HARAMAYA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

ASSESSMENT OF CREDIT RISK MANAGEMENT PERFORMANCE OF MICRO

FINANCE INSTITUTIONS (IN CASE OF OROMIA CREDIT AND SAVING
SHARE COMPANY HARAR TOWN BRANCH)

RESEARCH PROPOSAL SUBMITTED TO THE DEPARTMENT OF

ACCOUNTING AND FINANCE, COLLEGE OF BUSINESS AND ECONOMICS,
HARAMAYA UNIVERSITY FOR THE PARTIAL FULFILLMENT OF THE
REQUIREMENTS OF BACHELOR OF ARTS (BA) DEGREE IN ACCOUNTING
AND FINANCE

GROUP NAME ………………..…………....………. ID NO

1) IBSA ABDALAHI MOHAMMED………………….059/14

2) ILIYAS ISAKE ABDI ……………………………….063/14
3) NURADIN MUKTAR BEKER ……………………..090/14
4) ASANTU MOHAMMED ABDO……………………013/14
5) AYANTU MUSA ABRAHIM……………………….015/14

ADVISOR: ADANE TILAHUN (MA)

APRIL, 2025

HARAMAYA, ETHIOPIA
 Abstract

This study was conducted on the assessment of credit risk management performance of harar
town Oromia credit and saving (OCSSC). The main objective of this study was to assess,
examine, and evaluate the credit risk management performance of harar town Oromia credit
and saving (OCSSC). In order to achieve the objective of the study the researcher used both
primary and secondary source of data. The primary sources of data obtained from employees,
and managers of institution by means of structured interviews, open, and close ended
questionnaires. Secondary data obtained from institutions written documents and Ethiopian
micro finance institutions annual reports. The researcher uses descriptive analysis method to
analyze the responses. Market failure(risk) for borrower’s product, lack qualified personnel in
credit risk management, unsuitable repayment period, lack of evaluating collaterals periodically
and lack of giving the training to borrowers how they use the loan and, using manual system for
recording and posting transactions are a major problems that affect the credit risk management
performance of MFI. The institutions were recommended to hire qualified peoples, to examining
the collateral periodically, to adopt computerized system and to give training to the borrowers
in order to reduce credit risk.

Key word: harar town Oromia credit and saving (OCSSC), Credit risk management
performance.

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`

Table of Content Page

Abstract…………………………………………………………….…………………………II

Table of content………………………………………………..….……..…………….….....III

List of abbreviation……………………………………………………….…………………VI

CHAPTER ONE

1. Introduction…………………………………………………………………………………….1

1.1. Background of study………………………………………………………………………….1

1.2. Statement of problem ………………………………………………………………………..2

1.3. Research question …………………………………………………………………………...4

1.4. Objective of the study………………………………………………………………………...4

1.4.1. General Objective……………………………………………………………………..…....4

1.4.2. Specific objective …………………………………………………………………………..4

1.5. Significance of the study ………………………………………………….………………….4

1.6. Scope and limitation of the study………………………………………………….………….5

1.7. Organization of the study ……………………………………………………………….….5

CHAPTER TWO

RELATED REVIEW LITERATURE

2.1. Theoretical review……………………………………………………………………………5

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2.2. Managing risk in financial institutions.
……………………………………………………….6

2.2.1 Credit risk………………………………………………………....…………………………7

2.3. Causes of credit risk in MFI......................................................................................................7

2.3.1. Causes of credit risk at borrower level……………………………………………………..8

2.3.2. Causes of credit risk at financial institutions (Lender) level……………………..……..…8

2.4. Managing credit risk…………………………………………………...…………………......9

2.4.1. The goal of credit risk management………………………………………………..….….10

2.5. Method of mitigating credit risk…………………………………………………………….10

2.6. Collateral as means of credit risk mitigation in MFI…………..…………………;……...…11

2.6.1. Valuation of collateral………………………………………………………………...…...11

2.7. Components of credit risk management…………………………………………………….12

2.8. Board and senior management’s oversight………………………………………………….12

2.8.1. The responsibilities if senior management………………………………………………..13

2.8.2. Organization structure……………………………………………………………………..13

2.8.3. Systems and procedures for identification, monitoring, and control risks………………..14

2.8.4. Credit risk administration…………………………………………………………………15

2.8.5. Credit risk monitoring and control………………………………………………………..16

2.8.6. Credit analysis……………………………………………………………………………..16

2.9. Micro finance institution in Ethiopia……………………………………………………..…17

2.10. Empirical review…………………………………………………………………………...17

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CHAPTER THREE

3. Research methodology

3.1. Research design……………………………………………………………..………………19

3.2 source and data type………………………………………………………………………….19

3.3. Method of data collection ………………………………………………………..…………19

3.4. Sample techniques and size………………………………………………….……………...20

3.5. target population……………….…………………………………………..

