BANK SPECIFIC DETERMINANTS OF CAPITAL ADEQUACY OF LISTED DEPOSIT
MONEY BANKS IN NIGERIA
CHAPTER ONE111
INTRODUCTION
1.1
Background to the Study
Banks occupy an important position in the financial sector and their activities are
subject to regulation and supervision for the purpose of preserving financial stability. The
banking sector of an economy stimulates the economic competence by mobilizing
savings to investment channels. It serves as a bridge between savers and borrowers and to
execute all tasks concerned with the profitable and secure channelling of funds. Beyond
the intermediation function, the financial performance of banks has significant
implications for economic growth of an economy as sound financial performance rewards
the investors and other stakeholders for their investment and encourages additional
investment. On the other hand, poor banking performance may lead to banks‘ failure and
collapse which could negatively impact on the economic growth of the economy. Banks
serve as means of transmitting monetary policy of the federal government at the
macroeconomic level. At micro economic level, banks are major source of financing for
businesses and individuals. Banks therefore facilitate spending and investment that fuel
growth in the economy.
The soundness of banking systems plays a vital role not only for local depositors
but for foreign creditors and investors as well. If there is an increase in bad loans and
investments, the liabilities of the domestic banks will exceed the real value of their assets
and depositors will likely engage in bank run which will precipitate a banking crisis.
Although the risk can be avoided through a government‘s deposit insurance, complete
reliance on the deposit insurance can encourage banks to engage in riskier lending
(Feldstein, 2003). A systemic collapse can also hinder the ability of the deposit insurance
fund to cover all of the deposits. It is not possible to eradicate bank failure completely,
but governments want to make the possibility of default for any given bank very small.
Through this, it is hoped to boost the confidence of private individuals and businesses in
the banking systems by creating a stable economic environment. A major difference
exists between bank and non-bank firms in terms of bankruptcy. The bankruptcy of large
non-banking firms has relatively lesser impact on the economy as a whole compared with
the collapse of a bank. The bankruptcy of a bank results in a systemic crisis that
adversely affects the economy at large. This is mainly because bank failures adversely
affect investors‘ confidence in the financial system and this will decrease credit supply
which in turn results in economic recession. Furthermore, the banking business depends
to a large extent on public confidence which helps banks to attract deposit and invest
same in profitable investment opportunities.
Banks are expected to have adequate amount of capital in order to support its
business expansion; to serve as a buffer to prevent any unexpected loss that banks might
face and also to absorb losses arising from a various risks that they face. Banks are also
required to have a buffer according to the provisions of the minimum capital requirement
set by the regulatory authorities.
Bank regulators everywhere in the world are concerned with the safety of
depositors‘ funds. It is for this reason the capital adequacy becomes relevant and
important. Capital adequacy refers to the amount of equity capital and other securities
which a bank holds as reserves against risky assets as a hedge against the probability of
bank failure (Greuning & Sonja, 2003). It also refers to the extent to which the assets of a
bank exceed its liabilities, and is thus a measure of the ability of the bank to withstand a
financial loss. Capital adequacy in banking business gives protection against sudden
financial losses. According to the Capital Adequacy Standard set by Bank for
International Settlements (BIS), banks must have a primary capital base equal at least to
eight percent of their assets.
The regulatory authorities use Capital Adequacy Ratio (CAR) as an important
measure of ―safety and soundness‖ for banks and depository institutions because they
view capital as a buffer or cushion for absorbing losses (Abdul-Karim, 1996). Bank
regulators are very much concerned about capital adequacy because their primary
responsibility is to prevent bank panics and contagions. Capital adequacy is an indicator
of bank‘s risk exposure. Adequate capital in banking is a confidence booster. It boosts the
confidence of the customer, the public and the regulatory authority in the continued
financial viability of the bank. The depositor is confident that his money is safe; the
general public is also confident that the bank is in a position to give genuine
consideration to their credit and other banking needs in good and bad times and the
regulatory authority is optimistic that the bank is or will remain a going concern. All
things being equal, a bank with a high ratio of capital to assets will be in a better position
to absorb a sudden loss than a bank with a low capital-asset ratio. Capital adequacy
generally affects all entities. But as a term, it is most often used in discussing the position
of firms in the financial section of the economy, and precisely, whether firms have
sufficient capital to cover the risks that they confront.
Requiring banks to increase their capital seems to be a plausible regulatory
response to the risk of a systemic crisis which additionally can improve the soundness
and safety of the banking sector. The requirements that compel banks to hold sufficient
capital may alter their attitudes towards risk. Illustratively, when a bank holds a large
amount of equity capital, the bank has more to lose if it fails, and is consequently more
likely to pursue less risky activities.
