Factors Affecting Non-Performing Loan in the Case of the Development Bank of Ethiopia

Research Paper (undergraduate), 2018

68 Pages




1 Background of the organization
1.1 Back ground of the study
1.2 Statement of the problem
1.3 Research objectives
1.3.1 General objective
1.3.2 Specific Objectives
1.4 Research questions
1.6 Significance of the study
1.7 scope of the study
1.8 Limitations of the Study
1.9 Organization of the paper

Literature review
2.1 Introduction
2.2 Theoretical review
2.2.1. Financial Intermediation Theory
2.2.2 Information Asymmetry Theory
2.2.3 The Theory of Delegated Monitoring of Borrowers
2.2.4 Credit Assessment
2.1.5 Bank risks Credit risk
2.1.7 Meaning of Non-Performing Loans Types of non-performing loan
2. 1.7.2 Causes of non-performing loans
2.8 Strategies for recovery of non-performing loans
2.9 Literature from various scholars
2.1.1 Empirical Studies in Ethiopia
2.1.2 Conceptual framework model

3.1 Study area
3.2 research design
3.3 population
3.4 Sampling techniques
3.5 Data Collection Methods
3.5 Data analysis and presentation
3.6 Description and measurements of variables
3.7 Reliability and Validity

Chapter four
4.0 Introduction
4.3.1 Testing the significance of Regression Coefficient: Value: Hypothesis Testing
4.3.2 R-squared:

5.1 Summary and Conclusion
5.1.1 descriptive summary
5.2 Recommendations


Yom Institute of Economic Development

Joint Master’s Program with Debre Markos University

Factors affecting non-performing loan In The Case of Development bank of Ethiopia

By: Mequanint Zeleke

MSc Thesis Submitted to Debre Markos University and Yom Institute of Economic Development

A thesis submitted to the Department of Project Planning and Management of Debre Markos university and Yom Institute of Economic Development, in partial fulfillment for requirement of Masters of Science Degree in Project Planning and Management

May 2018

AA, Ethiopia


First of all, my limitless thank goes to the Almighty God, who have been helping me in all aspects of my life including the achievement of this master program. Along with, I would like to express my sincere gratitude to my advisor, Dr. Zerihun Birhane for his expert guidance, helpful criticism, valuable suggestions and encouragement at every stage during the completion of this work. It was pleasant and inspiring experience for me to work under his guidance.

Then my heartfelt gratitude goes to my father zeleke Tamene for his continuous encouragement and financial assistance and my brother walelegn zeleke for allowing time and creating conducive environment to focus on my study.

I also add a special note of admiration and gratitude to my friends, class mates, colleagues and associates for their moral support and encouragement while going through this research project.


Non-performing loans are a center of concern for banks in the financial system, among other things, it necessitates maintenance of a low level of non-performing assets. In this regard, to control the increasing non-performing assets in Ethiopian banking sector, the National Bank of Ethiopia allotted a directive which strictly requires all banks to maintain ratio of their non -performing assets below five percent.

This study is therefore attempted to examine factors affecting non -performing loan of development bank of Ethiopia. The main objective is to examine the factors affecting nonperforming loans in DBE central region. After problem identification, Research hypothesis was developed which inquires the relationship and effect of non-performing loans on development bank of Ethiopia. Both secondary and primary data were used in the research. The data is then analyzed using descriptive, correlation and regression techniques through SPSS and Stata software program. The findings of the study revealed that gross domestic product has a positive impact on the occurrence of non -performing loans while other model variables unemployment, inflation rate and exchange rate have no impact on the occurrence of non- performing loan in which negatively affect non-performing loan. according to my study result. Also the result of the primary data indicated that in regarding about customer’s specific causes, the result showed that credit culture of customers, lack of business knowledge, delayed approval, profit of the business, business location were determinants of non-performing loan while bank specific factors include poor credit assessment, poor customer selection, aggressive lending policy, borrowers culture, credit size affected non-performing loan.

1 Background of the organization

The concept of development financing has evolved; to become what it is today. It was the evil market failure that necessitated the formation of development financing (Asrat, 2013).

Development finance institutions provide finance to the private sector for investments that promote development and these institutions provide finance and the finance in general offered in the form of long term loans.

