PERFORMANCE AND PROFITABILITY ANALYSIS IN THE BANKINGINDUSTRY.

(Case Study of Commercial Banks in Nigeria, 1981- 2012).

AMUSA, JAMIU ABIODUNEastern Illinois UniversityCharleston Illinois, USA

Being a term paper for advance microeconomics, submitted to the instructor(Dr. Ali R. Moshtagh ), department of economics Eastern Illinois University,Charleston Il, USA.

Spring, 2014.

ABSTRACT

The banking sector in Nigeria have continuously struggled to make their

shareholders happy by justifying the confidence reposed in them through better

performance and high profit margins. But the low performance of the banking

sector in Nigeria over the last decade has remained a big concern. This study

explores the link between bank size, capital ratio, operating expenses, interest rate

and the economic situation of the country on the banking sector profitability and

performance in Nigeria. The ordinary least square regression model was employed

on time-series data obtained from the Central Bank of Nigeria statistical bulletin

(1981-2012). The results confirm that the bank size, capital ratio, operating

expenses, interest rate and the economic situation of the country have statistically

significant effects on banks’ profitability and performance in Nigeria. Thus,

government policies in the banking sector must encourage banks to regularly raise

1

their capital and provide the enabling environment that will accelerate overall

development in the country. Bank management must efficiently manage their

portfolios in order to protect the long run interest of profit-making.

TABLE OF CONTENT

Title

Page..........................................................

.......................................................1

Abstract......................................................

.............................................................2

Table of

Content.......................................................

...............................................2

Section 1:

Introduction

1.1

Introduction .................................................

.......................................................3

1.2 Commercial Banking and Reforms in

Nigeria....................................................4

2

Section 2:

Literature Review

2.1 Literature

Review........................................................

.....................................6

2.2 Theoretical

Literature ...................................................

...................................6

2.3 Empirical

Literature....................................................

......................................7

Section 3:

Methodology

3.1

Methodology...................................................

...................................................9

3.2 Model

Specification.................................................

..........................................9

3

3.3 Description of

Variables.....................................................

................................9

Section 4:

4.1 Results and

Discussion....................................................

...................................12

Section 5:

Summary, Conclusion and

Recommendations..............................................

..........15

References....................................................

...........................................................16

Section 1.1.1 Introduction.

As prime movers of economic life, banks occupy a

significant place in the economy of every nation and it is

therefore not surprising that their operations are perhaps the

most heavily regulated and supervised of all businesses.

4

Policy makers, economists and monetary authorities recognize

that the ability of banks to achieve the desired results and

to continue to play the role earmarked for them depends on the

existence of an enabling environment and the number of

operating banks and their performance from one financial year

to another. The business of banking is a rapidly growing

industry. Every bank is trying to enhance overall performance

plus profits to occupy a better position in financial system.

However, the services that the banks offer have changed

greatly since the 1990s due to deregulation and recent banking

reforms in the Nigerian financial system. Deregulation and

recent reforms (2004 Bank Consolidation in Nigeria) allowed

commercial banks to hold riskier financial assets on their

balance sheets and to merge with investment banks. As a

result, banks expanded the types of services they offered and

the fees from these services became a larger share of bank

revenue. Increased competition because of deregulation caused

a number of bank failures and triggered a series of mergers

and acquisitions.

The recent financial crisis dramatically underscored the

changes in the structure of the commercial banking industry

5

that occurred with the proliferation of risky new investment

products, the liberalization of lending practices, and the

merging of commercial and investment banks. Profit before tax

in the Nigerian banking industry has declined progressively

during this period. For instance, the profit before tax which

was 80.8% in 2000 fell dramatically and recorded a loss of

13.95%. Although Profit Before Tax peaked at 287.62% in 2007,

it declined to 49.14% in 2008 (Obamuyi,2012). Many banks were

forced to take large write-offs as the value of their assets

fell sharply. The crisis led to the collapse of several major

financial institutions, widespread mortgage foreclosures, and

economic recession.

