CH ARTER ONE INTRODUCTION 1.

1 BACKGROUND OF THE STUDY Sources of finance for starting, up development and expansion for any business enterprise is very crucial for the success of the business. Source of financing whether internal (ie company s assets, personal saving and retained profit) or external (ie floating of share, venture capital factory and hire purchase) has their advantages and disadvantages. It is therefore important for every enterprise to assess the sources in relation to the needs of the business. Business in Ghana are predominantly small and medium scale enterprises (SMES) and as a result some external sources of fund like floating of share venture capital and factory are limited and which usually are suitable for large organization are not available. Organization are however left with no choices to relieve and the few sources of finance apart from the traditional personal savings and retain profit. The main source of finance therefore is funds raised from lenders such as banks and other financial institutions typical in the form of loans and overdrafts. However, because of the high rate of default, experienced by these institutions they in efforts to be in business are left with no other option but o Charge huge interest rates to compensate for high level of non repayments o Require high collateral security

o Limit credit to only few institutions perceived to be trust worthy. These approaches adopted by the financial institutions have consistently being criticized by the stakeholders like the Association of Ghana Industries, Ghana Chamber of Commerce and other related business associations. Banks and other financial institutions therefore, are continuously seeking techniques and approaches of reducing the high levels bad loans in their portfolios. It is in this respect that the government signed into law the credit reporting act 2007 (act 726) on Apri, 13, 2007, the bank (amendment act) Act 2007 (act 738) and money lender act 2008( Act 744) to help the courses of defaults experienced by these institutions would enable these banks to adopt appropriate measures to reducing defaults thereby reduce the rather rigid ways they have currently alluded to. 1.2 statement of the problem Loans portfolios of financial and non financial institutions have be flooded with bad loans with millions of cedis written off at the end of the year. According to the Monetary Policy Committee (MPC) of Ghana latest report on the economy, the non performing loan (NPL) ratio remains high although declaring. The NPL ratio improved to 15. 3% in October in 2011 from 16.9% in October 2010.several reasons have been assigned generally to these high rates of non payment loans but little has been made to ascertain the real courses of loans defaults especially in the Ghanaian business contest. Financial institutions in their efforts to compensate of these high defaults usually charge high interest rate, which is gradually crippling the weak businesses who goes in for such fund. The researcher however seeks to investigate in to and make the contributing factors of the high default rate that are in the

high extend making loans and overdrafts which are the main source of finance unattractive in Ghana.

1.3 Research hypothesis HO There is no relationship between sufficiency of loan amount for intended purpose and loan default. HI There is a relation between the sufficiency of loan amount for intended purpose and loan default. B HO There is no relationship been diversion of funds and loan default HI There is a relationship between diversion of funds and loan default. C HO Economic conditions have no impact on peoples in ability to repay loans HI Economic conditions have an impact on people s inability to repay loans

1.4 Research question To what extent do borrowers contribute to their inability to repaying loans granted to them by the financial institution? How do external factors contribute to people inability to repay their loans facilities?

To what extent do financial institutions contribute to high rate of default in their loan portfolios? 1.4 Research objective 1. To ascertain how people can manage borrowed funds in order for them to be able to repay the amount and its interest and incidental charges 2. To establish ways by which financial institutions can adopt to reduce high rate of default in their loan portfolio. 3. To ascertain why people go for loans but fails to repay 4. To establish the conditions under which economic conditions pertaining in the country at a particular periods contribute to the borrower s inability to repay their loans. 5. To review literature on the loan default in poor developing countries 1.6 Definition of the terms The word financial institution used by the researcher encompasses a broad range of organizations that deal with the management of money. In Ghana, the financial institution is categorized into three main sectors. Banking and finance (including non banking financial services and forex bureau) Insurance Financial market \ capital market

y y y

The bank institution includes both foreign and local major banks, rural and community banks (RCBS) savings and loans company (SLCS) and other finance and leasing companies. Loans on the other hand used in this contest to mean personal loans and overdraft facilities the later