Banking sector provides a wide range of financial services and plays vital & central role in the economy and the society as a whole. Development bank of Ethiopia plays a vital role in the economic resource by lending to people for various investment purposes. It is one of state owned financial institutions that is engaged in as long as short, medium and long term credit over the last 107 years from its establishment till now. The Bank has been playing central role in promoting the over-all economic development of the country meanwhile its establishment and got national recognition in long-term investment financing and it is recognized internationally as an important on-lending channel for development agendas financed by bilateral and /or multilateral sources. The recent focus of the government in relation to the revised credit policy of DBE is to provide medium and long term loans for investment projects in the Government priority areas such as Commercial Agriculture, Agro-processing, Manufacturing Industries, Mining and Extractive Industries preferably, export focused as well as lease financing for Small and Medium Enterprises. DBE provides loan services to applicants after undertaking appraisal studies in reliable methods to ascertain the viability of the proposed projects and in parallel with provides technical support to new applicants and its clients. The bank also provides The Bank provides banking services such as deposit facilities in the form of time credit and current accounts as well as money transfer services. These services are provided to its clients and funding institutions. The Bank also gives international banking service and related activities, providing L/C services to its clients to import capital goods and raw materials and to export produced products. In line with the Agriculture Development Led Industrialization Strategy (ADLI) of the Country, the bank focuses provision of medium and long-term loans for investment projects in the Government priority areas encouraging investment in Commercial Agriculture, Agro-processing Industries, Manufacturing Industries, Mining and Extractive Industries and lease financing for Small and Medium Enterprises (SMEs). The Bank finances large scale irrigable besides rain fed agricultural farms. Financing for rain fed agricultural farms is to be only for the production of sesame and cotton located in agro-ecological zones with reliable rain fall. The Bank also offers loan for project expansion in the priority area: priority area project requesting for expansion will be those projects which have been properly implemented and proved to be successful financially as healthy as in the area of project management.

1.1 Background of the study

Banking sector provides a wide range of financial services and plays important & central role in the economy and the society as a entire. Among the financial services, Credit is used for investments to increase the productivity of agricultural operations or to diversify the economic activities of rural households. (AEMFI, 2010). It is in the realization of the fact that credit is a critical factor in economic development in general and agricultural development in particular that for most governments in the developing states, the channeling of bank lending to agriculture has increasingly become an important policy instrument for increasing agricultural output (Egbe, 1990).Recognizing the importance of farming, manufacturing sector and service in Ethiopia’s development, the government of Ethiopia established policies that make credit available to commercial farmers and small farmers, manufacturers and service delivers. More specifically, DBE gives a due emphasis for promoting the agriculture sector by considering this sector as a priority area for loan advancement along through the manufacturing and export sector in its strategic goal. DBE is one of the banking sector which extends credit to credit worthy borrowers and projects that have received appraisal and found to be financially and economically viable and socially desirable in terms of environment protection, employment generation and other social benefit that may be included in the framework of development regulation act of the Government. A sound financial system, among other things, requires building of a low level of nonperforming assets which in turn facilitates the economic development of a country in general and the bank in particular. Nonperforming assets are a major issue and challenge for banking industry which have been threatening profitability through loss of interest income and write-off of the principal loan amount itself. Problem of non-performing assets [NPAs] in financial institutions has been a matter of great concern not only for the banks but also the real economy in general, as NPAs can choke further expansion of credit which would impede the economic growth of the country. AS possible, proper credit management and speedy reduction and elimination of non-performing asset is one of the major critical and main tasks of banks. Credit risk management should also be at the center of banks operations in order to maintain financial sustainability and reaching more clients with diversified business taking its financial statuesque and building huge capital at large. Loans and advances are the risky activities which expose development bank of Ethiopia to the risks of default from its borrowers. Due to this, National Bank of Ethiopia which is governing all banks issued repeated directives to standardize the reporting system and regular monitoring of non-performing assets in Ethiopian banking sector. The directives also strictly require all banks to maintain ratio of their non -performing loans below five percent (National Bank of Ethiopia, 2008). Non-performing assets (NPAs) are a hot issue that affects the stability of financial markets and the economy in general and the banking industry in particular. One of the major challenges of the current banking industry is credit risk which has been exposing the fast growing industry to non-performing assets. An efficient and well-functioning financial sector is essential for the development of any economy, and the achievement of high and sustainable growth having Asset quality which is one of the indicators of financial sector’s health. As discussed by Mac Donald and Koch (2006), loans are the dominant asset and represent 50-75 percent of the total amount at most banks, which also generate the largest share of operating income and represent the banks greater risk exposure.

