Effect of Credit Rating Practices on Loan Book Performance of Commercial Banks in Kenya

Abstract

Credit rating is an appraisal of the credit worthiness of an individual client, business entity or government agency. This assessment is made by a credit rating agency on the account holder's capacity to pay back a loan facility when it is due and the likely probability of default. Credit rating is one of the most critical procedures in banks and other financial institutions’ credit management decisions. There exists varying relationships between the credit rating practices and its effects on the loan book performance in commercial banks. The desired relationship between a good credit rating policy and the value of the loans is directly proportionate to each other such that the higher the application of a good credit rating method, the higher the amount of loans disbursed. The aim of this study was to establish the effects of credit rating practices on the loan book performance of commercial banks in Kenya. The project aimed to determine whether historical background of customers, capacity to pay loans, credit reference report for each customer, collateral for the loan and credit rationing influence the performance of the loan book in commercial banks of Kenya. The project used a cross-sectional survey design. This study aimed at collecting and analysing data on the credit rating variable and its impact on the loan book performance of commercial banks in Kenya. The population of the study comprised of all the 44 commercial banks in Kenya. Data was collected from both primary and secondary sources. The primary data was collected using a semi-structured questionnaire while secondary data was collected from the commercial banks annual reports. Primary data collected was mainly on the extent to which the commercial banks applied credit rating practices while the secondary data collected was on the loan book performance. The data was analyzed using a multivariate regression analysis with the help of SPSS version 21. The results indicated a positive relationship between credit rating practices and performance of the loan book in commercial banks of Kenya. The regression analysis revealed that all credit rating variables had positive impacted on the performance of the loan book of commercial banks in Kenya. The most influential variable was capacity to pay loan followed by credit reference report. Historical background, collateral for the loan and credit rationing were also considered important in credit risk assessment by the commercial banks. The study concluded that credit rating practices are a predictor of loan book performance of commercial banks in Kenya. The commercial banks use both relationship and statistical models of risk assessment and all managers are involved in credit decisions. The study concluded that commercial banks consider the historical background of borrowers, capacity to pay loan, credit reference report, collateral for the loan and credit rationing in assessment of the credit risk. The most important factors were capacity to pay loan and credit reference report. The study recommended that the management of commercial banks’ should emphasize use of credit rating practices to reduce on the loan default rate. The project further recommends that banks should provide unique credit products to their customers by becoming sensitive to the general prevailing economic conditions in order to achieve long-term sustainability since the customers play a key role in determining the success of the banks.