The implication of this crisis is that banking habits and

activities have been seriously threatened thereby reducing the

amount of funds that can be mobilized by banks. The foregoing

concerns the worry of Sharma and Mani (2012) that the

performance of banks has become a major concern for economic

planners and policy makers due to the fact that the gains of

the real sector of the economy depend on how efficiently the

banks are performing the function of financial intermediation.

As Saona (2011) argues, an efficient financial system improves

6

banks’ profitability by increasing the amount of funds

available for investment.

Although monetary authorities have taken some measures to

stabilize the financial system and build confidence in the

banking system, it is still relevant to know what factors

affect banks profitability in order to influence policy making

in the banking sector.

It is thus, hypothesized that, ‘there exists a

significant relationship between banks’ profitability and

each of the bank size, capital ratio, operating expenses,

interest rate and the economic situation in Nigeria.

The result of this paper will help us determine a

decision making for possible adjustment for the bank. This

study thus becomes relevant because it will raise additional

attention of the policy makers and the bank management to

further pursue policies that have long lasting positive

implications. The study provides additional knowledge for

researchers and the general public about factors affecting

banks’ profitability.

1.2 Commercial Banking and Reforms in Nigeria.

7

The history of the Nigeria banking system is stuffed with

growth and burst cycles in the number of operating banks and

their branches. The Central bank of Nigerian’s resolve to

carry out reforms in the banking sector was borne out of the

past of the nation’s banking industry. Between 1994 and 2003

a space of nine years, no fewer than 36 banks in the country

closed shop due to insolvency. In 1995 four banks were closed

down. But 1998 may go down well in history as the saddest

year for the banking industry as 26 banks closed shop that

year. Three terminally ill banks also closed shop in 2000. In

2002 and 2003 at least one bank collapsed. The failed banks

had two things in common: small size and unethical practices.

Of the 89 banks that were in existence as at July 2004, when

the banking sector reforms were announced, no fewer than 11 of

them were in a state of distress. According to the CBN,

between 69 and 79 of the banks were marginal or fringe players

(Soludo, 2004).

The decade 1995 and 2005 were particularly traumatic for

the Nigerian banking industry; with the magnitude of distress

reaching an unprecedented level, thereby making it an issue of

concern not only to the regulatory institutions but also to

8

the policy analysts and the general public. Thus the need for

a drastic overhaul of the industry was quite apparent. In

furtherance of this general overhauling of the financial

system, the Central Bank of Nigeria introduced major reform

programmes that changed the banking landscape of the country

in 2004. Out of the 89 banks that were in operation before the

Reform (2004 bank consolidation), more than 80 percent (75)

of them merged into 25 banks while 14 that could not finalize

their consolidation before the expiration of deadline were

liquidated (Afolabi, 2004).

Currently, there are 21 commercial banks in Nigeria which

includes: Access Bank, Citibank, Diamond Bank, Ecobank

Nigeria, Enterprise Bank Limited, First Bank of Nigeria, First

City Monument Bank , Guaranty Trust Bank, Keystone Bank

Limited, Mainstreet Bank Limited, Skye Bank, Stanbic IBTC Bank

Nigeria Limited, Standard Chartered Bank, Sterling Bank, Union

Bank of Nigeria, United Bank for Africa, Unity Bank Plc, Wema

Bank and Zenith Bank.

Section 2.

9

2.1 Literature Review.

The efficiency and performance of the banking system has

been one of the major issues in the new monetary and financial

environment. The efficiency and competitiveness of financial

institutions cannot easily be measured, since their products

and services are of an intangible nature. Many researchers

have attempted to measure the efficiency of the banking

industry using outputs, costs and performance. The scale and

scope economies of banking have been one of the issues related

to the competitiveness and efficiency of banks which have been

studied extensively.

