THE IMPACT OF CAPITAL ADEQUACY ON BANK PERFORMANCE: EVIDENCE FROM COMMERCIAL BANKS IN NIGERIA
ABSTRACT
This paper examines the impact of capital adequacy ratio on Nigeria’s commercial bank's performance after the impact of the 2008-2009 Global Financial Crash using Ordinary Least Square Methods with two models. The first model proxy bank performance with return on assets while the second with return on equity. From the descriptive statistical analysis, the mean value of capital adequacy for the study period is 14.30%, which provides evidence that Nigerian commercial banks maintain a higher level of a capital requirement than prescribed by IMF’s Basel agreement of 8% and CBN’s 10%. The regression results indicate that even after the Global Financial Crash, capital adequacy ratio showed evidence of strong significance at 5% level in explaining bank performance proxy by return on asset ratio. However, the second model showed a weak correlation as all the determinants were insignificant at 5% levels but had their correct economic signs. Although the variables on asset quality and liquidity risk proxy by non-performing loans ratio and liquidity ratio variables respectively were not statistically significant in explaining Nigerian banks performance. Risk management institutions like the Asset Management Company of Nigeria (AMCON) have to do more in riding the sector of toxic debts.
TABLE OF CONTENTS
Title page - - - - - - - - - - i
Certification - - - - - - - - - ii
Dedication - - - - - - - - - - iii
Acknowledgement - - - - - - - - - iv
Table of contents - - - - - - - - - v
Abstract - - - - - - - - - - viii
CHAPTER ONE: INTRODUCTION
1.1. Background Of The Study - - - - - - 1
1.2. Statement of the Problem - - - - - - 7
1.3. Objectives of the Study - - - - - - - 7
1.4. Research Questions - - - - - - - 8
1.5. Hypotheses - - - - - - - - - 8
1.6. Significance of the Study - - - - - - 8
1.7. Scope and Limitations of the Study - - - - - 9
1.8. Organization of the Study - - - - - - 9
CHAPTER TWO: REVIEW OF LITERATURE
2.1 Introduction - - - - - - - - 10
2.1 The Nigerian Banking Sector: An Overview - - - - 14
2.3 Highlight of the Basle Report - - - - - - 19
2.4. The Bank Lending Channel - - - - - - 21
2.5 The Concept of CAMEL - - - - - - 23
2.5.1 Capital Adequacy and Banks Profitability - - - 24
2.5.2 Asset Quality and Profitability of Banks - - - - 25
2.5.3 Management Efficiency and Profitability of Banks - - 25
2.5.4 Earnings and Banks Profitability - - - - - 26
2.5.5 Liquidity and Banks Profitability - - - - - 26
2.5.6 Banks Capital and Liquidity - - - - - - 27
2.6 Banks Capital Adequacy Regulation - - - - - 30
2.7 Problems and Challenges of Bank Regulation - - - 35
2.8 Linkage between Corporate Governance and Bank Performance 39
2.9 Empirical Literature - - - - - - - 42
2.4 Gap in Literature - - - - - - - - 50
CHAPTER THREE
METHODOLOGY
3.1 Data Description - - - - - - - - 51
3.2 Model Specification - - - - - - - 51
CHAPTER FOUR
EMPIRICAL ANALYSIS AND DISCUSSION OF RESULTS
4.1Descriptive Statistics - - - - - - - 54
4.2 Correlation Matrix - - - - - - - - 55
4.2 Correlation Analysis for Model 1 - - - - - 57
4.3 Correlation Analysis for Model 2 - - - - - 58
CHAPTER FIVE
CONCLUSION AND RECOMMENDATION
5.1 Summary of Findings - - - - - - - 60
5.2 Conclusion - - - - - - - - - 61
5.3 Recommendations - - - - - - - 61
References - - - - - - - - - 62
Appendix - - - - - - - - - 69
CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Thefinancial sector is the backbone of the economy of any country;it works as a facilitator for achieving sustained economic growth by providing efficient monetary intermediation, (Okafor, 2011). A strong financial system does this bymobilizing savings, financing productive business opportunities, efficiently allocating resources to makes easy the trade of goods and services. In a market-oriented economy,by using various financial instruments to secure surplus funds from those that forgo present consumption for the future, banks serve the vital intermediary role and have been seen as the key to investment and growth. They also make same funds available to the deficit spending unit (borrowers) for investment purposes. In this way, they make available the muchneeded investible funds required for investment as well as for the development of the nation’s economy (Nwude, 2012).
