ABSTRACT
Profits of banks are often under pressure of huge nonperforming loan portfolio and other operations in risk assets and this creates weaknesses in the financial strength of banks, and sometimes leads to distresses and collapse of such entities with negative consequences on stakeholders. This study investigates the effect of risk assets management on the financial performance of commercial banks in Nigeria, employing structural equation model to test for moderating and mediating effect.Data were collated from the audited annual report of ten (10) selected banks for 15 years from 2005 to 2019 to measure return on assets (ROA), return on equity (ROE), earnings per share (EPS) and return on capital employed (ROCE) which are proxies for financial performance while TDLR, NPLR CADR DEQR and CRR were used as proxies for measuring risk assets. Panel moderated multiple regression technique using structural equation model (SEM) was used in analyzing data. The first and third models were not statistically significant. While the result in the second model shows that DEQQR has a positive statistical significance with financial performance while TLDR, NPLR have negative significance with financial performance. CRR and CAR did not show anysignificant relationship with the financial performance indicators.DEQR has a significant effect on ROCE. The calculated value for DEQR (0.0204) is less than the accepted significance value of 0.05. This means that the null hypothesis for DEQR against ROCE is rejected while the alternative hypothesis accepted. Thus, DEQR has a significant effect on the return on capital employed of listed commercial banks in Nigeria.The fourth model had positive and negative significance but individual parameters did not show any significance.The interaction of hedging (H) in the relationship between risk asset management and financial performance is also insignificant (B = 0.104, t = 0.429, p >0.668). This implies that the null hypothesis (Ho) is accepted and the alternate rejected meaning hedging does not moderate the relationship between risk asset management and financial performance. However, the moderated result revealed that partial impact exists when there is an interaction between hedging, risk assets management, and at higher or lower hedging, risk asset management still impact financial performance.There is the need for banks to adopt stricter measures of managing risk assets using the appropriate techniques like IRB, adhere to CAMEL assessment and other models recommended by the BASEL committee on banking supervision and the central bank prudential guidelines
Keywords: Derivative assets, derivative liabilities, hedging, liquidity, nonperforming loans, return on assets, earnings per share, return on equity.
TABLE OF CONTENTS
Title
Page i
Declaration ii
Certification iii
Dedication iv
Acknowledgements v
List
of Tables x
List
of Figures xi
Abstract xii
CHAPTER 1: INTRODUCTION
1.1
Background to the Study 1
1.2
Statement of the Problem 7
1.3
Objectives of the Study 8
1.4
Research Questions 9
1.5
Research Hypotheses 10
1.6
Scope of the Study 11
1.7
Significance of the Study 11
1.8
Operational Definition of
Terms 13
CHAPTER 2: REVIEW OF
RELATED LITERATURE
2.1 Conceptual Review 15
2.1.2 Conceptual
relation between risk assets management and financial
performance 15
2.1.3 Risk assets management and procedures in the
banks 18
2.1.4 Internal audit mechanism and assets Risk
management in banks 20
2.1.5 Risk assets recognition and assessment
principles 22
2.1.6 Banks risk assets components 23
2.1.7 Risk rating leveraged loans and financial
performance 24
2.1.8 Banks operations in derivatives markets 25
2.1.9 Financial derivatives as moderating and mediating factors on
banks Profitability 26
2.1.10 Mediating effects of derivatives on risk
assets and banks financial
performance 28
2.1.11 Interest rate risk exposure and financial
performance of banks 29
2.1.12
Capital requirements and regulatory
reform (The Basel Accord) 31
2.1.13
Capital adequacy ratio (CAR) and banks
risks weighted assets (RWA) 33
2.1.14 Cost of capital and financial performance of
banks 36
2.1.15 Banks deposits as risk asset components 38
