An Empirical Study on Determinants of Loan Repayment Behaviour of SMEs Towards Commercial Banks

Abstract

India, as a developing economy even after five decades of planning, still has a long way to catch up with the advanced economies of the globe. The goal may be distant, but surely, the time needed to reach can be reduced by accelerating the pace of development. One way of doing this is by the development of industrial and business ventures. There exists a positive relationship between the growth of an economy and the growth of small and medium enterprises (SMEs). SMEs play a vibrant role in the development of an economy. Access to the formal source of credit by entrepreneurs is essential in a growing economy. Lending to SMEs is a risky activity for the banks as repayment of these loans are less guaranteed. The research article attempts to analyse the factors influencing the loan repayment behaviour of SMEs towards commercial banks. Data are collected using the convenience method of sampling from 80 registered SMEs belonging to the manufacturing and service sectors in the Bangalore region, and data are analysed using statistical tools such as correlation and logit regression analysis, conclusions are drawn based on these findings. The study reveals that characteristics of loan and lender influence the repayment to the maximum extent. The findings are helpful for commercial banks in redesigning suitable policies and schemes to reduce loan defaults.

Keywords

Bank advances commercial banks India loan repayment small and medium enterprises economic development

Introduction

The Indian economy is anticipated to grow by more than 8% per annum till 2021 and become the second largest in the world, ahead of the USA by 2050, and the third largest after China and the USA by 2032. Industry specialists believe that this target would be difficult to reach without the active engagement of the micro, small and medium enterprises (MSMEs). Banks and financial institutions have played a vibrant role in supporting the MSME sector to grow. Bank loans and lines of credit are the main sources of external finance for MSMEs. In comparison to large enterprises and microenterprises, small and medium enterprises (SMEs) have been underserved in terms of access to credit. However, more recently, collateral free loans through bank lending have become available to SMEs with most commercial banks’ growing focus on SME financing.

SMEs can grow into large firms, changing the game locally, carving their niche globally. In addition, SMEs can create significant income opportunities for employees and generate tax revenues for the government. SMEs are a part of dynamic and growing value chains whose job opportunities raise incomes, increase living standards and improve lives. There is a need for further investigation of factors hindering credit repayment by small businesses. Adverse repayment behaviour remains an obstacle in future access to finance.

Lending is a risky activity because repayment of the loan is seldom fully guaranteed. Lending to SMEs is more important for the economic and social development of India. Since banks are predominant sources of finances in India, the Reserve Bank of India (RBI) includes MSMEs in the list of priority sector lending. However, advancing loans to the business sector are risky as there exists repayment risk or default risk. Lack of financial records and lack of assets for collateral or limited credit history made lending not only costly but also very risky. Despite their efforts, banks show an increase in outstanding balance of advances, which is a problem faced by banks. Repayment of loans by MSMEs is influenced by many factors such as age, marital status, place of business, gender, interest rates, size of the loan, lack of monitoring and follow up. Poor repayment affects the financial health of banks and financial institutions in the long run. Hence, to overcome these problems, lending institutions should initiate loan recovery strategies. Delays of repayment lead to two ominous effects for financial institutions, which include non-refinancing of a large number of safe borrowers and the collection of late instalments by the loan officer, driving to an increase of its loads without compensation in resources. In addition, because of the delay of a member, other members will then be incited to delay their repayment and even to negotiate with the institution the possibility to abandon the last part of the loan.

Repayment performance is the capacity of a borrower to service a loan effectively as and when loan instalments are due. The willingness to repay advances is central to the continuation of a healthy financial system. As repayments are not enforceable by third parties, most borrowers default the payment, and credit contracts cannot be profitably executed by the lenders. Repayment problems weaken the financial health of financial institutions. This problem affect SMEs’ relations with the financial institutions negatively. To lessen these problems, financial institutions should induct strategies for loan recovery.

Loan recovery is the main objective of financial institutions as it enables them to refinance and reach the public. The institutions should loan out funds and recover the same to be active in the industry. A loan is said to have been defaulted if the borrower does not make a payment after the first day when the loan instalment is due.

Literature Review

James (2019) examined the factors causing loan repayment default in microfinance banks in Kenya. The study reveals that both institutional characteristics and borrower characteristics have a positive relationship with the repayment of the loan in microfinance banks. Outcomes of the study infer that to reduce loan repayment default, banks should train their staff to conduct proper credit appraisals of the projects and continuous monitoring of the application of funds.

A study conducted by Rajmani and Raj (2019) focused on the financial obstacles faced by MSMEs during their life cycle and analysed the impact of a firm’s attributes, financial obstacles, sources of finance and different stages of the life cycle of MSMEs on access to finance. The author framed the conceptual framework, based on the analysis, to help the policymakers for MSME financing.

