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Most banks fail as a result of mismanagement of credit risk. In this paper, the management of credit risk as it affects loan portfolio management and proactive strategy to seek out relative value opportunities are considered. An operational research technique, linear programming, is applied to the management of loan portfolio of banks. With the results obtained, using Simplex method, an answer is provided to the question of how to avoid possible occurrence of non-performing loans, bad and doubtful debts in banks when some percentage of the loans they give out are not secured.

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**LOANS AND BAD DEBT RISK CONTROL IN BANKS
**

AGARANA M. C., ANAKE T. A. & ADELEKE O. J.

Department of Mathematics, College of Science and Technology, Covenant University, Ota, Ogun State, Nigeria

ABSTRACT

Most banks fail as a result of mismanagement of credit risk. In this paper, the management of credit risk as it

affects loan portfolio management and proactive strategy to seek out relative value opportunities are considered.

An operational research technique, linear programming, is applied to the management of loan portfolio of banks.

With the results obtained, using Simplex method, an answer is provided to the question of how to avoid possible

occurrence of non-performing loans, bad and doubtful debts in banks when some percentage of the loans they give out are

not secured.

KEYWORDS: Bad Debt, Linear Programming, Loan Portfolio, Credit Risk, Sensitivity Analysis, Simplex Method,

Unsecured Loan

INTRODUCTION

Apart from fraud, one of the greatest problems facing most banks today is debts (non-performing debts or loans,

bad and doubtful debts) [l]. The success of any bank in a very competitive lending environment will depend largely on the

way and manner the loan portfolio of the bank is being managed. An effective way of evaluating bank’s credit policies for

bad debt is through the linear programming approach. Linear programming is a time-lasted-problem solving approach that

enhances decision making of managers especially when certain restrictions or constraints exist which could affect the

decision making process. It is a procedure for finding the maximum or minimum of a linear function where the augments

are subject to linear constraints. The Simplex method, first proposed by Dantzig in 1947 [9], is one well known algorithm

belonging to this class [4].Bad debt can be defined as debt that occurs when a firm believes that a debtor is unable or

unwilling to pay and business will never be able to recover the money owed[3]. Bad debt has been a critical issue in the

banking sector. Some of these issues arise when loan are given to customers, but due to insincerity or other reasons these

loans are not paid back.

This affects the banks returns. Despite the low emphasis on loans and advances in most economies, the problem

of bad debts would continually constitute a major threat to the banking industry. This paper seeks to find an optimal way of

managing the loan portfolio of banks in other to maximize profit. Linear programming technique is adopted.

This technique has become, nowadays, a quantitative technique most decision makers use in solving a variety of problems

related to management decision, from scheduling, media selection portfolio selection, firm planning, financial planning to

capital budgeting and transportation [5]. The bank loan strategy should seek to construct a broadly diversified portfolio of

bank loans that maximizes return and minimizes default risk over the long run [1].

FORMULATION OF MODEL

The various notations and variables to be used in developing the model are defined as follows:

BEST: International Journal of Management, Information

Technology and Engineering (BEST: IJMITE)

ISSN 2348-0513

Vol. 2, Issue 7, Jul 2014, 93-102

© BEST Journals

94 Agarana M. C., Anake T. A. & Adeleke O. J.

Definition of the Decision Variables

The values of x

ì]

denotes the unsecured amount to be allocated to investment type ] within the loan class i.

The decision variables are shown in the following table:

Table 1: Showing the Decision Variables

S/N Loan Classification Investment Type

Source of Loan

Finance

Decision

Variables

1 Long term loan Mortgage finance Lease Finance Commercial Bank x

11

x

12

2 Medium term loan Hire purchase SMS Enterprise Commercial Bank x

21

x

22

3 Short term loan LPO Finance Contract Finance Commercial Bank x

31

x

32

Where

x

11

= the percentage of unsecured long term loan to be allowed to mortgage finance within the long term scheme.

x

12

= the percentage of unsecured long term loan to be allocated to lease finance within the long term scheme.

x

21

= the percentage of unsecured medium term loan to be allocated to Hire purchase within the medium term

loan scheme.