2.1.16 Cash
reserve ratio requirements for banks 39
2.1.17
Non-performing loans and banks financial
performance 41
2.1.18
Risks associated with mergers and
acquisition 44
2.1.19 Financial performance measures 47
2.2 Theoretical
Framework 53
2.2.1
The risk-return hypothesis 53
2.2.2
Risk management theory 54
2.3 Empirical
Review 55
2.4 Summary of
Literature 81
2.5
Gap in Literature 88
2.5.1
Gap in Variables Measurement 88
2.5.2 Lack
of Robustness in Model development 89
CHAPTER 3: METHODOLOGY 91
3.1 Research Design 91
3.2 Population of the Study 91
3.3 Sample
Size Determination 92
3.4.Justification for
Banks in the sample 93
3.5 Method of Data Collection 93
3.6 Technique of Data Analysis 94
3.7 Model specification 94
3.8 Description of Variables 99
CHAPTER 4: DATA
PRESENTATION AND ANALYSIS
4.1 Data Presentation 101
4.1.1 Descriptive statistics 101
4.2 Data
Validity Test 103
4.2.1 Unit
root tests 103
4.3 Test
of Research Hypotheses 104
4.3.1 Effect of risk assets (TLDR, NPLR, DEQR, CAR
and CRR)
management on earnings per share 104
4.3.2 Effect of risk assets (TLDR, NPLR, DEQR, CAR
and CRR)
management on return on assets 107
4.3.3 Effect of risk assets (TLDR, NPLR, DEQR, CAR
and CRR) management
on return on capital employed of commercial
banks in Nigeria. 110
4.3.4 Effect of risk assets (TLDR, NPLR, DEQR, CAR
and CRR) management
on return on equity 113
4.3.5 Moderating Effect of hedging on the
relationship between risk assets
management and financial performance 117
4.3.6 Mediating Effect of hedging on risk assets
management and financial performance 118
4.4 Discussion and Interpretation of Results 120
CHAPTER 5: CONCLUSION AND
RECOMMENDATIONS
5.1 Summary 125
5.2 Conclusions 126
5.3 Recommendations 127
5.4 Contribution to Knowledge 128
5.5 Area of Further Research 129
REFERENCES 130
APPENDIXES 139
LIST OF TABLES
3.2.1: Summary
of banks net worth 92
4.1.1: Descriptive Statistic Table 101
4.2.1: Unit
Root Test Table 103
4.3.1: Model
Summary 1 104
4.3.2: Model
Summary 2 107
4.3.3: Model
Summary 3 110
4.3.4: Model
Summary 4 113
4.3.5b: Moderating
effect tests of Hypothesis five (5) 117
4.3.6: Mediating
effect tests of Hypothesis six (6) 118
4.3.6: Result of Sobel Test 119
LIST OF FIGURES
2.1: The structural
equation modeling (SEM) 16
2.2: Conceptual Model of the
Moderating effect of hedging
on the relationship
between risk asset management and
financial performance 17
2.3: Conceptual model of
the mediating effect of hedging on risk
assets management and financial performance 17
4.3.5: Pathway
moderating result of RAM*H 116
4.3.6: RAM▬H▬FINPER 118
CHAPTER
ONE
INTRODUCTION
1.1 BACKGROUND TO THE
STUDY
Risk is a concept that closely relates to
uncertainty of adverse outcomes that do not reach the expected profit and
negatively affect firm performance and profitability. Firms often have to apply
the use of risk analysis to minimize adverse outcomes of losses in the course
of operations (Samuel & James, 2018). Risk analysis is useful in decision
making concerning the use of financial investment decisions, developing
business plans, and also in informing partners about enterprise’s performance
level. Financial risk analysis involves the use of specific indicators like
financial leverage, financial breakeven and leverage ratio which presents
interest in optimizing the financial performance and viability of any company
operating under a market economy (Nwude & Okeke, 2018).
A risk asset is one that has a significant
degree of price volatility, such as equities, commodities, high-yield
bonds, real estate and currencies. Specifically, in
the banking context, risk asset refers to an asset owned by a bank, whose value
may fluctuate due to changes in interest rates, quality, and repayment. It
includes equity
capital in a financially stretched or
near-bankrupt company, as its shareholders’ claims would rank below those of
the firm’s bondholders’ and other lenders (Basel III, 2006).
Risk assets management is the identification,
assessment and prioritization of risks followed by coordinated and economical
application of resources to minimize, monitor and control the probability and
impact of unfortunate events (Adekunle, Ishola & Ernest, 2011).
