Perceived Loan Risk and Ex Post Default Outcome: Are The Banks’ Loan Screening Criteria Efficient?

Prospective borrowers from commercial banks are usually made to pass through stringent lending procedure. The screening procedure is intended to forestall likely default intents and reduce credit risks. Banks, through the analysis are able to predict the inherent risk level in the loans they administer and avoid risky borrowers. The recent rise in defaults rates and the size of non-performing loans among the Nigerian commercial banks therefore puts to question the efficiency of the banking system screening criteria. An efficient screening technique is expected to approximate the estimated and the ex post default risk outcome. Disparities between the two reflect the extent by which the assessment of risks by banks was inefficient. This paper provides evidence that bank screening criteria do not effectively foreclose total default risk, and affirm that perceived and ex-post default risks differ. Using data obtained from a survey of investment loans made to 210 borrowers between 2000 and 2012 among 15 commercial banks in Nigeria, this study observed that the banks’ screening criteria was limited by the presence of information asymmetry. Adverse selection and moral hazard were observed to persist in the loan markets irrespective of the stringency of the banks’ screening measures. The observed difference between estimated and ex-post default risk incidence arise because of the presence of information asymmetry.