Part of the problem is attributed to management and governance of MFIs. Good management practices and governance are therefore critical to MFIs operations. Using panel data from RCBs in Ghana, Kyereboah-Coleman and Osei shows that governance plays a critical role in the performance of MFIs and that the independence of the board and a clear separation of the positions of a CEO and board chairpersons have a positive correlation with performance measures. This in part emanated from high recovery rates since the board and management were both independent and credit officers have the power to decide who qualify for loans and how much by critically appraising the loan applications. When this is absent, it means management and board are contributing to the default among clients thus causing corporate governance problems. Chaffai, Dietsch and Godlewsky used a database of around 2154 banks located in 29 emerging countries in Eastern Europe, Asia and Latin-America for the period 1996-2000. They found that corporate governance problems occur whenever the bank’s owners or the regulators lose control of the decisions of banks managers, so that the latter can adopt too risky lending policies.
Problem loans may pose problems at the micro and macro levels. At the macroeconomic level then, problem loans may be a signal of a wrong allocation of credit which may cause a decrease of the funds available for good and safer investments. Moreover, problem loans influence expected losses and so they may influence the state of the economic cycle causing a reduction in the supply of loans or changing the perception of depositors about the risks that banks take.
Berger and DeYoung find that the relationships between loan quality and cost efficiency run in both directions. Their results provide support for the ‘bad luck’ hypothesis -high level of NPL oblige banks to devote efforts and suffer costs to working out and selling off these loans -, as well for ‘bad management’ hypothesis – lower cost-efficiency is followed by an increase of NPL. In short there is a bidirectional relationship between loan quality and cost efficiency in financial institutions including MFIs.
Bad loans sometimes occur due to the due to maturity and cost and terms of the credit such as repayment arrangements. For example Rajan and Dhal utilise panel regression analysis to report that favourable macroeconomic conditions (measured by GDP growth) and financial factors such as maturity, cost and terms of credit, banks size, and credit orientation impact significantly on the NPLs of commercial banks in India. The literature discussed so far show that bad loans are always likely to exist and financial institutions including MFIs need to make enough provisions for that. Fair provisioning on bad and doubtful loans is therefore of great importance for bank managers, board and regulators. This is because at the global level there has recently been intense discussion on the merits of Basel 2, the revised capital accord that would much better capture the actual risks taken by banks (Basel Committee, 2003). The Basel Accord is keen on making all provisions that will capture anticipated bad debts but with MFIs, it will be prudent for management and board to reduce the occurrence of bad loans because of the small size nature of their capital.