This chapter attempts to review the relevant literature on rural banks and its loan recovery strategies. The literature review covers areas such as: emergence and evolution of rural and community banks in Ghana; the legal, regulatory, and supervision framework governing rural banks in Ghana, Services provided by Rural Community Banks in Ghana.; credit risk; causes of problem loans; granting credit; credit analysis; methods used to measure credit quality; credit collection policy; functions of the credit risk management departments of banks.
EMERGENCE AND EVOLUTION OF RURAL AND COMMUNITY BANKS (RCBs)
Rural Banks started to operate in Ghana in 1976. Before the establishment of Rural and Community Banks in Ghana availability of formal credit or loans in rural communities for small farmers, fishermen and small scale enterprises was extremely limited. The main sources of financial credit or funding were moneylenders, friends/family and traders charging exorbitant interest rates. The Government of Ghana formulated some policy measures to improve access to financial credit in rural areas. These measures included a requirement that commercial banks lend at least 20 percent of their portfolio for agricultural uses. The establishment of the Agricultural Development Bank (ADB) in 1965 was exclusively mandated to lend loans to agriculture and allied industries in rural areas of Ghana. Subsequently, commercial banks and the ADB opened branches in rural areas, with an emphasis on cocoa-growing rural areas. However, lending to these rural areas remained low; the commercial banks used their rural branches primarily to make payments to cocoa farmers and collect deposits for lending in urban areas. Other banking services, like credit, were not provided as initially envisioned. Commercial banks demanded higher deposit accounts and stronger collateral requirements to provide loans to rural areas. Many small farmers, fishermen and agro-based business did not have deposit accounts in commercial banks, and the collateral they had available was not satisfactory for commercial lending (Andah and Steel 2003). Mensah (1993) and Ranade (1994) found that the ADB’s credit provision and coverage were limited. Only 27 percent of its branches were in rural areas, and lending to smallholder farmers made up only about 15 percent of its total portfolio. In view of this situation, the Government of Ghana (GoG) considered supporting the establishment of community banks in rural areas that would be dedicated to providing financial services in those areas.
THE LEGAL, REGULATORY, AND SUPERVISION FRAMEWORK GOVERNING RCBs
Under the Banking Act, the BoG has overall regulatory and supervisory authority in all matters related to banking institutions in Ghana. According to Andah, and Steel (2003), Rural and Community Banks are incorporated as limited liability companies and licensed by the BoG within the framework of the Banking Act. In 2008 there were 127 rural banks licensed and supervised by BoG. The statutory role of the BoG in the operation of rural banks includes the licensing of new banks, supervision, and liquidation. The capital requirements for all financial institutions in Ghana were increased in 2007. The other local commercial banks were given until 2012 and foreign-owned ones until 2009 to meet the new minimum level of capital (GHc 60 million, or US$46.4 million), but RCBs have not been given a specific date to achieve the minimum capital level of GHc 150,000 (US$116,135) Government of Ghana. (2007). RCBs whose capital falls below the stipulated minimum of GHc 150,000 will not, however, be allowed to pay dividends or open new branches or agencies until they attain the minimum level of capitalization. RCBs must maintain primary and secondary liquidity reserve requirements to mitigate liquidity risk. As a primary liquidity reserve ratio, rural banks are required to maintain 8 percent of their deposits with the BoG and 5 percent of their deposits with the ARB Apex Bank. As a secondary liquidity reserve, rural banks are required to maintain 30 percent of their deposits as liquid investments such as BoG bonds.
The BoG supervises rural banks through its Banking Supervision Department (BSD). The BSD supervises operations of rural banks through on-site and off-site inspection, issuance of administrative directives, and attendance of rural bank annual general meetings. Rural banks are required to submit monthly, quarterly, and annual returns on a variety of financial and nonfinancial indicators (Box 2.2 shows the key returns filed by rural banks). The BoG can penalize rural banks for non-submission, incomplete submission, delayed submission, or inaccurate submission of any of these returns. The BoG is expected to conduct an on-site evaluation of rural banks at least annually. Annual on-site supervision takes about five days in each rural bank. The on-site supervision reviews various aspects of a bank’s operations, including books, records, and use of fixed assets. During these visits, BoG supervisors also check physical cash, inspect the cash storage security system, verify compliance with the liquidity reserve ratio, check insurance policies, and examine customer turnaround time. The examination is carried out without prior notice to the rural banks. In the course of the evaluation, inspectors may also interview staff, clients, and directors as necessary. The output of the evaluation is a report followed by a directive outlining actions that the bank must implement. Based on the annual returns filed by rural banks and on-site inspections, BoG categorizes rural banks as satisfactory or mediocre. The key performance indicators used to arrive at this classification are paid-up capital, net worth, the capital adequacy ratio, loans and advances, investments, liquidity, deposits, and total assets. The BoG can revoke the license given to a rural bank if the capital base of the bank is signifi cantly eroded and liabilities exceed assets unless the shareholders are able to inject additional capital to restore the bank to normal operation within six months of the capital erosion. Effective supervision of rural banks by the BoG is made difficult by the large number of rural banks spread over a large geographical area. Because of manpower constraints, the BoG has been unable to conduct regular on-site examinations of all rural banks annually. As a result, some poorly performing banks that need these on-site examinations the most do not receive them. Until recently, RCBs were required only to submit paper-based returns, and this situation often meant poor data quality because of missing data or data errors. To improve the quality of supervision and monitoring, the BoG recently introduced an electronic Financial Analysis and Surveillance System (e-FASS) system that requires rural banks to send their periodic returns electronically (Government of Ghana. 2002; 2004; 2006; Apex, 2008;).
