Impact of Bank Stability on Commercial Banks Performance in Nigeria

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

A safe, stable and sound banking system ensures the optimal allocation of capital resources, and regulators therefore aim to prevent costly banking system crises and their associated adverse feedback effects on the performance of the bank by ensuring bank stability. Over the past three decades, before the consolidation of the commercial bank in 2004, Nigeria experienced several periods of banking system instability and full-blown banking system crises. Bank instability could be observed across banking sectors as a consequence of reforms in banking legislation as well as national and international developments in financial markets (Kick and Andreas, 2011). The major indicators of bank stability comprises three components: an institution’s score (i.e., the standardized probability of default), a credit spread, and a stock market index for the banking sector (Gertler and Nobuhiro, 2010).

Unlike price stability, bank stability is not easy to define or measure given the interdependence and the complex interactions of different elements of the financila system among themselves and with the real economy. This is further complicated by the time and cross-border dimensions of such interactions (Thomas and Koetter, 2007). However, over the past two decades, researchers from central banks and elsewhere have attempted to capture conditions of bank stability through various indicators of financial system vulnerabilities. Indeed, many central banks through their financial stability reports (FSRs) attempt to assess the risks to bank stability by focusing on a small number of key indicators. Moreover, there are ongoing efforts to develop a single aggregate measure that could indicate the degree of bank fragility or stress (Thomas and Koetter, 2007). Composite quantitative measures of financial system stability that could signal these conditions are intuitively attractive as they could enable policy makers and financial system participants to: (a) better monitor the degree of banking sector stability of the system, (b) anticipate the sources and causes of financial stress to the system and (c) communicate more effectively the impact of such conditions. The approach to the development of these measures of financial system stability has changed over the years as the locus of concern moved from micro-prudential to macro-prudential dimensions of financial stability (Thomas and Koetter, 2007).

 From the analysis of early warning indicators to monitor the state of the banking system, particularly the risk of default of individual institutions, the focus has shifted to a broader system-wide assessment of risks to the financial markets, institutions and infrastructure. More recently, the analytical focus has further concentrated on the dynamics of behaviour, the potential build-up of unstable conditions as well as the so called transmission mechanisms of shocks. A key issue underlying these analytical developments is the need to bridge the data gaps in several areas. Clearly this is an ongoing debate and a work in progress (Hanschel and Monnin, 2005).

Similarly, banking sector reforms in Nigeria like every other nation are driven by the need to deepen and ensure stable financial sector and reposition the Nigeria economy for growth; to become integrated into the global financial structural design and evolve a banking sector that is consistent with regional integration requirements and international best practices. It also aimed at addressing issues such as governance, risk management and operational inefficiencies, the centre of the reforms is around firming up capitalization (Ajayi, 2005). 

An early view of bank consolidation was that it makes banking more cost efficient, stable and sound because larger banks can eliminate excess capacity in areas like data processing, personnel, marketing, or overlapping branch networks (Somoye 2008). Consolidation is viewed as the reduction in the number of banks and other deposit taking institutions with a simultaneous increase in size and concentration of the commercial entities in the sector (BIS, 2001). Irrespective of the cause, however, bank consolidation is implemented to strengthen the banking system, ensure more stability in the banking system, embrace globalization, improve healthy competition, exploit economies of scale, adopt advanced technologies, raise efficiency and improve profitability of the ban (Adegbagu & Olokoye 2008). Ultimately, the goal is to strengthen the intermediation role of banks and to ensure that they are able to perform their developmental role of enhancing economic growth, which subsequently leads to improved overall economic performance and societal welfare they concludes. 