A study conducted by Mohamed et al. (2019) investigated the factors affecting the loan repayment performance of banks in Somalia. Primary data were collected from the loan defaulters’ SMEs in the study area. Loan distinctiveness, purpose of the loan and the borrower characteristics were the independent variables used. The study revealed that the purpose of loan and loan repayment were largely associated. The findings also recommended that the banks should apply more efficient and successful credit risk management techniques that ensure that the loans match with repaying ability, as well as none or minimal insider lending.

Ramanujam and Murugesh (2018) investigated the factors that determine an MSME’s loan repayment performance of borrowers in commercial banks. The purpose of the research was to understand the concept of relationship lending and understand the impact of the lending relationship among the borrowers and banks. Different variables were used by researchers to understand the concept of relationship lending. The most important factors influencing repayment performance was co-operative concern and access.

Felix and Wachira (2018) examined the effect of lender factors on loan default by SMEs in Kitui Central Sub-county. The study was mainly based on primary data collected from the SMEs. The analysis of the study revealed that the mode of loan repayment and the structure of interest rate highly influenced loan default. The study recommended that the lenders should revise their lending policies so that they can reduce loan repayment problems arising from these lender characteristics.

Veluchamy et al. (2017) examined the effect of demographic characteristics on credit repayment performance in MSMEs. The researchers used a survey method for data collection by using a questionnaire in Virudhunagar district in Tamil Nadu. The research inferred that there was no relationship between borrower’s demographic characteristics and repayment of credit by MSMEs.

Ahmed (2017) examined the importance of credit adequacy and repayment behaviour of MSMEs. The researcher used primary data and it was found that many MSMEs depended on the informal source of finance because of lack of appropriate collateral security, and 52% of the MSMEs felt that the amount financed was insufficient.

A study conducted by Murthy and Mariadas (2017) investigated the factors contributing to loan repayment default in microfinance institutions that were based in Shah Alam, Selangor, Malaysia. From the analysis of the study, it was found that the nature of business operated by loan borrowers was one of the factors that influenced loan repayment. The age of the borrower and diversion of the funds by the borrower and the repayment schedule did not have any impact on loan defaults.

Venkateswaran and Gnanasaranya (2016) reported that adequacy of loans, the process of borrowing and marketing of MSME products played a major role in deciding repayment behaviour, and a majority of the MSMEs were regular in their loan repayments, and there was a positive correlation between cash realisation and repayment behaviour.

Nyamboga et al. (2014) analysed the impact of financial literacy on SME loan repayment. The author used primary data for the study. Analysis revealed that credit management, bookkeeping and budgeting skills have a high influence on the ability of SMEs to repay the loan. The author suggests that the government and other industry players should initiate more financial literacy programmes for SMEs for proper credit management so that repayment of loans will be better.

Makorere (2014) examined the factors affecting loan repayment behaviour in Tanzania. The research was based on primary data, rate of interest, profitability, grace period, economic stability, which were the factors that influenced loan repayment behaviour. Appropriate policies and institutional framework are necessary to improve loan repayment behavior of SMEs.

Ogeisia et al. (2014) examined the impact of borrower character on loan repayment in commercial banks in Kakamega town. The cross-sectional survey design was employed to analyse the data collected from 105 respondents. The study notes that there exists a positive relationship between borrower character and loan repayment, Further, the study suggests that banks should take steps in designing the policies towards MSME lending.

A study conducted by Ahmmed et al. (2012) investigated the repayment behaviour of customers of private commercial banks of Bangladesh. The study was mainly based on primary data collected from the borrowers of Mercantile Bank Limited, Bangladesh. The study revealed that the age of the clients, education and nature of business influenced the loan recovery.

Richard (2011), in his study, revealed that a mix of factors affected loan recovery, while natural calamities and high interest rates made the loan repayment very difficult. Other factors like credit period, size of the loan influences the benefits of the firm.

Benard (2011) attempts to understand the relationship between interest rate ceiling and loan repayment in equity bank. Research reveals that a high rate of interest and lack of entrepreneurial skills have a major impact on the repayment of loans among customers.

Gebeyehu (2002) evaluated the variables causing the loan default of Small Scale Enterprises (SSEs). Primary data were used for the study. The study outcome revealed that loan diversion and type of activity were factors that affected the rate of loan recovery. Characteristics of borrowers such as business experience, education and age had a positive impact on loan recovery.

Research Objectives

The purpose of the research is to determine the factors influencing the loan repayment by SME borrowers. Specific objectives are as follows:

to determine the effect of loan characteristics on loan repayment by SMEs;

to determine the effect of borrower characteristics on loan repayment by SMEs;

to determine the effect of lender characteristics on loan repayment by SMEs; and

to determine the effect of characteristics of the firm on loan repayment by SMEs.