The contribution of loans to the growth of any country is huge in that banks are the main intermediaries between depositors and those in need of fund for their viable projects. If there is sound financial system, borrowers can get recognition easily for the intended purposes which enhances economic development by implementing the loan they got for viable projects. Indeed, managing loans in a proper way has positive effect on the performance of banks’ and the borrower firms’ in particular and a country as a whole.

Provision of credit alone does not support the economic development of the country unless it is accompanied by the existence of factors necessary for efficient utilization of the fund in order to repay the loan in accordance with the agreement. The sustainability of the bank depends not only on domestic and foreign source of fund but also on its loan recovery rate too. The loan repayment performance of its clients must be effective so that the bank will be sustainable and financially stable with good asset quality. One of the measurements by which bank’s asset quality can be measured is the nonperforming loan ratio (NPLs ratio). Hence, in order to get soft loan from its lenders, DBE’s asset quality has to be regularly examined and assessed whether it is within the acceptable standard or not that is 15% of the total unpaid loan which is set by Association of African Development Finance Institutions.

Most of the default arose since poor management procedures, loan diversion and unwillingness to repay loans, etc. Because of this, the lenders must give various institutional methods that aimed to reduce the risk of loan default (Ahmmed et al., 2012). Bank in sound financial position, the loans extended to various sectors of the economy must be recovered in full. Both the principal which is used for re-lending as well as the interest to meet the operating costs must be recovered. Due to various factors, Bank’s loan repayment performance has been very low. These factors explained among others the credit repayment behavior of borrowers, lending behavior of the Bank and macro-economic factors. These factors brought significant impact on the sustainable provision of credit to the potential savers and existence of the bank as a financial institution (DBE Annual Report, 2014).

Knowing the critical factors and investigating deeply the impact that brought helps the bank to recover existing loans and tackling and minimalizing the problem which enhancing loan recovery of projects to stabilize the bank financial position and the economy in general.

1.2 Statement of the problem

Credit has been considered as one major tool for bank capital growth and economic development. Similarly, DBE provides sustainable credit facility for those engaged in agriculture, industrial and other service sectors which can consequence in development of the country. So, in order to maintain this objective, the bank needs to strengthen its liquidity position by enhancing its loan recovery performance. The return of loans is a bank’s major source of revenues. Banks sometimes have to accept some risky loans because of the pressure of revenues (Singh, 2005). If banks can successfully diversify their sources of revenues, it should be able to ease the pressure of revenues from loans and thus, effectively reduce the rate of nonperforming loans (Nobuo, 2005). Most nonperforming loans are caused by borrower decisions. Sometimes borrowers decide to qualify for loans without thinking enough about the future and what else they need to buy with their income. Any sudden market change can change the loan market by affecting how much money people have to take out loans and make payments. If the market suddenly changes and the prices of products increase due to shortages or superior demands, borrowers will have less money to pay their loans, which can lead to greater overall nonperformance. Non-performing loans can be treated as undesirable outputs or costs to a loaning bank, which decrease the bank’s performance (Chang, 1999). The risk of non-performing loans mainly arises as the external economic environment becomes worse off such as economic despairs (Sinkey and Greenawalt, 1991). Banks with large sizes have more resources to evaluate and to process loans. These can improve the quality of loans and thus, effectively reduce the rate of nonperforming loans (Singh, 2005). Bank’s sizes hence are anticipated to be negatively related to non-performing loans, but at a diminishing rate (McNulty et al, 2001). Due to NPLS bank’s profitability is eroded and there is capital depreciation. Having this, banks are not eager to take on new risks and invest in new customers. Secondly, the prolonged problem of non-performing loans has preserved inefficient corporations and industries and thus lowered the productivity of the banking industry and the economy as a whole. Thirdly, concerns about the stability of the financial system cannot be maintained due to the problem of non-performing loans and, as a result, corporations and households have become prudent in their investment and consumption behavior, which in turn serves to block economic recovery (Swamy, 2012).

