MSC Project Topics in Accounting and Finance
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.
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 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 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 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 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 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.
MSC Project Topics in Accounting and Finance
BASEL II AND FINANCIAL PERFORMANCE OF DEPOSIT MONEY BANKS IN NIGERIA
Department: Accounting and Finance (M.Sc)
Format: MS Word
Chapters: 1 - 5, Preliminary Pages, Abstract, References, Appendix.
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Delivery: Email
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