32ent o1ligations. 8his e6aluation has to ta/e into account 6arious
characteristics of the 1orrower natural or legal "erson#) which should lead to a differentiation of the credit
a""raisal "rocesses in accordance with the 1orrowers ser6ed 13 the financial institution Raai, et al) 2++(#.
Further2ore) it has 1e ta/en into account that for certain finance transactions interest and "rinci"al re"a32ents
should 1e financed e7clusi6el3 fro2 the cash flow of the o1,ect to 1e financed without the "ossi1ilit3 for
recourse to further assets of the 1orrower Se3fried) 2++1#.
'ol.() No.1*) 2+1%

7
In this case) the credit re6iew 2ust address the 6ia1ilit3 of the underl3ing 1usiness 2odel. 8his 2eans that the
source of the cash flows re=uired to 2eet interest and "rinci"al re"a32ent o1ligations has to 1e included in the
re6iew. 43 anal3>ing a 1orrower?s situation using the 69 "rinci"les) the co2"arati6el3 2ore difficult situations
encountered 13 a loan officer 1eco2e ca"acit3 and condition 1ecause in addition to the understanding and
anal3sis of the infor2ation a1out ca"acit3 and condition) it is also necessar3 to deter2ine whether an3 future
changes will affect the financial situation and the loan re"a3ing a1ilit3 of an enter"rise. 8herefore) if an e7cellent
"rofessional loan officer can accuratel3 and co2"letel3 collect infor2ation in these ca"acit3 and condition) then
the 6alue of the 6aluation re"ort will 1e high :onaghue) 2++%C -1rahi2) 2++*C 2++(C Ioddard) 2++%#.
8he loss gi6en default is affected 13 the collaterali>ed "ortion as well as the cost of selling the collateral. 8his is
where the collateral fetches a lower 6alue on sale and the cost of selling e.g. ad6ertising is high. 8herefore) the
calculated 6alue and t3"e of collateral ha6e to 1e ta/en into account in designing the credit a""raisal "rocesses
Ioddard) 2++%#.
In the 6ast 2a,orit3 of the cases descri1ed here) the e7"osure at default corres"onds to the a2ount owed to the
financial institution 4essis 2++2#. 8hus) 1esides the t3"e of clai2) the a2ount of the clai2 is another i2"ortant
ele2ent in the credit a""raisal "rocess. 8hus) four factors should 1e ta/en into account in the seg2entation of
credit a""raisal "rocesses; t3"e of 1orrowerC source of cash flowsC 6alue and t3"e of collateralC a2ount and t3"e
of clai2.
In general) t3"e of 1orrower is used as the highest la3er in credit a""raisal "rocesses. 8his is due to the higher
"riorit3 of re6iewing legal and econo2ic conditions within the su1stanti6e credit re6iew "rocess 4essis 2++2#.
8he wa3 in which the econo2ic situation is assessed greatl3 de"ends on the a6aila1le data. 8he following
seg2ents can 1e distinguished; so6ereigns) other "u1lic authorities e.g. regional go6ern2ents) local authorities#)
financial ser6ices "ro6iders including credit institutions such as 4an/s) 4uilding societies) @utual funds and
Insurance co2"anies# and cor"orate and retail entities. 5suall3) at least the seg2ents of cor"orate and retail
custo2ers are differentiated further e.g. 13 "roduct categor3# 4essis 2++2#.
8he distinction of so-called s"eciali>ed lending fro2 other for2s of cor"orate finance is 1ased on the fact that
the "ri2ar3) if not the onl3 source of reducing the e7"osure is the inco2e fro2 the asset 1eing financed) and not
so 2uch the unrelated sol6enc3 of the co2"an3 1ehind it) which o"erates on a 1roader 1asis Se3fried) 2++1#.
8herefore) the credit re6iew has to focus on the asset to 1e financed and the e7"ected cash flow Raai, et al)
2++(#. In order to account for this situation) the seg2entation of the credit a""raisal "rocesses should distinguish
1etween credits to cor"orations) "artnershi"s) or sole "ro"rietors and s"eciali>ed lending.
9redit institutions ha6e to distinguish 1etween the following for2s of s"eciali>ed lending in the calculation of
regulator3 ca"ital; "ro,ect finance) o1,ect finance) co22odities finance and finance of inco2e-"roducing
co22ercial real estate. 8his is 1ecause each of the a1o6e re=uires different ca"ital outla3s and also the3 ha6e
different ris/s.
'alue and t3"e of collateral ha6e a significant i2"act on the ris/ in6ol6ed in lending. &f "articular rele6ance in
this conte7t are those t3"es of collateral which afford the lender a clai2 on the collateral) and those "roduct
constructions under which the lender has legal and econo2ic ownershi" of the asset to 1e financed Raai, et al)
2++(#. 8wo for2s of finance are "articularl3 rele6ant in "ractice; 2ortgage finance and leasing finance.
@ortgage finance and easing are those for2s of finance which often gi6e the lender a su1stantial degree of
control o6er the asset 1eing financed 4ol) 2++*#. 8he strong legal "osition resulting fro2 such collateral 2a3
warrant s"ecial treat2ent of the rele6ant for2s of finance.
#"#", -a&uation of Co&&atera&
8he 6aluation of the collateral "ro6ided 13 the credit a""licant is an essential ele2ent in the credit a""ro6al
"rocess and thus has an i2"act on the o6erall assess2ent of the credit ris/ in6ol6ed in a "ossi1le e7"osure Raai,
et al) 2++(#. 8he 2ain feature of a collaterali>ed credit is not onl3 the 1orrower?s "ersonal credit standing) which
1asicall3 deter2ines the "ro1a1ilit3 of default !:#) 1ut the collateral which the lender can reali>e in case the
custo2er defaults and which thus deter2ines the 1an/?s loss. 'ia the ris/ co2"onent of loss gi6en default AI:#
and other re=uire2ents concerning credit ris/ 2itigation techni=ues) the 6alue of the collateral is included in
calculating the ca"ital re=uire2ent under 4asel II .a2") !fingsten and !orath) 2++(#.
In order to calculate the ris/ "ara2eters under 4asel II correctl3) it is i2"ortant for the 6aluation of the collateral
to 1e effected co2"letel3 inde"endentl3 of the calculation of the 1orrower?s !: in the credit rating "rocess. 8his
should ensure that the "ro1a1ilit3 of default and the loss gi6en default are shown se"aratel3 order to 2eet the
4asel re=uire2ents of s"litting u" the re6iew into a custo2er rating which reflects onl3 the !: on the one hand)
and a transaction 6aluation which also contains a 6aluation of the collateral to su""ort the credit decision on the
other Raai, et al) 2++(#.
9ollateral is generall3 di6ided into "ersonal and "h3sical collateral) In the case of "ersonal collateralC the
"ro6ider is 1asicall3 lia1le with his entire fortune. -7a2"les of "ersonal collateral are the following; suret3 shi"C
guarantee and letter of su""ort and collateral "ro2ise Raai, et al) 2++(#. In the case of "h3sical collateral) the
1an/ recei6es a s"ecific securit3 interest in certain assets of the 1orrower or the collateral "ro6ider. -7a2"les of
'ol.() No.1*) 2+1%

$
"h3sical collateral are the following; 2ortgage) "ledge of 2o6a1le assets on securities) goods) 1ills of
e7change#) securit3 assign2ent and retention of title of an asset e.g. land Raai, et al) 2++(#.
