AN INVESTIGATION INTO HOW CREDIT RATING AFFECTS LOAN APPROVALS IN COMMERCIAL BANKS.

MARCH 2013

“A research project proposal submitted to the school of business and public management in partial fulfillment of the requirement for the award of the degree of bachelor if commerce finance option in KCA University.”

TABLE OF CONTENTS pages
DECLARATION 3
CHAPTER ONE 3
1.0 Introduction 3
1.1 Background 3
1.2 Statement of the problem 3
1.3 Research objectives 3
1.4 Research questions 3
1.5 Importance of the study 3
CHAPTER TWO: Literature review 3
2.0 Introduction 3
2.1 Literature review Error! Bookmark not defined.
2.2 Chapter summary 3
CHAPTER THREE: Research methodology 3
3.0 Introduction 3
3.1 Research Design 3
3.2 Population and sample 3
3.3 Data Collection Methods 3
3.4 Data Analysis 3
REFERENCES 3
APPENDIX ONE: Questionnaires Error! Bookmark not defined.
APPENDIX TWO: List of Kenyan Banks in the study 3

CHAPTER ONE
1.0 Introduction Credit rating has been defined in different ways: Admin (2008) defines it as the degree of credit worthiness assigned to an individual based on the credit history and financial status. Credit rating also assesses the credit worthiness of a country and corporation. It helps lenders or investors to know if the subject will be able to pay back a loan and can also be used to adjust the insurance premium, to determine employment eligibility. There are different ways in which the financial institutions can get information about an individual who wants a loan which include application form which gives information on an individual’s salary, family size, reasons for loan and also past dealings with the bank, the credit references agency files helps the bank to obtain information such as the court records, financial data, fines, medical history, any default in payments more than six years ago.
1.1 Background and setting Edward (2008) defines a Bank as a financial institution that provides a number of services to its customers like money deposit services, transfer of money from one person or business to another, lend money to individuals and business and other services like credit cards, personal loans, home and car loans, business loans etc. Benson (2006-2007) talks of banking industry in Kenya being governed by the company’s act, which is the Central Bank of Kenya act, which mainly regulates how the banks should carry out their activities. This sector was liberated in 1995 and they have an association called Kenyan bankers association that serves as a lobby for the banks interest and also addresses issues affecting the member institutions. This sector has grown since independence; he talks of the oldest foreign bank in Kenya being the Standard Chartered Bank which opened its branches in January 1911 with only two of them one at treasury square in Mombasa and the other in Kenyatta Avenue in Nairobi. 97 years later that is 2008 it has excellent franchise network with 28 branches across the country, automated teller machines and 1040 employees and has been in the NSE since 1989. There are a total of 43 banks with standard chartered bank, Kenya Commercial Bank and Barclays Bank being the three largest banks and many more other financial institutions that act like banks. Admin (2008) he defines Credit rating as the degree of credit worthiness of an individual, it is where the financial institutions determine if an individual who wants a loan is capable of paying back and thus it helps lenders to decide whether to give an individual a loan or not. Credit rating is a process which is made up of the following information, historical data on loan, Credit vehicles, credit cards and banks even check how many times credit rating has been checked. All these information is then entered into a computer and Bank having different scaling agencies called credit bureau which are companies that award credit scores of an individual credit worthiness, use this to rate you by getting your score, he gives an example of a credit rating agency called FICO which has its score between 300-850 points where a score of 650 and above indicates a very good credit history and a score below 620 may prevent a borrower from getting the best rates as high interest have to be charged to cover for the risk but it does not mean that he won’t get a loan. Another credit rating agency he talks about is one in Canada where they use North American Standard account ratings also called R rating which rate between R0 and R9 where
