Home Accounting Project Topics BASEL II AND FINANCIAL PERFORMANCE OF DEPOSIT MONEY BANKS IN NIGERIA

BASEL II AND FINANCIAL PERFORMANCE OF DEPOSIT MONEY BANKS IN NIGERIA

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ABSTRACT

The main thrust of Basel II framework is to ensure that banks maintain adequate liquidity and higher capital buffers that will match their operations in the course of financial intermediation. In spite of this thrust, unanimity does not exist among bankers, financial regulators, scholars and researchers on the ability of Basel II to prevent future banking crisis and the effects it may have on the profitability of banks. While the protagonists lauded it to be a remarkable financial reform, the critics rebutted it to be a formidable regulatory reform that will affect the financial performance of banks adversely. In view of this divergence, this study examined the impact of Basel II on financial performance of deposit money banks (DMBs) in Nigeria. Secondary data were collected over a period of 5 years from the annual reports and accounts of 8 sampled DMBs. A correlational research design was adopted while a parametric analytic technique of the OLS multiple regressions with panel data methodology was used to analyze the data. The results of the study, using STATA 10 as a statistical tool, revealed that capital adequacy ratio (CAR) strongly and negatively influences returns on assets (ROA) of the DMBs under study at 5% level of significance with a t-value of -2.32.On the other hand, the study found that the liquidity coverage ratio (LCR) has strong and positive impact on the ROA of the DMBs at 1% level of significance with a t-value of 3.91while the asset quality ratio(AQR) used as a variable notation for the credit risk has no significant impact on the ROA of the sampled DMBs as its p-value of 0.198 is not statistically significant at 10%. Based on these findings, the study recommended that the financial regulators should continue to enforce capital adequacy ratio on banks even if it squeezes their financial performance. This is because the standard can restrain obnoxious risk-taking on the part of banks and help promote banking sector stability and resilience to shocks. Also, due to the fact that the LCR has positive and significant impact on the financial performance of the sampled DMBs in Nigeria, the study recommended that the improvement and maintenance of proper LCR by the financial regulators and the banks’ management in Nigeria can give rise to improvement in financial performance of the DMBs in Nigeria.

TABLE OF CONTENTS

Title page- – – – – – – – – – – i Declaration- – – – – – – – – – – iii Certification – – – – – – – – – – – iv Dedication – – – – – – – – – – – v Acknowledgement – – – – – – – – – vi Abstract – – – – – – – – – – – ix Table of Contents – – – – – – – – – – x List of Tables- – – – – – – – – – xii List of Appendices – – – – – – – – xii CHAPTER ONE
1.1 Background to the Study- – – – – – – 1
1.2 Statement of the Problem- – – – – – – 6
1.3 Research Questions – – – – – – – – 8
1.4 Objectives of the Study- – – – – – – – 8
1.5 Research Hypotheses – – – – – – – 9
1.6 Scope of the Study – – – – – – – – 9
1.7 Significance of the Study- – – – – – – 10
CHAPTER TWO: LITERATURE REVIEW
2.1 Introduction – – – – – – – – 11
2.2 Concept of Basel II – – – – – – – – 11
2.3 Concept of Financial Performance – – – – – – 23
2.4 Conceptual Framework of the Study – – – – – – 25
2.5 Review of Empirical Studies – – – – – – – 25
2.6 Theoretical framework of the Study – – – – – – 35
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CHAPTER THREE: RESEARCH METHODOLOGY
3.1 Introduction- – – – – – – – – 38
3.2 Research Design – – – – – – – – 38
3.3 Population of the Study and Sample Size – – – – – 38
3.4 Source and Method of Data Collection- – – – – 39
3.5 Technique of Data Analysis and Justification for Technique used – – 39
3.6 Model Specification – – – – – – – 40
CHAPTER FOUR: DATA PRESENTATION AND ANALYSIS OF RESULTS
4.1 Introduction- – – – – – – – – 42
4.2 Descriptive Statistics – – – – – – – 42
4.3 Correlation Matrix- – – – – – – – – 45
4.4 Diagnostic Tests- – – – – – – – – 47
4.5 Presentation and Discussion of OLS Regression Results- – – – 49
4.6 Discussion of Research Findings and Policy Implications- – – – 54
CHAPTER FIVE: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS
5.1 Summary- – – – – – – – – 57
5.2 Conclusions – – – – – – – – – 57
5.3 Recommendations – – – – – – – – 58
5.4 Limitations of the Study – – – – – – – 58
5.5 Areas for Further Research – – – – – – – 59
Reference – – – – – – – – – 61 Appendices – – – – – – – – 70
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CHAPTER ONE

INTRODUCTION
1.1 Background to the Study