As financial intermediaries, rural banks provide primary services consisting of savings, loans, and payments. Several products are offered within each of these categories. Given the community-owned nature of these institutions, they also generally support community development services. As financial institutions actively supported by the government, RCBs offer special products and services for specific target groups on behalf of government- and donor-financed programs, such as Microfinance and Small Loan Center (MASLOC), the Social Investment Fund, the Community Based Rural Development Project, and the Millennium Development Authority. The rural banks use a variety of techniques to promote their services and products, including traditional outreach by bank staff and use of electronic and print media. For example, some banks use local FM radio to promote their products (particularly microfinance) and broadcast information about services available. This approach has been successful in reaching many clients in remote parts of the operational area. Several social occasions such as funerals have been used to disseminate important information such as repayment reminders (Rural and community banks. 2000–08).
Rural banks offer all the general savings products such as the regular savings accounts, current accounts, and time deposits. Typically, the largest share of the deposit portfolio in a rural bank is held in the savings account. Interest rates offered on these accounts are typically very low, however, and often negative when inflation is taken into account. In 2008 in the sample banks, interest rates on savings deposits varied from 5 to 16 percent, while inflation ranged between 11 and 18 percent. Further, interest on savings accounts is often provided only when the savings balances are more than a specified amount. Unlike in most commercial banks, however, rural banks do not require high minimum balances to maintain a savings account and do not charge a high ledger fee. A unique deposit offered by rural banks is their susu deposits. These deposits are daily or weekly savings deposits that are collected by susu collectors, who are either rural bank employees or agents paid on a commission basis. This deposit and deposit collection technology builds on the traditional system of susu collectors in Ghana. Susu collectors mobilize daily deposits by visiting individuals at their houses and business premises. A susu collector has a schedule and an agreed savings plan with a client and collects the amount of deposit according to the agreed plan. One susu collector visits up to 300 clients per day (Box 3.1). Most of the susu collectors are men, whereas a majority of the participants are women. Safety is an area of concern since the women physically carry money with them. Typically, no interest is paid on susu deposits, and depositors pay a fee for the service. Banks use different savings mobilization methodologies. Many banks use the susu approach. Some banks use deposit mobilization centers, which operate in the market on market days. Some rural banks also offer special deposit products that target specific target groups such as small traders and fishmongers, or purposes such as children’s education.
According to Rural and community banks (2008) the major credit products offered by the rural banks include microfinance loans, personal loans, commercial loans, salary loans, susu loans, overdrafts, and others. Microfinance loans and susu loans are the two special loan products that most directly benefit the low-income population. A significant portion of the salary loans, however, would also be considered microloans in the Ghanaian context. Consequently, the microcredit portfolio of rural banks is larger than the sum of the microfinance and susu loan portfolios. Most banks are using a “credit with education” approach adapted from Freedom from Hunger to deliver microfinance credit products. In this approach, banks educate and sensitize members of microfinance groups for about six weeks before disbursing the loan. First, members of microfinance groups participate in a financial education program on basic bookkeeping and preparation of business proposals for credit. Then, credit officers assess the readiness of the group members before releasing funds. This methodology is intended to reduce credit risk caused by clients’ inability to manage and use loans in a productive way that allows for repayment. The training is provided by microfinance officers, and some RCBs outsource training to NGOs. The training typically includes education on savings; the purpose of group formation; group management; good business practices; and bookkeeping. In addition to the financial education, clients also receive education on health and nutrition. The group is required to collect compulsory savings during the six-week training period to cultivate the habit of saving and managing funds. Following the satisfactory completion of the training and compulsory savings, the group is eligible to obtain formal credit from the bank. The bank requires 10–20 percent of the compulsory savings as collateral and a group guarantee of the loan. The salary-loans are given out to salaried workers such as teachers, nurses and mostly civil servants in the community. Their salaries at the end of each month serve as a guarantee for repayment. Most of these clients should have their salaried through these banks so that guarantee for payment is assured. Deductions are made every month from the salaries of these clients. With this form of loans, the credit risk is mostly very low as rural banks have assess to credit given at the end of each month (Rural and community banks ,2008).
