IMPACT OF MICRO-PRUDENTIAL INDICES ON CAPITAL ADEQUACY RATIO OF DEPOSIT MONEY BANKS IN NIGERIA

MSC Project Topics in Accounting and Finance

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Capital Adequacy Ratio (CAR) is one of the fundamental measures of the strength and wellness of banks the world over. The term is an important measure of ―safety and soundness‖ for banks and depository institutions because it serves as a buffer or cushion for absorbing losses (Abba, Peter, & Inyang, 2013). Capital Adequacy is the first letter ‗C‘, in the popular acronym ‗CAMELS‘ in banking parlance. The importance of the concept has drawn the attention of financial experts and policy makers both locally and internationally, especially Central Banks, Federal Reserves, Deposit money banks, Insurance Companies and the World Bank and has led to the popular Basel Accords. The Basel Capital Accord is an international standard for the calculation of capital adequacy ratios. The Accord recommends minimum capital adequacy ratios that banks should meet. Applying minimum capital adequacy ratios serves to promote the stability and efficiency of the financial system by reducing the likelihood of banks becoming insolvent. When a bank becomes insolvent, this may lead to loss of confidence in the financial system, causing financial problems for other banks and perhaps threatening the smooth functioning of financial markets.

Lindgren, Garcia and Saal (1996) observed that since 1980, over 130 countries, comprising almost three fourths of the International Monetary Fund‘s member countries, have experienced significant banking sector problems, with 41 instances of crisis in 36 countries and 108 instances of significant problems. This situation posed serious concern for the policy makers and regulators. In the aftermath of the financial crisis, there have been efforts by regulatory authorities to make banks stronger. To accomplish this, governments across the developed and developing worlds are compelling banks to raise fresh capital and strengthen their balance sheets, and if banks cannot raise more capital, they are told to shrink the amount of risk assets (loans) on their books. In the case of Nigeria, the Central Bank of Nigeria, being the apex regulator of the banking industry increased the minimum capital base for commercial banks to twenty-five billion naira in 2005. This policy popularly referred to as the recapitalization or consolidation policy resulted in the reduction of Nigeria motley group of mainly anaemic eighty-nine banks to twenty-five bigger, stronger and more resilient financial institutions (Williams, 2011).

The global response of the fragility and incessant crisis that characterised the banking world is the Basel Accords. The Basel Committee on Banking Supervision handed down the first Basel Accord in 1988 which is the popularly referred to as Basel I. This marked a significant milestone in the governance of the global financial system as it focused on defining regulatory capital, measuring risk-weighted assets, and setting minimum acceptable levels for regulatory capital (Blom, 2009). Basel I incorporated a risk-weighted approach and a two-tier capital structure. The latter means that there was base primary capital (stocks, retained earnings, general reserves, and some other items) and a second tier of limited primary capital including some types of subordinated debt. The second tier capital could not exceed half of total base capital in counting towards the capital adequacy ratio (Blom, 2009). So far there have been Basel I, Basel II and Basel III. Basel I and Basel II fixes minimum capital adequacy ratio at 8% while in 2010, the world‘s central bankers, represented collectively by the Bank of International Settlements (BIS) handed down Basel III hiked capital adequacy ratio requirement from 8% to at least 10.5% of a bank‘s risk-weighted assets (Hanke, 2013). The aftermath of the international banking crisis and negative trends in the currency and banking markets attracted the attention scholars who investigated the immediate and remote causes of the crisis and the impact of capital adequacy ratio in the survival of banks. Some of these scholars include: Davidoff, Steven and Zaring (2008); Coffee (2009); Chorafas (2009); Brewer, George and Larry (2008); Bordo (2008); Bieri (2008); Bayne (2008); Atik (2011); Williams (2011); Al-Sabbagh (2004); Al-Tamimi and Obeidat (2013); Wong (2005) and Abba, Peter, and Inyang (2013). These various scholars raised a host of questions bothering on the linkages between capital adequacy ratio and financial sector deregulation as well as various micro and macro prudential issues such as risk level and risk behaviour of banks, asset quality, profitability, deposit level and macro-economic indicators including inflation rate, size and growth rate of the economy, money supply, lending rate, minimum wage and banking sector regulation. The scholars further studied the impact of these micro-prudential and macro-prudential indices on capital adequacy ratio.