The need to strengthen regulatory standards of banks against systemic crisis, which negatively affects the investors‟ confidence and financial system at large by the supervisory and financial regulatory authorities, has been reinforced by the Basel Committee on Banking Supervision (BCBS) through its release of a new regulatory capital standard called Basel II in 2004. Basel II is the second Capital Accord of the BCBS, which requires higher capital buffer for banks to accommodate credit as well as operational and market risks in the business of financial intermediation. Its objectives among others include eliminating regulatory arbitrage by getting risk weights right and align regulation with best practices in risk management. It provides banks with incentives to enhance risk measurement and management capabilities and seeks to align regulatory capital of banks with economic risk. It sets regulatory benchmark of capital for three categories of risks, which are credit, operational and market risks; and unlike its predecessor called Basel I, the capital charges of the Basel II standard are based on asset quality rather than on asset type. With a broader objective of halting the erosion of capital standards in the international banking system, Basel II was released as a substitute for the first Capital Accord of 1988, which was approved and adopted by the Governors of the Group of 10 countries in July 1988 under the auspices of the Bank for International Settlements.
Recently, the importance of implementing the Basel II framework by banks has been reiterated following the recognition by the financial regulators that the liquidity is as important to the financial stability of the banks as are capital requirements. To strengthen the regulation and supervision of the internationally active banks and address the financial
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innovation, which had occurred in recent years, the BCBS published a Revised Capital Framework, called Basel II in June 2004. According to the BCBS (2015), Basel II better reflects the types of risks banks face in an increasingly market-based credit intermediation process. It ensures sustained improvements in the risk measurement, control of internationally active banks and deepens the soundness and stability of the international banking system against the fundamental risks banks take. The main thrust of Basel II therefore is to address the financial innovation, which had occurred in recent years. Meanwhile, to assess banking sector‟s ability to absorb unanticipated adverse shocks arising from financial and economic stress in recent times, three financial soundness ratios have become more applicable by the financial regulators and international banking rating agencies under Basel II. These ratios are the Capital Adequacy Ratio (CAR), the Liquidity Coverage Ratio (LCR), and the Asset Quality Ratio (AQR) of banks.
The Capital Adequacy Ratio (CAR) is one of the financial soundness ratios commonly used by the financial regulators to assess sound banking practices and financial performance of banks. It is a financial regulatory ratio introduced to improve banking sector‟s ability to absorb unanticipated adverse shocks and to ensure that banks cover a sufficient percentage of total assets with their own funds. It is used to restrict procyclicality by limiting the build-up of leverage in banks. The CAR is fully loss absorbent on a going-concern basis and serves as part of a bank‟s regulatory capital. It shows the extent the bank equity holder can absorb losses without being forced into liquidation and enables banking industry to take full advantage of its profitable growth opportunities. From the Central Bank‟s point of view, the CAR is the core measure of a bank‟s financial strength and it enables the Central Bank of Nigeria (CBN) to categorize banks into well-capitalized banks, under-capitalized banks, significantly under-capitalized banks, critically under-capitalized banks and insolvent banks
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in Nigeria. As a regulatory ratio, the CAR is measured as the addition of the Tier 1 and Tier 2 capital divided by the total (risk-weighted) assets of the banks. Under the Basel II framework, the CAR has a regulatory benchmark of 8%. However, the effect of CAR and financial performance of banks from the extant literature has so far produced diverging results. While the studies of Swamy (2011) and Dietrich & Wanzenried (2009) have found a positive relationship between the CAR and profitability of banks, those of Saona (2011) and Elsayed (2013) have shown a negative relationship. This situation necessitates the reexamination of the CAR as a financial soundness ratio in this study.