Rural banks offer both domestic and international money transfer payments. Both these services are managed across the network by the ARB Apex Bank. Domestic transfer payments are offered through Apex Link, a domestic transfer system, set in place in 2003. Both inward and outward money transfer services are available at all 455 outlets of the rural bank network. Apex Link also allows for money transfer to and from other commercial banks and selected nonbanks in Ghana. International money transfers are offered through partnership agreements between the ARB Apex Bank and several major international money transfer companies such as Western Union, Vigo, and Money Gram. In 2008, rural banks facilitated 128,875 domestic money transfers worth about GHc 63.3 million (US$48.8 million) and 32,392 international money transfers worth GHc 9.3 million (US$7.1 million) (Agwe, & Kloeppinger-Todd. 2008; Rural and Community banks. 2000–08). Both the domestic and international money transfer services are provided by rural banks through a fee-sharing agreement with the Apex Bank. The Apex Bank is responsible for negotiating the fee-sharing arrangements with the external institutions—banks within Ghana for domestic transfers and international money transfer companies.
Payment services are a key service provided by rural banks. Rural banks provide this service through the Apex Bank, which is a member of the national clearinghouse. The introduction of MICR checks in 2002 gave rural banks’ cheques the same legitimacy as cheques issued by other financial organizations. Before the introduction of MICR cheques guaranteed by the Apex Bank, many institutions and commercial establishments refused to accept rural bank cheques. With the introduction of the cheques -clearing system in 2002, the number of cheques for clearing grew by an average of 43 percent a year. Because of their location and network of branches, rural banks are used by the central and local governments and private companies to make salary and pension payments to their employees in rural areas. The salary payment system in particular enabled the rural banks to consolidate their salary loan products that are closely tied with the salary transfers. Licensed buying companies (LBCs) also use rural banks to pay cocoa-producing farmers in their catchment areas. In 2008, rural banks facilitated GHc 68.8 million (US$56 million) in payments to cocoa farmers and earned about GHc 2.75 million (US$2.1 million) in commissions (Ajai Nair & Azeb Fissha, 2010; Rural and community banks (2008).
Many rural banks support social development activities in the communities where they operate as part of their social responsibility to their communities. Activities generally supported include financing of infrastructure such as school buildings, community libraries, and community roads, as well as scholarships for girls and medical students. These activities also help RCBs gain acceptance in their communities as a locally owned financial institution rooted in the community (Ajai Nair & Azeb Fissha, 2010).
LENDING TECHNOLOGY AND CREDIT-RISK MANAGEMENT
Taking credit risk is part and parcel of financial intermediation. Yet, the effective management of credit risk by financial intermediaries is critical to institutional viability and sustained growth. Failure to control risks, especially credit risk, can lead to insolvency. However, too often, the mere perception of high credit risk can dissuade financial intermediaries from entering a particular market segment when a large contributing factor to that perception may be lack of adequate credit risk evaluation and management techniques. This seems to be the case with rural finance, especially lending to small- and medium-scale agricultural producers and if financial institutions do enter rural areas, they tend to limit exposure to agricultural finance and to favour clients with established credit histories and significant collateral. As a result, a relatively small number of financial intermediaries have a presence in rural markets and an even smaller number have significant agricultural lending portfolios. This limited presence of financial intermediaries in rural areas and the bias against agricultural lending creates access and segmentation problems.
Appropriate lending technology and credit risk management are among the most important factors in the sustainability of a lending institution. The tasks involve identifying creditworthy borrowers, appraising and approving loan applications in a timely manner, managing credit portfolios so that revenue is maximized and delinquencies minimized, and taking appropriate action in case of delinquency (Ajai Nair & Azeb Fissha, 2010). This management has generally been a weak area in rural banks, with the result that the percentage of nonperforming loans has generally been higher than that in other financial institutions in the rural financial sector in Ghana.
As in other lending institutions, lending in rural banks is typically guided by credit manuals and credit policies approved by the boards. Some banks follow standardized credit appraisal procedures. Loans are assessed by credit officers and project officers.
