DETERMINANTS OF BANK EFFICIENCY IN NIGERIA: A PANEL EVIDENCE

ABSTRACT

This study is motivated by the recent global financial crisis that lasted between 2007 and 2009 and affected the world at large but started partly due to the inefficiency of banks in the United States. There have been however several reforms in the financial sector to strengthen banks and improve reliability. The study analysis the determinants of bank efficiency from a CAMEL perspective. The data from the annual bank reports was used to run a panel model for 12 banks, employing the panel stochastic frontier model and the fixed effect panel model. The findings of the study suggest that capital, management and liquidity are significant determinants of bank earnings while asset is not a significant determinant. Also the results show that banks in Nigeria are efficient in their consumption of inputs in optimizing output. The results show that 10 of the banks are not significantly different from Access Bank in determining earnings, and only Guaranty Trust Bank was statistically significant. The study therefore recommends that the government should maintain the capital enhancement policies as well as other policies that strengthen the CAMEL parameters and improve bank efficiency.

TABLE OF CONTENT

Cover Page……………………………………………………..…………….i

Title Page……………………………………………………………….……………ii

Certification Page ………………………………………………………….………….iii

Approval  Page ………………………………………………………………. ……….iv

Dedication ……………………………………………………………….………….v

Acknowledgements ………………………………………………………….………….vi

Abstract………………………………………………………………………………vii

Table of Content ….………………………………………………viii

List of Tables ……………………………..………….x

List of Figures…………………….……………………………..………x

Appendix…………………….……………………………..…………..….xi

CHAPTER ONE: INTRODUCTION

Background to the Study……………………………………………………..1

Statement of the Problem…………………………………………………….5

Research Questions…………………………………………………………………….7

Objectives of the Study…………………………………….……………………7

Statement of Hypotheses…….………………………………………………….7

Significance of the Study………………………………………………….7

Scope of the Study …….………………………………………………….8

Limitations of the Study…….…………………………………………..8

Organization of the Study……………………………………….……………….8

CHAPTER TWO: LITERATURE REVIEW

Conceptual Literature……………………………………….………………..…………9

Efficiency of Banks…………………………………………………………..9

CAMEL…………………….…………………………..………………………..9

How Reforms can lead to Efficiency…………………………………….11

Overview of the Banking Environment….………………….…………………11

Theoretical Literature…………………………………………………………….16

Theories on Banking Technology and Performance …………………16

Measurement of Banking Technology and Performance …16

Specifying Outputs and Inputs in Structural Models of Production 17

Specifying Capital Structure in Performance Equations …..17

Specifying Output Quality in the Performance Equation. .17

Banking Efficiency and Reform ………………………………….18

Bank Performance and Competiveness…………………….………18

Empirical Literature: International Evidence…………………….…20

Empirical literature: Nigerian Evidence………………………….23

Limitation of Previous Study………………………………………….…27

CHAPTER THREE: METHODOLOGY AND DATA

Introduction………………………………………………….…………………28

Theoretical Framework………………….………………….…………….……28

Model Specification…………………………………….…………….……..30

Estimation Technique ……………………….…………………………..……..31

Data Source………………………….……………………………………32

CHAPTER FOUR: EMPIRICAL RESULTS

Presentation of Stochastic Frontier Panel Analysis ………..33

Results of the Stochastic Frontier Efficiency Analysis .35

Panel Results for Independent Banks using the Fixed Effect Analysis …..36

CHAPTER FIVE: SUMMARY, POLICY IMPLICATIONS AND CONCLUSION

Summary ………………………………………………………..…38

Conclusion ………………………………………………………………….39

Policy Implications……………………………………………….……………..39

Suggestions for Further Study ……………………………………….…….……40

References…………………………………………………………….………….41

LIST OF TABLES

Table 4.1: Stochastic Frontier Panel Analysis Results…….………..34

Table 4.2: Efficiency Results …………………..36

Table 4.3: Results for the Panel Analysis Including the Individual Bank Effect .….37

LIST OF FIGURES

Figure 1.1: Rating of Nigerian Banks Using the CAMEL Parameters……3

APPENDICES

APPENDIX 1: Stochastic Frontier Panel Analysis Results…………..I

APPENDIX 2: Fixed Effect Panel Analysis Results ……..…………..II

APPENDIX 3: Stochastic Frontier Efficiency Analysis Results …….III

APPENDIX 4: Panel Analysis Result with Independent bank effect ……IV

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The efficiency of the banking system has been one of the major issues in the new monetary and financial environment. The competitiveness of financial institutions is stirred up by their efficiency levels, since their products and services are of an intangible nature. Efficiency in banking can be distinguished between allocative and technical efficiency. Wherein, allocative efficiency is the extent to which resources are being allocated to the use with the highest expected value. A firm is technically efficient if it produces a given set of outputs using the smallest possible amount of inputs (Falkena et al, 2004). Efficiency in the banking system is important at both macro and micro levels and in order to allocate resources effectively, banks should be sound and efficient (Hussein, 2000).