8he internal guidelines collateral catalog# should la3 down the t3"e of collateral which each 1an/ generall3
acce"ts Raai, et al) 2++(#. 4an/s should ta/e a close loo/ at that collateral whose 6alue is su1,ect to "articularl3
strong fluctuations andBor whose reali>ation is longwinded or often cu21erso2e. Aiens) for e7a2"le) usuall3
"ose relati6el3 few "ro1le2s for their holders and "ro6ide the2 with a rather strong creditor "osition) as the
related 6alue of the collateral gi6en is generall3 easier to assessB6alue than the "ersonal lia1ilit3 fund of a
guarantor Raai, et al) 2++(#.
8he collateral catalog has to include a""ro"riate instructions on assessing the collateral "otentiall3 acce"ted 13
the 1an/ as well as deter2ining its collateral 6alue Raai, et al) 2++(#. A descri"tion of the "rocesses and
"rinci"les in deter2ining the collateral 6alue for each t3"e of collateral will "ri2aril3 ha6e to 1e drawn u" in
accordance with the 1usiness orientation of each 1an/ and the co2"le7it3 of the a""ro6ed collateral Dellwig)
199$#. Ieneral "rinci"les go6erning the 6aluation of collateral such as accounting for sustaina1le 6alue or
6aluing the collateral 1ased on the li=uidation "rinci"le should 1e included in the deter2ination of collateral
6alue. Si2ilarl3) it should also include general ris/ deductions haircuts as well as deductions for "rocedural cost
e.g. long ti2e re=uired to sell the collateral#. 8his allows a 2ore accurate esti2ate of the "otential reali>ation
"roceeds.
Ehat all for2s of collateral ha6e in co22on) though) is that while the a""lication of credit ris/ 2itigation
techni=ues reduces credit ris/s) it also creates new ris/s for the 1an/ 4essis) 2++2#. In "articular) it will 1e u" to
each 1an/?s ca"a1ilities to identif3 and 2easure the ris/ in6ol6ed with collateral in order to deri6e an o1,ecti6e
assess2ent of the total ris/ inherent to a secured e7"osure 4essis) 2++2#. A2ong other 2easures) 4asel II ta/es
this into account 13 sti"ulating s"ecial re=uire2ents concerning the wa3 in which collateral arrange2ents can 1e
enforced and reali>ed Raai, et al) 2++(#. Further2ore) the new 9a"ital Accord re=uires the use of sounds
"rocedures and "rocesses to control and 2onitor these ris/s. 8his should 1e achie6ed 13 esta1lishing collateral
2anage2ent in line with 1usiness 6olu2e which uses co2"uter-aided "rocesses collateral data1ase) 6aluation#.
Ehat still has to 1e noted is that) as a rule) the 6aluation of collateral should 1e carried out 13 s"eciali>ed
e2"lo3ees and "ossi1l3 in se"arate organi>ational units which do not 1elong to the front office) or 13 e7ternal
"ro6iders e.g. real estate a""raisers# 4essis 2++2#.
#"#". Credit *isbursement Check
!rior to dis1ursing the credit) the indi6idual credit e7"osure should 1e su1,ected to a final chec/. 8his chec/
should co6er at least the following "oints; co2"liance with internal guidelinesC co2"leteness of the credit
a""licationC recei"t of confir2ation that the credit a""licant has co2"lied with the conditions i2"osedC and
signing of the credit and collateral agree2ents in accordance with the decision-2a/ing structure Raai, et al)
2++(#.
9hec/lists should 1e used to achie6e a ris/-2itigating standardi>ation of the "rocess Raai, et al) 2++(#. Suita1le
sa2"les seg2ent-s"ecific) if necessar3# should 1e included in the internal guidelines. 'arious 2odels 2a3 1e
"ro6ided to carr3 out the credit dis1urse2ent chec/. In ter2s of efficienc3) it 2a3 1e useful to centrali>e the
credit dis1urse2ent chec/ for seg2ents with a large nu21er of co2"ara1le credit a""lications. In 2an3 cases)
howe6er) the credit dis1urse2ent chec/ is carried out 13 the i22ediate su"eriors of the e2"lo3ees res"onsi1le
for the e7"osure. Ris/ as"ects re=uire the s"ecific design of the "rocess to 2a/e sure that the e2"lo3ee
"erfor2ing the chec/ arri6es at a decision inde"endentl3 of the e2"lo3ees res"onsi1le for the e7"osure wor/ing
in sales) ris/ anal3sis) or credit a""ro6al "rocessing Raai, et al) 2++(#.
#"$ Monitoring of 'oan %erformance
8he lending function is considered 13 the 1an/ing industr3 as the 2ost i2"ortant function for the utili>ation of
funds Sto2"er) 2++%#. Since) 1an/s earn their highest gross "rofits fro2 loansC the ad2inistration of loan
"ortfolios seriousl3 affects the "rofita1ilit3 of 1an/s. Indeed) the large nu21er of non-"erfor2ing loans is the
2ain cause of 1an/ failure. 4an/s are learning to re6iew their ris/ "ortfolios using the criteria laid down 13
4asel II Sto2"er) 2++%#. Ireens"an 2++1 indicated that 4asel?s goal is to induce 1an/ers to i2"ro6e their ris/
2anage2ent ca"a1ilit3) including how the institutions "rice "roducts) reser6e for loss) and control their
o"erations Reh2) 2++2#. 8he "ur"ose of 4asel II is to reduce a 1an/?s o"erational ris/ during the lending
"rocess through a 1etter 2onitoring of the e2"lo3ees in the lending de"art2ent.
8hroughout the contractual relationshi" 1etween the credit institution and its 1orrowers) econo2ic de6elo"2ents
2a3 1ring a1out changes that ha6e an i2"act on ris/ Sto2"er) 2++%#. 4an/s should 2onitor their credit
e7"osures continuousl3 to detect such changes in ti2e. In general) this is done 13 2eans of so-called "eriodic
and regular chec/s. Indi6idual e7"osures are chec/ed at fi7ed "eriodic inter6als. @an3 1an/s integrate these
chec/s in the roll-o6er of credit e7"osures which 1eco2es due as "eriods e7"ire Sto2"er) 2++%#.
In order to detect ris/s alread3 "rior to the "eriodic chec/ to 1e carried out due to the e7"ir3 of a s"ecified ter2)
2an3 1an/s use earl3 warning s3ste2s Raai, et al) 2++(#. 4ased on earl3 warning indicators which ha6e to 1e
defined for each seg2ent) a differentiated re6iew "rocess is triggered. A2ong other things) these earl3 warning
'ol.() No.1*) 2+1%

9
s3ste2s ta/e into account defaults with regard to the contractual relationshi" 1etween 1an/ and 1orrower. &f
great i2"ortance here is the insufficient "erfor2ance of interest and "rinci"al re"a32ent o1ligations 4essis)
2++2#. In order to react to these situations) 1an/s ha6e set u" re2inder "rocedures to infor2 the de1tor of the
default. 8herefore) this section loo/s at the structure of re2inder "rocedures.