2.2 Theoretical Literature

This includes the signalling theory, expected bankruptcy

cost hypothesis, risk return hypothesis, market power and

efficiency structures hypotheses. Signalling hypothesis

suggests that a higher capital is a positive signal to the

market of the value of a bank. As Berger (1995) observe, under

the signalling theory, bank management signals private

information that the future prospects are good by increasing

capital. Thus, a lower leverage indicates that banks perform

10

better than their competitors who cannot raise their equity

without further deteriorating the profitability.

On the other hand, bankruptcy hypothesis argues that in a

case where bankruptcy costs are unexpectedly high, a bank

holds more equity to avoid period of distress. The signalling

hypothesis and bankruptcy cost hypothesis support a positive

relationship between capital and profitability.

However, the risk-return hypothesis suggests that

increasing risks, by increasing leverage of the firm, leads to

higher expected returns. therefore, if a bank expects

increased returns (profitability) and takes up more risks, by

increasing leverage, the equity to asset ratio (represented by

capital) will be reduced. thus, risk-return hypothesis

predicts a negative relationship between capital and

profitability (Dietrich and Wanzenrid, 2009; Saona, 2011;).

Consequently, the Market Power (MP) and Efficiency

Structure (ES) theories explain the relationship between the

bank size and profitability. Olweny and Shipho (2011) observe

that the market power posits that performance of banks is

influenced by the market structure of the industry and that

the Efficiency Structure (ES) hypothesis maintains that banks

11

earn high profits because they are more efficient than the

others. Concluding on the MP and ES theories, Olweny and

Shipho (2011) argue that MP theory assumes that the

profitability of a bank is a function of external market

factors, while the ES assume that bank profitability is

influenced by internal efficiencies.

2.3 Empirical Literature.

Empirical review of this study is done by identifying

similarities and differences across the various economies

studied by previous researchers. The factors affecting banks’

profitability have been empirically examined by many authors,

especially in the developed countries.

Athanasoglou et al. (2005) studied the effect of bank-

specific, industry-specific and macroeconomic determinants of

bank profitability, using an empirical framework that

incorporates the traditional Structure-Conduct-Performance

(SCP) hypothesis. The results indicated that all bank-specific

determinants, with the exception of size, affect bank

profitability significantly in the anticipated way.

Saona (2011) examined the determinants of the

profitability of the US banks during the period 1995-2007. The

12

empirical analysis combined bank specific (endogenous) and

macroeconomic (exogenous) variables through the GMM system

estimator. He found a negative link between capital ratio and

profitability, which supports the notion that banks are

operating over-cautiously and ignoring potentially profitable

trading opportunities. The performance of the new US

commercial banks was examined by DeYoung and Hasan (1998). The

profit efficiency of the new banks improves rapidly during the

first years of operation, but on average it takes about nine

years to reach established bank levels. Small banks lend a

larger proportion of their assets to small businesses than do

large banks. In the USA, Jayaratne and Wolken (1999) found

that it is likely that a small firm will have a line of credit

from a bank and this does not decrease in the long run. This

happens when there are few small banks in the area, although

short-run disruptions may occur. Staikouras and Wood (2004)

constructed the OLS and fixed effect models to examine the

determinants of European bank profitability from 1994 – 1998.

The authors found that the profitability of European banks is

influenced not only by factors related to their management

decisions but also to changes in the external macroeconomic

13

environment. Khrawish (2011) accessed the Jordanian commercial

bank profitability from 2000 through 2010, and categorised the

factors affecting profitability into internal and external

factors. the author found that there is significant and

positive relationship between return on asset (ROA) and the

bank size, total liabilities/ total assets, total equity/

total assets, net interest margin and exchange rate of the

commercial banks and that there is negative relationship

between ROA of the commercial banks and annual growth rate for

gross domestic product and inflation rate. Dietrich and

Wanzenrid (2009) analysed the profitability of commercial

banks in Switzerland over the period 1999 to 2006. Their

findings revealed that the most important factors are the GDP

growth variable, which affects the bank profitability

positively, and the effective tax rate and market

concentration rate both have a negative impact on bank

profitability. Macit (2011) investigated the bank specific and

macroeconomic determinants of profitability in participation

banks for Turkish banking sector using ROA and ROE. He found

that for the bank specific determinants of profitability, the

14

ratio of non-performing loans to total loans has a significant

negative effect on profitability.

