LITERATURE AND CONCEPTUAL FRAMEWORK ON LOAN DEFAULT

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2.0 Introduction

Research studies have shown that effect of loan default on financial performance is practical and realistic (Karim et al, 2010). In this chapter, conceptual issues on loan default are well discussed. Relevant literatures on the effect of loan default on financial performance are also reviewed.

2.1 Conceptual Issues

2.1.1 LENDING

Lending has been defined by Biney (2006) as an amount of money provided by a lender and taken by a borrower, payable at some future date on specific terms and conditions and governed by legal contract. Ribeiro (2006) also defines lending as the offer of money to a person or entity with the expectation that repayment would be made with interest either by installments or in one amount by a specified date, where necessary a lender will protect himself, by asking the borrower to provide some collateral. Due to intense competition amongst financial institutions, some financial institutions do not take collateral in order to win clients to their banks.

According to Rouse (1989), lending is an art rather than science because it involves experience and common sense. This assertion to some extent is true. These two factors alone can perfect some aspect of lending, but not to its entirety. It is through science that lenders come out with accounting procedures, credits and risk’s analysis to assess customer’s ability to pay, regulatory framework among other factors. He explained that a lender lends money and does not give it away. There is therefore a judgment that on a particular future date repayment will take place. The lender needs to look into the future and ask whether the customer will repay by the agreed date. He indicated that there will always be some risk that the customer will be unable to repay, and it is in assessing this risk that the lender needs to demonstrate both skill and judgment.

Bank lending has been a major source of funding for most businesses. There is the need therefore for banks and other financial institutions to be careful in their loan administration to prevent the inherent risk associated with the product in order to maximize shareholders returns and enhance the image of the institution (Agyemang, 2010). Banks have over the years helped customers to augment capital for most businesses and make them financially strong to accelerate nation building. Anaman (2006) maintains that as much as banks’ lending help business to flourish, banks also have its fair share in the forms of fees and incomes to sustain its operations.

2.2 Loan Default

In finance default occurs when a debtor has not met his or her legal obligations according to the debt contract, example has not made a scheduled payment, or has violated a loan covenant (condition) of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt. This can occur with all debt obligations including bonds, mortgages, loans, and promissory notes. (Wikipedia, 2011)

Loan default can be defined as the inability of a borrower to fulfil his or her loan obligation as at when due (Balogun and Alimi, 1990). High default rates in SMEs lending should be of major concern to policy makers in developing countries, because of its unintended negative impacts on SMEs financing. Von-Pischke (1980) states that some of the impacts associated with default include: the inability to recycle funds to other borrowers; unwillingness of other financial intermediaries to serve the needs of small borrowers; and the creation of distrust. As noted by Baku and Smith (1998), the costs of loan delinquencies would be felt by both the lenders and the borrowers. The lender has costs in delinquency situations, including lost interest, opportunity cost of principal, legal fees and related costs. For the borrower, the decision to default is a trade-off between the penalties in lost reputation from default versus the opportunity cost of forgoing investments due to working out the current loan.

2.2.1 DETERMINANTS OF LOAN DEFAULT

Berger and De Young (1997) identified poor management as one of the major causes of problem loans. They argue that managers in most banks with non-performing loans do not practice adequate loan underwriting, monitoring and control. Rouse (1989) identifies that lack of good skills and judgment on the part of the lender is a possible cause of loan defaults. Bloem and Gorter (2001) point out that deficient bank management, poor supervision, over optimistic assessments of creditworthiness during economic booms, and moral hazard that result from generous government guarantees are some of the factors that lead to loan defaults.

Ahmad, (1997), mentioned some important factors that cause loan defaults which include; lack of willingness to pay loans coupled with diversion of funds by borrowers, willful negligence and improper appraisal by Credit Officers. In addition, Hurt and Fesolvalyi (1998), cited by Kwakwa, (2009) found that, corporate loan default increases as real gross domestic product decline, and that the exchange rate depreciation directly affects the repayment ability of borrowers. Balogun and Alimi (1988) also identified the major causes of loan default as loan shortages, delay in time of loan delivery, small farm size, high interest rate, age of farmers, poor supervision, non-profitability of farm enterprises and undue government intervention with the operations of government sponsored credit programmes.

