CREDIT RISK MANAGEMENT IN RURAL BANKS: A CASE STUDY OF AMENFIMAN RURAL BANK-THREE BRANCHES.

CHAPTER ONE GENERAL INTRODUCTION

1.0 INTRODUCTION The banking industry tends to be the lifeline of any developed and developing economy. The industry is one of the most important financial pillars of the financial system which plays a vital role in the success or failure of an economy or an economic unit such as agriculture and small scale businesses. The banking system is the fuel or injection system that spurs economic efficiency by mobilizing savings and allocating them to high return investment. However due to perceived high credit risk associated with agriculture and small scale businesses which are the main economic activities in rural communities, such economic units were starved of credit facilities for fear of incurring bad debts. According to ASIEDU-Mante (2011), financial intermediation in the 1970s was at a very low level in rural areas as compared to the situation in the urban areas. As a result, economic units in the rural areas were starved of financial resources due to the perceived high risk. Therefore, the traditional/ commercial banks which operated branches in the rural areas served largely the interest of large and medium size businesses and resource based companies. The banks were reluctant to modify their operations to suit the needs of the small scale farmers/fishermen and petty traders. A quick look at the landscape of customers in the rural areas and their needs highlights why rural dwellers were perceived to be high risk borrowers. The population is spread out across the countryside and so is more dispersed and harder to reach. In general, income levels are lower in rural areas than in urban areas. And
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agriculture, which is influenced by crop cycles, weather, and natural disasters, is typically the primary basis of customers income and deposits, their collateral for loans, and their ability to repay (Booz & Company). This necessitated the establishment of rural banks to provide banking services to the rural population, providing credit to small scale farmers and businesses and supporting development projects. The first rural bank was established in Agona Nyakrom in the Central region in 1976.

1.1

BACKGROUND

According to Nimal Fernando A (2008) credit risk is the risk to earnings or capital due to borrowers late and non payment of loan obligations. Credit risk includes both transaction risk and portfolio risk. Transaction risk is referred to the risk in individual loan while portfolio risk is referred to the risk inherent in the composition of the overall loan portfolio. On the other hand, credit risk management is the process that identifies loss exposures involved in lending and selection of the appropriate measures to curb or at least minimize credit default. Credit risk management is a very important area for the banking sectors particularly the rural/ community banks and there are wide prospects of growth. The banks have to maintain a balance between the risks and the returns because a large customer base banks need to have a variety of loan products. Should a bank lower the interest rates for the loans it offers, it tends to suffer. In terms of equity, a bank must have substantial amount of capital on its reserve, but not too much that it misses the investment revenue, and not too little that it leads itself to financial instability and to the of regulatory non-compliance. Credit risk management is risk assessment that comes in an investment. Risk often comes in investing and in the allocation of capital. The risk must be assessed so as to
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derive a sound investment decision. And decision should be made by balancing the risks and returns. Giving loans is a risky affair for bank sometimes and certain risks may also come when banks offer securities and other forms of investments. The risk of losses that result in the default of payment of the debtors is a kind of risk that must be expected. A bank has to keep substantial amount of capital to protect its solvency and to maintain its economic stability. The greater the bank is exposed to risks, the greater the amount of capital must be when it comes to its reserves, so as to maintain its solvency and stability. Credit risk management must play its role then to help banks be in compliance with Bassel II Accord and other regulatory bodies. For assessing the risk, banks should plan certain estimates, conduct monitoring, and and portfolio analysis in order to determine risk involved. Banks must be active in managing the risks in various securities and derivatives. Still progress has to be made for analyzing the credits and determining the probability of defaults and risks of losses. Hence, credit risk management becomes a very important tool for the survival of banks. Amenfiman Rural Bank being a lender faces a lot of credit risks which have to be properly identified, assessed and managed 1.2 Problem statement.

Rural banks are primarily set up to help local rural economies with credit facilities. Rural banks normally cater for rural borrowers comprising farmers, small and micro wage earners and low income salaried employees. With this type of clientele, credit risk could be high. Judging from the financial statement of Amenfiman Rural Bank, it is realized that the major challenge facing the bank is high default rate. Peterson (1998) declared in his research findings that the heart of any credit financing system lies in the ability of both lenders and borrowers to assess credit risk. Therefore, the
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study was undertaken to know the techniques that are applied in Amenfiman Rural Bank and its branches for appraisal of credit and reduce the risk of default.

1.2

OBJECTIVES OF STUDY The overall objective of this study was to review and analyze the credit risk management of rural banks using Amenfiman Rural Bank as a case study. The research was also determined to find out whether the credit risk management practices are effectively followed to minimize default. Using the specific, measurable, achievable and timely (SMAT) approach, the study was focused on the following objectives. Understanding credit risk management concept. Making a depth study of the method in which the individual branches of the bank go about credit management Studying the difference between retail credit risk management and corporate credit risk management practiced by Amenfiman Rural Bank Understanding the importance of the credit risk management and how useful it is to the bank and how it benefits them (branches) in various ways.

1.4

Justification

Amenfiman Rural Bank was set up in a rural community to mobilize savings from depositors and to lend them to borrowers at a profit in the form of interest. In general, income levels are relatively low in rural communities. Agriculture, which is influenced by crop cycles, weather, and natural disasters, is typically the primary basis of customers income and deposits, their collateral for loans, and their ability to repay. Further, the nature of landownership rights and land distribution is critical to determining what collateral can be offered and what recourse the bank has if customers default. These factors may cause the bank to operate at higher cost,
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lower revenues and higher risk if effective and efficient credit risk management techniques are not put in place to bring the obvious credit default to the barest minimum since the bank can not afford to decline to extend credit to agricultural operators (high risk borrowers) as they form the buck of the banks customers. Hence, the need to research into the credit risk management practices of the bank, identify the challenges of credit risk management and to recommend reasonable measures that will reduce the banks operating cost, increase revenue and reduce risks associated with lending. This study will go a long way to ensure solvency of Amenfiman Rural Bank, earn much to pay reasonable dividend to shareholders, continue to contribute significantly to the economy of Wassa Amenfi traditional area and other areas where the bank operates. Finally, the study seeks to add to the growing literature on prudent financial management of rural banks in general.

1.5 1.6

Limitation Organization of study

The study is divided into five chapters. Each chapter has sub sections. Chapter one is the general introduction, it briefly discusses the introduction, statement of the problem, provides the objectives of the study, methodology, scope and then the organization of the study. Chapter two comprises the review of literature on challenges of credit risk management. This is made up of a review of available literature on the subject both in Ghana and other countries. Chapter three presents the research methodology and the organizational profile of Amenfiman Rural Bank. Chapter four takes care of analysis of empirical research findings while chapter five presents summary of the findings, conclusion and recommendations. Appendix follows with sample questionnaire.