Research Methodology

The type of research used in the study was descriptive. The non-probabilistic convenience method of sampling was used to select the sample of respondents in the study area. The study was mainly based on primary data. Questionnaires were used to collect primary data from the SMEs. Sample size of 80 registered SMEs were taken from both manufacturing and service sectors to understand their repayment behaviour towards commercial banks. Special care was taken to design the questionnaire as the study was considerably based on primary data. Data were analysed using different statistical tools such as correlation analysis and logit regression analysis. Required secondary data were collected from books, national and international journals and annual reports of the Ministry of MSME and various websites.

Results and Discussion

Framework of the Study

Loan repayment default is a dependent variable. Characteristics of borrowers, loan, lender (Institutional) and firm are independent variables.

L R D 1 = f (X 1, X 2, X 3, X 4, \dots n)

Factors Influencing the Loan Repayment

These are many factors that lead to non-repayment of loans by the borrower as specified in the loan contract. A loan repayment default means that the borrower fails to pay back the loan instalments when they are due. There are diverse factors identified, which have an impact on loan repayment, viz. age, marital status, location, interest rates, loan size, lack of monitoring, no proper follow up, etc.

Borrower characteristics: These are factors specific to the borrower, which may influence his/her loan repayment. It includes the age, gender and income of the borrower. Individual characteristics also determine whether loans will be repaid or not.

Loan characteristics: These are the factors specific to the loan advanced to the borrowers—they include loan size, period of repayment, interest rate charged and other conditions.

Lender characteristics: These are the factors internal to the bank, and lending institution that is advancing the loan influences the loan repayment rate.

Firm characteristics: These are the characteristics that are specific to the firm, which influence its repayment. These include the type of ownership, nature of the business, the distance between the business place and the lending bank.

Variables in the study have a Cronbach’s alpha value above the prescribed threshold of 0.7. Therefore, it indicates that the variables used in the questionnaires are reliable. Table 1 shows the business and demographic details of the respondents and Table 2 shows the reliability Statistics.

Table 1.

The Business and Demographic Details of the Respondents.

Particulars	Items	Number	Percentage
Gender	Male	62	77
Gender	Female	18	23
Age	18–25	12	15
	26–35	40	50
	36–50	18	22
	Above 50	10	13
Type of Industry	Manufacturing	66	82
Type of Industry	Service	14	18
Registration	No	00	00
Registration	Yes	80	100
Place of the business	Urban	59	74
Place of the business	Rural	21	26
Years of the business	Up to 2 years	09	11
	More than 2 years and less than 5 years	39	49
	More than 5 years and less than 10 years	24	30
	More than 10 years	08	10
Nature of ownership	Sole proprietorship	44	55
	Partnership	22	27
	Private Ltd	14	18
	Public Ltd	00	00
Number of workers	Less than 20	61	76
	21–50 years	16	20
	51–100 years	03	04
	101–300 years	00	00
	More than 300 years	00	00

Source: Primary data.

Table 2.

Reliability Statistics.

Variable	Cronbach’s Alpha	No. of Items
Loan characteristics	0.710	6
Borrower characteristics	0.722	8
Lender characteristics	0.745	6
Firm characteristics	0.833	7

Source: Primary data.

Table 3 presents the descriptive statistics. It shows the mean values and standard deviations of each variable. Results indicate that the loan characteristics are the most important characteristics, which influence loan repayment by SMEs, followed by lender characteristics and borrower characteristics. While characteristics of loan and lender influence repayment of loans to a large extent, borrower characteristics influence the latter to a moderate extent. A firm’s characteristics influence the loan repayment the least.

Table 3.

Descriptive Statistics of the Respondents.

Variables	N	Mean	Std. Deviation
Loan characteristics	80	3.5646	0.6727
Borrower characteristics	80	3.2056	0.59668
Lender characteristics	80	3.5229	0.74665
Firm characteristics	80	2.9643	0.92707

Source: Primary data.

Table 4 presents the correlation results. Correlation between the repayment status and other variables is the point-biserial correlation as the repayment status is a dichotomous variable. Table 4 indicates that there is a statistically significant moderate positive correlation between repayment status and loan characteristics. On the other hand, the repayment status shows a statistically significant moderate negative correlation with the firm’s characteristics. However, the repayment status does not show any significant correlation with borrower characteristics and lender characteristics.

Table 4.

Correlation Analysis.

	Repayment Status	Loan Characteristics	Borrower Characteristics	Lender Characteristics	Firm Characteristics
Repayment Status	1.000
Loan Characteristics	0.360**	1.000
Borrower Characteristics	–0.054	–0.093	1.000
Lender Characteristics	0.139	0.264*	0.388**	1.000
Firm Characteristics	–0.332**	–0.207*	0.342**	–0.057	1.000

Source: Primary data.

Note: Correlation analysis is used to study the correlation that exists between variables. **—Correlation is significant at the 0.01 level and *—Correlation is significant at the 0.05 level.