A World Bank policy research working paper on Non-Performing Loans in Sub-Saharan Africa revealed that loan defaults are caused by adverse economic shocks coupled with high cost of capital and low interest margins (Fofack, 2005). Goldstein and Turner (1996) stated that ‘’the accumulation of non-performing loans is generally attributable to a number of factors, including economic downturns and macroeconomic volatility, terms of trade deterioration, high interest rate, excessive reliance on overly high-priced inter-bank borrowings, insider lending and moral hazard’’. Bloem and Gorter (2001) indicated that non-performing loans may rise considerably due to less predictable incidents such as the cost of petroleum products, prices of key export products, foreign exchange rates or interest rates change abruptly.

Moreover, Akinwumi and Ajayi (1990) found out that farm size, family size, scale of operation, family living expenses and exposure to sound management techniques were some of the factors that can influence the repayment capacity of farmers. According to Olomola (1999), loan disbursement lag and high interest rate can significantly increase borrowing transaction cost and can also adversely affect repayment performance.

Thomas (2000) emphasizes that education enhances the borrowers’ ability to repay. The better educated borrowers are deemed to have more stable and higher income employment and thus a lower default rate. Borrowers with high level of education are more likely to repay their loan since they occupy higher positions and with high income levels.

Boyle et al. (1992) confirm that older borrowers are more risk adverse, and therefore the less likely to default. Thus banks are more hesitant to lend to younger borrowers who are more risk averse. Arminger et al (1997) note that gender in addition to age is one of the most used socio-demographical variables to differentiate the predictive power between men and women. There is clear evidence that women default less frequently on loans possibly because they are more risk adverse. According to Coval and Shumway (2000) gender is a fair discriminatory base on the statistical default rates of men versus women. There are ample evidences that women default less frequently on loans because women are more risk adverse. According to Dinh and Kleimeir (2007), marital status affects the borrower’s level of responsibility, reliability, or maturity. The probability of default is higher for married than single borrowers. They discover that the marital status is typically related to number of dependents which in turn reflects financial pressure on the borrower and borrower’s ability to repay a loan.

It is because of these reasons that it has become necessary to identify the causes of these loan defaults in the Ghanaian banking environment, looking at the case of Fidelity Bank. This would form the basis for cogent recommendations to be made towards solving the problem.

2.2.2 MINIMIZING LOAN DEFAULT

2.2.2.1 Collateral

Stigliz and Weiss (1981) argue that banks’ requirement for collaterals when making loans reduces the adverse selection problem, which in turn leads to lower default rate. Aghion and Bolton (1992) also suggest that collaterals are effective tools to guarantee borrowers’ good behaviour.

2.2.2.2 Credit Securitization

According to Marsh (2008), credit securitization is the transfer of credit risk to a factor or insurance firm and this relieves the bank from monitoring the borrower and fear of the hazardous effect of classified assets. This approach insures the lending activity of banks. The growing popularity of credit risk securitization can be put down to the fact that banks typically use the instrument of securitization to diversify concentrated credit risk exposures and to explore an alternative source of funding by realizing regulatory arbitrage and liquidity improvements when selling securitization transactions (Michalak and Uhde, 2009).

2.2.2.3 Compliance to Basel Accords

The Basel Accords are international principles and regulations guiding the operations of banks to ensure soundness and stability. Compliance with the Accord means being able to identify, generate, track and report on risk-related data in an integrated manner, with full auditability and transparency and creates the opportunity to improve the risk management processes of banks. The New Basel Capital Accord places explicitly the onus on banks to adopt sound internal credit risk management practices to assess their capital adequacy requirements (Chen and Pan, 2012).

2.2.2.4 Adoption of a sound internal lending policy

A lending policy guides banks in disbursing loans to customers. Strict adherence to the lending policy is by far the cheapest and easiest method of credit risk management. The lending policy should be in line with the overall bank strategy and the factors considered in designing a lending policy should include the existing credit policy, industry norms, general economic conditions of the country (Kithinji,2010).

