Credit Default Theory, Agency Theory, and Deterrence Theory of the Financial Performance

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Credit Default Theory

The relevance of this theory is seen in a situation where an indirect relation between the effects of loan default and the financial performance exist. This theory has been hypothesized by one scholar, Sy (2007) who delineates credit default for a secured loan as the occurrence of both delinquency and insolvency and an occurrence of delinquency in the case of unsecured loan. According to Sy (2007), most existing credit default theories do not demonstrate the linkage between the causes directly to the influence of default and are unable to assess the credit risk involved in a fast changing market environment. The author postulates that a credit default is brought about by both delinquency and insolvency.

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Loan delinquency is a state of liquidity failure or a situation where an individual has insufficient cash flow to service the loan. Delinquency is simply defined as a failure to meet a loan payment by a required due date, whereas insolvency is defined as a situation where assets are less than liabilities. Delinquency occurs when a borrower is unable to make a loan payment by the due date, usually caused by negative cash flow which is the one of the major causes of liquidity failure. Delinquency triggers a solvency assessment which may lead to a conclusion of negative equity situation causing loan termination and a probability of loss by the lender. The theory proposes two cardinal ratios with regard to nonperforming loans: Loan Serviceability Ratio (LSR) is defined as the maximum loan interest rate an owner-occupier borrower can service a loan amount from net disposable income after living expenses. The evolution is traced to the point of risk in loan serviceability which is attributed to the fact that serviceability changes over time due to changes in individual circumstances as well as changes in the economic environment.

A loan which may have started off as being easily serviceable loan may become a struggle for the borrower due to unanticipated adverse developments. In summary this theory is seen to be in collaboration on studies on the relationship between non-performing loans and financial performance as it notes that delinquency occurs when a borrower is unable to make a loan payment by the due date, caused by liquidity failure. This theory explains why an individual would start accruing loan penalties due to defaulting yet at the beginning they were compliant.

Agency Theory

The agency theory is gaining a lot of popularity in explaining the financial performance of organizations. The first scholars to propose, explicitly, that a theory of agency be created, and to actually begin is creation, were Ross (1973) and Mitnick (1973), independently and roughly concurrently. Ross (1973) is responsible for the origin of economic theory of agency and Mitnick (1973) for the institutional theory of agency, although the basic concepts underlying these approaches are similar. In fact, the approaches can be seen as complementary in their uses of similar concepts under different assumptions. The theory seeks to explain the relationship that exists between the management of an organization and the owners of the organization who are usually the people holding stocks for the organization. The management of an organization is usually considered as an agent who has been contracted by the stockholders to work towards enhancing the stockholder value through good financial performance. The management is therefore expected to act in the best interests of the owners and enhance the financial performance of the organization. However, the theory suggests that the managers who are agents may be involved in activities that are aimed at serving personal interest at the expense of the owners of the organization.

The theory suggests that when this happens, the financial performance of the organization may easily suffer. Stockholders therefore can employ a number of strategies to ensure the management acts in the interest of the organization. The theory suggests that management can be rewarded financially in order to motivate them to work for the interests of the company. The owners can also issue threats such as hostile takeover to force management of perform the required duties. In addition, the principal may also incur agency costs such as the audit fee to monitor the performance of the management. In summary, this theory is seen to be in line with the study as it suggests that the managers who are agents may be involved in activities that are aimed at serving personal interest at the expense of the owners of the organization therefore, a lot needs to be done to ensure the management carries out its mandate fully.

Deterrence Theory

The deterrence theory is attributed to the early seminal works of classical philosophers including Cesare Beccaria (1738–1794), Jeremy Bentham (1748–1832) and Thomas Hobbes (1588–1678). Together, the foregoing theorists complained against the legislative policies that were dominant in European thought for over a thousand years, as well as against the spiritualistic accounts of criminal acts on which they were commonly attributed to. Further, in addition to foregoing complaints, these social philosophers offered the basis for modern deterrence theory in criminology.

Deterrence theory is grounded on the foundation that the indispensable rationale of the criminal justice system is to discourage perpetrators from indulging in crime. With a view to address this objective, the establishments would increase the severity of law, policy, and extra-legal prohibitions to raise the risks related to correction for crime. In non-compliance with respect to loan repayment for instance, among the measures taken would be to increase the severity of compliance laws in the event of defaulting, in order to deter perpetrators from non-compliance and motivate them to repay. Accordingly, Franklin et al. (1973) opines that the authorities may, according to deterrence theory, realize lower criminal activity rates via displaying greater repercussions to indulging in a given criminal activity than the conceivable benefits that may be realized. Deterrence happens in two broad forms, that is general and specific deterrence. The former inhibits members of the public from indulging in a given crime from observation of the penalties of the committer’s actions. The latter on the other hand specific discourages the committer from indulging in a comparable crime in the future, by demonstrating to an individual the repercussions of their actions.

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