Thus, risk assets management involves the
process of identifying risks, assessing their implications, deciding on a
course of action, and evaluating the results thus, effective risk management
seeks to maximize the benefits of a risky situation while minimizing its
negative effect.
Risk assets management in the form of
Risk-weighted assets (RWA) represents an aggregated measure of different risk factors affecting the evaluation of financial instruments
including cash. Major risk components of the RWA calculation are credit risk,
market risk, and operational
risk. These risk components are considered together
to adjust the nominal value of financial
assets to its more realistic value. In this way, a
proper measure of the extent to which the underlying risk is increasing or
decreasing the accounting value of financial assets is generated to adjust
error of window dressing/ creative accounting (Crouhy, 2006, Saunders &
Cornett, 2007).
Credit risk for example is the risk that a
borrower will not perform in accordance with its obligations. It may arise from
either the inability or unwillingness on the part of the borrower to perform in
the pre-committed contracted manner. Credit risk arises whenever a lender is
exposed to loss from a borrower, counterparty, or any financial/ contractual
agreement which fails to honor debt obligation as contracted (Luy, 2010).
The main causes of credit risk include limited
institutional capacity, inappropriate credit policies, volatile interest rates,
poor management, inappropriate laws, low capital and liquidity levels, directed
lending/ poor lending practices, massive licensing of banks, poor loan
underwriting, reckless lending, poor credit assessment, laxity in credit assessment,
government interference and inadequate
supervision by the central bank(Yimka, 2015).
In Nigeria, the Oceanic bank scenario was a
typical example of the above risks and Sanusi, (2005) pointed out that the
corporate scandals that shrouded the bank was hinged on non-disclosure of loans
advancement, and other insider dealings which were not healthy for the
institutions growth and were not in line with the credit policy put in place.
In the case of credit risk for instance, it
becomes a loss for banks if debtors fail to pay interest and principal installments
in accordance with a predetermined time period. This results to lower asset
quality, increasing non-performing assets when it is high, thus, hampering the
operational and financial performance of banks. This is dependent on whether
the banks have adopted the standardized
or internal risk base (IRB)
approach under the Basel II framework (Basel II, 2005).
Managing risk is a complex task for any
financial organization, and increasingly important in a world where economic
events and financial systems are linked. Global financial institutions and
banking regulators have emphasized risk management as an essential element of long-term
success, (Perignon & Smith, 2010). Therefore, Risk management has been a
global issue which has attracted worldwide crusade in the banking industry.
In its efforts to ensure effective risk assets
management in the banking sector, the Basel Committee
on banking supervision recommended that banks should hold enough
capital to equal at least 8% of its risk-weighted assets (Basel, 2006). The committee defines risk assets in threefold: Operational
risk, which is the risk of loss resulting from inadequate internal processes,
people and systems, or external events. In other words, it represents the
probability that the value of a financial asset is influenced by unpredictable
factors, resulting from running the bank activity.
The Basel
( BCBS
III, 2006) also presented financial risk as the risk that comes from banks
sources of capital and include equity, debts (in form of long stocks, bonds and
other marketable securities) or a mixture of the two. It is the possibility
that corporate stakeholders will incur losses if the company's cash flow proves
inadequate to meet its obligations.
Joffre and Simon 2007, identify the main
categories of financial risk affecting company’s performance to include market
risk and credit risk. Market risk is the risk of asset value change associated
with systematic factor and are usually outside the control of
the banks, as they are determined by factors that affect the overall economy.
The BASEL Committee III (2007) also included degree of financial leverage,
foreign exchange rate exposure as indicators of market risk. It also includes
Fair value of interest rate risk,
which is the risk that the value of
a financial instrument will fluctuate due to changes in market interest rates.
Basel III (2006) observed that credit risk arises whenever a lender
is exposed to loss from a borrower or counterparty who fails to honor their
debt obligation as they have contracted, as cited by Luy, (2010). This loss may
derive from deterioration in the counterparty’s credit quality, which
consequently leads to a loss to the value of the debt, or according to Crouhy
(2006), the borrower defaults when he is willingly to fulfill the obligations.