In a bid to building the financial muscles of the Nigerian Banks and safeguard capital from erosion through rising risk level, the Nigerian Apex Bank increased banks‘ capital base and joined the league of Basel compliant Central Banks by adopting the Basel Capital Accord and it currently operates Basel II. Since the advent of bank consolidation, the capital base of Nigerian banks has steadily risen through merger, takeover and public offers, among others. The regulatory Capital Adequacy Ratio (CAR) has also risen over time. In a bid to understanding the behaviour of CAR in respond to changes in various economic indicators, Williams (2013) carried out a study on the determinant of Capital Adequacy Ratio (CAR) in Nigerian deposit money banks with focus on macro-economic variables such as inflation rate, economic growth, money supply, interest rate, openness of the economy, exchange rate and total investment. Significant level of relationship was observed between CAR and the variables of the study.

Since macro-economic variables are purely external factors to deposit money banks, this study focuses on behaviours of variables that are considered internal to the operations of the banks. Based on studies conducted in other developing economies, landmark policies of the apex bank, the Prudential Guidelines of 2010, the Basel capital adequacy ratio computation model as well as the peculiarity of the Nigerian banking industry, certain variables have been selected and included in this study. These variables include level of deposits with banks, profitability, asset quality of banks and loans to deposits ratio.

Al-Sabbagh (2004) identified nine different variables which according to him were major determinants of capital adequacy ratio in Jordan. These variables include: total assets of banks, risk to assets ratio, loan to assets ratio, return on equity ratio, returns on assets, deposits to assets ratio, equity ratio, dividends payout ratio and loan provision ratio. Al-Tamimi and Obeidat (2013) also carried out a similar study in Jordan on the determinants of capital adequacy ratio using seven independent variables which were as follows: interest rate risks, liquidity risks, credit risks, capital risk, revenue power, return on equity and return on assets. They observed significant relationships between the various variables and capital adequacy ratio. Wong (2005) also studied the determinants of capital adequacy in Hong Kong and identified the following as the major determinants of capital level of banks in Hong Kong: risk level of banks, bank size, business growth, cost of capital, regulatory framework, peer pressure, returns on equity and market discipline

In Nigeria, although not much research have been carried out on micro-prudential indices or bank-specific determinants of capital adequacy ratio, the increasing trend of non-performing loans in the banking sector attracted the intervention of the apex bank with several banks affected by the policy response of the bank. Since increase in non-performing loans affects the operations of banks in terms of lower profitability, an empirical study of the effect of the rising trend on the overall financial capacity and capability of banks is necessary. Also, as regards the effect of profitability on CAR, most of the relevant literature reviewed including Al-Sabbagh (2004), Al-Tamimi and Obeidat (2013) and Wong (2005) established the fact that profitability is a determinant of capital adequacy ratio. The three Basel accords also recognized the role of profit in determining the level of capital in a bank‘s balance sheet and as such, include retained earnings and various other statutory and discretionary reserves in the capital adequacy ratio computation model. This justifies the inclusion of asset quality ratio and profitability in the independent variables of the study. Furthermore, the Basel accord emphasizes risk measurement and management in banking operations and marked the beginning of the risk-base capital maintenance era. As such, all researchers on bank-specific determinants of capital adequacy ratio include banking risk among the determinants of capital adequacy ratio. Al-Tamimi and Obeidat (2013) and Abba, Peter, and Inyang (2013) focused their study primarily on the impact of risk level on capital adequacy ratio and observed significant relationship between the variables. The Basel Accord also has among many of its objectives, protection of depositors fund against bank failure and to this end, it is expected that banks should secure deposits with commensurate capital adequacy ratio level. To measure the reaction of banks capital adequacy ratio to changing deposit level of deposit money banks, deposit to asset ratio has been introduced in the model of this study. Al-Sabbagh (2004), Al-Tamimi and Obeidat (2013) and Abba, Peter, and Inyang (2013) also measured the effect of changing deposits levels on capital adequacy ratio of banks.

