Loan delinquency, causes, effects and strategies of managing delinquent loans. PDF

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FACULTY OF COMMERCE DEPARTMENT OF ACCOUNTING AND INFORMATION SYSTEMS Authors Dzidzai Hwandi and Hardion Gama (Students) [email protected], [email protected] May 2015 Credit risk analysis paper no#1 Abstract This paper gives an outline of the definition, causes (internal and external), effe...

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FACULTY OF COMMERCE

DEPARTMENT OF ACCOUNTING AND INFORMATION SYSTEMS

Authors Dzidzai Hwandi and Hardion Gama (Students)

[email protected], [email protected]

May 2015

Credit risk analysis paper no#1

Abstract This paper gives an outline of the definition, causes (internal and external), effects of loan delinquency and possible strategies of managing delinquent loans in a firm. 1. Explain internal and external causes of delinquency. 2. Examine the effects of delinquency. 3. Evaluate the different strategies of managing delinquent loans in a firm.

1 Delinquency is the situation that occurs when loan payments are past due. It can also be referred to as arrears or late payments, measures the percentage of a loan portfolio at risk. Delinquency is measured because it indicates an increased risk of loss, warnings of operational problems, and may help predicting how much of the portfolio will eventually be lost because it never gets repaid. There are three broad types of delinquency indicators: Collection rates which measures amounts actually paid against amounts that have fallen due; arrears rates measures overdue amounts against total loan amounts; and portfolio at risk rates which measures the outstanding balance of loans that are not being paid on time against the outstanding balance of total loans (CGAP, 1999). This essay focuses on internal and external factors that cause delinquency. Internal Causes Failure to adhere to set out lending policies; this whereby a lending officer grants a loan to a borrower without the full considerations agreed in the lending policy of the institution may be because of past experience and relationship. The economic conditions are dynamic as such granting a loan basing on past experience may result in loan delinquency. Insider lending; this occurs when loan is given out to employees such managers, directors among others without following proper lending procedures. Improper appraisal techniques by lending officers; this is when a lending officer conducts appraisals of the viability of the loan’s purpose, may come up with inappropriate judgement pertaining to issues like productivity of the business and the progress being made. This may result in the lending officer failing to note variations between the proposal and what is on the ground. Hence this would result in post payments of loans borrowed. Deficient analysis of project viability; in the case where management came up with decisions to grant a loan basing on ineffective project viability analysis. Usually the expected returns from the project may be slowly realised hence late repayment of the loan.

External causes Changes in government policies; the government may negatively interfere with the operations the borrower from which cash flows for the repayments of the loans are expected to be generated, for instance increase in corporate taxes. Increase in taxes will lead to high costs burden resulting in thin retained profit margin. Thus, the repayment may not be made in accordance with the agreed terms leading to loan delinquency. Individual crisis; unpredicted individual crisis may led to loan delinquency. The crisis may include death of a near relative, fired from work, salary reduction among others. This will lead to the profits generated or the amount borrowed being used to cater for those unanticipated commitments hence failure to meet loan repayment deadlines. Natural disasters; natural disasters such as floods, drought and earthquakes

may hinder the

monitoring the progress of the project, for example appraisal visits may thwarted by such disasters. This may also affect the infrastructure of where the borrower’s project is geographically located. For instance if the borrower was in agriculture and has been affected by one or more of the disasters, his or her yields will be suppressed hence the borrower may look for other secondary sources of repayment which requires considerable amount of time, thus delayed repayment. State of the economy; business cycles (boom, depression and recovery) affect delinquency in several ways. In a depressed economy, the probability of late repayment is relatively high as compared to an economy at boom or recovery stages of business cycle. This is mainly because economies in depressed state face liquidity challenges hence the expected returns from borrower’s projects will be negatively affected leading to delinquency. Transaction costs of the loan; many transactions costs associated with the borrower may end up reducing the amount left on hand even before the execution of the project, for example a borrower needs $5 000.00 to finance his or her project of which $500.00 will be associated with transaction costs hence the project will be funded with $4 500.00 which is less than the required amount. If the project is not fully capitalised, the feasibility of the project compromised or the

borrower will find other sources to sufficiently fund the project. Thus, the repayment of the loan will be delayed.