For bank regulators worldwide, safety of depositors’ funds remains the major concern. It is in this respect the capital adequacy becomes relevant and important. Capital adequacy refers to the amount of equity capital and other securities, which a bank holds as reserves against risky assets as a hedge against the probability of bank failure. In a bid to ensure capital adequacy of banks that operate internationally, the Bank of International Settlements (BIS) established a framework necessary for measuring bank capital adequacy for banks in the Group of Ten industrialized countries at a meeting in the city of Basle in Switzerland. This has come to be referred to as the Basle Capital Accord on Capital Adequacy Standards.
The Basle accord provided for a minimum bank capital adequacy ratio of 8% of risk-weighted assets for banks that operate internationally. Under the accord, bank capital was divided into two categories – namely Tier I core capital, consisting of shareholders’ equity, and retained earnings and Tier II supplemental capital, consisting of internationally recognized non-equity items such as preferred stock and subordinated bonds. The accord, allows supplemental capital to count for no more than 50 percent of total bank capital or no more than 4 percent of risk-weighted assets. In determining risk-weighted assets, four categories of risky assets are each weighted differently, with riskier assets receiving a higher weight. Government securities are weighted zero percent, short-term interbank assets are weighted 20 percent, residential mortgages weighted at 50 percent while other assets are weighted 100 percent. Consequently, a bank with say $100 million in each of the four asset categories would have the equivalent of $170 million in risk-adjustment assets. It would need to maintain $13.6 million in capital against these investment, out of which not more than $6.8million (ie. one-half of the amount) would be Tier II capital.
Although coming into effect since 1998, the risk based Basle Capital accord has been criticized by practitioners and scholars for the “arbitrary” nature of its provisions – one of such criticisms relates to the unchanging 8 percent minimum capital assigned to risk weighted assets. This and other such knocks led to the adoption of an amended Basle II accord, whichcovered most of the areas of concern. The capital adequacy standards under the Basle Accord have been widely adopted throughout the world by bank regulators. In Nigeria, the CBN reviewed the capital base of banks, upwards from N2 billion to N25 billion minimum with effect from 31stDecember, 2005. According to (CBN., 2004), out of 89 banks in Nigeria as at 2004, 62 were classified as sound/satisfactory, 14 as marginal and 11 as unsound, while 2 of the banks did not render any return during the period. The inadequacy of some of the ailing banks wasevidenced by their overdrawn position with the CBN, high incidence of non-performing loan, capital deficiencies, weak management etc. In addition to this, with the precarious exchange rate depreciation of the naira, the present level of capital in banks before the consolidation (N2 billion) has become grossly inadequate to meet domestic and global realities in the financial system.
A profitable and sound banking sector is better place to endure adverse upsets and adds performance in the financial system.In addition, performance evaluation through the determination of profitability is one of the significant acts for enterprises to give incentive and restraint to their operations, and it is an important channel for enterprise stakeholders to get performance information. Performance through profitability evaluation of banks is usually related to how well the bank can use its assets, shareholders’ equities and liabilities, revenue and expenses. The performance evaluation of banks is important for all parties including depositors, investors, bank managers and regulators.
One of the ways to define the performance of banks is by the determination of its profits. The evaluation of banks performance usually employs the financial ratio method, which provides a simple description about banks financial performance in comparison with previous periods and helps to improve its management performance. The industry standard is financial ratios based on CAMEL framework, which arerelated to capital, assets, management, earnings and liquidity considerations. These ratios include return on assets (ROA), capital adequacy ratio (CAR), non-performing loan ratio (NPL), credit to deposit ratio (CDR), yield to earnings ratio (YEA) and liquidity ratio (LR).
The upward review of the of the capital base of banks has been one of the biggest achievement in the financial sector in the Nigerian economy. This has resulted in larger, stronger and more resilient financial institutions.Capital adequacy is a key financial soundness indicator. It can be define as the percentage ratio of a financial institution's primary capital to its assets (loans and investments), used as a measure of its financial strength and stability.