#"$"! %eriodic Reviews and Ro&&/over
8he "rocesses go6erning the design of "eriodic re6iews and roll-o6er differ onl3 in a few as"ects. 8he
ter2inological distinction is 1ased on different "rocess triggers Raai, et al) 2++(#. Ehile "eriodic re6iews are
carried out at inter6als to 1e deter2ined in the internal guidelines) the roll-o6er is triggered 13 the e7"ir3 of a
contractuall3 agreed "eriod Raai, et al) 2++(#. In "ractice) 1an/s tr3 to carr3 out u"co2ing roll-o6er in the
course of the "eriodic re6iew. If it is not "ossi1le to do 1oth at the sa2e ti2e) the internal guidelines 2a3
sti"ulate a "eriod after the 2ost recent re6iew during which a roll-o6er can 1e carried out without the need for a
new credit re6iew Raai, et al) 2++(#. If this "eriod has e7"ired) the "rocess of "eriodic re6iew also has to 1e
conducted in case of a roll-o6er. 4elow) we "resent the "rocess of "eriodic re6iew as the 1asic "rocess. 8he onl3
difference 1etween a "eriodic re6iew and a roll-o6er is that the latter offers the "ossi1ilit3 to agree changes in the
contractual sti"ulations of the credit e7"osure with the custo2er e.g. new conditions# or to ter2inate the
e7"osure "ro"erl3 Sto2"er) 2++%#.
83"icall3) a "eriodic re6iewed is carried out at one-3ear inter6als starting fro2 the date of credit a""ro6al. For
co2"anies "re"aring financial state2ents) the "eriodic re6iew should 1e carried out as shortl3 after the 1alance
sheet date or the date of su12itting the 1alance sheet as "ossi1le. 8he re6iew of credit e7"osures should
co2"rise four 2a,or acti6ities; assessing the "ersonal and econo2ic situation of 1orrowers 1ased on current dataC
ada"ting the rating) if a""lica1leC chec/ing and e6aluating the a6aila1le collateralC and chec/ing and 2odif3ing
the conditions Raai, et al) 2++(#.
8he re6iew should focus on the de6elo"2ent since the 2ost recent a""ro6al or re6iew Raai, et al) 2++(#. 8he
decision-2a/ing structure should sti"ulate who is res"onsi1le for "eriodic re6iews Raai, et al) 2++(#. In 2ost
case) it will 1e that le6el of authorit3 which would also 1e in charge of a""ro6ing new credit a""lications. In
order to 2a/e the re6iew as efficient as "ossi1le) 1an/s t3"icall3 distinguish 1etween three t3"es of re6iew. 8he
re6iew of standardi>ed credits usuall3 co2"rises s2all-6olu2e credit e7"osures for which the rating "rocess has
deter2ined a low "ro1a1ilit3 of default :ia2ond) 19$%#. 8he internal guidelines ha6e to define the li2its of
auto2ated re6iew 1ased on e7"osure 6olu2e) credit standing) and t3"e of credit 4ol) 2++*#. 8he additional
re6iew triggered 13 ris/ signals fro2 the earl3 warning s3ste2 2a/es u" for the 2anual chec/. Just li/e the
re6iew of standardi>ed credits) the a11re6iated re6iew is a tool used for reasons of efficienc3 Raai, et al) 2++(#.
Dere) too) a full and co2"rehensi6e re6iew of the credit e7"osure is not carried out. In general) the 1an/s ,ust
u"date the re6iew-related docu2ents and use a short) standardi>ed =uestionnaire which has to 1e co2"leted 13
the e2"lo3ee fro2 the credit anal3sis de"art2ent res"onsi1le for the e7"osure Raai, et al.) 2++(#. 8his
=uestionnaire confir2s the recei"t of the re6iew-related docu2ents and the "lausi1ilit3 chec/ of these docu2ents.
83"icall3) the =uestionnaires relating to the a11re6iated re6iew "rocess contain chec/lists to chec/ the data
recei6ed for 6alidit3 and "lausi1ilit3. 8he following list is an e7a2"le of the content of a =uestionnaire relating
to the a11re6iated re6iew "rocess; recei6ed 1alance sheetBstate2ent of recei"ts L dis1urse2ents) and "lausi1ilit3
chec/C chec/ing de1t ser6ice ca"acit3C re6iewing account 2o6e2entsC chec/ing and assessing significant
de6iations of financial figures or "ersonal data co2"ared to the "re6ious re6iew of the e7"osure Raai, et al)
2++(#.
A detailed la3out of the =uestionnaires has to 1e found in the internal guidelines 4ol) 2++*#. In an3 case) there
should also 1e guidelines sti"ulating a full re6iew in case certain credit assess2ent changes occur. 8he decisi6e
factor for the range of a""lication of the a11re6iated re6iew "rocess is M as was alread3 the case for the re6iew
of standardi>ed credits M the e7istence of an earl3 warning s3ste2 Raai, et al) 2++(#.
8he earl3 warning s3ste2 2a/es u" for the co2"rehensi6e re6iew which is not? triggered 13 ris/ signals and is
not carried out here Raai, et al) 2++(#. A full re6iew co2"rises a co2"rehensi6e re6iew of the 1orrower?s
econo2ic and "ersonal situation in analog3 to a new credit a""lication Raai, et al) 2++(#. 8he di6ision of tas/s
1etween sales and credit anal3sisB"rocessing is t3"icall3 the sa2e as that for the "re"aration of the credit
"ro"osal for new transactions.
8he e6ents triggering a re6iew of credit e7"osures descri1ed in section a1o6e are inde"endent of the occurrence
of ris/ signals arising fro2 the 1usiness relationshi" with the 1orrower Raai,) 2++(#. Ris/-triggered re6iews) 13
contrast) are contingent on the actual occurrence or the assu2"tion of negati6e criteria with regard to the
1orrower?s credit standing 1etween re6iew dates.
#"$"# Reminder %rocedures
In case of default on interest or "rinci"al re"a32ent on the "art of a 1orrower) a for2al re2inder "rocedure has
to 1e initiated. Re2inder "rocedures are "art of the credit 2onitoring of indi6idual credit e7"osures 4ol 2++*#.
In order to a6oid forgetting to send out re2inders) credit institutions should a""l3 standardi>ed and auto2ated
re2inder "rocedures Raai, et al) 2++(#. If the I8 s3ste2 registers the occurrence of a default on interest or
'ol.() No.1*) 2+1%

1+
"rinci"al re"a32ent) a collection letter should auto2aticall3 1e sent to the 1orrower. 8he length of the waiting
"eriod has to 1e sti"ulated in the internal guidelines and i2"le2ented in the s3ste2s. 8his ensures that collection
letters are sent out in ti2e in e6er3 case Raai, et al) 2++(#.
