CHAPTER 1

The Problem and Its Background

This chapter presents the problem and its background. The chapter is divided into nine sections.

Section one and two presents the introduction and background of the study, respectively. Section

three and four reviews theoretical framework and conceptual framework by providing measurable

factors and explanation to the dependent and independent variables. Section five exhibits the

statement of the problem while section six presents the hypothesis of the study. Section seven

explains the research’s scope and limitation and section eight states the significance of the study.

Lastly, section nine shows the definition of terms related and said in this research.

Introduction

In finance, loan is a written or oral agreement for a temporary transfer of a property (usually

cash) from its owner (the lender) to a borrower who promises to return it according to the terms of

the agreement, usually with interest for its use. If the loan is repayable on the demand of the lender,

it is called a demand loan. If repayable in equal monthly payments, it is an installment loan. If

repayable in lump sum on the loan's maturity (expiration) date, it is a time loan. Banks further

classify their loans into other categories such as consumer, commercial, and industrial loans,

construction and mortgage loans, and secured and unsecured loans. (Business Dictionary). Most

individuals, organizations, and other entities are in need of help specifically when it comes to

financial matters for it is a natural system that people purchase, pay bills and expenses, create

investment to acquire returns, and other things that require financial exchange. The focus would

be on the point of view of the lender as the entity that provides resources and properties (usually
cash) to certain individuals or organizations. Lenders expect return from loans the same for the

risk they bear. It is ideal to have returns but, most of the time, borrowers become slack in paying

their loans in a specific duration of time producing non-performing loans or bad loans that affect

the lenders’ financial performance. The researchers are to identify the impact of these events to

certain lenders (rural banks in the Philippines) particularly to their financial performance and the

factors that create this non-performing or bad loans.

Background of the Study

In Finance, loan is the process of lending money organizations and individuals to other

people and entities wherein the recipient incurs debt,and is usually obliged to pay interest on the

debt until it is the said interest and amount borrowed are completely paid. There are a lot of reasons

why people apply for loans. (1) For the purpose of bill consideration- Every individual has bills or

some sort of debt to pay whether it is for credit card, utilities, schooling and the like. Some people

prefer to consolidate all their debts for the convenience of dealing with a single loan instead of

several instance of debt. Single payment sounds more easier than handling several payments. (2)

House improvement projects and automobile purchase- There are a lot of families who apply for

loans for this specific reason whether it is for family use, work or just personal situation change.

Due to the large amount of lumpsum payment or at least a down payment, people would resort to

applying for a loan in order to obtain the amount needed. (3) Launching of business- When starting

a business usually requires a huge amount of money to invest to begin with. Finding large capital

is quite hard for most of the people that is why they would apply for a loan in order to have the

sum of money that would suffice the investment requirement.

 As convenient and easy it might seem, applying for a loan would benefit an individual to

get money in a short period of time however, reality has it that some of the loans applied for

become bad debts or result in loan default. Default is the failure to repay a debt including interest

or principal on a loan or security. A default can occur when a borrower is unable to make timely

payments, missed payments, or avoids or stops making payments. Individuals, businesses, and

even countries can fall prey to default if they cannot keep up to their debt obligations

(Investopedia). Lending is the most common type of financial service that provides assistance to

one or more individuals, organizations, and other entities in terms of financial assistance. Millions

of transactions happen everyday and they all involve financial exchange, but the fact that there are

events that limit people’s financial capacity, individuals or business organizations tend to enter

into loans that will support the insufficiency of their resources. Default also occurs when an

individual lack willingness to pay loans, wilful negligence and improper appraisal by credit

officers (Ahmad, 1997). Furthermore, loan default increases as real gross domestic product decline

and the exchange rate depreciation directly affects the repayment ability of the borrowers (Kwaka,

2009). Studies have shown that delay in time of loan delivery, small farm size, high interest rates,

age of borrowers, poor supervision, non- profitability of enterprises and undue government

intervention with operations of government sponsored credit programs also contribute to loan

default (Balogun and Alimi, 1988). Other factors that significantly affect the delinquency of loans

are type of loan, long term interest rate, poor credit history, borrower’s income and transaction

cost of loans (Okorie, 1986).