The government policy-promoted bank consolidation rather than market mechanism has been the process adopted by most developing or emerging economies and the time lag of the bank consolidation varies from nation to nation (Somoye, 2008). For example, what was termed “government guided” merger was a unique banking sector reform implemented in 2002 by the Central Bank of Malaysia BNM (Bank Negara Malaysia) guiding 54 depository institutions to form 10 large banks (Rubi, Mohamed & Michael,  2007). This was partly a response to the banking crises perpetrated by the 1997-1998 Asian financial crises, they noted. BIS (2001) also noted that in Japan during the banking crises of the 1990’s, government funds were deployed to support reconstruction and consolidation in the banking sector. 

A similar stance was taken by Soludo (2004) when he announced a 13-point reform program for the Nigerian Banks. The primary objective of the reforms is to guarantee an efficient and sound financial system. The reforms are designed to enable the banking system to efficiently perform its functions as the pivot of financial intermediation (Lemo, 2005). Thus, the reforms were to ensure a diversified, strong and reliable banking industry where there is safety of depositors’ money. Of all the reform agendas, the issue of increasing shareholders’ fund to N25 billion with an option of mergers and acquisitions and the need to comply before 31st December, 2005 generated so much controversy especially among the stakeholders. Although evidence on continuous stability indicators for the banking system is less comprehensive, some important studies can be noticed. Bordo et al. (2001) develop and examine a discrete financial stress index including time series on business failures, banking conditions, the real interest rate and a quality spread describing the condition of the US financial sector. Puddu (2008) constructs a real continuous indicator for the US banking system by aggregating balance sheet variables of the commercial banking sector and examines the impact of different weighting schemes on the replication ability of financial crisis events.

1.2 Statement of the Problem

BIS (2001) points out the motives for bank stabilization include; Cost savings; Revenue enhancements; risk reduction; change in organizational focus and managerial empire building. It is believed that increased size could potentially increase bank returns, through revenue and profitability through cost efficiency gains. It may also, reduce industry risks through the elimination of weak banks and create better diversification opportunities (Berger, 2000). Bank stability could increase banks’ propensity toward risk taking because of increases in size, capital and leverage and off balance sheet operations (Ogowewo and Uche, 2006). In addition, scale economies are not unlimited as larger entities are usually more complex and costly to manage (De Nicoló, Greg, Brenda, 2003).

Consolidation, whether market–induced or government–policy promoted normally holds out promises of:-

  • Revenue enhancements and resources maximization.
  • Gains in cost-efficiency or costs saving due to economies of scale.
  • Risk reduction.

Proponents of bank stability are of the opinion that banking sector reform help banks become stronger players, and in a manner that will ensure higher returns especially to shareholders over time. Also, that bank stability can lead to increased profits/ revenue for a variety of reasons including; increase in size, increased product diversification, expanding the pool of potential customers, increased size allowing firms to increase the riskiness of their portfolio (Ogowewo and Uche, 2006). Empirical evidence is consistent with the risk-reduction hypothesis and that efficiency may also improve due to greater risk diversification. Banks seeking to reduce default risk via increased size may prefer targets with lower credit risk. Acquiring banks prefer to acquire small and low risk targets and that post-merger risk reduction is most likely in mergers between high-risk and low-risk targets. However, some scholars argue that more capital does not necessarily mean more safety, and that since capital is costly to raise banks would be under pressure to generate higher returns from the additional capital, thereby forcing them to take on greater risks. Increase in the size of institutions per se tends to be associated with a greater appetite for risk and thus a greater probability of insolvency and credit risk.

Thus this research investigate the impact of bank stability on bank performance in Nigeria with clear focus on how bank stability improve the bank return on asset, returns on investment among others.

1.3 Objectives of the Study

The broad objective of this study is to determine the impact of bank stability on bank performance in Nigeria. Where the specific objectives includes;

  • To ascertain the effect of capital to assets on bank profitability.
  • To determine the effect of non-performing loan on bank profitability.
  • To examine the effect of returns on equity on bank profitability.

1.4 Research Questions

The research shall be guided by the following research questions;

  • To what extent does capital to assets impact on bank profitability?
  • To what extent does non-performing loan impacts on bank profitability?
  • To what extent does returns on equity impact on bank profitability?