The assessment techniques vary by product. For individual loans, the creditworthiness of the borrower is assessed on the basis of the individual’s character, the purpose of the loan, and the credit history of the individual with the bank. The level at which credit decisions are made also varies from bank to bank and has changed over time. In some banks, all credit decisions are made by credit committees in the head office or by the board. In others, smaller loans are approved by branch-level credit committees. According to Apex, 2008 and Government of Ghana (2006; 2007) until late 2008, loans equivalent to and greater than GHc 2000 (US$1,542) were required to be submitted for review and approval by the BoG.
Loans to members of boards of directors, regardless of their size, are appraised and approved by BoG. With this exception, boards of directors can approve all loans amounts less than 25 percent of the net worth of the bank. Loan amounts greater than 25 percent of the net worth of the bank must be approved by BoG. RCBs also use group lending and guarantees by salaried individuals to reduce credit risk. The use of insurance, asset collateral, and other financial risk management tools is not common in the rural banks. Microfinance groups have monthly savings that are separate from the group loan account that will be used to repay the loan in case of default. Additionally, the banks hold a certain percentage of all loans as security. For microfinance loans, individual savings of group members are used as security. Boards of RCBs are increasingly involved in cases of delinquency, and this has reportedly improved loan recovery. In cases of delinquency, the bank management usually notifi es the board. The board and the credit officer follow up with the client. Board members may also visit the client at his or her household or business. If a loan is delinquent for three months, a demand notice is sent to the client and the case is transferred to the bank’s lawyer. In some cases, village chiefs are also involved in persuading the borrower to repay the loan. In case of lending to individuals via a group, the group chairperson, the treasurer, and other group members work together to recover the loan from the individual. In some cases, groups have paid the amount due from their group savings (Government of Ghana; 2006; 2007)
Internal Controls or Operational Risk Management
RCBs have operational manuals that stipulate managerial and administrative policies and procedures. All banks are required to have internal auditors, who are responsible for internal controls. Internal auditors are expected to be autonomous from the management and report to the audit committee of the board. The internal auditor is responsible for:
- instituting internal control measures within a bank;
- ensuring that transactions of the bank are undertaken according to the general regulations and operational manual of the bank;
- examining records to ascertain their originality and minimize fraud;
- ensuring that risks are identified, prioritized, and reported;
- monitoring the credit cycle from appraisal to disbursement, ensuring the integrity of the process, and advising management on any change required; and, investigating and reporting on any irregularity in financial management.
At the beginning of every year, internal auditors prepare an audit plan. The plan consists of full inspection activities; snap checks; follow-ups on previous recommendations; special investigations in case of staff problems; and other duties assigned by the board. A full inspection looks at all operations of an agency, including cash accounts, current accounts, savings accounts, cocoa purchase accounts, interagency operations, and others. Additionally, sample credit applications are reviewed. The internal auditor assesses whether the bank is properly following credit appraisal procedures and whether the quality of the assessment process meets the bank’s requirements. Loan disbursement processes are also examined against the required operational procedures. The process includes checking whether the proper interest rate has been applied. A schedule is prepared for each agency, and inspection visits are made without prior notification to the agency.
Managing credit risk
In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively losses may result from reduction in portfolio value due to actual or perceived deterioration in credit quality. Credit risk emanates from a bank’s dealing with individuals, corporate, financial institutions or a sovereign. For most banks, loans are the largest and most obvious source of credit risk; however, credit risk could stem from activities both on and off balance sheet Bhattacharya (1996).
Bhattacharya (1996) also wrote that direct accounting loss, credit risk should be viewed in the context of economic exposures. This encompasses opportunity costs, transaction costs and expenses associated with a non-performing asset over and above the accounting loss. Credit risk can be further sub-categorized on the basis of reasons of default.
Components of credit risk management
A typical Credit risk management framework in a financial institution may be broadly categorized into following main components (Van Greuning, Brajovic Bratanovic. 2003.
a) Board and senior Management’s Oversight
b) Organizational structure
c) Systems and procedures for identification, acceptance, measurement, monitoring and control risks.
Board and Senior Management’s Oversight
According to them, it is the overall responsibility of bank’s Board to approve bank’s credit risk strategy and significant policies relating to credit risk and its management which should be based on the bank’s overall business strategy. To keep it current, the overall strategy has to be reviewed by the board, preferably annually. The responsibilities of the Board with regard to credit risk management shall, interalia, include:
a) Delineate bank’s overall risk tolerance in relation to credit risk
b) Ensure that bank’s overall credit risk exposure is maintained at prudent levels and consistent with the available capital
c) Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function
d) Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of credit risk.
e) Ensure that appropriate plans and procedures for credit risk management are in place.
