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EFFECTS OF CREDIT RISK MANAGEMENT ON THE PERFORMANCEMOF DEPOSIT MONEY BANKS IN NIGERIA, 2010-2020
CHAPTER ONE
INTRODUCTION
Background of the study
The financial services provided by quoted deposit money banks are essential to economic and financial development in an economy. The role of deposit money banks as financial intermediaries enhances rapid economic growth and financial stability in a nation by providing support especially to the real sector of the economy. Financial stability is vital for any nation so therefore the deposit money banks need to be properly managed. Stephen and Joseph (2015) posited that the volume of loans and advances disbursed in an economy significantly influences the productive activities in a nation. The main goal of deposit money banks is to redirect funds from the surplus sector to the deficit sector in a most profitable and sustainable manner. The extent to which deposit money banks extend loans and advances otherwise called credit facilities to members of the public for productive activities accelerates the pace of a nation’s economic growth, financial stability and its long-term sustainability.
Egide and Paul (2017) posited that efficient management of credit risk in deposit money banks is crucial for the survival and growth in the economic globalization waves. He also posited that the Swedish Banking Crisis in the 1990s; the credit losses for the Swedish banks were extremely high. The Swedish banks managed to get through the global mortgage crisis relatively well compared to banks in other countries due to help from the Swedish Government and “Riksbanken” (Central Bank of Sweden, 2009) still they were faced with large losses because of their operations in the Baltic states (FI, 2009). These crises show that the banking industry is exposed to high degrees of risks. He then concluded that efficient management of credit risk in deposit money banks is critical for the survival and growth in the economic globalization waves.
Ravi (2012) posited that credit risk management is best practice in banks and above 90% of the banks in country have adopted the best practice. Inadequate credit policies are still the main source of serious problem in the banking industry and hence effective credit risk management has gained an increased focus in recent years. The main role of an effective credit risk management policy must be to maximize a bank’s risk adjusted rate of return by maintaining credit exposure within acceptable limits. Moreover, banks need to manage credit risk in the entire portfolio as well as the risk in individual credits transactions.
In the study of Kolapo, Ayeni and Oke (2012), deposit money banks in some economies of the world such as Thailand, Indonesia, Malaysia, Japan and Mexico experienced high nonperforming loans and significant increase in credit risk during financial and banking crises, which resulted in the closing down of several banks in Indonesia and Thailand. Financial crisis has not only shaken big economies of the world but developing economies have also been severely affected. Many financial institutions in Africa have either collapsed and or are facing near collapse because of improper functioned subprime mortgage lending to firms and people with bad and unreliable credit. Green (2008) posited that since the late 1950s when Ghana became the first Sub-Saharan African country to gain independence, which has been regarded across the world as a “torchbearer for African aspirations” also faced financial crisis because of real estate losses in early 2000. Sheng (1996) posited that deposit money banks in Ghana experienced several liquidations which affected Meridian BIAO Bank, Bank for
Housing and Construction, National Savings and Credit Bank, Ghana Co-operative Bank and Bank for Credit and Commerce (Amidu, 2007; Appiah, 2011). These high-profile failures, in turn, raise questions on the credit risk management practices of banks in Ghana. Deposit money banks in developing economies like Nigeria also face problems in the management of credit risk as a result of banking crisis in the past. Banking crises in Nigeria have shown that not only do banks often take excessive risks but the risks differ across banks leading to collapse of some banks. Most banks quality of assets have deteriorated as a result of significant dip in equity market indices (BGL, 2010). The lessons learnt from financial crisis are to open awareness of the government and business people on the important role of implementing good risk management in Nigeria. Thus, as a way out of the tide, the Central Bank of Nigeria (CBN) on July 6, 2004 introduced measures to make the entire banking system a safe, sound and stable environment that could sustain public confidence and promote financial stability in Nigeria quoted deposit money banks (Owojori, Akintoye, & Adidu, 2011).
