MONETARY POLICY AND FINANCIAL PERFORMANCE OF DEPOSIT MONEY BANKS IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The financial sector of the economy plays a huge role in the economic development of a nation and this cannot be overstressed. It is the channel through which idle funds are made available to the productive sector, thereby facilitating the use of surpluses in the economy to generate employment and promote economic welfare (Aurangzeb, 2012).  The financial sector provides strong confidence for depositors, thereby motivating and encouraging saving in the economy. A strong financial sector also helps to sustain an economy against external shock that may arise from fall in external capital flow. A strong and well-developed financial sector is needed to achieve a sustained growth (Aurangzeb, 2012). Akomolafe (2014), in his view, opined that sustainable economic growth is often associated with countries with strong financial sector. The study indicated that the recent incidence of banking and financial crises in the world, and its aftermath on the world economies give credence on the importance of the sector on the performances of an economy. More importantly, the financial sector also serves as the avenue through which the monetary policies of the government are carried out. The banking industry is one of the sectors that play an important role in the allocation of capital resources and risk sharing of future flows in any given economy or country. An efficient and effective banking industry in any economy is likely to facilitate increased growth and welfare, and it will smooth business cycles.

For instance banks provide money changing and payment processing services; transformation of assets in terms of their maturity, quality, and denomination and more recently management and control of risks. These functions give banks a central position within the process of saving and investment allocation. However, these functions make banks vulnerable to different sources of shocks, and they have a negative effect on the economy because of banks’ central role. Consequently, there is a case for strong regulations in a banking environment. Because of the type of functions banks perform there is need to have in place proper monetary policy involving issues such as barriers to entry, market concentration, the borrower-lender relationship, deposit insurance, and the taxation of financial intermediation in order to improve the performance of the financial sector (Ibrahim & Muritala, 2015).

The primary objective of Nigerian banks’ consolidation reform was to guarantee an efficient and a sound financial system. The reform was designed to enable the banking sector develop the required capacity to support the economic development of the nation by efficiently performing its functions as the head of financial intermediation (Lemo, 2005). Thus, it was to ensure the safety of depositors’ money, position banks to play active developmental roles in the Nigerian economy; become major players in the sub-regional, regional and global financial markets and compete favorably with international banks. The Central Bank of Nigeria’s (CBN) recent reform to consolidate the banking sector through drastic increase to 25 billion naira as minimum capital base of any bank led to a remarkable reduction in the number of banks from 89 to 24 in 2005; changed their mode of operations and their contributions to the nation’s economic development (Zhao & Murinde 2009).

The Nigerian banking sector had undergone a number of major changes over the last two decades caused by restructuring and liberalization of the financial sector as well as technological progress. Before 1987, the Nigerian monetary authorities restricted entry, controlled branch expansion and set both deposit and lending rates. This institutional framework led to a situation of virtually little or no competition in the sector, with the concentration of activities in the four largest banks. In 1990s, a lot of structural reforms were observed in the sector. There was a significant closure of banks, takeover of management and control by the Central Bank of Nigeria (CBN) and the Nigerian Deposit Insurance Corporation (NDIC). The mandatory capital level was increased to 500,000.00 naira, while the statutory minimum risk-weighted capital ratio remained at 8 percent on average, the number of banks in Nigeria shrank by approximately 22 percent between 1997 and 1999 (Asogwa, 2004).

The adoption of universal banking in Nigeria necessitated the CBN to strengthen the regulatory and supervisory framework. The requirement of capital base was again increased to 2 billion naira in 2002 while the risk-weighted capital ratio was raised to 10 percent. In 2004, the CBN announced a new 13 point reform agenda which was intended to promote soundness, stability and efficiency of the Nigerian banking sector and to enhance its competitiveness in the African regional and global financial system. One of the 13 point agenda was to raise the minimum capital base to 25 billion naira with the statutory minimum risk-weighted capital ratio maintaining at 10 percent. When the new reform was announced, out of the 89 banks operating in the banking sector, about 5-10 banks’ capital base was already 25 billion naira; 11-30 banks’ capital base was within 10 billion naira to 20 billion naira; the remaining 50-60 banks were quite below 10 billion naira (Zhao & Murinde, 2009).

The attempt to meet the minimum capital base triggered the merger and acquisition in the industry. Further, banks raised capital from local as well as foreign direct investment. This led to the increase in the industry’s capitalization as a percentage of stock market capitalization and market’s liquidity (Somoye, 2008). The reform brought about changes in size, structure and operational characteristics of the Nigerian banking system. It is argued that consolidation could increase banks’ propensity towards risk taking through increases in leverage and off-balance sheet operations (Somoye, 2008). Furlong (1994) stated that an early view of consolidation in banking was that it made banking sector more cost efficient because larger banks could eliminate excess capacity in areas like data processing, marketing or overlapping.

Monetary policy forms part of the macroeconomic environment that is very critical in enhancing the financial performance of organizations. The financial development of any economy largely depends on the short run stabilization of the monetary policy of any economy. Financial performance therefore plays a very significant role in implementation of monetary policy (Amassoma, Nwosa, & Olaiya, 2011). There is a very high degree of interdependence between monetary policy implementation and the financial performance of deposit money banks in an economy (Amassoma, Nwosa, & Olaiya, 2011)

The Central bank of Nigeria is the lender of last resort in the country and is the banker to all the deposit money banks operating in the country. The main duty of The Central Bank of Nigeria is to ensure proper functioning of the financial system in Nigeria, the liquidity in the county and the solvency of the banks. However, the banking industry in country faces a number of challenges stemming from unstable macroeconomic environment such as frequently changing interest rates and mandatory deposits. This is likely to affect their financial performance. In view of this, it is therefore pertinent to evaluate the impact of monetary policy on the financial performance of the deposit money banks.