Further2ore) tight re2inder deadlines are useful for ris/ considerations Raai, et al) 2++(#. 8his is true in
"articular as the lender?s "osition 2a3 deteriorate co2"ared to other creditors of the 1orrower during this "eriod.
In order to 2a/e collection letters as effecti6e as "ossi1le) so2e 1an/s use a discri2inating a""roach which is
1ased on the classification of the 1orrower identified 13 an earl3 warning s3ste2 Raai, et al) 2++(#. 83"icall3)
1oth the wording of the te7t and the "a32ent deadline are 2odified accordingl3 Raai, et al) 2++(#.
For 1usiness reasons) it is "ossi1le to e7clude certain custo2ers fro2 the standardi>ed re2inder "rocedures
indi6iduali>ed re2inder "rocedures#. 8he "rere=uisites for an indi6iduali>ed re2inder "rocedure ha6e to 1e
sti"ulated in detail in the internal guidelines 4ol) 2++*#. It is i2"ortant that no general e7ce"tion is 2ade for
entire grou"s of custo2ers. Nuite on the contrar3) the e7ce"tion should a""l3 onl3 to those custo2ers whose
contri1utions to earnings ,ustif3 the resulting ris/ and the associated "rocess cost Raai, et al) 2++(#. 8herefore
the rules should define 2ini2u2 contri1ution 2argins. If the indi6iduali>ed "rocess usuall3 in for2 of a
"ersonal con6ersation with the 1orrower does not 3ield an3 results) the standardi>ed re2inder "rocedure should
1e initiated Raai, et al) 2++(#.
#"+ Management of 0ad 'oans
If a 1orrower?s credit standing deteriorates) the 1an/ should interfere in the standardi>ed ser6icing "rocess and
tr3 to control credit ris/s that are i22inent or ha6e alread3 ta/en effect Raai, et al) 2++(#. 8his should ensure
that ade=uate 2easures to secure clai2s can 1e ta/en in ti2e. 8he o1,ecti6e is not onl3 an i2"ro6ed collateral
"osition of the lender co2"ared to other creditors caused 13 the ti2e gained 13 ta/ing earl3 "recautionar3
2easures#) 1ut also an effecti6e restructuring of the 1orrower?s de1t) thus "re6enting the total loss of the credit
e7"osure Raai, et al) 2++(#. It does not 2a/e econo2ic sense to continue the credit e7"osure) the wor/out of the
e7"osure and the resulting sale of the collateral should 1e initiated Raai, et al) 2++(#.
8he dri6ers of lending re6enue are o"erating fees and interest inco2e that are dri6en 13 new loans and e7isting
loan 6olu2es. 8he dri6ers of lending e7"enses consist of interest e7"ense) o"erating e7"ense) loss re6enues and
une7"ected losses in co22ercial loans. &thers =uestion such to"-down a""roaches in 1oth "rinci"le and "ractice
-1rahi2) 2++*) 2++(C Dill horst) 2++*C Naidoo) 2++*#. 8he3 contend that such a""roaches fail to co2"rehend)
are too distant fro2) and 2a3 not e6en reach into the grassroots where aid and de6elo"2ent are needed 2ost.
Instead the3 call for other for2s of inter2ediation with those at the "eri"her3 of aid and de6elo"2ent
organi>ations and) in contrast to what is officiall3 called for) see/ less to"-down and 2ore 1otto2-u"
accounta1ilit3 in6ol6ing grassroots grou"s.
@ore intriguing) and of "articular interest) has 1een the de6elo"2ent of 2odels that can 1e used to 2easure
credit 2igration and default ris/ at the "ortfolio le6el and that can also 1e used to allocate ca"ital Aewis and
@adon) 2++%#. 8hese can 1e 1roadl3 classified into two t3"esC "ro"rietar3 internal# 2odels of credit ris/
2anage2ent and the 6endor-2ar/eted 2odels. 8he latter 2odels) in-s"ite of their general-a""lication nature) are
al2ost uni6ersall3 =uite ela1orate. For clear reasons) not enough infor2ation can 1e o1tained a1out the
ca"a1ilities of the for2er categor3 of these 2odels. Dowe6er) so2e detail is generall3 a6aila1le a1out the latter
categor3. 8his categor3 includes 2odels 2ar/eted 13 Algorith2ic) credit2etrics) creditris/O) .@'?s "ortfolio
@anager) Aoan !ricing 9or"oration) and @c.inse3?s 9redit !ortfolio 'iew Aewis and @adon) 2++%#.
9redit@etrics is one of the first "ortfolio 2odels de6elo"ed for e6aluating "ro1le2 loan and credit ris/. It
incor"orates a 2ethodolog3 for assessing a "ortfolio?s 6alue at ris/ 'AR# arising fro2 changes in counter"art3
credit =ualit3. It esta1lished an e7"osure "rofile of each counter"art3) re"resented within the "ortfolio) and
co21ines the 6olatilities of the indi6idual instru2ents ta/ing into account correlations 1etween credit e6ents# to
2odel the 6olatilit3 of the aggregate "ortfolio Ritchie and Richardson) 2+++C 2++%#.
9reditRis/O) 2ar/eted 13 9redit Suisse) is an ada"tation of the 9redit Suisse Irou"?s 2ethodolog3 for setting
loan loss "ro6isions. It is ca"a1le of assessing ris/ ca"ital re=uire2ents in an en6iron2ent where illi=uid loans
with little associated data# are held to 2aturit3. Accordingl3) its 2ethodolog3 2a3 1e 2ore a""ro"riate for
fir2s with retail and institutional loan "ortfolios) as o""osed to those with 2ore 1ond-oriented co2"ositions
Ro1erts and Sca"ens) 19$(#.
.@'?s !ortfolio @anager 2easures the ris/ and returns characteristics of a "ortfolio and allows the user to
e7"lore the incre2ental effect of a changing e7"osure to an indi6idual asset. It also "ro6ides for an e7a2ination
of the effect of a large-scale change to the "ortfolio 2i7 and) an assess2ent of "otential changes in tactics and
strateg3. Further) it can 1e a 6alua1le tool for deter2ining aggregate ca"ital re=uire2ents and the allocation of
econo2ic ca"ital Ro1inson) 2++*#.
Finall3) @c.inse3?s 9redit !ortfolio 'iew ta/es into account s"ecific countr3 and industr3 influences in order to
arri6e at 1etter esti2ates of default and credit 2igration "ro1a1ilities. It incor"orates the e6olution of the glo1al
2acro-econo23 into countr3- and industr3-s"ecific s"eculati6e default rates. It then 2a"s these rates into
cu2ulati6e 2igration "ro1a1ilities 13 countr3 and 13 industr3. As this descri"tion of so2e of these 2odels
'ol.() No.1*) 2+1%

11
suggests) the increasing co2"le7it3 of the world of "ro1le2 loan and credit ris/ has gi6en rise to an e=uall3
co2"le7 set of 2odels designed to 2easure and 2anage this ris/ 5ddin and Do""er) 2++1#.