One of the most important economic dimensions for ensuring the success of a company is the efficiency with which it uses its resources. An efficient banking system is a sine-qua-non for efficient functioning of a nation’s economy. Thus, for the industry to be efficient, it must be regulated and supervised in view of the failure of the market system to recognize social rationality and the tendency for market participants to take undue risks which could impair the stability and solvency of their institutions (Thatcher, 2002; Onyido, 2004; Lemo, 2005; Balogun, 2007; Alao, 2010).

Bank efficiency and its determinants are vital issues confronting the public and policy makers. The banking industry in Nigeria plays a very significant role in the economic development of the country. According to Nzotta (2004), banks as part of the Nigerian financial system channel scarce resources from surplus economic units to deficit units and they exert a lot of influence on the pattern and trend of economic development through their lending and deposit mobilization activities. This is why Abdullahi (2002), states that the banking industry in particular play a crucial role in the economic development by mobilizing savings and channeling them for investment especially in the real sector which increases the quantum of goods and services produced in the economy, thus national output increases and the level of employment improves. The banking industry in Nigeria is able to play the positive role only if it is functioning efficiently. However if it is repressed, inefficient and incapable of providing timely and quality services, the banking system could become a major hindrance to economic growth and development. Nigerian banking industry suffered a historic retrogressive trend in both profitability and capitalization. In 2009 just 3 out of 24 banks declared profit, 8 banks were said to be in “grave” situation due to capital inadequacy and risk asset depletion; the capital market slummed by about 70 percent and most banks had to recapitalize to meet the regulatory directive (CBN, 2010).

This now makes bank efficiency analysis very essential for the evaluation of banks’ performance and its efficiency. Bank efficiency is the capacity to generate sustainable profitability (European Central Bank, 2010). In recent years, the intensive and continuously increasing competition in the financial services market creates a need for an access to informa­tion that would allow the evaluation of these commer­cial banks operating in this market; therefore, it is of considerable interest to measure the efficiency of evolving institutions. Creditors and investors use such efficiency evaluations to judge past performance and current position of banks. Due to the growth of competition, management of banks is interested in enhancing efficiency. According to Baten and Kamil (2010), bank efficiency studies are of crucial importance for operational purposes and it links an organization’s goal and objectives with organization decisions.

According to Uboh (2005), financial performance failure in Nigerian banks resulted to loss of public confidence in the banking sector and that bank efficiency can be grouped into two basic types; those that relate to results, output or outcomes such as competitiveness and profit; and those that focus on determinants of results such as prices or products. The assertion above suggests that efficiency can be based on results and determinants and hence the importance of efficiency analysis. As observed by Casu et al. (2006), bank efficiency analysis is an important tool used by various agents operating either internally to the bank or who form part of the banks external operating environment, This is why investors in share and bonds issued by banks consider the investment outcome based on the performance before forming an opinion about the ability of its management.

The bank rating system referred to as CAMEL (represents Capital, Assets, Management, Earnings and Liquidity) rating according to the Central Bank of Nigeria CBN (2003), is designed to be used by bank supervisors in evaluating the performances and efficiency of banks. It serves as an “early warning device” to detect emerging problems of banks. The rating system provides a more scientific basis for supervisory actions such as preliminary management discussions and priority scheduling of on-site examinations. These on-site examinations are designed to identify  problems  in  individual  banks  and  to  ensure  banks’  compliance  with  existing laws  and regulations. It is a qualitative and a quantitative approach of evaluating the factors that materially affect the condition and development of banks. The quantitative approach is undertaken by evaluating Capital Adequacy, Asset Quality, Management, Earnings and Liquidity (CAMEL parameters). Examiners score each of  these  factors  as a  single  number from 1 to 5,  with  1  being the  strongest rating,  and develop  an  overall  CAMEL rating  from  1  to 5 from the  factor  scores.  As  a rule  of thumb,  banks  with  a  CAMEL rating  of 4  or 5  are considered  to be problem banks.  In evaluating the CAMEL parameters, weights have been allocated to each parameter. Each parameter is subdivided into components and credit points assigned based on performance of such components. A composite rating of all the parameters is worked out and a bank is rated very sound, satisfactory, marginal or unsound. A bank rating could be reduced from “sound” to “unsound” if certain judgemental factors observed so dictate. With respect to the concept of efficiency the ratio of total expenses to total income (efficiency ratio) is first of all computed. For a ratio of 100% or more, the credit point is zero. Qualitative factors that should be considered are compliance with laws and regulations and other fundamental factors. The rating of Nigerian banks between 2001 and 2009 are as illustrated below;Figure 1: Rating of Nigerian banks using the CAMEL parameters.

