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ONYEBUCHI SABINUS EZE
PG/MBA/08/47550
RISK MANAGEMENT IN BANK LENDING:
A CASE STUDY OF EQUITORIAL TRUST BANK
PG/M. Sc/09/51723
RISK MANAGEMENT IN BANK LENDING:
A CASE STUDY OF EQUITORIAL TRUST BANK
BUSINESS ADMINISTRATION
A THESIS SUBMITTED TO THE DEPARTMENT OF BANKING AND FINANCE,
FACULTY OF BUSINESS ADMINISTRATION, UNIVERSITY OF NIGERIA ENUGU
CAMPUS
Webmaster
Digitally Signed by Webmaster’s Name
DN : CN = Webmaster’s name O= University of Nigeria, Nsukka
OU = Innovation Centre
MARCH, 2012
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TITLE PAGE
RISK MANAGEMENT IN BANK LENDING: A CASE STUDY OF EQUITORIAL TRUST BANK
BY
ONYEBUCHI SABINUS EZE
PG/MBA/08/47550
RESEARCH PROJECT SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENT FOR THE AWARD
OF MASTER OF BUSINESS ADMINISTRATION (MBA)
DEPARTMENT OF BANKING AND FINANCE FACULTY OF BUSINESS ADMINISTRATION
UNIVERSITY OF NIGERIA ENUGU CAMPUS
SUPERVISOR DR. J.U.J ONWUMERE
MARCH 2012.
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DEDICATION
To my parents, Mr. and Mrs. Edwin O. Eze for their Love,
Concern and passion for their children.
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CERTIFICATION
This is to certify that this research work by Onyebuchi
Sabinus Eze, Reg. No. PG/MBA/08/47550 presented to the
department of Banking and Finance, University of Nigeria,
Enugu Campus is original and has not been submitted for
award of any degree or diploma either in this or any other
tertiary institution.
…………………………… ………………………… Onyebuchi Sabinus Eze PG/MBA/08/47550 This is to certify that this study:RISK MANAGEMENT IN BANK LENDING,carried out by Onyebuchi Sabinus Eze under supervision,has satisfied the necessary requirements for the award of Business Administration degree in Banking and Finance of the University of Nigeria. ……………………………. DR. J.U.J ONWUMERE Date Project Supervisor
…………………………… ………………………… DR. J.U.J. ONWUMERE Date Head of Department
…………………………..
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…………………………… ………………………… External Supervisor Date
ACKNOWLEDGMENTS
My immense appreciation to the Almighty God for his mercies
upon this generation irrespective of our shortcomings.
I owe a lot of thanks to my supervisor, Dr. J.U.J Onwumere,
for his invaluable and dedicated guidance throughout this
research process. I also appreciate his able leadership of the
department of Banking and Finance, which encourages zeal
and passion for academic excellence.
For the encouragement and support in the course of this
program I feel a sense of gratitude:
To my sister, Mrs. Ifeoma Isiwu, for living a life of
integrity and service and for supporting my desire for
academic growth and development. It’s easy to teach
principles loved ones live.
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To my brothers, Uchechukwu, Chijioke, Chinedu and
Cosmas for their constant love, interest,insights and
purity of soul.
To my younger sisters, Nneka and Obioma for their
constant demonstration of love.
To my grandmother for her many living descendants and
for her constant demonstration of love.
To my nephews Chiamaka, Chidiebere, Chinaemerem,
Chinagorom and Chikamso for their inspiration.
To my friends, Uchechukwu Gregory, Obinna Otti, Agbo
Philip, Ogechukwu Ugwu, Chibogwu Nnaji and Onyeka
for their encouragement and assistance.
To all my friends and classmates in MBA class
2008/2009 session.
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ABSTRACT
The emergence of Banks owned by the local private sector began in the mid-1970s. Financial markets in the period since independence have been dominated by foreign and government owned commercial banks. But deficiencies in financial intermediation provided an opportunity for local private investors to enter financial markets. Between the late 1970s and the mid-1980s, 13 local Banks were set up in Nigeria. The growth of local banks accelerated dramatically in the second half of the 1980s, with 70 Commercial and Merchant Banks established between 1986 and 1991 when the Central Bank of Nigeria suspended issuing new licenses: almost all of these were wholly owned by local investors. In Nigeria, the rising cases of bank distress have also become a major source of concern for policy makers. As a result of attractive interest rate on deposits and loans, credits were given out indiscriminately without proper credit appraisal. The resultant effects were that many of these loans turn out to be bad. It is in realization of the consequence of deteriorating loan quality on the banking sector and the economy at large that this paper is motivated. This paper, therefore, attempts to evaluate the effect of risk management in bank lending, using Equitorial Trust Bank as a case study.
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TABLE OF CONTENTS
Title Page … … … … … … … … … i
Dedication … … … … … … … … ii
Certification … … … … … … … … iii
Acknowledgment … … … … … … … iv
Abstract … … … … … … … … … vi
Table of Contents … … … … … … … vii
List of Table … … … … … … … … x
CHAPTER ONE: INTRODUCTION
1.1 Background of the Study … … … … … 1
1.2 Statement of the Problem … … … … … 8
1.3 Research Questions … … … … … … 10
1.4 Objectives of the Study … … … … … 11
1.5 Research Hypothesis … … … … … … 12
1.6 Scope of the Study … … … … … … 13
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1.7 Significance of Study … … … … … 14
1.8 Operational Definitions of Terms … … … 15
References … … … … … … … … 18
CHAPTER TWO: LITERATURE REVIEW
2.1 Introduction … … … … … … … 20
2.2 Types of Bank Credits … … … … … 22
2.2.1 Overdraft… … … … … … … 23
2.2.2 Loans and Advances … … … … 24
2.2.3 Special Credits … … … … … … 27
2.3 Constraints on Bank Credit Portfolio … … 29
2.4 Management of Portfolio … … … … … 30
2.5 Bank Consolidation in Nigeria … … … … 33
2.6 Credit Analysis … … … … … … … 35
2.7 Credit Risk Management and Prudential Regulation 40
2.8 Types, Analysis and Evaluation of Risk … … 43
References … … … … … … … … 52
CHAPTER THREE: RESEARCH METHODOLOGY
3.1 Introduction … … … … … … … … 53
3.2 Research Design … … … … … … … 53
3.3 Procedure for Data Collection … … … … 54
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3.4 Population of the Study … … … … … 54
3.5 Validity and Reliability of Measuring Instruments 55
3.6 Data Analysis Technique … … … … … 55
References … … … … … … … … 58
CHAPTER FOUR: DATA PRESENTATION AND ANALYSIS
4.1 Introduction … … … … … … … … 59
4.2 Data Presentation … … … … … … 60
4.3 Test of Hypothesis … … … … … … 62
References … … … … … … … … 74
CHAPTER FIVE: SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATION
5.1 Summary of Findings … … … … … … 75
5.2 Conclusion … … … … … … … 77
5.3 Recommendation … … … … … … 79
Bibliography … … … … … … … … 81
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LIST OF TABLES
Table I: Equatorial Trust Bank Asset Quality between 2003-2007… … … … … … … 60 Table II: Percentage of Equitorial Trust Bank Performing and Secured Loans to Total Loans and Advances 61 Table III: Equitorial Trust Bank Income Distribution (2003-2007) … … … … … … … 61
Table IV: Regression Table … … … … … … 62
Table V: Calculation of Standard Error of Coefficient 66
Table VI: Regression Table … … … … … 69
Table VII:Calculation of Standard Error of Coefficient 71
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RISK MANAGEMENT IN BANK LENDING (A CASE STUDY OF EQUITORIAL TRUST BANK)
BY
ONYEBUCHI SABINUS EZE PG/MBA/08/47550
DEPARTMENT OF BANKING AND FINANCE FACULTY OF BUSINESS ADMINISTRATION
UNIVERSITY OF NIGERIA ENUGU CAMPUS
JULY, 2010.
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CHAPTER ONE
INTRODUCTION
1.5 BACKGROUND OF THE STUDY
The Nigerian financial institutions have faced difficulties over
the years for a multitude of reasons but the major cause of
serious banking problems in recent times continues to be
directly related to lax credit standards for borrowers and
counterparties, poor portfolio risk management or a lack of
attention to changes in economic or other circumstances that
can lead to a deterioration in the credit standing of a bank’s
counterparties. Credit risk is most simply defined as the
potential that a bank borrower will fail to meet the obligations
in accordance with agreed terms. The goal of risk management
in bank lending is to maximize a bank’s risk adjusted rate of
return, maintaining risk exposure with acceptable parameters.