………………..20

3.6. Method of data analysis …………………………………………………….……………....20

Reference…………………………………………………………………..………………….....21

List of Abbreviation
AEMFI Association of Ethiopian micro finance institutions
BOD Board of directors
CRMC Credit risk management committee
CRMD Credit risk management department
FI Financial institutions
MFI Micro finance institutions
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NGO Non-governmental organization
PAR Portfolio at risk
PD Probability of defaults
RRR Repayment rate ratio
SME Small and micro enterprise

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CHAPTER ONE
1. INTRODUCTION
1.1 Back ground of the study

Credit risk has become a necessary consequence of a vibrant and ever changing economy,
because the economy is supported mostly by the interference of financial institutions (Jennifer et
al. 2008). Due to such effect commitment to prudent lending has become a major concern and
discussion issue in a global financial institutions context today. In this regard noted that without
the provision of credit from country’s financial institution especially through micro financial
institutions, no development of modern industrial community and fostering of investment that is
achieving the target growth of economy by the state would have been impossible. As a result,
most of the financial institution and micro finance industries are looking into managing their
credit risks in different business cycle and environment that can help to alleviate crisis and major
losses that could damage long-term functionality of the institutions. Therefore, effective credit
risk management is very essential to achieve this economic objectives and to optimizing the
performance of financial institutions.

Credit risk is one of the main risks that seriously affect micro financial institutions’ viability
(GTZ, 2000). Credit risk can be arises from the potential that an obligor is either unwilling to
perform on an obligation or its ability to perform such obligation is impaired resulting in
economic loss to the financial institutions (Santomero, 1997). Therefore, these institutions
required to design sound credit risk management that entails the identification of existing and
potential risks inherent in lending activities. Micro finance institutions in Ethiopia are not
different from the other world micro finance institutions. Therefore, they are also entitled to
design sound credit risk management in order to achieve their desired objectives.

Chua et al. (2000) also noted that the credit decision is based on the financial data and
assessment of the market outlook, borrower, management and shareholders. The follow-up is
carried out through periodic reporting reviews of the micro finance institutions commitments by
customer (Chua et al. 2000). Credit risk management incorporates decision making process;
before the credit decision is made, follow up of credit commitments including all monitoring and
reporting process (Alex Fayman &Ling T. He 2011)
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Credit risk management is one of the key functions of the micro financial institutions. This
micro financial institutions, which analyze credit risks more consciously, protect themselves
from negative events, thus obtaining competitive advantage over competitors. That is why
careful credit risk management is important for smooth cash flow and success of overall financial
performance of micro finance institutions.

The development of micro finance institutions in Ethiopia is a recent phenomenon. The

proclamation, which provides for the establishment of micro finance institutions, was issued in
July 1996. Since then, various microfinance institutions have legally been registered and started
delivering micro finance service (Wolday, 2000). In particular, the licensing and supervisions of
microfinance institutions in both urban and rural areas at it authorized them among other things
legally accept deposits from the general public (hence diversifying sources of funds), so draw
and accept drafts and to manage funds for the micro finance business (Getaneh, 2005).

According to association of Ethiopian micro finance institutions (AEMFI), the number of

microfinance institutions currently reached to 34 institutions.

1.2 Statement of Problem

Microfinance in Ethiopia has been established in accordance with the proclamation issued by the
national bank of Ethiopia in 1996. Microfinance is one of the financial institutions that provides
loans to clients to help them engage in productive activities and to raise their small business.
Most of microfinance institutions approve loans for productive purpose, because income
increment is positively indicator to which all development activities are addressed (Daniel,
2010).

The primary objectives of most micro finance institutions are to provide financial service (credit
and saving) to the peoples in order to get profit. Micro finance institutions offer loans mostly to
urban and rural peoples who cannot afford collaterals to get loans from institutions. Financial
services in Ethiopia are characterized by high urban concentration (Facet, 2013). To fill the gap
micro finance institutions provide credit to poor who lack access of formal credit financial
institutions.

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Credit risk management challenges are implicit in financial institutions (including micro finance
institutions) activities because credit risk events are typically uncertain (Laurentis, 2009).
Therefore as Nancy et al. (2001) noted an effective credit risk management process is required to
helps institution’s top leadership establishes rules to prevent operating losses due to human error,
employee carelessness, technological malfunction, or fraud. To illustrate, a micro finance's
management may put into place internal controls and procedures as well as periodic internal
audit reviews to ensure that employees comply with rules when performing duties in credit risk
management. A credit risk management policy also may cover financial risks of financial
institutions (Marquis Codija, n.d.)

The credit risk management performance is greater role for any micro finance institutions.
Micro finance sector currently face challenges of loan repayment (default) by clients. The poor
loan controlling system causes serious challenges to micro finance institutions. Every micro
finance institutions try to maximize it repayment rates helps to reduce the dependence of micro
finance institutions on subsidies. One of the indicator effectiveness of micro finance institutions
is the loan repayment performance of borrower.