According to Owojori (2011), available
statistics from liquidated banks clearly showed that inability to collect loans
and advances extended to customers and creditors or companies related to
directors or managers was a major contributor to the distress of liquidated
banks in Nigeria which hampered their financial performance. When this
occurred, a number of banking licenses were revoked by the Central Bank of
Nigeria (CBN).
Soludo (2004) also observed that the Nigerian
banking system was becoming more fragile and marginal. He identified the
problems of the banks, especially those seen as feeble, to have persistent
illiquidity, unprofitable operations and having poor assets
base. Poor assets base emanates from inadequate risk management of those assets
largely due to unhealthy operations and governance failure.
The third category of risks identified by the
Basel committee on banking supervision (Basel III, 2006) is liquidity risk which can be described as the risk
of a funding crisis. Thus; the risk that
an entity meets in procuring the necessary funds to meet commitments related to
financial instruments. Liquidity risk may also result from the inability to
quickly sell a financial asset at a value close to its fair value (Nwude &
Okeke, 2018).
Prior to 2004, it was estimated that total
nonperforming loans in the Nigerian banking system rose from N21.27bn in 2002
to N260.19bn in 2003 and to N350.82bn in 2004. Nonperforming loans as a
percentage of total loans declined from N59.38bn in 2002 to N21.59bn in 2003
and marginally rose to 23.08bn in 2004 (Nnamdi & Nwakanma, 2011). In view
of the dangerous situation, the Central Bank of Nigeria (CBN) in 2009 injected
N620billion to cushion the effect of nonperforming loans of about N1.0trillion
fraudulently perpetrated by bank executives (Sanni, 2010) and this was further
followed by setting up the Asset Management Company of Nigeria, (AMCON) in 2010
to deal with the issue of toxic assets on permanent basis in accordance with
international best practices (Onoh, 2014).
As a follow-up, the CBN further announced a
13-point agenda to stabilize the base of the banking industry. The essence of
the reform policy was to consolidate the banking institutions through mergers
and acquisitions, thereby making them stronger. It may be necessary, at this point, to stress that since the emergence of 25 consolidated
commercial banks in Nigeria in 2005, to 14 banks as at 2019, the industry has
been faced with how best to manage the post-consolidation challenges that
confront the Nigerian banking industry and the economy (Adedipe, 2005).
The Central Bank of Nigeria in furtherance of
its mandate to resuscitating the banks from financial collapse requires that
banks with international subsidiaries maintain capital adequacy ratio (CAR) of
15% while 10% for banks without international subsidiaries. The rules, which
will align the banking industry with the international accord (Basel III) also
require lenders to create buffers that should help them in the case of a crisis
(Adedipe, 2005).This work is directed at discussing the risks that banks face
and how such risks are to be managed and the continuity, success and further
improvement of banks performance in the market depends on their ability to
surrounding risk management and its dependence on plans that are consistent
with its goals (Al-Tamimi and Al-Mazrooei, 2007).
1.2 STATEMENT OF THE
PROBLEM
Financial management crisis around the
world such as the Enron, WorldCom and Barings Empire has proven that risk
management practices are indispensable for firms that aim at sustaining
customer and shareholder patronage. Alan (2016), stated
that risk management failures occur, and in two instances - the highly
publicized cases of baring, long term
capital management which proved destabilizing and deficiencies in risk
management resulting in wide spread failures. He further stressed that the
failure of a very large derivative participant in the case of market risk will
impose heavy credit losses on its counterparties and yields a chain of
failures.
In
Nigeria, the surge in capital base requirement during the consolidation era put
pressure on risk management frameworks, which consequently led to the erosion
of the financial position of banks to the extent that some of them remained for
some time on ‘life support’ from the Central Bank of Nigeria (CBN), leading to
the injection of N192 billion naira stimulation fund into the banking sector to
save the banks and the economy at large. This proved that effective risk
management in banking operations cannot be compromised (CBN, 2005).
The rising non-performing credit portfolios in banks have
significantly contributed to the financial distress in the banking sector
(Kabiru, Mohd., & Norland, 2012) as many banks continued to extend fresh
facilities to customers who already had hard-core and un-serviced debts with
other banks and financial institutions.