2.2.2.5 Asset-by-asset Approach:

Traditionally, banks have taken an asset-by-asset approach to credit risk management. While each bank’s method varies, in general this approach involves periodically evaluating the credit quality of loans and other credit exposures, applying a credit risk rating, and aggregating the results of this analysis to identify a portfolio’s expected losses. The foundation of the asset-by-asset approach is a sound loan review and internal credit risk rating system. A loan review and credit risk rating system enable management to identify changes in individual credits, or portfolio trends in a timely manner. Based on the results of its problem loan identification, loan review, and credit risk rating system management can make necessary modifications to portfolio strategies or increase the supervision of credits in a timely manner (Greuning and Bratanovic, 2009).

2.2.2.6 Portfolio Approach

While the asset-by-asset approach is a critical component to managing credit risk, it does not provide a complete view of portfolio credit risk, where the term risk refers to the possibility that actual losses exceed expected losses. Therefore to gain greater insight into credit risk, banks increasingly look to complement the asset-by-asset approach with a quantitative portfolio review using a credit model. Banks increasingly attempt to address the inability of the asset-by-asset approach to measure unexpected losses sufficiently by pursuing a portfolio approach. One weakness with the asset-by-asset approach is that it has difficulty identifying and measuring concentration. Concentration risk refers to additional portfolio risk resulting from increased exposure to a borrower, or to a group of correlated borrowers (Greuning and Bratanovic, 2009).

2.2.2.7 Credit Scoring Systems

A credit granting process comes in place when a company which needs a loan from a bank or lending institution hands in an application demanding for a loan. This application then goes through some procedures or processing in the bank which evaluates the application using their individual evaluation method to determine the credit worthiness of the company. Some banks do the evaluation using numbers (credit scoring) while others do so using subjective evaluation like personal ID of the company or the owner. Credit scoring is a statistical technology that quantifies the credit risk posed by a prospective or current borrower and seeks to rank them so that those with poorer scores are expected to perform worse on their credit obligations than those with better scores. Credit scoring has an advantage in that it saves time, cost and believe to increase access to credit, promote competition and improve market efficiency. Credit scoring reduces subjective judgment and possible bias during the credit assessment process (Holger Kraft, 2002). This shows that if a good credit scoring is taken by a bank before granting loans to customers, it can determine the ability of the customers to pay back the loans although in some cases it may not really be a guarantee since the future is uncertain. The way things or situations can be seen today may change tomorrow and obviously affect already taken decisions.

2.3 Effect of Loan Default

At large, the main effect of bad loans on banks is the fact that increasing bad loans limit the financial growth of banks (Karim, Chan & Hassan, 2010; Kuo et al., 2010). This consequence is as a result of the fact that bad loans deprive banks of the needed liquidity and limit their capability to fund other potentially viable businesses and make credit facilities available to individuals. Karim et al. (2010) argues that there are a lot of other viable businesses that the bank cannot explore as a result of the fact that its funds are caught up in bad loans. In the face of these consequences, the bank experiences a shortfall in generated revenues (Ghana Banking Survey, 2013), and this translates into reduced financial performance (Karim et al., 2010; Nawaz et al. 2012; Ghana Banking Survey, 2013).

Another basic effect of bad loans on the bank is a reduction in the bank’s lending potential (Karim et al., 2010). Though this has been acknowledged earlier, it is important to discuss it as a primary independent effect. Banks make a greater part of their revenues and profit from lending activities (Karim et al., 2010; Nguta & Huka, 2013). As a result, when banks lose much of their lending capital to bad loans, it is likely that a greater part of their revenue is lost. Once revenue is lost in one financial year, the capability of the bank to provide access to credit facilities to other businesses and individuals would practically fall in the following financial years. This means that the bank would fail to lend, or it would reduce its amount allocated to lending in the next financial year. In this study, the amount located to lending is referred to as annual “loan size”.

Research studies have shown that the effect of bad loans on the bank in terms of net financial performance (i.e. return on investment/net profit) and lending potential (i.e. annual loan size) is practical and realistic. These studies would be identified from the perspectives of foreign countries and Ghana. The studies of Karim et al. (2010), Obamuyi, (2007), Nguta & Huka, (2013), Nawaz et al., (2012), Fidrmuc & Hainz (2009), Chelagat (2012) and Aballey (2009) provide such evidence in a foreign country context. Apart from the report in Ghana Banking Survey (2013), a few other studies (Appiah, 2011; Awunyo-Vitor, 2012) have shown that bad loans negatively influence banks in terms of financial performance and lending potential in Ghana.