Effective and sound credit risk management is a foundation for the safe and sound operation of a
micro finance institution to improve their performance. Therefore, the purpose of this research
proposal is to assess the credit risk management performance of harar town. In connection with
this issue, different empirical studies were conducted internationally. Nagarajan (2001) in his
study of risk management for microfinance institutions in Mozambique found that risk
management is a dynamic process that could ideally be developed during normal times and
tested at the wake of risk. Fernand (undated) conduct research study on managing microfinance
risks: some observations and suggestions stated that risk management has become more
important now and its importance will continue to grow in the future. In Ethiopia, the studies by
Wolday (2001), Befkadu (2007), Zigju (2008), and Michael (2006) focus on progress of micro
finance institutions in terms of number of clients, loan amount, and number of branches the
institutions have throughout the country.

The empirical study that have been reviewed in the preceding section focused on the different
micro finance institutions issues that affect the performance of micro finance institutions.

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In addition, most prior studies regarding credit risk management tried to examine the possible
methods to manage credit risk including the use of credit score rating, and the impact of
borrower’s financial positions on credit risk management and the impact of relation of borrower
and lender on credit risk management. However, none of them assessed and examined the credit
risk management performance of micro finance institutions especially in harar town. As a result,
this study were designed to fill the aforementioned gaps( particularly in harar town) the credit
risk management performance of micro finance institutions in harar town.

1.3. Research Questions

In conducting this study, the researcher answered the following questions:

1. What factors can affect the performance of institutions in credit risk management?
2. What is the credit risk management procedures adapted by the institutions?
3. What is the effectiveness and efficiency of institutions in internal control quality
review to manage credit risk?
4. What is the performance of institution in credit administration and loan
documentation procedures to manage credit risk?
1.4 Objective of the study
1.4.1 General objective
The main objective of this study was to assess, examine, and evaluate the credit risk management
performance of harar town.
1.4.2 Specific objectives
• To find out factors that affects the performance of credit risk management in Oromia
Credit and Saving harar Town Branch.

• To identify the credit risk management procedures adapted by the institutions.

• To see efficiency and effectiveness of institution in internal control quality review to

manage credit risk.

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1.5. Significance of the study
The researcher believes that the result of this research will be enable the governing body,
specifically the managements, and the higher responsible body, risk management department of
the institutions to be aware of about credit risk management and its effect on growth of
institutions income. In addition to this, it shows the major tools or techniques used by OCSSC to
manage and examine the performance of credit risk management. Finally, paper will be uses as
an initiation for those who are interested to conduct a detailed and comprehensive study
regarding the performance of OCSSC in credit risk management practice.

1.6. Scope and Limitation of the Study

The researcher believes that the findings of this study would be productive if has been conducted
on all MFI in Oromia region. However, due to the time and financial constraints it’s out the
researchers to incorporate all MFI in this study. Due to this, the paper is limited to only harar
town OCSSC. Besides the researcher also subjected to limitation of empirical research no more
access of previous research on the issue of harar town MFI and credit risk management
performance of harar town OCSSC.

1.7. Organization of the study

This study organized in to five chapters. The first chapter is background of study and it includes
introduction of the study, statement of the problem, research questions, general and specific
objectives, significance of the study and, scope and limitation of the study. The second chapter
is related to literature review, and in encompasses, theoretical concept and empirical studies
focus on the topics. The third chapter deals with research methodology. Chapter four contain
data presentation and analysis by using the method adopted to test objective answer the questions
and interpretation of the result from the analysis was also included under this chapter. The fifth
chapter includes findings, conclusions and some recommendations forwarded by the researcher.

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CHAPTER TWO
LITERATURE REVIEW

2.1. Theoretical Review

According to risk management framework in micro finance institutions by GTZ (2000) risk is an
integral part of financial services. When financial institutions issue loans, there is a risk of
borrower default. When MFI collect deposits and on-lend them to other clients (i.e. conduct
financial intermediation), they put clients’ savings at risk. According to GTZ frame work any
institution that conducts cash transactions or makes investments risks the loss of those funds.
Development finance institutions should neither avoid risk nor ignore risk. Like others financial
institutions, micro finance institutions face risks that they must manage efficiently and
effectively to be successful. If the OCSSC does not manage its risks well, it will likely fail to
meet its social and financial objectives. As Nancy et al.(2001) noted when poorly managed risks
begin to result in financial losses, donors, investors, lenders, borrowers and savers tend to lose
confidence in the organization and funds begin to dry up.

When funds dry up, MFI is not able to meet its social objective of providing services to the poor
and quickly goes out of business. Nancy et al. (2001) also noted that managing risk is a complex
task for any financial organization, and increasingly important in a world where economic events
and financial systems are linked. Global financial institutions have emphasized risk management
as an essential element of long-term success. Rather than focusing on current or historical
financial performance, management and regulators now focus on an organization’s ability to
identify and manage future risks as the best predictor of long-term success. Therefore since
micro finance institutions are part of these financial institutions they are also be aware of about
risk particularly credit risk they face and the way how to manage these risks.