being the safety net on ones current account allows him\her to borrow up to a certain limits even if there is no money in the current account. 1.7 Significant of the study Bank loans and overdraft are consistently becoming more and more expensive, inaccessible and unattractive in recent time. Recessions technically refers to as credit crunch, there has been a reduction in the general availability of loans (credit) and sudden tightening of the conditions required to obtain loans from financial institutions. This is because of the increasing volume of bad loans in the portfolios of financial institutions which already has crippled several of them including big player like non -professional brothers and the citi groups in the western arena. It is for this reason that the research is being conducted to make known the courses of loan default in the financial institution to identify ways of reducing the increasing rate of default in these institutions are currently facing out. 1.8 Limitations The limitation to this study is in the form of finance and time constraint. Finance was a problem because, if the researcher had adequate funds it he could employ the services of research assistance to assist in the data collection from a wider population but that could not be than. Time was a limitation to the findings because the academic calendar did not allow the researcher to stay longer enough on the field to collect all the data possible for thorough conclusion.

CHAPTER TWO LITERATURE REVIW 2.0 INTRODUCTION This section presents an in-depth background on financial institutions, the role they play as intermediaries and the procedures they adopted in reducing the increasing trend of bad loans in their portfolios. The section also explain how borrowers contribute to high rate of interest rate trend in the Ghanaian how the n economy as well as review how economic conditions affect the portfolio of financial the institutions with particular emphasis on one of the premier Rural and community banks in Ghana; Asorkor Rural Bank. 2.1 THE ROLE OF FINANCIAL INSTITUTIONS AS FINANCIAL INTERMEDIARIES Financial institutions are class of companies that provide financial services for their client. They act as financial intermediaries and largely the most regulated class of companies. They include Deposit-taking institutions that accepted and manage deposit and make loans, insurance companies and pension funds, brokers underwriters and investment funds, Khan (2008) defined a financial institution as any non-banking institution or financial company engaged in the activity of; financing by any of loans advances acquisition of shares or stock or bonds or debentures or securities, hire purchase, any class of insurance, stock broking, and collection of

money by way of subscription or sale of unit other instrument or any other manner and their disbursement.

Peter and Hudgins (2008) explain that banks and other financial institutions are financial intermediaries that interact with two types of individual in the economy: deficit spending individual and institutions whose current expenditures for consumption and investment exceed their current receipt of income and who, therefore need to raise funds externally through borrowing or issuing stocks . Surplus spending individuals and institutions whose current receipts of income exceed their current expenditure on goods and services so they have surplus fund that can be saved and invested. Financial institution act as a bridge between surplus spending and deficit spending individuals by offering convenient financial services to the surplus spending unit in order to attract funds and then allocate those funds to the deficit spenders. By this act, they accelerate economic growth by expanding the available pool of savings; one of the principal tasks of financial institutions is the provision of loan or credit to its clients. A loan is a debt instruments that entails the distribution of financial assets overtime between lender and the borrower where the borrower initially receives or borrows an amount of money called principal, from the lender and is obligated to repay an amount of money to the lender later. A loan is generally provided at a cost referred to as interest, which acts as incentive for the lender. Financial institution as intermediaries receive deposit from their customers and give these deposit out in the form of loans in anticipation that the principal and all accrued interest will be paid when they fall due. However, because of the probability of non- repayment of either all or part of the

amount borrowed what Peter and Hudgins (2008) referred to as credit risk. Financial institutions usually seek for ways and means by which they reduce the level of default in their portfolios. As intermediaries between surplus spending unit and deficit spending, financial intermediaries are usually confronted liquidity and credit risk. According to Peter and Hudgins (2008), liquidity risk refers to the danger on running out of cash when cash is needed to cover deposit, withdrawals and to meet credit request from good customers. They also explained credit risk as when financial intermediaries makes loans and take on securities, those securities are nothing more than promise to pay when such loans fall due. However, when they fail to make some or all of their promised payment, these defaulted loans and securities resulted in losses that can eventually erode the institutions capital. 2.2 FINANCIAL ADMINISTRATION IN GHANA Bank of Ghana is by the banking act of 2002 (Act 612) authorized to manage the monetary and banking system of Ghana. Its core mission is to purse sound monetary and financial policies aimed at price stability and create a enabling environment for sustainable economic growth. The bank of Ghana has the overall supervisory and regulatory authority in all matters relating to banking and non-banking financial business with the pursue to achieve a sound, efficient banking system in the interest of depositors and other customers of these institutions and the economy as whole.