Loan defaults also affect the lending entities as well. Loan default results to credit risk

which leads to capital inadequacy (insolveny). This means that the financial capability of the bank

to meet up with its financial obligations or uncertainties. Hence, the more loan default, the more
the bank is exposed to risks and that should not be the case because the more capital the bank has,

the more are its creditors or the government insurance agency protected, and the greater is the

capital loss that can be sustained without resulting in bankruptcy (Shah, 1996). There will be also

problems as regards to the liquidity of the lending entity. A more liquid bank will be more able to

meet up with financial demands from its customers and thus create more value (Breger and

Bouwman, 2009). Having records of enormous amount of loan defaults will surely make the entity

less liquid and its value will decrease in no time. Also effects of loan default include: the inability

to recycle funds to other borrowers; unwillingness of other financial intermediaries to serve the

needs of small borrowers and creation of distrust (Von-Pisckle, 1980). According to Bloem and

Gorter, (2001), though issues relating to non-performing loans may affect all sectors, the most

serious impact is on financial institutions such as commercial banks and mortgage financing

institutions which tend to have large loan portfolios. Besides, the large default loans will affect the

ability of banks to provide credit. Huge non-performing loans could result in loss of confidence on

the part of depositors and foreign investors who may start a run on banks, leading to liquidity

problems. Caprio and Klingebiel (2002), also reported that during the banking crisis in Indonesia,

non-performing loans represented about 75% of total loan assets which led to the collapse of over

sixty banks in1997. This means that banks holding huge default loans in their books can run into

bankruptcy if such institutions are unable to recover their bad debts.

The study would focus to loan default factors that economically affect the financial

performance of selected rural banks in the Philippines which are the most common entities that

are involved in lending to individuals or organizations that are presumed to be the most common

subject of default.
Theoretical Framework

It is crucial to know the different factors and variables in order to facilitate the study well.

The following are the frameworks from different studies about bad loans which the researchers

find fit for the current study.

Figure 1

Borrower’s Characteristics (Monsha, 2016)

Figure 1 illustrates the borrower’s characteristics. The characteristics that affects the

default of loans are gender, marital status, income level and education level (Monsha, 2016).

Such study is further supported by (Makorere, 2014) in his study on factors affecting loan

repayment behavior. The objective of this study was to assess the default rate of the selected

MFIs for the period between 2004 and 2014; determine factors influencing the likelihood of loan

default and identify effects of loan defaults to borrowers and MFIs. The study used cross-

sectional design to gather information at the study area. Non-purposive (simple random)

sampling technique was applied to select 196 respondents. Purposively, Microfinance institutions

and key informants were selected. Primary data were collected directly from the respondents
using structured interview and semi - structured interview whereas secondary data were collected

through a documentary review of sources including published and unpublished materials. Data

obtained were analyzed by descriptive statistics and logistic regression using SPSS version 11.5.

Logistic regression model estimated the factors influencing the likelihood of borrowers to

default. The results of the Logistic regression model shows that age of borrowers and interest

rate charged by MFIs were significant at (P<0.05) and business type, business management

education and loan uses were found to be significant at (P<0.01). Majority of respondents

identified loss of collaterals and denial of future loan as major effects of loan default. Loss of

Interest incomes, reduction of operating profit through provision for bad debts and reduction of

lending capacity are effects reported by MFIs. Further, this study recommends MFIs should

involve borrowers in reviewing loan repayment terms, effective monitoring of loans, credit

training programs and where necessary the use private debt collectors.

Loan Factors

- Loan size

- Interest rate

Figure 2

Loan Factors (Jote,2018)

 Figure 2 shows the loan factors namely loan size and interest rate. (Jote, 2018) believes

that the said factors significantly affect the failure of loan payments and loan defaults in financial

institutions. The objective of this study was to identify and examine the determinants of loan

repayment in MFIs in Gedeo zone, SNNPRS, Ethiopia. In fact, identifying and examining such

determinant factors of loan repayment is vital in the achievement of profitability and

sustainability of MFIs. Out of total population of 6662 (1610 defaulter and 5052 non-defaulter

borrowers), 364 representative sample from borrowers are selected by using stratified random

sampling from borrowers by dividing the borrowers in to two strata, in terms of loan payment

status as defaulters and non-defaulters. In this connection, the researcher collected data from

primary and secondary sources and analyzed by using binary logistic model. A total of ten

explanatory variables were included in this model and out of these, six variables were found to

be statistically significant to influence the probability of loan repayment. These significant

variables are educational level, method of lending, nearness of borrower’s residence to the

institutions, family size, and income from activities financed by loan and training. The researcher

suggests that the identified significant variables to be a spring board for further interventions by