#"+"! *esign of the 1orkout %rocess
An efficient e7ecution of the wor/out "rocess is contingent u"on the e7istence of clear guidelines on handling
different t3"es of clai2s and collateral Raai, et al) 2++(#. 8herefore) the internal guidelines should contain
rele6ant "rocess rules. As 2an3 e7a2"les show) de6iations fro2 the wor/out strateg3 defined in the internal
guidelines should not 1e "er2issi1le in the course of wor/out. 8herefore) the leewa3 for e2"lo3ees in charge of
wor/out should 1e defined narrowl3 Raai, et al) 2++(#. So2eti2es credit e7"osures 1elow a threshold 6olu2e
to 1e defined in the internal guidelines are handed o6er to collection agencies. 8he internal guidelines also ha6e
to clarif3 whether this in6ol6es a sale of the clai2) or whether the collection agenc3 2erel3 "erfor2s the ser6ice
on 1ehalf of the 1an/ Raai, et al) 2++(#. 8he sa2e is true for the 2ode of wor/out. In "ractice) one can find 1oth
lu2"-su2 fees and fees defined as a certain "ercentage of the collection "roceeds.
8hose e7"osures that are not handed o6er to e7ternal collection agencies should 1e assigned to an organi>ational
unit s"eciali>ing in the reali>ation of collateral Raai, et al) 2++(#. 8his unit chec/s if selling the collateral 2a/es
econo2ic sense. It also deter2ines the t3"e of reali>ation that "resents the 1est o"tion if 6arious a""roaches are
"ossi1le. If this is feasi1le) the necessar3 ste"s to reali>e the collateral in legal or out-of-court "roceedings ha6e
to 1e ta/en. In 2an3 cases) the collateral is not reali>ed i22ediatel3 1ased on the argu2ent that higher "roceeds
are to 1e e7"ected or that the sale will 2a/e econo2ic sense onl3 at a later ti2e Raai, et al) 2++(#. 8he ti2e of
reali>ation does indeed ha6e a significant i2"act on the reali>ation "roceeds. For real estate in "articular)
"ost"oning the dis"osal 2a3 1e sensi1le due to fluctuations in the 2ar/et Raai, et al) 2++(#. Dowe6er) the
ad2inistration of this deferred collateral re=uires a 2a,or "ortfolio 2anage2ent effortC therefore) the internal
guidelines should contain 2andator3 rules li2iting the use of this o"tion Raai, et al) 2++(#.
#"+"# Risk %rovisions
Finall3) the "rocesses concerning the set-u" of s"ecific loan loss "ro6isions as well as recording the write-off of
clai2s are discussed in sections 2.(.2.1 and 2.(.2.2 1elow) res"ecti6el3. Aoan loss "ro6isions are an i2"ortant
"art of 1an/ acti6ities ai2ed at co6ering the 1an/ in case of custo2ers defaulting.
#","#"! Setting u) S)ecific 'oan 'oss %rovisions
8he funda2ental regulations go6erning the deter2ination of s"ecific loan loss "ro6isions are sti"ulated in the
co22ercial and the ta7 code Raai, et al) 2++(#. For reasons of co2"leteness and eas3 access) these nor2s
should 1e contained in the internal guidelines Raai, et al) 2++(#. 8he set-u" of s"ecific loan loss "ro6isions
re=uires a forecast including all factors that can 1e e7"ected to affect the e7tent of the "ro6isions Raai, et al)
2++(#. Further2ore) the deter2ination of the reduction in 6alue re=uires the 6aluation of the collateral associated
with the e7"osure Raai, et al) 2++(#. In accordance with the lending "rinci"les sti"ulated in the internal
guidelines) the current loan-to-6alue ratio for2s the initial 6alue used to deter2ine the collateral 6alue. If there
are an3 dou1ts a1out the actual 6alue) the loan-to-6alue ratio has to 1e re6iewed and 2odified if necessar3 Raai,
et al) 2++(#. 8he internal guidelines should la3 down the "ossi1ilities to deter2ine loan-to-6alue ratios in the set-
u" of s"ecific loan loss "ro6isions. 8his lending 6alue 2a3 1e reduced fro2 case to case to account for the
2ar/eta1ilit3 of the asset as well as an o1,ecti6e assess2ent of the sales "ros"ects at the 1alance sheet date
Raai, et al) 2++(#. 8he e2"lo3ee in charge has to ,ustif3 the reduction in 6alue in the credit files. Further2ore) it
has to 1e ensured that the reali>ation costs are ta/en into account when deter2ining the collateral 6alue rele6ant
for the s"ecific loan loss "ro6ision Raai, et al) 2++(#.
8he set-u" of s"ecific loan loss "ro6isions is su1,ect to s"ecial docu2entation re=uire2ents Raai, et al) 2++(#.
8his should hel" a6oid in=uiries and du"licate efforts with regard to an e7ternal re6iew. In general) the re=uest
for setting u" a s"ecific loan loss "ro6ision is filed 13 the e2"lo3ee in charge of the e7"osure in credit a""ro6al
"rocessing in coordination with the account 2anager res"onsi1le Raai, et al) 2++(#. !ro6isions for e7"osures
that ha6e alread3 1een transferred to restructuring or wor/out are set u" 13 the e2"lo3ees 2anaging the
e7"osures in those de"art2ents Raai, et al) 2++(#.
#","#"# 1rite/offs
Erite-offs of clai2s refer to those a2ounts 13 which clai2s are reduced as a result of 1eco2ing uncollecti1le
Raai, et al) 2++(#. 8his includes direct write-offs as well as the utili>ation of s"ecific loan loss "ro6isions. 8he
e7"osure should 1e written off if firstl3) the collateral of the related e7"osure has 1een reali>ed in full or is of no
6alue. Secondl3) the clai2s were wai6ed in "art or in full) and finall3 no 2ore "a32ents on the re2aining clai2
are to 1e e7"ected Raai, et al) 2++(#.
Sti"ulations go6erning the decision-2a/ing authorit3 ha6e to 1e laid down in the internal guidelines Raai, et al)
2++(#. 8he re=uest for a write-off of clai2s should include the "resentation of the reasons for the default.
Further2ore) it should contain a state2ent as to whether the clai2 should 1e "ursued an3 further Raai, et al)
2++(#. 8he clai2s should 1e recorded in a central list of defaulted clai2s which is unifor2 for the 1an/ as a
whole. :e"reciation and "ro6isions should 1e recorded continuousl3) also throughout the 3ear Raai, et al) 2++(#.
In su22ar3) in order to assess the credit ris/) it is necessar3 to ta/e a close loo/ at the 1orrowers? econo2ic and
'ol.() No.1*) 2+1%

12
legal situation as well as the rele6ant en6iron2ent Se3fried) 2++1#. 8he =ualit3 of credit a""raisal "rocesses
de"ends on two factors) i.e. a trans"arent and co2"rehensi6e "resentation of the ris/s and an ade=uate
assess2ent the ris/s) Raai, et al) 2++(#. Johnson and Johnson 19$(#) De2"el and Si2onson 1999# and .och
and @acdonald 2+++# all "ointed out that the acti6ities in the "rocessing of loans follow eight ste"s. 8hese ste"s
are a""lication) credit anal3sis) decision) docu2ent "re"aration) closing) recording) ser6icing and ad2inistration)
and collection. 8he =ualit3 of the credit a""raisal "rocess fro2 a ris/ "ers"ecti6e is deter2ined 13 the 1est
"ossi1le identification and e6aluation of the credit ris/ resulting fro2 a "ossi1le e7"osure Raai, et al) 2++(#. 8he
credit ris/ can 1e distri1uted a2ong four ris/ co2"onents; "ro1a1ilit3 of default !:#C loss gi6en default AI:#C
e7"osure at default -A:# and 2aturit3 @#.
