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 soundnessâ€" 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 â€�”C‘, in the popular acronym â€�”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 nonperforming 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. AlSabbagh (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 bankportfolio 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.
1.3 Objectives of the Study
The main objective of this research is to use multiple regression model to assess the
impact of micro-prudential indices on capital adequacy ratio of deposit money banks
in Nigeria.
The specific objectives of the research are as follows:
i) To examine the relationship between Deposit to Assets Ratio (DAR) and
Capital Adequacy Ratio (CAR);
ii) To determine the nature of relationship between Return on Assets (ROA)
and Capital Adequacy Ratio (CAR) of Deposit Money Banks; and
iii) To analyse the relationship between Asset Quality Ratio (AQR) and
Capital Adequacy Ratio (CAR).
iv) To investigate the relationship between Loans to Deposits Ratio (LDR)
and Capital Adequacy Ratio (CAR);
1.4 Hypotheses Formulation
The hypotheses for this study are stated below:
H01: There is no significant relationship between Capital Adequacy
Ratio (CAR) and Deposits to Assets Ratio (DAR)
H02: There is no significant relationship between Capital Adequacy
Ratio (CAR) and Returns on Assets (ROA)
H03: There is no significant relationship between Capital Adequacy
Ratio (CAR) and Assets Quality Ratio (AQR)
H04: There is no significant relationship between Capital Adequacy
Ratio (CAR) and Loans to Deposits Ratio (LDR)
1.5 Significance of the Study
In spite of the importance of banks as financial intermediaries, capital adequacy
modeling has not been in the mainstream of econometric research in the financial
sector in Nigeria. Analyses of the banking sector have so far focused on qualitative
assessment of growth trends and sectoral behaviour patterns in the industry.
Discussion in those studies has, for instance, suggested a number of factors that may
influence the failure pattern of banks, bank products and management. There has been
no model designed to determine the relative impact of various bank wide and bank
specific indices on capital adequacy ratio as well as the possible direction of linkages
between the various indices and capital adequacy ratio. Since independence, no
consensus has been reached by different Scholars as regards the determinants of
capital adequacy within the Nigerian banking industry. A good understanding of the
relationship between the variables will aid good policy formulation as well as capital
regulation in the financial sector of the economy.
Thus, this study will be of great importance to the Central Bank of Nigeria (CBN) in
its policy formulation on minimum capital requirement for Deposit money banks
(MDBs). Recently the Central Bank proposed an increase in the minimum capital base
of the commercial banks. This research will show the major factors to be considered
in setting this limits and the relative impact on the capital strength of the banks, thus
contributing to CAMELS analysis and decision. The Nigerian Deposit Insurance
Corporation (NDIC) in safeguarding the interest of depositors will also find the
research relevant; commercial banks and other related financial institutions will find
the research relevant in capital planning and maintenance, which is one of the
elements in the Financial Reporting Framework as contained in the International
Financial Reporting Standards (IFRS). Other researchers, academicians, financial
analysts, economists as well as accountants in practice will also find the research and
data analysis useful either for financial decisions, client advisory services or for the
expansion of the frontiers of knowledge in capital adequacy ratio re-engineering.
1.6 Scope of the Study
This study covers ten years period, that is 2005 – 2014. The period before 2005 was
not considered in this research due to the anemic nature of the large number of banks
that ceased to exist with effect from 31st December, 2005 with the dawn of the
twenty-five billion naira recapitalization policy of the Central Bank of Nigeria. Thus
capital regulation in 2005 brought about a sharp increase in capital base of the banks
that survived the policy and a drastic decrease in the number of deposit money banks
from eighty-nine to twenty five. However, this study is not primarily focused on the
impact of banking sector consolidation on the capital adequacy ratio (CAR); rather the
study is an attempt to study the impact of micro-prudential indices on capital
adequacy ratio of deposit money banks in Nigeria within a ten years period. Within
this ten years period, there have been series of mergers and acquisitions which have
also significantly affected the value of the banking sector capital base and capital
adequacy ratio. This consideration has been factored into the study in determining the
appropriate and reasonable sample size.
The population of the study was the fifteen listed deposit money banks in the Nigerian
financial system as at 31st December, 2014. The sample of twelve deposit money
banks was drawn from the fifteen listed deposit money banks, thus leaving out only
three deposit money banks due to non-availability of their financial statements on
their websites during the major parts of the period of the study. See Appendix J for the
list of all the deposit money banks and sample selected.
The explanatory variable for this study was Capital Adequacy Ratio (CAR) which
was computed using the Basel Capital Accord table. The explained variables are
Deposits to Assets Ratio (DAR), Asset Quality Ratio (AQR), Returns on Assets
(ROA) and Loans to Deposits Ratio (LDR).
CHAPTER TWO
LITERATURE REVIEW AND THEORETICAL FRAMEWORK
2.1 Introduction
This chapter contains the conceptualization of the research work where different
concepts that are fundamental to the study are discussed. The chapter also
encapsulates the review of empirical literature on the subject matter as well as the
theoretical framework that underpin the study.
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