On the other hand micro finance institutions (OCSSCs) were established to fill the gap in the
financial services sector by providing funds to the poor and lower income group and thus
alleviating poverty and enhance their business activities. The OCSSCs also provide funds for
start-up business or for working capital (Woller et al., n.d). In addition, some OCSSCs also
provide funds for non-business activities such as for education and emergencies purpose.
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In doing so agency problems like, moral hazard and adverse selection of clients exist because of
information asymmetries.

2.2. Managing Risk in Financial Institutions

Risk management is a cornerstone of prudent financial institutions practice. Undoubtedly, all
financial institutions in the present-day volatile environment are facing a large number of risks
such as credit risk, liquidity risk, foreign exchange risk, market risk, and interest rate risk, among
others – risks that may threaten a financial institution’s survival and success.

In other words, financial institutions are business of risk (A. Kanwar, 2005). For this reason,
efficient risk management is required. The purpose of financial institutions is to maximize
revenues and offer the most value to shareholders by offering a variety of financial services, and
especially by administering risks. Recently many financial institutions have appointed senior
managers to oversee a formal risk management function their objectives (Thornton, 2010).

2.2.1. Credit Risk

According to a risk management framework for micro finance institutions of GTZ (2000) credit
risk is the most frequently addressed risk for micro finance institutions is the risk to earning or
capital due to borrowers late and non-payment of loan obligation.

Credit risk encompasses both the loss of income resulting from the micro finance institutions
inability to collect anticipated interest earning as well as the loss of principal resulting from loan
defaults. Credit risk includes both transaction risk and portfolio risk.

A Transaction risk: This is related to the individual borrower with which the OCSSC is
transacting. A borrower may not be trustworthy and capable of repaying loan, which will result
in loss of loan. All loss of loan related to delinquency of individual clients which can be because
client’s migration, willful defaulting, business failure is called transaction risk.

B. Portfolio risk: Portfolio risk is related to factors, which can result in loss in a particular class
or segment of portfolio.

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For example, an OCSSC may lose a portfolio with a particular community, locality, or a
particular trade due to some external reasons. These reasons could be political, communal,
failure of an industry /trade, etc.

2.3. Causes of Credit Risk in MFI

According to Macaver and [Link] (undated), the source of credit risk can be either from
borrower level or from financial (lender) level.

2.3.1. Causes of Credit Risk at Borrower Level

The cause of loan default at the borrowers’ level includes:

• Failure of investment to generate sufficient income due to improper technical advice,
inadequate support services, marketing risks or natural disasters.
• Diversion of loan from desired objective operations to non-essential consumption which
makes it difficult to meet repayment commitment on time.
• Existence of liabilities towards informal lenders, which may get precedence over
institutional lenders, leading to delinquency and default.
• Contingencies at the borrower household, such as sickness, accident or death (pure risk).
• Operation at very low level of subsistence, forcing additional income generated through
loan-supported activities to be appropriated for basic needs.
• Prevalence of low real rate of interest or pegging of interest rate far below the market
rate.
• Absence of incentives for prompt repayment, or penalties for delayed repayment.

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2.3.2. Causes of Credit Risk at Financial Institution (Lender) Level
At the financial institution level, loan default may be due to any or a combination of the
following:
♦ Defective procedures for loan appraisal, which could lead to financing of bad projects, thereby
giving rise to delinquencies and defaults.
♦ Quality of loan officers, their mobility in the field, and their capacity to judge borrowers as
well as the incentive package available to them affect repayment. When loan officers are
assessed more based on compliance with lending targets than with recovery performance, it
could lead to bad loans. When responsibility for lending and recovery are vested with separate
officials in a credit agency, recovery tends to decline.
♦ Untimely loan disbursement and inappropriate repayment schedules. In addition, when the
procedure for repayment is bulky, borrowers tend to default.
♦ Inability or reluctance of lenders to enforce sanctions against conspicuous defaulters.
♦ when institutions have limited contact with borrowers, default tends to increase. But when
borrowers are in frequent contact and use several services of lenders, default reduces.
♦ Absence of sound accounting and management information system.

2.4. Managing Credit Risk

Credit risk Management is a discipline at the core of every financial institution and encompasses
all the activities that affect its risk profile. It involves identification, measurement, monitoring
and controlling risks to ensure that; the individuals who take or manage credit risks clearly
understand it, the organization’s risk exposure is within the limits established by Board of
Directors. Risk taking decisions are in line with the business strategy and objectives set by
BOD, the expected payoffs compensate for the risks taken, risk taking decisions are explicit and
clear, sufficient capital as a buffer is available to take risk (Nagarajan 2001).

