Loan performance and lending rate: Testing the existence of adverse selection in the Nigerian credit market

Abstract

Leaning on the loan pricing theory, this study provided empirical proof of the existence of adverse selection in the Nigerian credit market using the interrelation between the lending rate and non-performing loans as a decision factor. The paper employed Augmented Dickey Fuller (ADF), Phillips Perron (PP), and Kwiatkowski–Phillips–Schmidt–Shin (KPSS) for stationarity tests, Autoregressive Distributed Lag (ARDL) Bound Test for cointegration and an ARDL model for the regression analyses using quarterly data. The results of the analyses showed a positive and consequential link connecting non-performing loans and lending rates, proving the existence of adverse selection in the Nigerian credit market in the short-run and long-run. Based on the results, the study recommends that the apex bank implement a price ceiling in the credit market. Banks and other financial institutions should properly define their lending rates given their cost of funds and other operational expenses. And hence, carefully select viable borrowers from the credit market that suit the bank’s credit policy rather than adjust the lending rate up to compensate for higher risk.