Microfinance institutions, stakeholders and policy makers so as to come with a breakthrough to

significantly decrease or even avoid defaulting problems. On the basis of the study findings, the

researcher also provided some recommendations that are vital to reduce loan repayment

problems and improve loan repayment performance of borrowers in the study area. These

includes proper training, continuous supervision, enough loan officers or committee and

technical support for borrowers on profitable business activities

Financial Performance
 - Reduction of operating profit

- Loss of interest income

- Reduction of Lending

Capacity

Figure 3

Financial Performance Determinants

Figure 3 presents the financial performance determinants enumerated by (Monsha, 2016)

which are 1) reduction of operating profit 2) loss of interest income and 3) Reduction of Lending

Capacity. The findings of the study were borrowers with default history are affected negatively

in the following ways namely, denial of subsequent loan opportunities, bad image to the society

and loss of properties pledged as collateral and bad relationship with MFIs officers. Also, the

study revealed adverse effects to the respective MFIs. These were named to be the loss of the

expected interest income that could be obtained from the interest charged on each defaulted loan,

it reduction of MFIs operating profit through provision of bad debt as a result of loan default and

limited capacity to expand the access to financial services for potential and current loan

applications.

Conceptual Framework

It is said that in order to select variables for one’s study, variables should have significant

coefficients and have the capacity to at least form part in the explanation of the dependent

variable’s variance and such variables must have a close correlation with one another (Dinh and

Kleimeire, 2017).
The researchers have adopted the frameworks done by Monsha and Jote to further correlate the

variables that may show how borrower’s characteristics and loan factors affect the financial

performance of selected rural banks in the Philippines.

Loan Default Factors

1. Borrower’s Characteristics

- Gender Financial Performance

- Marital Status - Reduction of Operating Profit

- Income Level - Loss of Interest Income

- Education Level - Reduction of Lending Capacity

2. Loan Factors

- Loan Size

- Interest Rate

Figure 4

Conceptual Framework of the Study

Figure 4 illustrates the conceptual framework of the study which was adapted from

different theoretical framework of different studies to narrow down the feasible variables,

independent and dependent, that will show the correlation between the loan default factors and

financial performance of selected rural banks in the Philippines.

Independent Variable

The independent variables of the study are (1) Borrower’s characteristics which includes

gender, marital status, income level, and educational level (2) Loan factors which are loan size

and interest rate.

Borrower’s Characteristics

Borrower’s characteristics are said to be one of the determinants of loan defaults. As

(Monsha, 2018) mentioned in his study, gender, marital status, education level and income level

significantly affect the loan repayment which causes loan default on the part of the client. These

characteristics can be measured through use of a questionnaire which will be used by the

researchers as a main tool to collect the needed data for the study. The researchers would also

adopt the questionnaire used by Monsha.

Loan Factors

This is the second independent variable of the study. This includes the loan size and

interest rate. The interest rate of the loan can be measured with regards to the loan size. The

researchers will obtain the different rates on the loan with respect to the kind of loan, duration

and other factors, in the respective websites of the selected rural banks in the Philippines. The

loan size of individual loans can be measured using the questionnaire. A question for the range

of loan applied for will be included in the questionnaire in order to segregate the different

amounts of loans applied for. With regards to the overall or gross amount of loans lent by the

rural banks, the researchers will make use of the financial reports found in the respective

websites of the selected rural banks in the Philippines.

Dependent Variable
The dependent variable of the study is the financial performance which includes reduction of

operating profit, loss of interest income, and reduction in lending capacity. The operating profit

and loss of interest income can be measured by the researchers by comparing the financial

statements or reports of the selected rural banks from 2012 to present in order to establish a

concrete basis with regards to the fluctuations in the amounts and its correlation with regards to

its financial performance.