The acceptance and management of credit risk is inherent to the business of OCSSC as financial
intermediaries (Nusselder, 2003). Risk management as commonly perceived does not mean

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minimizing risk; rather the goal of risk management is to optimize risk-reward trade -off. Despite
the fact that OCSSCs are in the business of taking risk, it should be recognized that an institution
need not engage in business in a manner that unnecessarily imposes risk upon it: nor it should
absorb risk that can be transferred to other participants. Rather it should accept those risks that
are uniquely part of the array of OCSSC’s services (Nusselder, 2003). The overall responsibility
for risk management, which includes internal controls, rests with the board of directors.

The board is responsible for ensuring that a formal risk assessment is undertaken at least
annually for the purposes of making its public statement on risk management, including internal
control. The board should acknowledge, in this statement, its responsibility for the risk
management process and for reviewing its effectiveness.
Management is accountable to the board for designing, implementing and monitoring the
process of risk management, and integrating it into the day-to-day activities of the institutions
(Thornton, 2010).

2.4.1. The Goal of Credit Risk Management

The goal of credit risk management, as presented by the Basel (2000) is to maximize a financial
institution’s risk adjusted rate of return by maintaining credit risk exposure within acceptable
parameters. Consistent with principles of managing portfolio, it is requested that both the credit
risk arising from individual creditors or transactions and the risk of the entire portfolio should be
managed, and the relationship between credit risk and others must be considered as well.

2.5. Methods to Mitigate Credit Risk

According to Zoltan et al. (undated) the following are some of the methods that lenders can
mitigate credit risk. Pavla Vodova (undated) also noted the following as a means of credit risk
mitigation mechanisms.
Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who are more
likely to default, a practice called risk-based pricing. A lender considers factors relating to the
loan, such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield.
Covenants: Lenders may write stipulations on the borrower, called covenants, into loan
agreements:
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 • Periodically report its financial condition.

• Refrain from borrowing further or other specific, voluntary actions that negatively affect
the company’s financial position.

• Repay the loan in full, at the lender's request, in certain events such as changes in the
borrower's debt-to-equity ratio or interest coverage ratio.

Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in
total or to certain borrowers. For example, a distributor selling its products to a troubled retailer
may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.

Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a high
degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by
diversifying the borrower pool.

2.6. Collateral as a Means of Credit Risk Mitigation in MFI

Collateral is a risk reduction tool, which, like many other such tools, mitigates risk by reducing
credit exposure. The effect of collateralization is to substitute the credit risk of the issuer of the
collateral for that of the counterparty to the transaction. Collateral reduces credit risk but gives
rise to other forms of risk including legal, operational and concentration risk.

In lending agreements, collateral is a borrower’s pledge of specific property to a lender, to secure

repayment of a loan(E. Condolff, 2006). Anderson (2010) also noted that the collateral serves as
protection for a lender against a borrower's default - that is, any borrower failing to pay the
principal and interest under the terms of a loan obligation.
If a borrower does default on a loan (due to insolvency or other event), that borrower forfeits
(gives up) the property pledged as collateral - and the lender then becomes the owner of the
collateral. Collateral, especially within OCSSCs, may traditionally refer to secured lending (also
known as asset-based lending). More recently, complex collateralization arrangements are used
to secure trade transactions.

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2.6.1. Valuation of Collateral

The valuation of the collateral provided by the credit applicant is an essential element in the
credit approval process and thus has an impact on the overall assessment of the credit risk
involved in a possible exposure. The main feature of a collateralized credit is not only the
borrower’s personal credit standing, which basically determines the probability of default (PD),
but the collateral which the lender can realize in case the customer defaults and which thus
determines the OCSSCs loss.

2.7. Components of Credit Risk Management

According to the risk management guidelines for commercial banks and other financial
institutions in Pakistan. A risk management frame work for microfinance institutions (GTZ,1999
& 2000). Nancy et al. and Bruett (2001), principles for the management of credit risk Basel
committee (2000), Credit Institutions Regulatory Document Impairment Provisions for Credit
Exposures (Irish financial service authority, 2005). Guide lines on credit risk management for
financial institutions prepared by eastern Caribbean central bank (2009) ,appraisal guide for
microfinance institutions. (Isern et al. 2008) in their writing stated that typical credit risk
management framework in a financial institution may be broadly categorized into following
main components.
a) Board and senior Management’s Oversight
b) Organizational structure
c) Systems and procedures for identification, acceptance, measurement, monitoring and control
risks.
2.8. Board and Senior Management’s Oversight
It is the overall responsibility of Board to approve institution’s credit risk strategy and significant
policies relating to credit risk and its management which should be based on the institution’s
overall business strategy. To keep it current, the overall strategy has to be reviewed by the
board, preferably annually.

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The responsibilities of the Board with regard to credit risk management shall include:
• Explain institution’s overall risk tolerance in relation to credit risk.

• Ensure that institution’s overall credit risk exposure is maintained at prudent levels
and consistent with the available capital.

• Ensure that top management as well as individuals responsible for credit risk
management possess sound expertise and knowledge to accomplish the risk
management function.

• Ensure that the institution implements sound fundamental principles that facilitate
the identification, measurement, monitoring, and control of credit risk.

