Moral hazard can also arise when lenders are unable to discern borrowers’ actions that would affect the distribution of returns from an investment. This means that after a lender has extended finance to a client they are exposed to moral hazard, the risk that the client will not perform in a manner sufficient to meet the contract in order to repay the loan in future. For example, once a loan has been secured, a borrower could use the proceeds of the loan for a higher risk purpose or a non-income generating activity, necessitating costly ex-post monitoring of the financial contract which may also lead to default. In ex-ante, moral hazard refers relates to the idea that unobservable actions or efforts are taken by borrowers after the loan has been disbursed but before project returns are realized. These actions affect the probability of a good realization of returns. Expost moral hazards refers to the difficulties that emerge after the loan is made and the borrower has invested the funds. Armendariz and Morduch argue that even if those steps proceed well, the borrower may decide to take the money and run away once project returns are realized. These problems indicate that it is not only high interest rates that may cause borrowers to default.
If the moral hazard occurs, the solution advocated by the model is credit rationing. Mushinski argued that credit market imperfections in developing countries derive not only from moral hazard and adverse selection problems but also from increased cost of monitoring and contract enforcement. In contrast, countries characterized by well functioning legal systems, these problems are not as pronounced as in those where the mechanisms for enforcement of contracts are weak. Hence, the main reason for the contract enforcement problem is the poor development of property rights. Although this argument is not specifically drawn at small and medium scale businesses (SMEs), these problems are more associated with SMEs and individuals than large companies and corporate institutions. The worse scenarios are observed in sub-Africa and most less developed countries in Latin America and Asia. In developing countries however where contract enforcements are weak, lenders resort to court actions against notorious clients.
Empirical evidence suggests that microfinance clients default for many reasons. For example in Ghana high interest rates charged by MFIs have contributed to high default and client exit.
Okorie shows that the nature, time of disbursement, supervision and profitability of enterprises which benefited from small holder loan scheme in Ondo State, contributed to the repayment ability and consequently high default rates. Other critical factors associated with loan delinquencies are: type of the loan; term of the loan; interest rate on the loan; poor credit history; borrowers’ income and transaction cost of the loans. Loan default thus contaminates the quality of loans.
The quality of credit is a known critical issue in the literature where it is recognized that three different aspects, relating to macroeconomic, competition and MFI supervision issues, matter for its relevance. As for the first aspect, one needs to recognize that the financial structure of an economy plays a key role in the allocation of resources and MFI credit is a main connection with the real sector. Furthermore, bank MFI is still considered special in gathering information and monitoring borrowers, so that financing through financial markets cannot be seen as a perfect substitute for it. Moreover, the cost and the availability of MFI credit affect heavily investment choices both with respect to firms’ financial structure and in relation to the structure of household financial portfolios and banking liabilities. This point is particularly important and relevant for bank-based economic systems, such as in many European continental countries (Gambacorta, 1998; European Central Bank, 2003).