In order to detect ris/s "rior to the "eriodic chec/ to 1e carried out due to the e7"ir3 of a s"ecified ter2) 2an3
1an/s use earl3 warning s3ste2s Raai, et al) 2++(#. A2ong other things) these earl3 warning s3ste2s ta/e into
account defaults with regard to the contractual relationshi" 1etween 1an/ and 1orrower. &f great i2"ortance is
the insufficient "erfor2ance of interest and "rinci"al re"a32ent o1ligations 4essis) 2++2#. 8hese 2onitoring
2easure include "eriodic re6iews and roll-o6ers Raai,) et al.) 2++(#) earl3 warning s3ste2s and re2inder
"rocedures Raai,) 2++( and 4ol) 2++*#.

$" Research Methodo&ogy
$"! Research *esign
8his stud3 was 1ased on a descri"ti6e research design. According to 9oo"er 1996#) a descri"ti6e stud3 was
concerned with finding out who) what) where and how of a "heno2enon. 8riangulation was a useful a""roach to
esta1lish the credi1ilit3 of =ualitati6e research noting that) P2i7ing a =ualitati6e 2ethod and a =uantitati6e
2ethod to gi6e the researcher the "otential to co6er each 2ethod?s wea/nesses with strength fro2 the other
2ethod. 8he design has in the "ast 1een successfull3 used 13 N,oroge 2++*#) @a>rui 2++*#.
A sur6e3 design was conducted with the ai2 of esta1lishing the techni=ues of credit ris/ 2anage2ent as used 13
the 2icrofinance institutions in .en3a. 8his called for a co21ination of =uantitati6e and =ualitati6e 2ethods of
doing research) which ha6e 1een "racticed) as reco22ended 13 in 2anage2ent studies in the de6elo"ing
countries. 8he stud3 co6ered 2icrofinance institutions in .en3a and not an3 other finance agenc3 or 4an/ in
.en3a.
$"# %o)u&ation
8he "o"ulation of interest in this stud3 was all the 2icrofinance institutions o"erating in .en3a. 8here were (1
@icrofinance Institutions in .en3a according to the 9entral 4an/ of .en3a 2++6# director3 when this stud3 was
conductred.
$"$ Sam)&e Se&ection2 Sam)&e Si3e and Sam)&e %eriod
A rando2 sa2"le of *+ @icro-Finance Institutions was ta/en fro2 the "o"ulation. 8his constitutes ($J of the
entire "o"ulation. 8his sa2"le fairl3 re"resents the whole "o"ulation and was considered large enough to
"ro6ide a general 6iew of the entire "o"ulation and ser6e as a good 1asis for 6alid and relia1le conclusions.
!ur"osi6e sa2"ling was then used to select one credit officer and one loan officer fro2 each of the sa2"led
institutions. 8his ga6e a total of 6+ res"ondents who were sa2"led to "artici"ate in the stud3.
$"+ *ata Co&&ection Method
8his stud3 used "ri2ar3 data) which was collected 13 wa3 of structured and se2i-structured =uestionnaires with
1oth o"en-ended and closed-ended =uestions. 8he focus of "ri2ar3 data was on the techni=ues used 13 @icro-
Finance Institutions in the 2anage2ent of credit ris/. 8he =uestionnaires were ad2inistered 13 2ulti"le-
a""roaches that included dro" and "ic/ later 1asis and use of e-2ail to contact the res"ondents. 8o increase the
res"onse rate) a follow u" was done 13 use of tele"hone calls.
$", *ata Ana&ysis and %resentation
8he data was "resented through su22ar3 statistics "ercentages) 2eans standard de6iation# to 2easure the
interrelationshi"s 1etween 6aria1les. Ira"hs were used to dis"la3 the infor2ation to i2"ro6e the "resentation of
the anal3>ed results for ease of inter"retation.

+" *ata Ana&ysis and Resu&ts
8his section "resents the results of data anal3sis.
+"! Summary Statistics
+"!"! Res)onse Rate
A total of 6+ credit and loans officers fro2 a sa2"le of *+ @icrofinance Institutions were sa2"led. -6er3 officer
fro2 the sa2"led institution was gi6en a =uestionnaire out of which *% res"onded 13 co2"leting and returning
the =uestionnaire. 8his ga6e a res"onse rate of (7J. 8his can 1e regarded as a fair res"onse rate for a stud3 of
this nature considering the confidentialit3 attached to this infor2ation.
8he collected data was edited and coded. :ata anal3sis was done using fre=uenc3 ta1les) "ercentages) 2ean
scores and standard de6iations. 8he 2ean or a6erage is co22onl3 used in re"orting data. It is o1tained 13
'ol.() No.1*) 2+1%

1*
su22ing all the answers or scores and di6iding 13 the total nu21er. !ercentage e7"resses infor2ation as a
"ro"ortion of a whole. It is used in showing fre=uenc3 distri1ution of grou"ed data. Fre=uenc3 distri1ution is a
classification of answers or 6alues into categories arranged in order of si>e or 2agnitude. Standard de6iation is
used to 2easure the degree to which indi6idual 6alues 6ar3 fro2 2ean. It is the a6erage distance the a6erage
scores lies fro2 the 2ean. A high standard de6iation 2eans that the res"onses 6ar3 greatl3 fro2 the 2ean. Aow
standard de6iation indicates that the res"onses are si2ilar to the 2ean. Ehen all the answers are identical) the
standard de6iation is >ero. !resentation of data too/ the for2 of ta1les and gra"hs.
8he res"ondents were first as/ed to "ro6ide infor2ation on na2e of their institution) designation) ownershi" of
the institution) nu21er of 3ears the3 ha6e 1een in o"eration) the nu21er of 1ranches) custo2er 1ase and the
2ar/et seg2ent ser6ed. 4elow is a su22ar3 of results on ownershi" structure of @FIs.
Tab&e +"! (wnershi) of Microfinance Institutions
4requency %ercent
!redo2inantl3 local 16 %7
!redo2inantl3 foreign 1+ 29
4oth local and foreign $ 2%
8otal *% 1++
Source; Authors own co2"utation
8he results show that %7J of @FIs are locall3 owned while foreigners and locals ,ointl3 own (*J. 8he
i2"lication is that locals understand the do2estic en6iron2ent 1etter and hence can e7tend loans without fear.
+"!"# 5ears of ()eration2 0ranch 6etwork2 Customer 0ase and Market Segment Served
8he nu21ers of 3ears in o"eration influence an institution?s e7"erience in lending and 2anage2ent of credit ris/.