Ikpefan and Ochei (2012) posited that several factors led to the failure of some banks between 1977 and earlier 2000. Some of the reasons advanced are; poor asset quality, under capitalization, inexperienced personnel, illiquidity, inconsistent regulatory policies and supervision. Sanusi (2012) opined that in Nigeria, the economy faltered and was hit by the second round effect of the crisis as the stock market collapsed by 70 per cent in 2008–2009 and many Nigerian banks sustained huge losses, particularly as result of their exposure to the capital market and downstream oil and gas sector. The real economic crisis, which began in 2008 is still producing its harmful impact on the financial stability of deposit money banks as a result of continuous deterioration in the credit leading to increase in bad debts and of the other types of deteriorated receivables. The increase in non-performing exposure impacts in turn on the cost of the risk which keeps growing due to the need of the banks to increase provisions and impairment losses on loans. Therefore, the CBN had to rescue eight of the banks through capital and liquidity injections, as well as removal of their top executives and consequent prosecution of those who committed some infractions. These actions became necessary to restore confidence and sanity in the banking system.
Owolabi and Ogunlalu (2013) provided an overview of various liquidations between 1994 and 2003 that within nine years, no fewer than 36 deposit money banks in Nigeria were liquidated due to insolvency. In 1995, four banks were closed down. 1998 was the saddest year in the history of bank failure in the banking industry as 26 banks were closed in that year. Also, three terminally ill banks were closed in 2000. In 2002 and 2003 not less than two banks collapsed. The failed deposit money banks had two things in common – small size and unethical practices. As a result, banks were consolidated through mergers and acquisitions, raising the capital base from N2 billion to a minimum of N25 billion, which reduced the number of banks from 89 to 25 in 2005, and later to 24 (Sanusi, 2012).
Deposit money banks reforms which began in 2004 with the consolidation programme were necessitated by the need to strengthen the banks. The policy thrust at inception, was to grow the banks and position them to play pivotal roles in driving development across the sectors of the economy. Before Asset Management Corporation of Nigeria (AMCON) was created, the country witnessed a consolidation and clean-up of the banks under former Central Bank of Nigeria CBN governors: Charles Soludo and Sanusi Lamido, because most of the banks were substantially under- capitalized, arising mainly from non-performing loans (Olawale, Tomola, James, & Felix, 2015).
It was opined by Sanusi, 2012 that, some board members were found securing credits without adequate collateral which made it impossible for them to enshrine sound corporate governance practices in the banks and to also challenge the executives. It was discovered from the finding of the CBN audit report that, most of the loans given out were unsecured and no adequate provision for bad debts was made. Consequently, eight bank Chief Executive Officers and their respective board of directors were fired from their jobs. The affected banks were Afribank Plc, Platinum Habib Bank Plc, Equatorial Trust Bank Plc, Finland Plc, Intercontinental Bank Plc, Oceanic Bank Plc, Spring Bank Plc and Union Bank Plc (Chiejine, 2010). Consequently, corporate governance can be seen as one of the factors that contributed to the near collapse of the banking sector in Nigeria (Sanusi 2012). Following the conclusion of the consolidation programme in 2005, a Code of Corporate Governance for Banks in Nigeria was issued to the banking industry in order to strengthen governance practices (Sanusi 2012).
CBN (2014) defined the term corporate governance as the rules, processes, or laws by which institutions are operated, regulated and governed. It is developed with the primary purpose of promoting a transparent and efficient banking system that will engender the rule of law and encourage division of responsibilities in a professional and objective manner. Effective corporate governance practices provide a structure that works for the benefit of stakeholders by ensuring that the enterprise adheres to accepted ethical standards and best practices as well as formal laws. CBN further stated that a country’s economy depends on the safety and soundness of its financial institutions. Thus, the effectiveness with which the Boards of financial institutions discharge their responsibilities determines the country’s competitive position. They must be free to drive their institutions forward but exercise that freedom within a framework of transparency and effective accountability. This is the essence of any system of good corporate governance. Corporate governance has received increased attention because of high-profile scandals involving abuse of corporate power and, in some cases, alleged criminal activity by corporate officers. Following the conclusion of the consolidation programme in 2005, a Code of Corporate Governance for Banks in Nigeria was issued to the banking industry by CBN. The Code which became effective in April 2006 was designed to enhance corporate governance practices within the banking industry in view of the fact that governance mechanisms in banks was notably weak and Board members of financial institutions were unaware of their statutory and fiduciary responsibilities, and merely endorsed all proposals of executive management regardless of their implications to the financial condition and going concern status of such institutions.