On the part of the regulators, the paucity of
credit information had inhibited consistent classification of credits granted
to certain borrowers and their associated companies. This also constituted high
threats to financial performance as the nonperforming loans became doubtful and
resulted in loss (John, 2016).
Another challenging issue raised by Sanusi
(2011) was the fusion of risk management and corporate governance flaws as a
major factor responsible for the financial crisis in Nigeria and opined that
the surge in capital put pressure on risk management frameworks, thus the
consequence of risk management failure.
There is also poor assets base which emanates
from inadequate risk management largely due to unhealthy operations and
governance failure which leads to considerable vulnerability of a funding crisis
and loss of confidence from investors (Sanusi, 2005). Consequent to the above
problems, this study sets to investigate the effects of risk assets management
on the financial performance of commercial banks in Nigeria employing the use
of hedging for both moderation and mediation on the focus variables.
1.3 RESEARCH OBJECTIVES
The main objective of this research work is to
examine the effect of risk assets management on financial performance of
commercial banks in Nigeria.
The
specific objectives include to:
1)
examine the effect of risk
assets (total loans to deposit ratio, nonperforming loans ratio, capital
adequacy ratio, debt to equity ratio and cash reserve ratio) management on the earnings per share.
2)
ascertain the effect
of risk assets (total loans to deposit ratio, nonperforming loans ratio,
capital adequacy ratio, debt to equity ratio and cash reserve ratio) management
on return on assets.
3)
determine the effect
of risk assets (total loans to deposit
ratio, nonperforming loans ratio, capital adequacy ratio, debt to equity ratio
and cash reserve ratio) management on return on capital employed.
4)
evaluate the effect risk
assets (total loans to deposit ratio, nonperforming loans ratio, capital
adequacy ratio, debt to equity ratio and cash reserve ratio) management on
return on equity.
5)
examine the moderating
effect of hedging on the relationship between risk assets management and
financial performance of commercial banks in Nigeria
6)
explore the mediating
effect of hedging on the relationship between risk asset management and
financial performance of commercial banks in Nigeria.
1.4 RESEARCH QUESTIONS
The research questions of the study are as
follows:
1.
What effects do risk
assets management (TLDR, NPLR, DEQ and CRR) have on earnings per share (EPS)?
2.
To what extent do risk
assets management (TLDR, NPLR, DEQ and CRR) affect return on assets?
3.
What are the effects
of risk assets management (TLDR, NPLR, DEQ and CRR) on return on capital
employed?
4.
How do risk assets management
(TLDR, NPLR, DEQ and CRR) affect return on equity?
5.
What moderating effect
does hedging have on the relationship between risk assets and financial
performance?
6.
To what extent does
hedging mediate the relationship between risk assets management and financial
performance?
1.5 RESEARCH HYPOTHESES
The following research hypotheses were
formulated to answer the research questions.
H01: Risk assets
management (TLDR, NPLR, DEQR & CRR) have no significant effect on earnings
per share (EPS).
H02: Risk assets management (TLDR, NPLR, DEQR & CRR) have no
significant effect on return on asset (ROA).
H03: Risk assets
management (TLDR, NPLR, DEQR & CRR) have no significant effect on return on
capital employed (ROCE).
H04: Risk assets
management (TLDR, NPLR, DEQR & CRR) have no significant effect on return on
equity (ROE)
H05: Hedging does not
significantly moderate the relationship between risk asset management and
financial performance.
H06: Hedging does not significantly mediate the relationship between
risk asset management and financial performance.
1.6 SCOPE OF THE STUDY
This study evaluated the moderating and
mediating effects of hedging on risk assets management and financial
performance of commercial banks in Nigeria using Corporate Audited Annual Reports
of ten commercial banks for fifteen (15) years ranging from 2005-2019. An overview
of the moderating and mediating effect of hedging on the relationship between
risk assets management and financial performance was a focal point in this
study. Data on bank loans and total deposit, nonperforming loans, capital
adequacy ratio, debt- equity ratio and liquidity ratio was employed to measure
risk asset management of the banks, while return on assets, return on equity,
earnings per share and return on capital employed were proxies for financial
performance. Derivative assets and derivative liabilities were used as proxies
for hedging.