Similarly, the Liquidity Coverage Ratio (LCR) is another financial soundness ratio that is applied in the assessment of the banking institutions soundness and financial performance. Following the financial innovation and global market developments, which transformed the nature of liquidity risk of banks in recent years, the BCBS (2008) observed that the contraction of liquidity in certain structured product and interbank markets, as well as an increased probability of off-balance sheet commitments coming onto banks‟ balance sheets, have led to severe funding liquidity strains for some banks and central bank intervention in some cases. In a bid to address these events and ensure that internationally active banks have up to 30 days of high quality liquid assets to meet short-term institution specific and systemic stresses in the banking sector, the BCBS introduced the LCR. This ratio is aimed at enhancing banks‟ ability to cope with the short-run liquidity risk as well as exposure to a run on a bank‟s wholesale liabilities. As a metric of determining the soundness of the banking sector, the LCR is measured as the ratio of High Quality Liquid Assets (HQLAs) to the Total Assets of banks or the Net Cash Outflows over a 30-day horizon. The Bank for International Settlement (2014) requires this ratio to be at least 60%. Although, Ötker-Robe and Pazarbasioglu (2010), demonstrated in previous study that the LCR has significant
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impact on the profitability of the Asian and European banks, the study of Giordana and Schumacher (2012) in contrast showed that this ratio does not have significant impact on the profitability of banks in Luxembourg. Given these diverging results, this study is also encouraged to extend frontier of knowledge on this ratio. Furthermore, the Asset Quality Ratio (AQR) is another important financial soundness ratio commonly used by the financial authorities to assess the credit risk level and effective risk management of banks. According to Gaston and Song (2014) credit quality inadequacies and their resulting losses have always been one of the primary causes of bank failures. Despite the ongoing regulatory reforms six years after the global financial crisis as well as rounds of organized stress testing, deleveraging and balance sheet repair exercises, loan loss provisioning and asset quality still remain key issues for banks. Debelle (2015) explained that asset quality ratio of banks merits particular attention given its vital role in ensuring the safety and soundness of the banking system and following the collapse of many renowned world financial institutions in 2007-2009 and the recent market turmoil, which had exposed significant risk management weaknesses at banking institutions. As an indicator of risk measure, the AQR measures the level and size of the credit risk associated with the business operations and the risk management practices of banks. It shows not only the quality of loans, which provide earnings for banks, but also the quality of banks‟ assets, solvency level, as well as the capacity of banks to absorb losses. It can be measured as the ratio of the non-performing loans to the total loans or as the ratio of the loan loss provisions to the total loans of banks.
In its Financial Stability Report (2009), the Central Bank of Nigeria (CBN) reported that there is a cause of concern on the issue of the asset quality of the DMBs in Nigeria and that the credit risk threatens the stability of the Nigerian financial system and remains the most
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significant risk faced by the DMBs in Nigeria. Thus, there is a major challenge of inadequate risk management framework for identifying and controlling the risks associated with the activities of DMBs in Nigeria (CBN FSR, 2009). Following the above development and the mandate of the CBN to ensure adequate risk management framework for identifying the activities of the DMBs in Nigeria, the CBN appointed the Net Present Value Corp as the Basel II consultant to guide the Nigerian banking industry in its implementation. Also in its desire to see that banks adhere to international best practices in risk management and adopt globally acceptable framework like that of the BCBS in Nigeria, the CBN in December 2013, through two circulars, announced the implementation of the Basel II framework and officially put its adoption date by the Nigerian banks to be January 1 2014. Meanwhile, despite the Basel II objective of aligning banks‟ regulatory capital with the risk management of banks and its relevance to the Nigerian banking industry, its ability to contain and address future systemic banking crisis has been quizzed by financial analysts in recent times. During its drafting process and recent financial crisis, financial experts have raised concerns on whether the improvements in risk sensitivity of capital ratios to be guided by Basel II can worth the cost and be likely realized in practice. Policy analysts, banking representatives, supervisory agencies and researchers have equally debated over whether Basel II can be a panacea to future financial crisis and the effect it may have on the financial performance of banks.