The very first purpose of bank’s credit strategy is to determine the risk appetite of the bank. Once it is determined the bank could develop a plan to optimize return while keeping credit risk within predetermined limits. The bank’s credit risk strategy thus should spell out
a) The institution’s plan to grant credit based on various client segments and products, economic sectors, geographical location, currency and maturity
b) Target market within each lending segment, preferred level of diversification/concentration.
c) Pricing strategy.
It is essential that banks give due consideration to their target market while devising credit risk strategy. The credit procedures should aim to obtain an indepth understanding of the bank’s clients, their credentials & their businesses in order to fully know their customers. The strategy should provide continuity in approach and take into account cyclic aspect of country’s economy and the resulting shifts in composition and quality of overall credit portfolio. While the strategy would be reviewed periodically and amended, as deemed necessary, it should be viable in long term and through various economic cycles. The senior management of the bank 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
Detailed and formalized credit evaluation/ appraisal process.
Credit approval authority at various hierarchy levels including authority for approving exceptions.
Risk identification, measurement, monitoring and control
Risk acceptance criteria
Credit origination and credit administration and loan documentation procedures
Roles and responsibilities of units/staff involved in origination and management of credit.
Guidelines on management of problem loans (Van Greuning, & Brajovic Bratanovic. 2003)
In order to be effective these policies must be clear and communicated down the line. Further any significant deviation/exception to these policies must be communicated to the top management/board and corrective measures should be taken. It is the responsibility of senior management to ensure effective implementation of these policies.
TYPICAL FUNCTIONS OF CREDIT RISK MANAGEMENT DEPARTMENT CRMD INCLUDE:
According to Caoutte, Altman & Narayanan (1998) to follow a holistic approach in management of risks inherent in banks portfolio and ensure the risks remain within the boundaries established by the Board or Credit Risk Management Committee the bank should institute a Credit Risk Management Department.
The department also ensures that business lines comply with risk parameters and prudential limits established by the Board or CRMC.
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.
The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio.
Systems and Procedures
Banks 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 bank must make an assessment of risk profile of the customer/transaction. This may include
- Credit assessment of the borrower’s industry, and macro economic factors.
- The purpose of credit and source of repayment.
- The track record / repayment history of borrower.
- Assess/evaluate the repayment capacity of the borrower.
- The Proposed terms and conditions and covenants.
- Adequacy and enforceability of collaterals.
- Approval from appropriate authority
In case of new relationships consideration should be given to the integrity and repute of the borrowers or counter party as well as its legal capacity to assume the liability. Prior to entering into any new credit relationship the banks must become familiar with the borrower or counter party and be confident that they are dealing with individual or organization of sound repute and credit worthiness. However, a bank must not grant credit simply on the basis of the fact that the borrower is perceived to be highly reputable i.e. name lending should be discouraged. While structuring credit facilities institutions should appraise the amount and timing of the cash flows as well as the financial position of the borrower and intended purpose of the funds. It is utmost important that due consideration should be given to the risk reward trade –off in granting a credit facility and credit should be priced to cover all embedded costs. Relevant terms and conditions should be laid down to protect the institution’s interest.
Institutions have to make sure that the credit is used for the purpose it was borrowed. Where the obligor has utilized funds for purposes not shown in the original proposal, institutions should take steps to determine the implications on creditworthiness. In case of corporate loans where borrower own group of companies such diligence becomes more important. Institutions should classify such connected companies and conduct credit assessment on consolidated/group basis. Institution should not over rely on collaterals / covenant. Although the importance of collaterals held against loan is beyond any doubt, yet these should be considered as a buffer providing protection in case of default, primary focus should be on obligor’s debt servicing ability and reputation in the market (Caoutte, Altman & Narayanan 1998).
An important element of credit risk management is to establish exposure limits for single borrowers and group of connected borrowers. Institutions are expected to develop their own limit structure while remaining within the exposure limits set. The size of the limits should be based on the credit strength of the obligor, genuine requirement of credit, economic conditions and the institution’s risk tolerance. Appropriate limits should be set for respective products and activities. Institutions may establish limits for a specific industry, economic sector or geographic regions to avoid concentration risk. Some times, the obligor may want to share its facility limits with its related companies. Institutions should review such arrangements and impose necessary limits if the transactions are frequent and significant Credit limits should be reviewed regularly at least annually or more frequently if obligor’s credit quality deteriorates. All requests of increase in credit limits should be substantiated.
Ongoing administration of the credit portfolio is an essential part of the credit process. Credit administration function is basically a back office activity that support and control