FACULTY OF COMMERCE

DEPARTMENT OF ACCOUNTING AND INFORMATION SYSTEMS

Authors Dzidzai Hwandi and Hardion Gama (Students)

dzidzaihwandi@yahoo.com, hardiongama@gmail.com

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 loans 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 borrowers 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
borrowers 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 institutions 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 institutions business
through the dilution of the firms 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 firms 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 borrowers 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 borrowers
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
clients 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 groups 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 disincentivespenalty 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 Cs 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 clients
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 Cs 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 clients business. This enables the lending officer to have a better understanding of
the clients business exposure to risks arising from weaknesses and threats and the betterment of
the clients business in terms of strength and opportunities under consideration. The lending
officer will be able to weigh the benefits and risks of the borrowers 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.

Increasing

collection

costs

Decreasing

analysis,

operating

Causing
Leading

(visits,

program
to

to
ever-increasing

Threatening long-term institutional viability

legal

costs)
spreads

lose

credibility

repayment

problems