Loan Defaults and Credit Risk in Microfinance

This study investigates the probability of consumer default across both secured and unsecured assets, with a particular focus on borrower behavior and the role of moral hazard in shaping individual credit risk. It examines how different borrower decisions, such as investing in secured and unsecured projects after loan disbursement, affect default outcomes, especially under limited lender supervision. The Ornstein–Uhlenbeck process is used to capture the dynamics of risky asset returns and identifies the conditions under which borrowers are likely to switch from safer to riskier investments. We assume that borrowers may allocate loan funds to both secured and unsecured projects, thereby recognizing that credit risk assessment inherently involves behavioral factors that are difficult to quantify. Monte Carlo simulations are used to assess how return volatility influences borrower decision-making, showing that higher uncertainty increases the probability of returns exceeding the repayment obligation, thereby incentivizing risk-shifting behavior. The results indicate that unsecured lending is more exposed to strategic risk shifting and experiences more frequent and severe default outcomes than secured lending. As a result, this study recommends that microfinance institutions prioritize collateral-backed lending as a more effective strategy for mitigating credit risk and reducing exposure to borrower opportunism.