Statement of the Problem

The researchers aim to seek answers for the following problems:

a. The effect of loan default factors to the financial performance of selected rural banks in the

Philippines;

b. The factors influencing the feasibility of loan defaults in selected rural banks in the

Philippines;

Scope and Limitation

The researchers will focus on the selected rural banks in the Philippines for this type of

bank is usually subject to lending resources to people specifically to rural communities that are

presumably in need of financial assistance and subject to default.

Significance of the Study

The main purpose of this study is to help present and future researchers by providing

knowledge and information regarding the researchers’ proposed topic and contribute to further
understanding loan default factors and its effect on the financial performance of rural banks in the

Philippines.

Furthermore, the study may serve as a guide in predicting the likelihood of a loan default

which may help rural bank employees and management in making decisions and formulating

controls that will at least minimize the risk of loan defaults and improve their financial

performance.

Definition of Terms

Default- failure to fulfill an obligation, especially to repay a loan or appear in a court law

Loan -is money, property or other material goods given to another pary in exchange for future

repayment of the loan value or principal amount along with interest or finance charges.

Debt Restructuring- is a process used by companies to avoid the risk of default on existing debt

or to take advantage of lower available interest rates.

Debt- something, typically money, that is owed or due

Operating Profit- a profit from business operations (gross profit less operating expenses) before

deduction of interest and taxes.

Financial Performance- is a subjective measure of how well a firm can use assets from its primary

mode of business and generate revenue

Interest Income- is amount of interest that has been earned during a specific time period

Lending Capacity- is the amount of money available for a company to lend, based on the

company’s current financial state.

Risk- a situation that involves exposure to danger or unfavorable circumstances

Bad Loans- is the amount owed by a person/ entity that is considered unlikely to be paid in due.
 CHAPTER 2

Review of Related Literature and Studies

This chapter presents the literature related to this study, which reviews both theoretical and

empirical literature from different studies. moreover, this chapter provides theoretical explanation

and description regarding the researchers’ topics, Bank Loan factors and its effects to the financial

performance of companies of different industries.

Rural banks were established in the 1950s as the country lacked basic financial services,

which led to the decision of the government to set up measures to incentivize the establishment of

such lenders by way of lower interest and other perks. On the negative side, issues of

undercapitalization, illiquidity, and insolvency have led many rural banks to file for bankruptcy.

“The unfortunate closure of some rural banks resulted to the reduction of the number of banks

serving the market, but the joint enabling support of the Bangko Sentral ng Pilipinas (BSP) and

the Philippine Deposit Insurance Corp. via the Consolidation Program for Rural Banks (CPRB)

Plus with the specific push for merger and consolidation, coupled with other regulatory initiatives,

has admittedly helped further strengthen the industry,” the Rural Bankers Association of the

Philippine (RBAP) told BusinessWorld in an email. (Pilar, 2018)

According to an article in the Oradian, Large commercial banks are now spreading

throughout the country and reach out not only to urban zones but also to rural communities,

resulting to bigger competition for rural banks as lending companies in the lending sector. Thus,

Rural banks nowadays think of a better way to step up amongst all their lending competitors,

especially the commercial banks, by improving their efficiency with digitisation, by reducing
overhead costs with cloud technology, by providing better service, and by choosing technology

providers that enable growth.

State agencies launched the CPRB in 2015, which aims to strengthen the rural banking

system by way of consolidations. From the expiration date of August 25, 2017, the initiative was

extended up to 2019 to produce more mergers among small lenders and to fortify their financial

footing. The revived CPRB program dropped the five-bank requirement in order to be eligible for

the funding aid although merging banks still have to meet the required capitalization. (Pilar, 2018)

According to Banko Sentral ng Pilipinal (BSP) or Central Bank of the Philippines (CBP),

the function of rural banks and cooperative banks in the Philippines is to promote and expand the

rural economy in an orderly and effective manner by providing the people in the rural communities

with basic financial services. The difference between rural banks and cooperative banks is the

ownership. Rural banks are owned and managed by a private group or sector while cooperative

banks are owned and organized by cooperatives of different parts of the country.