Banks and credit institutions are considered particularly important for economic
growth and social welfare. To ensure viability of the banking sector and to reduce the risk
of bank failures, the industry has been subjected to extensive regulation and supervision
for many years. The Basel Committee on Banking Supervision is a central organ that
develops and standardizes banking regulation. The first standardized framework on
banking regulation; Basel I, was released in 1988 and the centerpiece of the document
was capital adequacy within the banking industry. In 2004, the framework was
superseded by the Basel II Accord. The Basel II framework was supposed to be more risk
sensitive and it encouraged banks to use internal models to determine capital levels.
However, the recent financial crisis demonstrated that the Basel II Accords were not
robust enough to assess the risks that banks faced. As a response to the crisis, the Basel
Committee released the Basel III framework in December 2010. Basel III framework was
as a result of the large number of bank failures in recent years and previous frameworks
(Basel I and II) were unable to assess the risks that Banks face. The purpose of the Basel
III Accord is to increase the resilience of the financial system and to create a competitive
level playing field worldwide. Basel III is an extension of the previous frameworks.
However, the capital requirements are more strict and the Basel Committee has also
added other liquidity requirements in the framework.
In general, the Basel documents are set of rules for banking regulation and
supervision. In particular, they set the global capital adequacy standards. That means,
they prescribe globally accepted standards for improving banks‘ ability to absorb
economic and financial shocks, improving risk management practices in banks,
strengthening transparency and disclosure requirements for banks and have been adopted
by more than 140 countries of the world. They are international agreements that describe
the risk sensitive framework for the assessment of regulatory capital and require banks to
take adequate precaution.
In Nigeria, the capital base of banks was raised up by the CBN from N2 billion to
N25 billion minimum with effect from 31st December, 2005. The upward review of the
capital base has resulted in bigger, stronger and more resilient financial institutions
(Olalekan & Adeyinka, 2013). According to Nwokoji (2013), the average CAR of the
banks in the industry was consistently above the stipulated minimum of 10.0 per cent in
the first half of 2012. The industry average CAR stood at 17.7 per cent, compared with
17.9 and 5.0 per cent at the end of December 2011 and the corresponding period of 2011
respectively.
This examines if these banks are committed by capital adequacy ratio and Basel
accord standards which was determined internationally at 8% and the study also
examines the relationship between Capital Adequacy Ratio and Return on asset, Loan
asset Ratio, Leverage, Deposit Asset Ratio, Loan Provision Ratio, and Liquidity.
1.2
Statement of the Problem
The Global financial crisis of 2008 reveals weaknesses in the banking system. It
was clear that the Basel II capital adequacy framework was not robust enough to address
the problems of the banking industry because despite the fact that banks were able to
meet the capital requirements of the supervisory institutions, it was not adequate for them
to maintain the financial stability. Banks in different countries, including European
banks, which have invested in the United States mortgage market were seriously affected.
In order to avoid bank bankruptcies, particularly governments of the EU countries gave
the unprecedented support to the banking sector. In view of this discouraging situation, a
more stringent capital strengthening measure; that is Basel III, was adopted.
The capital adequacy standards under the Basel Accord have been widely adopted
throughout the world by bank regulators. In Nigeria, the Central Bank of Nigeria (CBN)
reviewed upward the capital base of banks from N2 billion to N25 billion minimum with
effect from 31st December, 2005. According to (CBN., 2004), out of 89 banks in Nigeria
as at 2004, 62 were classified as sound/satisfactory, 14 as marginal and 11 as unsound,
while 2 of the banks did not render any return during the period. The weakness of some
of the ailing banks were manifested by their over drawn position with the CBN, high
incidence of non-performing loan, capital deficiencies, weak management et cetera. In
addition to this, with unending exchange rate depreciation of naira, the level of capital in
banks before the consolidation, (N2 billion) became grossly inadequate to meet domestic
and global realities in the financial system (Ezike & Oke, 2013).
CBN as the regulatory authority in the banking sector always tries to fix minimum
capital requirement for banks that will enable them to carry out their banking business
and meet all their expenses as at when due without any financial difficulty. However,
banks still become insolvent or even failed despite satisfying the regulatory minimum
capital requirement. For example, in 2009 CBN declared 5 banks as insolvent despite the
fact that they satisfied the 2005 25 billion minimum capital requirement. The banks were
Afribank, Union Bank, Oceanic Bank, Bank PHB and Intercontinental Bank. In 2011, the
Central Bank of Nigeria declared the take-over of Bank PHB, Sterling Bank and Afribank
by investors; in other words, it calls for the nationalization of those banks.
The adoption of Basel capital accord in Nigeria rendered most of the studies in
this area outdated because most of the studies carried out in this area did not adopt a risk
based approach in calculating their capital adequacy ratio as suggested by the Basel
committee on banking supervision. Thus, the aim of this study is to fill the identified gap
in the literature by adopting a risk based approach using multiple regression models to
examine the bank specific determinants of Capital adequacy of Listed Deposit Money
Banks in Nigeria.