Financial intermediation entails bridging the gap between resource surplus units or savers with
resource deficit units, the borrowers. The surplus or deficit units may be individuals, for- profit,
not-for profit firms or nations. Commercial banks, development finance institutions, Savings and
Credits Cooperative Societies ( Saccos) and deposit taking micro finance institutions are
authorized by statutes to conduct the business of financial intermediation. As the go-between or
brokers, these institutions provide a very useful service to both savers and borrowers by
leveraging on the principle of economies of scale. It would be prohibitively expensive for large
scale borrowers to reach out to millions of small savers to address their financing needs. In the
same vein, if left on their own devices, savers would feel quite insecure to keep their hard earned
funds under their mattresses! The business case for financial intermediation cannot be contested.
Stewardship role of lenders
An institution has to meet some statutory requirements that include among other things some
minimum share capital to be registered to engage in financial intermediation. Once they start
operating, these institutions embark on aggressive customer recruitment drives to collect deposits
from willing savers. The deposits thus mobilized have to be invested wisely earn sufficient
returns to cover the operations costs, a return to savers and some retention to support business
growth. Therefore, Savings are critical inputs or raw materials in the business of financial
One of the most lucrative ways of deploying savings that are not immediately required to meet
daily liquidity needs like customers’ withdrawals are lent to qualified borrowers. The spread
between the return to savers and the rate charged to borrowers forms the profit margin to the
lenders. It follows that the higher the spread, the more profitable the intermediation business,
ceteris paribus (i.e. all other things being equal).
It is important to note that institutions that are permitted by law to engage in financial
intermediation rely on public deposits or savings from third parties for their daily operations. In
other words, they trade with other people’s money. These institutions are custodians or stewards
of other people’s money. In exercising this fiduciary responsibility, the financial institutions are
expected to exercise due professional care and prudence.
Risks in lending
Lending being one of the principal activities that is also very lucrative also happens to be the
most risky. In this regard, the investment principle of risk-return trade off that posits that the
higher the risk, the higher the returns and vice versa is very appropriate. Every lending situation
has inherent default risk. There is nothing like risk free lending or investment. The notion that
investing in government paper is free has now and again been proved to be misplaced, what with
some countries that have been known to default!
To mitigate the default risk and manage the potential financial losses, lenders have to develop
certain risk selection tools for credit evaluation. Some of the commonest tools include 5C’s of
lending, (i.e. C-Character, C-Capacity, C-Collateral, C-Conditions, and C-Capital) and
CAMPARI (i.e. C-Character, A-Ability, M-Margin- Purpose, A-Amount, R-Repayment
and I- Insurance).
World over, majority of people of all ages, both men and women who have challenges
accessing loans from formal and informal lenders always attribute this to stringent collateral
requirements. Majority of them do not own the type of collaterals that are preferred by lenders,
e.g. real estate, chattels, quoted securities, etc. Lenders are always bashed for being ‘mean’,
insensitive and uncaring! This category of persons are not keen to internalize why lenders
demand for security or collateral.
Since every lending transaction always has an inherent risk of default which cannot be quantified
in advance, prudent stewardship requires the lender to cover the downside risk just in case it
materializes. Remember, the lenders are mere stewards or custodians of shareholders and
depositors money. They cannot afford to be reckless. Like other contracts that are consummated
by an exchange of some consideration, lenders require of borrowers to also part with something
in exchange for cash. The demand for acceptable marketable securities is therefore a legitimate
As a default risk mitigation strategy, collaterals act as a secondary source of loan repayment in
cases where the business or the borrower is unable to generate sufficient cash flows to repay the
facility. The amount a borrower can borrow is determined by their capacity to borrow not the
value or nature of security. For example, a potential borrower may be in a position to pledge
collateral worthy billions of shillings but still fail to access one thousand shillings if that ability
cannot be proven! Lenders are not in the business of selling borrowers’ collaterals as their core
activity. If lenders are in the habit of lending money without protecting themselves or not taking
care of the downside risk, they would soon close down for lack of money to lend. Many lenders
of all sizes are in corporate cemetery not for their inability to mobilize savings or shareholders’
capital but rather for imprudent default risk management strategies.
Character versus collateral
In credit evaluation, which is more important, character or collateral?
The 5Cs and CAMPARI credit evaluation tools can be summarized by two critical variables:
character and ability or capacity. Whereas not everybody is endowed with physical collaterals
that are the darlings of lenders, every human being has inalienable right to decide their
character. We have the free will to decide to ethical or unethical, to be good or bad, etc.
Potential borrowers have the free will to decide to repay loans or not.
A potential borrower may have the most suitable collateral in the world and even possess excess
capacity to repay a given facility but still fail to pay even a single installment if their original
motive is to defraud the lender. Nothing can cure the bad character of a borrower, not a
collateral, capacity, purpose, or even contribution!
Since lenders have no capacity to read the minds of potential borrowers to gauge their character
(i.e. lenders are not brain readers, or star gazers, even hiring witches would be of no use
anyway), they result to use of proxies. For example, Credit Reference bureaus provide useful
character information of a person’s behavior in terms of honoring other financial obligation like
credit cards, payment of utility bills, etc.
Physical collateral losing value
Currently, advances in ICT have made it possible to carry out very sophisticated analytics on a
person’s behavior and character. For example, some companies are able to assess a person’s
character by analyzing their social media and mobile phone behavior. The outcome of such
analytics forms the basis of lending decision. Already some companies in Kenya are already
disbursing billions of shillings through mobile phones every month without any paper work and
collaterals. This is character driven lending.
Character driven lending democratizes credit access
This technology driven character lending is the death knell of the much dreaded and unpopular
collateralized lending. The beauty about this development is that every human being is totally
responsible of molding their character. In this regard, there will be no more excuses and blame
game from those who have always blamed lenders for demanding traditional physical collaterals
that are the preserve of a privileged few. With increasing mobile telephony penetration
worldwide, affordable internet access and cut throat competition amongst lenders, credit access
and financial inclusion can only get better.
Just like the freedom to vote in democracies, character based lending that is driven by
technological innovations will continue to democratize credit access. And since every person has
absolute control over their character, then credit access or denial can only to attributable the
individual’s personal conduct. In a nutshell, a person’s character and ability to borrow will be
the key determinants to credit access. The ultimate development will be a confirmation of
lenders’ view that traditional collaterals are secondary source of loan repayment in cases of
default rather than the primary consideration in arriving at lending decisions.