• Ensure that appropriate plans and procedures for credit risk management is in
place.

2.8.1. The Responsibilities Senior management

The senior management of the institutions should develop and establish credit policies and credit
administration procedures as a part of overall credit risk management framework and get those
approved from board. Such policies and procedures shall provide guidance to the staff on
various types of lending including corporate, SME, consumer, agriculture, etc. At minimum the
policy should include
a) Detailed and formalized credit evaluation/ appraisal process.
b) Credit approval authority at various hierarchy levels including authority for approving
exceptions.
c) Risk identification, measurement, monitoring, and control
d) Risk acceptance criteria
e) Credit origination and credit administration and loan documentation procedures.
f) Roles and responsibilities of units/staff involved in origination and management of credit.
g) Guidelines on management of problem loans.

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2.8.2. Organizational Structure.
To maintain OCSSC overall credit risk exposure within the parameters set by the board of
directors, the importance of a sound credit risk management structure is required. While the
MFIs may choose different structures, it is important that such structure should be commensurate
with institution’s size, complexity and diversification of its activities. It must facilitate effective
credit risk management oversight and proper execution of credit risk management and control
processes.

Each MFI, depending upon its size, should constitute a Credit Risk Management Committee
(CRMC), ideally comprising of head of credit risk management Department, credit department
and treasury. This committee reporting to institutor’s risk management committee should be
empowered to oversee credit risk taking activities and overall credit risk management function.
The CRMC should be mainly responsible for:
a) The implementation of the credit risk policy / strategy approved by the Board.
b) Monitor credit risk and ensure compliance with limits approved by the Board.
c) Recommend to the Board, for its approval, clear policies on standards for presentation of
credit proposals, financial covenants, rating standards and benchmarks.
d) Decide delegation of credit approving powers, prudential limits on large credit exposures,
standards for loan collateral, portfolio management, loan review mechanism, risk concentrations,
risk monitoring, and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.

Further, to maintain credit discipline and to enunciate credit risk management and control
process there should be a separate function independent of loan origination function.
Credit policy formulation, credit limit setting, monitoring of credit exceptions / exposures and
review /monitoring of documentation are functions that should be performed independently of
the loan origination function. To do so the MFI should institute a Credit Risk Management
Department (CRMD). Typical functions of CRMD include:

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a) To follow a holistic approach in management of risks inherent in MFIs portfolio and ensure
the risks remain within the boundaries established by the Board or Credit Risk Management
Committee.
b) The department also ensures that business lines comply with risk parameters and prudential
limits established by the Board or CRMC.
c) Establish systems and procedures relating to risk identification, Management Information
System, monitoring of loan / investment portfolio quality and early warning. The department
would work out remedial measure when deficiencies/problems are identified.
d) The Department should undertake portfolio evaluations and conduct comprehensive studies
on the environment to test the resilience of the loan portfolio.

2.8.3. Systems and Procedures for Identification, Monitoring and Control

Risks.
Micro finance institutions must operate within a sound and well-defined criteria for new credits
as well as the expansion of existing credits. Credits should be extended within the target markets
and lending strategy of the institution. Before allowing a credit facility, the MFI must make an
assessment of risk profile of the customer/transaction.
This may include;
a) Credit assessment of the borrower’s industry, and macro-economic factors.
b) The purpose of credit and source of repayment.
c) The track record / repayment history of borrower.
d) Assess/evaluate the repayment capacity of the borrower.
e) The Proposed terms and conditions and covenants.
f) Adequacy and enforceability of collaterals.
2.8.4. Credit Administration.
Ongoing administration of the credit portfolio is an essential part of the credit process. Credit
administration function is a back office activity that support and control extension and
maintenance of credit. A typical credit administration unit performs the following functions:
a). Documentation. It is the responsibility of credit administration to ensure completeness of
documentation (loan agreements, guarantees, transfer of title of collaterals etc.) in accordance

15
with approved terms and conditions. Outstanding documents should be tracked and followed up
to ensure execution and receipt.
b). Credit Disbursement. The credit administration function should ensure that the loan
application has proper approval before entering facility limits into computer systems.
Disbursement should be effected only after completion of covenants, and receipt of collateral
holdings. In case of exceptions, necessary approval should be obtained from competent
authorities.
c). credit monitoring. After the loan is approved and draw down allowed, the loan should be
continuously watched over. These include keeping track of borrowers’ compliance with credit
terms, identifying early signs of irregularity, conducting periodic valuation of collateral and
monitoring timely repayments.
d). Loan Repayment. The obligors should be communicated ahead of time as and when the
principal/mark up installment becomes due. Any exceptions such as non-payment or late
payment should be tagged and communicated to the management. Proper records and updates
should also be made after receipt.
e). Maintenance of Credit Files. Institutions should devise procedural guidelines and standards
for maintenance of credit files. The credit files not only include all correspondence with the
borrower but should also contain sufficient information necessary to assess financial health of
the borrower and its repayment performance. It need not mention that information should be
filed in organized way so that external / internal auditors could review it easily.
f). Collateral and Security Documents. Institutions should ensure that all security documents
are kept in a fireproof safe under dual control. Registers for documents should be maintained to
keep track of their movement. Procedures should also be established to track and review
relevant insurance coverage for certain facilities/collateral. Physical checks on security
documents should be conducted on a regular basis.