As far as profitability and efficiency of banks are

concerned, Noulas (1999) examined the ROE and ROA ratios, the

ratios of leverage and operating efficiency for 19 Greek

bankfor the period 1993-1998. According to the result, there

are no significant difference in the return on equity and the

asset diachronically.

Section 3.

3.1 Methodology.

The methodology for this research is based on descriptive

and ordinary least square estimation techniques. The

descriptive approach was used to analyze the means and further

shows the normality of the Distribution. A preliminary

estimation of the correlation coefficients of the variables

was carried out to determine the relationship among the

variables. The secondary data for the study were obtained from

the Central Bank of Nigeria Statistical Bulletin for the

period (1981-2012).

3.2 Model Specification.

15

Five explanatory variables were included in the

regression analysis. The empirical model takes the following

form:

ROA = f ( BSecD, EFD,ε)....................................................................................................1

ROAt = β0+β1lnBSt+ β2CapRt+ β3OExprt + β4IR+ β5RGDPt +

εt .......................................2

3.3 Description of Variables.

Returns on Assets. (ROA)

The ROA provides information about how much profits are

generated on average by each unit of assets. Therefore the ROA

is an indicator on how efficiently a bank is being run. In

similar terms, it is a financial ratio used to measure the

relationship of earnings to total assets. ROA is regarded as

the best and widely used indicator of earnings and

profitability. Studies have shown that ROA assesses how

efficiently a bank is managing its revenues and expenses, and

also reflects the ability of the management of the bank to

generate profits by using the available financial and real

assets (Flamini et al., 2009).

16

For this study, bank profitability is proxied by return

on assets (ROA), defined as the net profit after tax over

total assets. ROA is considered as the key proxy for bank

Profitability, instead of the alternative return on equity

(ROE), because an analysis of ROE disregards financial

leverage and the risks associated with it (Flamini et al., 2009).

Bank Specific Determinants (BSecD)

This refers to internal determinants. The internal

determinants are the bank-specific determinants of

profitability. These measures are within the control of bank’s

management. They are calculated from the balance sheet and

income statement of commercial banks. Internal determinants

for the purpose of this study include:

Bank Size (BS):

Bank size accounts for the existence of economies or

diseconomies of scale. i.e the size of bank is helpful to

catch the possible economics of scale. The variable is

measured as the natural log of total assets (Saona, 2011).

Economic theory suggests that if an industry is subject to

economies of scale, larger institutions would be more

efficient and could provide service at a lower cost. Also, the

17

theory of the banking firm asserts that a firm enjoys

economies of scale up to a certain level, beyond which

diseconomies of scale set in. This implies that profitability

increases with increase in size, and decreases as soon as

there are diseconomies of scale. Hence, literature has shown

that the relationship between the bank size and profitability

can be positive or negative ( Flamini et al., 2009)

Capital Ratio (CapR):

Capital refers to the amount of own funds available to

support a bank’s business and, therefore, bank capital acts as

a safety net in the case of adverse development (Athanasoglou

et al., 2005). Capital Ratio is calculated as the ratio of share

holder equity to total assets. The ratio measures how much of

the banks’ assets are funded with owners’ fund and is a proxy

for capital adequacy of a bank by estimating the ability to

absorb losses.

Operating Expences Ratio (OExpr): This relates to the idea of

efficient management of banks’ resources. For this study, the

variable measures the ratio of operating expenses to total

assets. As Athanasoglou et al. (2005) observe, a negative

relationship is expected between expenses management and

18

profitability, since improved management of the expenses will

increase efficiently and hence raise profits.