While the financial analysts have argued that the push by the CBN for the DMBs to begin adopting and implementing Basel II requirements in Nigeria could amount to a regulatory action that might affect the DMBs‟ financial performance adversely, the panelists at the CIBN 7th Annual Banking and Finance Conference held on 10 to 11 September 2013 by
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Nigerian and International experts drawn from banking, finance, legal, academic, government and real sectors have unequivocally resolved that the CBN, the Nigeria Deposit Insurance Corporation (NDIC) and other safety net participants should promote and ensure the implementation of Basel II in Nigeria without delay. This, according to them, will ensure more safety of the depositors‟ funds and engender more confidence in the Nigerian banking system. An attempt to contribute to this argument empirically therefore prompts this study. The study is conducted to examine the impact of Basel II on financial performance of DMBs in Nigeria given the fact that the Nigerian banks, as parts of the global financial institutions cannot be exempted from the potential opportunities and challenges, which the implementation and adoption of Basel II standard may bring to the global banking system. Moreover, the fact that Basel II standard is designed to enhance banks‟ ability to cope with short-run liquidity risk and make banks cushion the effect of the credit risks, which have been a source of worry to many stakeholders in the banking system globally, also makes this study worthwhile.
1.2 Statement of the Problem
The introduction of Basel II as well as its implementation by banks in recent times has aroused the interest of the academic researchers, bankers, regulatory authorities and financial analysts. Concerns have been raised that the new Basel II Capital Accord will change the way banks analyze credits. According to Andre (2009) the recent credit crisis, which exposed significant weaknesses in the risk assessment frameworks of banks has raised serious concern at the global level; while in the Nigerian banking sector, the CBN Financial Stability Report (2009) shows that there is a major challenge of inadequate risk
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management framework for identifying and controlling the risks associated with the activities of the DMBs in Nigeria. A review of extant literature on Basel II also indicates that controversy exists among financial scholars and academic researchers on the cyclical nature of the Basel II and the impact it may have on the financial performance of banks. Likewise, unanimity does not exist among financial experts and policy analysts over whether Basel II can contain systemic banking crisis and be a panacea to the future financial crisis. While the protagonist have applauded the introduction and adoption of Basel II by banks because of the views that it can bring substantial increase in the quality of capital and liquidity positions of banks, improve banks‟ financial performance, strengthen the risk management of banks, and be a panacea to the future financial crisis, the critics have refuted such views. They retort that Basel II can never be a panacea for the future financial crisis because of its procyclical nature. They insist that in an imperfect credit market environment, a risk-based capital requirement tends to be procyclical since risk is countercyclical. Furthermore, they rebut and contend that the introduction and adoption of Basel II by banks can neither improve banks‟ financial performance nor contain the systemic banking crisis given the moral hazard factors and obnoxious risk-taking behaviour of banks.
In the heat of this argument, researchers like Barrios and Blanco (2003), Weber and Darbellay (2008), Kashyap, Stein and Hanson (2010) and Miles, Yang and Marcheggiano (2011) have argued that the overall effect of Basel II on financial performance of banks may be inconsequential, while other researchers like Jokivuolle and Peura (2004); Zicchino (2005); Otker-Robe and Pazarbasioglu (2010) and Angelini et al. (2011) have maintained that there will be significant costs in the implementation of the capital buffers and liquidity requirements of Basel II because it has tendency to limit banks‟ ability to do maturity
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transformation, which is a core function of banks. Looking at the tempo of this argument, this study perceived that the issue of Basel II has been on the front burner in international community, but while this issue has been vehemently debated by researchers in the advanced countries, the matter seems to attract little or no attention among researchers in Nigeria. Following this, and having observed a conspicuous absence of local studies on the impact of Basel II on financial performance of DMBs in Nigeria this study was conducted to fill this literature gap.