Also, as part of the clean-up exercises, CBN (2010) issued new Prudential Guidelines to banks to address various aspects of banks’ operations, such as risk management, corporate governance, know your customer, anti-money laundering, counter financing of terrorism, loan loss provisioning, peculiarities of different loan types and financing different sectors of the economy, among others. The guidelines became necessary to correct the extremely fragile financial system that was tipped into crisis by the global financial meltdown, which manifested in macro-economic instability, major failures in corporate governance, lack of investor and consumer sophistication, inadequate disclosure and transparency, uneven supervision and enforcement and critical gaps in prudential guidelines. The guidelines prohibit that the total outstanding exposure by a bank to any single person or a group of related borrowers is fixed at a maximum of 20 per cent of the bank’s shareholders’ fund unimpaired by losses while aggregate large exposures in any bank should not exceed eight times the Shareholders’ fund unimpaired by losses (CBN, 2010).
Bank and Other Financial Institution (2009) stipulated the duties of banks and regulatory compliance to prevent crystallization of credit risks that can lead to economic crisis. Mandatory compliance as prescribed by BOFIA in managing credit risks are; banks shall maintain, at all times, capital funds unimpaired by losses, in such ratio to all or any assets or to all or any liabilities or to both such assets and liabilities of the bank and all its offices in and outside Nigeria as may be specified by the Bank, No bank shall pay dividend on its shares until adequate provisions have been made to the satisfaction of the Bank for actual and contingent losses on risk assets, liabilities, off balance sheet commitments and such unearned incomes as are derivable therefrom, No manager or any other officer of a bank shall in any manner whatsoever, whether directly or indirectly have personal interest in any advance, loan or credit facility, and if he has any such personal interest, he shall declare the nature of his interest to the bank, every bank shall maintain with the Bank cash reserves, and special deposits and hold specified liquid assets or stabilization securities, as the case may be, not less in amount than as may, from time to time, be prescribed by the Bank by virtue of section 39 of the Central Bank of Nigeria Decree 1991, Banks will not during the period of any deficiency, grant or permit increases in advances, loans or credit facilities to any person without the prior approval in writing to the Bank (BOFIA, 2009).
Asset Management Corporation of Nigeria (AMCON) was then established in 2010 as a monetary policy response to solve the aching problem of non-performing loans troubling the deposit money banks. The Asset Management Corporation of Nigeria (AMCON) was established by the Federal Government in July 2010 to buy off trillions of toxic assets to stave off a major collapse of the Nigeria banks. Having succeeded in buying off about 95% of the non-performing loans, the corporation has achieved the primary purpose for which its act was made, with a caveat not to buy new non-performing loans. However, this economic bail out provides banks with cash and capital, the banks need to strengthen themselves for future success and a way out is an entrenchment of sound risk management framework (Owojori, Akintoye & Adidu., 2011).
In 2016, Nigeria faces another economic crisis in the form of falling oil prices, poorly performing financial market and worrisome exchange rate volatility, issues of credit defaults and non- performing loans have once again come to the forefront of economic discourse. CBN (2014) posited that the systemic impact of deposit money banks greatly depends on its degree of interconnectedness with other sectors of the economy can be measured by volume of credit facilities availed to the public which ensure economic growth and financial stability of a nation. Credit remains the main source of revenue for any deposit money banks around the world. However, the probability of default borrowers’ loan commitments has been an increasing concern for deposit money banks particularly in the area of unsecured loans and advances. The risk emanating from credit default is categorized as credit risk and weaken the intermediation efficiency of banking industry (CBN, 2016). The risk poses a significant exposure not only to deposit money banks (lenders) but also to the entire economy, which is evident in 2008 financial crises. This is because of the fact that banking is a vital industry of any economy and emphasizes the importance of managing the credit risk within the banking sector.
Banks grant loans to the customers with an expectation of receiving the capital together with an interest. A credit facility is considered to be performing if payment of both capital and interest are paid accordingly with agreed repayment terms. The Non-Performing Loans represents credits which the banks perceive as possible loss of funds due to customers failure to repay the monthly installments (CBN prudential guidelines, 2014). They are further classified into substandard and doubtful bank credit category hinders bank from achieving their set targets. Proper risk management is essential for the survival of a bank, and it enables management to allocate resources to risk management departments based on a tradeoff between risk and return potential (Ogboi & Unuafe, 2013).