 

1.2       Statement of the Problem

The performance of the deposit money banks is a function of majorly the monetary policies adopted in the country and this invariably has a multiplier effect on the economy developmental processes. Deposit money banks are usually considered around the globe as the most appropriate channels for implementing monetary policy by most Central Banks in many countries. Therefore, monetary policy should have an effect on the financial performance of deposit money banks in Nigeria. Despite the steady increase in the net worth of various deposit money banks, there have been several declines in total credit which were recorded for the period of 1981 to 2015, depending on net worth and total credit to measure deposit money banks’ performance. Therefore, this study aims at examining the extent to which monetary policy explains the fluctuations in the performance of deposit money banks.

 

1.3       Objective of the Study         

The main objective of this study is to examine the effect of monetary policy on the financial performance of deposit money banks in Nigeria. The specific objectives are to:

1. estimate the effect of the liquidity ratio on the financial performance of deposit money banks;
2. analyze the effect of lending rate on the financial performance of deposit money banks;
3. analyze the impact of loans to deposit ratio on the financial performance of deposit money banks and
4. estimate the effect of cash reserve ratio on the financial performance of deposit money banks.

 

1.4       Research Questions

1. What is the effect of the liquidity ratio on the financial performance of deposit money banks?
2. Does the lending rate have an effect on the financial performance of deposit money banks?
3. What effect does the loan to deposit ratio have on the financial performance of deposit money banks?
4. What is the effect of the cash reserve ratio on the financial performance of deposit money banks?

 

1.5       Hypotheses

The research hypotheses are: At 5% level of Significance

H₀1: liquidity ratio has no significant effect on the financial performance of deposit money banks in Nigeria.

H₀2: lending rate has no significant effect on the financial performance of deposit money banks in Nigeria.

H₀3: loans to deposit ratio has no significant effect on the financial performance of deposit money banks in Nigeria.

H₀4: Cash reserve ratio has no significant effect on the financial performance of deposit money banks in Nigeria.

 

1.6       Scope of the Study

This study examined the effect of monetary policy on the financial performance of deposit money banks in Nigeria. The study includes all the deposit money banks in Nigeria as captured by the Central Bank of Nigeria Statistical Bulletin 2015. The period of the study is 34 years (1981-2015) which were considered relevant to this study because of the availability and accessibility of the data as at the period this study was carried out.

 

1.7       Significance of the Study

This study is significant because it would provide information and recommendation to assist the government to come up with appropriate monetary policy that can enhance not only the performance of deposit money banks but the economy at large. The deposit money banks in Nigeria would be able to understand how changes and variations in monetary policy by the existing government are likely to affect or impact on their financial performance. This would enable them to take necessary approaches to react to variations in monetary policy.

 

1.8       Justification for the Study

Several studies exist on financial performance of the deposit money banks using variables such as return on assets (kolapo et al (2012), return on Equity ( Jhu and Hui 2012), return on Capital (Korir et al 2015)to measure their financial performance. Akanbi and Ajagbe (2012) in their study analysis of monetary policy and deposit money banks in Nigeria, employed panel data from 1992 to 1999 using net profit to measure the performance of deposit money banks.  Ajayi and Atanda (2012) study on monetary policy and bank performance in Nigeria also measured commercial bank performance using profitability from 1978 to 2008. Punita and Somaiya (2006) examined the impact of monetary policy on profitability of banks in India from 1995 to 2000 using return on asset and return on equity to measure profitability of banks. Udeh (2015) examined the impact of monetary policy instruments on profitability of deposit money banks in Nigeria from 2005 to 2012 using profit before tax to measure bank profitability. The study will contributes to the recent studies that exist on monetary policy effects on financial performance of deposit money banks by covering the period 1981 to 2015. Little emphasis has been placed on net worth despite its importance as a measure of financial performance. Hence, the study will include net worth as a variable for measuring the financial performance of deposit money banks in Nigeria.

 

1.8       Operational Definition of Terms

Net worth (NW): is the total asset minus total outside liabilities of an individual or a company. Net worth is used when talking about the value of a company or a personal finance for an individual’s net economic position.

Total credits: is the amount deposited in the account.

Deposit money banks: is any financial institution which has been legally authorized by a governing body of the State, Country, Nation (for example central banks Nigeria) to accept money in form deposits and also lend money to individuals for an agreed percentage.

Liquidity Ratio (LR): are the ratios that measure the ability of a company to meet its short term debt obligations. These ratios measure the ability of a company to pay off its short liabilities when they fall due.

Lending Rate (LR): is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Lending rates are typically noted on an annual basis, known as the annual percentage rate (APR).

Loans-to-Deposits Ratio (LDR): is used to calculate a lending institution’s ability to cover withdrawals made by its customers.

Top of Form

BottomTop of FormBottom of FormCash Reserve Ratio (CRR): is a specified minimum fraction of the total deposits of customers, which deposit money banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country.

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