The regulatory and legal framework within which banks, non-bank financial institutions as well as forex bureau operate in Ghana central bank as a regulator are defined in the Act 61 and Act 673 as follows:  To regulate, supervise, and direct the banking system and credit system to ensure the smooth operation of a safe banking system.  To appoint an officer designed as the head of banking supervision department, who shall be appointed by board.  To consider and propose reforms of the laws relating to banking business. Consequently, the central bank exercise its mandate to ensure that depositors funds are safe, solvency, good quality assets, adequate liquidity and profitability of banks are maintained as well as maintenance of an efficient payment system. 2.3 THE ECONOMY AND CREDIT REGULATION IN GHANAs According to the data available at the registrar General, 90% of companies registered in Ghana are Micro, Small and Medium Enterprises (SMEs). Traditionally, however, financial institutions in Ghana have been cautious with lending to this sector because of the high default rates and risks associated with the sector. The central bank and stakeholders of financial institutions are therefore continuously seeking ways by which they can reverse this trend by making the SMEs sector unattractive to financial institutions. It is because of this that the bank of Ghana has enacted several regulations to strengthen the financial institutions in their quest to provide financial services to the business community of Ghana. Notable among these are the borrowers and lending Act of 2002, Act 773 and the credit reporting Act of 2007, Act 726.

2.4 CREDIT REPORTING ACT2007, ACT 726 The credit reporting bill received presidential assent on April 27, 2007 after its passage by parliament. The purpose of the Act is to provide a legal and regulatory framework for credit reporting in Ghana. Borrowers tend to have a natural incentive not to reveal negative information about them. However, lack of credit information increases the risk of lending, and the causes of financial institutions to provide timely, accurate, and up-to- date information on the debt profile and repayment history of borrowers. The credit reporting Act is designed to promote the orderly development of a credit reporting system for Ghana and to promote public trust in credit bureau operations. Specifically, the Act provides for the licensing of private credit bureau (and gives the bank of Ghana the authority to set up a public credit bureau), regulate reporting system, and provides for credit data submission, data management and protection, and dissemination. It seeks to strike a balance between the rights of borrowers on the one hand, and the need to share credit information effectively, on the other. Access to credit reports prepared by a credit bureau is restricted under the Act. In accordance with the principle of reciprocity, only financial institutions who submit credit information to a credit bureau and show evidence of customer s consent to the insurance of a credit report will be eligible to access a credit bureau s data. Financial institutions that are eligible to access a credit bureau s database may only do so for credit risk management purposes including the assessment of a credit application. The bank of Ghana is the regulatory authority for the Credit Reporting Act 2.3 BORROWERS AND LENDERS ACT 2002 (ACT773)

The borrower and lenders Act 2002 (Act 773) is to strengthen the regulatory framework of the financial sector by ensuring high-level disclosure in creditor and borrower relations. It gives clarity to lending conditions and right s and obligations of the lenders and borrower including respect for contracts and role of collateral. It is intend to reduce information irregularity,

adverse selection within the credit system, and improve the quality of asset portfolio, reduce the cost of lending and interest rate spreads. The most common loans and /or overdraft facilities available to Ghanaian small scale enterprises and corporate are; 1. Working Capital Loans- maturity is usually one year e.g. overdrafts, short term loan etc 2. Development loans both short and medium term with maturity period of up to 5 years e.g. real estate s dealers, industrialists school construction etc. 3. Trade finance loans for handling payment in trade, bid bonds, guarantees for advance payment, import loans 4. Agricultural loans for financing business agricultural activities in production and processing. 5. Letter of credit to finance import trade.

2.4 LOAN REQUIREMENT AND APPRAISAL According to Steven A. Bernstein, senior Advisor and Director, while house initiative on African Mortgage Market of the United States Department of the treasury, one of the most important determinants of a successful micro lending operation is the successful

