Perfect borrower selection loan cannot be turned into bad, A loan disbursed by a bank can be turned into a bad loan in course of time due to various reasons. A loan may be bad because of the selection of wrong borrowers. It may The selection of wrong borrowers is the main reason for which a loan goes bad. This article focuses on the process of selection of wrong borrowers by banks which results to a large amount of bad loans in the banking sector of Bangladesh.
The lender and the borrower are involved in a loan contract. The lender may not have all information about the borrower since information is not symmetrically distributed in the financial system. When the borrower gives all information to the bank, it is easier for the latter to assess the creditworthiness of the former. But in many cases, the borrower tends to give partial, wrong or even misleading information to the bank which worsens its decision making process.
The credit market consists of both honest and dishonest borrowers. The challenge faced by a bank in lending is identifying and selecting right borrowers. While an honest borrower always gives true information, a dishonest borrower fills in the form by giving attractive information which may not be true. As a result, the filled out application of the dishonest borrower looks much better than that of the honest borrower.
Here lies the trap for the credit officer and she or he may make mistake in the selection of the right borrower. The credit officer may select a dishonest borrower at the cost of an honest borrower which leads to adverse selection. When an honest borrower is termed as a dishonest, it produces an error known as type-one error. There is another kind of error, type-two error, which occurs when a dishonest borrower is termed as an honest borrower.
Accepting a dishonest borrower makes the loan risky because the borrower who deceives the bank by providing false or misleading information has every possibility not to use the loan in the right manner. Such borrower engages in high-risk activities which turn the loan into a default loan causing trouble for the bank.
Perfect borrower selection process the credit officer can also visit the business of the borrower to observe his or her business condition. She or he can also talk to different stakeholders of the business like employees, accountants, legal advisors and raw material suppliers to gather information. If the credit officer can talk to those people properly, she or he will be able to identify the right borrower.