Financial institution like DBE should maintain its stable financial position by reducing the rate of increasing non-performing loan. The increasing number of nonperforming loans of different entities and individual creates a important impact and negative values to the financial stability and to country’s economy as a whole. In the long-run, this impact will reach the entire economy and leads to increase the credit crisis (Swamy, 2012). Nobuo (2005) argues that, if the non-performing loans are kept existing and continuously rolled over, the resources are locked up in unprofitable sectors; thus, hindering the economic growth besides impairing the economic efficiency. Even if actions are made by the bank and with the regulation of national bank of Ethiopia, NPLS rate should be at minimum of below 5%, around is still going to be serious problem that the total NPL of DBE during the fiscal year 2015/16 both principal and interest amounted to birr 5.6 billion (source annual report of DBE). As compared to the preceding year same period performance, NPLS amount of the head office and regional offices showed an increase by 43% and 28 % respectively (source annual report of DBE). From the fiscal year 2006/07 to 2015/16 for the last ten years, the average yearly growth rate of the total NPLS is 12 %. (source annual report of DBE). So this shows there is advanced level of total NPLS which destructs the financial position and its profitability and the economy as whole. Various studies have been studied at foreign banks in regarding about determinants of NPLS. Besides, most of the prior studies conducted in other countries focused on bank specific and macro-economic determinates of NPL. So taking this in to consideration the researcher is considering customer specific factors to study to reduce the default rate and to enhance the sustainability of the bank. Hence as per the researcher knowledge, it appears that adequate researches have not been made that comprehensively assess the determinants of Non-Performing Loan in DBE. Meanwhile, several studies obligated been undertaken on DBE, for example, a study conducted by Tefera (2005), focused on the credit operation and financial performance of DBE, which mainly focuses on the financial performance of DBE by using different financial performance measurement tools, like Return On Equity (ROE), Return On Asset (ROA). A study was also conducted by Gebeyehu (2002), on the loan repayment and its determinants of small scale enterprise financing, but, this study is very narrow and does not deal at large the whole financing the bank deal with its customers and did not touch the recovery of the NPL.

1.3 Research objectives

The objectives of this study were divided into two main categories, that is; general objective and specific objectives as itemized here below.

1.3.1 General objective

The general objective of the study is to examine the factors affecting nonperforming loans in DBE central region.

1.3.2 Specific Objectives

i To assess bank-specific factors affecting Nonperforming loans of DBE.
ii To assess borrower-specific factors that affect Non-performing loans of the DBE.

1.4 Research questions

The researcher tried to narrow the research gaps through focusing on factors affecting Non-performing loans financed by the DBE through the use of the following research questions.

1 What are the major bank-specific factors affecting Nonperforming loans of DBE?
2 What are the major borrower-specific factors that affect Non-performing loans of the DBE?

1.6 Significance of the study

This study examined the factors that affect non-performing loans in development Bank of Ethiopia and showed the bank and other stakeholders to alleviate the problem of non-performing loan. This study created awareness for bank industry in regarding about factors affecting non-performing loan for the purpose of future study to tackle the problem of the NPLS which highly affect the financial stability of the country in general and the bank in particular.

1.7 scope of the study

The study area covered development bank credit only. Thus, the results from the study did not reflect the overall situation in commercial bank and private banks and the whole Ethiopian Economy and the study area only covered about NPLS that affect the bank, not other factors affecting the financial stability of DBE.

1.8 Limitations of the Study

The limitation of the study was as follows: -

The time which is allocated for data collection was not enough since it is very important and tedious work due to the rigidity of the bank official not to give data about NPLS as it is a great problem concerning the bank.

1.9 Organization of the paper

The rest of the study was organized as follows: chapter two presented a brief review of the studies carried out chapter three discussed the data and methodology that were used, chapter four presents the estimation results and analysis, and the final chapter draws conclusions and provides some policy recommendations

2 Literature review

2.1 Introduction

Literature review includes relevant literature with the aim of gaining insight about non-performing loans within bank industry. It covers: hypothetical framework, conceptual frame work, and empirical studies which shows light on causes of loan default within banking industry.