Generally, banks are expected to absorb the losses from the normal earnings. But there may be some unanticipated losses which cannot be absorbed by normal earnings. Capital comes in handy on such abnormal loss situations to cushion off the losses. In this way, capital plays an insurance function. Adequate capital in banking is a confidence booster. It allows for the customer, the public and the regulatory authority with confidence in the continued financial viability of the bank. Confidence to the depositor that his money is safe; to the public that the bank will be, or is, in a position to give genuine consideration to their credit and other banking needs in good as in bad times and to the regulatory authority that the bank is, or will remain, in continuous existence.
The understanding that capital adequacy influences the financial sector's profitability is necessary not only for the managers of banks, but for many stakeholders such as the central banks, bankers associations, governments, and other financial authorities. Going further, studies like Kosmidou, (2008),Gul, Irshad and Zaman (2011) maintain that the capital adequacy of banks determines profitability. Without profits, no firm can survive and attract outside capital to meet its investment target in a competitive environment. Thus, profitability plays a key role in persuading depositors to supply funds in terms of bank deposits on advantageous terms. But in Nigeria, low capitalization of banks made them less able to finance the economy and more prone to unethical and unprofessional practices.
Soludo (2004) observes that many banks appear to have abandoned essential intermediation role of mobilizing savings and inculcating banking habit at the household and micro enterprise levels. Due to capital inadequacy of many banks in the country, they were faced with high cost of financial distress and this certainly affected profitability. Notwithstanding, Nwude (2012) opines that recapitalization may raise liquidity in short-term but will not guaranteeconducive macroeconomic environment required to ensure high asset quality and good profitability. From the foregoing therefore, this study examines to assess the effects of capital adequacy on the profitability of commercial banks in Nigeria.
1.2 Statement of the Problem
The stream of bank failures experienced in the USA during the great depression of the 1930s prompted considerable attention to bank performance and the attention has grown ever since then. Also the recent global financial crises of 2008 – 2009 also demonstrated the importance of bank performance both in national and international economies and the need to keep it under surveillance at all times. Knowing that the less a bank’s capital adequacy ratio, the more it risks instability with a likelihood of spreading throughout the financial sector. It is pertinent to know the capital adequacy of Nigerian banks after the 2008 global financial crash.
1.3 Objectives of the Study
After the global financial crash of 2008-2009, it is imperative to examine how financial stable the Nigerian banks are therefore, the immediate objectives of the study are;
1. To determine the impact of capital adequacy on the profitability of Nigerian banks.
2.To determine the impact of asset quality on the profitability of Nigerian banks.
3. To determine the impact of liquidity on the profitability of Nigerian banks.
1.4 Research Questions
The study looks at the banks so called “stress test” indicators of capital adequacy ratio, asset quality ratio and liquidity ratio (all independent variables) to ask, does bank profitability (measured by return on assets) have any relationship with them? If relationship is found, the study further seeks to know the direction of the relationship.
1.5 Hypotheses
The research null hypotheses are listed as follows;
Ho: Capital adequacy does not have any significant impact on the profitability of banks in Nigeria.
Ho: Asset quality does not have any significant impact on the profitability of banks in Nigeria.
Ho: Liquidity does not have any significant impact on the profitability of banks in Nigeria.
1.6 Significance of the Study
This study focuses on the relationship between three determinants (capital adequacy, asset quality and liquidity ratio) and the profitability of Nigeria’s commercial banks.Banks performance is measured by return on assets (ROA). Previous research in other economies shows the existence of a positive relation between capital adequacy and profitability (Berger, 1995, Ghosh et al. 2003). This study is considered important, as it is one of the most recent studies in this field, whichdeals with Nigerian banks, as well as being informative for both the academia and bank regulators. It is hoped that academicians will be able to carryon more studies on the same issue, and bank investors and customers will be able to make more inform investment decisions and gain more returns with less losses.
1.7 Scope and Limitations of the Study
The study looks into the impact of capital adequacy on the performance of Nigerian banksafter the global financial crash from the periodof 2010 to 2015. A major limitation to this study is that it will only be limited to the analysis of only the 21commercial banks post consolidations and mergers.
1.8 Organization of the Study
An overview of capital adequacy and other related financial soundness indicators and how they influence banks profitability with their corresponding empirical literature on the thesis is presented in chapter II. Chapter III outlines the data and methodology, while the empirical analysis and results are presented in chapter IV. Chapter V concludes the paper and proffers recommendation.
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