Thefinancial sector is the backbone of the economy of any
country;it works as a facilitator for achieving sustained economic growth by providing
efficient monetary intermediation, (Okafor, 2011). A strong financial system does
this bymobilizing savings, financing productive business opportunities,
efficiently allocating resources to makes easy the trade of goods and services.
In a market-oriented economy,by using various financial instruments to secure surplus
funds from those that forgo present consumption for the future, banks serve the
vital intermediary role and have been seen as the key to investment and growth.
They also make same funds available to the deficit spending unit (borrowers)
for investment purposes. In this way, they make available the muchneeded
investible funds required for investment as well as for the development of the nation’s
economy (Nwude, 2012).
For bank regulators worldwide, safety of depositors’ funds
remains the major concern. It is in this respect the capital adequacy becomes
relevant and important. Capital adequacy refers to the amount of equity capital
and other securities, which a bank holds as reserves against risky assets as a
hedge against the probability of bank failure. In a bid to ensure capital
adequacy of banks that operate internationally, the Bank of International
Settlements (BIS) established a framework necessary for measuring bank capital
adequacy for banks in the Group of Ten industrialized countries at a meeting in
the city of Basle in Switzerland. This has come to be referred to as the Basle
Capital Accord on Capital Adequacy Standards.
The Basle accord provided for a minimum bank capital adequacy
ratio of 8% of risk-weighted assets for banks that operate internationally.
Under the accord, bank capital was divided into two categories – namely Tier I
core capital, consisting of shareholders’ equity, and retained earnings and
Tier II supplemental capital, consisting of internationally recognized
non-equity items such as preferred stock and subordinated bonds. The accord,
allows supplemental capital to count for no more than 50 percent of total bank
capital or no more than 4 percent of risk-weighted assets. In determining
risk-weighted assets, four categories of risky assets are each weighted
differently, with riskier assets receiving a higher weight. Government
securities are weighted zero percent, short-term interbank assets are weighted
20 percent, residential mortgages weighted at 50 percent while other assets are
weighted 100 percent. Consequently, a bank with say $100 million in each of the
four asset categories would have the equivalent of $170 million in
risk-adjustment assets. It would need to maintain $13.6 million in capital
against these investment, out of which not more than $6.8million (ie. one-half
of the amount) would be Tier II capital.
Although coming into effect since 1998, the risk based Basle
Capital accord has been criticized by practitioners and scholars for the
“arbitrary” nature of its provisions – one of such criticisms relates to the
unchanging 8 percent minimum capital assigned to risk weighted assets. This and
other such knocks led to the adoption of an amended Basle II accord, whichcovered
most of the areas of concern. The capital adequacy standards under the Basle
Accord have been widely adopted throughout the world by bank regulators. In Nigeria,
the CBN reviewed the capital base of banks, upwards from N2 billion to N25
billion minimum with effect from 31stDecember, 2005. According to
(CBN., 2004), out of 89 banks in Nigeria as at 2004, 62 were classified as
sound/satisfactory, 14 as marginal and 11 as unsound, while 2 of the banks did
not render any return during the period. The inadequacy of some of the ailing
banks wasevidenced by their overdrawn position with the CBN, high incidence of
non-performing loan, capital deficiencies, weak management etc. In addition to this, with the precarious
exchange rate depreciation of the naira, the present level of capital in banks
before the consolidation (N2 billion) has become grossly inadequate to meet
domestic and global realities in the financial system.
A profitable and sound
banking sector is better place to endure adverse upsets and adds performance in
the financial system.In addition, performance evaluation through the
determination of profitability is one of the significant acts for enterprises
to give incentive and restraint to their operations, and it is an important
channel for enterprise stakeholders to get performance information. Performance
through profitability evaluation of banks is usually related to how well the
bank can use its assets, shareholders’ equities and liabilities, revenue and
expenses. The performance evaluation of banks is important for all parties
including depositors, investors, bank managers and regulators.
One of the ways to define the performance of banks is by the
determination of its profits. The evaluation of banks performance usually
employs the financial ratio method, which provides a simple description about
banks financial performance in comparison with previous periods and helps to
improve its management performance. The industry standard is financial ratios
based on CAMEL framework, which arerelated to capital, assets, management,
earnings and liquidity considerations. These ratios include return on assets
(ROA), capital adequacy ratio (CAR), non-performing loan ratio (NPL), credit to
deposit ratio (CDR), yield to earnings ratio (YEA) and liquidity ratio (LR).
The upward review of the of the capital base of banks has
been one of the biggest achievement in the financial sector in the Nigerian
economy. This has resulted in larger, stronger and more resilient financial institutions.Capital
adequacy is a key financial soundness indicator. It can be define as the
percentage ratio of a financial institution's primary capital to its assets
(loans and investments), used as a measure of its financial strength and
stability.
Generally, banks are expected to absorb the losses from the
normal earnings. But there may be some unanticipated losses which cannot be
absorbed by normal earnings. Capital comes in handy on such abnormal loss
situations to cushion off the losses. In this way, capital plays an insurance
function. Adequate capital in banking is a confidence booster. It allows for the
customer, the public and the regulatory authority with confidence in the
continued financial viability of the bank. Confidence to the depositor that his
money is safe; to the public that the bank will be, or is, in a position to
give genuine consideration to their credit and other banking needs in good as
in bad times and to the regulatory authority that the bank is, or will remain,
in continuous existence.
The understanding that capital adequacy influences the
financial sector's profitability is necessary not only for the managers of
banks, but for many stakeholders such as the central banks, bankers
associations, governments, and other financial authorities. Going further,
studies like Kosmidou, (2008),Gul, Irshad and Zaman (2011) maintain that the
capital adequacy of banks determines profitability. Without profits, no firm
can survive and attract outside capital to meet its investment target in a
competitive environment. Thus, profitability plays a key role in persuading
depositors to supply funds in terms of bank deposits on advantageous terms. But
in Nigeria, low capitalization of banks made them less able to finance the
economy and more prone to unethical and unprofessional practices.
Soludo (2004) observes that many banks appear to have
abandoned essential intermediation role of mobilizing savings and inculcating
banking habit at the household and micro enterprise levels. Due to capital
inadequacy of many banks in the country, they were faced with high cost of
financial distress and this certainly affected profitability. Notwithstanding, Nwude
(2012) opines that recapitalization may raise liquidity in short-term but will
not guaranteeconducive macroeconomic environment required to ensure high asset
quality and good profitability. From the foregoing therefore, this study
examines to assess the effects of capital adequacy on the profitability of commercial
banks in Nigeria.
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