External Factor Determinants (EFD)

This includes:

Interest Rate (IR).

The bank lending rate is expected to have a positive

impact on bank profitability. This is because interest rate

directly impacts bank interest income and expenses, and the

net result further affects bank profitability. If there are no

market frictions and transaction costs, lending and deposit

rates would be the same. This Variable is not logged because

it is a rate.

Real GDP Growth (RGDP)

The real GDP growth is used as a proxy of business cycle

in which banks operate, and controls for variance in

profitability due to differences in business cycles which

influence the supply and demand for loans and deposits. In

this study, GDP is used as a dummy in defining

favourable/unfavourable conditions, i.e., a dummy of the shift

in economic activities (GDP) from favourable (1) to

unfavourable (0) conditions. This is because an increase in

19

economic activities of the country signals that customers’

demand for loans will increase, and with improved lending

activities, banks are able to generate more profits.

β0 = Constant Parameter, β1, - β5 = Elasticity Parameter estimate

and ε = Stochastic Error Term.

Section 4.

4.1 Results and Discussion.

Table 1.1. Descriptive Analysis of the result.

ROA BS CapR OExp IR RGDP

Mean 0.017873

5.803475

0.184985 0.036113

0.216386

0.428571

Maximum 0.033912

6.180629

0.273878 0.053369

0.246100

1.000000

Minimum 0.004223

5.241929

0.086377 0.019274

0.182100

0.000000

Std. Dev. 0.008205

0.297715

0.058220 0.013391

0.022927

0.495124

Probabilit

y

0.000001

0.000000

0.000003 0.000000

0.000000

0.000000

Observatio

ns

32 32 32 32 32 32

Source: Computed from study data.

Table 1.1 presents the results of the descriptive

statistics of both the dependent and independent variables.

From the results, the analysis of the means shows the

20

following descriptive statistics: ROA (M = 0.018, SD = .008);

BS (M = 5.803, SD = 0.298); CapR (M = 0.185, SD = 0.058); DAR

(M = 0.036, SD = 0.013); IR (M = 0.216, SD = 0.023); and GDP

dummy (M = 0.429, SD = 0.495).

Tables1.2 Result of Correlation Coefficient of Variables.

ROA BS CapR OExp IR RGDP

ROA 1.000000

BS 0.461605

1.000000

CapR 0.463869

0.266741

1.000000

OExp 0.094419

-0.63407

1

0.390377 1.000000

IR 0.587544

0.840168

0.582986 -0.346919

1.000000

RGDP 0.584098

-0.19694

7

0.279562 0.702975 -0.13551

5

1.000000

Source: Computed from study data

The results in Table 2 indicate that a positive

correlation exists between ROA (measure of performance and

profitability) and each of the independent variables (bank

size, capital ratio deposit to asset ratio, money market

interest rate and dummy of real GDP growth). Hence, this

indicates that an improvement in the explanatory powers of the

model leads to higher profits for the commercial banks.

Table 1.3. Result of the Regression Model.

21

ROAt = β0+β1lnBSt+ β2CapRt+ β3OExpt + β4IRt+ β5RGDPt + εt

ROAt = 0.066257 - 0.020236BSt + 0.012692CapRt - 0.538509OExpt +

0.359810IR +

0.019362RGDPt

Variables

Coefficient

Standard Error

t-Statistic

Probability

R2 F.cal

Constant 0.066257

0.005025 13.18541

0.0000 0.743006 48.39692

BS -0.020236

0.001013 -19.97304

0.0000 Prob(Fstatistic)

0.001

CapR 0.012692

0.003304 3.841583

0.0001

OExp -0.538509

0.023125 -23.28645

0.0000

IR 0.359810

0.010755 33.45668

0.0000

RGDP 0.019362

0.000358 54.15272

0.0000

Source: Computed from study data

The result in Table 1.3 exhibits the findings of the

regression analysis. The R Square for ROA is 0.743006 which

22

means that 74% variations in ROA, is explained by changes in

bank size, capital ratio, operating expenses, money market

interest rate and the dummy variable of real gross domestic

product. From Table 1.3, the overall regression is

statistically significant, F = 48.396, p = .001, thus

supporting the fact that bank size, capital ratio, operating

expenses, money market interest rate and the economic

situation of the country (dummy variable of real gross

domestic product) are important factors in accessing the

profitability and performance of the banking sectors in

Nigeria.