x

22

= the percentage of unsecured medium term loan to be allocated to SMS Enterprise within the medium term

scheme.

x

31

= the percentage of unsecured short term loan to be allocated to LPO Finance within the short term scheme

x

32

= the percentage of unsecured short term loan to be allocated to lease Contract Finance within the short term

scheme

Table 2: Amount of Loan per Investment Type per Loan Class for 5 Years

S/N

Source of

Loan

Loan Class

Specification

Investment

Type

Amount of Loan

Decision

Variables

1

Commercial

Bank

Long term loan

3, 331, 920, 000

Mortgage finance

Lease Finance

o = 1SS192uuuu

b = 2 uuuuuuuuu

x

11

x

12

2

Commercial

Bank

Medium term loan

2, 323, 440, 000

Hire Purchase

SMS Enterprise

c = 1uuuuuuuuu

J = 1S2S44uuuu

x

21

x

22

3

Commercial

Bank

Short term loan

3, 983, 040, 000

LPO Finance

Contract Finance

c = 218Su4uuuu

¡ = 18uuuuuuuu

x

31

x

32

Formulation of Objective Function

The objective function to be minimized is

Minimize Z = ox

11

+ bx

12

+cx

21

+ Jx

22

+ cx

31

+ ¡x

32

Where o =Amount of loan for mortgage finance

b =Amount of loan forlease finance

c =Amount of loan forhire purchase

J =Amount of loan forsmall and medium enterprise finance

Application of Linear Programming Model to Unsecured Loans and Bad Debt Risk Control in Banks 95

c =Amount of loan forLPO finance

¡ =Amount of loan forcontract finance

We then have:

Minimize Z = 1,SS1,92u,uuux

11

+ 2,uuu,uuu,uuux

12

+ 1,uuu,uuu,uuux

21

+

1,S2S,44u,uuux

22

+ 2,18S,u4u,uuux

31

+ 1,8uu,uuu,uuux

32

Formulation of Model Constraints

The above objective function is subjected to the following constraints:

• In line with the banks’ policy to encourage small and medium scale businesses to have access to loan.

At least 50% of medium term loan generated from commercial bank is unsecured.

That is

x

21

+ x

22

≥ 1,161,72u,uuu (Su% o¡ 2,S2S,44u,uuu)

• All the investment type under short term loan are at least 70% unsecured in order to encourage the small

and medium scale business owners to have access to soft loans.

x

31

+ x

32

≥ 2,788,128,uuu (7u% o¡ S,98S,u4u,uuu)

• In accordance with the policy of the bank, at least 20% of all loans should be without collateral.

That is

x

11

+ x

12

+ x

21

+ x

22

+x

31

+ x

32

≥ 1,S27,68u,uuu (2u% o¡ 6,6S8,4uu,uuu)

The Model

Minimize Z = 1,SS1,92u,uuux

11

+ 2,uuu,uuu,uuux

12

+ 1,uuu,uuu,uuux

21

+

1,S2S,44u,uuux

22

+ 2,18S,u4u,uuux

31

+ 1,8uu,uuu,uuux

32

Subject to:

x

21

+ x

22

≥ 1,161,72u,uuu (Su% o¡ 2,S2S,44u,uuu)

x

31

+ x

32

≥ 2,788,128,uuu (7u% o¡ S,98S,u4u,uuu)

x

11

+ x

12

+ x

21

+ x

22

+x

31

+ x

32

≥ 1,S27,68u,uuu (2u% o¡ 6,6S8,4uu,uuu)

x

ì]

≥ u; i = 1,2,S onJ ] = 1,2

The dual can be formulated as:

Maximize P = 1,161,72u,uuu x + 2, 788,128,uuu y + 1, S27, 68u, uuu z

Subject to:

z ¸ 1, SS1, 92u, uuu

z ¸ 2, uuu, uuu, uuu

x + z ¸ 1, uuu, uuu, uuu

96 Agarana M. C., Anake T. A. & Adeleke O. J.

x + z ¸ 1, S2S, 44u, uuu

y + z ¸ 2, 18S, u4u, uuu

y + z ¸ 1, 8uu, uuu, uuu

x ≥ u, y ≥ u, z ≥ u

MODEL SOLUTIONS

We use simplex method to solve the standard maximization problem. The initial tableau is set up and slack

variables r, s, t, u, :, w are introduced in order to replace the inequalities in the constraints with equality.