2.2 Theoretical review

2.2.1. Financial Intermediation Theory

Financial intermediation is a process which involves surplus units depositing funds with financial institutions who then lend to deficit units. Matthews and Thompson (2008) identify that financial intermediaries can be distinguished by four criteria: first their main categories of liabilities (deposits) are specified for a fixed sum which is not related to the performance of a portfolio. Second the deposits are typically short-term and of a much shorter term than their assets. Third a high proportion of their liabilities are demanded (can be withdrawn on demand). And fourth their liabilities and assets are largely not transferable. The most important contribution of intermediaries is a steady flow of funds from surplus to deficit units.

2.2.2 Information Asymmetry Theory

This theory is based on that the borrower is likely to have more information than the lender about the risks of the project for which they receive funds. This leads to the problems of moral hazard and adverse selection (Matthews and Thompson, 2008). These problems reduce the efficiency of the transfer of funds from surplus to deficit units. The banks overcome these problems first by providing commitment to long-term relationships with customers and then through information sharing and finally through delegated monitoring of borrowers.

2.2.3 The Theory of Delegated Monitoring of Borrowers

Monitoring of a borrower by a bank refers towards information collection before and after a loan is granted, including screening of loan applications, examining the borrowers ongoing creditworthiness and ensuring that the borrower adheres to the terms of the contract. A bank often has privileged information in this process if it operates the client’s current account and can observe the flows of income and expenditure. This is utmost relevant in the case of small and medium enterprises and is linked to banks‟ role in the payments system (Matthews and Thompson, 2008). Engagement in financing begins with customer recruitment and selection. An issue of KYC (Know Your Customer) is so vital before proceeding to detail. Banks use various sources about its customers to get full information before yielding its credit. Use of financial statement, credit report from credit bureau, customers’ history if not new is the potential sources of (Bloem and Gorter, 2001).

2.2.4 Credit Assessment

Credit analysis is the first step in the process to tailor-make a solution to fit the customer’s needs. The assessment starts with an understanding of the customer’s needs and capacities to ensure there is a good fit in terms of the supporting solution. Credit assessment is the most important safeguard to ensure the underlying quality of the credit being granted and is considered an essential element of credit risk management (Cade, 1999).

The credit quality of an exposure generally refers to the borrower’s ability and willingness to meet the commitments of the facility granted. It also includes default probability and anticipated recovery rate (Saunders & Cornett, 2003). Credit assessment thus involves assessing the risks involved in financing and thereby anticipating the probability of default and recovery rate.

A credit analysis is used by the credit official to evaluate a borrower’s character, capital, capacity, collateral and the cyclical aspect of the economy, or generally referred to as the five C’s (Strischek, 2000). Detailed discussion of this model, also referred as the five C’s is done the next section.

The Five C’s of Credit

The credit analysis process, traditionally employed by the first banks, does not differ fundamentally from the processes used today (Caouette et al, 1998; Rose, 2002). The five C’s are considered the essentials of successful lending and have been around for approximately 50 years. Initially only character, capacity and capital were considered.

However, over the year’s collateral and conditions were added. These provided an even more comprehensive view and clearer understanding of the underlying risk and resulting lending decision (Beckman & Bartels, 1955; Reed, Cotter, Gill & Smith, 1976; Sinkey, 2002).

According to Murphey (2004a), these principles should be the cornerstone of every lending decision. The five C’s are discussed as follows:


Character refers to the borrower’s reputation and the borrower’s willingness to settle debt obligations. In evaluating appeal, the borrower’s honesty, integrity and trustworthiness are assessed. The borrower’s credit history and the commitment of the owners are also evaluated (Rose, 2000). A company’s reputation, referring specifically to credit, is based on past performance. A borrower has built up a good reputation or credit record if past commitments were promptly met (observed behavior) and repaid timely (Rose, 2002; Koch & McDonald, 2003). Character is considered the most important and yet the most difficult to assess (Koch & MacDonald, 2003).

Bankers recognize the essential role management plays in a company’s success. Critically analyzing quality of managing has been one of the ways of assessing character. The history of the business and experience of its management are critical factors in assessing a company's ability to satisfy its financial obligations.

The quality of management in the specific business is evaluated by taking reputation, integrity, qualifications, experience and management ability of various business disciplines such as finance, marketing and labor relations into consideration (Sinkey, 2002; Nathenson, 2004).

These factors can be regarded as a risk mitigants if a banker views these positively. Much of its success can in fact be attributed to competent leadership. Companies with strong and competent management teams tend to survive in an economic downturn.