When a bank fails to put in place a good credit risk management system, it will find itself faced with a lot of problems and negative consequences. There may be many interrelated problems but the most basic ones which are so obvious and interrelated revolve around trying to be profitable, solvent and liquid. Profitability is the proof of an effective and well managed business. The banks are into business like any other firm with the purpose of making a profit. For this to be attained, losses have to be minimized. Advising on losses suffered by banks is that the same basic causes tend to occur time and again so, it therefore makes sense that before reviewing office procedures, the causes of the different losses which have been incurred both within the bank and by competitors conducting similar business should be looked into (Richard and Simon, 2001). The bank has to be sure about the capability of repayment of the borrower before granting any loans.

Credit risk leads to capital inadequacy (insolvency). Capital adequacy means the financial capability of the bank to meet up with its financial obligations or uncertainties that may arise and thus will reduce the risk that it may face to some extent. An acceptable capital adequacy position is equivalent to saying that a bank is not over exposed to risks (Garderner, 2007). This is because its primary role or main function is to absorb unexpected and exceptional losses that it might experience especially in situations of uncertainty. The more capital a bank has, the more are its creditors or the government insurance agency protected, and the greater is the capital loss that can be sustained without resulting in bankruptcy (Shah, 1996).

Credit risk also bring liquidity problem. A more liquid bank will be more able to meet up with financial demands from its customers and thus create more value. Bank liquidity creation is positively correlated with bank value (Berger and Bouwman, 2009). Banks have as main service, the creation of liquidity, but, this good can be destroyed by the behavior of individual financial institutions (Gaffney, 2009). This being because when the monetization of the various types of collateral (such as land or capital) turns over slowly, the bank’s liquidity is lost. A loss in liquidity shows that they cannot meet up with demand if customers turn up and thus crisis can develop (Gaffney, 2009).

Von-Pischke (1980) states that some of the impacts associated with default include: the inability to recycle funds to other borrowers; unwillingness of other financial intermediaries to serve the needs of small borrowers and the creation of distrust. As noted by Baku and Smith (1998), the costs of loan delinquencies would be felt by both the lenders and the borrowers. The lender has costs in delinquency situations, including lost interest, opportunity cost of principal, legal fees and related costs. For the borrower, the decision to default is a trade-off between the penalties in lost reputation from default versus the opportunity cost of forgoing investments due to working out the current loan. Loan default is closely related to corporate bankruptcy.

According to Bloem and Gorter, (2001), though issues relating to non-performing loans may affect all sectors, the most serious impact is on financial institutions such as commercial banks and mortgage financing institutions which tend to have large loan portfolios. Besides, the large default loans will affect the ability of banks to provide credit. Huge non-performing loans could result in loss of confidence on the part of depositors and foreign investors who may start a run on banks, leading to liquidity problems. Caprio and Klingebiel (2002), also reported that during the banking crisis in Indonesia, non-performing loans represented about 75% of total loan assets which led to the collapse of over sixty banks in1997. This means that banks holding huge default loans in their books can run into bankruptcy if such institutions are unable to recover their bad debts.

Credit risk is the most important of these risks because it comes about as a result of failure of the borrowers to pay their debts or when there is a delay to meet up with their obligations in time. Credit risk has been pointed out or identified as the key risk in terms of its influences on bank performance (Sinkey, 1992). When this risk arises, it leads to less capital adequacy because the bank will look for other sources of finance to cover up the loss. It will also lead to less liquidity to meet up with other customers demand and thus less profitability because of a slowdown in business or even bankruptcy. This goes to show that credit risk and returns are so intertwined so, the more credit risk, the less returns and vice versa. But there is also a tradeoff between the two. Riskier securities (higher yield loans) pay a risk premium (higher average return) because there is a greater uncertainty of payment (Kohn, 1994).

The profitability of a bank is adversely affected by defaults. Provisions for bad and doubtful debts are directly subtracted from the revenues of good loans. Valid, flawless and expressly binding credit documentation reduces the tendency of willful default and enhances the performance of banks. The performance of a bank has linear relationship with the credit and recovery process (Asari et al, 2011). Asari et al. (2011) rightly argued that banks are unable to profit from credits in default. The study relating to validity of credit documentation (a medium to abstain defaults) has direct relevance to the performance of a bank. The provisions for loan defaults reduce total loan portfolio of banks and as such affects interest earnings on such assets. This constitutes huge cost to banks. Study of the financial statement of banks indicates that unsecured loans have a direct effect on profitability of banks. This is because charge for bad debts is treated as expenses on the profit and loss account and as such impact negatively on the profit position of banks (Price Water-House Coopers, 2009).