The problem of Bank distress in the Nigerian Banking Sector
has been observed since 1930s. In fact, between 1930 and
1958, over 21 Bank failures were recorded. The Bank failures
during the time were attributed to the domination of foreign
Banks in terms of the exclusive patronage by British firms.
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Other factors that led to mass failure of the indigenous banks
were low capital base, lack of managerial expertise and
untrained personnel.
The deregulation of the financial system was embarked upon
by the military administration in 1986 as part of the
Structural Adjustment Programme (SAP). The deregulation
witnessed sharp changes in banks’ operations, regulatory
environment and the distress syndrome resurfaced again in
Nigeria. The changes brought about by SAP included the
liberalization of the foreign exchange and money markets, the
introduction of prudential guidelines and accounting
standards, increase in minimum paid-up capital,
establishment of Nigerian Deposit Insurance Corporation
(NDIC), relaxation of mandatory sectoral allocation of credits,
etc.
The Late 1980s and early 1990s were years of financial boom,
as the number of players increased substantially in the
system? For instance, between 1986 and 1989, about 38 new
commercial and merchant banks were created. The increase in
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the number of banks over-stretched the existing human
resources capacity of banks which resulted to many problems
such as poor credit appraisal system, financial crimes,
accumulation of poor asset quality, among others. The
consequence was increase in the number of distress banks.
During 1994 alone, two banks had their licenses suspended
(Republic Bank Ltd and Broad Bank of Nigeria Ltd). Another
four banks has their licenses revoked. Also in 1994, the
number of banks adjudged distressed by the Central Bank
rose by 10 to 42, excluding the four banks that were closed
during the year. By the end of year in 1994, non-performing
loans and advances constituted about 60.33 percent of the
total deposits of the entire banking industry. Furthermore, the
ratio of non-performing loans and advances to the total loans
and advances in the entire banking industry was 43.03
percent while that for the distressed banks was 64.5 percent
according to CBN Annual Report 1994. By the year 1998, up
to 31 banks were being liquidated.
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The Global Financial crisis is yet to run its full course, but is
already one of the largest crises ever experienced according to
the existing literature. With its roots in banking, the sub-
prime mortgage crisis that commenced in the United States in
2007 soon resonated in other sectors of its financial system,
and the economy at large. The crisis later spread to Europe
and now has become a global phenomenon. The emerging
economies were not isolated. In the wake of the United State
Government bid to boost housing was a policy error that
permitted sub-prime clientele unrestricted access to mortgage
finance. Combined with the thriving derivative market, the
horizon for credit expansion widened to unprecedented levels.
The result was private over-borrowing accompanied by an
internal debt crisis. As long as capital flows and credit
expansion grew unchecked, lending expectedly spilt over from
financing safe and productive investments to risky and
speculative assets. Housing prices had trended upwards for
ten consecutive years up to 2004, enticing speculators.
Mortgages perfected imprudent lending practices.
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The cannons of basic lending were never followed in credit
creation. Credits were generally not collaterized in the
mortgage sub-sector.
Credits, especially in mortgage finance and commercial real
estates were excessive to the repayment ability of the
borrower. The housing market was overpriced. Investors
borrowed to enter the booming overpriced market without a
thought that the market could ever crash. It crashed
unexpectedly and commercial loan defaults became
widespread. Financial institutions gradually became illiquid.
Available stocks were dumped on the capital market to shore
up liquidity. Banks became unwilling to lend to one another.
The financial system was weakened by runs, bankruptcy,
takeovers, job losses and bail-outs. United State financial
institutions failed to honour maturing investments, especially
placed by foreign investors.
The Nigerian economic recession of 1982 could not have
dragged the rest of the world into a global recession because
the quantum of foreign investments in the Nigerian economy
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was minimal. Although there were defaults in the return of
deposits, it was an internal affair. Nigeria was in it alone and
had to steer to good financial health on its own accord. There
is hardly any bank anywhere in the world that does not have
correspondence arrangement with a bank in the USA, at least
for the confirmation and settlement of letters of credit as well
as for the transfer of funds. By arrangement, all such idle
funds are invested in the American financial system, especially
on high-yielding derivatives.
According to October 2008 IMF World Economic Outlook, the
global financial crisis did not have any direct and serious
consequences on sub-Saharan African, of which Nigeria is
one. However, Nigeria feels the pinch in various ways such as
difficulty in sourcing new credit lines by banks and real-sector
operators from abroad, possibility of non-renewal of expiring
credit lines to banks sourced from abroad, withdrawal of liquid
assets and other investment portfolio by foreigners, reduced
inflow of foreign direct investments etc.
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As at third quarter of 2009, there was a shift in the Nigerian
banking system as a result of audit carried out by the central
bank of Nigeria, the apex regulatory body, on Nigerian banks.
Consequent upon their findings, the CBN replaced the
leadership of Eight (8) Nigerian banks and injected N620
billion of liquidity into the sector for a rescue. This was a
natural consequence of bad lending decisions by banks
leading to huge provisions and erosion in their capital. A bulk
of depositor’s money was lent for speculative purposes in the
capital market. The attitude of some borrowers who are
unwilling to repay even when they are known to have the
means to service their debts. Such borrowers seek refuge
under the inadequate legal framework and cumbersome loan
recovery processes which make it difficult for the lending bank
to foreclose collaterals. Obtaining judgment when a loan
defaulter is sued is often lengthy, thereby increasing the cost
of banking business in Nigeria. In the case of some small
borrowers particularly in priority sector of agriculture and
small and medium scale enterprise, they willfully defaulted on
the wrong notion that the bank loans are part of their share of
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the “national cake”. There are also borrowers who through
connivance with some banks’ staff take bank loans with no
intention to repay such loans. These problems greatly
impaired the quality of banks’ assets as non-performing loans
and advances become unbearable and turn out to be a high
burden on many of them.
Insider abuse by bank owners, directors and management
staff is another factor which exacerbated loan defaults in some
weak banks. Insider in those banks obtained loans and
advances without adequate collaterals in contravention of
banking regulations. Sometimes, the loan applications were
poorly appraisal with inadequate documentation. Poor lending
and borrowing culture was contributory to distress in the
system.
1.6 STATEMENT OF THE PROBLEM
The banking sector has a crucial role to play in the growth of
Nigeria economy. A strong and viable banking industry which
can facilitate local and international transactions is a
necessary mechanism that any international investor would
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consider amongst other things prior to taking such investment
decisions.
The cornerstone upon which every successful financial
institution is built is nevertheless, a strong and effective credit
management process. A process which reinforces and
complements corporate objectives and goals. Managing risk
requires a top down approach. If the board and bank
executives are not supportive of the efforts, it will be difficult to
assemble the resources to control the risks deemed
acceptable. Wanting to manage the risks identified must be a
part of a corporate culture. As risks are identified and a means
to control those risks is also enacted, the organization has to
have the ability to adapt.
It is in view of these, however, that this research paper
undertakes to examine banks and the strategies in place to
stem the tide of non-performing loans. The statement of
problem is to critically appraise risk assessment techniques
and suggest measure(s) that improve the quality of risk assets
in banks.
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The outcome of this research study is expected to assist
stakeholders in the Nigerian baking industry in addressing the
following inherent problems;
Reliance on the financial statements of the borrowers as
a basis for lending which is fraught with serious danger.
Lack of understanding of the borrower’s business skills
and credibility
Adequate collaterization of credits
Subvention of regulatory guidelines on credit creation
Lack of data/information concerning the economic and
political situation that impact negatively on the debtor
Creation of new loans in total disregard to the
performance of the existing ones.
1.7 RESEARCH QUESTIONS
It is widely believed that the major cause of distress in the
banking system is as a result of poor risk management. To
establish this premise, it is important that we find answers to
the questions below;
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Do the board of executive directors, credit review
committee and others concerned in credit administration
function effectively?
Are there established risk management procedures and
programmes that are well documented and entrenched in
Nigeria banks?
Are credits limits set, and are these limits strictly
monitored to avoid extension of excessive credit to a
specific counterparty?
Do the volumes of the banks’ risk asset have impact on
its gross earnings?
1.4 OBJECTIVES OF THE STUDY
The extent of distress in banks in Nigeria has become a source
of worry to the banking public. This, to a great extent, has
eroded the confidence of the public in the financial system. It
has always been asserted that the major cause of failures in
the system was as a result of non-performing credits
engendered by insider abuse by bank owners, management
staff, willful defaults by borrowers, etc.
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In view of the risks prevalent in the credit risks management
in Nigerian banks, this study is meant to:
Identify lapses in the management of credit risk and
proffer corrective measure(s) to enhance the banks
overall credit quality.