2.8.5. Credit Risk Monitoring & Control

Credit risk monitoring refers to incessant monitoring of individual credits inclusive of Off
Balance sheet exposures to obligors as well as overall credit portfolio of the MFI.
OCSSCs need to articulate a system that enables them to monitor quality of the credit portfolio
on day-to-day basis and take remedial measures as and when any deterioration occurs. Such a
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system would enable a institutions to ascertain whether loans are being serviced as per facility
terms, the adequacy of provisions, the overall risk profile is within limits established by
management and compliance of regulatory limits. Establishing an efficient and effective credit
monitoring system would help senior management to monitor the overall quality of the total
credit portfolio and its trends. Consequently, the management could fine tune or reassess its
credit strategy /policy accordingly before encountering any major setback.

The MFIs credit policy should explicitly provide procedural guideline relating to credit risk
monitoring. At the minimum, it should lay down procedure relating to:
a) The roles and responsibilities of individuals responsible for credit risk monitoring
b) The assessment procedures and analysis techniques (for individual loans & overall portfolio)
c) The frequency of monitoring
d) The periodic examination of collaterals and loan covenants
e) The frequency of site visits
f) The identification of any deterioration in any loan
2.8.6. Credit Analysis
Credit analysis is geared toward one decision; does the FI grant the loan? The purpose of credit
analysis is to generate profitable loan that do not expose the lender to excessive amount of risk.
The reason for the acceptance or reject decision should be clearly documented and the decision
should be in accordance with the MFIs stated loan policy. The MFIs loan policies include the
desired portfolio of loan by category and include minimum credit standard such as collateral
requirements and minimum ratios. Other provisions include lending limits for certain loan
officers positions, standards for grading loan, requirements for monitoring existing loan ,polices
on inside loan and the documentation required to evaluate a loan applications.

2.9. Microfinance Institutions in Ethiopia

It is believed that the provision of micro credit to poor households would increase their assets
and income. As a result, microfinance credit is considered as one of the methods of alleviating
poverty. Since in the mid- 1980s, many non-governmental organizations (NGO) in Ethiopia
have started providing micro- credit to poor households for income generating activities
(Michael ,2006). Moreover, the development bank of Ethiopia, in collaboration with the
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ministry of trade, has launched a micro enterprise-lending program (Kereta, 2007). Since 1994,
recognizing the importance of microfinance facility, the present government issued a
proclamation that laid down the framework for licensing and supervision of the business of
microfinance institutions (MFIs) in July 1996, through Proc. No. 40/1996. The objectives of the
proclamation were:
(a) To provide a legal framework that brings monetary and financial policies and
(b) To provide a legal framework for the promotion of MFIs. The proclamation allows MFIs to
undertake both financial and non-financial activities.

The licensing and supervision of MFIs enhanced the status of MFIs as it authorized them to,
among many other things, legally accept deposits from general public (hence diversify their
sources of fund), draw and accept deposits, and manage funds for Micro Finance businesses.
According to the association of Ethiopian microfinance report currently there are 31 MFIs
operating throughout the country licensed under the national bank of Ethiopia

2.10. Empirical Review

Within the last few years a number of studies have provided the discipline into the practice of
risk management and other issue of micro finance institutions. An insight of related studies is as
follows:
Paul et al.(2001) in their study of viewing micro insurance as a social risk management
instrument examined that there should be efficient and equitable risk management for micro
finance institutions through micro insurance since micro insurances has positive impact on
effective credit risk management.
Eba and Sheriff (2010) in their study found that close and informal relationship between MFIs
and borrowers help in monitoring and early detection of problems that may arise in non-
repayment of loans that finally lead to credit risk. In addition, cooperation and coordination
among various agencies that provide additional support to borrowers may help them success in
credit risk management in their business. Method used is that quantitative research method.
Laurentis and Mattei (2009) conducted research on Lassoers’ recovery risk management
capability and found that the development of modern reliable systems of risk management can
enhance even more those management capabilities. This means that credit institutions should
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invest significant resources in projects aimed at correctly implementing rating systems and credit
risk models, and highlights once more the importance of these tools well beyond the scope of
regulatory compliance. The research method used is that mixed research method.
The study also noted that it is clear that micro insurance may be an acceptable means of
managing some forms of risk, but not all in micro finance institutions

Chua et al. (2000) conduct research on microfinance, risk management, and poverty indicated
that the relationship between risks to the client and risks to the loan portfolio has been largely
important to the microfinance industry. This is because a more explicit recognition of this
relationship in the design of products and services can reduce both the risk of borrowing for
clients and the risk of lending for OCSSCs. Products, services, and delivery mechanisms that are
designed to improve the capacity of clients to deal with risk in their lives (reduce their
vulnerability) and to reduce the risk of taking a loan can lead to better repayment, fewer
dropouts, and, accordingly, lower operating costs.