The dual of the model can now be written as follows:

Maximize P = 1,161, 72u,uuux + 2, 788, 128, uuuy + 1, S27, 68u,uuuz

Subject to:

z + r = 1, SS1, 92u, uuu

z + s = 2, uuu, uuu, uuu

x + z + t = 1, uuu, uuu, uuu

x + z + u = 1, S2S, 44u, uuu

y + z + : = 2, 18S, u4u, uuu

y + z + w = 1, 8uu, uuu, uuu

x ≥ u, y ≥ u, z ≥ u

Forming the initial simplex tableau we have:

Tableau 3

Rows x y z r x t u u w RHS

R

1

0 0 1 1 0 0 0 0 0 1,331,920,000

R

2

0 0 1 0 1 0 0 0 0 2,000,000,000

R

3

1 0 1 0 0 1 0 0 0 1,000,000,000

R

4

1 0 1 0 0 0 1 0 0 1,323,440,000

R

5

0 1 1 0 0 0 0 1 0 2,183,040,000

R

6

0 1 1 0 0 0 0 0 1 1,800,000,000

R

7

1,161,720,000 2,788,128,000 1,327,680,000 0 0 0 0 0 0 0

Tableau 4

x w z r x t u u w RHS

r 0 0 1 1 0 0 0 0 0 1,331,920,000

s 0 0 1 0 1 0 0 0 0 2,000,000,000

t 1 0 1 0 0 1 0 0 0 1,000,000,000

u 1 0 1 0 0 0 1 0 0 1,323,440,000

: 0 1 0 0 0 0 0 1 -1 383,040,000

y 0 1 1 0 0 0 0 0 1 1,800,000,000

p 1,161,720,000 0 -1,46u,448,uuu 0 0 0 0 0 -2,788,128,uuu -Su186Su4 × 1u

11

Application of Linear Programming Model to Unsecured Loans and Bad Debt Risk Control in Banks 97

Tableau 5

t w z r x t u u w RHS

r 0 0 1 1 0 0 0 0 0 1,331,920,000

s 0 0 1 0 1 0 0 0 0 2,000,000,000

x 1 0 1 0 0 1 0 0 0 1,000,000,000

u 0 0 0 0 0 -1 1 0 0 1,323,440,000

: 0 0 0 0 0 0 0 1 -1 383,040,000

y 0 1 1 0 0 0 0 0 1 1,800,000,000

p 0 0 -2,622,168,uuu 0 0 -1,161,72u,uuu 0 0 -2,788,128,uuu -618uSSu4 × 1u

11

RESULT ANALYSIS AND INTERPRETATION

The optimal solution to the dual problem is read from the trial table as

x = 1,uuu,uuu,uuu

y = 1,8uu,uuu,uuu

P = 618uSSu4 × 1u

11

The optimal solution of the primal problem appears under the slack variables in the last row of the simplex tableau

associated with the dual problem

x

21

= 116172uuuu

y

32

= 2788128uuu

z = 618uSSu4 × 1u

11

Substituting these values into the primal objective function and the dual objective function, respectively,

give the same result (61,8uS,Su4 × 1u

11

) which implies the maximum value of P is equal to the minimum value of z.

The values under the slack variable columns of the trial tableau of the dual problem represent the percentage of

the unsecured loan to be given out.

The value of-116172uuuu in the t column suggests only 1161720000 naira unsecured medium term loan should

be given for higher purchase investment type.

The value of-2788128uuu in the w column means only 2788128000 naira unsecured short term loan should be

given out for contract finance investment type.

The total unsecured loan that is safe to be given out in 5 years in order to control the risk of bad debt to a large

extent and still achieve the goals of the bank is61,8uS,Su4 × 1u

11

.