Logit Regression Analysis

The study developed a binary logistic regression model to examine the influencing factors on loan repayment status. Hosmer and Lemeshow’s chi-square test is used to test the overall effectiveness of fit of the proposed model. Table 5 exhibits the result of Hosmer and Lemeshow test. Table 5 shows a statistically significant chi-square value (χ² (8, N = 80) = 35.832, p < 0.01), indicating that the proposed model is fit.

Table 5.

Hosmer and Lemeshow Test.

Chi-square	df	Sig.
35.832	8	0.000

Source: Primary data.

The logit regression model employed in this study is as follows:

\Pr (Y_{i}) = α + \sum β_{i} X_{i} + μ_{i}

The results presented in the Table 6 indicate that the McFadden R-squared is 0.2017. This indicates that though the model is fit, the covariates in the current model do not give much predictive information about the outcome. This is confirmed by Nagelkerke R-squared, which has a value of 0.293. Both of them indicate that the variance extraction in dependent variable by all the independent variables included in the model collectively is weak. The results indicate that the proposed model classified 72.5% of the respondents correctly.

Table 6.

Coefficients of Logit Regression Model.

	Coefficient	Std. Error	z-Statistic	Prob.
Loan characteristics	0.922097	0.431725	2.135843	0.0327
Borrower characteristics	0.870704	0.572406	1.521129	0.1282
Lender characteristics	–0.587033	0.387006	–1.516858	0.1293
Firm characteristics	–0.713317	0.330256	–2.159888	0.0308
Constant	–1.08551	1.481082	–0.732916	0.4636
Mean dependent var	0.725	SD dependent var		0.449331
McFadden R-squared	0.201715	Nagelkerke R-square		0.293408
Log likelihood	–37.56211	Akaike information criterion		1.064053
Schwarz criterion	1.212929	Hannan–Quinn criteria		1.123742
Number of cases ‘correctly predicted’	58 (72.5%)

Source: Primary data.

Though the explanatory power of the model is less, it shows that the coefficient for loan characteristics is positive and statistically significant at the 5% level of significance. This indicates that loan characteristics positively influence loan repayment by SMEs. On the other hand, the coefficient for the firm’s characteristics is negative and statistically significant at the 5% level of significance. It indicates that a firm’s characteristics negatively influence the loan repayment by SMEs. However, the study does not find borrower characteristics and lender characteristics as statistically significant variables in predicting loan repayment by SMEs. Therefore, the logit regression model proposed earlier can be represented using the following equation:

\begin{array}{l} \Pr (Loan Repayment) = - 1.08551 + (0.922097 \times Loan Characteristics) + \\ (- 0.713317 \times Firm Characteristics) \end{array}

Managerial Implications

This study helps to understand the relationship between independent variables such as loan, lender, borrower and the firm’s characteristics with dependent variable being loan repayment. Lending to SMEs is risky as it involves credit risk. From the results, it is observed that loan characteristics are the major determinants of loan repayment, followed by lender characteristics and borrower characteristics Apart from this, economic and political conditions are the external factors affecting the loan repayment of SMEs. Since loan characteristics influence the loan repayment of SMEs, banks should revise terms and conditions attached to the loans, so that they can reduce repayment problems associated with this. Since SMEs have limited access to an alternative source of finance, banks should support emerging SMEs by modifying the lending policies of the banks. Policymakers like the RBI and concerned governments should develop policies that will standardise and ensure uniformity in the area of credit so as to reduce cases of loan default. This is because the characteristics of the lender were found to have a significant relationship with loan default in the study area.

Study Limitations

The study is restricted only to SMEs, and it is not applicable to large enterprises.

Loan repayment is confined only towards public sector banks.

Conclusion

Repayment of loans is the critical problem of the banks. This research examines the determinants of loan repayment by small and medium businesses. Repayment of the loan is a dependent variable, whereas independent variables are characteristics of loan, lender, firm, and borrower. The findings of the study reveal that loan characteristics and lender characteristics influence the repayment of a loan to a larger extent. This research provides valid inputs for the banks to redesign their lending policies. As the lender characteristics and loan characteristics were found to be the strong predictors of loan repayment, banks should draw a lot of initiatives on these factors as these will influence the overall repayment at the bank.

Scope for Further Studies

The objective of the research is to examine the determinants of loan repayment behaviour of SME borrowers in the Bangalore region. The study is focused only on major public sector banks. Therefore, it recommends the replication of the study in private sector banks and non-bank financial companies (NBFCs) of other regions throughout the country. Future studies can be carried out by considering other determinants like socio-economic factors, which are not covered in this study.

Footnotes

Declaration of Conflicting Interests

Funding

The authors received no financial support for the research, authorship and/or publication of this article.

ORCID iD

M. Nandini

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