Source: CBN (2009) and NDIC Annual Report (2007) as cited by Ofanson et al. (2010).

Figure 1 above shows a declining trend of all the indicating parameters. The marginal indicator was almost stable until 2005, and then dropped in 2006 and remained almost 0 till 2009. On the other hand, the sound indicator remained stable around 5 banks till 2004, and then dropped in 2005, improved in 2006, only to drop again in 2007 where it remained till 2009. The unsound indicator just like others remained relatively stable until 2004, worsened in 2005, improved in 2006, and remained at zero banks only to increase again in 2009. The satisfactory and total indicators were equally stable till 2004 but relatively high as the satisfactory indicator was around 60 and total indicators were around 90 banks. However, they both dropped to about 25 and 12 banks for satisfactory and total in 2006, and remained stable there till 2009. The overall trends of all parameters suggest that the ratings of banks have kept on declining over the years with a significant drop in 2006.  Ofanson et al. (2010), opine that the number of banks in Nigeria reduced from its 2001 figure of 90 to 24 in 2009, in 2006 none of the banks was found to be unsound due to the reform that was in place then. In 2009, however 9 banks were found to be unsound by the apex bank’s rating. There is no doubt that marginal and unsound banks will not play any meaningful roles in meeting the country’s development challenges.

There existed a low banking/population density of 1: 30,432 and the payment system that encouraged cash based transactions. To resolve this problem, the CBN and NDIC used an approximation by adjusting the book value of some predetermined rules based on experience and comparative study of other economies’ banking systems. Such rules include those based on Capital Adequacy, Asset Quality, Management Competence, Earnings Strength, and Liquidity Sufficiency (CAMEL). The classification of banks based on this rating system enabled the authorities to determine those banks that were distressed and their levels of distress (Ofanson et al., 2010). Baral (2005), asserts that CAMEL framework is the most widely used model and it is recommended by Basle Committee on Bank Supervision and IMF. CAMEL represents Capital adequacy, Asset quality, Management efficiency, Earnings performance and Liquidity. Capital adequacy measures the ability of the bank to absorb shocks. This requires banks to have enough equity in their financing mix (Kosmidou, 2009).

According to Aburime (2008), the profitability of a bank depends on its ability to predict, evade and monitor risks, possibly to cover losses brought about by risks that comes about. Although it is important for banks to be liquid to avoid a run on it, Kamau (2009), argues that when banks hold high liquidity, they do so at the opportunity cost of some investment, which could generate high returns. Again, Sufian and Chong (2008), draw a very strong relationship between firm performance and the management efficiency through management of expenses. Other studies have evaluated the efficiency of banks from an input-output perspective where the CAMEL version projects the earnings of banks as the output and other dependent parameters as inputs – Capital adequacy, Asset quality, Management efficiency and Liquidity.

Before now (up until 2004), the Nigerian financial environment was in dire need of major reforms since the military era when Nigeria was still a pariah state with a regulated modus operandi and the financial standing of banks that pointed to an inevitable collapse in a system fraught with corruption and poor corporate governance issues exemplified by high turnover in the Board and Management staff, inaccurate reporting and non-compliance with regulatory requirements. Others included the late or non-publication of annual accounts that obviates the impact of market discipline in ensuring banking soundness; and gross insider abuses, resulting in huge non-performing insider related credits. Also, there was low aggregate credit to the domestic economy (20% as a percentage of GDP before the banking consolidation in 2004). This study is therefore a focus on the determinant of bank efficiency in Nigeria using panel evidence.