The Effect of credit risk management on loan portfolio quality: evidence from state-owned development finance institutions in Kenya

Abstract

Development Finance Institutions (DFIs) are crucial for economic growth by providing long-term funding, but they have been struggling with poor loan portfolio quality, threatening the sustainability of their financing operations. This study aimed to examine the impact of credit risk management on loan portfolio quality, focusing on loan and credit risk identification, credit risk control, moral hazard behavior, and loan size. An explanatory research design was used, incorporating primary data from semi-structured questionnaires. The sample included credit/investment officers and managers from selected state-owned DFIs, targeting nine respondents from each of the thirteen DFIs, and data analysis utilized descriptive statistics and logistic regression, with model data reduction via diagnostic tests. The findings uncovered that loan size had a positive and significant effect while moral hazard had a negative and significant effect on the loan portfolio quality in state owned DFIs. Credit risk identification and credit risk control were found to have an insignificant effect on loan portfolio quality of state-owned development finance institutions in Kenya. Additionally, DFIs that are regulated were also found to have better loan portfolio qualities compared to those that were not regulated by CBK. The study recommends that state-owned DFIs should increase loan amounts by mobilizing additional resources for lending, expanding collateral options, and building long-term relationships with responsible borrowers. It also advises mitigating financial losses from moral hazard behavior through robust credit risk assessment and mitigation processes, including thorough due diligence, borrower track record evaluation, and advanced risk assessment models. These measures will help financial policymakers and practitioners achieve growth and sustainability of DFIs, and ensure development finance practitioners remain accountable given their limited resources.