CBN (2016) postulated in the Financial Stability report that deposit money banks in Nigeria experienced deterioration in assets quality at end-December 2016. “The ratio of non-performing loans (NPLs) to gross loans deteriorated in the second half of 2016 by 2.3 and 8.7 percentage points to 14.0 per cent at end-December 2016 compared with the levels at end-June 2016 and endDecember 2015, respectively. The deterioration in asset quality was largely attributed to the rising inflationary trend, dip in global oil prices, negative Gross Domestic Product (GDP) growth, and the depreciation of the naira”. As a result of the deterioration in assets quality, thus, the possibilities for default facilities are high leading to credit risk.
To monitor the credit risk more closely, deposit money banks are carrying out rigorous credit analysis of counterparties and various products. Banks are also upgrading their forecasting abilities to calculate credit risk in stressed market conditions. Additionally, regulators have been encouraging banks to monitor their credit risk very closely. The Central Bank of Nigeria has imposed a number of regulations to ensure financial stability in Nigeria quoted deposit money banks in the area of maintaining moderate credit risk before dividend can be paid to shareholders. Despite all these controls put in place, deposit money banks in Nigeria still experienced deterioration in assets quality at end-December 2016 (CBN, 2016).
The Basel Committee on Banking Supervision was formed in 1974 by G10 central bankers under the auspices of the Bank for International Settlements (BIS) following the collapse of Bankhaus Herstatt in Germany and Franklin National Bank in the United States in 1974 (Engelen, 2005). Initially, the Basel Accord was developed for internationally participating banks. However, it can equally be applied to banks with varying levels of complexity (BCBS, 2001).
The Basel Committee on Banking Supervision (2001) described credit risk as the possibility of losing the outstanding loan partially or totally, due to credit events. “The risk of loss resulting from the failure of an obligor to perform on an obligation, resulting in an economic loss to the bank”. Among other risks faced by banks, credit risk plays an important role on banks’ financial stability since a large chunk of banks’ revenue accrues from loans from which interest is derived. However, interest rate risk is directly linked to credit risk implying that high or increase in interest rate increases the chances of loan default. Credit risk and interest rate risk are intrinsically related to each other and not separable (Drehman & Stringa, 2008). Increasing amount of non-performing loans in the credit portfolio is inimical to banks in achieving their objectives. Non-performing loan is loan amount that were not serviced for at least three months (Ahmad & Ariff, 2007).
As a result of increasing spate of non-performing loans, the Basel II Accord emphasized on credit risk management practices. Compliance with the Basel II Accord means a sound approach to tackling credit risk has been taken and this ultimately improves banks’ financial stability. The Nigerian banking industry has been strained by the deteriorating quality of its credit assets which hindered banks to extend more credit to the domestic economy, thereby adversely affecting economic performance. This prompted the Federal Government of Nigeria through the instrumentality of an Act of the National Assembly to establish the Asset Management Corporation of Nigeria (AMCON) in July, 2010 to provide a lasting solution to the recurring problems of non-performing loans that bedeviled Nigerian deposit money banks. The study aims to investigate the effect of Total risk assets to total assets ratio, asset quality represented by nonperforming loan to gross loan ratio, Loan loss provision to total loan ratio and Total loans to total deposits ratio and the financial stability of quoted deposit money banks in Nigeria.
Statement of the Problem
Over the last ten years the deposit money banks in Nigeria have experienced problems as far as credit risk is concerned, this resulted in closure of several Banks including Intercontinental Bank, Oceanic Bank, Equatorial Trust Bank, Bond Bank and recently Skye Bank. CBN (2018) pointed out that loan defaults and toxic lending practices led to the failure of the said banks. To survive in a dynamic banking environment, Credit Risk Management is indispensable if financial stability has to be achieved in deposit money banks. The failure of deposit money banks to manage credit risks embedded in their activities had led to huge non-performing loans leading to traction of banks in Nigeria. According to the Financial Stability report of the Central Bank of Nigeria (CBN), banks recorded N1.02 trillion bad loans in the first half of 2016. Non-performing loans (bad loans) in the period grew by 158% from N649.63 billion at end-December 2015 to N1.68 billion at end-June 2016. Credit risk is expected to trend higher into the second half of 2016 owing to increased loan impairments resulting from depreciation of the Naira and inability of obligors to service foreign loans.