SENSITIVITY ANALYSIS OF THE MODEL PARAMETERS

Sensitivity analysis of the parameter in the model is significant because financial institutions such as banks

typically lend large sums of money to borrowers over long period of time. [1]

We now determine how different values of the decision variables x

ì]

(independent variable) will impact the

objective function z (a particular dependent variable) under a given set of assumptions.

Minimize

Z′ = 1SS192uuuux

11

i

+ 2uuuuuuuuux

12

i

+ 1uuuuuuuuux

21

i

+ 1S2S44uuuux

22

i

+

98 Agarana M. C., Anake T. A. & Adeleke O. J.

218Su4uuuux

31

i

+ 18uuuuuuuux

32

i

Subject to:

x

21

i

+ x

22

i

≥ u.1 % o¡ 2,S2S,44u,uuu

x

31

i

+ x

32

i

≥ u.2 % o¡ S,98S,u4u,uuu

x

11

i

+ x

12

i

+ x

21

i

+ x

22

i

+ x

31

i

+ x

32

i

≥ u.S % u¡ 66S84uuuuu

x

11

i

≥ u, x

12

i

≥ u, x

21

i

≥ u, x

22

i

≥ u, x

31

i

≥ u, x

32

i

≥ u

The constraints now become:

x

21

i

+ x

22

i

≥ 2,S2S,44u

x

31

i

+ x

32

i

≥ 7,966,u8u

x

11

i

+ x

12

i

+ x

21

i

+ x

22

i

+ x

31

i

+ x

32

i

≥ 19,91S,2uu

x

ì]

i

≥ u; i = 1,2,S onJ ] = I, 2,S

The dual can now be represented as follows

P′ = 2S2S44ux′ + 7966u8uy′ + 1991S2uuz′

Subject to:

z ¸ 1,SS1,92u,uuu

z ¸ 2,uuu,uuu,uuu

x + z ¸ 1,uuu,uuu,uuu

x + z ¸ 1,S2S,44u,uuu

y + z ¸ 2,18S,u4u,uuu

y + z ¸ 1,8uu,uuu,uuu

x ≥ u, y ≥ u, z ≥ u

Introducing the slack variable the dual becomes

Maximize

P′ = 2S2S44uX′ + 7966u8u¥′ + 1991S2uuZ′

Subject to:

z′ +r′ = 1,SS1,92u,uuu

z′ + s′ = 2,uuu,uuu,uuu

x′ + z′ +t′ = 1,uuu,uuu,uuu

x′ + z′ + u′ = 1,S2S,44u,uuu

y′ + z′ + :′ = 2,18S,u4u,uuu

Application of Linear Programming Model to Unsecured Loans and Bad Debt Risk Control in Banks 99

y′ + z′ + w′ = 1,8uu,uuu,uuu

x′ ≥ u, y′ ≥ u, z′ ≥ u.