Berger and De Young (1997), indicate that failing banks have huge proportions of bad loans prior to failure and that asset quality is a statistically significant predictor of insolvency. Fofack (2005) also reported banks holding huge loan defaults in their books can run into bankruptcy if such institutions are unable to recover their bad debts. A possible effect of loan defaults is on shareholders earnings. Dividend payments are based on banks performance in terms of net profit. Thus since loan defaults have an adverse effect on profitability of banks; it can affect the amount of dividend to be paid to shareholders. The effect of loan defaults on the amount of dividend paid to shareholders can also affect capital mobilization because investors will not invest in banks that have huge non-performing loans portfolio.

Kargi (2011) evaluated the impact of credit risk on the profitability of Nigerian banks. Financial ratios as measures of bank performance and credit risk were collected from the annual reports and accounts of sampled banks from 2004-2008 and analyzed using descriptive, correlation and regression techniques. The findings revealed that credit risk management has a significant impact on the profitability of Nigerian banks. It concluded that banks’ profitability is inversely influenced by the levels of loans and advances, non-performing loans and deposits thereby exposing them to great risk of illiquidity and distress.

Kithinji (2010) assessed the effect of credit risk management on the profitability of commercial banks in Kenya. Data on the amount of credit, level of non-performing loans and profits were collected for the period 2004 to 2008. The findings revealed that the bulk of the profits of commercial banks are not influenced by the amount of credit and non-performing loans, therefore suggesting that other variables other than credit and non-performing loans impact on profits.

It can be inferred from the literature on the effect of loan default that all banks incur certain loan losses when some borrowers default in repaying their loans. Irrespective of the extent of the risk involved loan default reduces profitability and liquidity of banks. Given the foregoing problems amongst others which banks can encounter if they do not manage their credit risk well, the managers should see into it that while carrying out their operational function of risk assumption, a judicious balance between profitability, liquidity and capital adequacy must be considered.

2.4 Loan Repayment

Loan repayment determines the bank’s ability to grant further loans, the profitability and suitability of depositors. Banks must therefore be cautions in its loan administration. Though customers’ records are used to determine the ability to service the loan; some customers have the tendency of hiding real position at hand. This makes it different for the banks to determine the true position as well as possible repayment. Some corporate bodies, small and medium scale enterprises repayment depends largely on collection period from debtors which determines the repayment pattern. The bank should be guided by the trend and the business lines of clients when granting credits.

Bruck (1997) contends that the administration of loan extend beyond the approval of loans. It requires control and supervision of outstanding loans to ensure their repayments. Personal loans granted to salaried workers, records a higher percentage of repayments. Nyarko (2005) perceives to employees guarantee given to the lender by the employers and due to the fact that deduction is effected at source, provided the necessary pre-lending procedures are adhered to Agricultural credit delivery to farmers should be clearly monitored to avoid decision of loan for social and acquisition of other assets at the expense of servicing the loan on maturity. Repayment on group lending is made possible because the joint and several liability clauses which serves as a respite for a lender and mandates the lender to severally take an action against the group and to the extent of their personal estates to recover the loaned funds.

2.5 Credit Risk

The concept of credit has a long history and can be traced back to ancient times. However, it was not until after the Second World War when it largely begun to be appreciated in Europe (Kiiru, 2004). In the United States of America (USA) banks extended credit to customers with high interest rates which sometimes discouraged borrowers. Thus the concept of credit was not popular in USA until the economic boom of 1885 when banks had excess liquidity and wanted to lend the excess cash (Ditcher, 2003). In Africa the concept of credit was largely appreciated in the 1950’s when most banks started opening the credit sections to extend loans to white settlers. In Kenya credit was initially given to the rich and big companies and was not popular to the poor. In 1990s loans extended to customers failed to perform well thus necessitating the need for intervention. Mechanisms to evaluate for the evaluation of customer’s ability to repay the loan were considered, but this didn’t work well as loan defaults continued unabated (Modoc, 1999).