1.5 Research Hypothesis

The following hypothetical statements were tested:

  • H0: Capital to asserts does not impact bank profitability.
  • H0: Non-performing loan does not impact bank profitability.
  • H0: Returns on equity does not impact bank profitability.

1.6 Significance of the Study

Nigeria presents a good case study of a country that has had persistent and numerous reforms in the banking sector. Despite the increased effort of government to maintain a stable financial system, the age-long problems affecting the banking industry seems unabated.  Existence of a sound banking system will to a large extent bring a turning point in the growth of the Nigerian economy. Considering the acclaimed importance of the banking sector in the growth of the economy, the outcomes of this study would likely prove to be beneficial to banks, policy makers, and future researchers. 

The expected benefits to each of the key stakeholders are illustrated as follows: 

  1. The Regulators.

The outcome of this study is expected to benefit policy makers such as government and its agencies in providing a platform for designing and redesigning policies that will enhance monetary and financial stability policies that will enable banks in Nigeria play its financial intermediation role well, as well as to grow the economy. Thus reiterating the views of (Ogewewo and Uche, 2006), for the need for monetary stability which is a prerequisite for a sound financial system. To the regulators of the industry, it will present an analysis that will help them to come up with policies to efficiently supervise and regulate the Nigerian banking system in its quest to repositioning it to be part of the global change. Ensuring that strong, competitive, and reliable banks are in place to compete favorably in the 21st century. It will also assist the regulators and supervisors in coming up with policies that will aid them to meet up with the challenges facing a post consolidation scenario such as size and complexity of the mega banks. 

  • The Sampled banks.

Specifically, for the banks studied, it will expose to a certain extent their performances in regards to our operational variables and present a comparative analysis of their activities over the studied period of time. Also, the studied banks will see the need to imbibe best-practice in corporate governance, the need to improve on self-regulation, internal control, enhance operational efficiency, institute IT-driven culture and seek to be competitive in today’s globalizing world.

  • The public.

To the general public that would come to appreciate the soundness and the liquidity position of Nigerian banks and be encouraged to access its services and products. It will also contribute to the enrichment of the literature on bank consolidation in Nigeria as well as serving as a body of reserved knowledge to be consulted and referred to by researchers.

1.7 Scope of the Study

This research work was planned to cover all the banks operating in Nigeria before and after the conclusion of the consolidation exercise. In line with previous empirical studies that identified some sets of variables believed to be major determinants of bank performance, this study focused mainly on three of such variables and are: Profitability as measured by ROE (Return on Equity), cost saving as measured by CIR (Cost Income Ratio), and credit risk or asset quality as measured by LLRGLA (Ratio of Loan Loss Provision to Gross Loans and Advances).

1.8 Definition of Operation Terms

Financial stability: Financial stability can be defined as “a condition in which the financial system – comprising financial intermediaries, markets and market infrastructure – is capable of withstanding shocks and the unravelling of financial imbalances, thereby mitigating the likelihood of disruptions in the financial intermediation process which are severe enough to significantly impair the allocation of savings to profitable investment opportunities” (ECB (2007)).

Bank stability: is a state in which the banking system, i.e. the key banking instruments and the financial institutional system is resistant to economic shocks and is fit to smoothly fulfil its basic functions: the intermediation of financial funds, management of risks and the arrangement of payments. Ideally, banking sector stability is equivalent to financial stability (Mpesum, 2010).

Bank consolidation: Bank consolidation occurs when two or more banks become one bank.According to American Banker, this happens through either a takeover by a bank or via a mutual merger between two or more banks. Thus, to consolidate is to combine assets, liabilities and other financial items of two or more entities or banks into one to make their operation more efficient, stable and reliable (ECB (2007).

Operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events, which includes but is not limited to, legal risk and Sharia’s compliance risk (ECB (2007).

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