Samuel (2006) tries to touch the issue of credit risk management in some micro finance
institutions in Ethiopia but they did not assess exhaustively the performance of micro finance
institutions in credit risk management.
The empirical studies that have been reviewed in the preceding section focused on the different
micro finance institutions issues that affect the performance of micro finance institutions. In
addition, most prior studies regarding credit risk management tried to examine the possible
methods to manage credit risk including the use of credit score rating, and the impact of
borrower’s financial positions on credit risk management.
However to the knowledge of the researcher, it is possible to concluded that although there have
been a number of studies on credit risk management and related issues both in developed and
developing countries, Ethiopia in particular, there are no studies that exhaustively examine the
credit risk management practice of micro finance institutions specially in harar town.
As a result, this study were designed to fill the aforementioned gaps and provide concluding
recommends having the main objective of analyzing and examining the credit risk management
performance of micro finance institutions in harar town.

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CHAPTER THREE

3. RESEARCH METHODOLOGY

3.1 Research Design

The research design is arrangement of condition for collection and analysis of data in manner
that aims to combine relevance to the research purpose with economy in procedure. In order to
achieve the research question stated in the previous section, the researcher used both qualitative
and quantitative (mixed approach) in collecting and analyzing data The selection of the one over
the other approach for the conducting of the study is based on research problem (issue or concern
that needs to be addressed), the researchers own personal experience and support of audiences
(Creswell, 2009).

3.2. Source and type of Data

To execute the study the researcher used both primary and secondary source of data. The
primary data gathered from the employees, customers and vice managers of Oromia Credit and
Saving S.C harar Town Branch (OCSSC). The secondary source of data obtained from
published and non-published materials about Oromia Credit and Saving S.C harar Town Branch
(OCSSC) activities. The researcher focuses on the primary source of data. Because of enough
and reliable information was gathered through primary source of data.
3.3. Method of data collection
Data used for this study gathered from two sources of data; primary and secondary source of
data. Primary data collected by using interview from credit mangers because, to get relevant
data and by using questioners from employees. In the questioners, the researcher use both close-
end and open- end questions. Secondary source of data obtained from institutions written
documents and Ethiopian micro finance institution annual reports. Before using secondary data,
the reliability and relevance of data was issued..

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3.4. Sample technique and sample size
To collects available data the researcher was prepare questionnaires for distribute to the
respondents by using sampling technique, the research data was whole employees of OCSSC
taking the sample size of 13 Employer from the total population of 13, taking the researcher
whole population (census) as sample, The reason for used this type of sampling technique would
be less costly and less time consuming.
3.5. Target population
The total population of Oromia Credit and Saving Share Company harar Branch is 13 employers
From those 13 total populations, taking as sample whole population (census) as sample (study
population)
3.6. Method of data analysis
The collected were data analyzed by using descriptive analysis method. The researcher used both
percentage to analyze the responses of the respondents and it presents in the form of table to
provide comprehensive and discussion of the assessing and examining credit risk management
performance of select institutions.

Reference

• Alex Fayman and [Link] T. the (2011) ‘ prepayment risk and bank performance; journal
of risk finance vol. 12 No.1, pp. 26-40
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• A Kanwar (2005) ‘Risk Management for Banks’, available at
[Link]
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• Al-Tamim and Faris Muhammad Al- Mazaroei (2007) ‘bank risk management: a
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• Anthony M. Santemero (1997) ‘commercial bank risk management an analysis of the

process, world development, vol. 25 No. 10 pp. 1731-1742

• Befekadu B. Kereta (2007) ‘outreach financial performance analysis of microfinance

institutions in Ethiopia; National bank of Ethiopia; Economic research and monetary
policy directorate, Addis Ababa Ethiopia’

• Daniel (2010) ‘credit management in MFI in Ethiopia, Arba minch university, Arba
minch Ethiopia

• Fitsum Tedelle(2014) ‘determinants of loan repayment in MFI

• Giacomo Deluarentis(2009) ‘ lessor recovery risk management capacity managerial

finance, vol. 25 No. 10 pp. 860-873

• GTZ (1999-2000) ‘a risk management frame work for MFI’.

• Habib Ahmed (2002) ‘finance micro enterprise an analytical study of Islamic MFI,
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• Jeniffer Isren, Julie Abrahim, Matthew Brown (2008) ‘appraisal guide for MFI.

• Nancy Natilson, Promajer Tillman A. Bruett(2001) ‘financial performance monitoring a

guide for board member of MFI

• Wolday (2000) ‘corporate governance of the deposit taking MFI in Ethiopia

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• Zigju (2008) ‘the role of micro credit institutions in urban poverty alleviation in Ethiopia

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