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CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
The banking crisis being experienced highlights the unstable nature of banking.
Following the failure of Lehman Brothers in September 2008, many banks went bankrupt.
Although it all started in the United States, Europe and Africa were affected as well. During
2007-2008, the European banks wrote down a total of $200 billion in bad debts (Haq& Heaney,
2012). At the end of 2007, most of the banks had leveraged up 30 times their equity (Carmassi,
Gros&Micossi, 2009). On the other hand, banks and governments are considering about new
proposals that will increase the health and soundness of the banking sector. These proposals were
designed to strengthen bank capital and liquidity regulation with a view to increase the stability
of the banking sector (Hag & Heaney, 2012).
To increase the stability of the banking sector, banks are required by regulators to make
provision which is known as loan-loss provisions (LLP) against expected credit losses. This right
is exercised by the corporate executives of banks. Such discretion being exercised by bank
executives are apparently misused for other purposes that could be of benefit to the banks
executives and consequently, it will create information asymmetric thereby sending misleading
information which could mislead the user of such information in terms of decision making.
Banks executive use this LLP to increase loan loss reserves during good times, and draw
resources from these reserves when the economy slows down and potential defaults become real.
In light of the above, Loan Loss Provisions (LLPs) are one of the banks‟ main accrual.
From the perspective of banking system soundness and stability, they are to be set aside in order
to cover future deterioration of the credit portfolio quality. In theory, from the perspective of the
banking supervisory authorities, loan-loss provisions should be used only to face expected credit
losses, but in many countries they are left to the judgment of the bank manager, thus becoming a
tool that managers can rely on to pursue various other goals. Even if banks‟ financial reporting
system is highly regulated, managers still hold some discretion, for example, in determining
when a loan can be considered impaired. This discretionary power gives them the opportunity to
substantially influence a bank‟s reported net income, sending distorted signals to a bank‟s
stakeholders, hiding the true economic substance of a bank‟s activity, and the actual value of the
bank.In order to better understand the role that loan loss provisions play in modern banking
activity, it must be highlighted that this statement of financial position account merges different
information and behaviors (Bouvatier&Lepetit, 2008). Typically, accounting practice
distinguishes between specific provisions and general provisions. The amount of specific
provisions depends on credit losses and it increases specific reserves, which are deducted from
the asset value. Specific provisions are also known as non-discretionary provisions and are used
to cover expected losses in a bank‟s loan portfolio. General provisions are set aside against not
yet identified losses and are added to general reserves on liabilities. Since they are linked to the
expansion of customer loans, general provisions are highly judgmental and prone to be
manipulated by bank managers for discretionary purposes.
The causes for loan default vary in different countries and have multidimensional aspects
both in developing and developed nations. Some of these include depressed economic
conditions, high real interest rate, inflation, and lenient terms of credit, credit orientation, high
credit growth, risk appetite, and poor monitoring among others. Loan loss provisioning is a key
accounting choice that directly influences the volatility of bank earnings, as well as information
properties of banks‟ financial reports with respect to reflecting loan portfolios ‟risk attributes.
While the precise form that more forward-looking provisioning should take remain an open
question, proposals to date generally incorporate a broader range of information and create an
expanded role for managerial discretion in assessing future expected losses. However,
accounting discretion is regarded as double-edged sword (Dechow& Skinner, 2000). While
increased discretion may facilitate in corporation of more information about future expected
losses into loan provisioning decisions, it also increases potential for opportunistic or misguided
accounting behavior by managers that can degrade bank transparency and lead to negative
consequences along other dimensions (Wall & Koch, 2000).
Loan Loss Provisions (LLPs) is calculated based on an incurred loss approach and
reflects the expected losses arising from their lending business. Banks‟ incentives to engage in
earnings management with LLPs depend on their business objectives, governance, and
performance. Especially the level and volatility of earnings and the need to build up capital
reserves through retained earnings play an important role (Fan and Wong, 2002; Ahmed, Takeda,
and Shawn1998; Liu, Ryan and Wahlen, 1997). On the one hand, banks might use the LLPs to
stabilize earnings levels, to reduce the volatility in earnings, and to implement the desired payout
policy. Hence, too high LLPs lower the reported profitability but increase the buffer against
expected losses.
On the other hand, low LLPs increase the reported profitability but also increase the
chance that a bank must use its capital to cover large losses. (Laeven&Majnoni, 2003). A key
feature of LLPs, unlike accruals of non-financial firms, is that they simultaneously influence
bank profitability and bank risk, which results in a trade-off (Bushman & Williams, 2012; Beatty
& Liao, 2011).
According toSanusi (2012) and Brownbridge (1996) among others have provided some
evidences of earnings manipulation in the Nigerian banking sector.Sanusi (2012) in
particular,explained that one of the eight reasons for banking crisis in 2008 was “inadequate
disclosure and transparency about financial position of banks.” Various terms have been used to
describe “inadequate disclosure and transparency”. Among the terms used are accounts
manipulation, income smoothing, big bath accounting, creative accounting and earnings
management. Whatever the term adopted, the whole essence is to mislead users of financial
statements and to render financial reports unreliable with the motive of some private gains.
However, Hassan (2011) stated that financial statement is misleading if it lacks the qualities of
accuracy, relevance, comparability and it contains fundamental errors or is prepared with the
intention to deceive/confuse users.
Conversely, the weakness of existing corporate governance mechanisms could facilitate
process of earnings management in banks. However, the existence of strong corporate
governance mechanisms in banks can lead to improvements in professional conduct in business
transactions and limit the opportunities for earnings management. In contrast, the existence of
weak corporate governance may encourage manipulation, corruption and mismanagement in the
business (Leventis&Dimitropoulos, 2012; Vafeas, 2005).