R0 is for new accounts
R1 is for bad debts
Credit rating considered very seriously in the developed countries like in the USA it is not easy to get a loan if you have poor credit rating. Tony (2008) says individual’s credit rating is seriously considered before being given a loan to extend that even if you go to the supermarket and you use your credit card and yet you have a poor credit history, Which they discover, from your credit card you may be denied access to the goods. There are also so many credit bureaus in the USA like the famous ones include Equifax. Experian and Trans Union and also credit rating agencies like FICO, which was started by fair Isaac and is used to get the credit score of an individual it ranges from 300-850. All these information will tell lenders whether to give an individual loan or tell you to get out. The credit rating history in Kenya is less researched on, According to Maseme and Benson (2008) they talk of KCB bank introduced a system where loan is approved within 24hrs, They also talk of three banks Trade bank, Daima bank and Trust bank collapsing in the mid eighties and early nineties with billions of investor’s money due to poor credit assessment and also they say that people with poor credit rating still get loans and that introduction of credit bureaus in Kenya will benefit borrowers with good repayment records as they will be given cheaper credit as the credit bureaus will keep the records to allow lenders access them, and this will allow banks to assess borrowers generally rather than individually like the banks do as information will be shared with them from the credit bureaus.
1.2 Statement of the problem According to Beattie (2008) credit rating is a major effect in a person’s life when you want a loan and he goes ahead and gives an example of credit rating agency used in the USA that has a score of 300-500 and that the average score of an American is 650-750. He mainly concentrates with the developed countries banks and other financial institutions and now this study will look at Kenyan banks if really they use credit rating to approval loan of individuals and also look at the credits rating systems used by the banks and if there is any other method of loan approval apart from the credit rating system.
1.3 Research objectives 1. To determine how credit rating does affect loan approval of an individual by the Kenyan banks. 2. To determine the credit rating systems used by the Kenyan banks to approve loans to individuals. 3. To identify if there is any other criteria of loan approval of an individual by the Kenyan banks if they are not using credit rating.
1.4 Research questions 1. How does credit rating affect an individual’s loan approval by the banks in Kenya? 2. What is the credit rating systems used by the Kenyan banks? 3. What other ways do the Kenyan banks approve loans to individuals if not using credit rating?
1.5 Importance of the study This study is aimed at identifying effects of credit rating on an individual’s loan approval by banks, credit rating systems used and other methods of loan approval used apart from credit rating. This will help the banks to avoid bad loans as they will know how to deal with borrowers with a bad credit rating. It is also beneficial to the borrowers as they will know how to manage their credit history so as to avoid problems in future of borrowing and will also benefit them in that banks will also look at other methods of loan approval so as not to exclude majority as looking at only one factor for approval could exclude the majority. It also helps other researchers to develop their research from here.
Limitations of study
The study will examine credit rating on loan approvals in commercial banks .the research will be carried out in KCB and Standard chartered bank due to limiting factors that work to impair the study coming out a success. These limitations will include time and financial and time constraints.
Basics assumptions
The information used for credit rating is adequate and efficient.