On the other hand, confidentially owned companies are generally managed by its owners. In this instance, succession planning must be in place, as the role of management remains vital to the success of the company (Koch & MacDonald, 2003).


Capacity refers to the business’s ability to generate sufficient cash to repay the debt. An analysis of the applicant’s businesses plan, controlling accounts and cash flow forecasts (demonstrating the need and ability to repay the commitments) will give a good indication of the capacity to repay (Sinkey, 2002; Koch & MacDonald, 2003).

To get a good understanding of a company’s capacity evaluating the type of business and the industry in which it operates is also vital. It plays a significant role since each industry is influenced by various internal and external factors. The factors that form the basis of this analysis includes: Type of industry, Market share, Quality of products and life cycle, whether the business is labor or capital intensive, the current economic conditions, seasonal trends, the bargaining power of buyers and sellers, competition and legislative changes (Koch & MacDonald, 2003; Nathenson, 2004). These factors lead the banker to form a view of the specific company and industry. The banker would regard this as a potential risk mitigate if he/she is confident about the company and industry and prospects for both appear to be positive.

Besides, the financial position is also a critical indication of a business’ capacity. The company’s financial position is evaluated by assessing past financial performance and projected financial performance. A company’s past financial performance is reflected in its audited financial statements (Koch & MacDonald, 2003). Financial projections consist of projected cash flows demonstrating the need intended for the facility and the ability to repay the facility (Sinkey, 2002). In this regard at least three years audited financial statements (balance sheet and income statement) are required for data analysis. A financial spreadsheet is used to undertake the analysis.

Commercial banks utilize the monetary spread (i.e. audited financial statement analysis and ratio calculations - DuPont) and it is applied through the Moody’s Risk Advisor. The model also performs a peer comparison and calculates the probability of default (Koch & MacDonald, 2003). The following financial ratio analyses are very critical in assessing business’ position (Koch & MacDonald, 2003):

- Liquidity ratios - reflect the company’s ability to meet its short-term obligations.

According to Conradie and Fourie (2002), the current ratio is calculated by dividing the current assets by the current liabilities.

- Activity ratios- indicate whether assets are efficiently used to generate sales.
- Leverage ratios- indicate the company’s financial mix between equity and debt and potential volatility of earnings. In height volatility of earnings increases the probability that the borrower will be unable to meet the interest and capital repayments.
- Profitability ratios- supply information about the company’s sales and earnings performance.

The cash flow analysis requirement to be done once the ratio analysis has been evaluated. The cash flow analysis allows the banker to distinguish between reported accounting profits (net income) and cash flow from operations (cash net income). Cash flow from operations gives an indication of how much cash is generated from normal business activities. The cash flow generated must be sufficient to service the banking facilities (Sinkey, 2002; Koch & MacDonald, 2003). These assumptions are evaluated against the company’s past performance, industry averages and expected economic trends (Nathenson, 2004).

An assessment of the financial capacity of a company should always include an evaluation of trends. Evaluating tendencies over a three to five-year period gives a clear picture of the direction a firm is heading. Ratio results should always be compared to a peer group of or an industry comparison. Is the firm accumulating faster or slower than the rest of the industry? Is this company more profitable than other companies just like them? In this regard making a maximum use of ratios by comparing the firm to its peers using established benchmarks is so vital. Comparison of the company to firms in the same line of business, geographic area and employee size provides a more accurate comparison.

The projections also reveal the purpose, amount and type of finance required. It also provides insight into the company’s ability to generate sufficient cash flow to service the debt (Murphey, 2004b; Nathenson, 2004). Banks must ensure that the type of financing is aligned to the purposed of finance (Rose, 2000).

Analysis of the financial capacity of the organization should also be carried out in order to determine a insolvent’s ability to meet financial obligations in a timely fashion. Its ability to pay may be much more important. It is critical to understand the difference. Watching customer payment habits over time is an excellent indication of cash flow. Also, checking bank and trade references, as well as any pending litigation or contingent liabilities are pivotal. Further checking for a parent company relationship is important as a parent company's guarantee may be available. Intercompany loans might affect financial solvency. Agency ratings that predict slow payment or default should be carried out before completion of investigating capacity of a borrower.


