Risk-return trade off and loan default consideration in lending decisions: a case study of whence financial services

Abstract

In a bid to construct a decision-making model to remedy the contradictions encountered in lending decisions, the study explored the dysfunctionality caused by risk-return and loans default considerations in lending decisions. Whence Financial Services, a microfinance institution was selected as a case study on the basis of being a good representative of the type of institutions that have exploited the niche under review in terms of size, capacity and range of services offered. Documentary review, survey questionnaire, in-depth interviews and a workshop were used to collect data for the study. Through analysis of this data, the study found that the dysfunctionality was primarily due to risk considerations and the risk was mainly due to information asymmetry between lenders and borrowers. Therefore, the decision-making model was constructed through establishment of a series of actions to be taken before a lending institution settles for guidelines to inform lending decisions, subject to the information asymmetry challenge. The model ensures the risk is managed through weaving together risk management measures to deal with the information asymmetry. The study established that the risk of default was at about 36% and this was way too high compared to the 2% residual risk internationally accepted for microfinance institutions. Therefore, in order to reduce this risk to acceptable levels, the Government and the central Bank of Zambia (BoZ) should take keen interest in local microfinance start-ups which usually start out operations using the money lenders certificate and support them through regulation and constant monitoring. This would greatly help in managing their risk exposure which is core to the dysfunctionality under review which continues to adversely affect the entire finance industry through moral hazard, adverse selection and excessive indebtedness. This is because such a development would increase customer and other stakeholder confidence in the microfinance institutions and this in turn would be vital as it would enable microfinance institutions to collaborate with other stakeholders, a development central to resolving the information asymmetry constraint. Keywords: Risk, Loans default, Microfinance, moral hazard, adverse selection, excessive indebtedness and information asymmetry.