In an interview with the head of the BSP’s Financial Consumer Protection Department and

Inclusive Finance Advocacy Office, Ms. Pia Bernadette Roman-Tayag, stated that “these [rural]

banks are perceived to have comparative advantage in granting relationship lending to small-sized

enterprises, including those belonging to the agriculture sector. For instance, big banks given their

sheer size, have ‘standardized’ their lending process. On the other hand, small banks have the

advantage of being community-based which afford them with more intimate information and

insights about the rural clients. Such local knowledge can be particularly valuable in determining

market opportunities and managing credit risk.”

As of June 2018, BSP shows the rural and cooperative bank group’s gross total loan

portfolio at around P135.94 billion, 4.6% higher compared to the figure as of June 2017.
 BSP’s Ms. Tayag likewise noted the rural banks’ current upward trend, citing the increase

of the group’s deposits by 4.8% to P169.6 billion versus the P161.8 billion in the same period last

year as well as the number of deposit accounts to 8.18 million as of June 2018 compared to 7.37

million and 6.57 million in 2017 and 2016.

BSP introduced a lending model in the Philippines, which is the Microfinance model.

Microcredit, also known as “microfinance loans,” are small loans granted to the poor and low-

income households for their microenterprise and small businesses to enable them to raise their

income levels and improve their living standards as per BSP. Microfinance is a provision of a wide

range of financial services to the poor and low income people. Other microfinance products include

loans, deposits, transfers, or payments or microinsurance.

According to BSP, it is essential to develop and strengthen credit bureaus and movable

collateral registries in order for microedit to reach its maximum potential.

Figure 1.0 flow of lending with credit bureau and movable collateral registry to achieve

microedit’s full potential

According to the article in Manila Bulletin on improving the microfinance model, the group

guaranteed loans are now being complemented by individual microloans, which have been

common in Latin America and are spreading in South Asia. Pacing of repayment terms outside the

weekly routine is another platform of many rural banks. Some loans are paid on a monthly basis
although it may also expose lenders to bigger repayment risks. Thus, this statement highlight the

issue if implementing repayment terms that coincide with the business recovery cycle. Grace

periods are presently and oftenly implemented. However, one problem arises as to the flexibility

terms could encourage more loan defaults. (Lagua, 2016)

Moreover, Lagua added that “micro lending and microfinance are not perfect solutions but

cannot be overlooked in the war against poverty. What is important is to address its weaknesses

and shortcomings and to move forward with solutions that will ensure that the impact to a bigger

portion of participants will be positive by way of a better quality of life. At the end of the day,

it is a business model whose potential deserves innovative intervention.”

According to Chapter 4 Section 81 of Loans to Banking and Financial Institutions, Banko

Sentral ng Pilipinas (BSP) has authority to extend rediscounts, discounts, loans and advances to

all banks under the authority of the former. According to Section 85 of the same article, it shall

collect appropriate interests and other charges from all the banks under the authority, with

exceptions to others. The Monetary Board is responsible for establishing and fixing rates of interest

and other rulings that concern loans and the same will be applicable to all banks under BSP.

According to the study of Emmanuel Severine Mosha , there are two related theories that

are related to this research topic, namely the Agency Theory. Moreover, the Agency Theory can

also linked with loan defaults as further explained in this chapter. (Mosha, 2016)

Other than a management and economic theory that explains the various relationships and

areas of self-interest in companies, Agency Theory also describes the relationship between

principals and agents. (Teeboom, 2018) Furthermore, it relates not just to the principal and agent’s

relationship but also to the delegation of control.

 Agency theory refers to how economic actors can and do construct contractual

arrangements, generally in the presence of asymmetric information. A standard practice of the

agency theory is to represent the behaviour of a decision maker under different circumstances and

to identify optimal decisions. (Mosha, 2018)

Makorere (2014), studied factors affecting loan repayment behavior which leads to default

in Dar -es- Salaam and Morogoro, Tanzania because experience shows that many financial

institutions are still facing poor loan recovery. The study made by Makorere used cross section

design, applied convenience sampling technique, questionnaires to capture primary data, and

descriptive statistics to analyze frequencies and percentages. The study concluded that government

intervention is important and financial institutions should assess credit risk management

adequately using collateral, condition, characters, capacity and capital measurement to control

delinquency rate.

