CHAPTER ONE

INTRODUCTION

1.1       Background to the Study

Sourcing money may be done for a variety of reasons. Traditional areas of need may be for capital asset acquirement – new machinery or the construction of a new building or plant. The development of new products can be enormously costly and here again capital may be required. Normally, such developments are financed internally, whereas where internal source in not enough the firm may result to external sourcing. In this day and age of tight liquidity, many organisations have to look for short term capital in the way of overdraft or loans in order to provide a cash flow cushion.

Generally, the financial system is more than just institutions that facilitate payments and extend credit. It encompasses all functions that direct real resources to their ultimate user. It is the central nervous system of a market economy and contains a number of separate, yet dependent, components all of which are essential to its effective and efficient functioning (Sanusi, 2012). According to Aruwa (2011), commercial banks remain the formal source of finance for enterprises. He states that banks have three social and economic functions: to collect and secure savings and other deposits; to finance the economy by handing out credits; and to facilitate payments and to transfer funds. Their role is to reduce the gap between supply and demand that exists between idle money and productive investment.

Bank lending is guided by credit policies which are guidelines and procedures put in place to ensure smooth lending operations. Bank lending if not properly assessed, involves the risk that the borrower will not be able or willing to honour their obligations (Feder& Just, 1980). Beyond the urge to extend credit and generate revenue, banks have to recover the principal’ amount in order to ensure safety of depositors’ fund and avoid capital erosion. Bank lending therefore has to consider interest income, cost of funds, statutory requirements, depositor’s needs and risks associated with loan proposals. For these reasons banks have overtime developed credit policies and procedures which stipulate the lending process. This process includes among others the credit appraisals, documentations, disbursement, monitoring and recovery processes of lending.

 According to Roy and Lewis (1971), giving credit to worthy borrowers is one of the most significant functions of commercial banks that are directly related to the development of the economy. If those loans or credit where not grow, the expansion of our production facilities and operations would almost be impossible or take a longer time.

Lending criteria are basic principles of lending which are Character, Capacity, Capital, Collateral and Conditions. Adeyemi (1994) describes using lending criteria as credit analysis as the ‘heart’ of a high quality portfolio. This involves gathering, processing and analyzing of quality information as way of discerning the client’s creditworthiness and reducing the incentive problems between the lenders as principals and the borrowers as agents. The bank’s credit policy, procedures and directives guide the credit assessment process.

Matovu and Okumu (1996) state that, banks should base their credit analysis on the basic principles of lending which are Character, Capacity, Capital, Collateral and Conditions, this Matovu and Okumu (1996) aver that, it is designed to ensure lenders take actions which facilitate repayment or reduce repayment likely problems. This information about the riskiness of the borrower has necessitated banks to beam their search lights on thorough scrutiny through measurement of debtor’s capacity and capital structure as lending criteria; they also take remedial actions like asking for collateral, shorter duration of payment, high interest rates and other forms of payments (Stiglitz & Karla, 1990). When these steps are not adhered to, loan performance is highly affected. Edminster (1980) stresses the importance of credit analysis, when he observed that its abandonment often resulted into several banks witnessing non-performing loans and bad debts. The variable we have, according to Hunte (1996) includes the scrutiny of debtors’ Capacity and Capital structure, credit experience, proportion of collateral security to the loan approved. It was found out that capital structure reflected in inability to repay larger credit facilities accessed, while Capacity reflected on shortage of credible performance information required to make informed credit decisions.

Non-performing loan is a non income earning loan, full payment of principal and interest is no longer anticipated, principal or interest is 90 days or more delinquent, the maturity date has passed and payment in full has not been made. The issue of non-performing loans (NPLs) has gained increasing attentions in the last few decades. The multiple consequence of large amount of NPLs in the banking system is liquidity problems and eventual distress. However, many researches on the causes of bank distress find that asset quality is a statistically significant predictor of insolvency and that failing banking institutions always have high level of non-performing loans prior to failure (Barr &Siems, 1994). There is no global standard to define non-performing loans at the practical level. Variations exist in terms of the classification system, the scope, and contents. Such problem potentially adds to disorder and uncertainty in the NPL issues.