Causes of Loan Default in Commercial Banks
Medium to large businesses greatly rely on commercial loans to obtain funding to finance expenses such as acquiring inventory and purchasing equipment or machinery. They are then required to be clearing some specified repayments over an agreed period of time. However, there are cases where this becomes a challenge resulting to missed payments and defaulting.
Some of the major causes of defaulting in commercial banks include:
- Wrong appraisals
Commercial banks are very keen in giving out funds to entrepreneurs and they usually set very strict appraisal procedures that should be followed at all times. These may include checking out the business plan, analyzing financial details, considering collateral, reviewing business or personal credit history and looking at cash flow projections among others.
In some cases, the loan officers may overlook such requirements due to close relations with the business owners or negligence among other reasons. This then results to wrong appraisals and some of the businesses may end up failing to settle the expected repayments.
- Increased competition
Apart from banking institutions, it is now possible to get business financing from other sources like credit unions and even private lenders. This has created increased competition forcing commercial banks to come up with ways of retaining and attracting customers. In trying to do so, some loan officers tend to lower their lending standards and they may end up advancing credit to high risk businesses.
- Lack of supervision
After giving out the approved amount, it is up to the credit officers to follow-up and ensure that the funds are used for the intended purpose. This may involve visiting the business’s premises, carrying out a physical inspection and even carrying out financial analysis. Lack of proper supervision can make it difficult to ascertain how the loan is spent and it can also be hard to notice early signs of failure.
With close supervision, it is very easy to tell if a business is struggling and even make adjustments to the loan terms. This also makes it possible for the credit officer to confirm that the initial lending decision is still valid based on the existing market conditions. The current value of the pledged collateral can also be considered where applicable.
- Economic factors
It is common with loan officers to consider the economic environment surrounding a given business before approving the required financing. Although this may be favorable to start with, things may change for the worst due to factors like:
- Inflation- will affect utilities, rent, cost of operation or production
- Increased interest rates
- High exchange rates- affects income or export business
- Recession- affects consumer spending
Such economic challenges will definitely lower the expected returns and businesses owners may experience challenges trying to raise the required repayment amounts. This will then increase the risks of defaulting.
- Poor business skills
There are skills that are mandatory to run a business efficiently and lacking some of them can easily contribute to defaulting. These include financial management, marketing and sales, proper communication, project planning and implementation, time management and problem solving. By having the mentioned skills, it should be easy to maintain proper records, increase sales and even re-invest to grow the business.
- Unrealistic terms
There are businesses that end up struggling to clear their debts after agreeing to unfavorable repayment terms. This is likely to happen where the loan officers do not spend enough amount of time in trying to carry out financial analysis and ascertain future financial projections. The situation can also occur where proper supervision is not done.
There are still other causes of loan default in commercial banks including natural calamities and individual crisis among others.