CHAPTER TWO: Review of literature
2.0 Introduction This chapter mainly focuses on the credit ratings in banks it mainly looks at the previous researches done on the same and thus helps to compare and contrast what researchers say about the credit ratings on the loan approval of individuals by banks and thus helps to identify the gap to be filled. Banks determine the credit rating of individuals so as to know if they are capable of paying the loan back and also to determine the interest rate to charge the customer according to the risk of paying back the loan. Beattie (2008) says that credit rating is considered a major effect in a person’s life, Be it a car loan or business loan and the credit score that lenders put on you when you ask for a loan will determine if they give you an easy ride or tell you to go away and no one can help you get a loan but your credit rating only. He talks of credit rating having different anatomy but the most common is the historical data on your previous loans and credit vehicles, different agency having different scores like FICO which is most commonly used in the USA has a score between 300-850 and that a score of 850 is non existent and below 400 is rare, and that the average score of an America is 650-750.
2.1 Credit rating According to Wilcox (2007) each country has its own credit rating and credit score like in Australia: credit scoring is widely accepted as the primary credibility is assessed. Credit scoring is also used to determine whether credit should be approved to an applicant, but credit scoring is also used in the setting of credit limits on credit cards or store cards, in behavioral modeling such as collection scoring and also in the pre approval of additional credit to company’s existing client base. He says the system of credit reports and scores in Canada is very similar to that in the United States, with the same three reporting agencies active in the country: Equifax, TransUnion and North Credit Bureaus (an Experian company). There are however some key differences. One such difference is that, unlike the United States, where a consumer is allowed only one free copy of their credit report a year. In Canada, the consumer may order a free copy of their credit report any number of times in a year as long as the request is made in writing and as long as the consumer asks for a printed copy to be delivered by mail. He also talks of credit rating in Sweden; he says that the system for credit score aims to find people with bad payment attitude. It has only two levels, good and bad. Anyone who does not pay a requested debt payment on time, and also not after a reminder, will have their case forwarded to Swedish Enforcement Administration, a nation authority who collects debts. The appearance of a person or accompany as a debtor in this authority will render a mark among private credit bureaus. This mark is called payment remark and can according to the law be stored for three years. Such a mark will make it very difficult to get a loan, a rental apartment, a telephone subscription or a job with cash handling. He talks of banks using income and asset figures in connection with loan assessment. He goes ahead to talk of credit rating in USA as a number based on a statistical analysis of a persons credit file, which represent the creditworthiness of that person, which is the likelihood that the person will pay their bills. A credit score is primarily based on credit reports information, typically from one of three major credit bureaus: Experian, Trans Union, and Equifax. There are different methods of calculating credit scores. FICO is accrediting score developed by Fair Isaac Corporation. Many mortgage lenders that use a risk – based system to determine the possibility that the borrower may default on financial obligations to the mortgage lender use it. The credit bureaus all have their own credit scores: Equifax’s score Power, Experian’s PLUS score, and Tran’s union credit score, and each also sells the vantage score credit score. Americans are entitled to one free credit report within a 12month period from each of the three agencies. The three credit bureaus run Annualcreditreport.com where users can get their free credit report, normally without credit scores. Credit scores are available as an add-on feature of the report, for a fee. In some states, such as California and Colorado, a consumer is entitled to a free credit report within 30days of being denied credit or receiving sub-normal credit terms from a lender, due to their rating. The FICO credit score ranges between 300 and 850. The vantage score ranges from 501-990.
2.2 Credit rating systems According to (Isaac, 1958) basing his argument on USA loans can be applied online no matter your credit rating history, it is an instant approval you apply today and the next day you have your cash. He says that one has to go to at the cash Net USA and save him the process of filling up loan forms and messing up around with the forms but you can just go to the website and apply and it’s available to all customers despite the credit history. Ducat (2008) talks of a bank determining one’s credit worthiness that is whether to give a loan or turn you down by looking at your credit score to determine if you make a good debtor. The score tells the bank whether there is any risk involved in lending you money. If you have a poor score it indicates that a greater risk, and that the bank will not get paid back the money lent out to you. On the other hand, a high credit score will tell the bank certainly will prefer to approve the loan, which would require them to take you to court or to pay a collection agency to recover their money-costly actions they will only take as a last resort. He goes ahead to talk of credit score determining your loan qualification and one’s financial life is an open book that is al the financial transactions can be determined from the record. Isaac (2001-2008), talks of FICO, which uses the three credit bureaus, Equifax, Experian, and Trans Union. He says each of these bureaus comes with a score and how the lender views you and is purchased and not valid after a period of 30 days and thus not accessible online after that period. According to (Isaac, 2008) the credit score is calculated to determine the credit worthiness of an individual, he talks of the FICO as fair Isaac Corporation determined most of the credit scores. He mainly concentrates on the US for example he gives the credit score among the US population in 2003 as follows.
Up to 499:1%
500 – 549:5%
550 – 599:7%
600 – 649:11%
650 – 699:16%
700 – 749:20%
750 – 799:29%
Over 800:11%