Tableau 6

x′ y′ z′ r′ x′ t′ u′ u′ w′ RHS

r′ 0 0 1 1 0 0 0 0 0 1,331,920,000

s′ 0 0 1 0 1 0 0 0 0 2,000,000,000

t′ 1 0 1 0 0 1 0 0 0 1,000,000,000

u′ 1 0 1 0 0 0 1 0 0 1,323,440,000

:′ 0 1 1 0 0 0 0 1 0 2,183,040,000

w′ 0 [1] 1 0 0 0 0 0 1 1,800,000,000

p′ 2323440 7966080 19915200 0 0 0 0 0 0 0

Tableau 7

x′ w′ z′ r′ x′ t′ u′ u′ w′ RHS

r′ 0 0 1 1 0 0 0 0 0 1,331,920,000

s′ 0 0 1 0 1 0 0 0 0 2,000,000,000

t′ 1 0 [1] 0 0 1 0 0 0 1,000,000,000

u′ 1 0 1 0 0 0 1 0 0 1,323,440,000

:′ 0 0 0 0 0 0 0 1 -1 383,040,000

y′ 0 1 1 0 0 0 0 0 1 1,800,000,000

p′ 2323440 0 11949120 0 0 0 0 0 -7966080 -14338944 x 10

9

Tableau 8

x′ w′ t′ r′ x′ t′ u′ u′ w′ RHS

r′ 0 0 0 1 0 0 0 0 0 -866,808,000

s′ 0 0 0 0 1 0 0 0 0 1,000,000,000

z′ 1 0 1 0 0 1 0 0 0 1,000,000,000

u′ 1 0 0 0 0 0 1 0 0 323,440,000

:′ 0 0 0 0 0 0 0 1 -1 383,040,000

y′ -1 1 0 0 0 -1 0 0 1 800,000,000

p′ -9625680 0 0 0 0 -11949120 0 0 -7966080 -26288064 x 10

9

From Tableau 3′ (the final tableau),

y′ = 8uu,uuu,uuu

z′ = 1,uuu,uuu,uuu

p′ = 26288u64 × 1u

9

For the primal problem

x

21

= 1194912u

x

32

= 7966u8u

Z′ = 26288u64 × 1u

9

Comparing the values of Z and Z′showsome reduction in the total unsecured loan safe to be given out as there is a

reduction in the percentage of the constraints.

Now considering a model with mixed constraints;

Minimize

100 Agarana M. C., Anake T. A. & Adeleke O. J.

z

ii

= 1SS,192,uuux

11

i

+ 2,uuu,uuu,uuux

12

i

+ 1,uuu,uuu,uuux

21

i

+ 1S2S44uuuux

22

i

+218Su4uuux

31

i

+ 18uuuuuuuux

32

i

Subject to:

x

21

i

+ x

22

i

≥ 1% o¡ 2S2S44uuuu

x

31

i

+ x

32

i

¸ 2% o¡ S98Su4uuuu

x

11

i

+ x

12

i

+ x

21

i

+ x

22

i

+ x

31

i

+ x

32

i

≥ S% o¡ 66S84uuuuu

x

11

i

≥ u, x

12

i

≥ u, x

21

i

≥ u, x

22

i

≥ u, x

31

i

≥ u, x

32

i

≥ u

Writing the constraints of its dual in standard form we introduce slack variables as follows:

Maximize p'' = 2S2S44uuux

ii

+ 7966u8uuy

ii

+ 1991S2uuuz

ii

Subject to:

z'' + r'' = 1SS192uuu

z'' + s'' = 2uuuuuuuuu

x'' + z'' + t'' = 1uuuuuuuuu

x'' + z'' + u'' = 1S2S44uuuu

y'' + z'' + :'' = 218Su4uuuu

y'' + z'' + w'' = 18uuuuuuuu

z'' ≥ u, y'' ≥ u, x'' ≥ u

Tableau 9

x'' y'' z'' r'' x'' t'' u'' u'' w'' RHS

r'' 0 0 1 1 0 0 0 0 0 133192000

s'' 0 0 1 0 1 0 0 0 0 2000000000

t'' 1 0 1 0 0 1 0 0 0 1000000000

u'' 1 0 1 0 0 0 1 0 0 1323440000

:'' 0 -1 1 0 0 0 0 1 0 2183040000

w'' 0 -1 1 0 0 0 0 0 1 2183040000

p'' 232344000 -79660800 199152000 0 0 0 0 0 0 0

Tableau 10

t'' y'' z'' r'' x'' t'' u'' u'' w'' RHS

r'' 0 0 1 1 0 0 0 0 0 133192000

s'' 0 0 1 0 1 0 0 0 0 2000000000

x'' 1 0 1 0 0 1 0 0 0 1000000000

u'' 0 0 0 0 0 -1 1 0 0 323440000

:'' 0 -1 1 0 0 0 0 1 0 2183040000

w'' 0 -1 1 0 0 0 0 0 1 2183040000

p'' 0 -79,660,800 -33,192,000 0 0 -2323,440,000 0 0 0

-232344 ☓ 10

12

Application of Linear Programming Model to Unsecured Loans and Bad Debt Risk Control in Banks 101

From the tableau above we have,

x'' = 1uuu,uuu,uuu

P

ii

= 2S2,S44 × 1u

12

For the primal problem

x

21

i

= 2S2S44uuu

Z

ii

= 2S2S44 × 1u

12

Notice that substituting x'' and x

21

ii

into the objective function of the dual and primal problems respectively give

the same result (2S2S44 × 1u

12

).