Ascertain the bank’s capacity to assess risk with regards
to the analysis and monitoring of the dynamics in the
operating environment with a view to evaluating its
impact on the bank’s past, present and future credit
decisions.
Assess the role played by the regulatory authorities in
enhancing bank’s risk management.
Identify if the perceived risk in a credit are matched by
commensurate return through appropriate pricing of
facility.
1.5 RESEARCH HYPOTHESIS
The hypothesis to be tested in the course of this research is
related to research Question One and the last question: Do the
board of directors, credit review committee and all concerned
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in credit creation function effectively and do the volume of
banks’ risk assets has impact on its gross earning? This leads
us to the following hypotheses:
HYPOTHESIS
H1: The volume of the bank’s risk asset has no outstanding
impact on its gross earnings.
H2: There is no correlation between the bank’s risk asset
portfolio and the effectiveness of its credit risk
management system.
1.7 SCOPE OF THE STUDY
This study is set to analyze the credit risk that is inherent in
Nigerian banking system. This is prompted by the need to
have an efficient and effective risk management
program to stem the tide of distress in Nigerian banking
industry. Data from both qualitative and quantitative sources
will be used to gain an insight and knowledge of the Nigerian
banking industry.
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1.7 SIGNIFICANCE OF STUDY
Sequel to the enormous challenges before the banking
institution in Nigeria in the management of their credit
portfolio in ensuring minimal loan loss through maintenance
of high quality risk assets while optimizing returns, this study
is focusing on the potential financial loss resulting from the
failure of customers to honour fully the terms of a loan. The
paper will also examine the role played by the regulatory
authorities in enhancing bank’s overall risk management
through checks on compliance to credit policies in the system.
This research, however, will help the bank constitute an
effective risk management program with an oversight from the
board and senior management. Managing risk requires a top
down approach. The quality of bank management and
especially, the risk management process are key in ensuring
the safety and stability in the banking system. It is the aim of
this research work to encourage the strict adherence to the
rules and policies by the operators and regulatory authorities
alike.
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1.8 OPERATIONAL DEFINITIONS OF TERMS
It is the intention of this portion of the study to define some of
the terms used in the work:
Credit: This involves the transfer of money or other property
on promise of repayment, usually at a fixed future date.
Risk: Uncertainty of future outcome or the possibility of loss
Portfolio: The Securities held by an investor or the
commercial paper held by a bank
Risk Assets: These relate basically to loans or facilities
granted to customers
Credit Analysis: A systematic examination or an inquiry that
can enhance the decision to lend.
Performing Credit: These are facilities having the payments of
both principal and interest repayments as at when due.
Non-Performing Credit: These are facilities that are not
serviced according to the terms of the agreement.
Doubtful Credit: A situation where the principal and/or
interest remained unpaid for more than 180 days but less
than 360 day
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Lost Credit: Facilities with unpaid principal and/or interest
remaining outstanding for 360 days or more and are not
secured by realizable collateral.
Substandard Credit: Those with unpaid principal and/or
interest remaining outstanding for more than 90 days but less
than 180 days.
Profitability Ratio: This ratio measures the firm’s ability to
earn a fair return from its investment
Efficiency Ratio: Used to calculate a bank’s efficiency
Liquidity Ratio: Measures the firm’s ability to meet its short-
term financial obligations as at maturity
Debt Management: This consist of all the activities involved in
obtaining funds from depositors and other creditors and
determining the appropriate mix of funds for a particular
bank.
Asset Management: This comprises the allocation of funds
among various investment alternatives.
Prudential Guideline: The guidelines were issued on
November 7th, 1990 by the CBN as an offshoot of the
statement of accounting standard No 10 on banks and other
financial institutions. The guidelines were to be strictly
adhered to by all banks in reviewing and reporting the
performance.
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REFERENCES
Anthony, O.B. (2009). “Nigerian Banking Crisis: from Irrational Market Exuberance to Regulatory Exuberance”, http://www.articlebase.com/banking-articles/nigeria
Donli, J.G. (2004). “Causes of Bank Distress and Resolution
Options”, CBN Quarterly, Vol. 28 No. 1. January/March
Fiakpa, Luky, A. Adekoya, H. Igbkiowubo (2008). “Nigeria: Global Financial Meltdown Country Panics”, htt://allafrica.com.
Freixas, X. and J. Rochet (2008). “Microeconomics of Banking”
(2nd Edition), MIT Press, London.
Haynes, C. (2003). “The Emerging Regulatory and Supervisory Framework for Managing Risks in the Carribbean Banking
Sector”, Paper presented at the Seminar on Risk Management and Investment in the Caribbean, Organized by Caribbean Centre for Monetary Studies.
Idehai, S.A.(1996). “Effect of Deregulation on Commercial Banking Activities in Nigeria, An Analytical Framework”, Journal of Economics Department, Ambrose Ali University, Ekpoma.
Nnanna, O.J (2003). “Today‟s Banking Risks and Current Regulatory and Supervisory Framework”, CBN Quarterly, Vol. 27 No.3, July/September.
Sanusi, L.S. (2010). “The Nigeria Banking Industry-What Went Wrong and the Way Forward”, Paper presented at The
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Annual Convocation Ceremony of Bayero University Kano, 26th February.
Sere Ejemba, A.A. (2008). “Nigeria Stock Market Reflection of the Global Financial Crisis: An Evolution”, CBN Quarterly, Vol.32, No.4 October/ December.
Quintyn, M. (2002). “Banking Intervention and Resolution in a Crisis Environment, Issues and Principles”, Paper Presented at IMF International Seminar on Legal and Regulatory Aspects of Financial Stability.
Van Greuning, H. and Bratanoic, S.B. (2003). “Analyzing and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk”, the World Bank, Washington, D.C.
xxxi
CHAPTER TWO
LITERATURE REVIEW
2.2 INTRODUCTION
Available record shows that Nigeria has had a bitter
experience of bank failures in the past. There was a rapid
growth in the number of indigenous banks in late 1940s and
early 1950s. It is evident from the available record that banks
more or less collapsed with the same rapidity with which they
were established. As at 1954, 17 out of the twenty-one (21)
indigenous banks collapsed owing to inadequate capital, lack
of skilled personnel and moreover corporate governance. These
failures did not augur well with the banking public. The
failures recorded in the sector can also be attributed to the
domination of foreign banks in term of exclusive patronage by
British firms (Soyibo and Adekanye, 1992). Ebodaghae (1977)
noted that few years have been traumatic for the Nigerian
banking industry. Although distress is not a new phenomenon
in the Nigerian banking sector, the manifestation of some of
the problems became discernable with some policy changes. In
1988, the CBN directives to banks that naira backing for
xxxii
foreign exchange application be lodged with CBN. The sudden
withdrawal of public sector deposits to CBN in 1989, and the
use of stabilization securities by the CBN to mop up excess
liquidity in the system. All these developments exposed the
imprudent practices and significance weakness in credit
control in several banks. It became noticeable that there are
problems in the liquidity positions of some banks. This
encouraged inter-bank borrowings in form of overdrafts at a
high cost. Failure of some of these banks to honour the
overdrafts lead the entire system into stress and it resulted to
defaults as transaction were truncated midstream.
What was thought to be a temporary liquidity problem for a
few banks soon caught up with a lot more banks. With the
identification of eight distressed banks worsened gradually
with 31 banks being liquidated by 1998 (Nnanna 0.J, 2003).
NDIC (1995) classified about one (1) out of every two (2) banks
in the industry as distressed. Thus, the 1990s can be rightly
characterized as a period of upheaval for baking industry.
Before the end of 2009, the apex regulatory body, CBN sacked
the management and board of eight (8) banks in Nigeria as a
xxxiii
result of poor credit risk practices in the industry which
resulted in illiquidity problem. Sanusi Lamido (2010) asserted
that the economy faltered and the banking system experienced
a crisis in 2009 and this resulted in the injection of N620
billion into the sector to stabilize the system and return
confidence to the markets and investors.
Elmer F.K , described credit risk as the potential financial loss
resulting from the failure of customers to honour fully the
terms of a loan or contract. Increasingly, this definition is
being expanded to include the risk of loss in portfolio value as
a result of migration from a higher risk grade to a lower one.
2.2 TYPES OF BANK CREDITS
Over the years several attempts have been made to offer a
comprehensive and acceptable definition of a bank or a
banker. Starting from the time of J.W. Gilbart, he regarded a
banker as a dealer in money. Banks is regarded as
intermediate parties between the borrower and lender (Iganiga,
1998). This is because the banks borrow from one party and
lend to another. It will be observed that this definition
xxxiv
emphasizes the two traditional functions of a bank, i.e. the
mobilization of deposit and the granting of loans and
advances.