management of credit risk or more simply, keeping loan delinquencies to an acceptable level. Thus maintaining low delinquencies is critical for minimizing moral hazard. Every financial institution before lending out money to prospective borrowers first considers the borrowers character, his or her ability to repay, the interest spread or margin, the purpose for which the amount is intended for, the quantum of amount requested, the repayment plan and insurance or security available at the disposal of the borrower. If it satisfies itself of these factors, then it proceeds to lend the amount requested to the borrower in anticipation of it being repaid with all accrued and incidental charges as and when they fall due. However, misjudgment on the part of the institution on any of the factors enumerated above would result in the borrower defaulting in the repayment of either all or part of the loan amount thereby eroding the institutions capital. 2.5 CHARACTER OF THE BORROWER According to the Encarta Dictionary, character refers to distinctive qualities: the set of mind and feeling. Single individuals predominantly own a small-scale enterprise which forms about 90% of the Ghanaian economy and as such the characters of these of a borrower s willingness to repay a loan are complex and determined by economic, legal and moral incentives and it s for this reason that the central government passed into law the credit reporting Act 2007, Act 726 which facilitated the establishment of credit reporting bureaus like the XDS data in Ghana to foster access borrows information like borrows pervious loan history with other financial institutions. Empirical studies shows that the likelihood of default rising as the value of the asset decreases relative to the

amount still owed on the loan. Legal system in Ghana and community pressure also contributes to a borrower s willingness to repay a loan. 2.6 BORROWER S ABILITY
Stephen Bernstein, senior Advisor and Director, white house initiative on African Mortgage Markets of united states Department of treasury in his article explain , managing credit risk in micro lending that the basic components of credit risk are a borrower s willingness and ability to repay a loan. Ability to repay a loan is straightforward. It refers to a borrower having the financial resources to make a

scheduled loan payment. Analyzing borrower s financial information and using the appropriate ratios in accessing the borrower s capacity is fundamental for every lending decision. Determination of ability to pay is primarily a function of a borrower s income and financial obligation. This is usually expressed as the ratio of a borrower s monthly payment obligation to the borrower s gross income. In absence of formal information sources, verification of income and obligation can be done through a process of interviewing and observation. 2.7 MAARGIN OR INTEREST SPREAD According to Peter and Hudgins (2008), loan pricing is the most difficult tasks in finance. Lenders want to charge high enough interest rate to ensure that each loan will be profitable and be able to compensate the institution fully for the risk involved. On other hand, loan rate must be low enough to accommodate borrowers in such a way that they would not be driven away to another lender. Higher competition in the market demands that lenders set their interest rates at par with the interest rates on similar loans available in the market. The cost-

plus loan pricing model assumes that, the rate of interest charge on any loan have four (4) components, namely,  The cost of the lender raising adequate funds to lend;  The lenders non fund operating costs:  Compensations paid to the lender for the degree of default risk inherent in a loan; and  The desired profit margin in each loan. There is a drawback for the cost-plus loan pricing model based on its assumption that a lending institution accurately knows what its cost are, which often is not the case. Moreover, this model assumes that a lender can price a loan with little regards for competition posed by other lenders; this assumption can also not be true. Competition will always have an impact on the lender s desired profit margin. The limitation of the cost-plus model led to price leadership in the banking and financial services industries. Major commercial banks established a uniform base lending fee, the prime rate, which is considered to be the lowest rate charged the most credit worthy customer on e short term loans. This led to the formula below MARK UP Loan interest rate= base or prime rate +team risk premium paid by long term borrowers Base or prime rate includes the lender s defined profit margin and overall operating and administrative cost. y Default risk premium refers to the premium paid by non prime rate borrower.

Long term loans are assigned a term risk premium because, lending over a longer period of time expose the lender to more opportunities for loss than does an otherwise comparable short term loan.

The risk premium in the above formula is collecting called the Mark-up. Financial institutions can expand or contract their loan portfolios simple by increasing or decreasing their loan rate mark-up. Many lenders however prefer to vary their loan rejection rates rather than changing their base rates or mark ups. In Ghana, bank of Ghana sets prime rate as the regulatory body of all financial institutions and so banks have no control over this component of the loan interest structure. Inflation and other economic factors have given rise to other loan pricing models like the prime price and the time loan pricing. Appropriate loan design is critical for both a borrower and a lender. Peter and Hudgins (2008) explain that, charging high risk borrowers full premiums is not always a wise decision. Such a policy may increase the chance that a borrower will default on a loan agreement resulting in the lender earning less return compared with what they would earn on prime quality loans. High risk borrowers usually adopt high-risk business strategies with small chance of success in an attempt to meet high loan payments. 2.7.1 THE PURPOSE OF THE LOAN Knowing the purpose for which the amount borrowed is intended for is also of great relevance. The lending institution must satisfy itself as to whether the purpose of the facility is not against its policy or government policy or whether it is with its limit or not. The lender must also know whether:

 The intended purpose is in the interest of the borrower,  The facility is being used as finance or for fixed asset acquisition. 2.7.2 AMOUNT OF THE FACILITY It is always appropriate to know borrowers stake and to establish whether the requested amount is corrected and there are no hidden costs, which the customer may not be aware. Moreover, the banking law stipulates that, saving and loans companies are not allowed to grant any advance, credit or undertake any guarantee or indemnity for any company or group consisting in aggregate 25% of the institution s net worth in case of secured transactions and 10% in the case of unsecured ones. Similar regulation exists for other financial institutions. It is prudent to consider these factors before making any lending decision. 2.7.3REPAYMENT PLAN Lenders use different methods in calculating loan payment schedules depending on their needs, the borrowers needs, the institution s interest rate policy (fixed or variable), the length of the loan, and the purpose of the borrowed money. They often give the borrowers flexibility to repay the loan by trying to accommodate the needs of the borrowers and letting them choose which loan payment method to use. The successful adherence to a particular repayment schedule, the financial institutions accept to reschedule the facility by either extending the payment period or by reducing the repayment amount, whichever way favorable in order to recoup their funds in full

from the borrower. In Ghana, loan durations are usually on short-term basis, which range from one month to twelve months. This is because short term loans are known to be risky compared with long term loan duration loans. 2.7.4 INSURANCE OR LOAN COLLATERAL Lenders usually are unwilling to tend money out without taking collaterals or guarantees to cover the loan amounts. They commonly ask for collaterals like building or vehicular documents, acceptable individuals as guarantors, and cash lien to secure their facilities. A guarantee simply implies the lender would recover in full the principal and interest, in the event of default by the borrower, the lender will use the collaterals to offset the facility. At times, the borrowers are made to pay either one term insurance premium or a periodic premium as a way of securing their loans. The borrowers and lenders Act (Act 773) has given the collateral registry of the bank of Ghana to principally register charges and collaterals created by borrowers to secure credit facilities provided by the lenders because of the numerous litigations in courts and substantial rates of bad debts in the country. The registry also provides information on the existence of relationship between lenders and borrowers. 2.7.5LOAN DEFAULT Ashanti (2005) explain default as when a borrower fails to make full payment (i.e. principal and interest) by the expiry or due date of a facility. Default can also be defined as any violation of a loan contract including failure to pay the interest and the principal when it is due and payable.

Thus, a loan is considered to be default or delinquent if it is over due in installment payment or if any of the principal and interest payment as per the loan, duration is not met or an amount is used when it becomes legally matured. Several a reasons may account for a default in a loan: this can be as a result of the lenders misjudgments or inefficiencies, the borrower s inappropriateness and or the economic conditions pertaining at that point in time. There has be some suggestions made by Stephen Bernstein, Senior Advisor and Director, white house initiative on African Mortgage Market of the United States Department of the Treasury that loan default can be reduced, and or brought to its emptiness minimum. These are as follows;  The inability of the lending institution to do due diligence on the loan appraisal may result in the borrower defaulting in the repayment of the facility. The lender must therefore do proper appraisals to ascertain the risk inherent in any loan proposal to design appropriate measures to curb or reduce the risk. Borrowers must endeavour to provide the all material information regarding their businesses thereby enable the lender to do better assessment.  The balance between the affordability needs of the borrowers and costs to the lender should always be obtained for default to be minimal. Often borrowers get upset over what appear to be usurious interest rates being charged by lenders in Ghana.  Financial institutions should make it easy for borrowers to pay their loans by setting up payment centers in communities or adopt door to door collection point.

 Financial institutions must be proactive in dealing with delinquencies, rather than wait until a loan goes into default. Financial institutions must investigate a loan within weeks of it first becoming delinquent. if caught early will enable the lender to work out an equitable repayment plan or give assistance to the borrowers.  Borrowers must ensure that borrowed funds are used for the purposes for which it was approved. For instance, some borrowers borrow funds in the name of the business but ending up in different thing which does not relate to the business. When this happens, the lenders funds are put at risk since the risk of default increases.  Borrowers must avoid the habit of taking multiple loans from different financial institutions at the same time. This usually increases the borrower s obligations and hence increases the risk of default. Borrowers must however be loyal and trustworthy and always stick to contractual agreements made between them and their lenders to foster good working relations with their financial providers.