2 Delinquency causes untold suffering mainly to the lending institution. These include slowing portfolio rotation, delayed earnings, increase in collection costs, decreasing operating spreads, causing lending programme to lose credibility, threatens long-term institutional viability, loan loss provision, loss of non-recoverable portion of the outstanding loan, written off loans require decapitalisation of the institution among others. Slowing portfolio rotation; delayed repayments will negatively affect the institution’s returns from its investments (loans). This hinders the ability of the firm in granting other loans to other different borrowers with diverse investment portfolios. This hinders the spread of risk through stifled diversification. Increase in collection costs; belated repayments of loans may raise collection costs which are inclusive of visits, analysis and legal costs. For example in the case where the institution had decided to sell its debtors through debt factoring which will subject to a discount thus a cost to the institution. Also, in the event where a court is required to provide a judgement on how the institution will be repaid, thus procedures involved are costly to the firm. Threatening long-term institutional viability; delinquency results in the institution losing confidence in terms of its sustainability. The delayed repayments suppress the future growth prospects of the institution as a result of delayed investments in other areas. This leaves the sustainability of the institution questionable. Lending programmes lose credibility; the reliability of every lending policy programme is heavily pinned on the time factor for repayment of the loan. The deviation between the expected repayment period and the actual repayment period will render the lending system ineffective. In the event of late resettlement of the loan obligations by the borrower, the time factor considered at first place will be discredited thus leaving the programme not reliable. Delayed earnings; every business is driven by earnings from its operations. Thus when lending, a financial institution expects earnings to be received on or before the agreed repayment date. Any late repayment will subject the institution to suffer from failing to meet its obligations and commitments in time for example statutory obligations like taxes.

Loan loss provision; Provisions are liabilities of uncertain timing or amount when it is probable that there will be an outflow of resources. In the case where the financial institution regularly encounters delinquency cases, it has to provide for any uncertain loan losses. The resources set aside will be representative of leakages from the circular flow of income of the institution. The institution will likely to suffer opportunity cost since the benefits that may accrue to the firm might be greater if the tied up resources were invested than would arise from hedging against risk of delinquency. Loss of non-recoverable portion of the outstanding loan; in lending transactions firms expect the repayment of the principal and or plus an interest. Some late repayments may become bad debts which are costs to an institution in form of a loss if it happens that the loan has not been recovered. Therefore these credit losses will repress the feasibility of the institution’s business through the dilution of the firm’s income. Written off loans require decapitalisation of the institution; loans are the assets of a lending institution, as such any written off loans will diminish the assets of the firm against the set aside provisions. This will reduce the firm’s financial position structure which might in turn affect its ability to borrow from other lending institutions for its own purposes. Ever-increasing repayment problems; late repayments is usually associated with penalties and interest increase. In scenarios where the late repayments are not subject to penalties and interest, borrowers may have a routine behaviour of not paying their obligations when they fall due causing cashflow problem to the firm. However, delinquency also affects the borrower’s reputation and hence he or she may face challenges in accessing funds from other lenders. The sources of funds of the borrower will be reduced and as such the operations of the borrowing entity may be negatively affected.

3 Kohansal and Mansoori (2009) were of the view that, lenders devise various institutional mechanisms aimed at reducing the risk of loan delinquency. These include pledging of collateral, third-party credit guarantee, use of credit rating and collection agencies among others. Proper client selection; when granting a loan, proper procedures, rules and regulations necessary in the selection of the best client must be followed. Credit analysis of potential borrowers should be carried out in order to judge the credit risk with the borrower and to reach a lending decision. Kay Associates Limited (2005) cited by Aballey (2009) states that bad loans can be restricted by ensuring that loans are made to only borrowers who are likely to be able to repay, and who are unlikely to become insolvent. Those borrowers who have the ability to repay in time will lead to reduced cases of loan delinquency. The institution is unlikely to encounter delinquency scenarios if best clients are selected.

Monitoring of clients; Loan repayments should be monitored and whenever a customer delays action should be taken. Thus financial institutions should

monitor loan repayments and

renegotiate loans when customers get into problems (Ameyaw-Amankwah, 2011). Financial institutions need a monitoring system that highlights repayment problems clearly and quickly, so that loan officers and their supervisors can focus on delinquency before it gets out of hand. Proper and adequate appraisal techniques such as visits are key to monitoring delinquency. Loan appraisal; This is the basic stage in the lending process. According to Anjichi (1994), the appraisal stage is the heart of a high quality loan portfolio. This includes diagnosing of the business as well as the borrower. This process of appraising the client will help the officer to assess the ability of the borrower to utilize the loan effectively. Before commencement, the process of collecting information on the client for the purpose of determining credit limits, the lending officer should have explicit information at hand which will assure that the data and figures provided by the client will have apro-margin error. Regular review of lending policies and procedures; the economic environment of every nation is dynamic. The general business policy and advice are considered. If the financial institution is sensitive to business development, it can revise its own credit policies and loan procedures as

