THE IMPACT OF NON PERFORMING LOAN ON THE PROFITABILITY OF DEPOSITS MONEY BANKS IN NIGERIA

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THE IMPACT OF NON PERFORMING LOAN ON THE PROFITABILITY OF DEPOSITS MONEY BANKS IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1 Background of the study

Nonperforming loans are those risk assets not generating income. As a first step, loans are often considered to be nonperforming when principal or interest on them is due and left unpaid for 90 days or more. Loan classification and provisioning entails much more than simply looking at amounts overdue.

The borrowers’ cash-flow and overall ability to repay amounts owing are significantly more important than whether the loan is overdue or not. For financial reporting purposes, the principal balance outstanding rather than delinquent payments is used to identify a nonperforming loan portfolio.

The nonperforming loan portfolio is an indication of the quality of the total portfolio and ultimately that of a bank’s lending decisions. There can be a number of reasons to explain deterioration in loan portfolio quality. It is unavoidable that banks make mistakes in judgment. However, for most failed banks, the real problems are systemic in nature and rooted in a bank’s credit culture and management style.

According to Greuning and Bratanovic (2003) credit risk is the most common cause of nonperforming loans and bank failures, causing virtually all regulatory authorities to prescribe minimum standards for credit risk management. They opine that the basis of sound credit risk management is the identification of the existing and potential risks inherent in lending activities.

Measures to counteract these risks normally comprise clearly defined policies that express the bank’s credit risk management philosophy and the parameters within which credit risk is to controlled. Specific credit risk management measures typically include three kinds of policies. One set of policies includes those aimed to limit or reduce credit risk, such as policies on concentration and large exposures, adequate diversification, lending to connected parties or over-exposures.

The second set includes policies of asset classification. These mandate periodic evaluation of the collectability of the portfolio of loans and other credit instruments, including any accrued and unpaid interest which exposes a bank to credit risk. The third set includes policies of loss provisioning or the making of allowances at a level adequate enough to absorb anticipated loss not only on the loan portfolio, but also on all other assets that are subject to losses.

Profitability in the form of retained earnings is typically one of the key sources of capital generation. A sound banking system is built on profitable and adequately capitalized banks. Profitability is a revealing indicator of a bank’s competitive position in banking markets and of the quality of its management. It allows a bank to maintain a certain risk profile and provides a cushion against short-term problems.

Interest income is a major source of bank profitability and is dependent on performing loans. Interest income originates from loans and all advances extended by a bank such as working capital overdrafts, among others. It also includes interest received on bank’s deposits kept with other financial institutions. Interest income is often eroded when a bank accumulates a large stock of nonperforming loans that do not yield income.

There is a growing body of empirical evidence to suggest that nonperforming loans (NPLs) have adverse effects on bank profitability that often lead to bank failures. Profitability is an indicator of a bank’s capacity to carry risks and / or to increase its capital. The capital adequacy of a bank is generally gauged by the extent to which owners’ funds provide cover for depositors in the event of loans and advances becoming nonperforming.

It is often the practice to measure capital adequacy by the extent to which the prescribed ratio is realized. Also, it is common to examine the extent to which shareholders’ funds cover nonperforming loans. For example, during the Nigerian banking crisis in the 1990s, while the total loans and advances in1990s was about N30bn, about N12bn, representing about 44 percent of the total was nonperforming.

The level of deterioration in loan quality contributed to low profitability and bank distress (NDIC, 1991). As the distress syndrome became wide-spread, the distressed banks’ total nonperforming loans and leases stood at N40.33 billion which represented about 55.69 percent of the total nonperforming loans and leases of the banking industry in December 1996 compared to N35.20billion or about 60.82 percent of the industry total as at the end of December 1995.

The distressed banks ratio of nonperforming loans and leases to total loans and leases increased from 68.87 percent to about 79.77 percent while the industry ratio stood at about 33.90 percent in 1996. These represent empirical indicators of declining profitability and potential bank failures (NDIC, 1996). Because the loans portfolio usually represents the largest risk asset of a bank, bank regulation always undertakes an appraisal of the lending culture of banks.

One of the principal objectives of such appraisal is to verify the quality of the credit portfolio and make a quantitative assessment on potential nonperforming loans or possible losses, and recommending remedial actions so as to ensure that the banks remain profitable. This is against the backdrop that profit is the bottom line performance result showing the net effects of bank policies and activities in a financial year, and nonperforming loans portfolio is not usually an indicator of bank profitability

1.2 Statement of the Problem

Banks are susceptible to many risks including credit risk that usually brings about nonperforming loans. Credit crystallizes when loans and other advances become nonperforming and almost irrecoverable.

During the financial crises of the late 1980s, 1990s and beyond, many banks collapsed mainly due to huge nonperforming, loans indicating that nonperforming loans portfolio is rather a sign of pending bank failure than a pointer to bank profitability.

For example, in 1993 insolvent banks accounted for about 20 percent of banking system assets and about 22 percent of deposits. In 1995 almost half of the banks reported being in financial distress, during which about 25 banks were liquidated as a result of nonperforming loans portfolio.

Moving into 2000s technically distressed banks in Nigeria had accumulated nonperforming loans in excess of the shareholders’ funds that led to the injection of about N700bn by the Central Bank of Nigeria and the formation of the Asset Management Company of Nigeria (AMCON) to participate in a bazaar of nonperforming loans (NPLs) as strategies to reviving the sick banks.

Qualitative data provide empirical evidence to suggest that bank executives and top managers in some of the failed banks in Nigeria were involved in insider illicit loan deals in excess of N125bn. Empirical evidence from other Sub-Saharan African countries prove that nonperforming loans portfolio was responsible for bank failures in many countries.

For example, in 1988-90, in Benin, all three commercial banks collapsed, 80 percent of banks loans portfolio were nonperforming, and in Cameroon, nonperforming loans portfolio reached 60-70 percent in 1993 and five commercial banks were closed and three others were restructured.

Also in 1998 in Cameroon, nonperforming loans accounted for 30 percent of total loans. Three banks were restructured and two were liquidated. In Sao Tome and Principle, 90 percent of the nonbank’s loans were nonperforming in 1992, and nonperforming loans of the largest bank in Mali reached 75 percent in 1989. (UGOANI, 2013A, 2013B; CAPRIO; KLINGEBIEL, 2002).

The issues of nonperforming loans portfolio and negative bank profit can be traced to insider abuse, compromise of sound credit risk procedures, overtrading, incompetence, complacency, inadequate supervision, among other shortcomings of corporate governance.

Objective of the study

The study was designed to explore the effect of NPL portfolio on bank profitability.

1.4 Delimitation of study

The study was delimited to commercial banks as financial intermediaries.

Limitations of the study

The study was constrained by lack of research grant and dearth of current literature. However, these limitations did not dilute the academic quality of the study.

1.5 Hypothesis

Based on the objective of the study, two hypotheses were formulated and tested at 0.05 level of significance to check the assumptions.

· Ho: Nonperforming loans portfolio has no negative effect on bank profitability

· Hi: Nonperforming loans portfolio has negative effect on bank profitability

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