Capital refers to the owner’s level of investment in the business (Sinkey, 2002). Banks prefer owners to take a proportionate share of the risk. Although there are no hard and fast rules, a debt/equity ratio of 50:50 would be satisfactory to mitigate the bank’s risk where funding (unsecured) is based on the business’s cash flow to service the funding (Harris, 2003).

Lenders prefer noteworthy equity (own contribution), as it demonstrates an owner’s commitment and confidence in the business venture.


Conditions are external circumstances that could affect the borrower’s ability to repay the amount financed. Lenders ponder the overall economic and industry trends, regulatory, legal and liability issues before a decision is made (Sinkey, 2002). Once finance is approved, it is normally subject to terms and covenants and conditions, which are specifically related to the compliance of the approved facility (Leply, 2003).

Banks normally include covenants along with conditions when credit facilities are granted to protect the bank’s interest. The primary role of covenants is to serve as an early warning system (Nathenson, 2004). Conditions normally stipulate that all the security relevant to the loan should be in order before any funds will be advanced.


Collateral (also so-called security) is the assets that the borrower pledges to the bank to mitigate the bank’s risk in event of default (Sinkey, 2002). It is something valuable which is pledged to the bank by the borrower to support the borrower’s intention to repay the money advanced. Supporting of the aforementioned, Rose and Hudgins (2005) define secured lending in banks as the business where the secured loans have a pledge of some of the borrower’s property (such as home or vehicles) overdue them as collateral that may have to be sold if the borrower defaults and has no other way to repay the lender.

The purpose of security is to reduce the risk of giving credit by increasing the chances of the lender recovering the amounts that become due to the borrower. Security increases the availability of credit and improves the terms on which credit is available. The offer of security influences the lender’s decision whether or not to lend, and it also changes the terms on which he is prepared to lend, typically by increasing the amount of the loan, by extending the period for which the loan is granted then by lowering the interest rate (Norton and Andenas, 1998: 144).

According to De Lucia and Peters (1998), in the banking environment, security is required for the following three reasons:

- to ensure the full commitment of the borrower to its operations,
- to provide safeguard should the borrower deviate from the planned course of action outlined at the time credit is extended, and
- to provide insurance should the borrower default.

The security value of an asset is based on the estimated re-sale value of the assets at the time of disposing of it (McManus, 2000) The specific type of property is valued by the bank to determine the property’s market value for security purposes (Rose, 2000).

Besides the physical collateral a third party can provide a suretyship for the debt of the borrower. Should the borrower not be in a position to repay the debt, the bank will then call on the surety for repayment (Koch & MacDonald, 2003). It is normal banking practice for the banks to take the suretyships of the shareholders/directors when funds are advanced to a company (Rose, 2000; Vance, 2004).

C’s” are well-known byline assessment principles, commercial banks have developed its own qualitative credit risk assessment models to assess whether the bank will agree to lend to a specific business (Sinkey, 2002).

Based on the credit information obtained about the borrower and credit assessment carried out, either by quantitative or qualitative model (through the use of the five C’s) or combination of both, credit sanctioning is done. The section that follows discusses the credit sanctioning or approval process.

An individual’s and or company’s credit record is observed and credit office communicates to those who request in regarding about company’s experiences with credit, leases, non-credit-related bills, monetary-related public records, and inquiries about the individual’s credit history.

Further according to Ferreti (2007), credit is usually integrated with data from other sources such as court judgments, electoral rolls and other private provided by others, which compile additional referring to a consumer. This is an ideal source of input for credit analysis. Credit providers use credit to conduct credit threat analysis of prospective borrowers in order to mitigate credit risk. Nobuo (2003) highlight that sharing is useful both at the origination stage and after credit has been extended. Especially at the origination phase, sharing reduces the problems of adverse selection. In fact, the exchange of credit improves non-performing loan ratios, leads to fewer losses through write offs and decreases interest rates for good credit risks. (Jentzsch, 2008). Jentzsch (2008) further supports that sharing credit among lenders intensifies competition and increases access to finance. Further, Nkusu (2011) highlight that sharing reduces adverse selection problems and thereby promotes financial stability; it serves as a borrower disciplining device. According to Adela and Julia (2010), greater sharing of trade credit data, particularly in the informal sector, could greatly expand credit access for small and medium enterprises. In addition, Khemraj and Pasha (2009) show that exchange will assist in minimizing lending corruption in banks by reducing asymmetry between consumers and lenders, improving the bribery control methods. The exchange of consumer credit kinds borrowers to be disciplined to repay loans because borrowers do not want to damage the good report which can variety it difficult for them to get credit ((Swiss National Bank, 2008) Once credit on the loan request is obtained bank officers precede with credit analysis or assessment process.