Thus in the wake of rising level of non-performing loans, expansion of banking operations and the attendant rise in their risk portfolio with the adoption of Basel II and preparations for the adoption of Basel III by the Nigerian banking industry, there is a great need for an empirical study on the major determinants of capital adequacy ratio, especially from the perspective of micro-prudential factors of deposit money banks in Nigeria.

1.2 Statement of the Problem

It has been widely observed that throughout the seventies, the capital ratios of many banks throughout the world declined significantly. In an attempt to reverse this decline, the bank regulators in several countries issued explicit capital standards for banks (and bank holding companies, as in the United States in December 1981). These standards required banks to hold a fixed percentage of their total assets as capital. Although these minimum regulatory standards have been given credit for increasing bank capital levels, the eighties also witnessed a number of bank failures (Nachane, Narain, Ghosh & Sahoo, 2000). Several authors, including Lindgren et.al. (1996) have observed that, since 1980, over 130 countries, comprising almost three fourths of IMF‘s member countries have experienced significant banking problems. Recent researches by Alfriend (1988) have also confirmed the fact that a weakness of the minimum capital standards was that they failed to acknowledge the heterogeneity of bank assets and, as a result, banks had an incentive to shift their portfolios from low-risk to high-risk assets.

In response to the widespread criticism about declining capital standards of banks and the consequent bank failures, in 1989, the Basle Committee on Banking Supervision (BCBS) announced the adoption of risk-based capital standards. The primary purpose of these standards was to make bank capital requirements responsive to the risk in the asset portfolio of banks. Although capital ratios at commercial banks have increased since the risk-based standards have been introduced, the question arose as to what degree of these increases were a response, specifically to risk-based capital maintenance, other bank specific ratios such as deposit asset ratio, asset quality ratio, loans to deposits ratio as well as financial performances of banks such as profitability. Furthermore, although the adoption of risk-based standards has focused attention on capital levels and bank lending, insufficient attention has been devoted to the related issue of how the adoption of the risk-based standards may have impacted bank-portfolio risk levels. In general, at least some theoretical and empirical research have raised the possibility that increasing regulatory capital standards might have caused banks to increase, rather than decrease, portfolio risk. Furthermore, greater amounts of capital, per se, are no guarantee that banks are adequately capitalised. Rather, from a public policy perspective, what is important is the amount of capital a bank holds relative to the level of risk in its portfolio.

Therefore this study employed multiple regression model to determine the extent to which changes in capital adequacy ratio in the risk-based capital regime are primarily determine by key bank-specific ratios as contained in the Basel accord model for capital adequacy computation as well as the Prudential Guideline of the Central Bank of Nigeria. Thus, the study used OLS, fixed and random effect models to determine whether there is significant linear relationship between capital adequacy ratio and risk indicators and other variables in the Nigerian banking industry; and if there is, whether the degree of linearity is such that capital adequacy could be largely a matter of operational effectiveness and movements of key banking sector indicators, as opposed to the current flex of legal muscles by the regulatory authorities (Williams, 2013).

Furthermore, the study is necessary in that there have not been sufficient researches on bank-specific determinants of capital adequacy ratio since the wake of the banking sector consolidation in 2005 and the adoption of Basel II and III in Nigeria. Thus, this study is an attempt to fill the identified gaps and thus contribute to literature on the subject matter in Nigeria.

MSC Project Topics in Accounting and Finance