Gestel et al, (2009) defines credit risk as the risk of loss due to a party in an agreement not meeting its contractual financial obligation in a timely manner. Credit risk can also be defined as the probability that some financial institution’s assets, especially its loans, will decline in value and possibly become worthless.

The Basel Community for Banking Supervision (1999), defined credit risk simply as the potential that a bank’s borrower or counter party will fail to meet its obligations in accordance with the agreed terms. Besis (1998), also defined credit risk as by the losses incurred in the event of the bank’s counter party or in the event of deterioration in the client’s credit quality. Besis, therefore classify losses as ranging from temporary delay of payments to chronic counterparty’s inability to meet its financial obligations, which often ends in formal bankruptcy.

Per the several definitions given, credit risk can be referred to as risk of loss to a bank through default by an obligor. It is thus the inability of a counter party of a transaction to meet the agreed upon obligation of principal and interest repayment. This inability has various degrees of impact depending on whether the default occurs before the value date or on the value date of the contract.

2.5.1 SOURCES OF CREDIT RISK

Credit risk can be caused by a variety of reasons of both internal and external sources. The main sources of credit risk recognised in the literature (e.g., Nijskens and Wagner, 2011; Breuer, Jandacka, Rheinberger and Summer, 2010; Qian and Strahan, 2007; Saunders and Allen, 2002) include, for example, poor governance and management control, inappropriate laws, limited institutional capacity, inappropriate credit policies, volatile interest rates, low capital and liquidity levels, directed lending, massive licensing of banks, poor loan underwriting, reckless lending, poor credit assessment, poor loan underwriting, laxity in credit assessment, poor lending practices, government interference and inadequate supervision by the central bank. The literature has identified these reasons that could lead to potential credit risk. The extent of credit risk incurred varies across sectors and countries.

Credit risk is often considered as a consequence of systemic risk derived from the macro perspective. Systemic risk represents the larger financial problems caused by the inability of financial market participants to meet repayment obligations on extensions of credit (e.g., Fukuda, 2012; Giesecke and Kim, 2011; Nijskens and Wagner, 2011; Wagner and Marsh, 2006). The problem is systemic because the inability of one participant to pay may lead to an inability of other participants to meet credit obligations. This domino effect played out in the market during the mortgage crisis of 2009 (Giesecke and Kim, 2011; Nijskens and Wagner, 2011). The rash of foreclosures caused by a lack of payments on mortgage loans led to mortgage companies being unable to meet financial obligations. This spread throughout the market, causing a lockup in liquidity where banks refused to lend money for fear of insurmountable financial risk.

There are also internal factors that can cause credit risk of financial institutions. For example, one of the internal factors is the financial incentives provided to the employees of a bank. Those people have a strong tendency to opportunism and moral hazards by lending to poorly performing firms and individuals with questionable credit records. The World Development Report (2012) by the World Bank shows that, in the condition of uncertainty and information asymmetry, it is hard to design an incentive system for bank employees who are in charge of credit and lending. The previous research concerning the cause of credit risk mainly concentrates on the internal management system of banks. An assumption is usually made by researchers that these employees will be responsible for what they are working for and their action perfectly reflects the interests of banks. To minimize the impacts of these factors, it is necessary for the financial system to have well-capitalised banks, service to a wide range of customers, sharing of information about borrowers, stabilization of interest rates, reduction in non-performing loans, increased bank deposits and increased credit extended to borrowers. Loan defaults and nonperforming loans need to be reduced (Louzis, Vouldis and Metaxas, 2012; Sandstorm, 2009). Corporate governance needs to be strengthened.

2.5.2 IMPORTANCE OF CREDIT RISK

The importance of credit risk is widely recognised. The literature has revealed that the most common cause that leads the banks to bankruptcy is credit risk (Zribi and Boujelbène, 2011; Alessandri and Drehmann, 2010; Calice, Ioannidis and Williams, 2010; Altman and Sanders, 1998). The most recent case was the sub-mortgage crisis took place in America in 2008. Credit risk is among the oldest and most important financial risks (Altman and Sanders 1998). The Basel Committee on Banking Supervision (2001) documents that for most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Indeed, over the years banks are also increasingly facing credit risk (or counterparty risk21) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions.