The deposits kept in banks need not be left idle, because from
experience banks are aware that depositors may not need all
the deposits at a time. It is therefore prudent of the banker to
lend such money to investors at a higher rate which brings
some revenues to them. They achieve this through overdraft,
loan, bills discounting or through direct investment (Idahosa
2000). Traditionally, bank lending could in broad term be
categorized into two, that is, overdraft and which could further
be split or analyzed on the type or purpose or tenor. Overdraft
and loan would be discussed followed by the other types of
credit which have become available overtime.
2.2.1 Overdraft
This is the most common form and simple type of credit
facility. It is usually granted for working capital purpose and
the amount outstanding is expected to fluctuate over the life of
the facility, depending on the borrower’s working capital
xxxv
financial needs. Usually, the customer is given a limit up to
which he may draw beyond his deposit with the obligation to
repay on demand or at least subject to review or termination
within a comparatively short time period. However, unless the
account develops unusual features, overdraft is normally
reviewed annually and in every practical sense it has acquired
the nature of long term financing. It has the virtue of being self
liquidating by normal turnover of the account and interest is
charged on only amount overdrawn. The amount is expected
to be swinging into both debits and credits, as much as the
limit is reasonably observed, but in most cases this was an
illusion because there is a tendency for account to remain
perpetually in debit.
2.4.2 Loans and Advances
Loans are the type of credit which a specified amount is
placed at customer’s disposal by passing it to the credit of the
current account. The customer thus has the opportunity to
draw out his own deposit plus the loan without the account
being overdrawn unless an overdraft arrangement is also in
force. Unlike in overdraft where the customer pays interest on
xxxvi
overdrawn balances, the borrower pays interest on the whole
amount standing to his debit in the loan amount.
Loan is more suitable in circumstance when the purpose is
well identified and not under such blanket request as “working
capital finance”. The amount required as well as the timing is
known with reasonable precision and repayments are effected
as agreed, usually monthly, quarterly or annually. A distinct
feature of loan is that it is unlike overdraft where the
overdrawn balance is shown in red as an apparent indication
of debt, the current account of the borrower under loan
arrangement is not in red, despite the loan. For control and
statutory returns, loans are usually categorized according to
their tenor and here their maturity periods, short terms,
medium term and long term loan are usually identified but
there has been no generally agreed standard as to the
duration of each. In general terms, however, loan of one year
maturity and below are usually categories as short term, while
those of up to five years are seen as medium term and long
term if more than five years.
xxxvii
Bank loans are also categorized according to purpose. This
would normally include term loan, agricultural loan,
educational finance, personal loan, car loan, amongst others.
Some of the short term loans are “bridge loan,” that is,
providing short term facility until an asset is disposed of or
money realized from other sources. An example is the
temporary financing of a fixed capital development pending the
raising of finance from other sources.
Advances, however, is a short term credit granted to a
customer for a definite period, usually between 30 and 180
days. It is actually a type of loan but given to finance a specific
project and the most important distinction is that the
repayment normally is on en bloc. An example of this type of
credit is Advance against Architect’s Certificate granted to
construction companies through the discounting of certificates
of value (of work done) issued to them by their Client’s
Supervising architects.
Unlike normal loan where repayment is programmed from
other sources, repayment of advance is usually from the
xxxviii
project finance. This type of finance is suitable for production,
licensed buying agents and all credits that are in the nature of
seed time to harvest period though must be comparatively of
shorter duration usually not exceeding six months.
2.4.3 Special Credits
Special credits that have mixed Characteristics of either
instruments. This type of credit includes the following:
Hire Purchase Facility
This is used in financing assets with installmental
repayment plan or agreement over a specified period of
time. In the repayment plan, the cost of asset and the
interest on it are usually calculated over the agreed
period and divided by the number of the installments.
The fund is usually not given to the hirer but the vendor.
Lease Financing
This facility is available for usage of an asset for a
specified period of time, the outright acquisition of which
is capital- intensive in nature and cannot be made
available by the borrower for an immediate purchase. The
borrower, while enjoying this facility, can have usage of
xxxix
the asset while the payments are handled by the lender.
The lease agreement may or may not be the type that
permits the transfer of ownership to the borrower at the
end of the lease period, i.e. operating or finance lease.
Account Receivable/Inventory Financing
This is also called working asset financing because it is a
source of working capital for a growing concern. Here
funds are raised by the assignment of inventory or
receivable to a bank in return for financing. The facility is
then paid down as the firm collects on the receivables or
sells down as the inventory. In spite of the arrangement
here, the day-to-day management of these assets remains
with the company.
Factoring
This is an outright sale of receivable to a factor without
recourse to the borrower (i.e. the seller) if the purchaser
of the goods does not pay. The role of banks, as with
most credit instruments, is financial intermediation
between the selling company and the factor to facilitate
the transaction. However, a bank may be a factor itself
xl
when it contrasts to discount or purchase some of the
bills of the customer and relaying principally on the
quality of the bills. In this case, the bank provides funds
to the customer in return for bills, while the bank
reimburses itself from the proceeds of the bills when
collected from the third party debtors who issued the
bills.
2.5 CONSTRAINTS ON BANK CREDIT PORTFOLIO
Constraints in credit creation in banks are the factor that
banks do not have limitless capacity for the creation of risk
assets. Several factors determine bank’s ability to expand its
credit portfolio. The factors that determine bank’s capacity to
lend include;
Macro-Economic Environment
This could affect the bank’s lending portfolio since the
state of the economy determines the investments and
viabilities of businesses.
Capital Adequacy
Bank’s risk asset, apart from being constrained by the
restrictions on liquid assets is, on the other hand, limited
xli
by the availability of capital. Capital may be viewed as
shareholder’s fund and defined as equity plus reserves.
Credit Policy
Banks capacity to create risk assets is constrained by
requirement to keep high cash ratio’s, to meet demand
for withdrawals by depositors, liquidity ratios,
stabilization by the effect of policy reversal and counter
reversals.
Capacity for Liability Generation
The bulk of the funds banks use in creation of credit are
depositor’s funds. Therefore, the extent to which bank
expands its credit portfolio depends largely on the level of
its deposit. Shrinkage in credit portfolio through loans
could occur if there is a reduction in deposit base. This
was visible in the Late 1980s when accounts of
parastatals and government agencies were withdrawn by
the government.
2.6 MANAGEMENT OF PORTFOLIO
Mismatching is inherent in banking. In fact, it is the essence
of maturity transformation, borrowing short and lending long.
xlii
If maturities are badly mismatched with short term liabilities
financing long term assets, a bank becomes illiquid. If interest
rate terms are badly mismatched a bank can incur large losses
when market rate change. If currency denominations of assets
and liabilities are badly mismatched, a bank can make large
losses if exchange rate varies.
The need to avoid or minimize the above and other banking
risks calls for a system approach to banks’ funds
management. It comprises a series of techniques whereby
holdings of remunerative assets (loans, advances and
investments of various kinds) are funded by related liabilities
and, or the other liabilities may be accepted in advance of
commitments and these liabilities subsequently deployed in
the acquisition of remunerative assets(Wilson 1987).
Assets and liability management is the primary focus of banks
fund management. It deals with the acquisition of funds
(liability management) and the allocation of funds (asset
management), the basic objective being maximization of
profitability consistent with liquidity, solvency and regulatory
constraints.
xliii
The essence of asset/liability management is the co-ordination
of the interrelationships between the sources and uses of
funds in short term financial planning and decision making. It
views the bank as a set of interrelationship that must be
identified, coordinated and managed as a system if the
decision made are to be consistent with the basic objectives of
maximum profitability consistent with liquidity, solvency and
regulatory constraints.
Assets and liability management incorporates features of other
approaches to bank funds management such as pool of funds,
asset allocation, shiftability approaches and liability
management. It also incorporates management experiences
and judgment into the decision process.
Assets and liability management consist of successful
execution and identification of key decision areas that impinge
on profitability such as gap management, liquidity and cost
control, etc. It also requires an analysis of the banking and
economic environment to identify opportunities and threats.
For instance, in the budget, which should be recognized,
xliv
provided for or taken advantage of, decisions backed by
management experiences and judgment consistent with the
overall objective of profit maximization with the constraints of
liquidity, solvency and regulatory requirement.