He also talks of three major credit rating agencies where the bank will get the credit reports and credit rates, which are transunion, Equifax and Experian. According to (Were, 2007) he talks of how credit rating is important in the financial markets, it says that Trade bank, Daima bank and Trust bank were once famous financial institutions but in the mid eighties and nineties they collapsed with billions of creditors money due to poor credit assessment.

2.3 Loan approvals Wilcox (2005) talks about how to improve your loan approval chances and mainly concentrates on Malaysia. The financial institutions look at the Debt Service Ratio (DSR). In Malaysia, a DSR is usually calculated as the percentage of total debt payments over income. Your debt service ratio represents your ability to service or handle your current debt. The lower your DSR percentage, the stronger a loan applicant you are. Acceptable DSR vary from lender to lender and can range from 30% to 60% with majority of financial institutions maintaining at 40% DSR. This does not mean that your loan will be approved if your DSR is below 40%. Financial Institutions also evaluate other factors such as your credit repayment track record and the favor ability of the collateral. However, a good DSR makes it more likely that you will get the loan, the sum you wish to borrow. Your DSR is usually evaluated in tandem with the strength of your collateral property, your credit repayment track record and other factors. If these factors are positive, financial institutions will look at your loan application more favorably if you have a good DSR. The benefit of being a strong loan applicant is firstly that you will be likely to get the home loan you want and your loan application will be processed in a shorter time frame than weaker applications. You may be able to also negotiate for better terms and conditions on the loan such as a slightly lower interest rate (or matching of an interest rate offered by another financial institution), fee waivers or for the bank to absorb some of the loan entry fees. Finally, maintaining a good DSR is good practice to ensure that you are not over burdened with debt obligations, you will be likely to meet you debt repayments as and when they fall due and therefore maintain a good credit rating. Ducat (2008) shows that a bad credit is a way of determining an individuals bad credit score before approving an auto loan, mortgage, or credit card request, financial institutions closely access an applicant’s credit report and determine whether they meet basic credit requirements. Some people make poor credit choices which affect their ability to get approved for future credit. A few financial institutions offer bad credit or “high risk” loans. Still, a bad credit rating typically results in a higher interest rate on car loans, and other types of loans. Furthermore, a low credit score can impact a person’s ability to obtain insurance or employment. He goes a head to talk about negative credit score resulting from late payments; skipped payments credit judgments, bankruptcy, repossessions, and foreclosures. Credit reports documents credit history. Likewise, credit mishaps remain on our reports for many years. Past mistakes can influence future credit, despite attempts to improve credit, while poor financial choices play a vital role in bad credit. Some people develop bad credit due to unavoidable circumstances such as loss of employment, sudden illness and other financial hardships. There are ways to increase a low credit score and many lenders offer bad credit loans as away to help sub prime borrowers improve their credit history.
2.4 Chapter summary There is much literature done on the effects of credit rating on loan approval of an individual by the banks and it is evidenced that most of the literature concentrate on the credit rating and its effect on the individual loan approval in the developed countries banks. For example Isaac (1958) talks about a credit rating agency called FICO, which was introduced by him in 1958, and mostly used by the USA and UK banks to get the scores of the individuals to determine if they are good or bad debtors. Other authors with the same idea as Isaac include Beattie, Ducat and Wilcox who also talk of FICO as the famous credit rating agency in USA and UK. Thus the gap to be filled is looking at if the Kenyan banks use the credit rating to approve loans being given to individuals and if there is any credit rating agency that they use.

CHAPTER THREE: Research methodology
3.0 Introduction In this chapter will discuss and explain how the data will be gathered and analyzed so as to answer the research questions and the research objectives. To attain all these four areas will be looked at that is research design, population and sampling, data collection methods and data analysis.
3.1 Research Design The design to be used is quantitative design. This is because in quantitative research the aim is to determine the relationship between one thing (an independent variable) and another (dependent or outcome variable) in population. Such designs are either descriptive study which establishes any association between variables or experimental which establishes causalities. This leads to the need to determine the relationship between credit rating in Kenyan banks and loan approval of individuals by the same.
3.2 Population and sample The target population to be considered is the Kenyan banks, which are a total of 43 commercial banks. Benson (2006-2009) for this study all the 43 banks will be looked at.
3.3 Data Collection Methods Primary data will be collected through questionnaires that will be dropped to the finance department of all the Kenyan banks to be filled by the finance manager and later picked after five days when they have been filled.
3.4 Data Analysis This is where the collected data is managed and examined so as to address the research questions. It involves verifying completeness of the collected data, its accuracy and if it is related to topic in question. Then a summary of presentation of the result and interpretation of the findings is done to finally come up with conclusions from them. The data collected is then analyzed through quantitative technique of percentages after editing and coding so as to make it simple for data interpretation. This also facilitates content analysis to analyze the data collected from the research. This will be done by looking at the different responses from the questionnaires and drawing relevant conclusions about the research questions according to the realized percentages.