8he 1ranch networ/ enhances outreach so that a 6ariet3 of custo2ers are reached and custo2er 1ase indicates
the growth of the institutions. 8a1le %.1 1elow shows the nu21er of 3ears the sa2"led @FIs ha6e 1een in
o"eration in .en3a.
Tab&e +"# 5ears of ()eration of Microfinance Institutions in Kenya
Qears of &"eration :istri1ution
Res"onse !ercentage
4elow 1+ 3ears $ 2*
1+-2+Qears % 12
21-*+ Qears 16 %7
*1-%+ Qears * 9
%1 and a1o6e 3ears * 9
8otal *% 1++
Res"ondents were as/ed to indicate the custo2er 1ase that their institutions ser6e. 8he anal3sis re6ealed that $$J
of the institutions had custo2er 1ase of less than 1+)+++ custo2ers. 8a1le %.* 1elow "resents the findings of the
data anal3sis.
Tab&e +"+ Customer 0ase of Microfinance Institutions in Kenya
:istri1ution
9usto2er 4ase Res"onse !ercentage
Aess than 1+)+++ *+ $$
4etween 1+)++1 and (+)+++ % 12
4etween (+)++1 and 1++)+++ + +
@ore than 1++)++1 + +
8otal *% 1++
8he stud3 sought to esta1lish the 2ar/et seg2ent) which the institutions ser6ed. 8he results of the data anal3sis
in figure %.2 1elow show that $(J of the institutions ser6ed 1oth 1usiness and indi6iduals.
Tab&e +", Market Segment Served by Microfinance Institutions in Kenya
Fre=uenc3 !ercent
4usiness * 9
!ersonal 2 6
4oth 1usiness and "ersonal 29 $(
8otal *% 1++
+"# Techniques of Credit Risk Management
8his section "resents the sur6e3 results on techni=ues used to 2anage credit ris/ in @icrofinance institutions in
.en3a.
'ol.() No.1*) 2+1%

1%
+"#"! The Use of the .C Technique of Credit Risk management
8he stud3 sought to esta1lish whether res"ondent organi>ations use the I9 to anal3>e the 1orrower?s situation.
8he results of the anal3sis re6ealed that 7%J of the institutions sa2"led use the 69 techni=ue of credit ris/
2anage2ent i.e. character) ca"acit3) condition) collateral) control and ca"ital as a 1asic tool when lending to
anal3>e the 1orrower situation. 8his 2eans that the 2icrofinance institutions are 6er3 conscious when lending
and the3 follow due "rocess to anal3>e 1orrower situation. 8he findings are shown in the figure %.* 1elow.
Tab&e +". The Use of .Cs in Credit A))raisa& among Microfinance Institutions in Kenya
Fre=uenc3 !ercent
Qes 2( 7%
No 9 26
8otal *% 1++
+"#"# 4actors 6ecessitating Credit Risk Management
Res"ondents were as/ed to state the e7tent to which the institutions ha6e 1een using the factors listed in ta1le %.%
1elow as /e3 in identif3ing 1usiness needs of credit ris/ 2anage2ent and focusing 1ench2ar/ing strategies.
8he results show that understanding the organi>ation?s e7"osure to custo2ers is a critical factor used to anal3>e
the credit worthiness of the 1orrower. 8his factor had a 2ean of (.12* and standard de6iation of +.1$9 as
co2"ared to efficient s3ste2s and "rocesses) which had a 2ean of * and standard de6iation of +.$9(.
+"$"$ Credit Risk Management %ractices
8he stud3 sought to esta1lish the credit ris/ 2anage2ent "ractices that are "ut in "lace 13 the institutions) to
ensure efficient credit ris/ 2anage2ent. 8he stud3 esta1lished that the institutions ta/e follow u" 2easures to
ensure that the conditions set in the loan agree2ent are 1eing followed to a6oid loan loses. As/ed whether their
institutions carr3 out loan re6iews) 7*J indicated that indeed the institutions ta/e loan re6iew anal3sis as the
2ost crucial as"ect of ris/ 2anage2ent 13 doing "ro"er docu2entation and anal3sis 1efore gi6ing an3 loan or
ad6ancing an additional loan see figure %.% 1elow#. In a situation where the 1orrower?s financial situation and
structure ha6e 1een altered and the original "ro2ised 6alue of collateral differ) 2icrofinance institutions resol6e
to ta/ing litigations which ha6e cost the2 a lot of 2one3 and ti2e since the s3ste2 of law is slow in .en3a.
+"#"+ Measures Used to Assess Credit Risk Management 7fficiency
Res"ondents were as/ed to indicate the e7tent to which their institutions used 2easures to assess efficienc3 and
related lending functions in the lending "rocess. 8his 1ecause efficienc3 2easures ha6e an i2"act on the credit
2anage2ent "rocess i.e. if there is efficienc3 in the lending "rocessC there is also a reci"rocated efficienc3 in
credit ris/ 2anage2ent. 8a1le %.( 1elow shows 2easures used to asses credit ris/ 2anage2ent efficienc3.
Tab&e +"8 4actors 6ecessitating Credit Risk Management among Microfinance Institutions in Kenya

*escri)tive
4actor Mean Std" *eviation
5nderstanding organi>ations
e7"osure to custo2ers
(.12* +.1$9
!roacti6el3 forecasting how 2an3
loans 2ight go 1ad
(.1++ +.+2*
@ini2i>ing losses when loans go
1ad
(.1++ +.1*6
8o effecti6el3 1alance high and low
ris/ 1usiness
(.1++ +.+29
8o hel" not turn good 1usiness
awa3
%.1(6 +.1++
8o o"ti2i>e 1usiness 6olu2e *.2++ +.69*
8o o"erate through efficient
s3ste2s and "rocesses
*.++ +.$9(
Tab&e +"9 The Use of 'oan Review Ana&ysis among Microfinance Institutions in Kenya
Fre=uenc3 !ercent
Qes 2( 7*
No 9 27
8otal *% 1++
8he results show that returns on e=uit3 with a 2ean score of (.12* and standard de6iation of +.199 is the 2ost
critical 2easure of efficienc3 as co2"ared to total o"erating e7"enses "er unit of out"ut with a 2ean score of
'ol.() No.1*) 2+1%

1(
%.1(6 and a standard de6iation of +.1++. 8his i2"lies that if 2one3 is lent and not re"aid) the return on e=uit3
will 1e the 2ost affected which will in turn affect the growth of the institution. 8he "roducti6it3 of a loan officer
is anal3>ed through the =uarterl3 loan sales as a /e3 to i2"ro6ing co22ercial lending "erfor2ance.
Tab&e +: Assessment of Credit Risk Management 7fficiency among Microfinance Institution
*escri)tive
Measures Mean Std" *eviation
Returns on e=uit3 (.12* +.199
Returns on assets %.9$+ +.+7*
Returns on in6est2ents %.(9+ +.1%6
@onetar3 out"ut "er staff %.2(+ +.+29
8otal o"erating e7"enses "er unit
of out"ut
%.1(6 +.1++
:ata en6elo"2ent anal3sis :-A# *.2++ +.69*
+"$", Mode&s Used in 7fficient Credit Migration and *efau&t Risk Measurement
Res"ondents were as/ed to indicate the e7tent to which their institutions use efficient lending "erfor2ance
factors. 8he results of data anal3sis are shown in ta1le %.6 1elow.