Kinyondo (2009) investigated the key factors that influence loan repayment among group

borrowers of microcredit institutions in Dar es salaam, Tanzania. The Logit model regression was

used in Kinyodo’s study, which suggested that the experience, training time, and sanctions have

positive and significant effects on loan repayment among group borrowers of microfinance

institutions. However, transaction costs and group size have negative and significant effects on

loan repayment performance. Finally, Kinyondo concluded by suggesting policy options to

improve loan repayment performance among borrowers of MFIs in Tanzania.

Moreover, Bichangga (2013) studied the causes of loan default within micro finance

institutions in Trans Nzoia County, Kenya. The method of collection by Bichanga was using

structured and semi-structured questionnaires. The study found out that loan default was as result

of non-supervision of borrowers by the MFIs, and also as a result of inadequate training of

borrowers on utilisation of loan funds before they received loans. Marjo (2010) reported that socio-

demographical and behavioural variables have effects on loan default. Among other socio-

demographical variables age, income, education and nationality were found significant.

Vasanthi and Raja (2006) found out in their research the likelihood of defaul risk associated

with income and other factors with Australian data (Australian Bureau of Statistics, ABS 2001).

Results showed that the age of the head of the household is significant in determining the

probability of loan default. The younger households, they tend to be adversely affected by the

increasing burden of repayments. Income as sociodemographic variable show to have a significant

effect, and that low income contributes to default. Another important factor was the loan to value

ratio, 16 educational level of the head of household and marital status had significance impact on

default. Vasanthi and Raja drew a conclusion that the probability of default is higher with an

uneducated, younger and divorced as head of the family compared to others.

Berhanu (2005) studied socio-economic, institutional and natural factors that affect loan

repayment capacity of smallholder farmers in North Gondar, Ethiopia. Berhanu used the two-limit

Tobit model to analyze factors influencing loan repayment and intensity of loan recovery among

smallholder farmers. A total of seven explanatory variables were considered in the econometric

model. Out of these seven variables were found to significantly influence the loan repayment.

These were land holding size of the family, agro-ecology of the area, total livestock holding,

number of years of experience, number of contacts, sources of credit and income from off -farm

activities.

For banks to give loans, they will need to accept deposits from customers and use those

funds as investments to acquire higher yield of return, ideally higher than the customers’ bank

deposits. (Mc Carthy et al., 2010) Loans represent the largest asset of most banks---around 50 to
75 percent, therefore, providing loans to community expose banks to certain height of risk. (Mac

Donald and Koch, 2006)

According to Mariana R. Alberto, Lyxen Maylyn Ocampo Tan, Maria Katrina L. Regalado,

Mico John W. Reyes on their study on The Effect of Foreign Bank Entry on the Performance of

Philippine Domestic Banks, in terms of accounting, profitability of banks is composed of activities

that are classified as lending or non-lending which will be the basis if banks efficiently generate

before-tax profits from their assets. The said research will contribute ideas to the current

researchers that the entry of foreign banks is a factor could affect the financial performance of

local banks.

Credit risk is also a factor of a bank’s profitability where it has a significant negative

influence on Return on Assets (ROA) and Return of Equity. Credit risk statistical distribution was

used as the basis of profitability. Capital Adequacy ratio will also an indicator if rural banks are

well-capitalized and capable of withstanding the unconscionable event of default, if ratio results

into negative figure it could mean that it is caused by losses from various activities. (Mendoza and

Rivera, 2018)
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How Rural Banks in the Philippines are becoming more competitive in their markets. Retrieved

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Functions of Rural Banks and Cooperative Banks in the Philippines from

http://www.bsp.gov.ph/banking/bspsup.asp

Negera, W. (January 2012). Determinants of Non Performing Loans The case of Ethiopian Banks.

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Alberto, et al. (2018). The Effect of Foreign Bank Entry on the Performance of Philippine

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Monsha, E.S. (2016). Determinants of Loan Defaults in Microfinance Institutions in Tanzania: A

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