Most of the previous accounting scandal that led to collapse of several banks was traced
to earnings management and this have raised serious concerns about corporate governance
practices in general and brought into sharp focus on the issues relating to the weak internal
control systems in corporate firms (Rusmin, 2010). The collapses of such large corporations in
the past have highlighted the intentional misconduct of managers. However, there is the need for
sound corporate governance in other to forestall the frequent collapse of banks. Corporate
governanceis one important monitoring system. Its primary objective is not to directly improve
corporate performance, but to resolve agency problems by aligning management‟s interests with
the interests of shareholders (Demsetz& Lehn, 1985). However, Gulzar and Wang ( 2011)
support the effectiveness of corporate governance as a monitoring system. Also, Xie, Davidson
and DaDalt (2003)and Klein (2002), among others, show that corporate governance reduces
management‟s ability to manage earnings. Among the corporate governance variables
institutional shareholding, managerial ownership, board size and audit committee are perceived
to be important monitoring system that may help to align the interests of managers and
shareholders and reduce the potential for opportunistic managers‟ behaviour.
Institutionalshareholding is argued to perform a monitoring role which reduces the
opportunities available to managers to reported earnings (Jensen & Meckling, 1976). Managers
will be more likely to engage in opportunistic activities in the absence of such monitoring
activities. According to Moyer (1990), institutional‟ monitoring acted as an efficient device to
reduce agency costs associated with the separation of ownership and control. Lang, Raedy, and
Wilson (2006) argue that the monitoring activities of institutional shareholders motivate
managers, thus reducing agency costs.
Managerial ownership represents the interest of managers in the equity shareholding of a
firm is also considered in this study as a variable which may perform a great monitoring role of
manipulating tendencies of managers. The reason behind the rise of this monitoring variable is
rooted in the agency theory, which assumes that managers‟ equity holdings encourages them to
act in a way that maximizes the value of the firm (Kantudu & Samaila, 2015) . However, Friend
and Lang (1988) stated that if the management of a company owns shares in the same company,
it becomes more efficient and effective in discharging its obligations and may translate to higher
quality reporting for the firm. Also, the monitoring role of managerial ownership is also
exercised through their numbers of shares and can use their voting right to align managers
interest with that of the banks. Thus, it is assumed that the more managers own shares the more
they make decision that would minimize earnings manipulations.
It is not only themanagerial ownership that enhances corporate governance monitoring
role but the size of the board of directors. For the board of directors, the code of corporate
governance recommends a board size of not more than 15 and not less than 5 including executive
and non-executive directors. The minority shareholders are also fully represented by at least one
director on the board. An active board size is essential characteristics of effective corporate
governance monitoring. Where there is larger board size, there is tendency of effective managers
monitoring.
Studies of Lipton and Lorsch (1992), Jensen (1993) and Yermack (1996), suggest that the
audit committee size affects management financial decision. Bédard, Chtourou, Courteau(2004)
argue that the larger the audit committee, the more likely it is to disclose and resolve potential
problems in the financial reporting process because it is likely to provide the necessary strength
and diversity of views and expertise to ensure effective monitoring.
1.2 Statement of the Research Problem
While the debate on reasons of the severe banking crisis that burst in 2008 and plagued
the economy for years to come remains unsettled, the banking sector is often presented at the
centre of the events and as one of the key drivers behind the downturn. In particular, banks have
been criticised for excessive loan losses, weak governance structures and lacking oversight. The
study considers practices and tendencies within banks‟ corporate governance practices and
changes in their ownership areas. Corporate governance should become subject to pressures from
their surrounding institutions and the stakeholder society to correct practices which will
safeguard depositor‟s money and give investors‟ confidence in the banking sector. The study
provide an assessment of whether such a connection can be demonstrated between corporate
governance and discretionary loan loss provisions and if so which influences have been most
effective in driving change in bank‟s corporate governance practices.
Studies such as (Abubakar, Abdu, & bdulmarooph, 2014; Shehu and Abubakar, 2012;
Shehu, 2011; Devi &Hashim, 2010; Dugan,2009;Hasan, & McCarthy, 2007; Barako, Hancock
&Izan, 2006; Rahman& Ali, 2006; Anandarajan& Borgia, 2005; Sanda, Mikailu, &Garba, 2005;
Adams &Mehran, 2003; Bello, 2002; Ahmed, Takeda, & Thomas, 1999; Schipper
1989;Greenawalt&Sinkey, 1988) concentrated on either the manufacturing companies or they try
to establish the link between loan loss provision and discretionary accruals in banking industry
but the study fail to consider a controlled mechanism that can constrain managers from
manipulating loan losses. In contrast to other sectors and loan losses, there are a number of
reasons why banking is particularly well appropriate for our purposes. First, the sector was
subject to intense turmoil during the financial crisis which may have increased the tendency to
adjust to changes in their managerial approaches. Also, banks have been under closer inspection
for its approach to risk-taking, in particular through prevailing financial incentive packages for
key executives, which further reinforce the linkage between corporate governance and the
earnings manipulation. Moreover, banks play a central role in the financial system and any
banking failures will amount to risk spilling over on depositors. This means that banks face other
governance issues than most other firms. Still, the crisis has shown how some of the largest and
most financially strong banks, operating in the world‟s most developed economies, were subject
to some of the most severe governance issues. This raises many questions, and we hope to
present an approach which brings us closer to an understanding of the interplay between
corporate governance and discretionary loan loss provisions.