1.3 Research Questions
To extend frontier of knowledge on the impact of Basel II and financial performance of DMBs in Nigeria, the following research questions have been raised:
i. To what extent does Capital Adequacy Ratio affect the financial performance of Deposit Money Banks in Nigeria?
ii. How does Liquidity Coverage Ratio influence the financial performance of Deposit Money Banks in Nigeria?
iii. What is the impact of Asset Quality Ratio on the financial performance of Deposit Money Banks in Nigeria?
1.4 Objectives of the Study
The main objective of this study is to examine the impact of Basel II on financial performance of DMBs in Nigeria. Specifically, the study sought to:
i. Ascertain the extent to which Capital Adequacy Ratio affect Return on Assets of Deposit Money Banks in Nigeria.
ii. Determine the degree to which Liquidity Coverage Ratio influences Return on Assets of Deposit Money Banks in Nigeria.
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iii. Examine the impact of Asset Quality Ratio on Return on Assets of Deposit Money Banks in Nigeria.
1.5 Research Hypotheses
To achieve the objectives of this study, the following hypotheses have been formulated:
i. Ho1: Capital Adequacy Ratio has no significant effect on Return on Assets of Deposit Money Banks in Nigeria.
ii. Ho2: Liquidity Coverage Ratio has no significant influence on Return on Assets of Deposit Money Banks in Nigeria.
iii. Ho3: Asset Quality Ratio has no significant impact on Return on Assets of Deposit Money Banks in Nigeria.
1.6 Scope of the Study
This study dwells on Basel II and financial performance of DMBs in Nigeria for a period of 5 years from 2009 to 2013. The timeframe of 2009 was selected for this study because it was a year after the outbreak of a huge credit crisis, when the financial market faced a credit crunch that led to a decline of production, sales and availability of funds for corporations (The New York Times, 2009). The period is also momentous because it coincided with the stress-testing period, in which the Central Bank of Nigeria examined the risk management framework and capital planning decisions of banks. The period of 2013, which is five years from 2009 is, however, considered relatively sufficient for examining the impact of Basel II on financial performance of DMBs in Nigeria. Equally falling within the scope of this study is one dependent variable, which is the financial performance of banks proxied using return on assets; and three independent variables, which are capital adequacy ratio, the liquidity coverage ratio and the asset quality ratio which represent proxies for Basel II.
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1.7 Significance of the Study
This study is significant because it is aimed at providing empirical evidence on Basel II and financial performance of DMBs in Nigeria. Generally, the findings of this work will have significant implications on various banking industry policymakers and stakeholders such as the existing and prospective investors, financial analysts, financial researchers, banking management and financial regulatory authorities such as the Central Bank of Nigeria, the Financial Reporting Council of Nigeria, the Federal Ministry of Finance, and the Nigeria Deposit Insurance Corporation. Since the goal of the financial system regulators remains the enhancement of the stability and resilience of the financial system to withstand unanticipated adverse shocks, the CBN as a financial regulator in Nigeria may be able to determine whether or not banks‟ activities in Nigeria are in tandem with this goal. Also, through the finding of this work, the CBN and other regulatory agencies can ascertain the extent to which the implementation of Basel II by DMBs in Nigeria affects their financial performance. For the existing and prospective investors, the finding of this study is envisioned to help them in identifying the Nigerian banks that are potentially profitable and resilient to shocks while the bank managers or management can identify any adverse factors influencing bank financial performance and hedge against them. Finally, the policymakers may have insight on the cost-benefit analysis of implementing Basel II standard in the Nigerian-banking sector while the interest of the upcoming researchers may be provoked to carry further study on other issues relating to Basel II standard.
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