The table below shows the effect of the changes in the parameters on the optimal solutions.

Table 11: Showing the Effect of Unsecured Loan on the Optimal Solution

S/N

Unsecured Medium

Term Loan

Unsecured Short

Term Loan

Unsecured

Total Loan

Optimal

Solution

1 ≥50% ≥70% ≥20% 618,035.04 ☓ 10

13

2 ≥0.1% ≥0.2% ≥0.3% 262,880.64☓ 10

11

3 ≥1% ¸2% ≥3% 232,344 ☓10

12

RESULTS AND DISCUSSIONS

From the table above, it is clearly seen that reduction in the unsecured loans reduce the optimal solution.

Likewise, the minimization objective function solution is better where the percentage of unsecure loans is reduced.

Also, we can see from the table that reducing the unsecured short term loan to2%, that is the class of loan which originally

was to be greater or equal to 70% was reduced to less than 2%, we have optimal solution greater that when this class of

loan was ≥0.2%.This implies that the policy of the bank which says that unsecured short term loan should be less than

2%, as against greater than 0.2%, does improve the optimal solution. It is important to note that because it is a short term

loan, it is not sensitive as regards minimizing the objective function. Finally, the generosity of the bank as regards giving

out loan without securities is not without a price. The price they have to pay is that a huge amount is required to be given in

order for the banks goals to be achieved, as shown by the optimal solutions. In order to reduce the risk of bad debt

incidence to the barest minimum, the banks should reduce the percentage of the unsecured loans since that will not

significantly affect the achievement of their aims and objectives.

CONCLUSIONS

Interest is on the loan portfolio management of banks. The analysis is carried out using simplex method and

specifically useful for banks whose corporate policy include giving out some percentage of some category of loans without

collateral. The peculiar situation is modelled as a linear programming problem. The dual of the minimization linear

programming problem is formulated and the resulting maximization linear programming problem is solved using simplex

method. A sensitivity analysis is carried out by altering the percentages of the unsecured loans. It is shown that a reduction

in the percentage of unsecured loan improves the banks objectives marginally especially when the loan is of a longer term.

Also for the bank to be seen as a small and medium scale business friendly bank, the price it has to pay is minimal

improvement in her returns from her loan portfolio. It was assumed that the beneficiaries of this unsecured loans are

responsible enough to pay back their loans as at when due.

102 Agarana M. C., Anake T. A. & Adeleke O. J.

REFERENCES

1. A. J. Tachia, (1998), Towards effective and efficient loan portfolio management in Nigeria commercial

bank : a study of Savannah bank (Nig) plc and Habib Nigeria bank Ltd, Thesis Amadu Bello University, Zaria

Nigeria.

2. O. AAdenyi. (1985) Employing Credit Scorning an aid to personal lending decision in Nigeria,

The University Banker Vol. 11 No 4.

3. M. C Agarana, (2014), An Application of Goal Programming Technique to loan Portfolio Management in

Banking Industry. ICAPTA 2014 conference, University of Lagos, by Mathematics Analysis and Optimization

Research Group. MANORG.

4. N. R. Al-Faraj and Taga (1990). Simulating the waiting line Problem: A Spread sheet Application, International

Journal of Operations and Production Management, Vol.11 No.2, pp 49-53.

5. O. O. Aniel, (2011). Optimum Loan Portfolio selection: a case study of Juaben Rural Bank, Ashanti Region.

6. J. C. Dandy, (1975) The Branch Banker London: the institute of Bankers pp 229-230.

7. J. Gendzio and A. Grotyey (2004, 2005). Parallel Interior Point Solver Structured Quadratic Programmes:

Application of Financial Planning Problems.

8. D. W. Drazner, (2009), Bad Debts: Assessing China’s Financial influence in Great Power Politics. International

Security Journal,. Volume: 34 Issue 2. Page 7- 45

9. G. B. Dantzig (1963). Linear programming and extensions. Princeton University Press, Princeton,

New Jersey.

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