Sanusi (2012) opined that in Nigeria, the economy faltered and was hit by the second round effect of the crisis as the stock market collapsed by 70 per cent in 2008–2009 and many Nigerian banks sustained huge losses, particularly as result of their credit exposure to the capital market and downstream oil and gas sector. Therefore, the CBN had to rescue 8 of the banks through capital and liquidity injections, as well as removal of their top executives and consequent prosecution of those who committed some infractions. These actions became necessary to restore confidence and sanity in the banking system. As a result, banks were consolidated through mergers and acquisitions, raising the capital base from N2 billion to a minimum of N25 billion, which reduced the number of banks from 89 to 25 in 2005, and later to 24 (Sanusi, 2012) Adeusi, Akeke and Obawale (2014) posited that credit failure in banks is not new or a rare occurrence, they affect their liquidity position as well as cash flows and profits and maintained that credit risk is the biggest threat to any banks financial stability and the principal cause of bank failures.
Owojori, Akintoye and Adidu (2011) posited that available statistics from liquidated banks clearly showed that inability to collect loans and advances extended to customers and creditors or companies related to directors or managers was a major contributor to the distress of liquidated banks in Nigeria. With the collapse of deposit money banks in Nigeria, one would wonder just what the best strategy is or strategies for a deposit money banks to adopt in order to completely eliminate credit risk or loan defaults. Credit risk management strategies is an issue of concern in deposit money banks today and there is need to come up with improved strategies to deliver better results for future performance. Effective credit risk management strategies minimize the credit risk, therefore the level of loan losses. Financial stability is a priority for all managers in the banking sector. For deposit money banks managers, strategic management of credit risk is equally very important. Managers need to reduce the risk of loan default because the banks financial stability is weakened by the loss of principal and interest.
A number of research studies in Nigeria have attempted to address the impact of credit risk management and financial performance of banks in Nigeria but these studied have not addressed comprehensively the impact of credit risk management on the financial stability in Nigeria quoted deposit money banks.
Olawale, Tomola, James and Femi (2015), investigated the effect of credit risk management on bank performance in Nigeria and used return on assets to measured performance. Also, Idowu and Awoyemi, (2014) carried out a study on the impact of credit risk management on the performance of commercial banks in Nigeria and used return on Equity and Return on Asset as performance indicators. From the foregoing, existing research works so far used one or two variables as indicators to measure the effect of credit risk management on the performance of banks. Also, the studies focused mainly on banks` performance but the current study will expand the scope of the previous studies to capture financial stability. This study therefore will introduce more variables to capture the concept of financial stability, that is, Capital Adequacy ratio, Liquidity coverage ratio, Fixed Dividend Cover, Total Debt to Shareholders fund ratio.
Therefore, it is on the basis of this gap that the present study will wish to establish the effect of Credit Risk Management and Financial Stability in quoted deposit money banks in Nigeria. The study investigated the effect of Total risk assets to total assets ratio (TRAR), asset quality represented by non-performing loan to gross loan ratio (NPLR), Loan loss provision to total loan ratio (LLPR) and Total loans to total deposits ratio (TLDR) and the financial stability of quoted money banks in Nigeria.
Objectives of the Study
The following objectives were set for the research:
1. To determine the measure of relationship between credit risk and profitability of deposit money banks
2. To determine the extent to which non-performing loans affect the performance of banks in Nigeria
3. To ascertain the effects of loan loss provision on the performance of banks in Nigeria.
4. To ascertain the effects of loans and advances on the performance of banks in Nigeria.
5. To ascertain the nature of the relationship between loanable funds ration and bank performance in Nigeria
Research Questions
1. What is the measure of relationship between credit risk and profitability of deposit money banks
2. What is the extent to which non-performing loans affect the performance of banks in Nigeria
3. What are the effects of loan loss provision on the performance of banks in Nigeria.
4. What are the effects of loans and advances on the performance of banks in Nigeria.
5. What is the nature the nature of the relationship between loanable funds ration and bank performance in Nigeria
Research Hypotheses
The following hypotheses were tested for the research work.
H01: Credit risk management does not have significant effect on debt-to-shareholders fund ratio of quoted deposit money banks in Nigeria
H02: Credit risk management does not have significant effect on capital adequacy ratio of quoted deposit money banks in Nigeria
H03: Credit risk management has no significant impact on the fixed dividend cover of Nigeria quoted deposit money banks
H04: Credit risk management has no significant impact on the liquidity of quoted deposit money banks in Nigeria.
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