1.7 SIGNIFICANCE OF THE
STUDY
This work, risk assets management and banks
financial performance has been the researchers focal point of interest
considering the recent consolidation aimed at restructuring the banks for
greater efficiency. The study was carried out in Nigeria, in an attempt to
mirror the effect of the banks recent consolidation and to examine the risk
management practices and how they have impacted on the financial performance of
commercial banks in Nigeria. This study will be beneficial to the following
interest groups
Bank Regulators: Banking sector in any economy serves as a catalyst for growth
and development and is therefore so
sensitive and sacrosanct to the economy in terms of stability and growth.
However, economists differ on the level of government intervention in the
economy, particularly on regulation imposed on the financial intermediaries.
While some believe that many regulations are necessary in order to protect the
banks.
Customers: A lending policy should be reviewed periodically and revised
in light of changing circumstances
surrounding the borrowing needs of the bank's customers as well as changes that
may occur within the bank itself. Most at times the customer is ignorant of the
inherent liability accompanying a loan facility. This work will serve as an eye
opener by discussing the issues surrounding advancement of loans.
Investors/Shareholders:
The market of derivatives and other financial
instruments requires sufficient knowledge
and understanding of the nature of the portfolio prices by the investor.
Because of the associated risk involved in the business of these instruments,
this study will provide some basic guides and fundamental information needed by
the investor/shareholders in order to ensure that their investment decision
such as risk evaluation and test, hedging and future financial impairment are
better off.
The commercial Banks: This study will be of immense benefit to banks’ management in observing the weight credit risk
management that exerts on the selected performance indices of banks. This is
likely to spur them to critical review their risk management styles. The
findings will enable investors and general banking public to
place judgment on the bank management in terms of leadership capacity.
Researchers and Policy
Analysts: Essentially, the results of the study will
provide an input reference document
for further researches in evaluation of risk management. It will also provide
policy makers with more insight into risk management and guide them in policy
making, implementation and monitoring.
1.8 DEFINITION OF TERMS
Credit Risk: Banks often collect deposits from customers in form of cash,
and in turn advance such deposits as
loans to the borrowers. These loans are classified as credit risk. This is
because certain situations can arise that will hinder the borrower from paying
such loans at the stipulated time, thereby causing high degree of loss or lower
returns for the lenders (the banks). When such conditions avail, we now have
loans that are not performing and those that are substandard and doubtful.
Financial risk: This risk comes from banks sources of capital and includes
equity, debts (in form of long
stocks, bonds and other marketable securities) or a mixture of the two. This
work will examine gearing leverage in using equity financing and debts
(DEBT/EQUITY RATIO) and the risk that comes with them. This will also entail
the use of capital adequacy ratio (CAR), a minimum requirement banks are
expected to maintain to avoid or cushions any risk that may come from
operation.
Gearing: This refers to the level of a company's debt related to its
equity capital, usually expressed in
percentage form. It is a measure of a company's financial leverage and shows
the extent to which its operations are funded by lenders versus shareholders;
the gearing ratio measures the proportion of a company's
borrowed funds to its equity. The ratio indicates the financial risk to which a
business is subjected.
Liquidity risk: Banks become incapacitated to meet immediate obligations,
thereby making investors or short
term creditors to divest. Liquidity implies that there is cash or liquid assets
to serve the above purpose. In this study, cash reserve ratio was employed.
Market risk: This is the probability that the risk asset may change in
value due to changes in interest
rates, inflation or market price. Market risk is also known as systematic risk,
(Hull, 2012). Most of the assets used here are derivatives. Derivatives are
portfolios used in hedging risk assets in the market. They serve as mediators
in minimizing market related risk from affecting the hedged assets.
Risk Assets: This will include customers’ deposits held by the banks and
which the banks advance same as
loans. Specifically, it will refer to an asset owned by a bank or financial
institution whose value may fluctuate due to changes in interest rates and
credit quality.
Risk Management: Risk management
occurs anytime an investor or fund manager analyses and attempts to quantify the potential for losses in an investment.
Risk takes on many forms but is broadly categorized as the chance an outcome or
investment's actual return will differ from the expected outcome or return.
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