2.5 BANK CONSOLIDATION IN NIGERIA
The Central Bank of Nigeria, in 2004, increased the minimum
capital base of banks from N2 billion to N25 billion. The banks
were given 31st December, 2005 as the deadline for
compliance. The CBN also stated that by end of October, 2005,
banks which fail to secure final merging approval from it
would stop operating. The banks were given guideline and
were expected to submit monthly returns of their consolidation
activities.
The Major Objectives of the reform are:
To enhance the compatibilities of banks to finance large
projects.
To ensure a capital base that can support service delivery
channels.
xlv
Size is a key factor in the banking sector that determines the
ability of the banks to provide funds to borrowers and
indication of stability to depositors. The recapitalization was
expected to enhance an effective provision of banking services
to customers by deploying various capital-intensive service
delivery channels. The over-dependence on cheap public
sector funds has negatively affected the drive of Nigerian
banks to provide these alternative service delivery channels
and therefore, undermined the need for banks to increase
their capitalization.
The CBN at this stage of the banking reform exercise may have
placed too much emphasis on the N25 billion capitalization
requirements at the expense of all supervisory, legal and
regulatory frameworks but a stronger and healthier banking
system.
There is no doubt that banking, like other economic activities,
needs sufficient capitalization to grow and stabilize. But the
risk inherent in the sector requires effective supervision on the
part of the regulatory authorities while ensuring that operators
xlvi
adhere strictly to ethical and institutional guidelines, as well
as credibility and transparency in service delivery to the
public.
Consolidation represents one of the most significant
developments in banking globally and the trend will
undoubtedly lead to a continuous reduction in the number of
banks. The capitalization policy would continue to encourage
mergers and acquisitions that would result in the emergence
of stronger banks with a pool of resources and increased
branch network.
2.6 CREDIT ANALYSIS
Credit analysis is a process of inquiry in making the decision
to lend, (Hale 1988). In the course of inquiry, the banker does
his best to replace emotional feelings such as hopes and fears,
with reasoned arguments based upon a careful study of
borrowers’ strength and weakness. The fundamental of
modern credit analysis are two folds; first is the examination
of the nature of the borrower’s business in the context of its
industry, and second is the analysis of cash flow.
xlvii
Nwankwo (1991) noted that credit analysis is a loan function
that is basis to minimizing loan losses. Thorough credit
analysis, the bank attempts to determine the ability of the
borrowers to repay legitimate loans extended to him. By
refusing credit to potential borrower whose analysis reveals
insufficient financing strength, the bank hope to improve on
its chances to avoid unnecessary losses in its loan portfolio.
Apart from financial statement and security analysis and
evaluation, this section of the loan policy sets out what
lending officers should learn such as environmental
appreciation, judgment ability, and what they should know,
for example, concepts of credit decision making.
H. Pierson Associations (1996) noted that fundamental credit
analysis is a thorough understanding of the various industry
groups which the bank chooses to operate in-market
identification and analysis, achieved through periodic detailed
and extensive industry studies. Poor or weak analysis leads to
bad decision and in time, to problem portfolio. Credit analysis
is the action of analytically reviewing and reporting on the risk
inherent in credit product and the repayment thereof. While
xlviii
the type of analysis may take many forms, it must be
continuous, performed not only at the credit time extended
but also throughout the life of the credit.
For the average bank, Net Interest Income (NII) provides the
lion’s share of the net revenue base. Similarly, as most
bankers would tell you, credit risk is the most significance
factor to the net revenue base.
NII is largely the compensation for the credit assumed by a
bank. From a managerial point of view, the turn factors should
be maximized (except for loan loss provision which should be
minimized). The risk factors on the other hand, should be
minimized by appropriately controlling credit risk and interest
rate risk, as well as operating and other risks. However, it is
important to note that it is market’s perceptions of the bank’s
risk that drives shareholder’s equity. Therefore, it is not
important for a bank to try control the various risk factors, but
also to make sure that the information is disseminated to
investors.
xlix
H. Pierson Associate (1997) identified three categories of bank
customer and basis of loan pricing.
(A) Prime Customer: Who
Are bank’s largest and most credit worthy customers.
Often call the shots as they have alternative sources of
funds
Cause banks to offer competitive lending rate
Often therefore difficult to bundle their pricing of loan
and services together for them
Loan pricing here is clearly straight forward as it is
directly tied to market sources of funds.
Are prime customers, but not necessarily prime rate
customers as market base-rate pricing could be below
prime
Pricing Model
Borrow at bank’s lowest rate or base loan (i.e. just above an
open market rate of interest)
l
(B) perceiving-Value Customer (poor elasticity of demand
for funds related to price)
These are:
Customers lacking alternative borrowing sources
Customer who views a loan as part of a total and larger
banking relationship. E.g. high wire transfer changes vs.
perceived value of relationship.
Pricing Model:
Here pricing is set on the basis of marginal benefit of loan to
customer.
(C) Relationship Customers
Majority of borrowers fit here
Range from between prime to weak marginal borrowers
Customers here often are using broad range of banking
services
Customers here borrow regularly and are strong source
of loan demand.
Strong relationship exists
li
Pricing Model:
Loan rates = base cost + spread with total focus on total
amount of profitability and yield.
A bank must determine the minimum account profitability
levels for various grades of risk assets. Profitability per
transaction is determined against this benchmark.
There are different models for measuring return on risk assets.
These include Gross Yield Approach, Net Borrowed Fund
Approach and ROE Approach.
2.7 CREDIT RISK MANAGEMENT AND PRUDENTIAL
REGULATION
Harrington (1987) observed that credit risk is inherent in
banking. All lending involves the risk that the borrower will
pay back or will not pay on time. In view of the risk inherent in
bank lending and the need to minimize or contain the risk
since they cannot be entirely avoided, and in view of liquidity
and profitability consistence with safety and regulatory
policies, the central issue in managing the lending portfolio is
balancing the potential risk with return. The borrower’s ability
to repay the loan has to be determined. This involves
lii
familiarity with the type of lending and the economic activity
involved-whether agriculture, real estate, manufacturing or
residential statement and security analysis to project the
income and cash flows, assess the source of repayment and
the economic and technical feasibility of the project. It also
requires the assessment and forecast of the economic and
political environment to ascertain not only whether the project
to profitable.
The introduction of the prudential guidelines attempts to bring
order and harmony in the reporting of loan provisioning and
classified risk assets. The prudential guidelines issued by the
CBN in November 1996 were aimed at proper loan asset
classification and income recognition. Before the introduction
of the prudential guidelines, banks had their individual
methods of classifying accounts, rating credit and categorizing
account as performing or non-performing. They treat accrued
interest on non-performing accounts as income.
The implications of their actions were the declaration of high
level of profit that was not actually realized.
liii
Also, before the guidelines, banks were guided in their
provisioning by Statement of Accounting Standard (SAS) 10.
Under the SAS 10, some banks charged interest income on
non-performing loans into interest suspense account, while
others recognized it as income thereby overstating their
profits. This allowed overstatement of unearned profit by
banks that enabled them to declare huge dividend eroding
their capital base. This abnormal situation became a serious
concern and regulatory authorities.
The prudential guidelines stipulate that under credit portfolio
classification system, banks are expected to review their credit
portfolio continuously with a new to recognizing any
deterioration in credit quality. Such reviews should be done
systematically and realistically so that classified banks’ credit
exposures are based on the perceived risk of default.
There are many effects of the guidelines:
Provisions for doubtful debts are to be made out of profits and
interest earned on these assets is to be suspended. Under the
new dispensation, non-performing assets are dying or dead
liv
assets and not yield any income; rather costs such as
administrative expenses incurred on bad debt are to be
incurred at the banks expense. As a result, many banks’ asset
kept dwindling as well as their profits.
Some of these banks which had not diversified their asset
portfolio had nothing to fall back except shareholders funds
and reserved and these were not enough to meet their
depositors claims (Ojo, 1993).
2.9 TYPES, ANALYSIS AND EVALUATION OF RISK
The following are some of the risk associated with banking:
Business Risk
This risk is associated with changes in the earning power of a
project. It has to do with the inability of a company to
maintain its competitive position in the market as well as
earnings, growth and stability. A fluctuation in industrial
output caused by an unexpected recession is an example of
business risk.
lv
Liquidity Risk
This is the possibility of loss that may arise from the inability
of a company to meet its obligation as they fall due. In the
case of a bank, it is a risk of loss from the bank not having
adequate funds to meet the deposit withdrawals and loan
demands of its customers. This risk is very serious because it
involves the credibility and confidence reposed in the bank.
Financial Risk
This form of risk affects a company that is highly geared. A
bank under this condition is said to be contending with the
menace of capital inadequacy. It occurs when a bank is unable
to generate sufficient funds to service its debt. Consequently,
the working capital assumes a negative position.