B Credit Analysis Process

Credit analysis is the first step in the process to make a solution to fit the customer’s needs by beginning understanding of the customer’s needs and capacities to insure whether there is financing solution. Credit valuation is the most important safeguard to ensure the underlying quality of the credit being granted and is considered an essential element of credit risk management (Goosen et al, 1999). It also includes default probability and anticipated recovery rate (Saunders and Cornett, 2003). Credit assessment thus involves assessing the risks involved in financing and thereby anticipating the probability of default and recovery rate. A credit analysis is used by the credit officials to evaluate a defaulter’s character, capital, capacity, collateral and the cyclical aspect of the economy, or generally referred to as the five C’s (Strischek, 2000).

C Credit Approval process

Extending credit is the careful balance of limiting risk and maximizing profitability while maintaining a competitive edge in a complex, global marketplace. Credit approval is the process of deciding whether or not to extend credit to a particular customer. The credit analysis process consists of a subjective analysis of the borrower’s request and a quantitative analysis of the financial provided.

Comprehensive presentation of the risks when granting the loan and an adequate assessment of these risks shows the quality of the credit Approval process. Due to the considerable differences in the nature of various borrowers and the assets to be financed as well the large number of products and their complexity, there cannot be a uniform process to assess credit risks (Khemraj and Pasha, 2009).

The quality of the credit approval process from a risk perspective is determined by the best possible identification and evaluation of the credit risk resulting from a possible exposure. The credit risk can be distributed among the following risk components; i) Probability of default (PD), ii) Loss given default (LGD) and iii) Exposure at default (EAD) according to Saunders and Cornett (2003).

i) Probability of default (PD)

Default probability is the possibility that the business will default on its repayment over the term of the facility. Reviewing a borrower’s probability of default is basically done by evaluating the borrower’s current and future ability to fulfill its interest and principal repayment obligations.

ii) Loss given default (LGD)

Exposure at default is the magnitude or exposure that would be materialized in the event of a default. It addresses what fraction of the exposure may be recovered through bankruptcy proceedings or through some other form of settlement in the event of a default. The loss given default is affected by the collateralized portion as well as the cost of selling the collateral. Therefore, the calculated value and type of collateral also have to be taken into account in designing the credit approval processes.

iii) Exposure at default

The exposure at default corresponds to the amount remaining to the institution. Thus, besides the type of claim; the amount of the claim is another important element in the credit approval process. Once has been gathered, the firm faces the hard choice of either granting or refusing credit.

D Loan Follow Up or Credit Monitoring Process

Lending decision is made on sound credit risk analysis/appraisal and assessment of creditworthiness of borrowers. A loan granted on the basis of sound analysis might go bad because of the borrower may not meet requirements per the terms and conditions of the loan contract. A loan granted on the basis of sound analysis might go bad because of the borrower may not meet obligations per the terms and conditions of the loan contract. It is for this reason that proper follow up and monitoring is essential. Monitoring or follow-up deals with the following vital aspects; i) Ensuring compliance with terms and conditions; ii) Monitoring end use of approved funds; iii) Monitoring performance to check continued feasibility of operations; iv) Detecting deviations from terms of decision; v) Making periodic assessment of the health of the loans and advances by nothing some of the key indicators of performance that might include: profitability, activity level and management of the unit and guarantee that the assets created are effectively utilized for productive purposes and are well maintained; vi) Ensuring recovery of the installments of the principal and interest in case of term loan as per the scheduled repayment program; vii) Identify early warning signals, if any, and initiate remedial measures thereby averting from possible default (Harris, 2006).


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Factors Affecting Non-Performing Loan in the Case of the Development Bank of Ethiopia
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Mequanint Zeleke (Author), 2018, Factors Affecting Non-Performing Loan in the Case of the Development Bank of Ethiopia, Munich, GRIN Verlag, https://www.grin.com/document/515299


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