Indeed, credit risk can lead to financial crisis. Financial institutions are subject to a number of risks such as credit risk, operational risk, and liquidity risk (Foot, 2002). These risks are related to each other and it is rather difficulty to isolate one from others in practice. Although credit risk has always been of primary concern to these institutions, its importance became paramount during the recent financial crisis. The financial crisis exposed the shortcomings of existing credit risk management systems, and several firms saw significant losses resulting from failure of their counterparties to deliver on contracts. As Demirgüç-Kunt and Detragiache (1998) argued, fast financial liberalizing worsens the risk and fragility of the whole financial system. They believe that financial crisis will take place when serious credit risk occurs. Credit risk is the consequence of inappropriate connections between different parties. Research conducted by Stiglitz and Weiss (1981) and Esstrella and Mishkin (1996) illustrates that the borrower could easily obtain more information of the project they have invested than the lenders do. This, therefore, raises negative selection and moral hazards in the credit market. Information asymmetry could leads to the credit risk. In the literature, it has been well-argued that serious competition in the market could also lead to commercial banks’ credit risk.

2.6 CREDIT RISK ASSESSMENT

A thorough credit and risk assessment should be conducted prior to the granting of loans, and at least annually thereafter for all facilities. The results of this assessment should be presented in a Credit Application that originates from the relationship manager/officer (―RM), and is approved by Credit Risk Management (CRM). The RM should be the owner of the customer relationship, and must be held responsible to ensure the accuracy of the entire credit application submitted for approval. RMs must be familiar with the financial institution’s Lending Guidelines and should conduct due diligence on new borrowers, principals, and guarantors.

It is essential that RMs know their customers and conduct due diligence on new borrowers, principals, and guarantors to ensure such parties are in fact who they represent themselves to be. All financial institutions should have established Know Your Customer (KYC) and Money Laundering guidelines which should be adhered to at all times. Credit Applications should summaries the results of the RMs risk assessment and include, as a minimum, the following details:

Amount and type of loan(s) proposed.

– Purpose of loans.
– Loan Structure (Tenor, Covenants, Repayment Schedule, Interest)
– Security Arrangements

In addition, the following risk areas should be addressed:

Borrower Analysis: The majority shareholders, management team and group or affiliate companies should be assessed. Any issues regarding lack of management depth, complicated ownership structures or inter group transactions should be addressed, and risks mitigated.

Industry Analysis: The key risk factors of the borrower‘s industry should be assessed. Any issues regarding the borrower‘s position in the industry, overall industry concerns or competitive forces should be addressed and the strengths and weaknesses of the borrower relative to its competition should be identified.

Supplier/Buyer Analysis: Any customer or supplier concentration should be addressed, as these could have a significant impact on the future viability of the borrower.

Historical Financial Analysis: An analysis of a minimum of 3 years historical financial statements of the borrower should be presented. Where reliance is placed on a corporate guarantor, guarantor financial statements should also be analyzed. The analysis should address the quality and sustainability of earnings, cash flow and the strength of the borrower‘s balance sheet. Specifically, cash flow, leverage and profitability must be analyzed.

Projected Financial Performance: Where term facilities (tenor > 1 year) are being proposed, a projection of the borrower‘s future financial performance should be provided, indicating an analysis of the sufficiency of cash flow to service debt repayments. Loans should not be granted if projected cash flow is insufficient to repay debts.

Account Conduct: For existing borrowers, the historic performance in meeting repayment obligations (trade payments, cheques, interest and principal payments, etc) should be assessed.

Adherence to Lending Guidelines: Credit Applications should clearly state whether or not the proposed application is in compliance with the bank‘s Lending Guidelines. The financial institution’s Head of Credit or Managing Director/CEO should approve Credit Applications that do not adhere to the bank‘s Lending Guidelines.

Mitigating Factors: Mitigating factors for risks identified in the credit assessment should be identified. Possible risks include, but are not limited to: margin sustainability and/or volatility, high debt load (leverage/gearing), overstocking or debtor issues; rapid growth, acquisition or expansion; new business line/product expansion; management changes or succession issues; customer or supplier concentrations; and lack of transparency or industry issues.