Earning Risk
Earning risk is concerned with the factors which may threaten
the achievement of a satisfactory margin between the incomes
anticipated on assets and the interest outflow on liabilities.
The problem is the ability to match accurately the inflow of
interest earnings and the outflow of interest earning and the
lvi
outflow of interest payments by level and maturity terms. As
far as banks are concerned, earning risk assumes a
substantial proportion of total risk.
Regulatory Risk
Banking industry is the most regulated industry. It is therefore
subjected to enactment of new laws and regulation or strict
enforcement of existing laws thereby limiting the bank’s
earning capacity or ability to reduce risks exposure by earning
new market or developing services.
Fraud Risk
This occurs when someone through deceit or trick gains
advantage he could not otherwise have gained through just or
normal process. The resultant effect of this on the bank is loss
of revenue, liquidity and increase in bad and doubtful loans.
Credit Risk
This is the possibility that the bank could sustain loss from its
loans and advances portfolio. It is the risk of default by credit
beneficiaries in the repayment of principal and interest as they
lvii
fall due. Credit risk is the risk with the largest loss in Nigerian
bank.
Exchange Rate Risk
Unpredictable changes in the rate of exchange between foreign
and local currencies bring about this form of risk. If a banker
lends money in a project and agrees to collect repayment in
foreign currencies under a “forward deals” at the time it agrees
on the contract with the importer. Such customer would have
paid the local currencies equivalent at the time the contract is
made. To avoid a situation of spending more local currency in
case of a fall in exchange rate, a rational banker would buy in
advance the total foreign currency required for the
transaction.
Risk Analysis and Control
Identification of risk inherent in a credit request is a key issue
in the sustenance of a healthy assets portfolio. However, its
analysis and evaluation is of great importance. Risk analysis
entails principally the appraisal of the statement of a
prospective borrower while risk evaluation assists in the
lviii
application of these appraisals for projecting future
occurrences and by extension arriving at the best decision.
These could be done under two main headings:
1. Risk analysis from financial statements
2. Qualitative risk analysis
Risk analysis from financial statement of the prospective
borrower employed expensive ratios and comparison of values
obtained with known or acceptable industry standard. On the
other hand qualitative risk analysis, also referred to as non-
financial risk factors, deals with a whole lot of variable which
are not analyzed solely by computation of ratios. These include
industry risk analysis, market position of the borrowing
enterprise. Its management adequacy, shareholders support
for its operations, political and legal risk and earning stability.
Risk Analysis from Financial Statement
In view of the increasing complexity of the credit decision, the
known basic factors credit analysis needs to be supplement
with other considerations. Credit officers do subject loan
application to rigorous ratio analysis. Ratio is mathematical
lix
aids used for the analysis of financial statement in order to
establish a relationship between two variables thereby
facilitating comparison.
Commonly used ratios in credit analysis are grouped into four
main types
1. Leverage Ratios
These ratios generally measure the relationship between
liabilities and shareholders funds. It shows the extent to which
company’s operations have been funded by external financing.
The level of debt ratios will provide idea as to the capacity of
the company to attract/absorb additional debt
finance/borrowing.
Debt Ratio = Total Debt Total Assets Debt Equity Ratio = Prior Charge Capital Shareholders Funds Debt Coverage Ratio = Total Tangible Assets Total Debt
Financial Leverage Ratio = Total Tangible Assets Shareholder’s Fund
lx
2. LIQUIDITY RATIO
This measures the firm’s ability to meet its maturing
obligations. This may be from liquid resources or from all of its
current assets
Current Ratio = Current Asset Current liabilities
Acid Test Ratio = Current Assets – Stock And Prepayment Current Liabilities
3. EFFICIENCY RATIOS
These measures how effective a firm’s assets are employed.
Days sales in inventory = Average Inventory x 365 Cost of goods sold 1
Debt days on hand = Trade Debtors x 365 Credit Sales 1
Credit days on hand = Trade Creditors x 365 Credit Purchases 1
4. PROFITABILITY RATIO
These ratios measure the firm’s ability to earn a fair return
from its investment.
Gross profit margin = Profit Before Tax Sales
Return on capital employed =
Profit before interest and taxes x 100 Capital employed
lxi
It is widely agreed that sufficient information can only be
contained for the purpose of making reasonable judgment on
the financial condition and performance of a company by
considering a group of ratios. Ratio analysis can be quite
informative as it adds meaning to trends within a company
and also shows areas of strength and weakness.
However, caution must be exercised in the use of ratio
analysis because of the identified shortcomings as it is only
historical, whereas, the past may not necessarily be a
reflection of the future, hence the need for a banker to look
beyond the ratios in order to enhance the quality of his credit
judgment.
QUALITATIVE RISK ANALYSIS
The basic consideration here is the industry which has to do
with determination of the risk sensitive pictures of industry in
which the company operates.
It covers such areas as;
Economic considerations which highlights the
vulnerability of the company to economic cycles,
lxii
technological changes, regulatory control and effect of
government spending.
Level of competition by which identification is made of
market and basis of competition among existing firms.
Nature of the product can equally define level of
competition
Management adequacy defines the competition of the
enterprises management as it affect production/services
delivery techniques and internal control.
Political/legal risk analysis focuses on the extent to
which the fortune of the firm could be affected by
changes in political and legal environment.
Generally, the whole exercise of risk analysis and evaluation is
to ensure that among other things that sound collectible loan
has been booked, profitable investment outlet for the bank has
been developed and that the credit granted meets the
legitimate needs of the customer.
lxiii
REFERENCES
Adam, J.A. (2005). “A Banking Sector Reform: The Policy Challenges of Bank Consolidation in Nigeria”, paper presented at the 46th Nigeria Economic Society (NES) Annual Conference, Lagos 23rd-25th August.
Al-Faki, A. (2005). “Bank Re-Capitalization and the Nigeria Stock Market”. Nigeria Securities and Exchange Quarterly Bulletin
Central Bank of Nigeria (1990). “Prudential Guidelines for Licensed Banks,” Circular Letter No. SD/DO/23 Vol. 1/11, November, 1990.
Freixas, X. and J. Rochet (2008). “Microeconomic of Banking” (2nd Edition), MIT Press, London.
Hennessy J.H (1986). “Handbook of Long-Term Financing”. Prentice Hall, New Jersey, USA.
Idahosa, N. (2000). “Principle of Merchant Banking and Credit Administration”, Rasjel Interbiz Group, Benin City.
Iganiga, A. (1998). “Contemporary Issue in Money and Nigeria Financial System”, Amtitop Book, Lagos, Nigeria.
Obamuyi, T.M. (2008). “Government Finance Liberalization Policy and the Development of Private Sector in Nigeria: Issues and Challenges”. Journal of Banking and Finance, Adekunle Ajasin University, Nigeria.
Soludo, C. (2009). “Global Financial and Economic Crisis. How Vulnerable is Nigeria?” CBN Monthly publication (online). www.cenbank.org.
Somoye & Ilo (2009). “The Impact of Macroeconomic Instability on Banking Sector Lending Behavour in Nigeria”. Journal of Money, Investment and Banking Issue (online). www.eurojournal.com.
lxiv
CHAPTER THREE
RESEARCH METHODOLOGY
3.1 INTRODUCTION
The preceding chapters have tried to evaluate the various
aspects of risk management in bank lending. However, the
rest of the chapter is to reflect the extent of the research
carried out by the researcher in an effort to prepare and
present a report worthy of reference.
3.4 RESEARCH DESIGN
Research design is the structuring of investigation aimed at
identifying variables and their relationship to one another. The
study is Ex Post Facto research. It is designed to use
mathematical models in the analysis. It is also designed to be
inductive in nature, since the researcher will be drawing
conclusion based on the analysis of the data collected.
3.5 PROCEDURE FOR DATA COLLECTION
In other to carry out the study, data was collected from the
various issues of the statement of accounts and annual report
of the chosen Bank.
lxv
Data was obtained from related textbooks, journals, and
Bank’s credit policy manual. Information for the study was
also gathered from regulatory authorities, that is, Central
Bank of Nigeria (CBN) and Nigeria Deposit Insurance
Corporation (NDIC).
3.4 POPULATION OF THE STUDY
A population consists of all conceivable or hypothetically
possible observations relating to a given phenomenon (Freund
and Williams, 1979). The researcher took for this population
Equatorial Trust Bank between 2003-2007.