well as advising its customers. As such policies implemented in a given time period does not suit the whole life time of the financial institution hence the necessity to regularly review lending policies and procedures to meet the current economic trend. Use of third party guarantee; financial institutions are assured by third parties to receive their repayments in the event of delinquency. This helps the cashflow of the financial institution to consistently flow as per their loan investment returns. Loan portfolio rotation will not be slowed down. It in turn gives the institution the confidence to grant loans knowingly since there is a guarantee that the lending programme would not lose credibility. Loan provisions; if it is probable that the institution will face loan delinquency, setting aside some resources to provide for delinquency is a way to reduce the risks associated with late repayments. The lending institution should establish a prudent loan loss reserves and write off policies and ensure that income and assets are accurately reflected in the financial statements. The institution is likely to absorb economic shocks so that the institutional long term viability will not be endangered since the provisions cover up for delayed earnings. Training of management; Another stage in the lending process which is critical to minimising default is the disbursement stage according to Sheila (2011). It is crucial to have continuous training both to management and clients before and after disbursement. The management will be equipped with necessary skills for them to cautiously plan, organise, monitor, control and be time sensitive on the repayment of the loan. This will enable management to be in line with the current economic trends. Reasonable interest rates; According to Olomola (1999), loan disbursement lag and high interest rate can significantly increase borrowing transaction cost and can also adversely affect repayment performance. For lenders to control repayment performance reasonable interest rates should be charged in order to reduce transaction costs. This will enable clients to be able to meet repayment deadlines. Adequate loan sizes; loans given out should commensurate with the size of the borrower’s operations that is bigger businesses should be granted bigger loans and smaller businesses should

be granted smaller loans. If the size of the loan borrowed is in tandem with the business operations, it is likely that the repayments will be made in time. Flexible repayment terms; lending institutions may have fixed and or flexible repayment terms. Repayment terms should not be rigid depending on the nature, size, and complexity of the client’s business, for example seasonal farming business is expected to repay after the farming season after production has been done. Thus, if the terms granted are suiting the business of the borrower, it is more likely that the borrower will meet the repayment deadlines. Group lending; giving out loans to a group is a strategy to control delinquency. This is when a loan is given out to a group and not as individuals in a group. This enhances controlling, monitoring and supervision of the group’s business operations within the members themselves. Also, if the group is about to face delinquency the members can assist each other using secondary sources in order for the group to have a better credit standing record. Incentive system; Establish an incentive system that uses both financial and non-financial incentives to encourage on time repayments. For the borrower these can include larger loans, follow up loans, interest rebates, and access to training (or disincentives—penalty fees, no further access to loans, collection of collateral, legal action.). Design an incentive system for the field staff/loan officers that include on-time payments as an important variable. An incentive system places the responsibility for portfolio quality on the shoulders of the loan officers who with support can best respond to repayment problems. It can motivate officers to look for and eliminate the causes of arrears. Clients must value the credit service; Loan products should suit clients’ needs, the delivery process should be convenient, and clients should be made to feel that the organization respects and cares about them. If the institution respects and cares about its clients, the clients will be motivated to meet the agreed repayment dates. This is as a result of a well established relationship between the lending institution and its clients. Use of credit rating agencies; credit rating agencies collect information like debt and credit suppliers, current indebtedness and court issues on business. Financial institutions are helped with the information in their lending criteria so that ever repayment problems will be deterred.

Portfolio information systems; systems that provide information to field workers that enable them to conduct effective and timely follow-up of loans and to manage their portfolios efficiently should be developed. The easier it is for the field staff to figure out whose payments are due and when, who is late and by how much, the more time they can spend with borrowers. The financial institution should develop a portfolio information system that enables management to conduct timely and useful analysis of portfolio quality, determine trends in the portfolio over time, and identify possible causes of delinquency. Institutional image and philosophy; the lending firm should create an image and philosophy that does not consider late payments acceptable. The benefit of creating disciplined borrowers is critical to the success of the financial institution. Costs-benefits of late repayment; lending institutions should ensure that the benefits of on time repayment and costs of late repayment far outweigh the benefits of late repayment and costs of on-time repayment from the borrowers’ perspective. Therefore, this will drive the borrower to strive repaying in time to avoid costs associated with delinquency. 5 C’s of credit; these include the analysis of character, capital, collateral, capacity and conditions (economic). Analysing of behaviour, the assets, security, ability and the cycle of the client’s business enables the lending officer to have a better understanding of the client in terms meeting obligations when they fall due. Thus, those who do not meet the desired criteria with regard to the 5 C’s of credit will not be granted loans and those who meet will be granted hence avoiding delinquency. SWOT analysis; this involves the evaluation of the strengths, weaknesses, opportunities and threats of the client’s business. This enables the lending officer to have a better understanding of the client’s business exposure to risks arising from weaknesses and threats and the betterment of the client’s business in terms of strength and opportunities under consideration. The lending officer will be able to weigh the benefits and risks of the borrower’s business and make favourable decisions that would not compromise the credibility of the lending institution. Management evaluation; the success or failure of the lending system of a business largely depends on the efficiency of management since it is involved in the planning, organising, leading

and controlling of lending programme. The institution must ensure that its management have high qualification and skills necessary on the management of delinquency. In conclusion, financial institutions manage delinquency through pledging of collateral, thirdparty credit guarantee, use of credit rating and collection agencies among others.

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