Loan Structure: The amounts and tenors of financing proposed should be justified based on the projected repayment ability and loan purpose. Excessive tenor or amount relative to business needs increases the risk of fund diversion and may adversely impact the borrower‘s repayment ability.

Security: A current valuation of collateral should be obtained and the quality and priority of security being proposed should be assessed. Loans should not be granted based solely on security. Adequacy and the extent of the insurance coverage should be assessed.

Name Lending: Credit proposals should not be unduly influenced by an over reliance on

the sponsoring principal‘s reputation, reported independent means, or their perceived willingness to inject funds into various business enterprises in case of need. These situations should be discouraged and treated with great caution. Rather, credit proposals and the granting of loans should be based on sound fundamentals, supported by a thorough financial and risk analysis.

2.7 Review of Theories

2.7.1 LIQUIDITY THEORY OF CREDIT

This theory, first suggested by Emery (1984), proposes that credit rationed firms use more trade credit than those with normal access to financial institutions. The central point of this idea is that when a firm is financially constrained the offer of trade credit can make up for the reduction of the credit offer from financial institutions. In accordance with this view, those firms presenting good liquidity or better access to capital markets can finance those that are credit rationed. Several approaches have tried to obtain empirical evidence in order to support this assumption.

For example, Nielsen (2002), using small firms as a proxy for credit rationed firms, finds that when there is a monetary contraction, small firms react by increasing the amount of trade credit accepted. As financially unconstrained firms are less likely to demand trade credit and more prone to offer it, a negative relation between a buyer’s access to other sources of financing and trade credit use is expected. Petersen and Rajan (1997) obtained evidence supporting this negative relation.

2.7.2 PORTFOLIO THEORY

Portfolio theory of investment which tries to maximize portfolio expected return for a given amount of portfolio risk or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although portfolio theory is widely used in practice in the finance industry and several of its creators won a Nobel prize for the theory ,in recent years the basic portfolio theory have been widely challenged by fields such as behavioral economics(Markowitz 1952).

Portfolio theory was developed in 1950’sthrough the early 1970’s and was considered an important advance in the mathematical modeling of finance. Since then ,many theoretical and practical critisms have been developed against it.This include the fact that financial returns do not follow a Gaussian distribution or indeed any symmetric distribution, and those correlations between asset classes(Micheal,Sproul 1998).

2.7.3 CREDIT RISK THEORY

Although people have been facing credit risk ever since early ages, credit risk has not been widely studied until recent 30 years. Early literature(before 1974) on credit uses traditional actuarial methods of credit risk ,whose major difficulty lies in their complete dependence on historical data. Up to now ,there are three quantitative approaches of analyzing credit risk: structural approach, reduced form appraisal and incomplete information approach (crosbie et al,2003).Melton 1974 introduced the credit risk theory otherwise called the structural theory which is said the default event derives from a firm’s asset evolution modeled by a diffusion process with constant parameters. Such models are commonly defined “structural model “and based on variables related a specific issuer. An evolution of this category is represented by asset of models where the loss conditional on default is exogenously specific. In these models, the default can happen throughout all the life of a corporate bond and not only in maturity (Longstaff and Schwartz.1995).

2.7.4 TAX THEORY OF CREDIT

The decision whether or not to accept a trade credit depends on the ability to access other sources of funds. A buyer should compare different financing alternatives to find out which choice is the best. In trade between a seller and a buyer a post payment may be offered, but it is not free, there is an implicit interest rate which is included in the final price. Therefore, to find the best sourceof financing, the buyer should check out the real borrowing cost in other sources of funds.

Brick and Fung (1984) suggest that the tax effect should be considered in order to compare the cost of trade credit with the cost of other financing alternatives. The main reason for this is that if buyers and sellers are in different tax brackets, they have different borrowing costs, since interests are tax deductible. The authors’ hypothesis is that firms in a high tax bracket tend to offer more trade credit than those in low tax brackets. Consequently, only buyers in a lower tax bracket than the seller will accept credit, since those in a higher tax bracket could borrow more cheaply directly from a financial institution. Another conclusion is that firms allocated to a given industry and placed in a tax bracket below the industry average cannot profit from offering trade credit. Therefore, Brick and Fung (1984) suggest that firms cannot both use and offer trade credit.