3.5 VALIDITY AND RELIABILITY OF MEASURING
INSTRUMENTS
Meyer (1970) defines validity of measuring instrument as the
degree to which an instrument measures what is supposed to
measure. Reliability refers to the degree to which a test (an
instrument) consistently measures what it measures. The
research has ensured both validity and reliability of the
measuring instrument in the study noting the nature of the
study.
lxvi
3.7 MODEL SPECIFICATION
In line with the research hypotheses, models of this study are
as follows:
(1) For the relationship between the banks risk asset and
its gross earnings.
Y = a + bx
Where Y is the dependent variable representing the bank’s
gross income
a = intercept
b = the income generating capacity of the risk assets
x = bank’s assets
b and a coefficient are estimated using the following formulas
b = n Σ x y- (Σ x) Σ(y) n Σ x2- (Σ x )2
a = Σ y – b Σ x N
lxvii
To evaluate how well the regression equation explains the
observation in the total gross earnings for the period being
reviewed, we use the Standard Error of Coefficient (Sb)
Sb = Σet2
(N-K) Σ(X-X)2
(2) For the relationship between the banks risk asset
portfolio and effectiveness of its credit risk management
system.
r = n∑xy - ∑x∑y
(n∑x2 – (∑x)2 (n∑y2 – (∑y)2)
Where;
X = Independent variable
Y = Dependent variable
N = Number of observation
Σ = Summation
TEST OF RELIABILITY
t = r n -1 1 – r2
lxviii
3.8 DATA ANALYSIS TECHNIQUE
In analyzing the secondary data obtained in the course of
study, we apply regression analysis, correlation analysis and
student’s T-test. The outcome of the hypothesis test is base on
the level of the significance. This is the statistical standard
which is specified for rejecting or accepting the null
hypothesis. The rejection of the null hypothesis implies the
automatic acceptance of the alternative hypothesis. The
reverse is true when null hypothesis is accepted.
lxix
REFERENCES
Asika, N (2001). “Research Methodology in Behavioral Sciences” Longman Publishers Plc. Ikeja, Lagos.
Egbui, k.I (1998). “Groundwork of Research Methods and Procedures”. Institute for Development Studies, University of Nigeria Enugu Campus.
Ezeja, E.O (2002). “Project Writing: Aquixotic Viaticum”, Adels Publishers, Enugu.
Freund J.F and Williams, F. J. (1979) “Modern Business Statistics”. Second Edition, Pitman Ltd, London.
lxx
CHAPTER FOUR
DATA PRESENTATION AND ANALYSIS
4.1 INTRODUCTION
The purpose of this chapter is to present, analyze and
interpret the data collected in the course of this research. In
the process of answering the questions identified, this study
considers the use of regression statistics as a method to test
the hypothesis raised in this research study.
The outcome of the hypothesis test is based on the level of
significance. This is the statistical standard which is specified
for rejecting or accepting the null hypothesis. The rejection of
the null hypothesis implies the automatic acceptance of the
alternative hypothesis. The reverse is true when a null
hypothesis is accepted.
4.4 DATA PRESENTATION
In order to carry out the study, data was collected from the
various issues of the Statement of Accounts and Annual
reports of the chosen bank. The data include time series and
lxxi
cross section data on average loans and advances, income
from risk asset and income or profit of the bank.
Below are the tabular presentation of data obtained from the
Statement of Accounts and Annual Reports of Equitorial Trust
Bank.
Table I: Equatorial Trust Bank Asset Quality between
2003-2007
BILLION
2007 2006 2005 2004 2003
Performing loan 32.40 25.39 16.99 20.83 18.13
Secured loan 38.29 36.28 22.59 22.38 18.92
Total loan & advances 39.89 37.10 22.53 22.63 19.08
Source: Equitorial Trust Bank Annual Report (2003-2007)
Table II: Percentage of Equitorial Trust Bank Performing
and Secured Loans to Total Loans and Advances
BILLION
2007 2006 2005 2004 2003
Percentage of
Performing Loans
81.22% 68.43% 72.21% 92.05% 95%
Percentage of
Secured Loans
96% 97.8% 96% 98.91% 99.15%
Source: From table 1 above
lxxii
Table III: Equitorial Trust Bank Income Distribution (2003-
2007)
BILLION
2007 2006 2005 2004 2003
Gross Income (y) 19.39 17.04 13.89 8.07 7.54
Income from risk assets (y1) 12.21 13.50 11.13 6.46 5.66
Income from non-risk
assets( Y2
7.18 3.54 2.76 1.61 1.88
Total loans & advances (X) 39.89 37.10 23.53 22.63 19.08
Source: Equitorial Trust Bank Annual Report (2003-2007)
Table IV: Regression Table
Year Y1 X XYl X2
2007 12.21 39.89 487.06 1, 591.21
2006 13.50 37.10 500.85 1, 376. 41
2005 11.13 23.53 261.89 553.66
2004 6.46 22.63 146.19 512.13
2003 5.66 19.08 107.99 364.06
Total 48.96 142.23 1, 503.98 4, 397.46
Source: From table III above
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4.5 TEST OF HYPOTHESIS
We are testing two hypotheses.
TEST ONE
For the purpose of testing, this hypothesis is restated into null
and alternative hypotheses as follows:
H0: The volume of the bank’s risk asset has no
outstanding impact on its gross earnings.
H1: The volume of the bank’s risk asset has outstanding
impact on its gross earnings.
This will be tested using regression analysis. The regression
equation is expressed as:
Y = a + bx
We can now solve for constants a, and b from the equation:
b = nΣxy – ΣxΣy nΣx2 – Σ(x)2
To substitute the value, we refer to table IV above
Substituting the values:
Y1 = 48.96; X = 142.23; XY = 1, 503.98; X2 = 4, 397.46;
n = 5, we have
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b = 5 (1, 503.98) – (142.23) (48.96) 5 (4, 397.46) – (142.23)2 = 7, 519.9 – 6, 963.58 21, 987.3 – 20, 229.37
= 556.32 1, 757.93 = 0.317 b = 0.317 a = Σy – bΣx n
= 48.96 – (0.317) (142.23) 5 = 48.96 – 45.07 5 = 3.89 5 = 0.778 a = 0.778
Substituting the values a, and b in the equation:
Y = 0.778 + 0.317x
However, Equatorial Trust Bank Income equation in the five
years under review could be stated thus: Yc =0.778+ 0.317x
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Where 0.778 (a) represents the average income of the bank,
0.317 (b) represent the average income generating capacity of
the risk assets, and x denotes the total risk assets.
TEST OF SIGNIFICANCE OF ESTIMATED PARAMETERS
We now determine the reliability of the estimated value of
coefficient b or how well does the estimated regression line fit
to the observed data. This is, however, referred to as test of
statistical significance. The level of significance is determined
on the basis of the standard error and t-ratio to t statistic.
Standard error (Sb), we use
Sb = Σ (yt – yte) 2 (N-K) Σ (Xt – X)2
Sb = Σet
2
(N-K) Σ (Xt – X) 2
Where X and Y1 are the actual sample values for the year t, Yc
is the estimated value of y in year t, X is the mean value of X, N
is the number of observation and et = y1 – yc is the error term
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and k is the number of estimated coefficients (2 in the case of
a bivariate regression equation, a and b). In fact, N-K is the
degree of freedom. From the table, the degree of freedom
equals N-K, i.e., 5 -2 = 3.
Table V: Calculation of Standard Error of Coefficient
Year X Y1 Yl Y-Yl (et) et2 (X-X)
2
2007 39.89 12.21 13.42 -1.21 1.46 130.87
2006 37.10 13.50 12.54 0.96 0.92 74.82
2005 23..53 11.13 8.23 2.9 8.41 24.21
2004 22.63 6.46 7.95 -1.49 2.22 33.87
2003 19.08 5.66 6.83 -1..17 1.37 87.80
142.23 48.96 14.38 439.37
N = 5, Σ X = 142.23, Σy1 = 48.96, Σet2 = 14.38
X = 28.45 Y = 9.8 Σ(X-X) = 439.37
Sb = Σet
2 (N-K) Σ(X-X)2
= 14.38 14.38
(5-2) (439.37) = 3 x 439.37
= 14.38 1, 318.11 = 0.01091 = 0.105 Sb = 0.105
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Having calculated the value of Sb, we calculate next the t-ratio.
The t-ratio (t) is defined as b/sb
Thus t = b/sb = 0.317 = 3.019 0.105 Conclusion
Using t-test, the test criterion is to reject the null hypothesis
H0 if tc > t, that is, the H0 States that the volume of the bank’s
risk assets has no outstanding impact on its gross earnings
and income against the alternative hypothesis H1 which states
that the volume of the bank’s risk asset has outstanding
impact on its gross earnings and income.
