According to (Wikipedia, 2009) the financial crisis from 2007 to 2010 is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It was triggered by a liquidity shortfall in the United States banking system and has resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market has also suffered, resulting in numerous evictions, foreclosures and prolonged vacancies.

(Brunnermeier, 2009) states that “the bursting of the housing bubble, which peaked in 2006, as being the first major sign that the values of securities tied to U.S. real estate pricing would plummet and damage major financial institutions such as; Lehman Brothers, Merrill Lynch, AIG globally. Questions regarding bank solvency, declines in credit availability and damaged investor confidence had an impact on global stock markets, where securities suffered large losses during late 2008 and early 2009. Economies worldwide slowed during this period, as credit tightened and international trade declined and banks were forced to write down several hundred billion dollars in bad loans caused by mortgage delinquencies.”

Moreover, the Federal Reserve Bank feared a deflationary period after the bursting of the Internet bubble and thus did not counteract the buildup of the housing bubble. At the same time, the banking system underwent an important transformation.

Traditional banking model, in which the issuing banks hold loans until they are repaid, was replaced by the ‘originate and distribute’ banking model, in which loans are pooled, tranched, and then resold via securitization. The creation of new securities facilitated the large capital inflows from abroad. (Wikipedia, 2009). Mechanical phenomena (domino effects due to the linkages between many of these financial institutions), resulted in simultaneous spread worldwide to many financial and economic areas.”

“The heavy exposure of a number of EU countries to the US subprime problem was clearly revealed when BNP Paribas froze redemptions for three investment funds, citing its inability to value structured products. As a result, counterparty risk between banks increased dramatically, as reflected in soaring rates charged by banks to each other for short-term loans and the began to spread into the European markets, Asian and eventually African markets.” (Brunnermeier, 2009)

A study done by Samuel Mwega on the contagion effects of the global financial crisis with reference to Kenya indicates that some developing markets that had seen strong economic growth saw significant slowdowns. For example, growth forecasts in Cambodia showed a fall from more than 10% in 2007 to close to zero in 2009. This saw to a dramatic rise in the number of households living below the poverty line, be it 300,000 in Bangladesh or 230,000 in Ghana.

1The central bank of Kenya argues that Kenya is primarily a rural agro-based economy with only a small minority of the population such as tourism and commercially- oriented agriculture such as horticulture, tea and coffee directly interfacing with the developed world. Indirectly, foreign exchange volatility, cost and availability of inputs would be impacted.

“The worst hit sectors however, were the banking industry and stock markets. In terms of ownership structure, foreign banks comprise about a quarter of all banks in the country, with 11 foreign banks out of 42 commercial banks as of 2007.thus, foreign banks account for about 40% of commercial banks core capital.” (Mwega, 2010)

In the stock markets, Portfolio flows have been adversely affected, with foreign sales exceeding foreign buys in many counters, as foreign portfolio investors diversify from the market. Moreover, the NSE 20-share index has taken a hit since mid-2008 on the back of the post-election violence and the global financial crisis.

Generally, Kenya achieved only 3-4% growth in 2009, down from 7% in 2007. According to the research by the Overseas Development Institute, reductions in growth been attributed to falls in trade, commodity prices, investment and remittances sent from migrant workers (which reached a record $251 billion in 2007, but have fallen in many countries since.

“Hitherto, the financial industry has always been affected by unsystematic changes such as changes in the economic situation (uncertain interest rates, foreign exchange rates), political changes, social changes and systematic risk such as internal controls, corporate governance and information technology systems as well.” (Committee, 2000). Risk management has become a main topic for the financial institute especially since financial services is a business sector related to conditions of uncertainty. The financial sector is the most influenced by the volatile conditions of the financial crisis. Financial institutions are exposed to a large number of risks through their activities. In order to promote confidence amongst a financial institution’s stakeholders and shareholders, the institution must invest money into a risk management system and promote strong risk management within their organization.

Statement of the Problem

The Basel committee’s document on principles for the management of credit risk (2000) states that while financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counterparties.

2Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organization.

Critiques argue that the current credit crunch would have been predictable. Risk management practices had become so secretive that, in some banks, the back office had no idea what Value at Risk (potential losses) the front office was taking. Today’s banking sector has been described as “a demonstrably fragile financial system that has produced unimaginable wealth for some, while repeatedly risking a cascading breakdown of the system as a whole.” This is not how capital markets should operate. The worst banking crisis in history requires more than just a business as usual response; it requires a

Current concepts of credit risk management in financial institutions must now be revisited for purposes of creating the solid financial footing that will regenerate trust in the market. They need to create a new model for investment banking built on the four principles of; transparency, peering, sharing intellectual property, and acting global.

Credit risk management generally, requires top-level management support, acknowledgment that risk is a reality, and a commitment to identify and manage them. One discriminator of a successful organization is the use of credit risk management to anticipate potential negative conditions, problems, and realities. Ineffective projects are forced to react to problems; effective projects anticipate them. An organization will be much better once it moves away from reacting to change, and toward proactive anticipation and management of change. Formal credit risk management must be an integral part of the entire management structure and processes. In fact, it should be the program manager’s number one priority.

This study therefore intends to explore the critical success factors that if adhered to by banks in Kenya, would offer adequate support to the credit risk management procedures already put in place.

1.3. Research Questions

• What are the critical success factors for effective credit risk management procedures by banks in Kenya?
• What credit risk exposures do these banks face?
• Which credit risk management measures have been put in place?
• Are these measures put in place effective in controlling credit risk?

Research Objectives

• To establish the causes of credit risk among banks in Kenya.
• To identify the approaches used to measure credit risk by these banks.
• To find out the credit risk management measures put in place by these financial institutions (banks).
• To establish whether the measures adopted are effective in controlling credit risk.

Scope of the Study

To begin with, the study will only cover a handful of financial institutions especially those within Nairobi. It is not possible to cover all financial institutions in Kenya due to financial and time constraints

The beneficiaries of the study are financial lending institutions and in particular banks which are majorly exposed to credit risk. They will be able to identify the most critical factors for effective credit risk management. Moreover, regulators within the industry such as the central bank of Kenya and the insurance regulatory authority will be in a position to come up with better strategies for adoption by these financial institutions in order that they effectively manage credit risk.

Moreover, future scholars inte