REFERENCES 1 Admin, 2008, credit rating: what is credit rating, 15 April, viewed 4 March 2009, http://www.mysmp.com/bonds/credit-rating.html

2 Admin, 2007, what’s a credit score, e-journal article, http://ejournalarticles.com

3 Ayny, 2007, how can a bad credit score affect you, ecommerce journal, vol. 3, pp 4

4 Beattie, 2008, Understanding your credit rating: Learn how bad debt habits affect loan approval, 14 January, Viewed 13 September 2008, http://mortgagesloans.suite101.com/article.cfm/understanding_your_credit_rating

5 Beattie, 2008, Credit rating, last modified 25 February 2009, viewed 3 October 2008, http://en.wikipedia.org

6 Barrack, 1998, Alarm as top banks goes under (Kenya’s trust bank collapses), African business, IC publications ltd

7 Beck, 2004, journal of money, credit and banking, vol. 36, no 4, pp 5-6

8 Beck, 2004,structural issues in the Kenyan financial system: improving competition and access, world bank policy research, vol. 34, no 2, pp10

9 Benson, 2006-2009, Banking industry in Kenya, price water house coopers, viewed 20 February 2009, http://www.pwc.com

10 Cocheo, 1999, fair lending case, ABA banking journal, vol. 91

11 Ducat, 2008, Your credit report: what it says about you, viewed 20 July 2008, http://www.frbsf.org

12 Edward, 2008, what is a bank, journal of finance, vol. 205, pp 30

13 Germain,GP,1996, bank marketing, united states, history

14 Isaac, 2001-2008, meaning of FICO, viewed 14 October 2008, http://www.freeficoscore.com

15 Isaac, 2008, How credit scores work, how a score is calculated, International journal, vol. 20, pp 40

16 Michael, 2002, credit ratings: methodologies, rationale and default risk, ISBN: 1899332693, pp 20-22

17 Obringer, 1998, how credit scores work, viewed 20 July 2008, http://money.howstuffworks.com/personal-finance/debt-management/credit-score.htm

18 Richard,2008,credit risk management system of a commercial bank in Tanzania, International journal of emerging markets, vol.3, no. 3, pp 323-332

19 Tony ,2008, how does my credit score affect getting a mortgage loan, 5 July, viewed 11 October 2008, http://ezinearticles.com/?How-Does-My-Credit-Score-Affect-Getting-a-Mortgage-Loan?&id=1302018

20 Wilcox, 2008, Credit rating agency, journal of finance, vol. 180, pp56

APPENDIX TWO: List of Kenyan Banks in the study Africa development bank | Barclays Bank of Kenya | Standard Chartered Bank | NIC Bank | Kenya Commercial Bank | Equity Bank | City Bank | Diamond Trust Bank | Cooperative Bank | East African Development Bank | National Bank of Kenya | Trust Bank | Commercial Bank of Kenya | Trade Bank | CFC Bank | City Finance Bank | K-Rep Bank | Bank of Baroda | Akiba Bank | Development Bank | Africa banking corporation | Industrial Development Bank | Bank of Oman | Trade Bank | Bank of India | Central Bank of Kenya | Bank of Tokyo | Victoria Commercial Bank | Consolidated bank | Middle East BANK | Bankers Trust | Korea Exchange Bank | Biashara bank of Kenya | Panafrican Bank | City Finance bank | Family Bank | Continental Bank Of Africa | Prudential Bank | Delphis Bank | River Bank Estate | Euro Bank | Mashreq Bank | Habib Bank | |

AN INVESTIGATION INTO HOW CREDIT RATING AFFECTS LOAN APPROVALS IN COMMERCIAL BANKS.

LOISE NYAMBURA MAINA
11/01777

“A research project proposal submitted to the school of business and public management in partial fulfillment of the requirement for the award of the degree of bachelor if commerce finance option in KCA University.”