Bank size has a negative but statistically significant

effect on banks’ profitability (ROA). The results indicate

that banks are likely to earn fewer profits. The negative

relationship could be that, as the banks are becoming

extremely large, the bureaucratic procedures have negatively

affected their performances. For instance, the forced mergers

and acquisitions of banks in Nigeria in 2006, where the number

of banks were reduced from 89 banks to 24 groups of banks in

2006, could have caused the returns of the banks to decline.

Thus, policy makers should be cautious. The results confirms

23

the works of Staikouras and Wood (2004) that growing banks may

face diminishing marginal returns which will cause average

profits to decline with size.

Operating Expenses has a negative and significant effect

on banks’ profitability as expected. This finding implies that

efficient management of banks’ expenses, by reducing the cost

of operations, improves the performance of the banks. The most

important policy lesson to the banks is that reducing the cost

of operations reduces the incidence of failure of the banks

and hence strengthens the confidence of the shareholders and

the public through improved financial performance of the

banks. Thus, as stated by Efficiency Structure (ES)

hypothesis, an efficiently managed bank will earn higher

profits than the less efficient ones.

In line with expectation, the variable of interest rate

was positive and statistically significant. This implies that

the profits of banks tend to increase with increasing rate of

interest. This is understandable in Nigeria because,

oftentimes, most banks charge high rate of interest on loans

and advances because of their perceived risk of doing business

in the country.

24

The dummy of GDP variable has positive and statistically

significant relationship with profitability. The positive

effect is an indication that higher GDP represents improved

business opportunities, which ultimately leads to higher

profitability.

Section 5.

Summary, Conclusion and recommendation

Several sources of theoretical and empirical reviews were

used to support the link between profitability and each of its

determinants. The theories include the signalling theory,

expected bankruptcy cost hypothesis, risk-return hypothesis,

market power and efficiency structures hypotheses. Ordinary

least square regression was employed for the study, using a

time-series data collected from the Central Bank of Nigeria

statistical bulletin (statement of assets and liabilities of

commercial banks) between 1981 and 2012. The results confirm

that the bank size, capital ratio, operating expenses,

interest rate and the economic situation of the country have

statistically significant effects on banks’ profitability in

Nigeria. Accordingly, the impact of GDP growth rate on

25

profitability indicates that banks can achieve higher or lower

profitability under favourable or unfavourable conditions.

Government policies in Nigerian banking sector must encourage

banks to regularly raise their capital and provide the

enabling environment that will accelerate economic growth in

the country.

These results have important implications for banks’

survival and growth. It is hoped that the study will guide the

policy makers and bank regulators in the formulation and

implementation of macroeconomic policies which may affect the

stability of the banking system in Nigeria.

The study result may be improved by removing some of the

restrictions to it. This study restriction includes the

unavailability of sufficiently long time-series data for

variables that are included in the theoretical models. The

researcher could collect annual data for only 32 years which

is less than was originally intended.

This study is a single-country study with the

applications of the study limited to the country studied

(Nigeria). A further extension of this research could be to

conduct a similar study for other countries particularly other

26

developing countries. Also a possible extension to this study

could be to include other depository institutions in the

banking sector such as microfinance banks and discount

houses.

The use of other explanatory variables if available in

quantified measures should be included in the study to reflect

the performance of the banking sector in Nigeria.

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