It was found that identif3ing counter "art3 default ris/ is the single 2ost i2"ortant "ur"ose ser6ed 13 the credit
ris/ 2odels. (9J of the sa2"led @FIs use 9redit @etrics and 12J use 9reditRis/O to deal with counter "art3
2igration ris/. Sur"risingl3) onl3 a 2inorit3 of @FIs utili>e either a "ro"rietar3 or 6endor-2ar/eted 2odel for
the 2anage2ent of their credit ris/.
Tab&e +"!; Mode&s used in Credit Migration and *efau&t Risk Measurement in Microfinance Institutions
in Kenya
*istribution
@odels used Res"onse !ercentage
Algorith2ic + +
9redit @etrics 2+ (9
9redit Ris/O % 12
.@'?s !ortfolio 2anager 1+ 29
Aoan !ricing 9or"orate + +
@c.inse3?s 9redit !ortfolio 'iew + +
+"$". 0enefits of 7fficient Credit Risk Management
8he res"ondents were as/ed to indicate whether their institutions ha6e 1enefited fro2 credit ris/ 2anage2ent
"ractices. 8he results of the data anal3sis in figure %.( 1elow show that 97J of the @FIs 1enefited fro2 the use
of the credit ris/ 2anage2ent "ractices though the3 ha6e 1een 2eeting challenges as discussed in the ne7t su1
section.
Tab&e +"!! 0enefits from 7fficient Credit Risk Management to Microfinance Institutions in Kenya
Fre=uenc3 !ercent
Qes ** 97
No 1 *
8otal *% 1++
+"$ The Cha&&enges 4acing the Microfinance Institutions in the Management of Credit Risk
8he stud3 sought to esta1lish the challenges that the @icrofinance Institutions face. 8he findings of the anal3sis
are "resented in ta1le %.7 1elow.
Tab&e +"!# Cha&&enges 4acing the Microfinance Institutions in Credit Risk Management
*escri)tive
Cha&&enge Mean Std" *eviation
Strict rules fro2 the 9entral 4an/ %.9$+ +.+7*
No "ro"er go6ern2ent "olic3 on @FI?s %.(9+ +.1%6
:ifficult3 in loan reco6er3 %.2(+ +.+29
Stiff co2"etition %.1(6 +.1++
5nscru"ulous @FI?s s"oiling the re"utation of the industr3 *.2++ +.69*
8he results show that the serious challenge facing the 2icrofinance institutions o"erating in .en3a in the
2anage2ent of credit ris/ is the strict rules fro2 the 9entral 4an/ with a 2ean of %.9$+ and standard de6iation
of +.+7*. 8he least challenge is the unscru"ulous @FIs s"oiling the re"utation of the industr3 with a 2ean of *.2
and standard de6iation of +.69*.
'ol.() No.1*) 2+1%

16
," Conc&usion
4ased on the anal3sis of the data collected fro2 the sur6e3) the following conclusions are drawn. First) 2ost
2icrofinance institutions 7%J# use 69 techni=ues of credit ris/ 2anage2ent) i.e. character) ca"acit3) conditions)
collateral) control and ca"ital as a 1asic tool when lending. As 2entioned 13 Rose 1991# the 69s are i2"ortant
reference inde7es for financial institutions when 2a/ing credit anal3sis to decide worthiness of a 1orrower.
8herefore) this i2"lies that the 2icrofinance institutions o1ser6e credit ris/ anal3sis re=uire2ents.
Secondl3) the findings also re6ealed that understanding the organi>ations e7"osure to the custo2ers is treated as
critical 13 the 2icrofinance institutions 2ean score (.12*#. Raai, et al) 2++(# "oints that =ualit3 credit a""raisal
"rocess fro2 a ris/ "ers"ecti6e is deter2ined 13 the 1est "ossi1le identification and e6aluation of the credit ris/
resulting fro2 a "ossi1le organi>ation?s e7"osure. 8his i2"lies that the 2icrofinance institutions are a1le to
detect an3 loo2ing credit ris/.
8hirdl3) to a6oid loan losses) the 2icrofinance institutions use follow u"s. 4ol 2++*# argued that re2inder
"rocedures) which could 1e in the for2 of follow-u"s) are "art of the credit a""raisal "rocess. 8he findings show
that @FIs ta/e loan re6iew anal3sis as an as"ect of ris/ 2anage2ent 13 doing "ro"er docu2entation and
anal3sis. 8he institutions also resol6e to ta/e litigations in situations where the 1orrower?s financial situation and
structure ha6e 1een altered and the original "ro2ised 6alue of collateral differ. 8he stud3 therefore concludes
that the 2icrofinance institutions are well "re"ared to a6oid an3 loan losses 13 e2"lo3ing credit 2anage2ent
"ractices.
Fourthl3) to assess efficienc3 in lending "rocedures) the stud3 esta1lished that the institutions use returns on
e=uit3 2ean score (.12*#. 8he results show that the institutions used factors such as returns on assets 2ean
score %.1(6#. 8herefore) all @FIs use accounting 2easure to deter2ine the efficienc3 of financial inter2ediation.
Fifthl3) the results indicate that a 2a,orit3 of the institutions (9J# used 9redit @etrics to 2easure the credit
2igration and default ris/. Ritchie and Richardson) 2+++C 2++%#) argued that 9redit @etrics 2odel was
de6elo"ed to e6aluate "ro1le2 loan and credit ris/ and is used in assessing a "ortfolio?s 6alue at ris/ 'AR#
arising fro2 changes in conte2"orar3 credit =ualit3. 8herefore) 2icrofinance institutions use the reco22ended
2odels to anal3>e the credit ris/ of the loans.
Aast 1ut not least) the results show that the 2icrofinance institutions are faced with the challenge of strict
o"erational regulations fro2 the 9entral 4an/ of .en3a 2ean score %.9$#. 8he go6ern2ent has also not "ut an3
"olic3 in "lace that concerns the o"erations of the @FIs. :es"ite the fact that the 2icrofinance institutions ha6e
"ut in "lace strict 2easure to credit ris/ 2anage2ent) loan reco6er3 is still a challenge to 2a,orit3 of the
institutions 2ean score %.2(#. 8his e7"lains the reason wh3 2ost financial institutions are either not growing or
are a1out to close down. 8here is also stiff co2"etition fro2 other financial institutions li/e the 1an/s insurance
and 2ortgage institutions.
8herefore) it is reco22ended that the 2icrofinance institutions di6ersif3 the loan "ortfolio in order to 2ini2i>e
credit ris/. Further2ore) 2icrofinance institutions should "ut in "lace 2ore 2easures to ensure that the
"erfor2ance of the loans are 2onitored to a6oid 1ad loans. Aastl3) the go6ern2ent should "ut in "lace "olicies
that are geared towards strengthening of the 2icrofinance institutions.

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