The tc is t value calculated while t is critical t obtained from
student’s t- distribution statistical table.
Result: Degree of freedom (df) = 3; table or critical t (t) at 5
percent, for a two-tail test is 2.365. Calculated t value (tc) =
3.019.
Decision: Under the two-tail test, the calculated t is greater
than the table or critical t; hence we reject the null hypothesis.
lxxviii
TEST TWO
The second hypothesis is restated into null and alternative
hypothesis as follows:
H0: There is no correlation between the bank’s risk-asset
portfolio and the effectiveness of its credit risk
management system.
H1: There is a correlation between the bank’s risk-asset
portfolio and the effectiveness of its risk management
system.
This will be tested using Pearson Correlation Coefficient
denoted by:
r = n∑xy - ∑x∑y
(n∑x2 – (∑x)2 (n∑y2 – (∑y)2)
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Table VI: CORRELATION COEFFICIENT TABLE
Year Y X XY X2 Y2
2007 32.40 39.89 1, 292.44 1, 591.21 1, 049.76
2006 25.39 37.10 941.97 1, 376.41 644.65
2005 16.99 23.53 399.78 553.66 288.66
2004 20.83 22.63 471.38 512.12 433.89
2003 18.13 19.08 345.92 364.05 328.70
113.74 142.23 3,451.49 4,397.45 2,745.66
r = n∑xy - ∑x∑y
(n∑x2 – (∑x)2 (n∑y2 – (∑y)2)
= 5(3,451.49) – (142.23) (113.74)
(5(4,397.45) - (142.23)2) (5(2,745.66 – (113.74)2)
= 17,257.45 – 16,177.24
(21,987.25 – 20,229.37) (13,728.3 – 12,936.79)
= 1, 080.21 1,179.57 r = 0.92
lxxx
Result: The relationship between X and Y is positive and is of
a high correlation. This implies that increase in one variable X
will automatically increase the other variable Y.
TESTING THE SIGNIFICANCE OF A CORRELATION
Having computed the correlation, we determine the probability
that the observed correlation did not occur by chance. That is,
we conduct a significant test. We apply test statistics thus;
t = r n -2 1 – r2 Where; r = 0.92 n = 5
∴ t = 0.92 5-1
1-(0.92)2 = 0.92 3
1- 0.8464 = 0.92 3 0.1536
= 0.92 19.53125
= 0.92 x 4.419417382 = 4.06
t = 4.06
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Decision: Table or Critical t at 5 percent for a 3 degree of
freedom is 2.353. Calculated t value tc = 4.06. Under the two
tail test, the calculated t is greater than the table or critical t.
However, we reject the null hypothesis.
Conclusion
The null hypothesis (H0) is rejected, which states that there is
no correlation between the bank’s risk asset portfolio and the
effectiveness of its credit risk management system. However,
the alternative hypothesis (H1), which states that there is a
correlation between the bank’s risk-asset portfolio and the
effectiveness of its risk management system, is accepted.
This indicates that there is a correlation between the bank’s
risk-asset portfolio and the effectiveness of its credit risk
management system.
lxxxii
REFERENCES
Dwivedi, D.N (2006). „Managerial Economics‟, New Delhi-India, Vikas Publishing House PVT Ltd.
Eqbui, K.I (1998). “Groundwork of Research Methods and Procedures”, Institute for Development Studies, University of Nigeria, Enugu Campus
KPMG, (1998). Loan Analysis System (http://www.kpmgconsulting.com)
Newbold, P. et al, (2007). “Statistics for Business, and Economics” (Sixth Edition), Pearson Education Inc., Upper Saddle River, New Jersey, USA.
Sharpe, W. (1963). “A Simplified Model for Portfolio Analysis”, Management Science, New York.
Ugbam, O. (2001). “Quantitative Techniques – An Introductory Text”, Chirol Publishers Enugu.
lxxxiii
CHAPTER FIVE
SUMMARY OF FINDINGS, CONCLUSION AND
RECOMMENDATION
5.1 SUMMARY OF FINDINGS
Evidence from this research study reveals the following:
That Equatorial Trust Bank experienced an appreciable
increase in the quantity of its risk assets. This is evident
in the consistent increase on the amount of total loans
and advances within the period (2003-2007).
Another major implication of the findings was the growth
in the rate of secured loans to total loans and advances.
This could be attributed to the efficiency and
effectiveness of the banks’ credit risk management
system.
The statistical result also showed that the average
income generating capacity of the bank’s assets relative
to the banks’ gross earnings remained appreciable during
the period, thus implying a positive relationship between
a banks’ gross income and the volume of its risk assets,
and more so the quality of its risk management system.
lxxxiv
There was also a noticeable variation in the percentage of
the performing loans and advances within the period
which the analysis could not provide an insight into some
of the causes and implications. It is invariably unclear
what could be responsible for the unstable rate of the
performing loans. This is, indeed, an issue necessitating
further study.
Finally, we have been able to identify the credit risk
management process adopted by Equitorial Trust Bank.
Although Equitorial Trust Bank appears to be gaining
grounds in terms of consistent improvement in the
quantity and quality of its risk assets, due to the
strengthening of its credit risk management system. It is
also encouraging that the income generating capacity of
these risk assets has remained high during the five years.
The implication here is that large portion of the bank’s
income is from risk asset. However, is prudent for the
bank to de-emphasize greater efficiency on its performing
loan which appears to be inconsistent.
lxxxv
5.3 CONCLUSION
The purpose of this research study was to discuss the risk
management in banking. This has become necessary because
the present financial crisis in the Nigeria banking industry has
been attributed to a lot of factors. The characteristics features
of the Nigerian banks show that the banking sector before the
global financial crisis was sound and vibrant enough to
support the nation’s economic growth and development.
Banks have good reason to worry about risk management;
they cannot continue to be caught by dramatic turns in the
economic cycle that arrive without warning. Even if these
turns could be predicted in advance, many activities are not
yet liquid enough to remove or hedge the risk. The recent
crisis in the emerging markets such as Nigeria indicates that
banks worldwide continue to have difficulty in dealing with
illiquidity.
Moreover, they appear to be caught in a vicious cycle that
moves between rapid growth in the good times and virtual
standstill when a crisis hits.
lxxxvi
Despite the growing emphasis on risk and return analysis as a
basis for facility pricing in Nigerian banks, a major problem
has been the ability to design a risk-rating system that would
be consistent in measuring risk profile of prospective
borrowers. Typically, the decision to participate in a particular
business and allocate resources to that business assumes a
large part of the risk. Once that decision is made, the bank
should be prepared to incur stress-related loses from time to
time.
However, there was some suggestion that competitive
pressures within the industry are inducing banks to assume
more risk in a bid to maintain market share. This view was
prefaced by the evidence that banks are becoming increasingly
lenient in their lending standards. Concern about “excessive
competition” was thought to be the primary factor driving this
trend; banks are lending large amounts to lower-quality
counterparties because of fears about loosing market share. It
was argued that a paradox was emerging. Specifically, where
there seems to be a fairly common perception amongst the
lxxxvii
public and consumer bodies that there is not enough
competition within the financial services industry, for industry
participants, competition is quite intense. Many participants
questioned the view that excessive competition is driving down
credit standards in Nigeria. While there is plenty of competition,
it was generally agreed that banks are reasonably cautious in
their lending strategies, particularly with regard to the middle
market where most uncertainty was thought to exist.
5.3 RECOMMENDATION
Risk management has undergone significant evolution over the
last decade. Twenty years ago a bank’s risk management
function was almost non-existent. Since that time, banks have
experienced an influx of mathematicians, actuaries,
behavioural scientists and marketers which have changed
banks’ approaches to managing risk. Whilst the industry has
come a long way, there is still further to go. The continually
changing dynamic of banking activities, the business
environments in which they operate and volatile nature of the
world economy, imply that the nature of risk, and its
lxxxviii
measurement and management, must also evolve over time.
Risk management should focus most attention on the tail of
the loss distribution. To develop an understanding of what
might happen under extreme circumstances; banks need to
adopt a stress-testing regime that systematically analyses the
impact of different scenarios on their earnings.
Finally, it is pertinent that the regulatory agencies strengthen
bank regulation and supervision in Nigeria. This is to sterm
the tide of recurrent bank failure in the country. They should
firm up prudential guidelines and encourage market
discipline. Well-trained on-site inspectors are important to
ensuring that banks comply with regulations, thus, strong
supervision must ensure that banks conduct careful credit
analysis of their borrowers to avoid bad loans.
lxxxix
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